“If we feel very confident with the events of the next few months, then we would feel a little more inclined to relax further,” Cabraal said in an exclusive interview with The Wall Street Journal.
“It will be a decision that will be taken around September, October; then we will really give it a careful look,” he added.
For the time being, though, Cabraal said monetary policy is likely on hold.
The Sri Lankan Central Bank reduced its target short-term borrowing rate in December from 7.75% to 7.5%, and then reduced it an additional half percentage point in May to 7%.
The next step will depend largely on how inflation performs. The bank is aiming for inflation to fall to around 5% or 5.5% by the end of this year, from 6.8% in June, and for the economy to grow by 7.5%, from 6.4% in 2012.
A big wild card for emerging-market central banks in the months ahead will be US monetary policy.
Many emerging markets have been buffeted in recent weeks by the US Federal Reserve‘s discussions of exiting from its easy-money policies.
The Fed’s $ 85 billion-a-month in bond purchases, launched in September, lowered US long-term interest rates, triggering a surge of capital into fast-growing emerging markets with higher rates.
The Fed sparked a reversal in those flows in June when the bank said it could begin reducing its bond buying later this year and end the program altogether by mid-2014 if the US economy improves as Fed officials expect. The news caused investors to restructure their portfolios, stoking volatility in currency, bond and equity markets around the globe.
Cabraal, who was in the US to brief investors on Sri Lanka’s finances, said the country is largely prepared for the Fed’s exit because it has tried to limit its exposure to swift changes in capital flows.
Sri Lankan authorities have been careful not to open up their debt markets too wide, too fast, he said, focusing on international investors looking for long-term exposure.
US investors have tended to buy long-term Sri Lankan debt, Cabraal said.
US pension funds that need to match up their long-term liabilities, for example, are far less likely to sell out of Sri Lanka in the near term, added N.W.G.R.D. Nanayakkara, Sri Lanka’s Superintendent of Public Debt.
“Many have said they want to hold until the bonds mature,” Nanayakkara said.
The Central Bank has also doubled its cash reserves in the last several years. It is planning to continue stockpiling foreign-exchange reserves over the next several years to give it an even bigger buffer against market volatility.
Furthermore, the Government in Colombo has been steadily cutting the budget deficit since the end of the civil war in 2009.
“Our credit story has been convincing,” Cabraal said. Investor demand, strong growth, a declining deficit and the end of conflict has pushed borrowing costs down several percentage points.
His bank isn’t the only one preparing for a Fed exit: Cabraal said that central bank governors in the region have been swapping strategies at recent meetings.
The Governor said his biggest fear in the global economy is the euro-zone crisis, where authorities haven’t been able to tame prolonged recession that threatens to deteriorate into something worse. Europe is one of Sri Lanka’s largest export markets.
If a harbinger for other emerging markets, Colombo’s response should be a cautionary tale for Europe.
Cabraal said many firms are now looking for alternative export markets: the currency union’s ongoing problems are spurring Sri Lankan officials to start negotiating a free-trade agreement with China. The bank also wants to expand its reserve holdings of Chinese yuan, he said.