Budget wants single-digit interest rates to stay as fiscal and monetary policies dovetail

• Markets await next week’s monetary policy meeting for cues and language 
• Authorities believe current bout of inflation is transitory and supply-driven 
• But others disagree that price pressure could last long and want tighter policy 
• Central Bank fears higher rates could scuttle economic resurgence after restrictions 
• Treasury bill yields across all maturities ease for second consecutive week 

In an apparent attempt taken at dovetailing the fiscal policy for next year with the monetary policy, which is increasingly getting skewed towards more tightening with foreign exchange challenges and inflationary pressures, the budget presented last week aims at supporting the interest rates at single digit levels. 

According to a senior Treasury official, who has closely associated with the budget making process, the budget will ensure that the current single digit interest rates to be maintained while retaining the inflation between 4 to 6 percent range—two extremely challenging objectives in the current context of soaring prices. 

“We wanted to ensure the single digit interest rate and the exchange value of the rupee at a stable level,” said Priyanka Dissabandara, the Tax Advisor to the Finance Ministry speaking at a post budget forum organised by the Institute of Certified Management Accountants of Sri Lanka earlier this week. 

The markets broadly expect the Central Bank to raise interest rates at least one more time this year and follow up with at least two or three more rate hikes next year to fend off the brewing external and price pressures in the economy. 

Colombo prices jumped to a four-year high in October to 7.6 percent from a year ago levels from 5.7 percent in September while the prices measured monthly accelerated to 1.9 percent, an  increase from 0.4 percent in September after the government abandoned price controls which caused prolonged shortages of many essentials and other commodities making September an inflation outlier. 

While these assertions at the highest levels of the Treasury could reassure the markets that the monetary policy would broadly remain dovish at least in the near term, their plans could be scuttled if authorities see worsened forex shortages and prolonged price increases than what they would have anticipated. 

The authorities do not believe it is prudent to overreact to the current spike in inflation, which is more to do with supply side constraints than demand side pressures, which will abate in a couple of months. Hence they are of the view that the premature rise in interest rates could damage economic recovery, which is coming out of the worst contraction caused by 
the pandemic. 

The stronger than expected data on the Purchasing Managers’ Index for October proved that the economy is gaining steam ahead of the festive season demand and the exports are seeing rising orders with the easing of local restrictions and the global economy returning to near normalcy.  While the pandemic is reasonably kept at bay for now, another virus resurgence and restrictions that could follow could make the path for the economy more gloomy. 

The budget 2022 expects to expand the economy by over 5.0 percent this year followed by 6 - 7 percent growth in the years that follow with unemployment maintained at below 5.0 percent.  Meanwhile, Sri Lanka also expects to raise at least US$ 10 billion from various sources in foreign exchange in the next six months and pins hopes on the faster recovery of tourism trade and the direct investment flows to alleviate short-term pressure on the domestic foreign exchange market.  Speaking at the same forum Dr. Chandranath Amarasekara, the Director Economic Research at the Central Bank said, after the US$ 500 million sovereign bond repayment in January, the country will get some breathing space to rebuild its foreign currency assets until the next billion dollar bond repayment comes in July. 

However, the Cabinet which met this week deliberated if the country should seek a standby arrangement with the International Monetary Fund to ride out the prevailing foreign exchange pressures which will also restore international capital market access to the country to raise dollar borrowings, but not decision was taken. 

Although the government wants to maintain the current single digit interest rates in the medium term to support economic recovery, the trajectory could become complicated if the budget’s over-reliance on the domestic borrowing sources put upward pressure on the interest rates. 

Total domestic financing of the budget deficit is estimated at Rs.1,874 billion for 2022, higher than the budget deficit itself which is estimated at Rs.1,826 billion as the government stays on course to bring down the outstanding foreign borrowings of the total public debt. 

Out of the total domestic borrowings, non-bank borrowings consist of Rs.1,569 billion, up from Rs.1,397 billion in 2021 and bank borrowings consist of Rs.368 billion, down from Rs.501 billion. 

Economists cautioned that if the government fails to raise moneys via bills and bond auctions, that would force the Central Bank to buy them via printed money in turn fuelling inflation while the bank borrowings run the risk of crowding out the private sector when excess liquidity is already in deficit in the money market. 

However, contrary to expectations, the bill yields across all maturities fell for the second consecutive week on Tuesday at its weekly bill auction with the benchmark one year bill yield falling by 2 basis points to 8.17 percent.