The Central Bank of Sri Lanka (CBSL) unexpectedly cut interest rates today but given our view that the rupee will come under downward pressure again this year, the scope for further loosening is limited.
- The Central Bank of Sri Lanka (CBSL) unexpectedly cut interest rates today but given our view that the rupee will come under downward pressure again this year, the scope for further loosening is limited.
- The CBSL’s decision to cut both its deposit and lending rate by 50bps to 6.50% and 7.50% respectively was a surprise. (See Chart 1.) Only one of the eight analysts polled by Bloomberg expected a cut of 25bps. We, along with the rest of the consensus, had predicted rates would be left unchanged today. The CBSL has now cut interest rates three times since last May.
- The accompanying statement made clear that the cut was aimed at “facilitating the envisaged recovery in economic activity”. Although growth in Sri Lanka looks to have slowed last year, we didn’t see any immediate need for further stimulus. With the tourism sector recovering strongly from the Easter Sunday terrorist attacks and fiscal policy being loosened aggressively following the government’s decision at the end of last year to slash the rate of VAT from 15% to 8%, the economy should rebound strongly this year. Our forecast is for growth of 5.0% in 2020, up from an estimated 2.8% last year.
- The central bank mentioned the risk to the economy from “the spread of coronavirus in China.” But Sri Lanka looks much less vulnerable than other countries in the region to the spread of the virus. Spending by Chinese tourists is equivalent to just 0.5% of Sri Lanka’s GDP. (See here.)
- It is possible that the CBSL was put under pressure from the new government to loosen policy. In late December, President Gotabaya Rajapaksa installed Weligamage Don Lakshman as the new governor. Lakshman is a former adviser to Mahinda Rajapaksa (a former president and brother of the new president).
- The CBSL hinted at the possibility of further easing. In its statement, the CBSL emphasised the need for lending rates to fall further “to support the envisaged pickup in credit growth and economic activity”.
- While further cuts in the near term cannot be ruled out, there is a risk the central bank will be forced to reverse course later in the year if, as we expect, the currency takes a turn for the worse. The VAT cuts will lead to around US$2bn in lost revenue (around 2% of GDP), causing the deficit to widen to around 6.5% of GDP this year. This is much larger than the 5.3% deficit target agreed with by the IMF.
- A larger deficit is likely to create friction with the IMF, who could decide to withhold future payments under the terms of its bailout agreement. This would risk undermining the confidence of international investors, which could cause bond yields to spike and the currency to come under downward pressure. The rupee has held broadly steady in recent months (see Chart 2), but this is likely to change. Sri Lanka’s large burden of FX debt makes the economy vulnerable to sudden falls in the rupee. While the outlook is particularly uncertain, we think that today’s cuts to the policy rate will be a case of one and done.
Chart 1: Policy Rates (%)
Chart 2: Sri Lanka Rupee vs. US Dollar