Macro Analysis /
Global

Sri Lanka: Monetary Policy Review July 2022 – Rates up 100bps in line with view

  • CB increases rates by 100bps; expects market interest rates to rise further

  • Private credit demand looks to taper down further; we forecast private credit to grow 4.0% - 6.0% YoY in 2022

  • Food inflation to remain elevated as supply constraints impact prices

Asia Securities
7 July 2022
Published byAsia Securities

In-line with our view, the Central Bank (CB) increased key policy rates by 100bps. 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 highlighted the need for fiscal consolidation measures to further stabilise the economy at this juncture. Our key takeaways are: 1) further rate hikes of 250 – 350bps likely for the rest of 2022, 2) inflation to spike up further in the near term but, to taper down towards year end if supply shortages are addressed, 3) improving political and social stability a key requirement for economic recovery. We expect 2022 GDP to contract 7.5% - 9.0% YoY. Our key concerns at this point are 1) continued fuel and essential food shortages, impacting economic activity, 2) low room for fiscal assistance to support growth, 3) the absence of a medium-term policy framework for the government’s expenditure policies and 4) elevated global commodity prices and 5) impact of a global recession. A demand slowdown in key export markets, specially apparel will have a negative impact on export earnings in 2H 2022.

CB increases rates by 100bps; expects market interest rates to rise further

In-line with our view, the CB increased key policy rates at yesterday’s meeting, bringing the hike in policy rates to 800bps so far this year. 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. Given the delays in fuel and gas shipments in recent weeks, we expect the current headwinds to continue in the near-term until a Staff level agreement is finalised. The Governor also stated that interest rates have also adjusted following the April rate hike, credit expansion looks to have eased as a result. As such, the weekly average AWPLR has increased approx. 16.70pp since January 2021 (currently at 22.62%) amidst an overnight liquidity shortage of approx. LKR 520bn. Government security bond yields have picked up in recent auctions, with the 1-yr bond yield now at 28.11% (up from 23.84% at the previous auction). Notably, CB holdings of government securities remained high, at LKR 2.1tn. However, we note that the SLR (15.50%) is higher than 3-mth yields (28.08%), creating an arbitrage opportunity in the market. We expect this to continue in the near term given the Government’s borrowing requirement in an environment of heightened uncertainty.

Private credit demand looks to taper down further; we forecast private credit to grow 4.0% - 6.0% YoY in 2022

MoM private sector credit was flat in May, while public sector credit grew 1.5% MoM as the rising interest rate environment and economic contraction deepened. Looking ahead, with the increase in policy rates, and the overall macro uncertainty, we factor in a lower credit demand. We note that the government’s domestic refinancing requirement may crowd up private sector credit growth to some extent. However, with the expected SoE reforms aimed at easing the Government’s pressure from public sector credit demand in the coming months, we expect this to normalise. We note that elevated public sector credit demand looks to continue in the near term.

Food inflation to remain elevated as supply constraints impact prices

We expect elevated food inflation as a result of supply side pressure, combined with the impact of lower fertiliser availability and the fuel shortage to continue. While the Government has agreed to provide fertilizer at a subsidized price of LKR 10,000/50kg, we note that this is significantly higher than LKR 350.00/50kg prior to the chemical fertilizer ban. Higher global commodity prices will also negatively impact inflation, where we factor in a sharp increase in electricity prices in the near term. As such, 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. Declining global oil prices is a key positive for Sri Lanka at this point. We also factor in wage inflation and higher interest rates to increase inflationary pressure, leading to inflation at approx. 40.0% in 2022.