Economic conditions have continued to improve in the past few months. The continued decline in inflation and inflationary expectations, the improvement in the external sector, containment of public sector borrowing, and growth in money supply and credit, have enabled the Central Bank to reduce its policy rates. Further, the corridor between the Bank's Reverse Repurchase (Reverse Repo) rate and its Repurchase (Repo) rate has been narrowed, to make the width of the corridor more consistent with the current level of interest rates. With effect from 16 October, the Central Bank's Repo rate would be reduced by 50 basis points to 7.00 per cent and its Reverse Repo rate by 100 basis points to 8.50 per cent.

Real Sector: Output Growth
The economy grew by 5.5 per cent during the second quarter of 2003, resulting in a 5.6 per cent growth in the first half of 2003, as against the 1.4 per cent growth in the corresponding period of the previous year.
The growth was driven by the industrial and the services sectors, as the agriculture sector contracted. During the second quarter of 2003, the industrial sector experienced a significant growth, indicating a recovery and enabling the achievement of a 6.9 per cent growth in this sector in the first half. Higher electricity generation in 2003 and the continued recovery in the manufacturing sector were primarily responsible. The services sector continued to experience high growth (7.2 per cent for the first half of 2003), benefiting from the high growth in the banking, insurance and real estate sector and the telecommunications sector, port activities and tourism related services. However, the agriculture, forestry and fishing sector contracted 0.2 per cent, despite the bumper paddy harvest and higher rubber output, due to the impact of the floods in the middle of the year on some crops and the significant decline in fish production.

Inflation
Inflation continued to decline as reflected in the downward movement of all measures of inflation. The annual average of the Colombo District Consumers Price Index fell from 3.5 per cent in August to 3.1 per cent in September, while the annual average growth in the Colombo Consumers' Price Index declined from 7.8 per cent to 7.6 per cent in September. The fall in prices has been driven by improved agricultural production, reduced pressure from import prices and prudent monetary policy which prevented building up of demand pull inflationary pressure. Meanwhile, the 12-month moving average of the Sri Lanka Consumers' Price Index (SLCPI) declined from 5.4 per cent in July to 4.8 per cent in August.

External Sector
The trade deficit (US dollars 824 million) has continued to decline in 2003 compared to the corresponding period in 2002 (US dollars 977 million). Cumulative export earnings during the first seven months of 2003 grew by 18 per cent to US dollars 2,871 million, while expenditure on imports during the same period grew by 8 per cent to US dollars 3,694 million.

The continued reduction in the trade deficit, together with increased foreign exchange flows from tourism, port services, private transfers and in the capital account, has enabled the Central Bank to purchase US dollars 333 million from the market during the first three quarters of 2003.

Foreign Exchange Market
The rupee depreciated against the US dollar up to June, but has recorded an appreciation since then. However, the rupee has depreciated against other major currencies such as the euro, the sterling pound and the yen. Most major currencies have appreciated against the US dollar. Despite the appreciation of the rupee against the US dollar, the rupee's depreciation against other major currencies and the faster decrease in domestic inflation have resulted in the real effective exchange rate recording a depreciation, indicating an improvement in the competitiveness of the country's exports. The 24-currency real effective exchange rate (REER) has depreciated by about 4.2 per cent in 2003 up to 15th October.

The country's gross official reserves have increased to around US dollars 2,065 million by end August 2003 from US dollars 1,700 million by end December 2002. The total gross international reserves increased to US dollars 2,903 million, which is equivalent to about 5.3 months of imports, at end August 2003.

Monetary Sector
Growth in broad money supply (M2b), on a point to point basis, was 12.1 per cent in August 2003 compared to 12.0 per cent in July. Despite a sharp increase in the net foreign assets of the banking sector, the growth in money supply remained within the projections. The average growth in money supply during the first eight months of 2003 was 13 per cent. The decline in credit to the public sector, i.e., the government and public corporations, helped to maintain monetary expansion within the programme. Meanwhile, credit expansion to the private sector is improving gradually, but is still below expectations.
Interest Rates
The Central Bank's policy interest rates, i.e., Repo and Reverse Repo rates, have been revised downward so far in 2003 by 225 basis points. At present, the Repo rate and Reverse Repo rates are at 7.50 per cent and 9.50 per cent, respectively.

With improvements in market liquidity and consequent on the reduction in Central Bank rates, the inter-bank call money rates declined and have remained around 7.80-7.85 per cent at end September. Treasury bill yield rates too showed a gradual decline from March. So far in 2003, the yields on 91-day and 182-day Treasury bills have declined by 271 and 273 basis points, respectively, while the yield on 364-day Treasury bills has declined by a total of 282 basis points. Commercial banks' prime lending rates moved in line with the trends in other short-term rates, although other lending rates still remain high.

Stock Market
Key market indicators have shown record performance in 2003. The ASPI, which was 815 at end-December 2002, crossed the 1,300 points level on 02 October 2003 for the first time since March 1994. The MPI recorded its highest levels with the index reaching the 2,500 mark. The MPI, which was 1,375 by December 2002, had reached 2,524 by 10 October 2003. On 02 October 2003, the Colombo Stock Exchange achieved a further milestone by crossing the Rs. 50 billion mark in cumulative turnover. During the past 10 months market capitalisation has also risen by almost 100 per cent. Market capitalisation was Rs 323.8 billion as against Rs 162.6 billion at end-2002.

Monetary Policy
Considering the above developments, the Central Bank has decided to reduce its Repurchase rate by 50 basis points and the Reverse Repurchase rate by 100 basis points. With this revision, the Repurchase rate and Reverse Repurchase rate would be 7.00 per cent and 8.50 per cent, respectively. The change in the rates narrows the corridor between the Repo rate and the Reverse Repo rate. A narrowing of the corridor is appropriate as the level of interest rates has declined and the bid-ask spread in the call market has decreased. The Central Bank expects a strong response to the lowering of rates from all financial institutions through an adequate and immediate reduction in their lending rates, and communication to the market of the new rates. The Central Bank will continue to monitor monetary and economic developments carefully and make changes to its monetary policy stance as appropriate. The next regular statement on monetary policy would be made on 11 November 2003.