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Sri Lanka raises rates, SRR to avoid higher inflation

Thursday, August 19, 2021 10:01

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Sri Lanka’s central bank became the 24th central bank to tighten its monetary policy stance this year as it raised both its key interest rates and reserve requirement, saying this aims to address imbalances in the external sector of the economy and “preempt the buildup of any excessive inflationary pressures over the medium term, amidst improved growth prospects.”

The Central Bank of Sri Lanka (CBSL) raised its Standing Deposit Facility Rate (SDFR) by 50 basis points to 5.0 percent and the Standing Lending Facility Rate (SLFR) by the same amount to 6.0 percent.

As the bank’s Bank Rate is linked with the lending rate, it automatically rises to 9.0 percent.
The central bank also raised its Statutory Reserve Ratio (SRR) on banks’ rupee deposits by 200 basis points to 4.0 percent with effect from the reserve maintenance period beginning Sept. 1, saying this will help induce a faster response of the market to its rate hike.

”The Sri Lankan economy is on a recovery path despite the pandemic related disruptions,” CBSL said, adding its monetary board had decided it was time to rollback some of the extraordinary support provided through fiscal and monetary measures last year.

Last year CBSL cut its key interest rates 5 times by a total of 250 basis points from January through July to support economic activity that was hard hit by the outbreak of the COVID-19 pandemic.

Today’s rate hike is the first by the central bank since November 2018, with the deposit rate now 3 percentage points below the level when it began easing in May 2019.

The central bank did not give any specific guidance as to its next policy decision, saying it would continue to monitor developments and take appropriate measures to ensure the economy reverts to its potential while inflation is within the target range.

After remaining moderate at the start of this year, Sri Lanka’s inflation rate has accelerated and economic growth in the first quarter exceeded expectations with purchasing managers’ indices for July showing continued strength.

Sri Lanka’s inflation rate has picked up speed since May and rose to 5.7 percent in July and the central bank expects inflation to hover around the upper bound of its 4.0 to 6.0 percent target range in the near term.

With global and domestic demand expected to improve, and energy and commodity prices putting upward pressure on inflation, CBSL said it was taking “preemptive policy measures to ensure the maintenance of inflation in mid-single digit levels over the medium term.”

Although many countries are experiencing inflationary pressures due to a supply-demand mismatch as economies recover from the pandemic, some central banks, such as Sri Lanka’s, fear the transitory pressures could become more persistent and have begun tightening their policy.

Sri Lanka’s central bank is the 8th central bank to have raised its rate this month alone, boosting the central banks that have raised rates this year to 24. These banks have raised rates 45 times.

Sri Lanka’s economy expanded by 4.3 percent year-on-year in the fist quarter of this year, the fastest growth rate since the fourth quarter of 2016, and CBSL said the economy was poised to record higher growth in the second quarter due to the comparison with last year.

Although economic activity could be weakened in the second half due to a re-emergence of the virus, the central bank said vaccines are being rolled out and it expects the economy to expand over 5 percent this year and momentum to be sustained in the medium term.

The Central Bank of Sri Lanka issued the following statement:

“The Central Bank of Sri Lanka tightens its Monetary Policy Stance

The Monetary Board of the Central Bank of Sri Lanka, at its meeting held on 18 August 2021, decided to increase the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank by 50 basis points each, to 5.00 per cent and 6.00 per cent, respectively. In addition, the Monetary Board decided to increase the Statutory Reserve Ratio (SRR) applicable on all rupee deposit liabilities of licensed commercial banks (LCBs) by 2.0 percentage points to 4.00 per cent, with effect from the reserve maintenance period commencing on 01 September 2021. These decisions were made with a view to addressing the imbalances on the external sector of the economy and to preempt the buildup of any excessive inflationary pressures over the medium term, amidst improved growth prospects.

The global economy is set to make a gradual recovery in 2021, although normalisation of economic activity would largely be uneven across regions

As per the July 2021 update to the World Economic Outlook (WEO) of the International Monetary Fund (IMF), the global economy is projected to grow by 6.0 per cent in 2021 and 4.9 per cent in 2022. Economic prospects have diverged across regions and access to COVID-19 vaccines has emerged as the principal factor that drives the global economic recovery in the period ahead. Most countries have experienced transitory price pressures due to supply-demand mismatches amidst the pandemic. Such transitory pressures could become more persistent, thereby warranting preemptive action by central banks in order to ensure stability in the period ahead. Accordingly, some central banks have already commenced tightening monetary policy while several others have signalled a

possible tightening of monetary policy in the period ahead.

The Sri Lankan economy is on a recovery path despite the pandemic related disruptions

Supported by fiscal and monetary stimulus measures, the Sri Lankan economy is gradually making headway following the setback in 2020. As per the estimates published by the Department of Census and Statistics (DCS), the economy witnessed a stronger than expected recovery during the first quarter of 2021, recording a real growth of 4.3 per cent, year-on-year. The economy is poised to record a higher growth rate during the second quarter of 2021, partly due to the sharp contraction observed in the corresponding quarter of the previous year. Possible disruptions to domestic economic activity from the re-emergence of the COVID-19 pandemic and related preventive measures could weaken the recovery to some extent during the second half of 2021. Nevertheless, with the successful rolling out of the national COVID-19 vaccination programme and the Government’s strategy to impose only selective mobility restrictions, the momentum of activity is expected to sustain in the period ahead. Available indicators and projections suggest that the real economy would grow over 5 per cent in 2021, and this momentum would be sustained over the medium term.

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.

Tightening of monetary policy stance is expected to support greater economic stability

In consideration of the current and expected macroeconomic developments as highlighted above, the Monetary Board decided to rollback some extraordinary support provided to the economy at the onset of the COVID-19 pandemic. Accordingly, with effect from 19 August 2021, the Board decided to increase the policy interest rates, i.e., the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR), of the Central Bank by 50 basis points each, to 5.00 per cent and 6.00 per cent, respectively. This would also result in the Bank Rate, which is linked to the SLFR with a margin of +300 basis points, automatically adjusting to 9.00 per cent. In order to induce a faster response of the market to these adjustments, the Monetary Board also decided to increase the Statutory Reserve Ratio (SRR) applicable on all rupee deposit liabilities of licensed commercial banks (LCBs) by 2.0 percentage points to 4.00 per cent, with effect from the reserve maintenance period

commencing on 01 September 2021. The Board expects these monetary policy decisions to iron out the prevailing imbalances in the domestic financial markets and the external sector of the economy, while preempting the buildup of any excessive inflationary pressures over the medium term, thereby supporting greater macroeconomic stability. The upward adjustments in market interest rates and the expected liquidity deficit in the domestic money market would also help the economy to absorb the large amount of currency held by the public observed since the onset of the pandemic in early 2020.

The Central Bank will continue to monitor domestic and global macroeconomic and financial market developments and take appropriate measures to ensure that the economy reverts to its potential, while maintaining inflation in the targeted 4-6 per cent range under its flexible inflation targeting

framework.”

www.CentralBankNews.info

Source: http://www.centralbanknews.info/2021/08/sri-lanka-raises-rates-srr-to-avoid.html

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