ICRA Lanka Economic Update: Restrictions unlikely to resolve problems
Sri Lanka’s restrictions imposed on the current account and capital account are likely to blowback rather than improve the balance of payment situation, ICRA Lanka Limited (ICRA Lanka) a Credit Rating Agency stated in its August economic update report. “Swaps and foreign currency loans would provide only temporary relief but will not be sufficient to generate a lasting improvement in the external sector. Many domestic industries are struggling to meet the demand due to shortages in inputs triggered by scarcity of forex and import controls,” it stated.
It also stated that foreign trading partners may push back as seen from a statement made by the European Union (EU) Mission in Sri Lanka early August. In addition, the Central bank of Sri Lanka (CBSL) imposed a 100% cash margin deposit requirement against the importation of selected goods which will tighten the liquidity position of the importers. This will further dent economic activity and bring about scarcity in the targeted goods.
Import controls and capital controls may be effective tools in managing short-term volatilities in the exchange rate but it comes at the expense of economic growth, external sector competitiveness, and cost of living for people. According to ICRA Lanka, the current inflation trajectory may breach CBSL’s inflation target in the medium term. At the global front, prices have retreated but historically domestic prices are relatively downward inelastic.
“Therefore, it may take a month or two to calm domestic inflation” it stated. As of 13 September, nearly 49% of the population is fully vaccinated while nearly 62% have received at least one dose. Sri Lanka imposed a fresh set of lockdown measures on 20 August and from early September infection rates seemed to be improving slowly. Since current lockdowns are less restrictive than in previous instances, the disruptions to economic activity are expected to be lower. The policy rate hike in August came as a surprise to many market actors.
The current, hawkish stance by the CBSL is quite a reversal of its loose monetary policy cycle that prevailed over a year previously. As an inevitable consequence of this, and rising inflation rate, we may see the entire term structure further adjusting upwards. “We doubt whether we have seen the end of the current monetary tightening.
Therefore, more rate hikes may still be on the cards. The financial sector may face higher funding costs moving forward, altering the balance sheet composition in the next few months. This, in combination with the gloomy outlook points to a slowdown in credit to the private sector. However, given the Government’s financing needs, State Banks may continue to expand their asset base at a moderate pace” the report concluded.