Oct 04, 2011 (LBO) – Sri Lanka’s short term interest rates are heading higher as liquidity tightens in money markets and policy contradictions in forex and money markets begin to bite, dealers said. The weighted average overnight rate in the repo market, where banks and primary dealers of Treasuries sell money to each other collateralized by gilts, rose to 7.21 percent Monday, the highest since 7.23 percent reached on January 07, before the last rate cut on January 11.
The highest deal for the day was done at 7.35 percent, according to official data.
In the call market, where money is loaned clean (without collateral), the most expensive deal of the day was done at 8.30 percent, the highest since January 11.
Rates are spiking to due to liquidity shortages generated by Central Bank sales of foreign exchange to defend a dollar peg at 110.20 rupees to the US dollar in the spot market.
The central bank has ‘sterilized’ forex sales with money printed via Treasuries purchases but lower-than-100-percent sterilization of interventions results in a gradual loss of control over interest rates analysts say.
On Monday excess liquidity in money markets fell to 19.6 billion rupees, the lowest since October 14 2010, shortly before the Central Bank stopped daily auctions to withdraw excess liquidity from money markets.
At the time excess liquidity came from dollar (foreign asset) purchases made amid low or negative credit growth.
The current excess liquidity is dwarfed by recent domestic asset purchases made to sterilize dollar sales by the monetary authority or received in return for reserve appropriations by the state.
The Central Bank’s Treasuries stock rose to 70.5 billion rupees Monday from Just 1.1 billion rupees at the beginning of September.
Expansionary sterilization of liquidity losses, help drive domestic credit, generating fresh demand for dollars, which result in more reserve losses, create a need for yet more sterilization.
Analysts say such a vicious cycle, can deplete large volumes of foreign reserves in a few months.
To halt a worsening cycle of reserve losses, sterilization has to be curbed below 100 percent, causing liquidity to fall and rates to go out of control.
According to the latest official data on forex sales by the monetary authority to commercial banks in August was 197.60 million US dollars, lower than the 416.99 million US dollars in July.
An analysis of domestic assets and liabilities of the central bank points to much steeper reserve losses in September, analysts say.
The last official foreign reserves reported have been in July 2011 of 8.1 billion US dollars.
Average overnight repo rates are now higher than the auction rate for 3-month Treasuries which rose to 7.15 percent on September 30 from 7.11 percent in September 16.
“Investors naturally do not want to buy 3-month bills when they can lend in the overnight market at higher rates,” a dealer said.
Such bills however can be either bought by the central bank with printed money (which will also sterilize forex interventions) or by state controlled ‘captive funds’ where beneficial owners have no control over how the money is invested.
The anomalies in the yield curve and spiking rates are a result of policy contradictions when a central bank tries to control both the interest rates and exchange rates with little success.
The International Monetary Fund has urged the Central Bank to halt peg defence and allow the rupee to float.
The central bank however has said it is expecting foreign inflows to come, and ease the developing balance of payments crisis.
Sri Lanka has a policy corridor of 7.00 percent to drain excess liquidity and 8.50 percent to inject liquidity, though money can be injected at a lower rate by direct purchases of Treasuries by the monetary authority.
So far rates repo rates have hovered around the lower end of the band and no eligible bank or dealer has gone to the discount window to borrow at 8.50 percent.
As long as excess liquidity remains, market participants can in theory borrow from each other. But banks have exposure limits to each other, even in the collateralized repo market.
“Most of the remaining liquidity in concentrated among a few foreign banks,” a dealer said. “They do not have (exposure) limits to small local banks.
“Even liquidity at state banks is gradually falling.
“Some are borrowing call money at 8.30 percent. If call money goes above 8.50 percent to perhaps 9.25 percent of 9.50 percent, people will go the window.”
Rates are heading higher as inflation continues to ease.