beyondbrics

Sri Lanka’s central bank raised key interest rates for the first time in five years on Friday and directed banks to slow lending in an effort to curb credit growth and to stem the worsening balance of payments.

The repo rate rose 50 basis points to 7.5 per cent a year and the reverse repo rate rose by the same margin to 9 per cent. It came despite the central bank’s downward revision of its GDP growth forecast for 2011 to 8 per cent from 9 per cent.

Analysts said the Central Bank of Sri Lanka was trying to arrest a surge in credit since the country’s 25-year civil war came to a bloody end in 2009.

“This move is to try to slow that credit growth down because we seem to be having a balance of payments problem – import growth has far outpaced export growth creating a record trade deficit,” said Murtaza Jaff, CEO of JB Securities in Colombo. “And this is simply to slow that down so that trade deficit could be minimised.”

According to the CBSL, inflation fell to 3.8 per cent in January, down from 4.9 per cent in January 2011. But in December 2011, credit granted by commercial banks to the private sector increased by 34.5 per cent year on year, “substantially exceeding projections”. Import-related credit increased more than 34 per cent in 2011, while export credit increased only 8 per cent.

In 2010, according to World Bank data, domestic credit provided by the banking sector was 40.5 per cent of GDP.

With that in mind, the CBSL directed commercial banks to moderate lending so that overall credit growth in 2012 does not exceed 18 per cent of their respective loan book outstanding at the end of 2011. Meanwhile, 23 per cent credit growth will be allowed for those banks that finance the extra 5 per cent from overseas.

Imports have risen sharply, and the island nation’s trade gap has widened substantially, reaching record levels.

In November, imports rose 78 per cent to $1.98bn, while exports rose 11.6 per cent to $879m. That same month, the country attempted to discourage imports by devaluing its currency by 3 per cent. During the first 11 months of 2011, the trade gap widened 111 per cent to $8.8bn.

That rise was driven in part by a six-fold rise in gold imports, to $553m – something India knows a thing or two about – and a doubling of spending on motor vehicles, to $913m, during the first 11 months of 2011, compared to the same period in 2010.

Meanwhile, the country’s current account deficit widened to $4bn in November, from $3.25bn the same month last year. Gross official government reserves fell to $5.9bn by the end of 2011, the equivalent of 3.6 months of imports.

With all that in mind, the CBSL felt compelled to act.

Per the CBSL’s statement:

Taking into consideration these macroeconomic developments,  the Monetary Board of the Central Bank of Sri Lanka is of the view that the continuous increase in credit extended to the private sector by commercial banks needs to be addressed for two main reasons: First, to  curtail import related credit, thereby reducing the trade deficit and the current account deficit, and second, to effectively ensure that inflation remains at the mid-single digit levels in the second half of 2012 as well, notwithstanding the sharp build up of credit in 2011.

Anuska Shah, economist at Citi, in a research note, said “we now expect rates to stay on hold for the rest of 2012. However, trends in private sector credit growth and foreign inflows (including FDI, remittances, tourism, etc ) would likely be closely monitored and play an important role in framing monetary policy decisions.”

For his part, Jaff said he took such guidance as an indication that Sri Lanka is entering into a tightening cycle, after a full year in which rates remained untouched. There was a 50bps cut in January 2011.

“This is the first increase in a series of increases that will have to come to arrest the balance of payments pressure,” he said. “There will need to be increases throughout the year – though I don’t know [to] what level.”