Inflation risks flagged over possible higher fiscal spending ahead of elections

• HSBC Global Research warns increased fiscal spending could spoil monetary policy easing
• CB will have to stand ready to guard against possible fiscal excesses by increasing interest rates

HSBC Global Research this week flagged the possibility of inflation creeping up, derailing the plans of Sri Lanka’s Monetary Board to ease monetary policy, should there be increased fiscal spending ahead of crucial national elections.  

Under an International Monetary Fund (IMF) reform package, Sri Lanka is currently on a fiscal consolidation trajectory. But the London-headquartered Asia-focused lender stated that the government is likely to overshoot its fiscal deficit target.

Sri Lanka is likely to record a fiscal deficit of 5.1 percent of the gross domestic product (GDP) this year from its “ambitious” 4.4 percent target, according to HSBC Research. 
“Just to put the things in to perspective, over the past three years (2016-18) the fiscal deficit has remained around 5.4 percent. 

“Add to this some of the domestic realities – weak GDP growth and Sri Lanka’s own history of overspending before general elections”, HSBC Research stated issuing a downbeat outlook on the Sri Lankan economy in their latest report on Asian economies. 

Sri Lanka’s June headline inflation stood at 3.8 percent predominantly based on base effects. HSBC gave a downbeat growth forecast of 2.7 percent for 2019, rising to 3.2 percent in 2020. 

Higher fiscal spending and fiscal deficit could feed into the already high inflation scuttling plans by the Monetary Board to continue on its easing path. 

Sri Lanka effectively began easing its monetary policy in November 2018 by way of reducing the statutory reserves ratio – the amount of deposits that should be held with the Central Bank by the banks – by 1.5 percent to inject liquidity into money markets. 

This was followed by another 100 basis points cut in February and a 50 basis point cut in key policy rates in May. 

On top of that, the Central Bank in April began capping deposit rates in a bid to tame lending rates to help quicken the pass-through of policy rates change to stimulate the moribund economy.

However the economists at HSBC appear to be holding on to the belief that the monetary policy changes would take longer than expected to take effect in the real economy. 
“However, the transmission to lower lending rates is likely to happen slowly, as the deposit base takes time to re-price. 
These steps, in our view, are well-timed and are likely to get transmitted into lower lending rates by early 2020, which is just about the time when election-related uncertainties begin to fade”, they said. 

If inflation creeps up due to election spending, an inflation targeting Central Bank will have to stand ready to guard against such fiscal excesses by increasing interest rates.  “The recent slowdown in private credit growth is a cause for concern, though part of it is linked to election-related uncertainties, which should dissipate over time. A combination of the cuts in policy rates, better transmission into lower lending rates, and improved liquidity will go a long way, in our view, to lifting growth,” HSBC Research noted. 

However, if the current low interest rate regime fails to create meaningful growth in the private sector credit as banks take a cautious approach to lending due to their weak asset quality, inflation pressure may not become evident, some economists opine. 

It appears that HSBC Research is of the opinion that interest rates alone will not lift private sector credit growth as they think the upcoming elections would play a pivotal role in the grand scheme of things. 

 “A lower cost of credit, along with improved business sentiment (once the election is over), will lead to a sustainable rise in private credit growth,” HSBC Research noted.