Sri Lanka rate hike is symbolic as fiscal dominance fuels money printing

The CBSL hiked by 100bps to 15.5% but, with inflation at 55% yoy, the real policy rate is still steeply negative

CBSL money printing reached nearly 5% of GDP in H1 to meet the government's spending needs, which will add fuel to fire

Hike is symbolic as primary market T-bill yields have already exceeded 28%, but may still aide IMF discussions

Sri Lanka rate hike is symbolic as fiscal dominance fuels money printing

Note: See here for a more detailed report on the state of Sri Lanka's debt restructuring published on 1 July.

Today, the Central Bank of Sri Lanka (CBSL) hiked its standing lending rate by 100bps to 15.5%, in line with the median forecast of seven analysts surveyed by Bloomberg (forecasts ranged from no hike to +300bps). The move comes alongside a sharp rise in inflation, with the Colombo CPI index rising nearly 55% yoy and 13% mom in June (with food rising 80% yoy and core rising 40% yoy).

With the three-month T-bill yield rising above 28% at yesterday’s auction, the hike is largely symbolic, and further monetary tightening is necessary to tame inflation. The CBSL projects a further increase to c70% in the coming months before it begins to moderate later in the year, and Sri Lanka’s -39% real policy rate is surpassed only by Turkey’s -65% as the most steeply negative among the set of 66 emerging and frontier markets that Tellimer tracks.

Further, while Prime Minister Wickremesinghe says that the government plans to limit money printing in 2023 and end the practice completely by the end of 2024, it has reached alarming levels this year. Through 5 July, the book value of the CBSL’s T-bill holdings has risen by LKR940bn (4.75% of projected full-year GDP), on pace to outstrip the LKR1,223bn (7.5% of GDP) rise in 2021 and LKR640bn (4% of GDP) rise in 2020.

With limited access to external financing and limited capacity by domestic banks and investors to absorb further issuance, the CBSL will be forced to keep printing money to meet the government’s spending needs. This will continue to place upward pressure on inflation and the LKR, which has been effectively repegged (using "market guidance", in CBSL parlance) at 360/US$ after depreciating by 44% since the March devaluation. If the peg is maintained, this could exacerbate FX shortages even further, with Sri Lanka having already completely run out of FX to pay for fuel and food imports and LKR now trading at a c7.5% premium on the parallel market.

In comments this week, Wickremesinghe said that IMF discussions have been made more complicated because the economy is completely bankrupt, but said he expects to reach a staff-level agreement in August. CBSL Governor Weerasinghe echoed that sentiment in an interview today, saying that he expects to reach an agreement soon, and adding that the IMF has already submitted its debt sustainability analysis (DSA) to Sri Lanka’s financial and legal advisors to serve as the basis for the IMF programme and debt restructuring. In the meantime, Wickremesinghe says that discussions are underway with India, Japan and China to form an aid consortium once a staff-level agreement with the IMF is reached.

However, in a detailed report on Friday, we outlined why Sri Lanka’s restructuring is likely to be a protracted process. As a result, despite Sri Lanka’s eurobonds now trading towards the lower end of our estimated recovery value range, we think things will get worse before they get better and that a more attractive entry point may emerge in the future. Today’s rate decision does nothing to change that thesis, and we maintain our Hold recommendation on Sri Lanka’s eurobond curve (excluding the 22s) at US$30.6 (31.3% YTM) for the SRILAN 7.55 03/28/2030s on a mid-basis as of cob on 6 July on Bloomberg.

Sri Lanka rate hike is symbolic as fiscal dominance fuels money printing

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