FREE

Economic Monthly for Sri Lanka - August 2016

​Executive Summary

-The Central Bank raised policy rates for the second time this year to curb credit growth and fill fiscal gaps. Response of market rates so far for the second hike has been limited.

-Foreign reserves increased in July owing to receipts of the sovereign bond issue. Foreign inflows to government securities continue at healthy levels. However, deteriorating external trade balances and significant foreign loan repayments remain key concerns.

Focus 1 – In this focus we are taking a look at foreign financing (project loans and grants) the government has received/signed so far in 2016 with an analysis on the breakdown by financing sources and type of projects.

Focus 2 – Given the second policy rate hike by the Central Bank (CBSL) for this year we have looked at how market rates have moved so far to gauge the impact of the tightening cycle in terms of movement in 12 month T-Bill rate, 4-year bond yield and the AWPLR.

In Our Report

Monetary policy to fill fiscal gaps

The Central Bank (CBSL) raised policy rates for the second time this year in its July Monetary Policy Review. Credit granted to the private sector has continued to be at high levels despite the rate hike in February this year and the resultant increase in market rates. The CBSL pointed out that a continuation of this trend could create excessive demand and high inflation in the future.

The measure is also expected to fill the gap left by a delay in necessary fiscal measures which were expected to increase government revenue and curb demand. In that sense, this can be viewed as a forward looking policy decision and could be positive for sentiment as well as it signals the readiness of monetary policy to support economic stability given any failure in fiscal policy measures.

Following the two rate hikes, market rates have adjusted upwards significantly. The 12 month T-Bill rate has increased about 360 basis points (BPS) so far in the year and the 4 year bond yield has added about 300 BPS. However so far, rates have responded very little to the second rate hike, with an initial increase of about 20-30 BPS followed by a decline to levels slightly higher than the levels seen before the second hike. In Focus 2, you can read more about how key market rates have moved in response to the two rate hikes this year.

Other positives and negatives

Foreign reserves increased by about USD 1.2bn in July, lifting the total figure to USD 6.5bn from the multi-year low of USD 5.3bn in June. This is largely owing to the receipts of the sovereign bond issue done during the month.

Foreign investments in government securities have continued to rise steadily. Investors have poured another Rs. 16bn into government bill and bonds in the last four weeks. Since early June, when the outflows trend turned into steady inflows, foreign inflows to government securities have totaled about Rs. 65bn so far.

With these foreign inflows, the CBSL has reduced its interventions to support the LKR in the currency market. It reduced its USD sales in July which resulted in net purchases of USD during the month, as opposed to the net sales we have been seeing in recent months. Less intervention in the forex market is very much in line with recommendations advocated by the IMF program as well, hence can be seen as a positive development.

The trade deficit expanded on a cumulative basis in the January-May period this year. We saw a contraction in the trade deficit from the beginning of the year mainly due to a decline in imports. Even though imports have continued to fall, a steady decline in exports in now weighing on the overall deficit. The lackluster demand in key global markets for tea exports is the key reason for the fall in exports. Weak growth in textile and garments have also added to the woes.

We have repaid about USD 3bn in foreign loans and interest in the first half of this year, according to data published by the CBSL. However, things don’t look any better in the second half of the year. July-September period is expected to see another USD 1.6bn in repayments, with more outflows of about USD 3.8bn scheduled from October this year to June 2017.