What the Prez-CB spat means to us citizen

by Arosha de Silva-June 26, 2020

Our President took to twitter (probably taking a cue from his US counterpart) and lashed out against the Central Bank (CB) for not giving him solutions to various problems confronting the economy.

I had a lengthy chat with my friends (finance and non-finance) discussing this and thought of writing my take for anyone who is interested in understanding what happened in recent days.

To summarize in layman’s terms, "You can’t eat unhealthy all your life, go into cardiac arrest and shout at the surgeon demanding an immediate cure. They can insert a stent but you’ve got to make a lifestyle change to completely recover; or your imminent demise is inevitable."

This rift between the CB and president is most likely due to the treasury’s inability to foot the government salary bill at the end of the month and the president’s effort to get over the issue. The solution suggested by the president/or his close advisers was to print money (which leads to inflation without any underlying economic growth) which was opposed by the CB.

What did the Central Bank do?

It reduced the SRR (Staturory Reserve Ratio) by 200 basis points to 2.00%. This isn’t rocket science and they didn’t have to burn the midnight oil to come up with this. The CB was working its way towards reducing SRR over time. They just went with the maximum possible to appease the president. The injection of capital to the economy roughly amounts to LKR 115Bn.

CB has also agreed to provide a funding line to Licensed Commercial Banks (LCBs) at a concessionary 1.00 % interest rate against a pledge of broad collateral on condition that the LCB’s will lend at a rate 4.00%. Thereby the total refinancing scheme offered by the CB amounts to over LKR 150Bn.

What does this mean?

The SRR denotes the amount of money that all banks should hold/deposit at the CB as a percentage of their Deposit Book. By reducing these requirement, banks now have access to more of their deposit money to lend to people (to start businesses).

Further the additional funding lines extended by the CB will greatly improve the liquidity in the market.

Does that solve the issue?

The real issue is not liquidity in the market but a lack of creditworthiness. The banks can’t lend blindly and accept the credit risk as it affects the NPL (non-performing loans) ratio. Hence what’s required is a comprehensive credit guarantee scheme.

The banks now look at a higher credit score to lend (due to uncertainty) to even the normal level of debt (which makes debt even more inaccessible to the public). The government should look at a comprehensive alternative to the CRIB (Credit Information Bureau) reports to assess creditworthiness.

The banks were already experiencing a higher NPL ratio which was further aggravated by the added provisioning requirement due to the adoption of IFRS-9 (the new financial instrument standard).

The repercussion of reducing SRR?

When there is excess money in the commercial banking system and it can’t lend such funds to the public, the banks will try to earn interest from their holdings. They can also move that money to the SDD (Standing Deposit Facility) at the CB on a no questions asked basis. SDD allows the CB to absorb liquidity (deposit) from commercial banks without issuing government securities in return to the banks (Aka, collateral. This is why it is fundamentally different from the reverse repo for the finance folk who are reading this).

When commercial banks have excess cash that they can’t lend, they will naturally use the SDD facility. Since CB also doesn’t have captive commercial banks with a funding shortfall to lend to, it will now have to foot the interest cost of this (The current SDD rate is 5.5%). Thus, it is natural for the CB to take the decision to reduce the SDD rate in its own interest of paying less to commercial banks.

Banks treasuries will then try to buy government bills and bonds (because they are less risky and virtually the next best substitute to the SDD scheme) from the secondary market which gives them higher yields than (5.5% or whatever amount SDD is reduced to). This pushes up the prices of the bonds and bills and brings the overall yield down ( as the yield is fixed when the bond or bill is issued, anything extra you pay reduces the yield.)

This will make the local debt markets even more unattractive to foreigners and cause further pressure on the rupee leading to inflation once again. In the view of CB, this is better than printing money as the total money in circulation in the economy is the same even though the end result still causes inflation.

As individuals what does this mean to us?

The value of the rupees is going to come down unless we (government and people) do some considerable fiscal consolidation in the next few years and run a very disciplined budget. Try to stay away from holding cash and move into asset classes which gives you a natural hedge against the rupee depreciation. Wherever you move (land, property, shares, etc.), always remember a gain is made on your buying price. So, don’t panic and overreact.

(The author is a Chartered Accountant based in London working for the M&A (Mergers and Acquisitions) consulting function of a Big 4 Accounting Firm. The above are his personal views).