The Central Bank of Sri Lanka (CBSL) held its policy rates steady at the meeting held on 05 March 2020 while allowing the impact of previous policy actions to materilise. However, as a COVID-19 relief measure CBSL reduced policy rates by 100bps in 3 emergency instances reducing the SDFR and SLFR rate to 5.50% and 6.50%.
With the recent reduction of SRR by 2%, liquidity position surged over LKR 200Bn and bulk of the excess liquidity of banks is likely to be parked in SDFR facility provided by CBSL at 5.50% rather than allocating for lending.
In order to discourage banks using the SDFR facility, First Capital Research considers the possibility of a major rate cut resulting SDFR a less attractive option for LCBs.
“Post pandemic, Sri Lanka’s stressed economic conditions remains a key weakness and reviving the economy is one of the objective of the government and CBSL. Reducing policy rates is one of the main tools that CBSL can utilise to increase economic activity and revive the economy,” the research firm said.
With the recent reduction of SRR additional LKR 115Bn of liquidity was injected into the banking system, allowing banks to accelerate credit flows into the economy while reducing cost of funds .
First Capital Research expects LKR 100Bn top -up, in the existing refinance scheme which may enhance additional liquidity to the domestic money market above LKR 250Bn.
“At the current level excess liquidity is already at a 16 -year high. Further top -up in existing refinance scheme may push CBSL Holding (printed money) closer to LKR 500Bn from current LKR 311Bn,” it said.
To dissuade banks from keeping excess money with the CBSL without lending, the research firm believes that the CBSL has to reduce its policy rates substantially both ; SDFR, the rate at which commercial banks can keep overnight liquidity with the CBSL, and the SLFR, as a stimulus to boost the credit growth .
As a result of injection of liquidity to the system CBSL holdings recorded a significant increase of more than LKR 200Bn since 13th March 2020.
Supported by import restrictions, LKR stays strong against the USD despite Covid -19 impact, while INR and PKR remain under pressure.
Accordingly, First Capital Research belives that the CBSL has three options at the current scenario to consider.
Option 01 – Policy Rate cut
First Capital Research believes a policy rate cut in both SDFR and SLFR is the one of the convenient tool available for the CBSL to boost lending in the economy while encouraging the public to borrow at a further low market interest rates To dissuade banks from keeping excess money with the CBSL without lending, the research firm believes that the CBSL has to reduce its policy rates considerably both; SDFR the rate at which commercial banks can keep their excess cash temporarily with the CBSL and the SLFR as a stimulus to boost the credit growth.
Option 02- Restrictions on CBSL liquidity window
In order to discourage LCBs in using the facility of SDFR in order to park the excess liquidity First Capital Research believes that CBSL also has two options available to restrict the access to liquidity window .
– Limiting the frequency of access to the SDFR liquidity window Option
– Limiting the amount that can be parked through the Liquidity window
Option 03- Credit Guarantee Scheme
It was identified that most banks are not willing to lend due to the credit risk. However, the research firm believes that this can be solved by a credit guarantee scheme where the Treasury acts as the guarantor for the loans lend by banks. However, this provision needs to be included in the current year or subsequent years budget of the Government resulting in a further increase in the budget deficit.
However, among the 3 options available, CBSL has already implemented the credit guarantee scheme on 28th Jun 2020. First Capital Research believes that above mentioned monetary action reduces the probability of the other two options being implemented. However, to stimulate the economy and to discourage banks using SDFR there is also a requirement to implement either of other two options (policy rate cut and restrictions on CBSL liquidity window) in order to help rates to sustain for a longer period.
The research firm believes that there is a higher likelihood of 90% that CBSL may provide a rate cut to ensure the continued supply of credit at a low cost of funding.
“Expected Monetary Policy Stance CBSL either can choose to hold interest rates steady, cut by a 50, 100, 150 and 200 bps while hike is off the table,” First Capital Research said.
“We believe that there is a higher probability of 40% for a 100bps rate cut to bring it closer towards the 4% special working capital lending rate and thus to discourage the LCBs from using the SDFR facility,” the research firm added.