VAT increase could cause inflation to hit 7 percent in January – CBSL Governor

By Hiran H.Senewiratne

Sri Lanka’s inflation could rise to 7 percent in January 2024 due to the VAT increase, the Governor of the Central Bank of Sri Lanka (CBSL), Dr. Nandalal Weerasinghe warned.

Speaking at a special press briefing held yesterday, Dr. Weerasinghe explained that an increase in inflation is likely due to the increase in the VAT and other external factors. He was speaking at the CBSL’s first Monetary Policy Review for this year held at Central Bank head office in Colombo.

The VAT was increased by 3 percent, from 15 percent to 18 percent, with effect from January 1, 2024, after the VAT (Amendment) Bill was passed in parliament on December 11, 2023, he said.

The Central Bank kept its policy rates unchanged at 10 percent at this its first monetary policy meeting in 2024. Market rates should fall further.

The Central Bank has operated a largely deflationary policy, selling down its Treasury bills portfolio against dollar inflows, thereby preventing pressure on the currency and building reserves, resulting in a balance of payments surplus.

Dr. Weerasinghe added: ‘Over the past month, the exchange rate has appreciated, which may also help offset a 3 percent hike in value added tax on traded commodities.

‘Headline inflation is projected to record an upward movement in the near term, as expected, driven mainly by domestic price adjustments due to the increase in the VAT and the elimination of certain VAT exemptions effective January 1, 2024, disruptions to the domestic food supply and dissipation of the favourable statistical base effect.

‘However, this acceleration of inflation in the near term is expected to be short-lived and the spillover effects of such one-off adjustments are likely to be muted due to subdued underlying demand conditions. Therefore, over the medium term, headline inflation is expected to gradually stabilise around the targeted level of 5 per cent (year-on-year), supported by appropriate policy measures.

‘Headline inflation, as measured by the year-on-year change in the Colombo Consumer Price Index (CCPI, 2021=100), was recorded at 4.0 per cent in December 2023, compared to 3.4 per cent in November 2023.

‘Following five consecutive months of deflation, the food category recorded inflation (year-on-year) in December 2023, reflecting mainly the weather-related disruptions, while non-food inflation (year-on-year) moderated compared to the previous month.

‘Despite the recent acceleration, headline inflation remains closer to the inflation target of the Central Bank and is in line with the envisaged inflation projections of the Central Bank. Meanwhile, core inflation (year-on-year) continued to moderate in December 2023, compared to the previous month, reflecting the subdued demand pressures in the economy.

‘The Board took note of the effects of the recent developments in taxation and supply-side factors that are likely to pose upside pressures on inflation in the near term.

‘The Board anticipates a broad based reduction in overall market lending interest rates in line with the monetary policy easing measures that have come into effect since June 2023.

‘The Monetary Policy Board will continue to assess risks to inflation projections, among others, and stand ready to take appropriate measures to maintain domestic price stability in the period ahead while supporting the economy to reach its potential.

‘The Central Bank decided to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 9.00 per cent and 10.00 per cent, respectively.

‘The Board arrived at this decision following a comprehensive assessment of domestic and international macroeconomic developments in order to maintain inflation at the targeted level of 5 per cent over the medium term, while enabling the economy to reach its potential.

‘However, the Board viewed that the impact of these developments would not materially change the medium-term inflation outlook. Further, the Board noted the space created by past monetary policy easing measures and the decline in the risk premia attached to government securities for further downward adjustment in market lending interest rates.

‘The Board underscored that the envisaged benefit of further reduction in market lending interest rates needs to be adequately and swiftly passed on to businesses and individuals by financial institutions.

‘Market interest rates continued to adjust downwards in line with eased monetary policy and administrative measures taken to reduce overall market lending interest rates.

‘The yields on government securities continue to decline, supported by falling risk premia. The Monetary Policy Board of the Central Bank is of the view that there is further space for market interest rates, especially the lending interest rates and yields on government securities, to decline in the period ahead, in line with the reduction in policy interest rates effected in the recent past.

‘The Sri Lankan economy recorded an expansion in the third quarter of 2023, following six consecutive quarters of economic contraction. Accordingly, the economy is estimated to have grown by 1.6 per cent, year-on-year in the third quarter of 2023, as per the GDP estimates published by the Department of Census and Statistics (DCS).

‘This was a broad-based expansion in economic activity, supported by expansions recorded in Agriculture, Industry and Services sectors, on a year-on-year basis. The rebound in domestic economic activity is expected to be sustained, supported by the faster passthrough of relaxed monetary policy to broader market interest rates and the resultant firming of credit demand, improvements in business and investor sentiments, improvements in supply conditions and the gradual rebound expected in external demand conditions.

‘The merchandise trade deficit is estimated to have moderated during 2023 in comparison to 2022. This, coupled with the notable recovery in trade in services, mainly earnings from tourism, and the strong momentum of workers’ remittances, is expected to have resulted in a surplus in the current account balance of the balance of payments for 2023.

‘Gross official reserves (GOR) improved notably to US dollars 4.4 billion by end December 2023, which include the swap facility from the People’s Bank of China (PBOC). This strong rebound of GOR was supported by the notable net purchases by the Central Bank from the domestic forex market and the proceeds from multilateral agencies. The Sri Lanka rupee, which appreciated by around 12 per cent against the US dollar in 2023, continued to show an appreciation so far in 2024.

‘In consideration of the current and expected macroeconomic developments highlighted above, and in keeping with the forward guidance provided at the last monetary policy review in November 2023, the Monetary Policy Board of the Central Bank of Sri Lanka, at its meeting held on January 22, 2024, decided to maintain the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank at their current levels of 9.00 per cent and 10.00 per cent, respectively.’