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Saturday May 15th, 2021

Sri Lanka’s central bank to trim policy corridor

ECONOMYNEXT – Sri Lanka will narrow its policy corridor further giving tighter control over short term rates to the rate to the Central Bank to control benchmark interest rates, rate setting monetary board, Deputy Governor Nandalal Weerasinghe said.

"When we move into an inflation targeting regime we would like to have a narrower band to manage interest rates," Weerasinghe said.

"So whenever there is an opportunity for us to revise the rates, we would be revising with that in mind."

The gap between Sri Lanka ceiling policy rate at 8.75 percent and the floor at 7.25 percent was narrowed to 150 basis points with a 25 basis point cut on the ceiling rate on April 04.

Sri Lanka’s active policy rate until a week ago was the floor rate with market rates halted from falling further by the standing deposit rate window.

Whenever credit slows and the central bank buys dollars generating liquidity (also sterilizes the forex purchases mopping up excess liquidity) overnight money market rate tends to move towards the floor without an overt rate cut.

Whenever credit picks up, and especially if the central bank then sells dollars to defend the currency generating liquidity shortages, which are then filled overnight through is reverse repo window, generating balance of payment crisis, rates moves towards the ceiling rate.

Through reverse repo auctions the rate can be kept lower than the ceiling, (in the middle of the corridor) worsening imbalances during periods of strong credit growth. With repo auctions rates can be kept higher than the floor, worsening a downturn after credit slows.

Analysts have pointed out that a wide corridor allows market rates to move towards the equilibrium rate without a formal decision of the monetary board.

In a central bank a monetary board – a bureaucratic panel which some critics describe as a politbureau – tries to second guess the market equilibrium interest rate.

A wider band could help compensate for delays in rate decisions.

Any errors in times of strong credit growth will lead to higher inflation and greater mal-investment which will lead to bad loans and economic downturns even with a floating rate as happened during the recent Great Recession.

In a soft-pegged exchange rate, a currency crisis will also happen. A wider band will allow rates to move in line with underlying market developments, without a formal monetary board decision.

Following Lanka’s last BOP crisis, when dollar purchases began in the second half of overnight rates fell over 100 basis points, and hit a little above floor rate without a rate cut, which analysts say would have helped create a ‘softer landing’ than otherwise.

Sri Lanka’s central bank has come under fire for usually for delaying rate cuts and pouring liquidity to the banking system to create currency pressure and trigger capital fight generating full blown balance of payments crises.

From around June 2017 the central bank became a strong net buyer of foreign exchange and overnight rates started to move down from a few weeks later.

Over the last week rates moved sharply to the ceiling 8.75 percent touching 8.65 percent, as excess liquidity ran out due to a seasonal cash draw down from the system. Monday’s ceiling rate cut will ensure that the current rate spike will not exceed 8.50 percent.

The banking system will ‘normalize’ in late April as festival cash comes back to the system.

If excess liquidity persists and there is no balance of payments pressure from the April cash injections, analysts say the floor rate will have to be cut for an actual ‘rate cut’ to take place.

Over the last year the central bank has kept the monetary system tight with the floor 7.25 percent rate and also mopping up excess liquidity (a type of quantity tightening) as it operates a pegged monetary system buying dollars, preventing the rupee from appreciating and building up forex reserves.

To mop up liquidity and build forex reserves the central bank has to sell its domestic asset holdings to commercial banks, squeezing credit and keeping lending rates high.

Inflation has now started to come down. Governor Indrajit Coomaraswamy said real interest rates have risen as a result.

Weerasinghe said while bank deposit rates have fallen there has been insufficient falls in lending rates.

"There was a kind of recent short term hike also. I think with this adjustment (ceiling cut) it will help reduce the margins."

"That is why decided to reduce the (policy rate) band. (Colombo/April05/2018)

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