Sri Lanka policy turns more hawkish

June 20, 2006 (Dow Jones)–Sri Lanka’s central bank signaled a more hawkish stance when it increased its policy rates sooner than expected last week. Although a return to a tightening had been anticipated, Friday’s surprise 25-basis-point increase each in the repurchase and reverse repo rates highlighted the authorities’ growing concerns over rising inflation.

“This month’s increase may not be sufficient to contain the inflationary pressures over the medium term. We are definitely in for more hikes in the coming months,” said an analyst at a local bank.

As money supply growth accelerated amid stubbornly high global oil prices, the central bank recently raised its inflation target to 11% for the year, up from 8%-9% earlier.

As a result, analysts expect the central bank to increase its repo and reverse repo rates by another 50-75 basis points before the year is out. The central bank has kept those rates unchanged since an upward adjustment in December.

It wasn’t so long ago that the central bank was hinting at a loosening as inflation edged markedly lower in the first few months of the year.

However, that lower inflation trend reversed after the government increased domestic fuel prices in April, and again in June. The price of diesel – used for public transportation and in industry – shot up 15% as a result. Higher transport costs usually push up food prices, a major component of the consumer price index basket.

“The possibility of a rate cut doesn’t exist anymore. It’s now a matter of how much they will raise rates this year, because higher petroleum costs have put upward pressure on inflation,” said Channa Amaratunga, economist at Boston Asset Management.

Sri Lanka imports all its crude oil requirements, and its oil import bill hit $1.6 billion last year, up from an annual average of around $800 million in the years before 2005, according to finance ministry statistics.

After averaging 11.6% in 2005, Sri Lanka’s consumer price index rose 9.4% in the 12 months ended May, compared with 9.2% in the year ended April.

The central bank justified its rate hikes this month, citing reserve money growth of around 18% in May, up from around 15.8% at the end of December. Broad money supply has also been rising, by around 20%, largely due to an expansion in private sector credit.

Reserve money, a basic form of the country’s money supply comprising domestic bonds and bills, usually has a direct impact on inflation. Broad money has a longer-term impact on domestic prices.

“This situation calls for the adoption of appropriate policy measures from both monetary and fiscal fronts to contain inflationary pressures,” said the bank, adding its response had become “more urgent” because of persistently high oil prices.

Last year, it went on an aggressive monetary tightening, raising the policy rates by a total 125 basis points, when inflation rose, also on the back of high oil prices.

A return to tighter policy measures this year isn’t totally unwelcome. Higher rates could help defend a beleaguered Sri Lankan rupee which has slipped about 1.5% against the U.S. dollar for the year to date, pressured by importer demand as well as fears that simmering tensions between the government and rebels could break out into another full-scale war.

The conflict between the government and Tamil Tiger rebels has escalated since April with rising violence threatening a 2002 ceasefire.

Last week, a suspected rebel attack on a passenger bus in a predominantly Sinhalese area in the north killed over 60 people, making the incident the worst single act of violence since the truce. The government retaliated with limited air attacks on rebel bases in the north and east.

The local currency appreciated by 2.3% in 2005, boosted mainly by post-tsunami donor fund inflows. Despite an improving economy, the rupee hasn’t benefited.

Official forecasts are for the economy to expand by around 7% this year, as key sectors such as telecommunications, tourism and construction contributing to what the central bank describes as “healthy” economic growth. Gross domestic product grew 6% last year.

Nivard Cabraal, secretary at Sri Lanka’s Policy Planning Ministry, said last week the economy likely grew more than 7% on year in the January-March quarter, helped by strong growth in services and exports, particularly of textiles and garments.

Cabraal’s forecast is slightly above the 6.5% average prediction of five analysts polled by Dow Jones Newswires, and compares with growth of 6.3% and 4.8% in the fourth and first quarters of 2005, respectively.

The central bank is expected to announce official first quarter GDP data by end-June. The bank’s next monetary policy announcement is scheduled for July 14 with analysts expecting the bank to keep rates unchanged and continue with its upward adjustments later in the year.