Low interest rates and growth

The Central Bank in its Road Map for 2021 has outlined its intention of keeping interest rates at single digit levels for a prolonged period of time. The key reasons for this is to boost Sri Lanka to achieve a much needed growth-turnaround this year after the economy contracted by an estimated 3.9% in 2020. Offsetting the COVID-19 impact will certainly be helped by lower interest rates but there are several other aspects the Government will have to focus on to put Sri Lanka on a sustainable growth path. 

At first glance the Central Bank’s dovish monetary policy appears sound because it is partnered with restrictive imports. Typically in Sri Lanka low interest rates trigger consumption rather than investment but since vehicle imports and other non-essentials have been choked there is greater chance of capital flowing to productive sectors. The Central Bank has pushed this possibility even further by promising to set up lending targets for specific sectors and eyeing a private sector credit expansion of 14% for 2021. 

However, with strong growth comes inflation and higher inflation can erode low interest rates. Therefore it is imperative that both monetary and fiscal policy is kept finely balanced to ensure there are demand and supply side issues that could trigger a change in headline inflation. Food inflation in particular can have a serious impact if not carefully monitored. Nonetheless, due to the economy growing at a subdued level for a prolonged period of time it also has the capacity to absorb a moderate level of liquidity before leading to any overheating.

On the external front the Government is still facing questions over debt sustainability and will have to keep a close eye on the rupee. Sri Lanka will have to repay about $4 billion this year and has limited reserves at its disposal. With successive sovereign downgrades it cannot raise funds from international financial markets and many investors remain concerned about the Government’s plans on this front.

Sri Lanka has also been encouraged by numerous entities and experts, including the World Bank, to continue reforms that would see key structural changes to its economy including continuing fiscal consolidation by broadening the tax base and aligning spending priorities; shifting to a private investment-tradable sector-led growth model by improving trade, investment, innovation and the business environment; improving governance and SOE performance; addressing the impact of an aging workforce by increasing labour force participation, encouraging longer working lives and investing in skills to improve productivity; and mitigating the impact of reforms on the poor and vulnerable with well-targeted social protection spending.

These hefty reforms will not be helped much by lower interest rates and the Government has to commit to a reform agenda. The Central Bank Road Map states that the policies introduced after the economic opening of 1977 will be “vigorously reviewed” but there is also the danger that once global value chains recover from COVID-19 they will be reformed, leaving Sri Lanka out of the loop once again. Therefore changing policies should ensure that Sri Lanka is not left isolated after the world rewires itself post-COVID. 

The Central Bank’s Road Map is critical for Sri Lanka’s success but it needs to be underpinned by much more from the Government to genuine change to be achieved.