5 basis points to 11.5 percent Friday and asked banks to raise deposit rates. "The Central Bank has noted that despite several policy rate increases in the past, banks have not sufficiently raised deposit rates," the bank said in its December monetary policy statement.
"Therefore, the Central Bank wishes that all banks raise deposit rates in line with the current policy rate increase and pass the benefit to their depositors."
Demand Pressure
The Central Bank warned last week that rates would be hiked as demand pressure built up in the economy driving headline inflation to 19.8 percent.
Though economic growth was high at 7 percent, critics had warned that Sri Lanka's balance of payments had come under pressure and inflation rocketed up due to excessive central bank financing of the budget deficit since February 2006.
The Bank said it had tightened policy by raising rates by 50 basis points in September continued to conduct active open market operations to mop up all excess liquidity from the banking system, supplemented by prudential measures to curb credit.
"However, reserve money growth rose to 18 per cent by end November 2006 and broad money grew at 16.8 per cent in October 2006 requiring continued monetary policy action," the bank said.
"Government recurrent expenditure has increased above the budgetary targets, necessitating increased bank borrowings."
According to data released last week central bank credit to government had risen to 108.3 billion rupees in October from 61.9 billion in March, showing the extend of debt monetization or money printing.
The Central Bank said the economy grew at a healthy rate, (8 percent in the first half) and is expected to end the year with 7 percent growth.
Economic Growth
At the moment, agriculture, fisheries was doing well though tea production was expected to fall with ongoing industrial action.
Heavy rains in the recent past have hurt vegetable production, pushing up prices, which may remain till early 2007.
Central Bank said some industrial sub sectors have shown a slowdown, but it is expected to grow by about 6.
5 percent in 2007 benefiting from development projects requiring industrial sector goods and the continued expansion of export demand from the European Union.
Telecommunication services, port services, domestic and international trade, and financial services, continued to expand.
"Notwithstanding the favourable developments in the economy, continued rise in inflation remains a concern," Central Bank said.
Inflation had started to increase from April due to demand pressure, price adjustments and increases in import prices and tariff and short supply of vegetables had also pushed prices up in November.
Colombo Consumers’ Price Index (CCPI) increased from 6.
4 per cent in March 2006 to 17.2 per cent in October 2006 and further to 19.8 per cent in November 2006.
"In view of the above developments, the Monetary Board decided to further tighten the monetary policy to subdue the demand pressures arising from monetary expansion and to contain inflationary pressures and inflation expectations," the bank said.
"Consequently, the Central Bank’s policy rates, viz.
the Repurchase and Reverse Repurchase rates, will be increased by 37.5 basis points to 10.00 per cent and 11.50 per cent, respectively."
In the two weeks before the rate hike, the Central Bank had already pushed up gilt rates by about 40 basis points by reducing debt monetizing.
External Sector
During the first ten months exports only grew by 6.5 per cent while imports grew by 15.8 per cent and the widening trade deficit was partially financed with remittance growth of 22 percent and dollar borrowings by the government.
Central Bank says the balance of payments surplus of 160 million was recorded by November 2006.
On Thursday Central Bank said the government had signed a deal with Citibank to raise a further 100 million US dollars.
But analysts say borrowing commercial dollars to prop up the currency and maintain reserves is an alternative to prudent policy.
Disruptive Slowdown
Sri Lanka's real interest rates are still below inflation and analysts say, rising central bank credit levels indicate that rates are not high enough to generate private savings to bridge the budget deficit, or to contain demand and balance of payments pressure.
In a report this week, the World Bank said South Asian countries that had zero or negative real rates would have to tighten fiscal and monetary policy to avoid a 'disruptive slowdown'.
Sri Lanka had shown the 'largest deterioration' of the current account of the balance payments with the deficit projected to reach about 4.9 percent of GDP in 2006 compared with 2.
8 percent in 2005.
"Should policy not tighten and demand continue to expand well in excess of supply, inflation outturns will be higher, current account deficits larger, and the subsequent slowdown more pronounced and disruptive," the World Economic Outlook report for 2007 said.
"Further, widening inequality in the region will not only make growth less potent at reducing poverty, but it may lead to new social conflict or exacerbate existing ones."
Updated