In response to large public holdings of currency and fears of credit-driven inflation, the monetary board decided to increase the Standing Deposit and Lending Facility rate by 50bps each.
The Monetary Board has also increased the Statutory Reserve Ratio by 200 bps effective on September 1. The Central Bank continues to maintain a single mid-digit forecast for inflation.
CBSL Governor Prof. W D Lakshman noted that the general public is hoarding physical currency.
This was partly driven by the need to hold currency during the uncertainty caused by the pandemic but also by the low rate of real interest offered by the banking sector. The recent move is expected to gradually increase lending rates and have an immediate boost to deposit rates. There is an estimated excess of Rs 280 billion in currency holding by the public.
Prof Lakshman was speaking on August 19 at a Press Conference held virtually following the Monetary Policy announcement.
Though still at the preliminary stages of discussion the Treasury and the Central Bank are working on mechanisms to create more societally beneficial allocations of credit. Accordingly, the CBSL and Treasury are expected to create direct financing arrangements (bypassing the state banking structure) for State-Owned Enterprises at a special rate of 4%. Other mechanisms are also to be formulated which will be partly financed by the increase in the statutory reserve ratio.
Moves to tighten monetary policy are in line with global monetary policy trends. Sri Lanka will be the first in the Asian continent to tighten. 19% of global monetary policy decisions have been towards tightening, 78% towards maintaining rates, and only 3% towards loosening policy.
Prof Lakshman noted that though this represented monetary tightening it did not represent the end of the easing cycle in monetary policy. He confirmed that real borrowing costs would continue to remain low without returning to the excessive real borrowing rates that were apparent in 2019.
So far the monetary easing measures account for a stimulus of 18.2% of nominal GDP to the economy.
The largest component and the majority (11.6%) of this monetary stimulus were involved in the purchases of treasury bills that looked to offset tax reduction measures by the government.
The savings in interest cost are estimated at 2.1% and 1.8% of GDP to the private and public sectors respectively.
Prof Lakshman noted an anomalous drop in remittances through the formal channels to the economy in June and July. Accordingly, remittances, as measured by the Central Bank, have fallen by 35.4% on a Y-o-Y basis in July.
Central Bank research noted that there had been a rise in imports led by a rise in the cost of petroleum-based products and the cost of intermediate goods used in export production. Accordingly, the trade deficit for the first half of the year had increased from US$ 3.3 billion in 2020 to US$ 4.3 billion in 2021.
The CBSL Governor noted that the exchange rates were set broadly within a gentleman’s agreement between the banks and the regulator. He noted that there was no formal mechanism in place to set FX rates.
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