Sri Lanka's central bank sent a powerful message to the local markets Tuesday when it hiked interest rates unexpectedly to keep rising inflation from skyrocketing out of control. Although the rupee climbed on the news, a clouded political outlook as a tight presidential race nears and continued worries over persistently high oil prices suggest the message may not pack the punch that will break the Sri Lankan currency out of its longer-term downtrend against the U.S. dollar.
"The hike isn't sharp enough to curb inflation, and it could have significant pressure on the economy over the medium term" unless rates are increased further, said Anjani Waidyaratne, analyst at Asia Securities.
Interbank liquidity is flush but analysts are mixed over whether further interest rate increases are likely. Some see another 25-50-basis-point hike before the year-end, but Waidyaratne believes another upward adjustment is unlikely until after presidential elections are concluded.
The Central Bank of Sri Lanka Tuesday raised its overnight repurchase rate to 8.50% from 8.25%, and the reverse repo rate to 10% from 9.75%, three days before a scheduled monthly policy rates review.
This is the third rate hike this year but the second that the central bank has surprised the market by moving ahead of a scheduled policy meeting; in June, it hiked its policy repo rates a sharp 50 basis points to curb money supply growth a day before policy makers were to meet. At the time, the Sri Lanka rupee strengthened against the U.
S. dollar but its rise was brief.
Analysts and traders don't expect the rupee to behave any differently this time round: It will strengthen a bit before succumbing to the same worries of the last few months - volatile politics, rising imports, and an uncertain economy.
After falling as low as Rs 101.30 during trading Tuesday, the dollar ended at Rs101.33, off from the previous close of Rs 101.43. The dollar is expected to weaken slightly more, possibly to Rs 101.
00, this week, before strengthening to Rs102.50-Rs103.00 by the end of the year, according to traders and technical charts. At 0425 Wednesday, the dollar was quoted around Rs.101.33.
The rupee has been on a slippery slope since early January when it soared to around Rs. 97.95 to the dollar on anticipation of donor aid flowing into the country for reconstruction of the tsunami-ravished economy.
For the year to date, it has risen slightly over 3.0%, reversing some of last year's 7.4% decline against the dollar. But when compared with its highest point on Jan. 11, the rupee is down about 3.3% versus the dollar.
The economy is forecast to grow more slowly this year but at a still decent 5% pace.
Gross domestic product expanded 5.4% last year and 6.0% in 2003.
However, persistently high oil prices this year are muddying the GDP outlook.
That is why, say economists, it's crucial for the country to quickly get the $3.2 billion in aid pledged by various multilateral lenders and governments after the India Ocean tsunami devastated parts of the country late last year.
Only $513 million has been received so far, filtered through to various rehabilitation projects across the island.
The rest of the money has been on hold since April 2003 when efforts to broker a solution between the government and the Tamil Tiger rebels broke down.
"A lot will depend on the new president's economic policies and efforts to revive the peace process," said a trader at a local bank.
No date has been set although voting for a new president is widely expected to be between Nov.
16 and Nov. 21, likely to be closely contested between Prime Minister Mahinda Rajapakse and his predecessor Ranil Wickremesinghe.
Premier Rajapakse is backed by a Marxist group and a Buddhist political party which adopt a hardline stance toward striking a peace deal with Tamil Tiger rebels, and are opposed to privatization and public sector reforms.
Markets generally favor Wickremesinghe, the leader of the opposition United National Party, as he is viewed as pro-business and expected to pursue peace with the Tigers.
Restoring the peace process and aid funds will alleviate the pressure from record high oil prices which have led to both faster inflation and higher imports.
Sri Lanka imports all its oil needs, and the government has had to raise domestic fuel prices this year, leading state-owned enterprises and the government to borrow heavily to pay for fuel, and money supply to grow over 18% in August, above the government's 15% target.
Oil imports are expected to rise to .
46 billion this year from 2004's $1.2 billion.
Oil imports are equivalent to about 15% of total imports.
In August, inflation, measured on a 12-month moving average basis, reached 12.
8%, higher than July's 12.7%. For 2005, the consumer price index is forecast to rise 11.5%, according to analysts.
Although a weak rupee favors the country's exporters, it also makes imports more expensive - an issue this year because of the oil factor.
According to traders, the central bank has intervened more selectively and less aggressively in recent months to shore up the flagging rupee. While some think that the central bank eased its grip on the market because it is comfortable with those levels, others see the relatively low foreign exchange balance as the reason.
Official reserves stood at $2.38 billion at the end of June, compared with .
20 billion at the end of last year.
Technical charts also show the dollar retains a medium-term bullish outlook against the rupee as the currency pair is firmly entrenched within an ascending channel pattern that has lasted since mid-January.
But the U.S. currency is likely to correct toward Fibonacci support at Rs. 101.16, the 38.2% retracement of the rise from late August, in coming sessions as daily stochastics staged a negative crossover in overbought territory Tuesday and both weekly and monthly stochastics are at overbought levels.
Quite strong support in the Rs. 101.00 region, which consists of the Aug. 16 high, the Aug. 29 low and 61.8% retracement, is expected to attract renewed buying interest based on the ascending channel that is in place.
As long as the ascending channel base, currently at Rs. 100.56, holds, the dollar is expected to resume its medium-term uptrend toward the channel top, now at Rs.101.76, in coming weeks. (Dow Jones)