ECONOMYNEXT – Sri Lanka’s should phase out term repurchase deals now that bank credit has slowed, allowing the central bank to be a net buyer of dollars, and floor of the policy corridor is active.

Central bank should instead shift to progressively selling down its Treasury bill stock.

Sri Lanka’s floor policy rate window, called the standard deposit facility rate, where new money generated from dollars purchased by the central bank is deposited is now 8.00 percent.

But overnight rates are near 8.50 percent because the central bank is taking deposits at a higher rate through term repo auctions at about 8.62 percent for 7 days. This is in fact higher than the 3-month Treasury bill yield two weeks ago.

If not for the short term repo cash overnight rate would have fallen close to 8.0 percent.

It was prudent to withdraw liquidity after the Easter Sunday bomb attacks, with capital flight expected. It was also prudent not to let rates fall too precipitately. But the danger now seem to have passed.

Term Repos are keeping rates artificially high

The central bank should move to periodic outright sales of its Treasury bill stock and phase out term repos, so that short term rates can naturally fall.

Now that credit is weak Sri Lanka’s peg with the US dollar is under upward pressure.

Excess liquidity is generated from central bank dollar buying to build up reserves or to prevent the rupee from sharply appreciating intra-day (the convertibility undertaking) and eventually meet the International Monetary Fund’s forex reserve target.

Any of this new money that are not loaned out by banks due to weak credit, will pile up, expanding excess liquidity (the aggregate positive balance of the banking system) pushing the overnight rate towards the lower end of the policy corridor.

In laymen’s terms this is a balance of payments surplus. If credit is sharply negative for a long time, in Mercantilist terms this is when a ‘Keynesian Stimulus’ is done.

As can be seen in the graph, overnight rates are now falling. In the second half of 2017 also rates fell below the ceiling rates as credit weakened and the peg strengthened.

This column has previously shown that the domestic operations department of the central bank was wrong to print longer term money below the overnight 9.00 percent policy ceiling rate.

The same logic now applies in reverse.

Short term repo deals are also an unsatisfactory method of mopping up (sterilizing inflows).

If this liquidity is permanently mopped up through Treasury bill sales, preventing banks from using the liquidity, they will remain in forex reserves.

As long as Treasury bills are steadily sold down, every week or every two weeks as dollars are purchased, the peg will remain on the strong side of the convertibility undertaking (the rate at which dollars are bought) and more dollars could be purchased.

The CU can be shifted to strengthen the peg as long as credit is weak.

Going by past experience allowing about 20 to 30 billion rupees to remain in the banking system does little harm. If there is pressure on the rupee from the external side in particular, the liquidity can be quickly mopped up and the rupee floated.

The US Fed has started to cut its excess reserve rate, which is like Sri Lanka’s deposit window rate, the effects of which are still unclear.  In general however a higher rate would tend to strenghten the US dollar. The Fed resumed paying interest on excess reserves after it started injecting massive amounts of bailout cash and quantity easing.

Sri Lanka’s inflation will tend to be somewhat high in the coming months, regardless of the interest rate since the price structure of the country has been pushed up by the collapse of the currency. The pressure from the traded goods side will eventually pass on to non-traded goods and services as well.

By allowing the rupee to appreciate some of the inflation from the traded goods side could be warded off. The erosion of disposable incomes, particularly on energy could also be reduced allowing the economy to recover faster.

At the moment many suppliers are taking hits on margins because demand is weak.

The Floor Rate is the Active Policy Rate

Since the floor policy rate is now the active rate with the peg on strong side there is little point in cutting the ceiling rate. The ceiling rate is now irrelevant, except in so far as punishing overtrading market participants (banks relying on window money to lend).

In the last policy rate hike the floor rate was raised 75 basis points. It can be restored or cut further in one or more cuts, and the ceiling rates should be allowed to remain at 9.0 percent as insurance against future instability.

At all events, avoiding shocks is prudent. Sharp rate cuts can also make foreign investors run.

Plans to narrow the corridor should be abandoned to prevent future economic instability of the type seen in 2018 in particular.

By halting term repos or accepting cash nearer to the floor rate at longer tenures, and progressively selling down the CB’s T-bill stock outright overnight rates can be brought down another 30 to 40 basis points even without a rate cut.

In 2018, the central bank generated two liquidity shocks, in April and in August/September to bring down overnight rates. The first liquidity shock was in April.

After the creditability of the peg was restored around rupee falling to over 160 to the US dollar in July and August, excess liquidity was allowed to build up, generating another shock to the credit system, seen in the second sharp dip in the curve.

Both price and quantity was involved in the shock. However the credit system now seems weak. It can be partly due to exporters unwinding loans.

The only risk appears to come from deficit spending as revenues can fall due to weak imports and credit. Having said that it is possible to deficit spend a little without causing too much of a problem, until the credit system picks up.

Permanent Collections of Forex Reserves

The central bank has about 155 billion rupees of Treasury bills so far. As long as bills are sold down to mop up inflows and collect IMF reserves, domestic credit will be curtailed below and economic activity will be reduced below full potential.

Any deficit spending will keep rates higher, than it would have otherwise been. Any reserve collections would also keep rates higher than it would have been. It may not matter much in the short term as most businesses are simply trying to come to grips with the currency fall and are not in the mood to expand.

However usually under IMF deals in Sri Lanka, activity is further reduced, due to delays in cutting rates. As long as there is a peg (or even in a floating rate) it is safest to cut rates after the currency crises had ended and credit had collapsed and there is a market driven BOP surplus.

Sri Lanka has to be extra cautious, since market participants can panic easily because the peg in this country has very little credibility now.

After the Treasury bills are exhausted, the central bank should issue its own paper (central bank securities) to build reserves. Past experience has shown that term repos are an unsatisfactory method of mopping up inflows and building reserves (Sri Lanka’s Central Bank should sell own securities in new credit cycle: Bellwether).

Sri Lanka’s rupee came under pressure from around February 2018 due to lack of CB Securities or an effective tool to mop up inflows and term repo auctions failed.

This column warned about it before. Like Bank Negara paper on other similar paper, longer tenure securities are needed to maintain a stable peg.

If Sri Lanka did not have a ceiling policy rate and there was only one fixed exchagne rate target, any amount of excess liquidity could be allowed to accumulate, since interest rates would free float and the currency would be hard pegged (the peg is credible) and no money would be printed in case there is captial flight or strong credit demand.

A wide corridor is an insurance against whatever convertibility undertakings that are in use.

As long as auctions of sterilization securities do not fail, the peg will remain strong and will not come under pressure due to domestic credit.

If domestic credit is weak (which will narrow the external current account deficit) there is also an opportunity to repay foreign loans without resorting to more dollar borrowings.

Put another way, it is possible to borrow domestically instead of borrowing abroad and selling to the central bank Treasury bills to generate dollars. Even if dollars are converted to rupees by selling to the central bnk it must be done in a phased manner to avoid liquidity shocks, especially after domestic credit picks up. (Colombo/May28/2019)