Liquidity Dries Up

Rapid credit and import growth are placing pressure on market liquidity, a banking source told this reporter.
As a result bank deposit rates are being raised as a ploy to attract liquidity into the system so that that in turn could be lent at a higher price to meet increasing credit demand, he said. Even to obtain low cost liquidity from Central Bank of Sri Lanka’s (CBSL’s) reverse repo auction or purchase window to meet this demand is a problem as Government securities (Treasury (T) Bill and Bonds) have to be given as collateral to CBSL in lieu, he said.
CBSL doesn’t lend money for nothing, the source said. Such borrowings from the CBSL have to be supported with T Bills as security.
But with T Bills fetching lower yields than bank fixed deposits (FDs), which bank in its right senses would want to invest its money in low yielding T Bills when having to pay much more to a customer who has invested in an FD with a bank? he asked. They would rather invest such money in the market which is high yielding than lend to the Government of Sri Lanka (GoSL) where the returns fetched from such credit are low, he said.
According to the source, the spread between bank FDs and T Bills virtually for all tenures, ie three months, six months and one year was as high as 400 basis points (4%). But a year ago the story was different, with banks’ FD rates being in tandem with T Bill yields for almost all tenures, the source said.
Not only credit growth, but high import demand too drains out rupee liquidity from the system, particularly so in a scenario where foreign inflows are less than foreign outflows, thereby creating a deficit in Sri Lanka’s foreign exchange (forex) income.
One way of solving this problem is by depreciating the rupee, thereby making imports more expensive and, ipso facto acting as a deterrent again making foreign purchases. But a possible fallback in this type of operation is that it also makes essential commodity imports needed by the poor, or which indirectly has a bearing on the poor such as diesel  needed for goods/public transport more expensive, thereby hitting the poor the hardest in such a scenario.
When an importer buys forex, usually US dollars ($s) to make an import, he drains out rupee liquidity from the system. The situation is compounded as there is a net foreign outflow of $s from the country rather than the opposite taking place. Part of the reason for this net outflow is because the rupee is being protected by GoSL/CBSL as a measure to control import prices.  But if the $ is too expensive, that would deter the market from going after the greenback, however if the $ is “cheap,” as it appears to be so now, that creates demand for $s in the market to make imports. Currently GoSL/CBSL in interbank trading is defending the exchange rate ((ER) (rupee)) at Rs. 113.90 to the $. But as demand for $s outpaces supply, GoSL/CBSL, as it’s defending the rupee at an administered rate, is forced to draw down from its forex reserves to quench the market of its thirst for $s, thereby going against market fundamentals as the value of the ER is fixed or administered, as opposed to being guided or determined by market dynamics.
So the sole seller of the ER at a low, administered price is CBSL. As a result CBSL gets flushed with rupee liquidity (when they sell $s to the market), while at the same time becoming poorer of its holdings of forex reserves. It may release this excess rupee liquidity to the market through its reverse repo auction or reverse repo purchase rate at a maximum overnight price of 8.50%*, but the hitch is that such borrowings from CBSL have to be supported by the borrowers (banks) by providing it with low yielding T Bills as security (lower than what could be gained if the same was lent to the market).
Therein lies the crunch! (See also business page editorial found on page 42)
* CBSL’s reverse repo purchase rate that prevailed at least till Thursday.

No Liquidity Problem
Foreign capital infusion has stayed away the liquidity crisis from one of the island’s smaller banks.
A consultant to this bank who didn’t want to be named told this reporter with its branch expansion, that that has absolved it from any possible liquidity stress due to deposit mobilization.