Sri Lanka monetary tightening welcomed by IMF – Update

Feb 03, 2012 (LBO) - A hike in rates and a credit ceiling to rein in loan growth would help narrow a widening external deficit in Sri Lanka, but exchange rate flexibility should be part of the policy package, the International Monetary Fund said. Strong credit growth put pressure on Sri Lanka's peg with the US dollar and the central bank hiked policy rates by 50 basis points Friday and slapped an 18 percent ceiling for credit growth for 2011.

Banks could increase growth to 23 percent with foreign borrowings. In 2011 commercial bank credit go business alone was around 35 percent.

"I think there is a common understanding that this challenge should be addressed," IMF mission chief Brian Aitken said.

"There was a strong policy response. We feel a more flexible exchange rate should be part of the package."

Sri Lanka's active policy rate shifted from 7.0 percent at which money is drained from the banking system to 8.

50 percent at which money is injected when liquidity dried up from forex market interventions.

With Friday's rate hike, policy rates have effectively risen 200 basis points from mid 2011.

Higher interests can reduce consumption, increase deposits available to banks to loan out and also cut total credit demand