Why another hundred?

Yesterday, the Central Bank of Sri Lanka (CBSL) increased policy rates by 100bps. This means that the very short-terms rates i.e. the SDFR and SLFR will be increased by 1% to 14.5% and 15.5% respectively.

Broad guidelines were also issued to the banking sector in order to provide concessions on certain loans, particularly to SME and Tourism sector related borrowings, while overall sentiments remained that this move, even with recessionary pressure being felt, was needed.

The main point under consideration was the political instability and risks associated with going back on promises, both domestically and to international actors. Certain key issues regarding public reforms in electricity, fuel and even the national carrier are yet to be addressed by the current Government. Coupled with the stress of the prevailing fuel crisis and supply shortages, a wave of public upheaval is not unlikely, with many likening the ground situation to the 2011 Arab Spring.

Moreover, deteriorating external liquidity position which stood at $ 1.9 billion in foreign reserves in May would worsen, owing to a weakening rupee. With no reliable credit lines on the horizon, a rate drop would be the beginning of the end of public finances, first for rupees and then forex wise.

Therefore, tighter policy rates were an inevitable evil to alleviate pressure on the currency and foreign reserves. Although discussions with the IMF are ongoing, a clear shot at reaching a staff-level agreement by the end of the month is palpable. A proactive measure to ensure stability; the nitty gritty of external debt restructuring has, to it, its own skink that only increasing policy rates can be considered a deep breath of fresh air on to.

Inflation being 54.6% in June can cause alarm bells to sound among consumers while coupled with increased taxation can point to higher returns requirements for investors. The rate of inflation is predicted to increase to 70% levels owing to energy market prices and continuing supply chain disruptions.

Despite rising inflation, the market remains hawkish, or expects a tighter monetary policy stance by CBSL to combat external pressure while the real economy is likely to experience a modicum positivity post-COVID.

The austerity stance set by the Government by improving taxes and the tightening of its belt, albeit not in all aspects, addresses concerns on the future sustainability of fiscal drains. Accordingly, the reward by CBSL for the economy for higher inflation and increased taxes can in fact be higher rates to compensate for abysmal real income and market participants’ lost margins.

The last week of June saw the secondary market yield curve edge upwards following primary market auctions. Bond and bill auctions that week experienced increased rates across the board with acceptances lower than the offered amounts. Market participants took the side-lines and did bid higher to compensate for budding uncertainties.

Given negative market developments and prevailing negative real returns, another rate hike was needed to meet expectations of the market maker to restore confidence and activity. Amidst the ballooning fiscal deficit, higher rates and encouraging investments via primary market entry may enable CBSL to downscale stockpile debt holdings. Standing at Rs. 2.1 trillion, this would improve the banks books significantly as the debt would be priced right, for the risk it holds.

Moreover, a rate hike can aim to drop the arbitrage spread between the short term three-month T-bill rates currently at approximately 23.85% and the very short-term interbank rate at 14.50%. This takes away the opportunity by banks and non-banking financial institutions to hoard, encouraging more deposit transactions into the system inadvertently improving bank system liquidity.

As per the 2021 article IV consultation of IMF, tighter monetary policy was a key recommendation of the comprehensive strategy. Therefore, even with the rising inflationary pressures, given they are not demand driven, the CBSL was right to consider further tightening policy rates.

However, the direction can be praised, only time will tell of the magnitude of the raise. As countries world over brace for a tightening frenzy, central banks would fight to take the plunge on the unpopular way forwards and tighten to escape further ruin and even stagflation – high inflation with little to no growth prospects.