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Central Bank Governor Prof. W. D. Lakshman
The Central Bank yesterday announced multiple moves to tighten monetary policy, becoming the first in Asia to do so since and despite the worsening COVID pandemic, but justified its stance saying it will help macroeconomic stability and revive growth.
The Monetary Board of the Central Bank at its meeting on Wednesday decided to increase the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) by 50 basis points (bps) each, to 5% and 6%, respectively. This would also result in the Bank Rate, which is linked to the SLFR with a margin of +300 basis points, automatically adjusting to 9%.
To induce a faster response of the market to these adjustments, the Monetary Board also decided to increase the Statutory Reserve Ratio (SRR) applicable on all rupee deposit liabilities of licensed commercial banks (LCBs) by two percentage points to 4%, with effect from the reserve maintenance period starting on 1 September.
The Monetary Board expects these moves to iron out the prevailing imbalances in the domestic financial markets and the external sector of the economy, while pre-empting the build-up of any excessive inflationary pressures over the medium-term, thereby supporting greater macroeconomic stability.
“The upward adjustments in market interest rates and the expected liquidity deficit in the domestic money market would also help the economy to absorb the large amount of currency held by the public observed since the onset of the pandemic in early 2020,” the Central Bank said.
It will continue to monitor domestic and global macroeconomic and financial market developments and take appropriate measures to ensure that the economy reverts to its potential, while maintaining inflation in the targeted 4-6% range under its flexible inflation targeting framework.
The multiple moves bring to an end the expansionary monetary policy stance maintained for the past year by the Central Bank in view of the pandemic. This also saw interest remaining at historically low levels since July 2020.
Addressing the imbalance in financial markets was also called for by the Ceylon Chamber of Commerce when it called on the new Finance Minister Basil Rajapaksa recently. It suggested a small increase in local interest rates of about 25 to 50 basis points.
“This will help reduce the interest rate arbitrage between interest rates for dollar fixed deposit rates and local rupee deposit rates,” the Chamber said.
The Central Bank also said the upward adjustments in market interest rates and the expected liquidity deficit in the domestic money market would also help the economy to absorb the large amount of currency held by the public observed since the onset of the pandemic in early 2020.
As of 18 August, Rs. 967.6 billion worth of currency was in circulation, up by Rs. 133 billion, in comparison to the 2020 figure of Rs. 834.8 billion. Between February and December 2020, the increase was Rs. 151 billion.
The Monetary Board highlighted that the economy is on a recovery path despite pandemic-related disruptions; the external sector continue to face a multitude of challenges requiring coordinated measures; most market interest rates have reached low levels resulting in expected acceleration in credit flows to the private sector; possible upside pressures on inflation are being addressed through pre-emptive policy measures and tightening of monetary policy stance is expected to support greater economic stability.
Central Bank said some of its global peers have already commenced tightening monetary policy while several others have signalled a possible tightening in the period ahead. In the past three months, 19% of the global monetary policy decisions have been more towards tightening and 78% unchanged and 3% easing.
Speaking to journalists, Central Bank Governor Prof. W.D. Lakshman said the 5% economic growth forecast for 2021 is still being maintained despite the ongoing spike in COVID cases as well as the delayed recovery of the tourism sector. As per IMF forecast, GDP will grow by only 4% in 2021.
“With the successful rolling out of the National COVID-19 vaccination program and the Government’s strategy to impose only selective mobility restrictions, the momentum of activity is expected to sustain in the period ahead. Available indicators and projections suggest that the real economy would grow over 5% in 2021, and this momentum would be sustained over the medium-term,” the Central Bank said.
It said supported by fiscal and monetary stimulus measures, the economy is gradually making headway following the setback in 2020. As per the estimates published by the Department of Census and Statistics (DCS), the economy witnessed a stronger-than-expected recovery during the first quarter of 2021, recording a real growth of 4.3% year-on-year.
The economy is poised to record a higher growth rate during the second quarter of 2021, partly due to the sharp contraction observed in the corresponding quarter of the previous year. Possible disruptions to domestic economic activity from the re-emergence of the COVID-19 pandemic and related preventive measures could weaken the recovery to some extent during the second half of 2021.
The Central Bank said the implementation of the essential growth-conducive stimulus measures, which resulted in the availability of low-cost credit to the private sector, led to a sustained increase in the demand for merchandise imports since mid-2020.
With the increase in import expenditure outweighing the improvements observed in earnings from exports, the trade deficit continued to widen during the first half of 2021 over the corresponding period of last year.
Moreover, the expected recovery in the tourism industry could be further delayed due to uncertainties associated with the resurgence of the pandemic globally.
Workers’ remittances, which recorded a significant growth in 2020 as well as in the first few months of 2021, have also displayed some deceleration.
According to the Central Bank, the limited conversion by exporters and the advancing of imports together with some speculative activity, prompted by anomalies between interest rates on the rupee and foreign currency products in the financial market, exerted undue pressure on the exchange rate in the domestic market.
It said amidst these developments, all debt service obligations of the Government, including the settlement of the International Sovereign Bond (ISB) of $ 1 billion in late July 2021, have been duly met thus far in 2021.
Gross official reserves were estimated at $ 2.8 billion with an import cover of 1.8 months by end-July 2021. This, however, does not include the bilateral currency swap facility with the People’s Bank of China (PBoC) of CNY 10 billion (equivalent to approximately $ 1.5 billion).
Measures are being taken by the Government and the Central Bank to secure foreign financing from several sources in order to reinforce the level of official reserves in the near future.
The Central Bank said the Government continued to aggressively explore avenues to enhance non-debt-creating foreign inflows, by strengthening the domestic production economy, which would help strengthen the external sector in the period ahead.
Focusing on inflation, which remained moderate during early 2021, the Central Bank said it accelerated somewhat in recent months due to high food inflation and some acceleration in non-food inflation. Inflation is projected to hover around the upper bound of the desired 4-6% target range in the near-term.
“The envisaged improvements in aggregate demand conditions and the likely increases in global energy and other commodity prices may generate some inflationary pressures in 2022, requiring pre-emptive policy measures to ensure the maintenance of inflation in mid-single digit levels over the medium-term,” it said.
