Turmoil in Sri Lanka’s cash markets hit treasuries; dealers refuse to discount gilts

September 27, 2006 (LBO) – Aftershocks of Tuesday’s withdrawal of the central bank’s standing cash facility has hit short-term treasuries, with Sri Lanka’s public debt office rejecting bids at Wednesday’s auction and dealers refusing to discount gilts as prices crashed. Meanwhile the Sri Lanka rupee closed sharply down against the dollar at 103.70 against the U.S dollar on Wednesday more than a rupee lower over the previous day. “Even when the Tamil Tigers hit the Central Bank and gilt settlements were delayed we did not turn away clients,” one dealer said.

“But now we simply cannot take the risk of discounting bills because we do not know where the rates are going.”

Price Collapse

Gilt prices crashed in thin trading with some dealers quoting 14.0 percent for discounting treasury bills for small value customers of around 100,000 rupees, but t-bills over a million rupees were quoted at around 16.0 percent, up around 530 basis points from Monday.

Hardly anyone was prepared to discount larger bills without a reference rate after the Public Department rejected all the bids at an auction for the first time Wednesday.

Primary dealers had put bids at around 16 to 17 percent, up sharply from the average 10.6 percent seven days ago.

“Fundamentally the treasury market has lost its main characteristic of a gilt market, which is liquidity,” a dealer said.

“We are having liquidity risk and volatility risk. What this means is that a customer can now get a loan against a bank deposit but not against a t-bill.”

The treasury bill market, (gilts of less than 12 months) has always been extremely liquid, though the bond market with longer tenures is illiquid.

But dealers say they have never turned away a client who wanted to discount a bond even though the inter-bank trading has been slack.

The chaos in Sri Lanka’s cash markets started Monday after the central bank took the lid off overnight rates by withdrawing the standing reverse repo facility through which unlimited amounts of liquidity was injected earlier.

Quantity Targetting?

The bank only offered 13 billion rupee volume at auction yesterday which pushed overnight rates to 13.01.

At today’s open market auction 12 billion rupees were offered at rates shot up to 13.8 percent.

The bank is now without a target policy rate, at least at the very short end, and seems to be toying with a quantity targeting regime.

Analysts who were waiting for today’s t-bill auction to gauge the policy direction on longer term rates, are no wiser as all the bids were rejected.

The public debt department, though a part of the central bank, carries an agency function for the treasury, a role which has drawn fire for being in conflict with its monetary policy obligations.

Economists point out that Sri Lanka’s interbank market is short because an outflow of dollars has drained liquidity.

Fiscal Dominance

The central bank which suffers from fiscal dominance problems has kept policy rates artificially low by printing money to buy up government treasury bills.

Critics have pointed out that Sri Lanka has high inflation and runs into periodic balance of payments problems because central bank credit or printed money is used to bridge the budget deficit.

Until the central bank withdrew the standing facility, with policy rates at 10.625 percent short term rates and t-bill rates have been negative, with 12 month inflation running at 15.3 percent.

But now interbank call rates were around 16.5 percent, and bank overdraft rates were also going up, which can curtail private sector borrowing.

Balance of Payments

Critics say loose monetary policy coupled with a high fiscal deficit has pushed quarterly growth to a blistering 8.0 percent level, fuelling demand for imports, while an intensifying conflict and defence expenditure has not helped the balance of payments either.

In September the monetary authority printed nearly 18 billion rupees to buy treasury bills. The Central Bank treasury bill stock which was 37 billion on 31 August had climbed to 54 billion last week.

It is up 37 billion rupees, from the February level of 17 billion rupees, before the latest round of balance of payments troubles started.