Sri Lanka becomes first in Asia to tighten policy in pandemic era

The Central Bank of Sri Lanka (CBSL) became the first in Asia, to raise interest rates since the pandemic began. The central bank increased the standing deposit facility rate and the standing lending facility rate by 50 basis points each to 5% and 6%, respectively. It also increased the statutory reserve ratio by 200 basis points to 4% with effect from Sept. 1. CBSL said that these decisions were made with a view to addressing the imbalances on the external sector of the economy and to preempt the buildup of any excessive inflationary pressures over the medium term, amidst improved growth prospects.

The Sri Lankan economy is gradually making headway after the negative impact of the pandemic in 2020. It is poised to record a higher growth rate during the second quarter of 2021, which is partly due to the base effect. But it also cautioned that there could be some weakness in the second half due to further outbreaks of infections. Inflation in recent months has accelerated due to higher food prices and some uptick in non-food inflation.  The July Colombo consumer price-based inflation rose 5.7% compared with June’s 5.2%, according to the latest data. Sri Lanka sovereign dollar bonds surged after the rate increases while the CSE All share index fell 1%.

Trisha Peries, head economist research at Frontier Research said that the policy rate hike has likely been taken as a measure to mitigate excessive pressures on the currency. And that is, even though the CBSL’s official rate hasn’t changed yet. The CBSL said the stimulus measures taken after the pandemic hit the economy resulted in low-cost credit which, in turn, led to a sustained increase in imports. And also added that the increase in import expenditure outweighing the improvements observed in earnings from exports. And then, the trade deficit continued to widen during the first half of 2021 over the corresponding period of last year.

Tourism contributes more than 12% to Sri Lanka’s GDP and the pandemic has dealt a major blow to foreign currency earnings. The Sri Lankan rupee is down about 8% this year. Gabriel Sterne, head of strategy services and global EM research at Oxford Economics said that the real issue is the balance of payments. The way interest rates normally work is to give incentives for investors to come in, but when they have capital controls, as Sri Lanka does, that makes it difficult. The government is actively looking for funding sources but has refrained from seeking a bailout from the International Monetary Fund. Peries said that they think it’s likely that there could be around one more rate hike before the end of the year. Which is particularly looks like they are moving towards an IMF programme, along with what is expected to be a tighter budget announced for 2022.