Page 18 - 2022 Abstract Book RUICHSS_2022_11_17 after conference

University of Ruhuna ISSN: 2706-0063
Matara, Sri Lanka

With the sharp hike in inflation, economies like Sri Lanka with high import
levels may struggle to pay for necessities imported from outside and interest on their
loans incurred abroad. Furthermore, governments of similar situation economies are
incurring more and more debt, and nonbank financial organizations like insurers,
pension funds, hedge funds, and mutual funds are particularly susceptible due to their
increased exposure to market risk. Rising rates have added a new layer of challenges
for businesses with weak (or leveraged) balance sheets. The loans and advances
amount to an 11.09% increase from 2020Q1 – 2022Q2, and 21.05% drop in
commercial banks' deposits in Sri Lanka.
Accordingly, Sri Lanka must be wary and watchful about its enormous or
rapidly expanding debt burden, which could exacerbate economic and financial
vulnerabilities. This is especially true for economies like Sri Lanka that rely heavily
on dollar-denominated debt from foreign lenders and are already grappling with
rising servicing costs or cash shortages. Nonetheless, the policy responses of Asian
economies to the Fed tightening of the monetary policy largely depend on the
prospect of domestic inflation, growth, and financial stability in these economies. In
the case of Sri Lanka, it is evident that the inflationary pressures continue to rise with
a slight fall in the unemployment level.

Central banks in the region have raised their policy rate in response to these
events, influencing all other interest rates, such as the commercial bank interest rate
applied to their borrowers and depositors. In other words, a rise in the policy rate
discourages the purchasing decisions by households and corporates due to higher
borrowing costs, thus reducing inflation. However, as Sri Lanka is facing persistent
currency depreciation pressure, hiking up of policy rates may not be sufficient to
control capital flow management policies to deal with potentially destabilizing and
unwanted capital outflows.
Generally, there is an increase in financial instability, capital outflows, and
currency devaluation in Asian economies when the US tightens its monetary policy.
The fluctuation of interest rates creates asset price uncertainties, making it more
difficult and taking longer for certain asset classes to trade at a given price. In
combination with existing weaknesses, low market liquidity might accentuate any
sudden, uncontrolled reprising of risk.

This suggests that the high inflation rate linked with a rise in commodity
prices presents policymakers with difficult issues, as they must balance the competing
goals of maintaining price stability and fostering economic growth. These difficulties

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