Feb 02, 2010 (LBO) – Sri Lanka is open to increasing the ratio of cash banks must deposit with the Central Bank as a policy to contain inflation, Governor Nivard Cabraal said, as consumer inflation accelerated to an eleventh month high in January. Sri Lanka’s market risk free rates have already started to move up slightly amid deficit spending by the government and a recovery in private sector credit.
The 3-month Treasury bill rate has moved up to 7.95 percent in the last week of January from 7.25 percent in the third week of November 2009. The 12-month yield has moved from 9.17 percent to 9.46 percent in the same period.
But Sri Lanka’s risk free interest rates have to rise further to prevent automatic monetization of government debt (money printing).
Up to November 2009 the liquidity was generated from foreign inflows as the Central Bank intervened to preserve its peg with the US dollar at around 114.50 rupees. But in recent weeks reserves have been generated domestically.
At 9.75 percent, the monetary authority’s main policy rate at which money is injected to the market is still higher than the three month Treasury bill rate. But Sri Lanka has a history of the central bank buying bills in and out of auctions.
Central Bank Treasury bill purchases inject money into the economy at longer tenures along the yield curve at rates higher or below the official policy rate. Such ‘quantity easing’ undermines the policy rates mechanism.
Due to a flaw in Sri Lanka’s monetary law, the Central Bank is also forced to give direct interest free credit to the government in the form of ‘provisional advances’ in another quantity easing measure.
Over the last few weeks, the government’s debt office has not sold all maturing debt to market participants, indicating risk free rates are not high enough to attract savings from the real economy and the monetary authority is taking up the slack.
Over the past two months, the Central Bank’s Treasury bill stock has swung widely between two billion and thirty billion rupees.
Sri Lanka could raise more funds from abroad to reduce pressure on domestic markets by raising the limit of Treasury bonds allowed to be bought by foreigners.
“That is also an option,” Cabraal said. “So far about 9 percent of the limit has been reached and we have a 1 percent reserve.”
The central bank is also due to relax exchange controls to allow foreign investors to buy into domestic corporate debt.
“We will not rule it (a reserve ratio hike) out,” Cabraal said. “But the rise in inflation is not unexpected. We expected inflation to rise until April and then moderate.”
Consumer prices in the capital Colombo rose to 6.5 percent in January 2010 up from 4.8 percent in December with prices jumping 1.4 percent in January alone.
The reserve ratio is the portion of deposits that a commercial bank has to place within the central bank. Sri Lanka’s banks have had excess reserves, above the official requirement, of about 20 to 30 billion rupees since mid-2009.
A reserve ratio hike could draw out some of the liquidity permanently but also raise the operating cost of banks. But by historical standards in the country, the current ratios are low.
Following Reserve Bank of India’s footsteps, the Central Bank brought down Sri Lanka’s reserve ratio to 7.0 percent from 10.0 percent in a series of cuts from October 2008 to February 2009 as the banking system ran out of liquidity in a balance of payments crisis.
Last Friday India raised its reserve ratio by 75 basis points to 5.75 percent amid surging inflation.
Sri Lanka and India are among a few countries in the world that still use reserve ratios as monetary policy tools. Most counties that have floating exchange rates rely on policy rates to control inflation.