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ECONOMYNEXT – Sri Lanka’s central bank is holding its policy corridor at between rate at 15.5 percent but is expecting market rates to fall further and the economy to start recovering in the second half.

The rate setting Monetary Board said its was “of the view that the maintenance of the prevailing tight monetary policy stance is imperative to ensure that monetary conditions remain sufficiently tight to rein in inflationary pressures.”

“Such tight monetary conditions, together with the tight fiscal policy, are expected to adjust inflation expectations downward, enabling the Central Bank to bring inflation rates towards the desired levels by end 2023, thereby restoring economic and price stability over the medium term,” the statement said.

The central bank has stabilized the exchange rate around 360/370 to the US dollar and is pegging by buying dollars through a surrender rule and releasing the same dollars for imports, with private credit in negative territory.

A soft-pegged or flexible exchange rate central bank triggers forex shortages by selling dollars and sterilizing the intervention with new money, triggering excess credit effectively re-financing private sector activity.

Sri Lanka’s 12-month inflation – as well as some absolute prices – have started to come down rapidly as a result. The widely watched Colombo Consumer Price Index ended 2022 at up 57.2 percent after peaking at 69.8 percent in September.

Sri Lanka’s GDP was estimated to have contracted by 7.1 percent in the 9 months to September.

“With tighter monetary and fiscal policies in place, along with disruptions to domestic supply conditions, real activity in the final quarter of 2022 is also expected to have remained subdued,” the central bank said.

“The economy is expected to make a gradual recovery during the year supported by the expected improvements in domestic supply conditions, underpinned by the timely implementation of corrective policy measures.

“Meanwhile, the anticipated improvements in foreign exchange flows and the resultant enhancement in business and investor sentiment are expected to reinforce the expected recovery in the period ahead.”

A fan chart published with the monetary policy statement shows a high probability of inflation falling close to zero by the end of 2023 and remaining at the levels thereafter.

In recent years, Sri Lanka’s inflation has tended to fall to near zero about 18 to 22 months after a currency crises ends, however at that time the central bank starts to dump large volumes of money into the credit system under ‘flexible inflation targeting’, triggering a currency crisis in that year.

The exchange rate the rupee then collapses under ‘exchange rate as the first line of defence’ instead of running complementary monetary policy. After the currency collapses, interest rates are then hiked and inflation moves up and growth slows.

Sri Lanka’s banking system had large liquidity shortages from from overnight sterilized interventions from the 2020-2022 currency crisis.

The central bank has injected over 300 billion rupees in term auctions in January largely replacing overnight borrowings easing maturity mis-matches in the banking sector and also cheaper funds at 15.5 percent.

The central bank also restricted access to its overnight window for excess liqudity at 14.5 percent in a bid to encourage interbank call market lending.

“Recent measures adopted by the Central Bank to reduce the overreliance of licensed commercial banks on the standing facilities of the Central Bank and the concurrent conduct of open market operations helped improve liquidity in the domestic money market,” the central bank said.

“This prompted activity in the interbank money market.

Interbank transactions which were only 1.4 billion rupees on January 01 went up to 11.9 billion rupees on January 23. The call market, which lends without collateral, operates at a much lower rate of around 15.5 percent compare to over 20 percent for the market.

However after the liquidity injections, slowing domestic credit and expectations of re-structuring assurances from creditors to unlock and IMF program, market rates have slowed.

“Improved liquidity conditions, along with improved investor sentiment on the anticipation of “financing assurances” from official creditors, led to a notable moderation in the yields on government securities recently, reflecting the easing of the high risk premia attached to government securities,” the central bank said.

Central Bank officials have said earlier that the regulator is in discussions with banks on deposit rates.

“Meanwhile, the market deposit rates have also shown a notable moderation, benefiting from improved liquidity conditions,” the statement said.

“These developments are expected to pave the way for an easing of excessive market interest rates in
the period ahead.

“Nevertheless, outstanding credit extended to the private sector by commercial banks continued to contract in response to the tight monetary conditions and the moderation in economic activity. Monetary expansion also moderated from peak levels, albeit at a slower pace.”

The central bank hinted at further measures to take market interest rates down.

Sri Lanka’s gilt yields are high due to a flaw in the IMF’s debt re-structuring framework where a cut off date for domestic – or foreign – re-structuring is not announced.

“While some downward adjustment in market interest rates has been observed lately, the Monetary Board is of the view that there is sufficient space for excessive market interest rates, including lending interest rates to Small and Medium Sized Enterprises (SMEs), to adjust downwards considering the recent
improvements in domestic money market conditions and sentiments along with the moderation
in the yields on government securities,” the statement said.

“However, the Board was also of the view that the anticipated further decline in the yields on government securities due to the narrowing of risk premia is unlikely to result in a significant improvement in underlying monetary conditions. The Central Bank will continue to closely monitor monetary conditions in the period ahead and will remain prepared to take swift and proactive measures, as appropriate.”

Read the full statement here.

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