How tight before we pass out?

As efforts are made to end a balance of payments crisis brought on by improperly targeted interest rates, data from the Central Bank showed that private credit in Sri Lanka decreased by Rs. 58.9 billion in August, falling for the third consecutive month. In the year to August, credit to the private sector increased by only 12%.

With credit money stock increasing 49.5% to Rs. 1,699.8 billion by September 2022, credit to State firms decreased by Rs. 54.2 billion, invested in severely underperforming aspects of the State economy. In order to recoup the losses on loans to State companies, the Government has set the price of fuel and electricity at market rate. It has also increased and maintained interest rates to restrain private credit and investment, halting credit-driven outflows and rupee depreciation. When the currency fails, energy utility losses are likely to increase.

When credit demand increases, a Central Bank with a soft peg creates money to maintain its policy rate, injecting liquidity into the banking system and, typically by buying Treasury bills, driving up bank credit without deposits.

To finance the deficit and reduce Treasury yields, the Central Bank may also purchase Treasury notes directly. Banks and the general public purchase Treasury bills and bonds when private credit declines when interest rates are adjusted, enabling a larger deficit to be covered. In August, banks increased their credit to the Government by Rs. 163.7 billion. In an effort to decrease Government borrowing and restrict money printing, Sri Lanka has increased taxes.

Although there were no policy meetings held throughout the month, the Central Bank maintained the key policy rates, which was consistent. SLFR is currently 15.50%, while SDFR is 14.50%. The one-year Government bond yield was much higher than the SLR, pricing in a larger level of uncertainty given the current environment. Considering the future, key policy rates are anticipated to not change at the October meeting, as the lag effect of previously deployed policy measures has not yet completely manifested.

In light of the tightening of global policy, there is also a limited possibility of softening policy measures. While both internal and external obstacles are predicted to keep inflation high in the short term, CBSL anticipates that once the supply constraint is resolved, inflation will begin to normalise in the medium run. In September alone, Colombo saw an increase in inflation from 64.3% to 69.8%, according to figures from the State statistics office. 

This occurred during the biggest currency crisis in the island’s intermediate regime history. However, due to high inflation and financial repression, central Government’s rupee debt in real terms decreased from $ 50.5 billion to $ 32.4 billion. The increased accessibility of necessities like fuel and gas now as opposed to earlier months is a major plus. 

By year’s end, the AWPLR is expected to stabilise between mid-20 levels. At recent auctions, Government security bond yields have slightly decreased; the one-year bond yield is now 30.26%. In particular, CBSL holdings of Government securities were substantial at Rs. 2.3 trillion. CBSL observes that monetary financing declined in August and will likely be low in the next months as a result of the Government’s revenue-generating efforts. However, this too following fiscal and monetary tightening measures, asks the question, how tight can we go?