The Central Bank of Sri Lanka (CBSL) is likely to maintain the same policy stance in this week’s monetary policy review, but given the concerns around economic growth, the CBSL is likely to retain the monetary policy stance at “accommodative”, First Capital Research (FCR) said in its pre-monetary policy report yesterday (24). FCR believes that there is a 50% probability to hold rates due to improvement in high frequency indicators and that there is a 25% probability for 25 bps and 50 bps, respectively, to support economic growth.  

Arguments against further relaxation in monetary policy 

Improvement in high frequency indicators with surplus liquidity in the system As a response to the measures taken by the government, private sector credit has improved to Rs. 87.4 billion in September while market liquidity has reached Rs. 140.0 billion by 13 November, indicating that there is surplus liquidity in the system. Moreover, the unemployment rate, which was at 5.7% in the Q12020 has declined to 5.4% in the second quarter. These indicators suggest that economic activity has remained steady without much deterioration in Q2, FCR said. “Except the GDP growth numbers, where the Q22020 figures are yet to be seen, other indicators are signifying a recovery, questioning the need of further policy easing at the upcoming review.”   Extended moratorium: A solution for grievances Considering the encounters faced by the businesses and individuals due to the second wave of Covid-19, the CBSL has extended the debt moratorium for another period of six months commencing 1 October 2020. FCR believes that the extension of the moratorium is one of the relief packages offered by the CBSL for individual/businesses to revive their business activities.   Rock-bottom market rates In response to previous monetary easing measures implemented by the CBSL, to bring down costs of borrowing of businesses and households, both market deposit and lending rates were adjusted notably so far during the year. The AWPR declined to historic lows in recent weeks, while banks’ lending rates also witnessed a downward adjustment in line with the CBSL’s expectations. FCR believes that considering the recovery in private credit and historic low levels in the AWPR, there is no vital requirement for the CBSL to provide a rate cut and to further bring down the market lending rates drastically.

 

Arguments for further relaxation in monetary policy

  A thrust for development: The need of the current Government First Capital Research estimates that Sri Lanka’s GDP would see its steepest contraction in history of -5.8% in 2020 following the unexpected contraction in Q1 GDP growth of -1.6% while Q2 GDP figures are yet to be seen. However, the current Government’s key drive is the development-oriented economic growth which was spelled out through the Budget 2021 as well. Accordingly, the Government plans to reach 6% and above GDP growth during the next five years commencing from 2021. “As we believe, a development-oriented budget coupled with a further low interest rate environment can support the Government’s medium-term goals. Therefore, the need to accelerate the GDP growth can be considered as a major factor favouring further policy easing at the upcoming review,” FCR said.   Access to less expensive domestic funding It is reasonable to assume that the Government is more focused on domestic funding to finance the budget deficit. This is reflected by the improved domestic-to-foreign debt ratio to 54:46 by end-July 2020 from the previous 51:49 as at end-2019. In the midst of limited access to international financial markets, the Government will opt to rely more on domestic borrowings to finance the budget deficit, and hence easing rates at the upcoming policy meeting results in reduced funding cost favouring the Government, FCR noted.   Yields heading north with auctions being undersubscribed Despite the improved liquidity position, yields in the secondary market witnessed a slight increase with low activities as market participants followed a wait-and-see approach amidst the looming uncertainty. The Treasury Bond auction on 12 November and Treasury Bill auction on 18 November were both undersubscribed by a considerable amount, reflecting the lack of clarity of market participants with the given economic condition and Covid-19 impacts. FCR believes a rate cut would be a sweetener to sustain the yields at the current low levels and to enhance the activities of the secondary bond market.     (conclusion para) In-line with FCR’s expectations, at the last policy meeting held in October, the CBSL maintained its monetary policy stance, particularly as market lending rates were yet to reflect the full passthrough of policy easing measures implemented up to that point.