Monetary Policy Review: No. 07 - October 2023
The Central Bank of Sri Lanka further reduces policy interest rates
The first monetary policy review by the Monetary Policy Board under the Central Bank of Sri Lanka Act, No. 16 of 2023 (CBA) was held on 04 October 2023. In this review, the Board decided to reduce the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank by 100 basis points (bps) to 10.00 per cent and 11.00 per cent, respectively. The Board arrived at this decision following a careful analysis of the current and expected developments, including low inflation and benign inflation expectations in the domestic economy, with the aim of stabilising inflation at the envisaged 5 per cent level in the medium term, thereby enabling the economy to reach its potential growth. The Board expects that this reduction of policy interest rates, along with the significant easing of monetary policy effected previously, including the directions issued by the Central Bank to licensed banks to reduce interest rates, and the significant reduction of risk premia on government securities, would accelerate the downward adjustment in market interest rates, particularly lending rates, in the period ahead. The financial sector is urged to pass on the benefits of the continued easing of monetary conditions to individuals and businesses adequately and swiftly, thereby supporting the envisaged rebound of the economy.
The significant deceleration of inflation has helped ease inflation expectations notably
Colombo Consumer Price Index (CCPI) (2021=100) based headline inflation (year-on-year) decelerated significantly below the target to 1.3 per cent in September 2023 driven by declines in both food and non-food inflation. Food items recorded deflation (year-on-year) for the third consecutive month in September 2023, while non-food inflation continued to moderate due to the easing of price pressures across many categories of the CCPI basket. CCPI based core inflation (year-on-year), which reflects underlying demand pressures in the economy, also moderated further in September 2023, reinforcing the disinflation process. However, this disinflation process is expected to turnaround from September 2023, with the dissipating impact of the favourable base, and converge towards the targeted level of inflation. Nevertheless, if the planned upward adjustments to administratively determined prices and tariffs, including electricity, as well as any
tax measures are implemented by the Government, a short-lived upward movement in headline inflation beyond the target is likely in the near term. Headline inflation is expected to stabilise at the target rate of 5 per cent over the medium term as reflected by the latest projections of the Central Bank.
Domestic economic activity is expected to rebound gradually during the second half of 2023 and sustain the recovery over the medium term
As per the GDP estimates published by the Department of Census and Statistics (DCS), the economy is estimated to have contracted by 3.1 per cent, year-on-year, in the second quarter of 2023. Industry and Services activities recorded a contraction during this period, while Agriculture activities recorded an expansion. The economy is projected to record a positive growth, year-on- year, in the latter half of 2023, supported by a broad-based expansion in all major economic sectors. While the continued normalisation of monetary policy and monetary conditions, improvements in business and investor sentiments, the relaxation of import restrictions, improvements in supply conditions, and the impact of growth promoting structural reforms are expected to support economic recovery in the period ahead, modest external demand conditions could weigh on expected growth in the near term.
The external sector is expected to remain resilient in the period ahead
During the eight months ending in August 2023, the trade deficit decreased notably, with a significant decrease in merchandise imports due to lower demand and import restrictions, and a relatively low decline in merchandise exports. Earnings from tourism and workers’ remittances improved considerably thus far in 2023 and are expected to improve further in the period ahead. Net foreign investment inflows were recorded in the government securities market so far during the year despite some sizeable outflows in recent months. The Sri Lanka rupee recorded an appreciation of around 12 per cent against the US dollar thus far during the year. Following the settlement of the bilateral currency swap with Bangladesh Bank and the provision of liquidity to the domestic foreign exchange market to facilitate the restructuring of Sri Lanka Development Bonds as part of the domestic debt optimisation (DDO) operation, the level of gross official reserves was estimated at around US dollars 3.5 billion as at end September 2023, including the swap facility from the People’s Bank of China.
Market interest rates have declined notably from their high levels while further decline is expected in the period ahead
Market interest rates, particularly lending rates, displayed noteworthy reductions in recent months as reflected by interest rate indicators. However, considering the presence of excessive interest rates on certain lending products and the inadequate downward adjustment in market lending interest rates relative to those of deposits, caps on interest rates on selected lending products were imposed by the Central Bank in late August 2023. In addition, broader guidelines were
issued to induce a downward adjustment in overall market lending interest rates on rupee loans and advances in line with the relaxed monetary policy stance of the Central Bank. The reduction of policy interest rates by 100 bps in this monetary policy review is expected to accelerate the reduction of market interest rates in the period ahead. Meanwhile, a reduction was also observed in the yields on government securities with falling risk premia following the finalisation of the debt treatment on rupee denominated instruments under the DDO operation. Although credit extended to the private sector by licensed commercial banks recorded some expansion during the period from June to August 2023, a noteworthy recovery is yet to be observed. However, the envisaged further reduction in market lending interest rates in line with the policy measures introduced thus far by the Central Bank and improved economic conditions would help boost credit flows to the economy in the period ahead.
Policy interest rates are further reduced in view of the faster deceleration of inflation
In consideration of the current and expected macroeconomic developments highlighted above, the Monetary Policy Board of the Central Bank of Sri Lanka, at its meeting held on 04 October 2023, decided to reduce the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank by 100 bps to 10.00 per cent and 11.00 per cent, respectively. The Board anticipates a swift and sizeable reduction in overall market lending interest rates in line with the monetary policy easing measures. The Central Bank will continue to closely monitor the developments in market lending interest rates and review the administrative measures appropriately. The Monetary Policy Board will continue to assess risks to the inflation outlook, among others, and stand ready to take appropriate measures to maintain domestic price stability in the period ahead while supporting the economy to reach its potential.
https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/press_20231005_Monetary_Policy_Review_No_7_2023_e_U53s8.pdf
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