Distributive policy

Sri Lanka’s policy rate remains unchanged amid slowing private credit

ECONOMYNEXT – Sri Lanka’s central bank said it was keeping key rates at 15.50% as data showed market interest rates nearly double the rate and private credit and imports decreased accordingly.

The central bank is injecting 740 billion rupees of money overnight into the banks at 15.50%, which was initially injected mainly after dollars for imports to keep rates low (sterilized interventions), pledging thus in the monetary financing of imports.

In June, there was a slowdown in private credit, making more private savings available to finance falling deficit rates, when concerns were raised about the possibility of restructuring domestic debt, again pushing up rate.

The Sri Lankan private sector is a net saver and is unable to trigger external pressure or a balance of payments deficit unless the central injects rupee reserves into the banking system (sometimes to finance deficits, but mostly to refinance maturing debt from past deficits to suppress Treasury yields, and sometimes sterilize interventions) to stimulate unsustainable private credit and trigger external imbalances.

Monetary Policy Review: N°06 – August 2022

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

Tight monetary and fiscal policies already in place, along with measures to reduce non-emergency import spending, are expected to lead to a significant contraction in credit to the private sector and possible upside risks to near-term unemployment. The Council considered that despite the fact that headline inflation is expected to remain high in the short term, the policy measures taken so far by the Central Bank and the government would help to contain any pressure from aggregate demand, thus anchoring expectations of inflation. inflation, as well as forecasts of lower world commodity prices and their impact on domestic prices in the period ahead.
Global economic growth is expected to slow at a faster pace

According to the International Monetary Fund (IMF) World Economic Outlook (WEO) July 2022 update, global economic growth is expected to moderate to 3.2% in 2022 from 6.1% in 2021. tighter financial conditions adopted by banks around the world following the emergence of inflationary pressures, a slowdown in the Chinese economy due to the resurgence of COVID-19, among others, and further negative spillovers from tensions Geopolitics in Eastern Europe have clouded global growth prospects.

Global inflation remains high mainly due to high energy and food prices as well as supply and demand imbalances, while downside risks appear in the outlook for global inflation in the short to medium term. term. Domestic economic activity is expected to register a noticeable slowdown The impact of persistent supply-side disruptions, mainly due to power and energy shortages, and uncertainties associated with socio-political developments are expected to have caused significant negative effects on economic growth in the second quarter of 2022, while this impact is also expected to continue through the third quarter of 2022.

This, combined with the negative growth already recorded in the first quarter of 2022 and restrictive policies, could lead to a larger-than-expected contraction in real activity in 2022. However, real GDP growth is expected to pick up over the outlook period. come, with the envisaged stabilization of the macroeconomic situation. conditions and the implementation of structural reforms in the economy.

Despite heightened challenges, positive developments are observed in the external sector Merchandise trade deficit continues to narrow in cumulative terms, mainly reflecting the impact of policy measures to reduce non-emergency imports, while export earnings remain high.

Foreign exchange inflows in the form of workers’ remittances remain below expectations, while improvements are seen in the tourism sector, with an increase in tourist arrivals. The pressures observed on the domestic foreign exchange market have largely eased with the significant drop in import expenditure and the improvement in the conversion of repatriated export earnings, supported by the strengthening of the control mechanism for the repatriation and conversion of export earnings.

As a result, the exchange rate remains broadly stable within market guidance that started from mid-May 2022, while the gap between the curbside market and official exchange rates has narrowed significantly. in recent weeks, and this gap is expected to remain narrow in the period ahead. with improving liquidity conditions in the domestic foreign exchange market.

Meanwhile, reflecting the impact of improved currency liquidity and the securing of significant financial assistance, the availability and distribution of essential commodities, such as fuel, cooking gas, medicines, fertilizers, etc., have improved considerably. Arrangements are in place to ensure a continuous supply of these essential products in the coming period. Gross official reserves, as of end-July 2022, are estimated at US$1.8 billion, including the People’s Bank of China swap facility equivalent to approximately US$1.5 billion, which is subject to conditions of use.

Negotiations with the IMF to reach a staff-level agreement on the Extended Financing Facility (EFF) arrangement are expected in the coming weeks, while swift action is taken to move the restructuring process forward debt with the help of financial and legal advisers. Market interest rates rose further in response to tighter monetary and liquidity conditions.

Credit growth to the private sector is on a downward trend. Year-on-year growth in credit to the private sector slowed markedly in June 2022, with a contraction in absolute terms from the previous month, reflecting the impact of significantly lower effective market interest rates. high and the moderation of economic activity. The net foreign assets of the banking system continued to contract, weighing on the expansion of the broad money supply.

With rising interest rates, a notable deceleration in the growth of private sector credit and broad money is expected in the period ahead. Monetary financing declined significantly in August 2022, while the need for additional monetary financing is expected to be low over the coming period, supported by the fiscal consolidation measures that have already been introduced, alongside the implementation of cost-reflective pricing by large state-owned enterprises. – commercial enterprises. Meanwhile, currency in circulation, which remains substantial, is flowing back into the banking system along with the high deposit interest rates that currently prevail.

The pace of inflation acceleration has slowed faster than expected

Headline inflation increased at a slow pace in July 2022, compared to recent months. This moderation is expected to continue over the coming period, leading to a low level of inflation by the end of 2022, compared to previous projections. As a result, the latest short-term forecast for headline inflation shows a faster deceleration, compared to the previous monetary policy review, mainly due to downward revisions in administered prices and their second-round effect, as well as as the moderation of certain food prices and the stability of the exchange rate. With moderate aggregate demand pressures resulting from tight monetary and fiscal conditions, expected improvements in domestic supply conditions as well as the expected normalization of world food and other commodity prices, and the effect of On a favorable statistical basis, headline inflation is expected to moderate going forward and stabilize within the desired range over the medium term.