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By Uditha Jayasinghe
The Central Bank yesterday kept rates steady predicting slowing inflation, potentially lower interest rates and subdued growth prospects for 2017 but called for the private sector to invest and have confidence in the domestic market.
In keeping rates unchanged the Central Bank disregarded a recommendation by the International Monetary Fund (IMF) to increase rates in its latest evaluation released last month. However, the IMF only highlighted tightening through macro-prudential measures and not necessarily through increasing interest rates.
Central Bank Governor Dr. Indrajit Coomaraswamy explained that the Monetary Board was of the view that tightening was unnecessary when the economy was performing below potential and the Government was well ahead in its fiscal consolidation targets.
“The IMF and we have different perceptions often. And we are not always wrong,” he told reporters with a veneer of light-heartedness.
However, the Governor also acknowledged Sri Lanka would continue to face challenges as relief measures for drought-hit areas are rolled out over the next few months. Slashing taxes on essential goods and increased imports of fuel and other items such as rice and sugar on the back of slower remittances would lead to current account pressure, he predicted.
“We think growth will be no more than 4.5% and there are some downsides to 4.5% as well. That’s to a significant extent due to weather-related disruptions. We have also had fiscal consolidation taking place, which has had an impact on domestic demand but that was necessary. One reason you are seeing benign interest rates and exchange rates is because of the good fiscal performance.
“The drought will cause some demand side pressures but we feel that can be accommodated. If you have good fiscal-monetary coordination, if one sees significant slippage, then it is up to the Monetary Board to tighten policy. That is what we have to watch carefully. At the moment we see no need for that.”
Nonetheless, the Governor was confident inflation would moderate. He projected inflation to increase over the next couple of months but reduce in November eventually ending the year at 5%.
“Inflation is roughly where we want it to be. The currency is adjusting in a very orderly way. The current account is the one area where the outcome is not as good as we hoped for but that is due to factors beyond our control and hopefully those factors will reverse themselves as the weather improves.”
The Monetary Report noted monetary expansion continued to remain high in May as well as in June 2017. While monetary growth was mainly driven by the expansion in domestic credit, net foreign assets (NFA) of the banking system also positively contributed to this expansion, it added.
Meanwhile, private sector credit that was growing at an elevated level during 2016 and early 2017, indicates clear signs of deceleration in recent months, although at a slow pace. In view of high nominal and real interest rates prevailing in the market, it is expected that growth of monetary and credit aggregates would moderate further during the remainder of the year. The recent decline in the yields on government securities is expected to gradually transmit to other market interest rates in the forthcoming period, the Monetary Report said. Private sector credit moderates to 18.6% in June, which resulted in banks extending a total of Rs. 80.3 billion.
“My gut reaction is we are close to the top of the interest rate cycle but there are important qualifications there; one is what happens to the Budget. If for various reasons there is slippage in the Budget we will have to respond to offset that. The other thing is if headline inflation goes up significantly then we have to be careful of results from that because it can lead to wage demand and expectations, in which case one may have to increase rates to anchor expectations,” the Governor said.
As securities interest rates reduce that will transfer to credit interest rates as well, Dr. Coomaraswamy assured. Stronger foreign inflows to Government securities would also ease pressure on rates.
“Market rates are coming down, even though the Monetary Board has done nothing, interest rates are reducing significantly. They will continue to come down and with a lag that will transfer to interest rates as well.
The Governor acknowledged private companies were more enthusiastic to invest abroad than in Sri Lanka but insisted the Central Bank was seeing hints the trend would reverse.
“Up to now that has been the case. That’s why I say foreigners are showing more confidence in the Sri Lankan economy than our domestic investors, so far. But some of our forward-looking perception indices seem to be sensing a change of perception.
“We really need investment now. There is always a tendency when growth slumps to loosen policy but that is completely the wrong thing to do because then you just get an artificial boost in growth, which is unsustainable. So there is no shortcut. We have to improve the investment climate, trade policy and reforms that increase the productivity of the economy. First the sentiments of the domestic sector need to be robust.”
About $ 400 million from the Hambantota Port deal will also flow into reserves this year the Governor said, $ 100 million immediately and $ 300 m after three months. Despite the flow of foreign exchange strengthening reserves to $ 6.7 billion by July, the Governor supported maintaining a flexible exchange rate to spur exports and encourage investment.
“The real effective exchange rate of the rupee is still overvalued so if we want to have a competitive currency, which in my view is crucial if we are to have an export transformation, for that we need a competitive currency. For that it needs to depreciate more but we will do it in a very orderly way that will not be disruptive. It is not in the best interests of the people of this country to have an appreciated currency. When you have an appreciated currency you are subsidising importers at the expense of our local producers. There is always a lot of political pressure to keep an overvalued currency because it keeps inflation artificially low and politicians like that because there are many more consumers than producers. But to survive as a country you have to produce.”
