Rates Were Surprisingly Lowered by Sri Lanka in an Effort to Stimulate Economic Growth; More Reductions Are Predicted

In a surprising move, Sri Lanka’s central bank has decided to reduce interest rates by 50 basis points. The bank also expressed its willingness to ease policy further in order to prioritize growth and help the economy recover from its severe financial crisis, which is considered one of the worst in decades.

Both the Holding Deposit Capacity Rate and the Standing Lending Facility Rate have been unexpectedly lowered by the National Bank of Sri Lanka (CBSL), which has brought them down to 8.50% and 9.50%, respectively. Due to the fact that the majority of economists and analysts polled by Reuters anticipated that the rates would remain unchanged, this decision came as a surprise to the markets.

“In the future, should we observe that inflation consistently stays within the range of 4%-5%, there is potential for further reduction in monetary policy during this cycle,” expressed P. Nandalal Weerasinghe, known as the Governor of the Central Bank of Sri Lanka (CBSL).

Weerasinghe mentioned that the monetary conditions are still restrictive at a press conference held after the policy changes were implemented. He also mentioned that according to the most recent projections, inflation is anticipated to fall between 4% and 5% over the next month to 18 months.

The most recent reduction brings the total number of interest rate reductions since the previous year to 700 basis points. This comes at a time when Sri Lanka has begun a complex process of recovery following the most severe economic downturn it has experienced since gaining freedom from the British in 1948.

Thilina Panduwawala, the head of research at Frontier Research, made the following observation: “The choice appears to be heavily influenced by a commitment to bolster demand conditions and enhance growth, capitalizing on the effects of reduced electricity tariffs and currency appreciation.”

In an Effort to Better Control Inflation, the Bank Left Rates Unchanged

In January, the bank decided to maintain its policy rates, aiming to control inflation. This decision came after a 3% sales tax hike at the beginning of the year led to price increases and a subsequent rise in inflation to 5.9% in February.

The central bank stated in its policy statement that although potential factors could increase inflation in the short term, these would not significantly alter the long-term inflation outlook. This is because projected economic activity is expected to remain below average for a prolonged period.

According to CBSL, decreasing rates would help keep inflation at the desired level of 5% in the foreseeable future while also allowing the economy to achieve its full potential.

The central bank emphasized the importance of market interest rates continuing to decrease. They also noted that demand conditions are still weak, and the recent tax policy change has had a more minor impact on inflation than anticipated.

The Restructure of Debt and Elections

The rate cuts enhance the optimistic outlook following the staff agreement by the International Monetary Fund. Still, they are not expected to influence the ongoing discussions on debt restructuring this week, according to Panduwawala from Frontier.

“The decrease in interest rates might not have a significant impact on credit, considering that borrowing is sluggish due to diminished trust, potential tax consequences, and investors adopting a cautious stance in anticipation of the upcoming elections,” stated Udeeshan Jonas, the principal strategist at CAL Group, an equity research company.

The South Asian country is set to hold its presidential elections in the second half of 2024.

Despite facing a significant challenge, the island nation of Sri Lanka, which was unable to pay its $12 billion debt in May 2022 due to low foreign reserves, is now in discussions with private creditors for debt restructuring. This event, while posing a significant hurdle, has not deterred the country’s spirit, as it continues to strive to meet its obligations and maintain essential services like fuel and medicine.

Following the recent staff-level consensus on the second review with the IMF, the island nation of Sri Lanka has made significant strides in its debt restructuring process. This positive development has not only boosted the country’s morale but also brought it closer to receiving the next payment in its $2.9 billion bailout package from the international lender.

Weerasinghe mentioned that the government needs to complete the debt restructuring process before the IMF’s next review.

Despite a 2.3% contraction in 2023, the fourth quarter saw growth of 4.5% for Sri Lanka’s economy, suggesting a bright future for recovery in 2024.

“CBSL stated that the positive growth trend is anticipated to persist in the forthcoming quarters.”