Sri Lanka denies de facto target rate was pushed up
ECONOMYNEXT – Sri Lanka’s central bank denied that a de facto target rate controlled through overnight repo auction was pushed up in the run up to a monetary policy meeting that left the floor of a policy corridor unchanged at 7.50 percent.
Sri Lanka’s floor rate is now active with weak bank credit reducing economic activity and imports generating a balance of payments surplus and putting upward pressure on a soft-peg with the US dollar.
When the central bank buys dollars, stopping the peg from appreciating the aggregate overnight balance of the interbank market (excess liquidity) goes up, pushing overnight rates down.
De Facto Target Rate
By withdrawing liquidity above the floor rate through a repo auction, the central bank creates a de facto target rate within the policy corridor of 7.50 percent and 8.50 percent.
Before a May 31 rate cut, the de facto target rate was kept a little above 8.50 percent, between the then corridor of 8.00 and 9.00 percent.
Unlike the US Fed which announces a target rate, Sri Lanka does not announce an official target rate but only announces a corridor.
The US re-recreated a floor rate after the large volumes of liquidity was injected to bail out collapsing banks in the 2008 collapse of an economic bubble and bank run.
Since the last rate cut on May 31, the overnight repo rate has moved down to about 7.71 percent, further than the 50 basis point cut.
The central bank is effectively stopping rates from falling below 7.50 percent in a balance of payments surplus with the standing window and the overnight repo (target) rate by deciding the maximum rate at which excess cash is accepted.
By varying the volume that is asked for and accepted, the central bank creates a target rate within the policy corridor, wittingly or unwittingly, analysts say.
The maximum rate at which liquidity was withdrawn suddenly went up from 7.72 percent on July 03 to 7.85 percent on July 11, as the central bank offered to take out large volumes of liquidity and took all the bids that came in.
The weighted average rate went up to 7.77 percent on July 11 from 7.71 percent on July 03.
On July 09, the central bank offered to take out 15 billion rupees of liquidity and took out all the 9.45 billion rupees that came.
On July 10, when domestic operations offered to take out 23 billion rupees despite no term repo maturities only 5.64 billion in bids came in. By accepting all the bids, the maximum rate was pushed up to 7.85 percent.
Reporters asked the central bank why large auctions to suck money out are announced.
"Depending on the day to day surplus liquidity we have offered," Deputy Governor Nandalal Weerasinghe explained, when asked why such large amounts were being offered in repo auctions.
"On some days the liquidity was 40 billion rupees."
He said that repo rates were not rising.
"We have been giving at below the middle rate of the corridor (7.75 percent)," he said.
"Rates are coming down."
Deputy Governor H. A. Karunaratne also appeared to be unaware of the recent action of the domestic operations department.
"Before it was (rising) but in recent weeks it was not," he said.
Analysts say it is naturally difficult to predict the aggregate balance precisely every day, but by not accepting the total volume of cash offered the rate can be kept at 7.70 percent or allowed to fall further.
If the total is accepted rates can spike.
The central bank’s main aim so far in 2019 has been to reduce bank lending rates to spur credit, and has even put price controls on deposits to reduce cost of funds for banks, and is offering better rates for banks to dump excess cash.
The central bank had also said that there is a possibility of a policy rate cut in August.
Pushing up the overnight repo rate therefore may go counter to the strategy.
Analysts who closely watch the central bank has suggested that the overnight auction be terminated altogether so that rates will fall to the policy floor.
Ending overnight repo operations will take the overnight rate down by another 20 to 25 basis points before the next rate cut.
The only risk to the credit system is from capital flight or a spike in state spending triggered by a fall in revenues from the credit and import collapse. Amid a credit contraction the central bank does not have to print money to enforce a rate cut.
As an insurance against such risks, it has been suggested that the ceiling rate not be cut.
Concerns had been raised before about anomalies generated by term repo and repo operations of the domestic operations department.
In the run up to the last currency crisis, primary dealers were also dropped from the auction process (when money was printed to enforce a ceiling rate) ostensibly because they were bidding at higher rates than banks.
A quick rise in rates will nip currency crises in the bud, and stability and growth will resume faster.
From the US Fed to the Bank of Thailand (which operates a more stable soft peg), primary dealers are the key counterparties to swiftly carry monetary policy decisions to the market.
Delays in rate hikes with keep the credit system short of liquidity for longer periods and which will generate output shocks, analysts have warned.
On Thursday, the central bank said that it has revised its growth target from 4 percent to 3 percent for 2019. (Colombo/Jul12/2019)