Sri Lanka benchmark gilt rates up on fiscal weakness, information assymetry

June 21, 2007 (LBO) – Sri Lanka’s gilt rates shot up 30 basis points, a day after the government recieved permission from lawmakers to spend extra money on newly created ministries. Average yields at this week’s treasury bills auction moved up 30 basis points to 17.34 percent with the 3-month rate, which has now become the signal interest rate in the market moving up 31 basis points to 17.40 percent, the public debt office said.

The 6-month rate moved up from 16.84 percent to 17.12 percent, while the one year rate edged up to 16.89 percent from 16.75 percent.

Fiscal Weakness

Sri Lanka’s Treasury bill rates have been edging up since the central bank stopped printing money in January with a budget deficit projected at 9.2 percent of GDP.

Last year an 8.4 percent deficit brought balance of payments pressure and 20 percent inflation because 38.5 billion rupees were printed by the central bank to keep interest low.

Though supplementary estimates that were presented to the parliament of 652 million rupees is relatively small in the face of the overall budget deficit, it signals a further deterioration of the country’s fiscal affairs as there were no revenue proposals presented to match it.

Sri Lanka already has more than a hundred ministers of various kinds, and critics have claimed that the country has the world’s largest cabinet.

Meanwhile, a failure to market-price petroleum products may also be putting pressure on the banking system, analysts say, and it may also boost expectations that government may have to step in with some assistance undermining the fiscal base further.

Information Asymmetry

Though rates have been moving up Sri Lanka’s savers do not seem to be getting enough information about the high Treasury bill rates, indicating that there is a serious information asymmetry in the market.

Last week the central bank started an advertising campaign in a pro-active bid to correct the problem, but analysts say the message is not yet getting through.

Sri Lanka’s banking sector is offering very low savings rates with the market leader the National Savings Bank still offering 5 percent and the average weighted deposit rate being 8.65 percent.

The average weighted fixed deposit rate calculated by the central bank is still 12.85 percent indicating that there is a serious problem in the country’s rate transmission mechanism for which the government is paying a heavy price.

The country also has a policy rate structure which is out of line with the budget deficit and has largely become irrelevant with the central bank no longer operating an active reverse repo cash injection mechanism.

Mental Block

But analysts say bankers may be finding it psychologically difficult to get out of the mindset that policy rates are signal rates, and therefore may be keeping deposits rates low in the expectations that market rates may match policy rates in the near future.

Sri Lanka’s interest rates have been suppressed for nearly three years, and critics warned at the time that flagrant financial repression as well as blunting of the transmission mechanism by the authorities would have serious negative implications for the country in the future.

Sri Lanka now has very high real interest rates in the gilt markets with the central bank firmly on a path to control inflation, but analysts say savers still lack enough information to participate in the treasury markets.

Analysts say banks would continue to profit from the situation until the information asymmetry is addressed more aggressively and meaningful steps are taken to trim the budget deficit.