Sri Lanka holds rates despite falling inflation amid peg defence

Nov 16, 2011 (LBO) – Sri Lanka is holding policy rates at between 7.00 percent and 8.50 percent despite falling inflation, the Central Bank said as rapid credit expansion put pressure on a peg with the US dollar amid strong economic growth. Inflation fell to 5.1 percent in October 2011 from 6.4 percent in September. Economic growth is forecast at 8.3 percent in 2011.

Credit

But credit growth remained strong with broad money supply growth 20.7 percent since June and credit to both private sector and the state, fuelling money supply.

Average credit to private sector was 37 billion rupees a month in 2011, the monetary authority said.

“Also contributing to the monetary expansion was the increase in net credit to the government by the banking sector,” the Central Bank said.

Analysts had warned that when dollar sales in forex markets were actively sterilized (offset with rupee injections), credit to the state would begin to dwarf loans to private sector and it will become the main driver of exchange rate pressure.

“Inflation is expected to continue to decrease during the rest of the year, benefitting from the improvements in domestic supply conditions, arising from the high growth momentum of the economy,” the Central Bank said in its November monetary policy statement.

“Considering the above, even though inflation and the inflation outlook remain benign, the Monetary Board is of the view that a change to the existing monetary policy stance is not warranted.”

Meanwhile both Moody’s and Fitch Ratings has raised concerns about deteriorating property rights and investor confidence after the state moved to seize assets in assets in 37 businesses through a law which critics said was deeply flawed.

Rate Direction

Though the official policy corridor set by standing facilities is 7.00 percent and 8.50 percent, a narrower de facto corridor of 7.08 percent and 7.25 percent has emerged since repo and reverse repo auctions resumed when liquidity was drained amid sustained peg defence.

Sri Lanka’s market risk free yields had risen up to 50 basis points below one year maturities and around 100 to 120 basis points for medium term bonds since substantial peg defence began around July 2011.

At Treasuries auctions where yields are under some financial repression the 3-month rate rose from 7.11 in the last week of July to 7.39 percent last week. The 6-month yield rose from 7.19 to 7.45 percent and the 12-month yield rose from 7.25 percent to 7.59 percent.

One year bonds which are more market driven rose from 7.30/7.35 percent levels in the last week of July to 7.80/90 levels yesterday.

Two year bonds rose from 7.60/63 percent levels to 8.40/8.60 levels, 3-year bonds rose from 8.00/8.05 percent levels to 9.20/30 levels, 4-year bonds from 8.20/8.25 levels to 9.70/80 levels and 5-year bonds to 8.38/40 levels to 9.65/80 levels.

Two way quotes are also widening as bond markets got less liquid dealers said.

It is not possible for a central bank to control both the exchange rate and interest rate at the same time without losing too much foreign reserves. The rupee is being defended at around 110/20 to the US dollar in the spot market.

External Snapshot

Meanwhile the state also jacked up fuel prices, which analysts say will directly kill demand in the economy and indirectly reduce further credit funded losses in energy utilities which will help reduce pressure on the exchange, inflation and also interest rates.

The central bank said fuel price rises may cause a temporary spike in the price index, but it would “minimise the adverse impact on future inflation and the economy through reduced price distortions.”

The Central Bank said in the past months two commercial banks had made plans to get foreign capital of 250 million dollars while 12 private firms have been given the nod to borrow 63 million dollars.

Analyst say the foreign money will help drive credit, spending and imports, boosting the trade deficit and economic growth with a time lag. However foreign financed spending is neutral on the exchange rate.

The central bank said preliminary data showed that spending on imports grew further in September 2011 due to intermediate and investment goods especially for state projects which were driven by 1,460 million dollars in state borrowings.

Sri Lanka has a large trade deficit mainly triggered by net government borrowings (capital account) and remittances (services account) which increase domestic purchasing power, over and above the money earned within the trade account through exports.

Update IV