ECONOMYNEXT – Sri Lanka’s central bank is propping up overnight rates about 20 basis points above its floor policy rate which was lowered 50 basis points on May 31, allowing a de facto target rate to fall 84 basis points since the last policy meeting, official data show.
The central bank cut the floor rate of its policy corridor through which excess liquidity is withdrawn from 8.00 to 7.50 percent on at the last monetary policy meeting amid weak private credit. The policy announcement is scheduled for July 11.
The floor rate (standard deposit facility rate) is the rate at which banks deposits cash in excess of statutory reserve requirements when credit is slow and there is a ‘balance of payments’ surplus in Sri Lanka’s soft-pegged monetary regime.
The central bank was propping up overnight rates at around 8.55 percent, in the days before the rate cut. Overnight rates started to float down, without any de-stabilizing money printing from reverse repo operations after private credit started to contract in early 2019.
As rates started to float down the central bank’s domestic operations department stopped fall through a combination of overnight and term repo auctions, about 50 basis points above the floor rate with term repo auctions of around 8.54 to 8.56 percent.
On May 31 the floor rate – which was now active due to weak credit – was cut to 7.50 percent. The ceiling rate is inactive.
The central bank since then had allowed the rate to fall or about 84 basis points (30 basis points higher than the floor rate cut) and is now propping up the rate with a de facto target rate of around 7.70-7.71 percent.
Overnight interbank call rates had fallen by about 60 basis points to 8.5 percent. Interbank call rates had fallen about 73 basis points to 8.58 percent. In Sri Lanka market repo rates are higher than market call rates due a state failure, analysts say.
Sri Lanka’s average prime lending rate fell 39 basis points to 11.13 percent in the week to July 05, the central bank has said. There are no controls on lending rates yet, but the central bank has contoversially slapped price controls on deposit paid to savers.
There had been capital flight ahead of the rate cut, central bank data shows.
Foreign holdings of rupee bonds fell from 166 billion rupees on April 03 to 146 billion rupees on May 28, with the heaviest selling seen in the last week of April, showing the central bank was right to hold the overnight rates up around 8.50 percent, analysts say.
By terminating overnight term repo auctions the central bank can allow the rates to fall at least 20 basis points without an official rate cut.
From January to April private credit has been negative by 17.1 billion rupees. With a contraction in central bank credit, and the conversion of some dollars by the government to bridge the deficit, total credit from the banking system was also negative in March and April, data shows.
Sri Lanka’s soft-peg with the US dollar faces appreciation pressure when credit is weak or negative central bank ‘rate cuts’ do not de-stabilize the economy as no money is printed to enforce the lowered floor.
The central bank’s Treasury bill stock has also been cut from 155 billion rupees on May 30 to 118 billion rupees by July 09, permanently mopping up inflows and building up monetary forex reserves.
Economic analysts have pointed out that as long as inflows are mopped up by Treasury bill sales in the central bank balance sheet or longer term central bank securities the exchange rate (the peg) will remain on the strong side of any convertibility undertaking in operation (the rate at which the peg is enforced by purchasing dollars).
Following the last week’s Treasury bill auction, the central bank bill holding was brought down to 118 billion rupees from 123 billion.
Foreign investors in bonds have also been relatively stable since the last rate cut.
Risks to economic stability are now from the fiscal side with an import collapse reducing revenues and new subsidies and salary hikes kicking in from July. It is not yet clear what the effects of these fiscal developments will be on the credit system.
However the government had indicated that it will cut capital expenditure and manage other expenses.
Problems have also started to emerge in state energy utilities, particularly the Ceylon Electricity Board, with a currency collapse in 2018 pushing up generation costs and more expensive emergency power coming into the system to accommodate demand.
EN Economic columnist Bellwether had said that some inflation is inevitable after liquidity shortages ended as the price structure of the country had been changed by the currency collapse and consumer goods and assets prices will move up as activity picks up, regardless of the policy rate.
Analysts have also called for a wider policy corridor as insurance against currency volatility and capital flight.
"If Sri Lanka did not have a ceiling policy rate and there was only one fixed exchagne rate target, any amount of excess liquidity could be allowed to accumulate, since interest rates would free float and the currency would be hard pegged (the peg is credible) and no money would be printed in case there is capital flight or strong credit demand," EN’s economic columnist has said.
"A wide corridor is an insurance against whatever convertibility undertakings that are in use."
Sri Lanka was hit by monetary instability within two years of the creation of a soft-peg in 1950.
Monetary instability had again become the single biggest risk to the economy after the war ended in 2009, as it was before the war began, analysts say. (Colombo/July10/2019)