An Echelon Media Company
Tuesday May 30th, 2023

Sri Lanka policy rate unchanged amid slowing private credit

ECONOMYNEXT – Sri Lanka’s central bank said it was holding its policy rates at 15.50 percent, while data showed market interest rates are close to twice the rate while private credit and imports falling as a consequence.

The central bank is injecting 740 billion rupees of overnight money to banks at 15.50 percent, which were originally injected mostly after reserves were sold for imports (or debt repayments) to artificially keep down rates (sterilized interventions), effectively engaging in monetary financing of imports.

The injections (sterilizing outflows) prevent the credit system from adjusting to the outflows and encourage unsustainable credit without deposits, which is the core problem with soft-pegged central banks, triggering a high rate and an economic slowdown later.

A severe correction is now taking place with prime lending rate around 25 percent and the three-month Treasury bill yield around 29 percent.

By June there was a slowdown in private credit making more private savings available to finance the deficit rates were coming down, when concerns were raised about the possibility of re-structuring domestic debt, pushing up rates again.

“Growth of credit to the private sector is on a declining trend,” the central banks said in its August monetary policy statement.

“The year-on-year growth of credit granted to the private sector slowed down notably in June 2022, with a contraction in absolute terms over the previous month, reflecting the impact of significantly high effective market interest rates and moderation of economic activity.”

“With increasing interest rates, a notable deceleration in the growth of credit to the private sector and broad money supply is expected in the period ahead.”

Related Sri Lanka private credit negative in June 2022, Rs189bn printed

Sri Lanka’s private sector is the net saver and is unable to trigger any external pressure or balance of payments deficit, unless the central injects rupee reserves into the banking system.

Rupees reserves are sometimes injected into the banking system to finance deficits, but mostly to re-finance maturing debt from past deficits and suppress Treasuries yields (price controls on maturing securities in this currency crisis), and regularly to sterilize interventions, drive unsustainable private credit and trigger forex shortages.

Forex shortages are a problem associated with soft-pegs, where an intermediate regime central bank suppresses interest rates with liquidity injections, targeting an inflation index despite operating a reserve collecting peg (dual anchor conflict) and are absent in currency boards or clean floats.

Sri Lanka still does not have a consistent single anchor regime and some interventions are still made for imports using deferred dollars due to India under the Asian Clearing Unions (weak side convertibility) while the peg is also pushed down with a surrender requirement (strong side convertibility) leading to excess liquidity, particularly at banks with dollar inflows who have curtailed credit.

Excess liquidity in plus banks was 286 billion rupees on August 17 with 744 billion rupees injected to banks which had made loans without deposits and triggered deficits in the balance of payments.

A float is usually required to snap the credit system out of a peg which has lost credibility, end sterilized interventions, which then leads to a faster fall in interest rates. Net foreign assets begins to turn when the currency is re-pegged after a successful float.

“Net foreign assets of the banking system continued to contract, weighing down the expansion of broad money supply,” the central bank said.

Extended operations of non-credible pegs can lead to be bigger output shocks and bad loans due to higher rates.

Attempts to suppress rates when private credit recovers in a pegged regime are followed by steep reserve losses, collapses of the currency, higher inflation and very steep rises in interest rates and an economic output shock.

Sri Lanka’s gross domestic product contracted 1.6 percent in the first quarter of 2022 and other projections are in excess of 7 percent.

Amid “already recorded negative growth in Q1 2022 and contractionary policies, could result in a larger than expected contraction in real activity in 2022,” the central bank said.

“Contractionary monetary and fiscal policies already in place, alongside the measures to curtail non urgent import expenditure, are expected to result in a notable contraction in credit to the private sector and possible upside risks to unemployment in the near term.”

However lack of credit, which reduces the ability of the banking system to push printed money to the broader economy and create further imbalances, is expected to slow inflation.

Data also shows a steady contraction in the monetary base, pointing to a real fall in demand for money and economic activity, despite continued anchor conflicts.

Sri Lanka has gone to the IMF 16 times with broken pegs and this time the country has also defaulted after taking on a large volume of commercial debt.

As a result the IMF program is not limited to hiking rates and raising taxes to fix imbalances, but the debt also has to be re-structured with foreign creditors no longer willing to rollover debt.

“Negotiations with the IMF towards reaching a staff-level agreement on the Extended Fund Facility (EFF) arrangement are scheduled in coming weeks, while expeditious measures are being taken to advance the debt restructuring process with the assistance of financial and legal advisors,” the statement said.

Monetary Policy Review: No. 06 – August 2022

The Central Bank of Sri Lanka maintains policy interest rates at their current levels
The Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 17 August 2022, decided to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 14.50 per cent and 15.50 per cent, respectively. In arriving at this decision, the Board considered the latest model-based projections, which point towards a larger than expected contraction in activity and a faster than expected easing of price pressures, compared to the previous monetary policy review.

Contractionary monetary and fiscal policies already in place, alongside the measures to curtail non urgent import expenditure, are expected to result in a notable contraction in credit to the private sector and possible upside risks to unemployment in the near term. The Board was of the view that despite headline inflation is projected to remain elevated in the near term, the policy measures taken by the Central Bank and the Government thus far would help contain any aggregate demand pressures, thereby anchoring inflation expectations, along with the anticipated decline in global commodity prices and its passthrough to domestic prices in the period ahead.

Global economic growth is expected to slow at a faster pace

As per the July 2022 update of the World Economic Outlook (WEO) of the International Monetary Fund (IMF), global economic growth is estimated to moderate to 3.2 per cent in 2022 from 6.1 per cent recorded in 2021. Tighter financial conditions adopted by central banks around the world following the emergence of inflationary pressures, a slowdown in Chinese economy due to the resurgence of COVID-19, among others, and further negative spillovers from the geopolitical tensions in Eastern Europe have dampened global growth prospects.

Global inflation remains high mainly due to elevated energy and food prices as well as supply-demand imbalances, while downside risks emerge in the outlook for global inflation in the near to medium term.

Domestic economic activity is expected to record a notable downturn

The impact of persisted supply side disruptions, primarily due to shortages of power and energy, and uncertainties associated with socio-political developments are expected to have caused significant adverse effects on economic growth in Q2 2022, while such impact is expected to have continued through Q3 2022 as well.

That, coupled with the already recorded negative growth in Q1 2022 and contractionary policies, could result in a larger than expected contraction in real activity in 2022. However, real GDP growth is expected to recover in the period ahead, with the envisaged stabilisation of macroeconomic conditions and implementation of structural reforms in the economy.

Despite heightened challenges, positive developments are observed in the external sector

Merchandise trade deficit continues to decline in cumulative terms, reflecting mainly the impact of policy measures to curtail non urgent imports, while earnings from exports continue to remain high.

Foreign exchange inflows in the form of workers’ remittances remain lower than expected, while improvements are observed in the tourism sector, with increasing tourist arrivals.

Pressures witnessed in the domestic foreign exchange market have eased to a large extent with the notable decline in import expenditure and improved conversions of repatriated export proceeds, supported by the strengthening of monitoring mechanism of export proceed repatriation and conversion.

Accordingly, the exchange rate remains broadly stable within the market guidance that commenced from mid-May 2022, while the gap between the curb market and official exchange rates has declined notably in recent weeks, and such gap is expected to remain narrow in the period ahead with the improvements in the liquidity conditions in domestic foreign exchange market.

Meanwhile, reflecting the impact of improved forex liquidity and securing of sizeable financing assistance, the availability and distribution of essential commodities, such as fuel, cooking gas, medicine, fertiliser etc., have notably improved.

Arrangements are in place to secure continuous supply of such essential commodities in the period ahead. Gross official reserves, as at end July 2022, are estimated at US dollars 1.8 billion, including the swap facility from the People’s Bank of China equivalent to around US dollars 1.5 billion, which is subject to conditionalities on usability.

Negotiations with the IMF towards reaching a staff-level agreement on the Extended Fund Facility (EFF) arrangement are scheduled in coming weeks, while expeditious measures are being taken to advance the debt restructuring process with the assistance of financial and legal advisors.

Market interest rates have increased further in response to tight monetary and liquidity conditions

Reflecting the transmission of significant monetary policy tightening measures introduced thus far by the Central Bank, market interest rates have increased notably amidst tight money market liquidity conditions.

Growth of credit to the private sector is on a declining trend. The year-on-year growth of credit granted to the private sector slowed down notably in June 2022, with a contraction in absolute terms over the previous month, reflecting the impact of significantly high effective market interest rates and moderation of economic activity. Net foreign assets of the banking system continued to contract, weighing down the expansion of broad money supply.

With increasing interest rates, a notable deceleration in the growth of credit to the private sector and broad money supply is expected in the period ahead. Monetary financing has reduced notably in August 2022, while the need for further monetary financing is expected to be low in the period ahead, supported by fiscal consolidation measures that have already been introduced, alongside the implementation of cost-reflective pricing by major state-owned-business enterprises. Meanwhile, currency in circulation, which remains large, is returning to the banking system with the high deposit interest rates prevailing at present.

The pace of acceleration of inflation has moderated faster than expected

Headline inflation rose at a slow pace in July 2022, compared to recent months. Such moderation is expected to continue in the period ahead, thereby resulting in a low level of inflation by end 2022, compared to previous projections. Accordingly, the latest near term forecast of headline inflation shows a faster deceleration, compared to the previous monetary policy review, mainly due to downward revisions to administered prices and their second-round impact, together with the moderation in certain food prices and the stability in the exchange rate. With subdued aggregate demand pressures resulting from tight monetary and fiscal conditions, expected improvements in domestic supply conditions along with the anticipated normalisation in global food and other commodity prices, and the favourable statistical base effect, headline inflation is expected to moderate going forward, and is projected to stabilise in the desired range over the medium term.
4

Leave a Comment

Your email address will not be published. Required fields are marked *

Leave a Comment

Leave a Comment

Cancel reply

Your email address will not be published. Required fields are marked *

Sri Lanka rupee at 296.75/297.25 to dollar at open, bond yields steady

ECONOMYNEXT – Sri Lanka’s rupee opened at 297 /297.50 against the US dollar in the spot market on Monday, while bond yields were steady, dealers said.

The rupee closed at 296.75 /297.25 to the US dollar on Monday after opening around 296.50 /297.50 rupees.

A bond maturing on 01.09.2027 was quoted at 26.50/75 percent steady from Friday’s close at 26.50/65 percent.

Sri Lanka’s rupee is appreciating amid negative private credit which has reduced outflows after the central bank hiked rates and stopped printing money. (Colombo/ May 29/2023)

Continue Reading

Sri Lanka rupee appreciation squeezes exporters

ECONOMYNEXT – Sri Lanka’s recent appreciation is starting to squeeze apparel exporters as their domestic costs including wages and energy, were hiked over recent months, when the rupee fell steeply, an industry official said.

Companies had raised salaries and emoluments at rates averaging 25 percent for workers while transport costs have also gone up but not has come down, Yohan Lawrence Director General of the Join Apparel Association Forum said.

Apparel factories in particular also provide transport and some meals for workers.

Electricity prices have also been hiked, based on the rupee which was weaker. A tariff cut is expected from June after the rupee appreciated and imported fuel prices fell.

Sri Lanka’s rupee collapsed in 2022 from 200 to 360 to the US dollar as interest rates were suppressed with liquidity injections and a failed attempt was made to float the rupee with surrender requirement in place.

From the second half of 2022, with higher interest rates and negative private credit, the central bank has avoided printing money under conditions which are generally accepted to be difficult, and is broadly running deflationary open market operations, triggering a balance of payments surplus and putting the rupee under upward pressure.

Central bank net credit to government which was 3,302 billion rupees in September in 2022, was down to 3,209 billion rupees by March 2023, part of which was due to rollovers, analysts say.

Market pricing of fuel and electricity by the Ministry of Energy and also spending controls and tax hikes buy have also helped contain domestic credit.

Sri Lanka also has mandatory conversion rules, imposed on exporters, which is a concern for exporters.

“We believe rupee should be at its natural level, but with forced conversions you won’t get the correct picture,” Lawrence said.

Sri Lanka has to release a plan to remove import controls, exchange controls and other restrictions imposed in the period where policy rates were suppressed with liquidity injections (so-called multiple currency practices and capital flow measures) by June under the IMF program.

Apparel exporters have also seen orders fall amid tighter conditions in Western markets.

The central bank has to peg (intervene actively in forex markets and create money) to meet reserve targets under an IMF program and cannot free float (avoid creating money through international operations) the rupee.

The newly created money has generally been absorbed in an overnight liquidity shortage.

There have also been foreign purchases of rupee Treasuries. Amid a contraction in credit, the inflows also do not turn into imports fast as the money if the money is spent.

By making purchases a little below what is allowed by the contraction in domestic credit, the rupee can be allowed to appreciate, analysts say.

The central bank has so far allowed the rupee to appreciate to around 300 to the US dollar from 360 levels under a transparent guidance peg up to February.

Except after the 2008/2009 currency crisis, Sri Lanka’s central bank has not previously allowed to the rupee to appreciate under IMF programs where the first year in particular sees balance of payments surpluses, before private credit and domestic investments picks up again.

One of the considerations used by third world central banks are Real Effective Exchange Rate indices.

The REER of the Sri Lanka rupee based on a basket of currencies calculated by the central bank was 61.12 points in February before the rupee was allowed to appreciate by lifting a surrender rule.

In March the index went up to 69.55 points, but remained steeply below 100. Real effective exchange rates are calculated also taking into account inflation in counterpart trading nations.

Sri Lanka’s inflation index had hardly risen since September amid rupee gains. Falling food prices can help contain pressure for further wage hikes, analysts say. (Colombo/May30/2023)

Continue Reading

Sri Lanka forum to discuss central bank independence vs sound money

ECONOMYNEXT – Central bank independence and sound money will be under discussion at a public event organized by the Sri Lanka chapter of the Bastiat Society today, May 30, as island is recovering from the worst episode of monetary instability since independence.

The forum will feature Lawrence H White, Professor of Economics at George Mason University in the US, and W A Wijewardene, former Deputy Central Bank Governor, of the Central Bank of Sri Lanka.

“The discussion will compare the current system against alternative systems and explore the relationship between such banking systems and sound money,” the organizers said.

White specializes in the theory and history of banking and money. He is the author of “The Clash of Economic Ideas” (2012), “The Theory of Monetary Institutions” (1999), “Free Banking in Britain” (2nd ed., 1995), and “Competition and Currency” (1989).

Wijewardene has been speaking on central bank independence in Sri Lanka long before it became a topic of wider discussion, but also on accountability.

In April, a Central Bank Independence and Other Matters, which includes a collection of his orations on the subject over the years as well a recent development was published.

The discussion comes as independent central banks in the West have created the worst inflation since the 1970s and early 1980s and are apparently unaccountable to parliaments and the public.

The early 1980s also saw the first wave of external debt crises in so-called soft-pegged countries in Latin America and Eastern Europe in particular as the US and UK tightened policy to end the Great Inflation.

The discussion will be held at 7.00 pm at the Lakmahal Community Library and those interested can register online, the organizers said. (Colombo/May30/2023)

Continue Reading