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Sri Lanka has a 50-pct chance of rate cut

ECONOMY NEXT | 05.04.2019

There is a 50 percent chance of cut in Sri Lanka’s 9.0 percent ceiling policy rate and a narrowing of a policy corridor on April 08, a financial research house has said.

“First Capital Research allocates a 50 percent probability for a policy rate cut in April 2019, as we are of the view that policy intervention is appropriate to address the overly sluggish economic growth,” the firm said in a research note.

“Keeping in line with the possible introduction of a single policy rate, we believe a rate cut, if at all, will be applicable only to Standard Lending Facility Rate.

“However, considering the negative liquidity position we allocate a further 50 percent probability for no change in rates as CBSL may consider to delay the rate cut upto the next policy meeting in May 2019.”

Sri Lanka’s central bank has already started injecting 7-day cash at around 8.50 percent by end March down from close to 9.0 percent earlier in the month.

In 2018, the central bank cut policy rates and over-issued printed money of up to 38 billion rupees in April 2018 to trigger currency pressure and monetary instability, killing a fragile recovery that started in the first quarter of 2018, analysts have said.

In January 2019 however private credit went negative from dual shocks of a currency collapse and capital flight in the previous year.

Sri Lanka has a soft-pegged exchange rate where any money printing when credit is strong generates a run on the currency, which rapidly worsens as the central bank intervenes in forex markets and prints more money to keep interest rates down.

In recent weeks amid slower credit the central bank had brought dollars and the liquidity had been swallowed up in a liquidity shortage, helping clear it. But in April real money demand expands amid the traditional New Year holiday.

In the absence of rate cut to disrupt the credit system and reckless injections, part of the festival drawdown is covered by dollars purchases from remittances and exporter firm conversions to pay festival advances.

Even so analysts have expressed caution about cutting rates in April where there is a seasonal drawdown in cash, and had said it is more prudent to cut rates in May after returning excess cash is withdrawn.

Analysts have also warned against narrowing the policy corridor, because the central bank employs several convertibility undertaking to operate the soft-peg and a wide policy corridor provides automatic protection against liquidity shocks.

Narrowing the policy corridor will allow the central bank to generate 2018 style monetary instability more easily.

Meanwhile FC Research said CBSL acted contrary to the firm’s expectations of unchanged policy stance in February, and cut the statutory reserve ratio by 100 basis points to inject liquidity into the money market.

The firm said that the SRR cut in February helped improve liquidity in money markets, and more recently, foreign inflows to the bond market, and foreign remittances ahead of the festive season are reducing the liquidity shortage.

“We expect the situation to further improve over the next few weeks.”

FC Research aid political uncertainty has reduced to some degree with the passing of the budget.

The dovish US Fed stance has seen global fund flows shift from US gilts towards emerging markets, favouring Sri Lanka, the firm said.

In addition to a forex reserve target by the International Monetary Fund, which requires an implicit strong side convertibility undertaking of the peg with the US dollar the central bank also has a real effective exchange index target.

To enforce convertibility undertakings on both sides of the peg, a wide corridor or floating policy rate is required, or the central bank has to keep the peg on the strong side by mopping up liquidity, analysts have said.

FC Research said according to Sri Lanka’s REER (real effective exchange rate, which is a weighted average of the currency against a basket of other currencies) the rupee is now undervalued. The REER value depends on the currencies in the basket and how imprudent or prudent other central banks in the basket are.

“We expect the REER to have reached 97-98 range with the rupee appreciation together with the strengthening of the dollar index in February and March 2019.

“REER for January 2019 recorded at 94.18 indicating the undervaluation of the currency.”

First Capital Holdings PLC is an investment bank and is the pioneer non-bank affiliated Primary Dealer in Treasury Bills and Bonds in Sri Lanka. With a track record of over 25 years, the Company was the first licensed primary dealer appointed by the Central Bank, and is also the only listed and rated primary dealer in Treasury Bills and Bonds in Sri Lanka
First Capital delivers the only source for fixed income research in the local financial services industry. The Company’s best-in-class research team provide dynamic reports including economic reviews and proprietary research, encompassing fundamental, quantitative and technical analysis.