Lend Low, Borrow High

• Hobson’s Choice Before GoSL

The brittleness of  the recent decline in certain money market yields including that of Treasury (T) Bills and Bonds in the past few weeks may have had been exposed when considering the fact that the market on a net basis was short by Rs. 5,898 million at Friday’s trading.
This shortfall was met by Central Bank of Sri Lanka’s (CBSL’s) standing reverse repo facility of 9.50%.
When the market is short it gives credence to a rate hike and not a rate fall in money market trading.
Market goes short due to submarket operations by the Government of Sri Lanka (GoSL) as described below or the real economy holding on to their liquid assets without banking them probably due to certain transactions revolving round the festive season.
With inflation at 9.5% and the market facing an illiquid situation, it may be hard to justify the recent contraction of T Bills and Bond yields.
In fact according to available data, commercial banks’ average weighted prime lending rate, ie the interest rate that it charges on good or blue chip borrowers rose by one bp week on week (WoW) to 14.31% as at December 14. And that is lending to the real economy, however WoW it fell to 14.15% by Friday.
Further, though T Bill and Bond yields are falling, there however is still room for the market to borrow cheap from CBSL’s reverse repo facilities and relend to the GoSL at higher interest rates, thereby raising another issue.
For instance though the weighted average yields (WAYs) at Wednesday’s T Bill auction came down to 10.23% for the three months tenure, 11.53% (six months) and 12.18% (one year)-see also page 34, the most expensive reverse repo rate, ie CBSL’s standing reverse repo rate at 9.50% is still 73 basis points (bps) cheaper than the one year T Bill yield of 10.23%, 197 bps cheaper than the six months and 268 bps cheaper than the one year T Bill yield.
This provides an opportunity to the market to borrow cheap from CBSL’s reverse repo window and relend such borrowed monies to the GoSL in the form of subscribing to risk free T Bills.
As the name denotes, investing in T Bills is risk free. Ipso facto as such investments are risk free, should they not at least command yields that are on par with CBSL’s standing reverse repo window?
Borrowings from CBSL’s reverse repo facilities have to be backed by giving CBSL T Bills as security.
While in the past few days or weeks T Bill yields have been falling due to various reasons as described elsewhere on these pages, those yields have however not been falling fast enough to come closer to or to be on par with CBSL’s standing reverse repo facility.
Though the market recorded a net surplus on Wednesday, in the six market days prior to that it was short on a net basis, with this shortfall fed through CBSL’s reverse repo facilities, which at times even led to CBSL having to conduct reverse repo auctions, which yields were lower than CBSL’s standing reverse repo facility, giving the market an opportunity to borrow from this window and invest in higher yielding T Bills and T Bonds either in the primary or secondary markets.
This is akin to borrowing from one arm of the government (CBSL) at lower interest rates and relending the same to another government arm (Treasury) at higher rates!
Though the market at Wednesday’s trading recorded a net surplus, certain counters were short to the tune of Rs.930 million, which shortfall was met by CBSL’s standing reverse repo facility at the 9.50% interest rate, which was lower as said aforesaid,  than the yields fetched at that day’s T bill auction.The following day Thursday too though the market on an overall basis recorded a surplus, certain counters were however short to the tune of Rs. 3,056 million, three times the number of the previous day’s shortfall, which was also met by CBSL’s standing reverse repo window, while the market on an overall basis was short on Friday.Meanwhile at the beginning of last week, ie on Monday, CBSL rejected offers received for its Rs. nine billion overnight (o/n) reverse repo* auction on the grounds that the market allegedly was asking for higher rates, “closer” to call money rates**, it’s  said.

Call money’s weighted average rate (WAR) on Monday was 10.34%***. CBSL however met Monday’s liquidity shortfall, ie a sum of Rs. 13,709 million by its standby facility at the 9.50% reverse repo rate*, a rate which is generally higher than the reverse repo auction rate.
The previous market day, ie Friday December 14, CBSL lent Rs. 15,500 million to the market at a 9.46% WAY through an o/n reverse repo auction, which however was 88 bps lower than that day’s WAR of call money transactions which was 10.34%.
It was also alleged that CBSL which held a term reverse repo auction for Rs. 15 billion the previous market day, ie on December 14, rejected those bids on the grounds that the market quoted too low!
In general however central banks reject offers made through its reverse repo facilities when offers received are “too low,” with the benchmark being their standby reverse repo facilities, which in Sri Lanka’s case is 9.50%.
But as the aforesaid events show, in the case of Sri Lanka, that need not be the only reason for the rejection of reverse repo auctions by CBSL.
Illiquidity starts when banks run short, mainly due to submarket operations where the culprit is the GoSL. This happens when GoSL borrows rupees from the market to settle its external commitments like foreign debt servicing or to pay off an oil or defence bill.
In such instances GoSL instead of buying the required foreign exchange (forex) from the market (from the rupees so borrowed), instead procures the same from CBSL’s forex reserves. This is done so as not to disturb the “stability” of the local forex market.
But the flip side to this activity is that it drains out rupee liquidity from the market to CBSL’s coffers, instead of allowing it to recirculate within the money market itself. As a result the market runs short, compelling CBSL to meet this liquidity shortfall through its reverse repo window.
However the possible weakness in this type of operation is that the maximum reverse repo rate is CBSL’s standby facility which is 9.50%. On the other hand the WAYs of T Bill rates as per the previous auction results (ie the auction held on December 12), though falling to 10.44% (ie the 91 day tenure), 11.78% (182 day) and 12.45% (364 day) levels, are still higher than CBSL’s standby reverse repo facility of 9.50%.
This means that the market had been given an opportunity to borrow at the low 9.50% rate from CBSL’s standby reverse repo facility and reinvest those money either in risk free T Bills of a 91 day tenure which will have had fetched him a premium of 94 bps, or in the 182 day tenure which will have had earned him a premium of 228 bps or in the 364 day tenure which will have had given him a return of 295 bps, over that of his borrowings from the standby reverse repo window then.
However if he borrows from CBSL’s reverse repo auctions, his margins would have had been even more higher!
Issuing of T Bills is one way GoSL raises money to meet its expenditure commitments.
Therefore If an opportunity is available for the market to borrow from one instrument of GoSL, in this instance CBSL, low (ie through the reverse repo facilities), and relend the same to another instrument of GoSL, ie the Treasury high, then there appears to be a lacuna in the system.
But this is what seemingly CBSL’s 25 bp rate cut of its key policy rates, ie the repo and reverse repo standby facilities, apparently encouraged. And with inflation at 9.5% last month, the recent rate cut doesn’t appear to be justifiable, but a rate increase would have had.
One way GoSL could get out of being cheated this way is to make use of captive funds to invest in T Bills at administered rates rather than the market. But then there is a limit to which captive funds may operate this way due to capacity constraints.
Further, captive funds are instruments such as the EPF, ETF and funds lying to the credit of state owned National Savings Bank. Those are also public money. If the same is not giving an adequate return to investors who are the public by being invested in administered low yielding T Bills, it’s the public who are then being cheated.
This may be exemplified by the fact that certain banks are paying interest rates ranging from 14-16%, with some banks offering a 15% rate for fixed deposits which have tenures as short as three months. That also indicates the liquidity crisis facing the market.
Further, CBSL’s reverse repo facilities are not inexhaustible.
The other way CBSL/GoSL may solve this problem is by rejecting bids received at those weekly T Bill auctions, with CBSL itself subscribing to those T Bills at administratively low rates and lending rupees to the Treasury in lieu. But that increases money supply which in turn feeds into inflation.
Probably the ideal way to increase money supply is by selling forex to CBSL and collecting rupees in lieu.
And the best way that this should take place is through the receipt of cost free or low cost foreign inflows by way of enhanced export earnings (exports however are falling), tourism receipts, remittances, grants, concessional aid (which is  on the decline) and foreign direct investments (which too is contracting).
Therefore a Hobson’s Choice lies before the GoSL.
*Reverse repo facilities are an instrument that CBSL uses to feed liquidity to a market that is short. Such borrowings have to be backed by surrendering risk free T Bills to the lender, ie the CBSL.
** Call money is o/n interbank borrowing rates.
*** By Thursday it had come down to 9.87%, but the following day Friday it remained unchanged at the 9.87% level.