Sri Lanka’s Central Bank continues to fight inflation with negative interest rates

November 14, 2006 (LBO) – Sri Lanka’s central bank on Tuesday froze interest rates, maintaining a wait-and-see policy over the economy, amidst soaring inflation, an expansion in money supply and real interest rates being negative. The bank said its benchmark reverse repurchase rate, used to manage liquidity and contain inflation, will remain at 11.125 percent.

The short-term repurchase rate at which it lends to commercial banks stays at a 3 ½ month high of 9.625 percent, the bank said following its monetary policy meeting on Monday.

The central bank’s unscheduled 50 basis point increase in September has taken the repurchase (repo) and reverse repo (reverse repurchase) rate up to 87.50 basis points.

Rising inflation has widened the negative real gap between interest rates and inflation and the bank says high consumer prices are due to the passing on of fuel costs to users.

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.

“This increase in the CCPI due to the upward revision of administered prices would be only a one-time increase in prices, but would bring beneficial results by way of better fiscal management by eliminating or reducing the subsidy component of the government budget, which otherwise has to be funded by borrowing from the banking sector,” the bank said in a statement.

However, former Deputy Finance Minister and UNP parliamentarian Bandula Gunawardena scotched the bank’s reasoning for high inflation.

“Inflation has now gone up to 17.2 percent, and oil prices are falling. 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,” Gunawardena, who also an economist said.

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.

Meanwhile analysts say market rates have moved ahead and upward movements in treasury rates after the last rate hike gave 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.

Taking a cue, the Central Bank expects that ‘the tight monetary policy measures’ taken so far, would ‘help contain the high growth in money supply and thereby reduce inflationary pressures in the economy.’

Broad money growth has eased to around 16 percent in September, which the bank said had come down from 18-20 percent during early part of the year, while reserve money growth had ‘moderated’ to 17.0 percent by first week of November.

Bank credit to the private sector is expanding by over 23 percent, the monetary board “has observed with concern”, as people buy consumer durables, motor vehicles and invest in property to avoid negative returns on their savings deposits.

“The current demand pressure in the economy, higher inflation and the regular use of reverse repo facilities by some banks (are) leading to high credit expansion. In that context, the Central Bank has cautioned commercial banks against using the reverse repurchase facility excessively as it contributes to high credit and monetary expansion,” the statement said.

Governor Nivard Cabraal told businessmen recently that the measures to tighten credit growth are aimed at curbing 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.”

Analysts say reserve money growth had started to slow during the second half of the year as the exchange rate and foreign reserves and net foreign asset growth tumbled, with the Central Bank stepping in to steady the currency.

Government borrowings have been crucial to shore up Sri Lanka’s official reserves which, critics say have been under pressure due to rising central bank credit to government.

Sri Lanka’s exports for the nine months to Sept, rose 8.8 percent, while imports grew by 17.4 percent.

The expanding trade deficit was financed through private remittances which grew 23 percent from Jan-Sept, government dollar borrowings, foreign direct investments and foreign loans.

Foreign direct investments or FDI has reached 340 million dollars from Jan-Aug, while the government signed up for 596 million dollars worth of loans and grants during the same period, the statement said.

By first week of November, the balance of payments had a surplus of 140 million dollars and reserves were at 2.47 billion dollars, sufficient to finance around three months of imports.

Today’s announcement did not take market players by surprise. Dudeepa Ratwatte, Head of Global Markets at Commercial Bank of Ceylon, says his “gut feeling” is that the bank may go for a 25-basis point hike at its next policy meeting in January. The bank’s next monthly policy announcement due to come out on December 15, 2006.