Monetary policy review : Only 50% chance of rate cut: FC Research

First Capital (FC) Research says there is a 50% possibility of a rate cut when the Monetary Board of the Central Bank of Sri Lanka (CBSL) meets for its scheduled monetary policy review later this week.


“Our previous pre-policy report had assigned a 60% probability for a rate cut in 20 October and 75% probability on 20 November. However, considering the improved macroeconomic indicators, we have reduced the probability of a rate cut by 10% to 50% on 20 October and by 25% to 50% on 20 November,” it said in its latest pre-policy analysis.

The following are the arguments for and against further relaxation in monetary policy FC Research highlights in the analysis report.


Arguments against further relaxation in monetary policy

Domestic financial conditions have eased substantially with banking system liquidity remaining in surplus – banks have abundant liquidity, following the CBSL infusing ample liquidity into the banking system via increased CBSL holdings (money printing). However, outlook for credit seems lacklustre given the uncertainty surrounding the pandemic.

Improvement in high-frequency indicators in the economy – recovery of manufacturing activities continued in August 2020 (Index Value 57.9) as reflected by PMI Manufacturing, benefitting from the normalisation of business activities in the country. PMI Services continued to expand for the third consecutive month with the index reaching 56.0 in August 2020. Additionally, the Index of Industrial Production (IIP) for July 2020 increased to 111.1 from 92.8 in June 2020. Political stability after the general election and a slow return to normalcy was depicted in the LMD-Nielsen Business Confidence Index (BCI) during June-September 2020 reflecting an improvement to 123 from 96. Domestic economic activities, which were adversely affected by the Covid-19 pandemic, are expected to recover in Q4 of 2020, thus not requiring further relaxation in policies.

Credit to the private sector reflects a gradual normalisation of economic activities – private sector credit rebounded in August 2020 by Rs. 78.3 billion, for the first time since April 2020 reflecting the fact that both businesses and individuals are accelerating their economic activities to make up for the lost opportunities during the lockdowns period.


Arguments for further relaxation in monetary policy

GDP growth in 2020E is expected to remain in the negative territory – FC 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%. Amidst the lack of demand for credit, import restrictions, and the slowness in recovery of consumer demand, GDP growth is expected to turn positive only by Q4 of 2020. Accordingly, GDP growth can be considered as a major factor favouring the further policy easing at the upcoming review.

Consumer confidence remains muted with weak demand – the pandemic-led disruption has had a lasting impact on the income of individuals with businesses being shut and either lay-offs or pay cuts experienced by salaried professionals. The lower disposable income in the hands of consumers will have a bearing on the demand for consumption with discretionary spending being either deferred or cancelled for a period of time. However, higher credit growth and consumer demand can be aggravated through a further policy easing.

Government leans heavily on domestic sources of funding – FC Research expects Sri Lanka’s budget deficit in 2020 to reach 10% of GDP. Generally, fiscal deficit is funded via domestic and foreign sources of borrowing. Lack of foreign direct investment (FDI) and limited foreign borrowing options in the current period may push the Government to borrow predominantly from the domestic market. The decline in domestic interest rates in response to the aggressive monetary easing delivered the required support to soften the pandemic impact on the economy; thereby maintaining a low-interest rate environment or further reducing interest rates to benefit government finances.

FC Research noted that its previous pre-policy report proved accurate.

“In-line with our expectations, at the last policy meeting held in August 2020, CBSL maintained its accommodative monetary policy stance, particularly as market lending rates are yet to reflect the full passthrough of policy easing measures implemented thus far,” it said.