COLOMBO (EconomyNext) - Sri Lanka has cut its policy interest rates by 0.5 percent despite concerns over higher domestic borrowing to cover state spending, saying counter measures could be taken if there are negative fallouts.
The policy rate corridor is now 6.0 percent to withdraw excess liquidity in money markets, which sets the rate floor. The rate at which money is injected has been brought down from 8.00 to 7.50 percent.
Sri Lanka's inflation fell to 0.1 percent in March from 0.6 percent in February as domestic credit remained muted and a stronger dollar pushed the price of imported and exported commodities down.
In the first quarter the state which controls prices, cut retail fuel prices, generating a delayed positive 'supply shock' to prices which would have happened earlier if petroleum was market-priced.
Inconsistent
In the first quarter gilt interest rates rose as the government borrowed large volumes of money from domestic markets and a controversial auction of bonds sent the 30-year yield up by over 200 basis points in a single day, killing the secondary activity.
"Current behaviour of market interest rates is viewed to be inconsistent with the continued low inflation and investments needed to address concerns on economic growth for the year," the Central Bank said.
Wednesday's rate cut comes six weeks after the Central Bank closed a 5.0 percent window outside the regular pushing up the floor rate by 150 basis points on February 28.
Other analysts say the current political uncertainty, budget deficit, retrospective taxes, targeting of small and medium businesses with sweeping price controls perhaps not seen from the 1970s by the Trade and Commerce ministry may also be affecting business confidence.
Though private credit seems to have slowed after the new administration came to power, reducing the potential for sharply higher aggregate demand, the effects on demand from higher state-driven consumption is not yet clear.
"If any of subsequent interim effects of further monetary relaxation are found to be of concern over other economic variables, a mix of other monetary policy tools is available to fine-tune such effects…" the Central Bank said.
If gilt rates go down - even temporarily - investors who bought bond at higher rates earlier in the year, would be able to sell them at a profit.
External Balance
Sri Lanka's foreign reserves have also been under pressure from August 2014 partly due to a pick-up in credit, but also due to errors in domestic liquidity management, even before the fiscal situation deteriorated further in 2015, analysts have pointed out.
Sri Lanka is pegged to the US dollar and any pretence of monetary policy independence, depends on an eventual willingness to lose foreign reserves or allow the rupee to depreciate, classical economic analysts point out.
While it is possible to have higher than required interest rate demanded by domestic private and state credit trends, it is not possible to do the opposite, regardless of inflation concerns, if total credit growth picks up without creating balance of payments problems.
The Central Bank said foreign reserves increased from 6.8 billion dollars from end March 2015 to 7.0 billion rupees to date.
The Central Bank however said official reserves would go up from the proceeds of a swap with India.
"Overall, the outlook in the balance of payments in 2015 remains favourable with continued inflows expected from current account related transactions, significantly lower expenditure on petroleum imports and receipts to the government, the banking sector and other private corporates," the Central Bank said.
Classical style analysts however say if consumption and credit is strong, all inflows will result in imports and other outflows. Foreign reserve growth happens when total credit by the domestic banking sector is lower than deposit creation, and external loan repayments.
A central bank in any country generate credit and economic bubbles, mal-investment and subsequent collapses mainly by manipulating interest rates downwards when credit demand in a banking system picks up.
Sri Lanka's new administration has however given a public commitment that it will auction government debt, which may allow state cashflow problems to be communicated quickly to credit markets, regardless of policy rates, helping maintain economic stability.
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