By Paneetha Ameresekere – Business Editor
What should a central bank’s policy rates, i.e those rates at which it lends or borrow money to and from banks on an overnight basis reflect?
Should not its overnight reverse repurchase rate (reverse repo) in particular, i.e. the rate at which it lends money to banks for a day reflect the rate at which cheap money could be borrowed by such lending institutions facing liquidity problems so that they in turn would make available cheap credit to the end user, in particular to the private sector, the engine of growth of the economy?
Similarly, should not a central bank’s overnight repurchase rate (repo) reflect the rate at which banks could park their excess liquidity or cash , giving it the best possible return, with the 100% guarantee of the safety of such deposits?
But if neither of these is happening, should not a central bank then question the relevancy of its policy rates?
This is the situation in Sri Lanka, where the Central Bank of Sri Lanka (C.B.S.L.) has policy rates which are seemingly unrelated to market dynamics.
While C.B.S.L.’s repo rate is 7.5% and its reverse repo rate is 9.75%, no bank appears to be using those rates either to borrow or to park their excess cash with C.B.S.L. simply because there are other alternatives from which banks can borrow cheaper, while at the same time park their excess cash by which they could get a higher return, and, equally secure, as the repo.
Banks prefer to park their excess cash in C.B.S.L.’s overnight open market operations (o.m.o.) instead of using its repo facility, where the rate offered is some 8% (it was 8.18% on June 24), 50 basis points (b.p.s) more than C.B.S.L.’s repo rate, thereby getting a better return than the repo, when parking their excess cash under the o.m.o. facility.
Similarly, the overnight inter-bank borrowing rate or call money transactions rate is in the region of 9.11%; more than 60 b.p.s cheaper than C.B.S.L.’s reverse repo rate. So why should banks borrow from C.B.S.L.’s reverse repo window when there are cheaper alternatives available?
C.B.S.L. says that the repo and reverse repo rates act as the corridor for money markets to operate, that argument is justificiable, on the basis that the market would determine rates, but in reality does that actually happen?
Why then does the market park their excess cash in C.B.S.L.’s o.m.o. which go beyond its policy rate corridor by offering overnight returns to banks which are 50 b.p.s. more than its repo rate?
O.m.o. is an exercise that C.B.S.L. resorts to, to drain excess liquidity from the market as a safeguard against inflationary pressure on the economy. These days those rates are in the region of 8%, 50 b.p.s. higher than C.B.S.L.’s 7.5% repo rate.
Therefore investors naturally prefer to park their excess cash under C.B.S.L.’s o.m.o. umbrella as they get a higher return compared with what they would get if they had parked their excess cash under C.B.S.L.’s repo window.
This market distortion was pointed out by one of our sources in an article published in these pages in our last week’s edition under the heading “Foreigners Continue To Exit Bourse.”
By its o.m.o., C.B.S.L. is paying the market 50 b.p.s (1/2%) more than what it would have had been paying if the excess liquidity in the system was drained out from C.B.S.L.’s Repo window only. Paying ½% more, even though it’s only on an overnight basis is still a lot of money when one considers the volumes involved, literally speaking in the billions of rupees.
For example, in the recent short week due to Friday, June 25 being a Poya holiday, on an average, the market parked some Rs. 20.88 billion of excess cash on an overnight basis with C.B.S.L. under its o.m.o. at an interest rate of around 8.18%, on a daily basis. In contrast the amount parked under its Repo window was a mere Rs. 2.72 billion.
If the interest payable under o.m.o. is rounded-up to 8%, i.e. ½% more than C.B.S.L.’s Repo rate of 7.5%, it would work out to C.B.S.L. paying an excess interest amounting to Rs. 286,027 daily to the market.
Multiply this by 365 days, then this figure would balloon to Rs. 104,399,855, i.e. the amount equivalent to the total excess interest that C.B.S.L would be paying the market annually from its o.m.o. window when compared with its Repo, a huge amount under any circumstances, which, however would not have had been the case if it only had its Repo window in place to drain out excess liquidity from the market.
If the argument that o.m.o. is a necessary evil to drain out excess liquidity from the system, why then should it be duplicated by C.B.S.L. operating a Repo window as well? The argument is that if C.B.S.L. stops having its o.m.o. it would help to bring down rates as the market would have no alternative other than to park its excess liquidity under the Repo window. C.B.S.L. is a public institution, therefore the monies it handles is public money. As such accountability should be drilled into its ethos. It’s also the regulatory body of financial institutions and espouses a good governance code to such.
But if it does not practice good governance in its own backyard, what example does it set? Quis custodiet ipsos custodes?