Productive investment lags private credit growth, says Monetary Policy Report

Sri Lanka's Central Bank says inflation has swung sharply higher, driven largely by the war in the Middle East, reversing more than two years of price growth that had been running too low.

The Bank's Monetary Policy Report shows headline inflation climbed from just 1.6 per cent in February to 7.3 per cent in July, now above the top of its target band. The Bank aims to keep inflation at 5 per cent, with a two-percentage-point margin either way. Before this, inflation had spent eight straight quarters undershooting that band altogether.

The Bank points to one central cause: the war in the Middle East, which escalated in late February. Disruptions to shipping through the Strait of Hormuz pushed global oil prices higher, forcing repeated increases in domestic fuel, LP gas and electricity prices. Housing, fuel and transport costs alone make up almost half the inflation basket, and the Bank says they're behind most of the recent increase.

In response, the Central Bank's rate-setting body, the Monetary Policy Board, raised its key interest rate by a full percentage point in May, to 8.75 per cent. That move ended an accommodative, low-rate stance that had been in place since mid-2023. But when the Board met again in July, it left the rate unchanged, saying it wanted more time for the May increase to work through the economy. That decision came before July's own inflation figure was known. The Bank's next policy review is in September.

The report also flags a fast-growing credit market. Bank lending to the private sector is up nearly 28 per cent over the past year, adding further demand pressure on top of the energy shock.

Private sector credit to banks rose 27.8% y-o-y in May and 27.4% in June. It’s more than double a reasonable estimate of nominal GDP growth. Gold-backed lending/pawning, consumer durables and vehicle financing are the biggest movers. What’s concerning is that it is not productive business investment.

On the external side, Sri Lanka posted a current account deficit for the first half of this year, its first in three years. Fuel and vehicle import costs outpaced export earnings, while tourism income fell. The rupee has weakened by around 7.4 per cent against the US dollar since the start of the year. It strengthened slightly in July, though, after the Bank tightened rules on how exporters convert their earnings.

The economy is still expanding, up 5.1 per cent in the first quarter, and the Bank expects growth of 4 to 5 per cent for the year as a whole. But behind the headline numbers, wage data in the report show real pay for public sector workers turned negative in May, meaning salaries are no longer keeping pace with the cost of living.

Looking ahead, the Central Bank expects inflation to ease back toward its target over the medium term. But it says the risks remain tilted to the upside, pointing to the possibility of renewed conflict in the Middle East, and the threat of El Niño-related weather disruption to food and power supplies.