Sri Lanka cuts rates by 175bp to boost lending

April 22, 2009 (LBO) – Sri Lanka’s central bank has cut its de facto signal policy rate by 175 basis points to 13.0 percent to spur lending as credit to the private sector fell 5.6 percent in February, and trimmed the repo rate to discourage excess reserves.

The rate cuts come as the rupee is being free floated after a long period of peg defence depleted most of the island’s foreign reserves.

Analysts say the rate cuts may contribute to further rupee weakness. But rupee depreciation will also clear accumulated past inflation and set the stage for a domestic economic revival.

On Tuesday the rupee weakened to 119.90/120.10 against the US dollar and strengthened after it was talked up by the central bank.

The central bank said it was also narrowing its reserve money growth target for 2009 from an average rate of 5.0 percent to 2.8 percent.

Since peg defence began in September 2008, capital flight and cuts in statutory reserves put the breaks on reserve growth.

But until a free float is properly established, analysts say the central bank will find it difficult to get an effective handle on reserve money growth.

Governor Nivard Cabraal said Tuesday that authorities were putting the final touches to an International Monetary Fund bailout which is likely to be disbursed in under three weeks.

The United States Treasury is also “consulting” with the State Department over the IMF deal, a US spokesman said Monday.

A unit of the US Treasury’s International Affairs Office vets all IMF loans. The US has the largest single voting block with the IMF’s executive directors at 16.7 percent.

Updated The so-called penal reverse repo rate, at which money is advanced to the banking system with no restrictions and sets the ceiling in the overnight money market, has now become the key signal policy rate of the country.

Sri Lanka also has another ‘reverse repo’ window at 11.75 percent but with restricted access. Reverse repo auctions are also conducted around those rates.

The central bank said it was cutting its repo rate by 125 basis points to 9.0 percent “to encourage commercial banks to lend their surplus funds to customers rather than entering into repurchase agreements with the Central Bank.”

“The Central Bank expects that these measures would result in more active lending by commercial banks supported by a reduction in their lending rates in accordance with the reduction in policy rates, thereby augmenting credit flows to the economy,” the Central Bank said in its April monetary policy review.

“The expansion in the money supply has decelerated to 9.9 per cent together with a sharp deceleration in credit to the private sector to 5.6 per cent by February 2009.

“Given the continuing decline in the general price level and the demanding conditions facing the real sector, the Central Bank is of the view that its monetary policy stance should be eased further.”

Sri Lanka’s inflation fell to 5.3 percent in March giving space to loosen monetary policy.