Practicalities and Economic Substance in Explaining Current Market

Interest Rates and Monetary Board actions

There is a series of articles being published recently discussing certain aspects in the economy, monetary
policy measures, government securities market and banking sector. From the perspective of an average
person, some articles warrant further clarifications and responded with another dimension of opinions,
practicalities and data as evidence. Opinions and comments should be backed by data to prove the
position.
Some constructive criticisms published these days seem to be directional but do not carry a single position
as they contradict the own opinions in the same article or different articles written at different times by
the same writer. One such recently published article says CBSL policy rates should be adjusted up to
increase the market interest rates so that inflationary pressure can be curtailed. However, the particular
article criticizes increase in the general interest rates due to the increased Statutory Reserve Ratio (SRR)
for commercial banks by CBSL. The same article further explains that market interest rates have increased
above the CBSL policy rates due to excessive borrowing by the Government and this has given arbitrage
opportunities for market participants. In another place of the article, it states that market interest rates
have currently increased as a results of CBSL selling dollars in the market and on the other hand printing
money through lending to the financial institutions. According to these articles, all actions taken by the
Monetary Board in the recent past are wrong and have no economic substance. For them, there are lot
of distortions in the market due to the actions by the Monetary Board. For rational analysts most of these
criticisms are non-other than blame games. For a rationale reader, these constructive criticisms are too
vague to gauge the most desirable action because these criticisms do not show one position.

Has the world ever come across an economy which sailed smoothly without any turbulence over a period
of time? If it is the case, we will have to get economics books and concepts re-written and all the Central
Banks can also be closed. Turbulence in an economy is inevitable and temporary turbulences can be
turned to crisis situations. Such crisis situation can be caused through fundamental issues in the real sector
or the finance sector or can be created simply due to irrational exuberance of a section of people or loss
of confidence due to speculations. Certain economic crises are alleged to occur or worsen due to
speculations created by few selected groups within the system or outside the system who worked for an
agenda.
Corrective actions and policy directions can be painful in the short run and can be harder or less hard on
different quarters of the economy. Short term increase in interest rates is a painful exercise for financial
institutions which are running a net large daily borrowing position in the market while it is favourable for
the counterparts which are running a net large lending position in the money market. During a currency
depreciation, importers will have to bear conversion losses and business losses while exporters are happy
earning conversion gains and business gains and wise versa. The fundamental question is whether the Sri
Lanka is really in an economic crisis which is going out of control today and how critical it is compared to
what the economies in the other parts of the world are experiencing today. Further, how we have
experienced previously similar or worse circumstances.
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CBSLs declaration on the actual status of the economy is unarguably a part of conduct under the
transparency and good governance. What is not acceptable in the eyes of the general public is that the
CBSL declaring a cherishing economy and adopting actions in contrast to the said status of the economy.
As analysts, if we try to undermine the deliberation by the CBSL to declare the actual status of the
economy as a pre-obituary notice, we are not endorsing transparency and good governance although we
advocate both attributes. It is an utter exaggeration to rate the current status of the economy as a patient
in a critical conditions where emergency unit treatments are required.

Have the recent CBSLs actions distorted the market interest rates
Low interest rate structure consists of all the interest rates in the market prevailing at low levels. Key such
interest rates are; Sri Lanka Inter-bank Borrowing Rate (SLIBOR), Average Weighted Deposit Rate (AWDR),
Average Weighted Prime Lending Rate (AWPLR), Treasury securities rates and Repo rate. In line with the
decline in overall interest rates, deposit rates represented by AWDR of the banks also declined and so the
banks lending rates also (as represented by AWPLR). Money market interest rates are always very volatile
within a very short period of time largely impacted by the day-to-day liquidity in the banking sector. CBSL
policy rates include two legs - CBSL Standing Lending Facility Rate (SLF) which is the lending rate to the
banks for overnight. The second leg is the CBSL Standing Deposit Facility (SDF) rate which is the rate at
which banks can park its excess money with CBSL for overnight. Currently, these two rates stay at 8% and
6.5%, respectively. Currently, SLIBOR has slightly gone above the SLF rate. However, it is not a situation
for banks to make arbitrage profits. Arbitrage profits are the risk-less profits made without committing
funds for a period, even for one day. SLBOR is the rate applicable for lending and borrowing by banks in
Sri Lanka in rupee terms without any collateral. Borrowing from CBSL standing facility by Bank X and
lending to such money to Bank Y at a higher rate does not fall within these definition of arbitrage profits.
Bank Y directly does not go to the CBSL and borrow at relatively lower rate than the rate charged by
Bank X because it does not have adequate government securities to pledge with CBSL as collateral for
borrowing. Therefore, Bank Y goes to Bank X and ask for money at inter-banking rate without
collateral. Therefore, Bank X assumes risk of Bank Y, therefore, risk premium should be added to the
interest rate charged from Bank Y. This money is lent by Bank X at least for one day. It is a misleading
definition for arbitrage profits.
As depicted in Graph 1, this phenomenon of SLIBOR going above the SLF rate is not a market condition
exceptional to the current status. If it is attributed to the results of mismanagement by the Monetary
Board, this mismanagement has been there systematically for above last 15 years. It is a short term
phenomenon which tends to prevail in the market when interest rates are under pressure. Currently,
SLIBOR is slightly higher than SLF rate by about 0.2%. In contrast, historically this difference between
SLIBOR and SLFR has been sometimes about 10% or more.

Graph 1
CBSL Policy Rates vs Market Interest Rates (SLIBOR)
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%

Dec-2000
Jun-2001
Dec-2001
Jun-2002
Dec-2002
Jun-2003
Dec-2003
Jun-2004
Dec-2004
Jun-2005
Dec-2005
Jun-2006
Dec-2006
Jun-2007
Dec-2007
Jun-2008
Dec-2008
Jun-2009
Dec-2009
Jun-2010
Dec-2010
Jun-2011
Dec-2011
Jun-2012
Dec-2012
Jun-2013
Dec-2013
Jun-2014
Dec-2014
Jun-2015
Dec-2015

0.00%

SLBOR

SDFR of CBSL

SLFR of CBSL

(Source data : CBSL website)

Are the depositors deprived under the current circumstances

Another misconception against the Monetary Board increasing the SRR is of the adverse impact on the
depositors since the deposit rates are reduced to accommodate the cost of increased SRR while lending
rates are kept at the same level. This opinion contradicts with reality and otherwise is proved by the
readily available market information about the movements of the banks deposit rates and the lending
rates (Graph 2).
Today, no bank or any other deposit taking finance institution is in a position to reduce deposit rates
arbitrarily as very easily their deposit base can be cannibalized by competitors. Banking sector deposit
rates increase but not as fast as the increase in the lending rate and wise versa. Lending rates are more
sensitive to the latest developments in the money market while deposit rates react with a time lag of few
months.
Therefore, what practically happens is that the banking sector passes the cost of increased SRR in the form
of increased lending rates to the borrowers which will make the borrowing costly, thereby curtailing the
credit growth. This is exactly the intention of the any monetary authority in using the SRR as a tightening
tool. It is what has been achieved in the market.

Graph 2
Movement in AWPLR, AWDR and
Interest Margins in the Banking Sector
25.00
20.00
15.00
10.00
5.00

Oct-15

Aug-14

Mar-15

Jan-14

Jun-13

Apr-12

Nov-12

Sep-11

Feb-11

Jul-10

Dec-09

May-09

Oct-08

Aug-07

AWPR

Mar-08

Jan-07

Jun-06

Apr-05

Nov-05

Sep-04

Feb-04

Jul-03

Dec-02

May-02

Oct-01

Aug-00

Mar-01

Jan-00

0.00

AWDR

(source : monthly rates from the CBSL website)

Do banks enjoy supernormal profits

Similar to the Monetary Board being a very easy and common target, the banking sector is also criticized
whether they make profits or losses. The misconception is that banks are making extraordinary profits at
every occasions whether interest rates increase or decline.
Thanks to too many financing institutions in the sector with all having the permission to accept some form
or all forms of deposits, the banking sector is so competitive with under-cutting practices in deposit
mobilization to lending. This is the actual and practical picture in the banking sector. During 2014 and
2015, banks interest margins narrowed to the bottom and negative margins were also experienced by
the sector (Graph 1). This means banks lent at lower rates than their cost of funds because they wanted
to keep both the depositors and the borrowers for future business profits. This is exactly what is
happening practically in the banking sector. During 2016, interest margins earned by banks slightly
increased by first quarter of 2016 due to increase in lending rates, not due to decline in deposit rate. But
this margins will narrow down in months to come as deposit rates follow up the lending rates with a time
lag of few months. Banks Lending rates get adjusted faster than the deposit rates during an increase or
decline in general interest rate structure. This is the exact practical scenario in the banking sector.
Therefore, it is not rational to conclude by looking at a point of data to say that banks are left for
supernormal profits.

It is a very primitive approach to measure the performance of whatever a business unit by simply looking
at profits. The most accepted parameter is profitability in which Return on Equity (ROE) and Return on
Assets (ROA) are evaluated. Every year, your profits will simply increase although under same rates of
return as you commit more and more money in the business. What matters is the rate of return you
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generate from the business on such committed money. If the Banks can simply reduce the deposit rates
detrimentally to the depositors and enjoy increased margins continuously, banks do not have a reason to
move away from core-banking business and increasing focus on non-core banking business. Banks tend
to do so because under the stiff competition, they cannot make adequate margins to make target rates
of returns for their shareholders through traditional lending activities. However, these is no any adversity
for the economy due to banks adding non-core banking activities into their business portfolio. This shift
has already occurred in other parts of the world and a large component of the banks bottom line is
contributed by non-core banking business. This is where financial innovation and efficient use of capital
is achieved.

Loan to value ratio for vehicles

Credit growth in the banking and finance companies was contributed considerably by leasing/hire
purchase on vehicles. Vehicle imports increased during 2015 at a high rate eating up the countrys foreign
currency. These imports were facilitated by the easy financing schemes offered by banks and other
financial institutions. This created three prong concerns to the economy and the stability of the finance
sector altogether.
1. Foreign currency drain was experienced on vehicle imports.
2. It added to the excessive credit growth exerting pressure on inflation.
3. It increased the risk exposure for the lending institutions which required them to keep more
impairment provisions. Under the new accounting standards, lending institutions are required to
assess the impairment under each institutions historical experience for about 1-3 years and make
provisions in accordance.

It is clear for a rational person that the increase in import duties for vehicles is not claimed by CBSL as a
revenue generation activities to the government, but as a mechanism to excessive control dollar outflows
one of deferrable imports. With the increase of this duties coupled with banks decelerated appetite for
vehicle leasing, the vehicle demand dropped drastically easing pressure on exchange rates during 2016.

Has the objective of the CBSL being achieved

Credit growth of an economy is promoted by low interest rates and the banking sector high liquidity.
Excessive credit growth is followed by the inflationary pressure. When SRR is increased the impact is two
folds. Firstly, commercial banks have to sterilize more funds from deposits received in rupee terms.
Commercial banks ability for money creations and lending through deposit money is restricted. Secondly,
a percentage of deposits equivalent to SRR does not generate lending income to the banks. Banks have
to increase the lending rates to recover their cost of SRR funds which are kept with the CBSL. Therefore,
through increase in SRR, both low interest rates and the excess market liquidity can be addressed. It will
bring desired results through curtailing credit growth in the banking sector. This desirable results are
already been achieved in the banking sector. Credit demand in the sector commenced decelerating. Both
lending and deposit rates increased. SRR swept part of excess liquidity in the banking sector which made
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money for lending is expensive thereby curtailing credit growth. In todays context of the banking sector
dynamics, it is beyond the reality to say that SRR is a dead duck as it has already brought intended results.

Institutional investors are always blamed

Officials of the public sector institutional investors are bombarded with various criticisms and allegations
for which they had to stand up and explain the investment strategy routinely. These criticisms and
allegations are existing for last 15 years, as the writer has experienced, against public sector institutional
investors including EPF and ETF and continue to emerge. The most common allegation emerging
throughout this long period is that few public sector institutional investors attempt to suppress the
government securities rates giving and undue advantage for the government. These criticisms came from
various market practitioners and professionals. Reference has been given in many instances in the reports
of certain multilateral agencies. They used to term these institutional investors as Captive Sources in
the government securities market. This public perception although it is wrong, was there due to several
institutional arrangements and size of the funds base. The fund size of these institutions account for
trillions to hundreds of billions of rupee. It is not a surprise for somebody to assume that with such a large
fund base whether these funds could overshadow the government securities market and suppress the
market interest rates. Seriousness of these long-term allegations against EPF and ETF, not like government
banks and other government funds, is that if EPF and ETF to suppress the market interest rates, the
realized losses or opportunity losses have to be borne by the working population of the country, not the
government. These were all only public perceptions due to institutional arrangements and other practices
adopted those days. However, what is interesting is certain parties which level allegations against
institutional investors change their stance from time to time on practices adopted by the institutional
investors. Because, certain parties now seemingly taken a U-turn in their criticisms against EPF in
particular. Those criticizing parties indicated two main reason as evidence for EPF funds to be Captive
in the government securities market. First is the perception of the market of a conflict of interest as the
CBSL being the custodian of the EPF money and at the same time CBSL being the agent for the government
to manage public borrowings. As the manager for the public debt, Monetary Board has to time public
debt placements and the quantum trying to reduce the interest rates on the government securities in
order to reduce the cost of funds to the government. On the other hand, as the manager of the EPF money,
the Monetary Board is vested with the fiduciary responsibilities to earn the highest possible interest rates
for the EPF money while ensuring the safety of such investments. This is where the perceived conflict of
interest by the Monetary Board arises in the eyes of the general public. This perception is worse when the
Deputy Governor in charge of EPF and the Deputy Governor in charge of the Public Debt Department is
the same. It is a very prudent measure taken by the Monetary Board several years ago to place these two
departments which carry very conflicting objectives and responsibilities fall under two Deputy Governors
so that the same Deputy Governor does not have to recommend the Monetary Board of the EPF bidding
rates in the primary auction and at the same time recommend the Monetary Board with the acceptable
rates and quantum of government securities primary auctions of the PDD.

The other very strong criticism level against EPF playing as a Captive Source to government is the EPFs
direct access to the primary issues of the government securities. Market suspected that when EPF had the
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direct access, through over-the-counter transactions, whatever the quantum is allocated to EPF at
presumably lower rates relative to the market rates. Market participants suspected that only the balance
part is made available to the rest of the competitive bidders. The market criticisms were on both the
perceived appropriate rate and the quantum received by the EPF to distort the market with artificially
suppressed rates. Apart from that, EPF members also raised questions on the rates EPF received at the
primary auctions through direct bidding. They questioned whether these rates can be the best rates
possible for EPF funds. These perception and assumptions were not healthy for the EPF management,
orderly market performance and the EPF members. Under these circumstances, it is a very prudent
approach to restrict EPF and any other public sector institutional investor coming directly to the
government securities auctions through private placements.

On the other hand, it is a new and seemingly implausible criticism to say that the government securities
market can be dominated and manipulated by few private sector investors with several billions of rupees
in hand. Based on the ample size of the government securities market, this criticism is much beyond the
acceptability.

Should or not the auctions be cancelled by the Public Debt Department

Public Debt Department (PDD) of CBSL has necessary legislative powers to accept or reject an auction.
However, market participants and primary dealers criticize PDD for auction cancelations complaining that
their trading and investment transactions cannot be planned properly. Further, they have to incur cost of
bidding arrangements and time allocation which are wasted once the auction is canceled. The other side
of the story is that, on the basis of a borrower, PDD also has its rights to postpone the borrowing or scale
down when the rates and funds supply are not in its faviour. At the same time it is acceptable for the
borrower to scale up the borrowings given he needs funds for a cause at acceptable rates. It is not different
than an individual going for a personal loan from a bank. The individual borrower submits the application
filled and signed and awaits the offer from the bank. Bank makes an offer with all the terms and conditions
and the interest rate applicable. Assumed all the terms and conditions are agreeable, but if the interest
rate is not affordable should the borrower go ahead and borrow from the Bank. Instead, the individual
borrower will differ his borrowing or will go to another bank. He will borrow from another bank only if
that bank charges a lower rate than what was quoted by the previous bank. Therefore, PDD also has two
similar approaches either cancel the auctions when they are not comfortable with the bidding rates or
approach other lenders. This was where the EPF members and market participants were puzzled
previously when EPF was given direct access to private placements of government securities. However,
this perception does not exists now as the EPF is not permitted for private placements as per the market
information.

Further, important to note that cancelation of primary auctions is not an extraordinary feature adopted
by the PDD of the CBSL only during the recent history. Auction cancelations were witnessed previously
also. These auction cancellations tend to happen when interest rates are under pressure (Table 1).
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Table 1 No. of auctions in which no volume was accepted

Year

No. of auctions
in which no volume
was accepted
1
5
0
1
1
8
13
48
27
17
0
0
0
0
0
18
12

2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016

(source data : CBSL website)

By Sanjeewa Fernando, CFA

(The writer is a former Fund Manager in the EPF Department of Central Bank of Sri Lanka and the former
Vice President Integrated Risk Management in DFCC Bank.)