Citi forecasts hike in policy rates amid worsening forex crisis

• Says last week’s decision to hold policy rates will worsen SL’s forex issues
• Expresses surprise over rate decision due to heightened inflationary pressures 
• Expects govt. to reach out to IMF by early next year

Amid worsening external imbalances, the Central Bank (CB) is likely to increase policy rates by a minimum of 50 basis points (bps) by year-end and 150 bps by next year with the government reaching out to the International Monetary Fund (IMF) around the same time, Citi Research weighed in.

Commenting on the CB’s decision to hold policy rates last week, Citi highlighted this move is likely to further deepen existing  foreign exchange shortages in the country.

“CBSL’s latest move makes, in our view, the monetary policy more inconsistent with any potential IMF programme, and is likely to continue to deepen FX shortages. 

We think the bias towards keeping front-end rates low and FX stable when the risk premiums for holding rupee assets have risen amid rapidly dwindling reserves is unsustainable, and we believe the ongoing external and price pressures will push CBSL to belatedly hike rates,” Citi Research stated. 

In particular, Citi Research outlined that lack of confidence in the FX peg continues to fuel US dollar shortages, as reflected in the recent decline in official remittance inflows as conversions are circumventing formal banking channels.

The CB at its monetary policy review meeting held on 14th of this month decided to maintain the policy rates unchanged. Accordingly, the Standing Deposit Facility Rate and Standing Lending Facility Rate were kept at 5 percent and 6 percent respectively.

Citi Research opined that this move has not only  failed to consider recent local and global developments, but it might also be contradictory to recent key decisions taken by the government, providing the markets with a signal on the future discourse. Therefore, it noted that the move had taken the markets by a complete surprise.  

“The decision would have come as a surprise to the market, given the mounting inflationary pressures, as managed/regulated price controls are being adjusted to address shortages (LPG, food prices) while more adjustments are pending (e.g., for fuel) amid a surge in global energy prices, accelerating credit growth, sharply declining  FX reserves,” it elaborated.

Further, Citi Research pointed out that the CB itself has already “allowed” market yields to rise substantially, where 1-year T-bill rate surged by 116 bps within the past month.