Sri Lanka’s Central Bank likely to freeze main interest rates

June 12, 2006 (LBO) — Sri Lanka’s central bank is likely to keep its benchmark interest rates unchanged for the sixth month in a row, preferring a wait-and-see policy over the economy amid deteriorating security situation and a gradual rise in inflation. “There is at the present time no room for a Norwegian initiative in the peace process,” Norwegian envoy Erik Solheim told AFP in Oslo last week after failing to get the Tigers to negotiate. The repurchase rate (repo rate) is likely to stay at 8.5 percent, while the reverse repurchase rate may remain at 10 percent, according to six out of the seven analysts in a LBO survey.

The “reverse repo” rate is the level at which the central bank lends to commercial banks, backed by their government security holdings.

The repo-window is the key benchmark, which sets the floor in the overnight call money market, as it enables lenders to invest excess funds in treasury bills and bonds held by the Central Bank (i.e. at near zero risk).

The market is now short of cash caused by an outflow of foreign reserves and rates are hitting the upper reverse repo band.

But market interest rates such as the short term call money rates as well as Sri Lanka interbank offered rates are now above central bank’s policy rate band.

The weighted average call rates were 10.84 percent last week while the maximum rate peaked to 11.38 percent, but market participants were borrowing from the Central Bank around 9.75 percent.

The central bank’s rate-setting Monetary Policy Committee (MPC) is due to make their monthly announcement on June 16.

In May inflation jumped 5.4 percent, the highest monthly increase seen for at least ten years on the back of a 2.7 percent rise in April, but at least a part of this could be due petroleum price hikes, which are cost-push.

Though market players expect the bank to retain its ‘cool’ in the backdrop of galloping crude oil prices, the reality is somewhat different.

In May year on year inflation hit a 13.2 percent ending a eight–month downward trend.

Oil and oil-related products accounted for over 21 percent of Sri Lanka’s total imports, as soaring oil prices, which remained above 70 dollars a barrel, continued to push up the value of imports.

The Central Bank revised year end inflation figures upwards from 9.0-9.50 percent to 11.0 percent recently to accommodate spikes in crude, wheat and sugar prices.

“It thus appears to be a question of ‘when’ and not ‘if’ the Central Bank will now increase its policy rates in a bid to curb inflation,” says Economist Channa Amaratunga of Boston Asset Management.

While there was reasonable potential for a rate cut in first quarter of 2006 amidst a fall in inflation, this is now longer true, he says.

“We believe the Central Bank will take decisive action to control inflation by increasing its policy rates in the short term, probably this month itself,” Amaratunga said. “The extent to which rate hikes per se will succeed in controlling cost-push inflation however remains questionable.”

However economists say a rate rise may be needed to compress imports, in the context of the reserve outflow that became evident in May.

However the central bank’s current ability to keep the money markets short, may persuade the monetary board to keep rates steady.

The ability to keep the markets short depends on the borrowing requirement of the government.

In 2004, the Central Bank, which has fiscal dominance problems, worsened a reserve outflow by refusing to raise rates and printing large volumes of cash for the government.

The sudden rise in aggregate demand caused by such actions, automatically pushes up domestic prices and also boosts imports.

However the government has this year responded from the fiscal side by raising fuel prices, which will help contain a further deterioration of the fiscal front as well as containing overall demand in the economy.

Economic 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, which has killed over 680 people.

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 will also get revised in my view,” notes Maninda Wickremasinghe Managing Director/CEO First Capital Group.

Hopes for peace in Sri Lanka, however, have all but vanished after Norway failed to bring opposing parties to the table, after six-years of trying to broker peace.