Macro Analysis /
Global

Sri Lanka: Monetary Policy Review August 2022 – Key policy rates on hold

  • CB maintains rates; expects a steeper than anticipated contraction in growth

  • Inflation to peak in August following electricity price hike; looks to reduce gradually thereafter

  • Reserves at USD 1.8bn in July including USD 1.5bn swap; we factor in an IMF SLA in September

Asia Securities
18 August 2022
Published byAsia Securities

In-line with our view, the Central Bank (CB) maintained key policy rates at yesterday’s meeting. SDFR currently stands at 14.50%, and SLFR at 15.50%. However, the arbitrage opportunity remains, where the 1-year Government bond yield was significantly higher than the SLR, pricing in a higher level of uncertainty against the current backdrop. The CBSL noted that discussions with the IMF for a Staff Level Agreement (SLA) are scheduled for the coming weeks. We factor in a SLA by early September, with the first tranche from an IMF program in December ‘22/January ‘23. Our key takeaways are: 1) further rate hikes of 150 – 250bps likely for the rest of 2022 if demand pull inflation materialises, 2) inflation to spike up further in the near term but, to taper down towards year end as supply shortages are addressed, 3) improving political and social stability a key positive to boost investor sentiment. We expect 2022 GDP to contract 7.5% - 9.0% YoY. Our key concerns at this point are 1) low room for fiscal assistance to support growth, 2) the need for a strong social safety net to support poverty levels, 3) impact of stringent fiscal consolidation measures through higher taxes and 4) the impact of a global recession. A softening demand in key export markets, specially apparel will have a negative impact on export earnings in 2H 2022.

CB maintains rates; expects a steeper than anticipated contraction in growth

In-line with our view, the CB maintained key policy rates at yesterday’s meeting, following the 100bps rate hike in July. While inflation is expected to remain elevated in the near term owing to both domestic and external headwinds, the CB expects this to normalise in the medium term once the supply shortage is rectified. A key positive at this point is the improved availability of essentials like fuel and gas compared with previous months. The CB noted that a steeper than initially anticipated contraction in GDP growth is likely in 2022, with 2Q and 3Q being the worst impacted. This is in-line with our view, where we factor in a 7.5% - 9.0% YoY contraction in growth for the year. Meanwhile, the weekly average AWPLR has increased approx. 19.50pp since January 2021 (currently at 25.31%) amidst an overnight liquidity shortage of approx. LKR 450bn (compared with LKR 518bn at the beginning of July). We expect the AWPLR to settle at 23.0% - 25.0%. Government security bond yields have eased marginally at recent auctions, with the 1-yr bond yield now at 29.14% (down from 29.53% at end July). Notably, CB holdings of government securities remained high, at LKR 2.4tn. The CB notes that monetary financing has eased in August, with upcoming monetary financing low in the period ahead following the Government’s revenue generating policies. Elevated levels of money in circulation has also eased following higher banks deposit rates

Inflation to peak in August following electricity price hike; looks to reduce gradually thereafter

A key positive is that inflation has been growing at a slower pace in recent months. However, we factor in a sharp step-up increase in the August inflation numbers, given the 75% electricity price hike during the month. We expect this to trickle into food inflation to some extent, and expect food prices to continue to add pressure. While we note that the Government has taken steps to import the required fertiliser for the Maha season, this is expected to be at a subsidised price of LKR 10,000/50kg, significantly higher than LKR 350.00/50kg prior to the chemical fertilizer ban. Lower global commodity prices bode well for Sri Lanka at this point. We expect inflation to spike up to at least 60%-70% YoY in the near term, while tapering down to some extent towards year end. The recent downward price revision of cooking gas will also help ease non-food inflation to some extent. We forecast inflation at 40.0% - 45.0% in 2022, easing to single digit levels by end 2023.

Reserves at USD 1.8bn in July including USD 1.5bn swap; we factor in an IMF SLA in September

The CB noted that official reserves were at USD 1.8bn in July. While the CB notes that negotiations have already begun with bilateral and multilateral partners to obtain bridging financing, we expect this to materialise post an announcement of an IMF staff level Agreement in September. We expect the first tranche of an IMF program to materialise by December ‘22/January ’23. The Government’s fiscal consolidation plans and debt restructuring plans are crucial at this point to secure further bilateral and multilateral lending. We do not factor in any significant inflows towards fiscal and external funding by multilateral an bilateral lenders for the remainder of the year.