Fuelling Growth By Monetary Policy Easing

In the absence of Central Bank of Sri Lanka (CBSL) not making an attempt to cap interest rates, Government of Sri Lanka’s (GoSL’s) strategy to fuel growth appears to be by easing policy rates and pumping liquidity through its reverse repo facilities at the expense of creating demand side inflationary pressure on the economy.
A country to achieve a 7.5% growth rate as envisaged by CBSL this year, cannot reach that target when interest rates are closer to the 20% range, a market source told this newspaper.
As such GoSL will try to rein in interest rates administratively similar to what they have had done to finance companies, this time making it applicable to banks as well, he opined.
They will try to bring it (interest rates) down to the low double digit level beginning with deposit rates, he theorized.
But when this reporter brought this matter before CBSL Governor Ajith Nivard Cabraal, he said that they have no plans to cap bank interest rates.
“But our plans to create a low interest rate regime is enunciated in our monetary and financial policy roadmap that was released on Wednesday,” he said.
Another CBSL source said that CBSL will use the monetary policy easing mechanism in order to bring down interest rates. “We used it last month, by which strategy we brought down policy rates by 25 basis points (bps) each,” the source said.
In 2011 GoSL tried to control both the interest rate and the exchange rate (ER) in the hope that foreign inflows to the tune of US$ ($) one billion will come within that period for Sri Lanka’s succour, but that didn’t happen. As a result they then let go of both the interest rate and the ER the following year (2012), resulting in one year Treasury (T) Bill yield rising by 400 bps to 13% and the ER depreciating by some Rs. 20, a market source said.
So they may play the same game at least in the first quarter, hoping that something good, in the form of inflows will happen during the interim, the source said.
Inflows help to boost the country’s reserves, reduce pressure on the ER, create liquidity in the market, thereby also helping to bring down interest rates.
“I’m looking at the market on a quarter (Q) by Q basis, not beyond that horizon,” the source said. On inflationary pressure and the fuelling effect that liquidity created by easing monetary policy will have on such? The source said not to think about such.
A repeat of what happened from the first Q of last year when T Bill yields of one year tenure went up from 9% to 13% by the third Q, before declining in the 4th, such a cycle may recur on a Q by Q basis beginning from this Q in the event there are no inflows to sustain a low interest rate economy, he said.
“it’s a gamble,” the source said, referring to CBSL’s current stance of easing policy rates in an illiquid situation.
It’s Similar to the gamble which President Mahinda Rajapaksa and his Government took at the beginning of 2009 with the war raging and interest rates shooting sky high and the ER badly depreciating, he said.
But by good fortune the war was over and that helped to turn the tables.
Nevertheless Sri Lanka could have had fared better afterwards, post war, if proper policies, both in the economic and political front were adopted by the Rajapaksa Government, the source said.
He further said that in secondary market trading on Tuesday (1.1.13.), GoSL used captive funds to try to bring down yields of Treasury (T) Bonds and Bills, which worked successfully.
Captive funds are public monies held in the accounts of institutions such as the EPF, NSB and ETF.
As a result, on a rule of thumb, T Bills and Bonds of tenures of between 2014-18 were trading in the range of 11.65-11.90% on Tuesday, he said.  
The following day Wednesday, they declined sharper, by between 30-35 bps coinciding with the declines registered in the T Bill auction of date, with declining yields continuing in secondary market trading on Thursday as well.
The T Bill and Bond market was however subdued on Friday (see the lead story on page 33).
In regard to the maturing Rs. 72 billion T Bond (see the lead story in the business pages of last week’s The Sunday Leader issue) due on January 15 and its pressure on rates? The source was of the opinion that the same tinkering treatment would be applied to that as well, due to which the market too will have to fall in line by quoting low for those proceeds which are bound to be re-issued.
T Bonds are also needed by the market as it’s a liquid asset, he said.
On the possibility of allowing foreigners to subscribe to T Bills and Bonds of upto 20% of their outstanding value, from the current 12.5%, a subject which GoSL had had apparently been toying with, but which was shelved in Budget 2013?* The source said that if that happens and foreigners are tempted to subscribe to the bigger volume, that will be a sign that foreign investors are having confidence in the economy, ie in the event it does take place and foreigners do subscribe to the increased volume on offer.
He further said that last month’s spurt of foreign exchange (forex) inflows helped to strengthen the ER, bring down T Bill and Bond yields, whilst also aiding CBSL to reduce its T Bill holdings.
The ER which at the beginning of last month was trading at the Rs. 129/35/45 levels in two way quotes** in interbank spot trading against the US dollar ($) (see The Sunday Leader of 9.12.12.) has since strengthened by Rs. 2.10 (1.6%) to be trading at the Rs. 127/25/35 levels in two way quotes interbank spot trading as at Friday.
 Further, yields of T Bills and Bonds during the 36 day period ending on Friday (ie from 30.11.12. to 4.1.13.), on an average has had dropped by 225 basis points (bps) to 10.60/70% in two way quotes in regard to T Bonds of 2018 maturities, by 230 bps to 10.70% in regard to T Bonds of 2017 maturities and by 175 bps to 10.90/11.00% in regard to T Bonds of 2014 maturities***.
Meanwhile during the period 30.11.12. to 4.1.13., yields of  2015 maturities had had dropped by 141 bps to 10.90/11/00%, while that of 2016 maturities in the 29 day period covering 7.12.12. to 4.1.13. had had dropped by  168 bps to be commanding a yield of 11%.
“On rule of thumb, T Bills and Bonds from 2014-18 maturities were trading in the range of between 11.65-11.90%**** in secondary market trading on Tuesday, before declining sharply, by between 30-35 bps on Wednesday, coinciding with the steep declines in T Bill auction yields on that day,” he said.
Those yields as shown aforesaid declined further on Thursday, before stabilizing on the following day Friday.
Similarly T Bill yields in the four weekly T Bill auctions held from 12.12. 12. To date, have had fallen by 88, 105 and 148 bps to  9.91%, 10.99% and 11.38% in respect of T Bills of 91 day (three months), 182 day (six months) and 364 day (one year)  maturities.
 When T Bill yields are on a continuous declining trend, that has an impact on market interest rates, he said. However that has yet to take place. In fact CBSL data showed that commercial banks’ average weighted prime lending rate, ie the average borrowing rate that banks charge blue chip borrowers had, in the 35 day period, from 30.11.12. to 4.1.13., had increased by 11 bps to 14.26%.
Meanwhile CBSL’s T Bill holdings, including that which has had been surrendered to the market as security in repo borrowings, in the period 30.11.12. to 1.1.13. had had declined from Rs. 198,177.47 million to Rs. 149,916.18 million, indicating that the difference, ie Rs 48,261.29 million worth of T Bills has not only been retired, but that an equivalent amount of money has also been taken out from the economy and transferred to CBSL’s income account, thereby reducing money supply by that amount, which in turn will have had helped to ease inflationary pressure on the economy.

Inflation

Government controlled Census and Statistics Department (CSD) reported that the month on month (MoM) change in inflation as measured by the year on year (YoY) fluctuation in the Colombo Consumers’ Price Index (CCPI) declined by 0.3 percentage points to 9.2% last month.
Inflation is the measurement of prices, if prices increase, inflation increases, whereas if prices decline, inflation too declines. Inflation and its attendant increase hits the poor, the vulnerable and the fixed wage earner the hardest.
The month of December being the festive season is generally a high spending month.
 As such prices tend to go up in December fuelled by increased demand for goods and services and not the contrary taking place.
“Therefore the fact that inflation has declined on a MoM basis in December as reported by CSD is difficult to believe,” the source said on Monday.
He also pointed out to the fact that certain banks were offering deposit rates as high as 15%, a figure which is 5.8% more than CSD’s 9.2% inflation figure as something which was not normal. Usually the premium on deposit rates should be slightly higher than the inflation number and not show a wide disparity as 580 bps.
“This month however will be crucial, it may indicate the direction in which interest rates will take,” he said.
Usually, lower the inflation, lower too will be interest rates and higher the inflation, higher too will be interest rates as a carrot to entice investors to deposit their money in fixed income instruments, which in turn may be lent at even higher borrowing rates so that banks may make money in such a scenario.
Interest income is one of the key sources of revenue to banks.
Meanwhile Monday’s overnight (o/n) market repurchase transactions’ weighted average rate (WAR), ie the rate at which banks and primary dealers may borrow from each other on an o/n basis after surrendering risk free T Bills as collateral, in fact increased by seven bps to 9.02% over that of the previous market day’s (Friday, December 28) close, unfazed by the MoM declining inflation rates as reported by CSD.
On Tuesday it increased to 9.08%, before falling to 8.97% on Wednesday, on the back of heavy declines in T Bill yields at Wednesday’s auction, before increasing to 9.04% on Thursday and stabilizing at those levels on Friday.
Further, call money’s (Interbank borrowings) WAR remained unchanged at the 9.83% level, and so were yields on T Bills and Bonds in secondary market trading on Monday, he said.
The following day Tuesday call rates increased by a further one bp to 9.84%, before marginally declining to 9.83% on Wednesday, but increased again to 9.84% on Thursday, before marginally declining to 9.82% on Friday.
In the meantime the money market was short for the second consecutive day at Monday’s (December 31) trading, being short by a sum of Rs. 7,564 million on a net basis. Generally a liquidity shortfall in the money market gives rise to a situation which encourages interest rates to go up so as to entice investors to make bank deposits in order to overcome this shortfall.
On the previous day the market on a net basis was short by Rs. 2,617 million. Monday’s shortfall coincided with the maturing of a Rs. 8,000 million loan, lent to the market by CBSL through a term reverse repo auction held on December 7.
On Tuesday, the market on a net basis was short by Rs. 6,398 million; with CBSL announcing that they will hold a term reverse repo auction for Rs. 12.5 billion the following day Wednesday, 2.1.13.
 The following day Wednesday, the market on a net basis was short by Rs. 13,882 million, while Thursday’s shortfall was Rs. 3,868 million on a net basis and Friday’s net shortfall, Rs. 11,547 million. Additionally, CBSL held a 30 day term reverse repo auction for Rs. 10,000 million on Friday, with settlement tomorrow and maturity on 6.2.13.
Market shortfall is generally caused by submarket operations by GoSL, where it borrows money from the market to buy $s to meet its external commitments such as servicing foreign debt, buying defence stores and paying petroleum bills, where it refrains from buying the necessary $s from the market for fear that that will cause pressure on the ER, but instead buys the required $s from CBSL’s forex reserves possibly at administered prices.
In such circumstances rupee liquidity goes out from the market and ends up in CBSL’s accounts instead.
The panacea for this state of affairs is to entice increased forex inflows, so that the market will have both sufficient rupee liquidity and forex to counter any possible negativity.
The source further said that with the GoSL placing the economy on a “high” growth trajectory, that will create a climate which is more conducive to a high inflationary and a high interest rate regime than towards the contrary.
Among one of several measures taken by CBSL earlier last year to protect its forex reserves was by placing an 18% credit growth ceiling (at the cost of GDP growth) on a YoY basis.
This ceiling however has had been lifted for this year.
Borrowings to make investments are needed to spur the economy.
Borrowings also place pressure on liquidity which in turn has an upward effect on interest rates. That in turn leads to high prices, a net effect of which is high inflation, leading to a vicious cycle of a high interest rate, high inflationary and an illiquid regime.
The proper soother to this from an economic perspective is to entice higher forex inflows, rather than by printing money to fill the breach.
* However a CBSL source said that there were and are no such moves on the cards in this regard.
** Generally the middle rate in two way quotes is considered as the rate at which deals are executed. In that instance it will have had been Rs. 129.40.
***Ie during the 28 day period from 7.12.12. to 4.1.13. in the case of a T Bonds and Bills maturing on 2014., on a rule of thumb.
**** When considering the fact that T Bonds of 2017 maturities on Tuesday, according to the source was trading at the 11.70% level and the 2018 at the 11.75%, on the basis that longer the tenure, higher the yield, then there is a 15-20 bp gap that needs to be reconciled, assuming that T Bonds and Bills from 2014-2018 tenures were trading at the 11.60-11.90% range on Tuesday, as what was said to this newspaper by the source.