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Sri Lanka to stand pat on key rates amid economic recovery

13 Apr 2021

Fitch Solutions recently stated that it continues to expect the Central Bank of Sri Lanka (CBSL) to keep its Standard Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR) unchanged at 4.50% and 5.50% respectively, through 2021.  At the 8 April monetary policy meeting, the monetary board maintained its policy rate at its historical lows, following 250bps of rate cuts in total in 2020. In its accompanying statement, the CBSL struck an optimistic tone, highlighting that “the Sri Lankan economy is expected to record a high growth momentum in the medium term”. Nevertheless, the CBSL maintained its commitment to keep monetary policy loose to ensure “continued support for a sustained economic recovery, in the context of the prevailing low inflation environment and well-anchored inflation expectations”. Fitch Solutions believe that the CBSL will have little need to cut its policy rates further, given that economic recovery is already underway.  “We forecast 2021 real GDP growth for Sri Lanka to come in at 4.8% from a 3.6% contraction in 2020. With economic activity likely to continue normalising further on strengthening domestic demand, the worst is likely over for the Sri Lankan economy. Both the manufacturing and services Purchasing Managers’ Index (PMI) readings have remained firmly in expansionary territory, standing at 59.4 and 56.5 respectively in February, driven by expansions observed in business activities.” Further, it believes that the CBSL will hold off further monetary easing as such a move will reduce the attractiveness of Sri Lankan assets and place further depreciatory pressure on the currency. As of 9 April, the rupee had already depreciated by 5.4% against the US dollar thus far in 2021, standing at Rs. 201 per USD.  Moreover, the country's foreign reserves only stand at $ 4.1 billion as of end-March. Although this would barely meet the recommended minimum three months of import cover, it is important to note that Sri Lanka has a further $ 2.7 billion of debt repayment due this year, accounting for 58% of the country's current foreign reserves.  “As such, should Sri Lanka not pursue strategies to ramp up its foreign reserves significantly, as repayment of this debt will take a huge toll on its foreign reserve position and the central bank's ability to manage volatility on the currency. A weakening rupee will also make repayment of foreign currency-denominated external debt more expensive. Indeed, the Sri Lankan authorities are already concerned about the depreciating rupee and have implemented capital and import controls to limit currency outflows since July 2020. As further monetary easing could trigger a further selloff in Sri Lankan assets, causing the currency to depreciate further, the CBSL is unlikely to cut its benchmark policy rates over the coming months,” it added. Fitch expects inflation to average 4.8% in 2021, up from the year-to-date average of 3.5% YoY over the first three months of 2021. Fitch’s forecast reflects our view for inflation to remain within the central bank’s inflation target range of 4.0-6.0%, thereby allowing the CBSL to keep monetary policy accommodative. Inflation rose to 4.1% YoY in March, from 3.0% YoY in January, owing to a sharp acceleration in food inflation to 9.6% YoY from 6.8% YoY over the period, while transport inflation remained elevated around the 5.0% level YoY.  “We expect headline inflation to continue trending higher over the coming months owing to a multitude of factors. The central bank has significantly ramped up money supply growth as seen in the acceleration in the growth print for M2b money to 23.7% YoY as of January 2021, up from 8.3% YoY just a year ago. This alone has already constituted significant upside pressure on domestic prices. Moreover, the surge in money supply growth has also had an adverse impact on the Sri Lankan rupee, which has tumbled by 11% since January 2020, making imports more expensive.”


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