Sri Lanka’s central bank holds rates watching tax cuts, budget deficit

ECONOMYNEXT – Sri Lanka is holding policy rates at current levels, amid a widening the budget deficit so far this year and recent tax cuts announced to stimulate economic activity, which need clarity, the central bank said.

“…[R]ecent tax revisions would support lower inflation and higher economic growth in the short term, but was of the view that greater clarity with regard to the medium term fiscal path of the government is required to assess the impact on the economy over the medium term,” the central bank said in it November monetary policy review.

Sri Lanka’s cabinet of ministers had announced a cut in value added tax from 15 to 8 percent and while a non-recoverable 2 percent tax on domestic goods and services will be dropped from December 01.

Other cuts have also been announced for personal income tax, a debit tax on financial transactions, a debt service levy on banks, removal of taxes from information technology, for which a date has not been set.

Officials have said a revival in economic activities would boost tax revenues eventually keeping the deficit at 5 percent of gross domestic product in 2020, while spending will be slashed.

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The central bank said there was a slight increase in deposit rates after price controls were lifted, but it still expected lending rates to fall further.

“Specifically, the Average Weighted Prime Lending Rate (AWPR) is expected to reduce by a further 70 basis points to 9.50 per cent by end 2019, while the Average Weighted Lending Rate (AWLR) is projected to decline by around 120 basis points to below 12.50 per cent by March 2020,” the central bank said.

“Interest rates on the stock of deposits continued to decline, while interest rates on new deposits, which declined notably until September 2019, showed some increase in the month of October 2019, following the removal of the cap on deposit interest rates of licensed banks.”

The central bank said private credit grew 26 billion rupees in October, state enterprises borrowed 34 billion rupees and credit to central government was flat.

The central bank is holding is policy rate at which printed money is injected to the market at 8.0 percent and the rate at which excess liquidity is removed at 7.0 percent.

However it can inject large volumes of excess liquidity at any time to keep overnight rates below 8.0 percent, especially when private or state domestic credit picks up.

The injections tend to de-stabilize a highly non-credible peg with the US dollar, which is labelled a ‘flexible exchange rate’.

Sri Lanka’s tax revenues were hit and private credit slowed in 2019, after the flexible exchange rate collapsed in 2018 as liquidity injections were made to target a call money rate, generating an output shock, worsening the deficit and pushing up bad loans, analysts have said.

Growth fell to 1.6 percent as suicide attacks on Easter Sunday added to the effects of the currency collapse.

“Economic growth is predicted to be modest during the remainder of the year, with likely subpar growth in Industry and Services activities as implied by leading indicators,” the central bank said.

“However, improved investor confidence, supported by political stability and fiscal stimulus driven boost to aggregate demand, is expected to drive short term growth.

“The introduction of an appropriate policy mix, which utilises the available limited policy space prudently, would support the economy to reach as well as enhance its potential over the medium term.”

Inflation is expected to be around 4-6 percent, the central bank said.