The Monetary Board of the Central bank of Sri Lanka (CBSL) is expected to keep its key interest rates steady at today’s (18) meeting after consecutive rate hikes in the previous three policy meetings, the research arm of the Sri Lanka’s First Capital PLC (FC Research) Group said.
“We have assigned a probability of 60 per cent for no change in policy rates. However, there is also a 40 per cent probability for further tightening in the midst of prevailing political deadlock and in order to preserve the currency and foreign reserves” they stated in a pre-policy rates review.
During last meeting Monetary Board decided to increase policy interest rates; SDFR and the SLFR by 700bps to 13.50 per cent and 14.50 per cent respectively and this can be considered as the highest ever policy rate hike delivered in the history of Sri Lanka.
On a cumulative basis, policy rates have increased by 850bps for this year at three policy announcements.
Accordingly, considering above factors FC Research believes that CBSL might prefer to conserve its policy space and use it judiciously in the latter part of the year while also allowing the impact of previous rate hikes to get materialised as it takes roughly a three to six month period to get reflected in the economy.
Therefore, FC Research believes that there is a lower probability for further rate hikes at the upcoming policy meeting.
They also stated that bond auctions are getting filled up indicating reduced burden on CBSL holdings T-Bill auction held on 11 May was 92.3 per cent subscribed while auction held on 4 May was fully subscribed with yields across the tenures were seen easing somewhat after two weeks of moderating.
It appears that the yields have peaked for now following the sharp correction that took place soon after the jack up in policy rates by unprecedented 700bps rate hike on 8 Apr.
Moreover, the total accepted amount from 1Yr T-Bill at the recent weekly auctions were seen gradually rising relative to previous weeks while also attracting market participants towards long-term maturities (1Yr T- Bill) with the gradual restoration of the confidence.
As a result, the distortion in yields between 3M, 6M and 01Yr is getting evaded.
Gradually, full subscriptions of bill and bond auctions are expected to unwind CBSL holdings which surpassed Rs 1.8 trillion.
It also reflects that market expectations regarding further rate hikes are gradually fading away indicating that further tightening in policy rates would not be required at the upcoming policy review.
Market interest rates
Market interest rates have been gradually adjusting upwards in response to tight monetary policy measures adopted thus far.
Accordingly, in response to 700bps rate hike on 8 April, AWCMR moved to 14.5 per cent while AWPR was uplifted to 19.55 per cent . Further, FD rates of major commercial banks were seen shifting upwards in response to policy adjustments with FD ceiling on.
Non-banking financial institutions (NBFI) increasing to 26.22 per cent as of 12 May. Moreover, in response to increased lending rates, credit disbursed for February 2022 and January 2022 declined to Rs 33.50 billion and Rs 36.10 billion respectively. Hence, FC Research believes that further hike in policy rates would not be required at the upcoming policy review.
Policy tightening may not curb cost-push inflation
Increase in global commodity prices has become a key determinant factor of the soaring inflation in Sri Lanka.
In that, escalating crude oil prices due to supply-side constraints play a major role in the domestic context by inflating prices of the overall economy.
Moreover, import restriction and Sri Lanka’s heavy dependency on imports are also promoting supply-side shocks, while also wearing out the competitiveness of certain local industries and thereby causing detriments to the consumers due to discretionary rise in prices of goods and services by suppliers. Therefore, a monetary tightening may not address these issues arising via cost-push effects on inflation.
Impending fiscal and structural
reforms on the cards
As per 2021 article IV consultation report, IMF recommends to have a substantial revenue based fiscal consolidation which includes reforms on strengthening VAT and income taxes, through rate increases and base broadening measures accompanied with energy pricing reforms to reduce fiscal risks from loss making public enterprises.
Accordingly, FC Research believes that government will have to resort to an upward revision in power tariff sooner than later while there are speculations on further fuel hikes.
In the midst of impending tightening of fiscal policy measures, it is most likely that CBSL may delay further monetary policy tightening and use it prudently in the latter part of the year whenever required.
Persistent political deadlock at the helm and tightened policy measures as a requisite to protect the currency and derailing foreign reserves.
Currently Sri Lanka is at an unresolved political deadlock and threatening any action for recovery.
This has also resulted in a loss of confidence among market participants and investors.
Moreover, in the midst of worsening external conditions and lack of foreign inflows foreign reserves amounted to USD 1.8 billion by April 2022 while usable foreign reserves were down to less than USD 50.0 million resulting in the Government. having to continuously rely on credit lines to bolster its finances, including from China and India.
Derailing foreign reserves and ongoing political crisis have also led to significant pressure on the currency and since CBSL’s decision to allow the flexibility in the currency on 7 March, LKR depreciated significantly by more than 75 per cent while in unofficial trading platforms the LKR being quoted at an even far weaker rate.
Hence, to arrest the existing pressure on the currency and reserves, FC research believes that CBSL should further tighten its policy rates.
Tightening policy stance is one of the key propositions by the IMF.
Currently, Sri Lanka is seeking financial support from the IMF, while planning to present policy proposals to the IMF in the near future.
As per 2021 article IV consultation of IMF, tighter monetary policy and a market-based exchange rate were recommended as part of the comprehensive strategy. Given rising inflationary pressures and expectations, IMF believes that near-term monetary policy tightening is warranted to ensure that the recent breach of the inflation target band is only temporary.
Therefore, there is a likely hood that CBSL may consider further tightening policy rates at the upcoming meeting.
Sri Lanka recorded one of its highest inflation of 29.8 per cent in April 2022 relative to 18.7 per cent in March 2022 causing an alarm among the consumers in the country.
Going forward, inflation is expected to remain high due to elevated energy prices and continuing supply chain disruptions, prompting stronger monetary policy responses by the central bank. Rising inflation and negative real policy rates warrant a further hawkish monetary policy stance by CBSL, FC research concluded.