Sri Lanka’s central bank combats inflation with negative real rates

Chandi Dharmaratne

Sept 15 (LBO) – Sri Lanka’s central bank said it was not raising interest rates despite expanding money supply, rising inflation and real interest rates being negative. .

The bank said it was holding the repo rate at which excess money is drained from the banking system at 9.125 percent, and reverse repo rate, the rate at which money is injected, at 10.625 percent.

“Having reviewed the recent economic developments and prospects, the Monetary Board at its meeting held on September 14 2006 decided to maintain the policy interest rates of the Central Bank at their current levels and to continue with the conduct of open market operations to decelerate the monetary expansion to the desired path,” Central Bank said in its September monetary policy statement.

“Inflation as measured by the point-to-point change in the Colombo Consumers’ Price Index (CCPI) which was 14.7 per cent in July 2006 increased to 15.3 per cent in August 2006.”

Meanwhile, the 12-month moving average inflation increased from 10.4 per cent in July to 10.8 per cent in August 2006.

The central bank also held rates steady in August, despite inflation being high.

Negative Gap

In June, the central bank raised policy rates by 25 basis points and in July by 12.5 basis points, but rising inflation had widened the negative real gap between interest rates and inflation.

Central bank says the current high increase in consumer prices is mainly a reflection of the pass-through of the increase in fuel prices.

The bank was also expecting 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 was at 18 percent, which the bank said had come down from 18-20 percent during January, while reserve money growth had ‘decelerated’ to 17 percent by August 2006.

External Sector

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 as the bank acted 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 grew by 6.1 percent in the first seven months while imports grew by 20.2 percent.

During the second quarter exports grew at a faster rate of 19.6 percent.

The expanding trade deficit was financed through private remittances which grew 24 per cent, and government dollar borrowings.

By end August the balance of payments had a surplus of 199 million dollars and reserves were at 2.5 billion dollars from 2.4 billion dollars in January, which is now sufficient to finance around three months of imports.

Growth Engine

Meanwhile the economy is expanding at a blistering pace with agriculture also bouncing back.

Senior bank officials said earlier that Sri Lanka’s economy grew by 7.7 percent and the first half growth was estimated at 7.9 percent.

“Major sub sectors of the manufacturing sector have also recorded a healthy growth during the first seven months of 2006 and are expected to expand further benefiting from the robust global economic growth and with the preferential market access under the GSP+ scheme,” Central Bank said.

“The services sector will continue to grow with major contribution from telecommunications, ports and financial services sub sectors.”