Rupee Strengthens, But Illiquid Status Worsens

• 2014 T Bond Yield Goes Below One Year T Bill Rate In Secondary Market

The rupee further strengthened at Friday’s (September 21) trading due to a mix of sluggish import demand and possible foreign investment in the Government Bond market, a source told this newspaper.
As a result, the exchange rate (ER) strengthened by 25 Sri Lanka cents (SLc) over Thursday’s close to Rs. 131.25 to the US dollar ($) in interbank spot trading, while in secondary market trading, the yield on the “more popular” 2014 maturing Treasury (T) Bond decreased by 50 basis points (bps) to 13% due to a culmination of possible foreign investments on this tenure coupled with state names buying the same, he said.
The ER week on week (WoW) has strengthened by 95 SLc to the $ in interbank spot trading, having had closed at Rs. 132.20 to the $ in the previous Friday.*
The possible foreign investment in the 2014 Bond may have had been the reason for the ER to strengthen on Friday, the source said.
Now, that tenure is trading lower than the one year (364 day) T Bill yield which fetched 13.30% at the last primary auction (Wednesday, September 19).
But on the flip side the market was short by Rs. 15 billion,** making state owned Central Bank of Sri Lanka (CBSL) to hold a reverse repo auction, a practise that it has been indulging for the 6th consecutive day since last Friday (September 14) in order to get over the liquidity problem and thereby bridle rates.
The source said that he cannot understand this situation, where, on the one hand the yield on 2014 maturing T Bonds having had gone below that of the one year T Bill yield, while on the other hand the market being short by Rs. 15 billion*, a situation which is ripe for yields to further deepen due to a liquidity crisis overtaking the economy, and not vice versa, as that which happened on Friday, where the 2014 yield actually fell in secondary market operations.
The market, for the worse will correct this anomaly in the next few days, he said.Meanwhile two “positive” things happened in the foreign exchange (forex) and money markets at Wednesday’s (September 19) trading.
The ER on the back of sluggish import demand coupled with exporters encashing their forex ($) proceeds saw it strengthen by 25 SLc then too  over that of the previous day’s (Tuesday’s) interbank spot sales to be trading at Rs. 131.50 to the $ and held on to those levels the following day Thursday as well.And the other were that T Bill yields in the weekly primary auction (held on Wednesday) for the first time after a lapse of two months fell at that auction.
However that may be, the market’s illiquid status continued for the 6th consecutive day on Friday, forcing state owned CBSL to meet these shortfalls through its reverse repo facilities.
One of the chief reasons for the market’s illiquid status is Government of Sri Lanka’s (GoSL’s) foreign debt servicing where it borrows rupees from the market to buy $s from CBSL’s forex reserves to meet such external commitments.
An illiquid status in the market makes rates to rise; one to attract deposits and the other, ie a rise in lending rates to meet the increased deposit costs, conditions that are harmful to the economy. The only way this may be mitigated is by encouraging forex inflows, preferably cost free inflows such as foreign direct investments (FDIs). Such inflows may be sold to CBSL for rupees in lieu, thereby meeting the twin requirements of soothing pressure on the ER, whilst providing rupee liquidity to the market which would also assist in rates to come down.
Meanwhile GoSL/CBSL in recent times has adopted various measures to “kill” import demand (by making imports too expensive) and thereby tide over a balance of payment crisis.
Those included the free float of the rupee, increasing import taxes on vehicles and most recently on canned fish and potatoes; uplifting the administered prices of energy, bus fares, milk foods and bread; increasing policy rates and limiting bank credit growth year on year to 18% this year, with the exception that it could be uplifted by a further 5%, provided the required additional funding comes from overseas sources. Nevertheless Wednesday’s T Bill primary auction saw the weighted average yields (WAYs) for all three tenures on offer decline for the first time in two months.
The WAY for the 91 day tenure fell by three bps WoW to 11.41%, that of the 182 day tenure by 21 bps to 12.91% and that of the 364 day tenure by six bps to 13.30% at that auction.A market source on Wednesday explaining the rationale behind the fall in T Bill WAYs to this reporter said that even T Bond yields in secondary market activity since the previous week has had been falling.
Prior to Wednesday’s fall, T Bill yields last declined in the auction of July 25 where the 91, 182 and 364 day tenures fell by one, six and one bp each to 11.35%, 12.85% and 13.15% respectively (see The Sunday Leader business pages of 29.7.12.).
Those declines then were possible due to the receipt of the proceeds of a $ one billion sovereign bond floated by the GoSL at that time, where part of the proceeds were used to infuse rupee liquidity to the market by selling those to CBSL and obtaining rupees in lieu, which helped to ease pressure on rates, including those of T Bill yields.
But since then T Bill yields had been on a steady ascent, interspersed by being stagnant at times due to inflationary pressure besetting the economy, in part due to the recent policy measures such as the free float of the rupee which had made the local   currency to fall by nearly 20% in under a year that has made prices to rise as Sri Lanka is an import dependent economy and the other being CBSL’s huge stock of T Bill holdings of over Rs. 200 billion that gives it little manoeuvrability to intervene in money markets in order to soothen rates.
Meanwhile the ER at Tuesday’s (September 17) trading too strengthened, to the Rs. 131.75 level to the $ in interbank spot trading on the back of exporters encashing their $ proceeds, a source said on Tuesday.
The market is “slushed “with $s, he added.The source however said that at the beginning of trading on Tuesday, the ER weakened to Rs. 132.10 on the back of speculation before making gains.Volumes were moderate, he added
At the beginning of last week on Monday (September 17) the ER strengthened to the Rs. 132 level after closing at the end of the previous trading day Friday, September 14 at the Rs. 132.20* level. Trading volumes on Monday were between $ 30-40 million, he added.

Money Market

The money market’s illiquid status continued for the 6h day running on Friday, compelling CBSL to have a reverse repo auction for Rs. 15,000 million to meet this shortfall.**
On the previous day Thursday, the market was short by Rs. 8,364 million. CBSL met Rs. 7,513 million of this shortfall through a reverse repo auction at a 9.65% WAY, while the balance was met by its standby reverse repo window at the 7.75% interest rate.
On Wednesday the market was short by Rs. 943 million, Tuesday (Rs. 1,143 million), Monday (Rs. 2,573 million) and last Friday (September 14)-Rs. 3,870 million.
Meanwhile a source speaking a day prior to Wednesday’s T Bill auction told this reporter, “The money market may see interest in tomorrow’s (September 19) weekly gilt edged and risk free T Bill auction for the longer tenure 364 day T Bill by banks.
They will consider this tenure as an attractive investment tool rather than to be used for trading purposes,” he had then said.
At the previous week’s T Bill auction, all three tenures on offer, ie the 91, 182 and 364 day tenures stagnated at the 11.44%, 13.12% and 13.36% level respectively.
The source further said that as a result of the expected demand for the 364 day T Bill at tomorrow’s (September 19) auction, the WAY should weaken for this tenure.
He however predicted that the WAY for the other two tenures, ie the 91 and 182 day tenures would increase by a few  bps at this auction, which, however as the unfolding events showed, were not to be.
But another source, referring to the fact that T Bill yields stagnated at the previous week’s auction said that CBSL had given a clear message to the market at the previous week’s auction that they don’t want yields to go up.
He was of the opinion that CBSL used a mix of captive forces together with the market to prevent yields going up at the previous auction. Examples of a few captive funds are the EPF and ETF.
T Bills are an instrument used by GoSL to borrow money from the market to meet its expenditure commitments.
When yields deepen or increase, that also means that GoSL’s borrowing costs too increase. Further T Bill yields are also known as the benchmark interest rates, meaning that market rates move in tandem with T Bill yields. So when T Bill yields rise, market interest rates too rise, making borrowings costly not only for the purposes of consumption, but also for investments as well.
When investments slowdown, especially due to high borrowing costs, that has an impact on production, income, exports and job creation, all these being precursors to create social, political and economic instability in a country. Further when interest rates rise it may also result in an increase in banks’ bad debts due to debtors reneging on their repayment commitments on bank borrowings due to the higher costs now involved.
And when bad debts increase that may also cause a systemic risk to a country’s banking and financial system as a whole.
Meanwhile liquidity in the money market continued to be short the whole of last week, following a pattern that began last Friday (September 14), a harbinger that there is room for interest rates to go up further.
On Monday the market was short by Rs. 2,573 million on certain counters. This compelled CBSL to meet Rs. 2, 000 million of this shortfall through a reverse repo auction at a 9.37% WAY, while the balance was met by its reverse repo standing facility at the 9.75% interest rate.
The following day Tuesday (September 18) the market was short by Rs. 1,143 million, which shortfall was met by CBSL’s reverse repo auction at a 9.65% WAY, 28 bps more than the previous day’s WAY of 9.37%, while on Wednesday the shortfall was Rs. 943 million, all of which was met CBSL’s standby reverse repo window at a 9.75% interest rate.
On Thursday the shortfall was a hefty Rs. 8,364 million. CBSL met Rs. 7,513 million of this shortfall through a reverse repo auction at a 9.65% WAY, while the balance was met by its standby reverse repo window at the 9.75% interest rate.
While this shortfall further increased to Rs. 13.510 million on Friday, with Rs. 10,660 million met through the CBSL’s reverse repo auction at a 9.65% WAY and the balance through its reverse repo standing facility at the 9.75% interest rate.
Last Friday (September 14) too the market was short by Rs. 3,870 million; of which shortfall Rs. 3,000 million was met by a reverse repo auction at a 9.64% WAY, while the balance was met by CBSL’s reverse repo window at the standard 9.75% rate. The market tends to be short when GoSL resorts to an offmarket activity of buying $s from CBSL’s forex reserves to meet its foreign debt obligations.
In such an action, it borrows rupees from the market to buy the required $s from CBSL.
This sometimes results in the market going short in the event if “ large” amounts of rupees are required to buy the necessary $s to service such commitments.
On the other hand if GoSL buys the required $s from the market to meet this commitment, then the rupee liquidity stays on in the system (rather than being absorbed by CBSL).
But such an activity may cause pressure on the ER to decline, particularly so if the required $s for such debt servicing are relatively large and the market capacity to service such being relatively small.
When the ER weakens, it makes imports more expensive, a terrible cost for an import dependent, poor, developing country such as Sri Lanka, where such a scenario will hurt the poor, the vulnerable and the fixed income earner the most.
However that may be, liquidity to the market may be infused in two ways, ie by printing and flooding the market with rupees as CBSL has the sole authority to print rupees, or otherwise making the economy attractive to attract large amounts of forex inflows, preferably in the form of FDIs.
Excessive printing of rupees without a commensurate increase in economic growth (which translates to an increase in the wealth of a people of a country), tends to create inflationary pressure on an economy, ie for prices to rise, on the supply and demand theory, ie too much of money chasing after too fewer goods, the hapless victims of such a scenario being the poor and the fixed wage earner.
And to dampen inflationary pressure, a natural consequence is a rise in interest rates with the attendant evils that go with thus.
On the other hand if there are sufficient amount of forex inflows, those will not only help to strengthen the ER thereby making imports cheaper (vital for an import dependent country such as Sri Lanka), but the excess may also be sold to the CBSL and thereby obtain rupees in lieu, therewith flooding the market with rupee liquidity, which would help to bring down rates.
Borrowed forex inflows however come at a price, with debt servicing and all that included, which in turn sooner or later will cause pressure on both the ER and market liquidity as the aforesaid events go to show.
*In The Sunday Leader business pages of the previous week, it was reported that the ER on Friday September 14 had weakened to the Rs. 132.25 level. It had however not given the ER’s closing figures for that day.
**According to CBSL data, the market was short by a total of Rs. 13,510 million on Friday. Rs. 10,660 million of this shortfall was met by CBSL by a reverse repo auction at a 9.65% weighted average yield, while the balance Rs. 2,850 million was met by CBSL’s reverse repo standing facility at the 9.75% interest rate.
The original amount offered in CBSL’s reverse repo auction was Rs. 14.5 billion. Further, according to available CBSL data, inflows into the Government Securities Market in the week ended Wednesday, increased by Rs. 3,428 million ($ 28.9 million) week on week to Rs. 394,558 million (1$=Rs. 131.25).