50% likelihood of rate cut by CBSL: First Capital

• CBSL to announce latest monetary policy stance on Thursday 
• Probability of rate cut reduced on private sector credit growth and pick up in sectors 
• Stubbornly subdued growth could push CBSL to tinker with rates 
• Keeping rates low beneficial for Govt. borrowing and deficit financing 

Stronger private sector credit growth and gradual normalisation of economic activities has reduced the odds of the Central Bank of Sri Lanka (CBSL) changing rates, when it announces its latest monetary policy stance this week, First Capital Research said yesterday, projecting there was only a 50% probability of a rate cut.   Releasing its latest pre-policy report, First Capital said that in its earlier report it had indicated a 60% probability for a rate cut when the monetary policy stance is announced in October and 75% when in November. 

“However, given the improved macro-economic indicators, we have reduced the probability of a rate cut by 10% to 50% in October and by 25% to 50% in November,” the report said.     

Presenting their arguments against further relaxation in monetary policy, First Capital Research pointed out domestic financial conditions have eased substantially with banking system liquidity remaining in surplus. 

“Banks have abundant liquidity, following CBSL infusing ample liquidity into the banking system via increased Central Bank holdings, otherwise known as money printing. However, outlook for credit seems lacklustre, given the uncertainty surrounding the pandemic.” 

In addition, there has been an improvement in high frequency indicators in the economy. Recovery of manufacturing activities continued in August (Index Value 57.9) as reflected by the Purchasing Managers Index (PMI) Manufacturing, benefitting from the normalisation of business activities in the country. PMI Services continued to expand for the third consecutive month with index reaching 56.0 in August. 

“Moreover the Index of Industrial Production (IIP) for July 2020 increased to 111.1 from 92.8 in June 2020. Political stability after General Election and a slow return to normalcy was depicted in LMD-Nielsen Business Confidence Index (BCI) during Jun-Sep 2020, reflecting an improvement to 123 from 96. Domestic economic activities, which were adversely affected by the COVID-19 pandemic are expected to recover in the 4Q of 2020, thus not requiring further relaxation in policies.”

First Capital Research noted that credit to the private sector reflects a gradual normalisation of economic activities. Private sector credit rebounded in August by Rs. 78.3 billion, for the first time since April, reflecting the fact that both businesses and individuals were accelerating their economic activities to make up for the lost opportunities during the lockdown period.

However there are arguments for further relaxation in monetary policy, with economic growth for 2020 expected to remain in negative territory. 

“First Capital Research estimates that Sri Lanka’s GDP would see its steepest contraction yet – 5.8% in 2020, following the unexpected contraction in 1Q GDP growth of -1.6%. Amidst the lack of demand for credit, import restrictions and the slowness in recovery of consumer demand, GDP growth is expected to turn positive only by 4Q of 2020.  Accordingly, GDP growth can be considered as a major factor favouring the further policy easing at the upcoming review.” 

Consumer confidence also remains muted with weak demand. The pandemic-led disruption has had a lasting impact on the income of individuals with businesses being shut and either lay-offs or pay cuts experienced by salaried professionals. The lower disposable income in the hands of consumers will have a bearing on the demand for consumption, with discretionary spending being either deferred or cancelled for a period of time. However, higher credit growth and consumer demand can be aggravated through a further policy easing.

First Capital Research expects Sri Lanka’s budget deficit in 2020 to reach 10% of GDP. Generally, fiscal deficit is funded via domestic and foreign sources of borrowing. Lack of FDI and limited foreign borrowing options in the current period may push the Govt. to borrow predominately from the domestic market. 

Decline in domestic interest rates, in response to the aggressive monetary easing, delivered the required support to soften the pandemic impact on the economy. Thereby, maintaining a low interest rate environment or further reducing interest rate benefits the Government finances, the report said.