CBSL to Hold Policy Rates Steady – First Capital
By Ishara Gamage
The Monetary Board of the Central Bank of Sri Lanka (CBSL) in its today’s (13) crucial Monetary Board meeting either can choose to hold policy rates steady or hike by 25bps or 50bps while, a rate cut is off the table due to the high debt repayment and the high domestic borrowing requirement, Head of Research of First Capital Holdings PLC, Dimantha Mathew, told Ceylon FT.
“We believe that there is a significant probability (70%) to hold rates due to the considerable improvement in high frequency indicators with the fiscal and monetary measures implemented so far. However, there is a 30% probability for 25bps/50bps rate hike to balance external pressure” he said.
Arguments against Hike in monetary policy
1. Lockdown Likely to Hurt 3Q GDP Growth
The Sri Lankan economy is likely to grow at a much slower pace in the 3Q2021 compared with the 2Q2021 due to the COVID-19 virus-induced restrictions on economic activities.
Sri Lanka’s economy grew at a robust 12.3% in the 2Q2021 resultant to an extremely low base of -16.4% in 2Q2020 due to 1st wave lockdown, which resulted in the complete closing of the economy. Sri Lanka's Purchasing Managers Index (PMI) for the manufacturing and service sectors contracted in Aug 2021.
Manufacturing PMI declined 12.7 points, from 57.8 in Jul to 45.1 in Aug, driven by a decrease in subindices of new orders, production, employment, and stock of purchases. Meanwhile, Services PMI dropped 9.5 index points, from 55.7 in July to 46.2 in August, largely due to restrictions imposed to contain the spread of the highly contagious Delta variant.
ariant. 2. Cost push inflation cannot be controlled by rate hikes
Inflation has shown signs of a rising trend with above 5.0% inflation during the last 4 months, touching 6.0% in Aug 2021 and slightly dipping to 5.7% in Sep 2021. The primary reason for the rise in inflation is the significant depreciation in the currency resulting in repricing of most commodity prices. As rise in inflation is the cause of cost push inflation, monetary policy adjustment may not impact inflation though it may support the stabilisation of the currency. However, in the current situation the Government has taken a stance to control the exchange rate as well
3. Continuous Quantitative Easing Hindrance Further Rate Hikes
CBSL continued to infuse ample liquidity into the system via increased CBSL holdings supporting the fiscal shortage. The CBSL holdings rose to Rs 1,442.8Bn on 7th Oct 2021 from 1,174.2Bn as of 19th Aug 2021. We believe CBSL’s continuance in quantitative easing strategy may delay further policy rate hikes.
Arguments for hike in monetary policy
1. Rapid Climb In Government Securities Secondary Market Rates
Yields in the secondary market continued to witness an increase with moderate market activity from participants, followed by a wait-andsee approach amidst the looming uncertainty in the economy. The last 11 T-Bill auctions were undersubscribed by a considerable amount, getting accepted in short tenors (3-6 months) reflecting the lack of clarity among market participants on future interest rate trajectory. We consider that a rate hike may support CBSL in raising additional funding via Government Securities .
2. Relaxing Import Restrictions May Further Add Pressure on the Exchange Rate
Despite the import restriction, imports have been on a rising trend, expanding trade deficit compared to the previous year for the 5th consecutive month in July 2021. Further relaxing import restrictions may also fuel consumer demand leading to a further depletion in foreign reserves adversely impacting the exchange rate. Therefore, in order to preserve the foreign reserves which is considered to be the talk of the town, there is a possibility of a rate hike.
3. Private Sector Credit Picks Up Pace While Liquidity Stays Negative
Private sector credit increased by Rs 134.0Bn in Aug 2021 indicating a sign of strong acceleration amidst continual support from monetary stimulus. Despite significant quantitative easing strategies liquidity continues on a negative ground.
YTD growth stands at 10.1% broadly slightly above First Capital Research (FCR) expectation of c.12% for 2021E as YoY growth rises above 14%. With AWPR still remaining on low ground and liquidity negative, further tightening is likely to slow down credit growth and improve the liquidity position.
FCR believes that CBSL may consider maintaining the same policy stance in this policy review but given the considerable improvement in high frequency indicators to prevent an overheating of the economy, there is a considerably high probability (30%) that CBSL may hike its policy rates.
With high frequent indicators improving in line with expectations, we have eliminated any probability of a rate cut. FCR expects a continued increase in probability for a rate hike in order to prevent overheating of the economy amidst the given fiscal and monetary stimulus.