Sri Lanka’s Central Bank takes the lid off short term rates; cash markets in shock

September 26, 2006 (LBO) — In a major policy shift, Sri Lanka’s central bank Tuesday allowed the rate at which it injects overnight cash, to move above its policy rate, sending shockwaves through the country’s money markets. However since April the government has raised fuel prices which helps strengthen the fiscal side and in turn reduce the need for printed money while policy rates were also raised marginally. Market participants who borrowed 13 billion rupees through the standing ‘reverse repo’ facility on Monday at 10.625 percent, were forced to buy overnight rupees at 13.01 percent this morning as the central bank suddenly withdrew the standing ‘reverse repo’ facility which kept rates at the upper policy rate band.

“The Central Bank has decided to conduct a daily auction for reverse repurchase transactions to provide liquidity if there is any shortage of liquidity in the banking system,” the Bank told market participants in a terse statement.

“Accordingly, the availability of the reverse repurchase transactions under the standing facility at the Reverse Repurchase Rate of the Central Bank will be suspended temporarily with effect from 26 September 2006 until further notice.”

Upshot

Overnight call rates moved up to around 15.5 percent, with some contracts going up to 17.0 percent as desperate borrowers grabbed cash, dealers said.

“Call rates may ease tomorrow,” a dealer said. “Today’s announcement took the market by surprise and the high rate may have been a knee jerk reaction.”

Call rates have been high at around 14 percent in recent days, as banks which did not have treasury bills to discount with central bank, borrowed clean at higher rates.

Short term rates have moved up since the Interbank market has been short on a net basis, this month due to the outflow of dollars from the monetary system.

Policy Problem

The Bank has come under fire from some quarters for keeping policy rates low, printing money to bridge the budget deficit, allowing inflation to rise and making the balance of payments crisis worse, by refusing to raise policy rates.

Sri Lanka’s 12-month inflation is now 15.3 percent, but policy rates have remained at 10.625 percent resulting in a negative real interest rate environment.

In the course of defending an artificially low policy rate, the central bank also intervenes in the primary auction of treasury bills by extending central bank credit to the government.

By withdrawing the standing facility the bank has now stopped defending the policy rate in the overnight market.

The bank did not say whether it would continue to defend the overnight 13.0 percent rate, but it can do so by altering the volume of cash it offers through the auctions.

The central bank also did not say whether it would continue to defend the 10.625 percent policy rate in the treasury bill market and provide cheap credit to bridge the budget deficit.

Dealer Crisis

Dealers are waiting for the t-bill auction to close on Wednesday to see whether the bank would continue to print money in the primary market.

Primary dealers who have been funding treasury bill portfolios through reverse repo money are now in crisis and met in emergency sessions today.

Analysts have pointed out that the Sri Lankan rupee had been under pressure since the second quarter as the central bank printed large volumes of money by extending credit to the government.

Economic activity has been booming in the negative rate environment, fuelling imports, while a worsening security situation has dampened tourism and pushed up military expenditure.

Central Bank holdings of treasury bills rose to 54 billion last week from 37 billion rupees at the beginning of the month. In February it was as low as 17 billion rupees.