Macro Analysis /
Sri Lanka

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

  • CB maintains rates; FX liquidity in the banking system continues to improve

  • Inflation to gradually ease as supply side pressure improves

  • Reserves at USD 1.8bn in September including USD 1.4bn swap; we factor in an IMF EFF in January 2023

Asia Securities
6 October 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 bilateral creditors have commenced, while preliminary discussions with private creditors have commenced. We factor in an IMF EFF program finalisation by January 2023. Our key takeaways are: 1) fiscal consolidation to support lower demand-pull inflation, 2) inflation to gradually ease towards year end, 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. We perceive the higher economic activity levels and improving FX liquidity in the banking system as key positives for 4Q 2022.

CB maintains rates; FX liquidity in the banking system continues to improve

In-line with our view, the CB maintained key policy rates at yesterday’s meeting, following the 100bps rate hike in July. Meanwhile, the weekly average AWPLR has increased approx. 21.04pp since January 2021 (currently at 25.95%) amidst an overnight liquidity shortage of approx. LKR 363bn (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 29.75% (down from 29.85% from the previous auction). Notably, CB holdings of government securities remained high, at LKR 2.4tn. The CB noted that Dollar liquidity in the banking system has improved, supporting essential imports in the months ahead.

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 continued its contracting trend, while public sector credit also declined as the rising interest rate environment and economic contraction deepened. Looking ahead, against this backdrop, we expect credit demand to remain weak. With the expected SoE reforms aimed at easing the Government’s pressure from public sector credit demand in the coming months, we expect public sector credit growth to continue its negative trend in the medium term.

Inflation to gradually ease as supply side pressure improves

A key positive is that inflation has been growing at a slower pace in recent months. While inflation is expected to remain elevated in the near term owing to both domestic and external headwinds, the CB expects this to gradually ease in the coming months, with improving supply side factors. We factor in 1) improved availability of essentials like fuel and gas, 2) lower global fuel prices despite the recently announced oil production cuts, 3) fertiliser availability going into the Maha season and 4) low demand-pull pressure into our forecasts. 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 fertiliser ban. 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 10.0% - 15.0% in 2023.

Reserves at USD 1.8bn in September including USD 1.4bn swap; we factor in an IMF EFF in January 2023

The CB noted that official reserves were at USD 1.8bn in September. While we do not factor in material refinancing inflows for the remainder of the year, we expect the first tranche of an IMF EFF to materialise around January 2023 following bilateral creditor negotiations. A key factor at this point is that while discussions with the advisors of private creditors and official committees have commenced, the actual discussions and negotiations with private creditors can only commence following approval of the IMF agreement by the Board, likely to take place in December. The Government’s fiscal consolidation plans expected at the 2023 budget are crucial at this point to ensure continued fiscal management in the near term.