High Inflation, Illiquidity Persist

• Reduction Unwarranted

In the backdrop of Wednesday’s key policy rate cut of 25 basis points (bps) of Central Bank of Sri Lanka’s (CBSL’s), Friday saw the market short by at least Rs. 28 billion*, with CBSL meeting Rs. 15 billion of this shortfall by an overnight (o/n) reverse repo auction, while the balance was met by a term reverse repo auction, a market source told this newspaper.
A rate cut usually is made to spur credit growth by offering an incentive for interest rates to come down. But with high illiquid levels besetting the economy coupled with high inflation (it was 9.5% last month), conditions are ripe for a rate hike and not for a rate cut.
A source said that state owned People’s Bank, generally considered as an agent for the Government of Sri Lanka (GoSL) was allegedly in the market, involved in extensive rupee purchases. O/n call money rates in two way quotes were going at the 10.35/40%* levels, slightly higher than the previous day’s level, he said.  Meanwhile on the previous day Thursday, call money transactions’ weighted average rate (WAR), after its steep contraction on Wednesday, fell by a marginal one bp to 10.31%, while o/n market repurchase transactions fell by 17 bps to 9.34%.
Treasury (T) Bond trading in the secondary market was subdued on Friday, holding on to the previous day’s level, a source said. T Bonds of 2014 and 2015 maturities in secondary market trading were being quoted at the 12.10/35% levels, that of the 2017 maturity at 12.40/55% levels and the 2018 at the 12.75/95% level, he said. There were hardly any bids for the 2016 maturity, he said.  However on the previous day Thursday, T Bond yields of 2014 maturity fell by 15 bps to 12.25/35% in two way quotes; while the other tenures leading up to the 2018 fell by 10 bps each to:- (2015): 12.35/40%, 2016: 12.55/60%, 2017: 12.65/70%, 2017: 12.65/70% and 2018: 12.70/75, a source from another bank said. Meanwhile   the exchange rate (ER) which appreciated to the Rs. 128 level to the US dollar ($) in interbank spot trading on Friday on the back of exporters encashing their foreign exchange (forex) proceeds and the receipt of remittances, afterwards fell to the Rs. 128.60/70 level allegedly due to HSBC buying $s from the market.
Demand for $s makes it dearer. GoSL doesn’t necessarily have accounts only with the two state banks, they may well maintain accounts with other banks such as allegedly with HSBC. Their external commitments such as meeting an oil bill or foreign debt servicing or an arms procurement bill, may make them to seek $s from the market to settle such payments. But on the previous day Thursday, the ER buttressed by exporters encashing their forex proceeds due to seasonal commitments, coupled with remittances strengthened to the Rs. 128.45/55 level in two way quotes against the $ in interbank spot trading one banker said, while another said that the ER was being quoted at the Rs. 128.40/60 level on that day.
On Thursday the ER continued to strengthen and T Bond yields continued to fall on the back of Wednesday’s CBSL’s 25 bp policy rate cut, a source said. Another however said that with inflation at 9.5% and the market being short of liquidity almost on a daily basis, those didn’t warrant for Wednesday’s policy rate cut.
On the aspect that the market when short could always borrow from CBSL’s reverse repo instruments? He said that while the market may borrow cheap from CBSL’s reverse repo instruments, it may even “abuse” such borrowed money by investing in gilt edged T Bills after borrowing cheap which will in turn give him a higher return, thereby negating the very purpose of having reverse repo instruments under the current scenario where reverse repo instruments command lower yields than T Bill yields. Therefore under those circumstances an environment of a “low” interest rate regime on the one hand and a high inflationary regime compounded by the money market being short virtually on a daily basis on the other is unsustainable, he opined.The panacea for this is enhanced forex inflows.
Meanwhile following Wednesday’s steep fall in T Bond yields in secondary market trading, those had a spillover effect the following day Thursday as well, with T Bond yields of 2014 maturity falling by 15 bps to 12.25/35% in two way quotes; while the other tenures leading up to the 2018 fell by 10 bps each to:- (2015): 12.35/40%, 2016: 12.55/60%, 2017: 12.65/70%, 2017: 12.65/70% and 2018: 12.70/75, a source said.
However the market on a net basis was short by Rs. 1,131 million on Thursday, which shortfall was met by CBSL’s reverse repo window at its new 9.50% interest rate. Call money transactions WAR, after its steep contraction on Wednesday, fell by a marginal one bp to 10.31% on Thursday, while o/n market repurchase transactions fell by 17 bps to 9.34%. In other developments on Thursday, the ER buttressed by exporters encashing their forex proceeds due to seasonal commitments, coupled with remittances strengthened to the Rs. 128.45/55 level in two way quotes against the $ in interbank spot trading one banker said, while another said that the ER was being quoted at the Rs. 128.40/60 level on Thursday.
State owned Bank of Ceylon (BoC) was on the buying side, if not of which the ER would have had strengthened further on Thursday, a source said.  Institutions such as BoC generally buy from the market to collect forex to meet GoSL’s external commitments.
Meanwhile on the previous day Wednesday, with CBSL’s Monetary Board in their press release issued on that day announcing a 25 bp cut in its policy rates, that seemingly had a cascading effect on the money market, with the yields of T Bonds trading in the secondary market coming down by as much as 25 bps in regard to certain tenures, a source said.
He said as an example that that the yield of the 2014 maturity fell by 25 bps over Tuesday’s close to be trading  at the 12.45/50% level in two way quotes, while the 2015 maturity also fell by a similar amount to the 12.50/55% levels. Greater the demand for T Bonds in the market, lower the yield (ie the narrowing down of the price gap that exists vis-à-vis the price that such a Bond will fetch at the time of maturity and the price at which such a T Bond was sold in the secondary market prior to maturity), thereby creating a sellers’ market, due to the expectations that yields (interest rates) will fall further. However if the market expects interest rates to rise in the economy, then secondary market yields will get steeper due to a buyers’ market being in operation.
 Those secondary market yield falls of Wednesday were replicated on the longer tenures as well, going up to the 2018s, he said.
Wednesday’s rate cut also had an impact on call money (o/n interbank borrowings), with the WAR of call money transactions declining by 21 bps over its previous day’s WAR to 10.32% and the WAR of o/n market repurchase transactions (ie borrowings made with T Bills as collateral) declining by 15 bps to 9.51%.
However that may be, the money market on a net basis was short by Rs. 1,209 million on Wednesday. CBSL met this shortfall through its reverse repo window.  The policy rate cut also had a cascading effect on T Bill yields at Wednesday’s primary auction, with the weighted average yield (WAY) of the182 day (six months) tenure falling by 32 bps week on week (WoW) to 11.78% and that of the 364 day (one year) tenure by 41 bps to 12.45%.
Similarly the 91 day (three month) T Bill, which bids were rejected at the previous week’s auction, probably due to the market having had asked for higher yields then, saw its WAY decline by 35 bps to 10.44%, over that of the WAY fetched at the November 28 auction.
Meanwhile the ER on the back of inflows strengthened to the Rs. 128.60/65 level in two way quotes in interbank spot trading against the $ on Wednesday.  The previous day Tuesday it had closed at the Rs. 128/85/95 level.
In other developments, Selected T Bond yields which expanded on Monday (December 10), reversed this trend the following day Tuesday, by contracting by 10 bps across the board due to renewed demand, while the ER weakened for the second consecutive day because of import pressure combined with nominal buying interest by the state, a source said on Tuesday. As a result the ER weakened by 15 Sri Lanka cents to Rs. 128/85/95 in two way quotes in interbank trading against the $ over that of the previous day’s (Monday’s) close, while the yields of T Bonds of 2014, 2015 and 2016 maturities contracted by 10 bps each to 12.70%, 12.80% and 12.90% respectively, which the source said was due to investors taking a long term view of the market, expecting interest rates to come down, hence demand for those Bonds in secondary market trading.
When T Bills and Bonds are in a contracting mode, an effect that may be caused by interest rates (market) coming down, that creates a sellers’ market for T Bills and Bonds to the advantage of the holders of such government securities in secondary market trading.
The reverse is also true in a scenario when interest rates are rising, which in turn creates a buyers’ market for such securities to the disadvantage of the holders of such, who may have to divest those holdings at a loss in secondary market trading.
Elsewhere in the money market, the market which on a net basis was excess by a marginal Rs. 645 million on Monday, saw this excess dissipate the following day, to be short by Rs. 1,038 million on Tuesday. CBSL met this shortfall through its reverse repo window.
Generally the market goes short due to sub market operations, the purveyor of which is the GoSL. This happens when GoSL has certain external commitments like having to service foreign debts, or settle an oil or defence bill, where though they borrow rupees from the market to buy the required $s to settle such commitments, they however avoid buying the required foreign currency from the market, and instead buy the same from CBSL’s forex reserves. This is done (ie by not buying the required $s from the forex market) so as not to disturb the forex market, on the basis that such an action may cause the ER to depreciate. A weak ER makes imports more expensive, especially for an import dependent economy like Sri Lanka, which in turn will hit the poor, the vulnerable and the fixed wage earner the hardest.
 But on the flip side such an activity drains out rupee liquidity from the market, thereby causing stress on interest rates.
On the other hand if GoSL had purchased the required $s from the market, rupee liquidity would have had remained with the same.
Meanwhile at the beginning of the week on Monday, the ER weakened on the back of import demand while the anomaly which was there in the T Bond market where the longer tenures were trading lower than the shorter was being rectified, a source then said.
But as the aforesaid events showed, this anomaly was once more restored due to renewed demand for T Bonds of a “longer” tenure by the market.
He also  said that the ER which opened Monday (December 10) at Rs. 128/40/50**  level to the $ in two way quotes in spot trading weakened to the Rs. 128/70/80 on thin volumes. He added that the ER opened Monday at the same price as the previous week’s close.** “The weakening of the ER was due to import pressure, GoSL stayed away from the market on Monday,” he said. However as said above, GoSL once more returned to the market the following day Tuesday, albeit buying $s in nominal quantities from the same.
The source further said that the T Bond market on Monday was an active buyers’ market, with the distortion that prevailed in the money market previously, ie of T Bonds of a longer tenure fetching yields (interest rates) that were shorter (lesser) than that of the one year T Bill rate being rectified.***
This correction began after last month’s inflationary figures were out, he had then said. The point to point change in inflation as measured by the Colombo Consumers’ Price Index (CCPI) maintained by the Census and Statistics Department increased to 9.5% last month, a 0.6 percentage point climb over the previous month’s year on year change. At the previous week’s auction, one year (364 day) Treasury (T) Bill yields rose by one bp to 12.86%. However last Friday (December 7), the yields of T Bonds maturing between 2014-16 were delivering yields of 12.70%, 12.60% and 12.70% respectively, while those of 2018 maturity were being quoted slightly higher, at the 13% level.
But by Monday those anomalies were gradually being rectified, with the yields of the 2018 maturities increasing to 13.30/40% in two way quotes, that of the 2014 to 12.85/95% and so on, only to see the widening of those yields reversed the following day, except for T Bonds of 2017 and beyond, which hardly witnessed any trading on Tuesday (December 11), with buying interest confined to T Bonds of 2014-16 maturities in secondary market trading that day, a source had then said. The fact that bona fide buyers stayed away from the market when the one year maturities were fetching higher yields than those of the longer tenure T Bonds, helped to fix this anomaly, he said on Monday.
*CBSL as at Friday hadn’t released their open market operations’results of  that day to the press.
**Another source said that the ER in the previous week closed at the Rs. 128/40/60 levels to the $ (see the business pages of this newspaper’s last week’s issue).
***Generally, due to perceived risks, shorter the tenure, shorter the yield and longer the tenure, longer or higher the yield and not vice versa (see also the business pages of this newspaper’s 25.11.12.  and 2.12.12. issues).