Sri Lanka raises rates, SRR to avoid higher inflation

Most market interest rates have reached low levels resulting in the expected acceleration in credit flows to the private sector

With the gradual transmission of accommodative monetary policy measures, most market deposit and lending interest rates declined to their historic low levels. Supported by the low interest rate environment, credit to the private sector expanded notably during the first half of 2021, surpassing the annual expansion of credit observed in 2019 and 2020. The momentum of credit expansion is expected to continue in the period ahead, with increased credit flows to productive and needy sectors of the economy. Meanwhile, credit obtained by the public sector from the banking system, particularly net credit to the Government, also increased notably thus far during the year, amidst the impact of the pandemic on government revenue and recurrent expenditure. Reflecting the impact of increased domestic credit, the growth of broad money (M2b) continued to remain elevated.

The external sector continued to face a multitude of challenges requiring coordinated measures

The implementation of the essential growth-conducive stimulus measures, which resulted in the availability of low cost credit to the private sector, led to a sustained increase in the demand for merchandise imports since mid-2020. With the increase in import expenditure outweighing the improvements observed in earnings from exports, the trade deficit continued to widen during the first half of 2021 over the corresponding period of last year. Moreover, the expected recovery in the tourism industry could be further delayed due to uncertainties associated with the resurgence of the pandemic globally. Workers’ remittances, which recorded a significant growth in 2020 as well as in the first few months of 2021, have also displayed some deceleration. Limited conversion by exporters and the advancing of imports together with some speculative activity, prompted by anomalies between interest rates on the rupee and foreign currency products in the financial market, exerted undue pressure on the exchange rate in the domestic market. Amidst these developments, all debt service obligations of the Government, including the settlement of the International Sovereign Bond (ISB) of US dollars 1 billion in late July 2021, have been duly met thus far in 2021. Gross official reserves were estimated at US dollars 2.8 billion with an import cover of 1.8 months by end July 2021. This, however, does not include the bilateral currency swap facility with the People’s Bank of China (PBoC) of CNY 10 billion (equivalent to approximately US dollars 1.5 billion). Measures are

being taken by the Government and the Central Bank to secure foreign financing from several sources in order to reinforce the level of official reserves in the near future. Meanwhile, the Government continued to aggressively explore avenues to enhance non-debt creating foreign inflows, by strengthening the domestic production economy, which would help strengthen the external sector in the period ahead.

Possible upside pressures on inflation are being addressed through preemptive policy measures

Inflation, which remained moderate during early 2021, accelerated somewhat in recent months due to high food inflation and some acceleration in non-food inflation. Inflation is projected to hover around

the upper bound of the desired 4-6 per cent target range in the near term. The envisaged improvements in aggregate demand conditions and the likely increases in global energy and other commodity prices may generate some inflationary pressures in 2022, requiring preemptive policy measures to ensure the maintenance of inflation in mid-single digit levels over the medium term.