March 27, 2007 (LBO) – Sri Lanka’s Interbank call rates rocketed to a new 12-year high of 50 percent Tuesday with state banks on the borrowing side, dealers said. Interbank call rates hit 38 percent Monday with the Central Bank keeping cash tight in a bid to dampen raging inflation brought on by excessive money printing in 2006.
The rate spike was brought about by an estimated one or two billion rupee shortfall.
However analysts point out that the danger of rate spikes are inherent with quantity rationing in place.
Second best option
A rationing creates a ‘black market’ with banks that are liquid being able to borrow at lower rates and re-sell to banks that are short.
Analysts say having a high policy rate band of around 16-17 percent or would give less price shocks to the system than have a low policy rate of around 12 percent and trying to make up the shortfall with cash rationing.
Economists say rationing by definition is a second best option to a market based on price signals though the monetary authority’s resolve to contain inflation is appreciated by most market participants.
In January inflation hit 20.5 percent with heavy government borrowing from the banking sector and borrowings from the Central Bank or printed money hitting 112.9 billion rupees in December from just 66.3 billion rupees in January 2005.
Borrowing from banking sector
Total credit to government from the banking sector hit 357.3 billion rupees in December 2006 from just 256.9 billion rupees with credit from commercial banks rising to 143.6 billion rupees from 114.9 billion rupees in January 2005.
Critics point out that Sri Lanka’s loose fiscal policy with a very high budget deficit has been the main source of instability to the country since independence from Britain in 1948, with loose monetary policy from time to time also adding fuel to the fire.
Central Bank tightened monetary policy in December and blocked access to its discount window to prevent banks from re-lending Central Bank cash to the economy.
State banks borrowing especially from the central bank discount window and on-lending to the treasury has been a source of economic and currency instability before.
Analysts point out that the treasury overdraft with state banks have been around 40 to 50 billion rupees during three balance of payments crisis Sri Lanka underwent in the last decade.
The monetary authority has since called on banks to raise deposit rates.
Critics says Sri Lanka’s economy has been under unprecedented financial repression since mid-2004 with interest rates being kept artificially down and the country’s central bank being forced to print money through fiscal domination of monetary policy until independent monetary policy returned in December 2006.
Accounts of the National Savings Bank showed that fixed deposits fell to 136.3 billion rupees in 2006 from 138.8 billion a year earlier, as customers pulled out deposits.
With interest rates around just above ten percent, analysts point out that the bank should have been able to show a growth in fixed deposits of at 10 percent if it was able to at least retain the old deposits.
But Sri Lanka’s negative real rate framework has started to correct since December.
Most analysts believe that the monetary authority has since been able to reduce inflationary pressure as well as pressure on the currency by calling a halt to money printing.
The central has pushed down its Treasury bill stock (the principle source of money printing or central bank credit) to 45 billion in March with aggressive open market operations and even sterilized official capital inflows.
However analysts say the bank has to be guard against allowing the rupee to appreciate as the currency is already technically overvalued by some 13.7 percent by its own index that measures inflation differentials.
An appreciation of the currency could also persuade buyers of government dollar bonds to sell out in a bid to lock in capital gains.
The rupee rose to a high of 108.90 in early morning trade today as exporters rushed to convert their dollars and lend rupees at high rates in the call market.
â€œAt these levels [50 percent] nobody wants to be in dollar,” one dealer told LBO.
The rupee closed at 108.95 Monday after opening at 109.60 levels when call rates peaked at 38 percent.
Sri Lanka’s call rates hit 102 percent in 1995 as the monetary authority tried to cope with the effects of a profligate ‘election’ budget of a year before.