Budgetary Ploy To Check ER, Interest Rates

• Pressure Builds On Forex, Money Markets

The exchange rate (ER) weakened under import pressure, while Treasury (T) Bond yields held on Friday  after sharply falling across the board at Wednesday’s and Thursday’s trading, a market source told this newspaper.
The ER closed the week at Rs. 129.00/129.10 in two way quotes to the US dollar ($) in interbank spot trading, down from the previous day’s Rs. 128.95/129.05 close and weaker by 65 Sri Lanka cents (SLc)/55 SLc week on week. The ER in the previous week closed at the Rs. 128.30/128.50 levels in two way quotes.
Meanwhile the liquidity shortfall in the money market in certain counters sharply increased to Rs. 8,265 million on Friday, compared to a mere Rs. 977 million in the previous, causing further pressure on interest rates to rise.
On Thursday, Government of Sri Lanka (GoSL) which during the first three days of trading last week was defending the ER at the Rs. 129 levels in spot, interbank trading against the $, let go of this defence, which however saw the ER  hold on to the Rs. 128.95/129.05 levels in two way quotes , a  source said on Thursday.
“The consolation was that the state was not there to buy $s from the market, which, to a certain extent relieved pressure on the ER to deteriorate,” he said.
The state, generally through its controlled commercial banks, namely  People’s Bank and Bank of Ceylon, buys $s from the market to meet commitments such as oil imports, defence bills and foreign debt servicing. “There is pressure for the greenback to dip further,” the source however said.
He speculated that GoSL was trying to control both the foreign exchange (forex) and money (interest rate) markets at least until the presentation of the budget due early next month. “After that they will let go of defending both of these markets,” he alleged.
A “cheaper” ER keeps both the GoSL’s and the consumer’s costs down in relation to matters such as oil and defence import bills and debt servicing on the part of  GoSL, and in the case of the consumer, imported essentials such as medicines, sugar and dhal. The same is true when it comes to interest rates as it helps to keep borrowing costs down whether it be GoSL, or the ordinary entrepreneur or consumer, or such like, who is the borrower.
But with liquidity short in the market, there is pressure for interest rates to move further up, the source said.  This pressure was reflected at Thursday’s secondary market trading in T Bonds where the yields appreciated by 30 basis points (bps) in the case of the longer tenure T Bonds and by 10 bps in the case of the shorter tenures, he said.
As a result the yields on the 2015 maturities went up to 12.90%, 2016s (13.20%), 2017s (13.30%) and 2018s (13.55%), the source said.He further said following the previous week’s one month term reverse repo auction for Rs.  eight billion held by Central Bank of Sri Lanka (CBSL) to meet the market’s liquidity shortfall, a similar auction is also billed to be held on Friday ( 19.10.12.), this time for Rs. six billion, also to meet the market’s liquidity shortfall.
That however turned out to be an overnight auction, from which Rs. 5,065 million was subscribed to by the market at a 9.68% weighted average yield, while another Rs 3, 200 million was sold to the market through CBSL’s  reverse repo window at the 9.75% rate. “With import demand once more overtaking the forex market due to seasonal pressure, GoSL however refused to allow the market to determine the value of the ER, by defending the same at Rs. 128.80 to the $ in interbank spot trading on Wednesday (October 17),” the source further said. On Tuesday the ER continued to remain stable at the Rs. 128.70/128.90 levels in two way quotes over that of Monday’s close, after finishing the previous week at the Rs. 128.30/128.50 levels to the $, another source said. On a rule of thumb, it’s the middle rate in two way quotes of the ER that deals are executed. He said that the reason for the weakening of the ER was due to capital outflows from the Government securities market. “With T bond yields increasing recently in secondary market trading, foreign investors felt that it was a good time to exit at a profit, hence the reason for the weakening of the ER,” the source said.  That outflow of forex has also caused pressure on the ER to dip.

According to latest available CBSL data, foreign investments in T Bills and Bonds in the week ended 10.10.12. , had had declined by Rs. 1.333 million week on week ( WoW) to Rs. 393,153 million.
When T Bond yields contract, it creates a market for the trading of such on the expectation that there is room for yields to fall further, thereby making the investment in T Bills and Bonds, a sellers’ market. However in a situation where the interest rates are on an upward swing, the contrary takes place.
This is on the grounds that when the yields of such Bonds and Bills are on the rise, that may then be more profitable for investors to buy from the primary market on the expectations that the yields in the primary market too would be deeper, thereby virtually creating a buyers’ market for such in the secondary market, resulting in yields growing higher and higher, in order to induce a market for such.
The source at the beginning of last week said that the state was there to defend the ER at the Rs. 129 level, not allowing it to depreciate further.
“I think GoSL will not permit the ER to depreciate beyond the Rs. 129 level until the presentation of Budget 2013 in Parliament next month,” a source said earlier last week.Previously GoSL/CBSL tried to control the ER at the Rs. 110 level, but with grave consequences to its forex reserves.
A weak ER makes GoSL’s external costs to go up, which is not in the best interest of the state. “It’s therefore in the interest of the GoSL to have a comparatively ‘strong’ ER,” the source said. If GoSL allowed market forces to play on the ER, it may well sink to the Rs. 131-132 levels, but not beyond that, the source speculated.
In the recent past, the lowest level to which the ER had had dipped to was to the Rs. 134 level.
“It however won’t go down to those levels in the event of a free float now,” the source alleged.
Fifty per cent of the market is the GoSL, so it has the strength to determine the course of both the forex and money (Interest rate) market at these levels, he said.
The source was alluding to the fact that the two state banks-People’s Bank and Bank of Ceylon, which play a key role in GoSL’s operations of these two markets, having a 50% share in the banks’ total loan portfolio.
That’s why secondary market yields in T Bills and Bonds contracted so steeply in recent times, he said.
Meanwhile CBSL data showed that commercial banks’ average weighted prime lending rate (AWPR) in the week ended October 12 had had WoW declined by seven basis points (bps) to 13.76%, before increasing sharply by 30 bps to 14.06% by Friday.
It however showed that T Bills’ weighted average yields ( (WAYs),  GoSL’s domestic interest rate cost due to local borrowings) in the week ended October 12, had had declined much more sharply,  by 37, 33 and 19 bps to 10.63%, 11.77% and 12.29%, for 91, 182 and 364 day tenures respectively, WoW, before increasing to 10.66%, 11.83% and 12.37% respectively by Friday.
However a year ago all of these borrowing costs were in the single digit range, with the AWPR at 9.16% and T Bill WAYs at 7.21%, 7.27% and 7.34% respectively (longer the tenure, higher the yields, on the basis that the risk factor on such investments  increases with time).
GoSL/CBSL may however control markets up to a point, but not beyond that, with factors such as external inflows/outflows taking over the market from that point onwards.
When the ER was previously administered at the cheap Rs. 110 levels, in the absence of inflows, there was demand for the $, which in turn caused a liquidity crisis, as the market had to pay CBSL in rupees to buy the discounted $s from it in return.
CBSL also tried to control GoSL’s borrowing costs (ie to keep such costs low) during this period by subscribing to T Bills at the expense of flooding the market with rupee liquidity (inflow of printed money with no forex inflows to back the same), thereby causing inflationary pressure (tending prices to go up) in the economy.
However with the partial liberalization of the ER, begun as a first step with the presentation of Budget 2012 in November last year where the rupee was devalued by 3%, followed by a further flexibility of the ER which tended it to dip even more as proven by subsequent events, even the money markets too, which were previously controlled by the CBSL, were allowed to be liberalized by it then,  causing interest rates to rise, not least GoSL’s borrowing costs, in the form of deepening of the WAYs in the T Bill primary auctions that followed (see also page 35).

5% Shareholder Wealth Lost
The bourse, at Friday’s trading made pyrrhic gains on a low turnover.
The benchmark ASI increased by 24.21 points (0.4%) to 5,649.53 points and the more sensitive MPI by 6.57 points (0.1%) over that of Thursday’s close on a Rs. 306.1 million turnover.
However the stock market in the three weeks ended Friday (ie from 28.9.12. to 19.10.12.) has seen the ASI decline by 322.46 points (5.4%) and the MPI by 509.47 points (9%). Meanwhile market capitalization which translates to shareholder wealth, in the review period had had fallen by Rs. 121 billion (5.3%).
Previous market price manipulation and a high interest rate regime prevailing in the economy have been attributed to the current reversals experienced by the bourse.
The only silver lining was that the bourse so far for the year having had experienced a Rs. 33.6 billion net foreign inflow (see also The Sunday Leader business pages of 7.10.12.).