The Central Bank of Sri Lanka (CBSL) became the first in Asia on Thursday to raise interest rates since the pandemic began, as it acted to stem inflationary pressure and high imports, one of the factors behind the rupee’s 8 percent depreciation this year.

The central bank increased the standing deposit facility rate and the standing lending facility rate by 50 basis points each to 5 percent and 6 percent, respectively.

It also increased the statutory reserve ratio by 200 basis points to 4 percent with effect from September 1.

“These decisions were made with a view to addressing the imbalances on the external sector of the economy and to preempt the buildup of any excessive inflationary pressures over the medium term, amidst improved growth prospects,” CBSL said.

The Sri Lankan economy is gradually making headway after the negative impact of the coronavirus pandemic in 2020 and is poised to record a higher growth rate during the second quarter of 2021, partly due to the base effect, the CBSL said.

But it also cautioned that there could be some weakness in the second half due to further outbreaks of infections.

Inflation in recent months has accelerated due to higher food prices and some uptick in non-food inflation, and the CBSL projects it to hover around the upper bound of the 4-6 percent target range in the near term.

The July Colombo consumer price based inflation rose 5.7 percent compared with June's 5.2 percent, latest data showed.

Sri Lanka sovereign dollar bonds surged after the rate increases while the CSE All share index fell 1 percent.

“The policy rate hike has likely been taken as a measure to mitigate excessive pressures on the currency, even though the CBSL's official rate hasn't changed yet,” said Trisha Peries, head economist research at Frontier Research.

External sector concerns

The CBSL said the stimulus measures taken after the pandemic hit the economy resulted in low-cost credit which, in turn, led to a sustained increase in imports.

“The increase in import expenditure outweighing the improvements observed in earnings from exports, the trade deficit continued to widen during the first half of 2021 over the corresponding period of last year,” CBSL said.

“Moreover, the expected recovery in the tourism industry could be further delayed due to uncertainties associated with the resurgence of the pandemic globally,” it added.

Tourism contributes more than 12 percent to Sri Lanka's GDP and the pandemic has dealt a major blow to foreign currency earnings.

The Sri Lankan rupee is down about 8 percent this year, also weighed down by external debt service obligations. The government has met all its external payments but worries remain over potential defaults.

“At the margins its significant,” said Gabriel Sterne, head of strategy services and global EM research at Oxford Economics.

“But the real issue is the balance of payments. The way interest rates normally work is to give incentives for investors to come in, but when you have capital controls, as Sri Lanka does, that makes it difficult.”

The government is actively looking for funding sources but has refrained from seeking a bailout from the International Monetary Fund.

“We think it's likely that there could be around one more rate hike before the end of the year, particularly if it looks like we are moving towards an IMF programme, along with what is expected to be a tighter budget announced for 2022,” Peries said.