Sri Lanka faces tough call on interest rates in face of rising inflation

November 13, 2006 (LBO) – Sri Lanka faces a tough call on interest rates on Tuesday as it balances the need to keep inflation in check and ensure economic growth remains on track, analysts said. Sri Lanka’s economy is growing by near eight percent, the stock market is at record highs, corporate profits are strong and the property market is booming.

The stock market is at record peaks, with the broader index up 30 percent since the beginning of this year on deal making in selected blue chip and mid sized stocks.

In that positive mix, inflation too is picking up, with the Colombo Consumer Price Index (CCPI), the country’s main measure of inflation, now running at a high of 17.2 percent in October from 15.4 percent in September.

“Inflation has now gone up to 17.2 percent, and oil prices are falling,” says former deputy finance minister and UNP parliamentarian Bandula Gunawardena. “They (the government) can no longer say inflation is caused by rising oil prices. It is because they are printing money to finance the budget deficit.”

Despite a slight dip in oil prices, domestic factors such as rising inflation, robust bank credit and money supply growth and a strong underlying economy favour further tightening, says Central Bank’s Assistant Governor H N Thenuwara.

“However, we must keep in mind that 17 percent inflation is mainly due to heavy rains, that’s disrupting supplies of foodstuffs like vegetables. A newly developed core-inflation index, is showing a downward trend of 10 percent in October and we expect it to ease down to about 8.5 percent by year end,” Thenuwara told businessmen during a seminar on international trade organized by Hatton National Bank on Monday.

Over the last few months, the bank has raised policy rates by 87.5 basis points to curb credit demand and stamp out inflation.

Central Bank’s repurchase or repo rate now stands at 9.625 percent, while the reverse repurchase rate is kept at 11.125 percent.

“I think policy rates will stay where they are, the Central Bank might favour a wait-and-see attitude before the budget on Thursday,” says Sadduk Ghazzali, Manager Portfolio Management Services, First Capital Asset Management Ltd.

“It’s a tough call,” said Dudeepa Ratwatte, Head of Global Markets at Commercial Bank of Ceylon, adding that his “gut feeling” was that the bank would go for a 25-basis point hike – if not on Tuesday, then at its next policy meeting in January.

Meanwhile, others say market rates have moved ahead and upward movements in treasury rates after the last rate hike has given room for the monetary board to raise policy rates without antagonizing the fiscal authorities further.

Analysts say a recent dressing down received by state banks after they raised deposit rates, indicate that fiscal authorities still want rates to remain as low as possible, though monetary authorities have indicated that they are in favour of economic stability.

Bank credit to the private sector is expanding by over 23 percent – much to the Central Bank’s dismay – as people buy consumer durables, motor vehicles and invest in property to avoid negative returns on their savings deposits.

Governor Nivard Cabraal told businessmen recently that the bank was taking measures to contain credit growth with an aim to curb inflationary pressures, so that growth could be sustained over the longer term.

“You should not think that we are putting a dampener on your activities,” Cabraal said. “We want to sustain the high growth path we have achieved by having stable conditions to sustain growth over a longer period.”

“If the bank wants to curtail credit growth, they must raise interest rates, then people will save without borrowing to spend. The way things are going there’s no impact,” said Ratwatte.

Sri Lanka is due to post a 8.0 percent growth in the nine months to Sept, treasury secretary P B Jayasundara said last month, after the economy expanded 8.0 percent from Jan-June 2006.

Cabraal says the island is heading for an 8.0 percent growth next year, the best in 28 years, when the economy expanded by 8.2 percent.

“In the short term, the government has very little room to maneuver because high inflation. I hope the budget will spell out what they plan to do to fundamentally change things,” quips Dushyanth Wijayasingha head of research at Asia Securities.

“The problem is the government is printing money and that’s not helping the current situation, given the heavy military expenses and no signs of trimming the public sector,” says Wijayasinghe.

Central Bank credit to the government in terms of treasury bill purchases have climbed up to 63 billion rupees as at end October from about 20 billion rupees in February.

The bank’s practice of printing money and taking up treasury issues has come under fire from critics as it increases inflation and puts pressure on the balance of payments. During the last two years, treasury bill rates have been fixed around the short term policy rates in a bid to keep down government borrowing costs, a policy that has gradually been relaxed as inflation started to rocket up.