Sri Lanka likely to maintain key interest rates, despite deteriorating security situation

May 14, 2006 (LBO) – Sri Lanka’s Central Bank is likely to maintain its policy rates for the fifth straight month amidst a possible bottoming out of inflation, analysts said Sunday. “The present uncertainty (in the security situation) would keep the authorities away from any downward revisions…It’s too early to look at any upward revisions either,” observes Hasitha Premaratne, Head of Research at HNB Stockbrokers.

– By Mel Gunasekera However, state coffers could come under severe strain to finance unexpected military spending following an escalation of violence between the government and the Tamil Tiger rebels, which has seriously dented the four-year truce pact.

If the government digs deeper into the domestic debt market – there are signs that things are being controlled through state pension funds and banks – policymakers may be forced to raise rates.

The Central Bank’s repurchase rate currently stands at 8.75 percent and the reverse repurchase rate is at 10.25 percent.

The repurchase rate is the return on cash deposited by commercial banks with the central bank and the reverse repurchase rate is the cost of borrowing from the Central Bank.

Following the monetary board meeting, the bank is due to announce its monthly monetary policy announcement early Wednesday morning.

The bank raised key interest rate by 1.25 percentage points in four stages in 2005, to cool inflationary pressures brought about by excessive credit expansion.

Since then, inflation has fallen by around 50 basis points per month from 12.5 percent in October 2005 to 9.2 percent in April 2006, giving the bank room to cut rates to encourage economic expansion.

However, point-to-point inflation rose sharply from a 23-month low of 6.4 percent in March 2006 to 9.2 percent in April 2006, as the government raised fuel prices by 8.00 rupees mid-April, for the first time since June last year.

“We believe that the rise in point-to-point inflation is an advance reflection of the impact of the retail fuel price hike on 15 April,” notes economist Channa Amaratunga of Boston Asset Management.

But prices spike up usually in April due to New Year holiday season demand as well as supply shortfalls.

This year cash outflows from the banking system during the festival holiday season were at a record high of 165 billion rupees.

According to weekly retail prices released by the Central Bank fish and vegetable prices have started to come off their April peak.

Petroleum prices have low direct weighting while calculating inflation data, since the basket is heavily weighted (62 percent) towards food items. But food prices are influenced by rising transport costs, which in turn has a knock-on effect on inflation.

Bus fares have already been raised since and Amaratunga says the impact of the recent fuel price hike will be more accurately reflected in the near term inflation data.

While average inflation appears close to bottoming-out, and the rate of monthly decline will certainly ease in the short-term amidst likely higher food prices, before possibly even picking up in the event a further retail fuel price hike to reflect global crude oil prices.

The current decline in inflation can certainly accommodate a rate cut, notes Amaratunga. “We believe that the Central Bank will defer such a decision until the impact of the recent petroleum retail price hikes and their likely upward impact on inflation becomes clearer.”

With the economy also depicting steady growth momentum, of a robust 6.3 percent during the last quarter of 2005, Amaratunga says there is little necessity to cut rates to kick-start the economy.

The South Asian island’s economy has had uninterrupted expansion since a February 2002 ceasefire, which put a stop to three decades of civil war, which claimed the lives of more than 60,000 people.

Growth may slow if peace talks between the government and separatist Tamil Tigers, fail to support the truce that was threatened by an escalation in violence since December.

Increased violence in Sri Lanka’s north and east since December threatened the ceasefire and jeopardised 4.5 billion dollars in international aid pledged to the island on conditions that progress is made toward settling the civil war.