The Year 2021 Monetary Policy Operations in Sri Lanka – A Quick Graphical Illustration

 

The objective of this short article is to highlight monetary policy operations carried out by the Central Bank of Sri Lanka in the year 2021. However, no comments are made on their suitability or macroeconomic outcome or policy objectives.

Present Sri Lankan Monetary Policy Model

As in many central banks in developing countries, Sri Lankan monetary policy is operated through two key policy instruments. They are policy interest rates based open market operations (OMO) and statutory reserve ratio (SRR). Both instruments are used to regulate the liquidity in the inter-bank market to prevail in line with policy targets set by the Monetary Board.

• Policy Rates

Policy rates are the two interest rates of the Central Bank used to carry on financial transactions in domestic currency on daily basis with commercial banks and primary dealers in government securities (OMO participants). The Central Bank accepts overnight deposits from them at the standing deposit facility rate (SDFR) whereas it lends overnight at the standing lending facility rate (SLFR) to them against collateral of government securities.

SDFR and SLFR are operated as the interest rates target corridor for overnight interest rates in the inter-bank bank.

• Open Market Operations (OMO)

OMO contain several financial transactions carried out by the Central Bank with OMO participants to ensure that overnight inter-bank interest rates behave within the policy rates corridor.

First is the above stated standing deposit facility (SDF) and standing lending facility (SLF). As a result, an OMO participant does not need to lend below SDFR or borrow above SLFR in normal market conditions.

Second is the Repurchase operations (Repos) in government securities used to mop up liquidity from the banking system. Repos are the sales of government securities with agreement to buy them back at a future date as agreed. The yield rates on Repos are repo rates. Repos carried out by the Central Bank are generally Overnight Repos and very short-term Repos. The Central Bank uses Repos to mop up the banking sector excess liquidity in order to raise the overnight inter-bank interest rates towards the upper bound of policy rates corridor (SLFR) by reducing the inter-bank market liquidity.

Third is the Reverse Repurchase operations (Reverse Repos) in government securities used to inject new liquidity to the banking system. Reverse Repos are the opposite operations of Repos, i.e., buying government securities with the agreement to sell them back at a future date as agreed. The relevant yield rate is the Reverse Repo rate. Reverse Repos also are conducted as overnight and short-term. Therefore, Reverse Repos are carried out by the Central Bank to inject new liquidity to the banking system so that overnight inter-bank interest rates are controlled well below the upper bound of the policy rates corridor as desirable to the Central Bank.

Fourth is the outright trade (purchases and sales) of government securities with OMO participants. Outright purchases are carried out to inject permanent liquidity to the banking system whereas outright sales are conducted to mop up liquidity from the banking system on permanent basis. Therefore, outright trade is rarely used in monetary operations.

Repos, Reverse Repos and outright operations are conducted through auctions where the Central Bank announces the volume or total amount on offer while the yields/prices are determined through competitive bidding. Therefore, bidding participants get their yields/prices on bids up to the cut-off point decided by the Central Bank. Therefore, the Central Bank announces total amounts as well as minimum yield, maximum yield and weighted average yield after each auction.

Fifth is the Intra-day liquidity facility provided to OMO participants under the payment system stability support. Under this facility, they can borrow interest free from the Central Bank against the collateral of government securities conditional upon the repayment with same day. This facility is used to finance the during-the-day dealings without any interest cost or affecting the monetary figures at the end of the day. Therefore, this facility can be practically used to address liquidity shortages of OMO participants without limits conditional upon the availability of government securities. However, as the daily volume of the use of this facility is not transparent, this instrument is not used in this article.

However, mostly operative OMO are the standing facilities, i.e., SDF and SLF, as they are directly related to overnight inter-bank interest rate target (policy interest rates) of the Monetary policy.

OMO together with policy rates are expected to affect the banking sector liquidity and to drive market interest rates for the objective bank credit control in line with the monetary policy. 

• Statutory Reserve Ratio (SRR)

The SRR is the percentage of commercial banks' local currency private sector deposit liabilities that should be held at the Central Bank at SRR rates determined by the Monetary Board. This policy instrument is expected to regulate the banking sector credit creation ability.

• Primary Market Treasury bills Yield Rates

The Central Bank as the public debt manager conducts weekly Treasury bills auctions to raise short-term borrowings, i.e., 91 days, 182 days and 364 days, to the government. Therefore, it attempts to control or guide the primary market Treasury bills yield rates to influence short-term market interest rates including inter-bank interest rates. For this purpose, the Central Bank has a historical practice of directly subscribing to Treasury bills issuances outside the auctions by printing money (as in the case of SLF and Reverse Repo operations) to keep yield rates within its control consistent with the present monetary policy direction. 

However, as in the case of overnight inter-bank interest rates, the Central Bank does not announce any targets for such yield rates. Therefore, primary Treasury bills yield rates are de-factor short-term policy interest rates based on the short end of the yield curve. However, the general tradition of central banks is to carry out secondary market trades in government securities to influence market interest rates at preferred points or segments of the yield curve.

• Money Printing and Reserve Money

Above OMO affect money printing of the Central Bank in routine manner. In addition, Central Bank's provisional advances to the government and the net foreign currency reserve of the Central Bank also have a major impact on the reserve money. The amount of money printing is estimated as the reserve money. In the conduct of the monetary policy, the Central Bank also has a target for the preferred reserve money level and carries out OMO within the reserve money target.

Monetary Policy Operation Indictors

As briefly present above, direct indicators of the monetary policy operations are as follows.

• Monetary Rates

SRR
Policy Interest Rates – SDFR and SLFR
Overnight inter-bank interest rate
Weekly primary Treasury bills yield rates, 91 days, 182 days and 364 days

• Monetary Volumes

SDF, SLF and inter-bank lending daily volumes
Total daily outstanding volume of Central Bank liquidity operations
Daily Treasury bills holding of the Central Bank
Monthly reserve money

Following three charts show the behaviour of the above indicators during the year 2021.

Highlights of Monetary Operation Indicators 2021 (see Three Charts Above)

• With effect from 19 August 2021, policy interest rates have been raised by 0.50% to 5% and 6%, respectively, and SRR raised by 2% to 4% (with effect from 1^st September 2021). As a result, all key monetary interest rates have been rising faster than increase in policy rates.

• The overnight inter-bank interest rate which was closer to the middle of policy rates corridor has risen to closer to its upper bound (6%) after the policy rates increase.

• The increase in SRR by 2% and aggressive mop up of inter-bank liquidity through overnight and 7-Day Repos/term Repos in addition to SDF have led to the significant increase in inter-bank interest rates due to considerable reduction in the inter-bank liquidity level.

• As a result, the use of SLF and inter-bank lending have risen excessively while the volume of SDF has fallen in opposite. It shows that SDF daily volume has declined from Rs. 118 bn to mostly Rs. 70 bn.-90 bn level where as SLF has increased from Rs. 109 bn to a level of Rs. 450 bn.- 500 bn. Therefore, the liquidity shortage has caused the Central Bank on one occasion to inject even Rs. 100 bn through a 60-day Reverse Repo auction at the yield rate of 7.20%. At the end of 2021, the outstanding amount of liquidity injected by the Central Bank into the banking system in response to tight liquidity conditions created by the significant increase in SRR by 2% and aggressive Repos operations amounted to Rs.450 bn. This has lead a good risk free interest income source to the Central Bank.

• The fast increase in Treasury bills yield rates, despite the fact that policy interest rates were kept at 5% and 6% after 19th August 2021, shows tighter monetary conditions expected in the monetary policy. Until the policy tightening, Treasury bills yield rates also have been maintained within the policy rates corridor through the increase in the Treasury bills holding by the Central Bank from Rs. 740 bn to Rs. 1,170 bn. However, immediately after the policy tightening on 19th August, yield rates have been fast rising far above the upper bound of the policy rates corridor (6%), despite the fast increase Treasury bills holding of the Central Bank up to the level of Rs. 1,460 bn. in early November. However, in months of November and December, Central Bank’s Treasury bills holding has somewhat decelerated to Rs. 1,360 bn level allowing somewhat money/debt market forces to operate. This high volume of Treasury bills holding is also a good source of risk free income to the Central Bank.

• Reserve money has started rising faster since September showing an increase of only Rs. 324 bn as at end of November as compared to the end of 2020 level. Such a lower increase despite the increase in money printing for subscriptions (an increase of Central Bank Treasury bills holding of nearly Rs. 7o9 bn. from end December 2020 to end November 2021) to Treasury bills auctions is seen due to the significant fall of the net foreign assets of the Central Bank as a result of heavy protection of the Sri Lanka Rupee despite the acute shortage of net foreign currency inflows to the country.

The Central Bank in its monetary policy press release dated 19th August 2021 indicated that this policy tightening decision was made with a view to addressing the imbalances on the external sector of the economy and to preempt the buildup of any excessive inflationary pressures over the medium term, amidst improved growth prospects. As the subsequent two monetary policy meetings kept the present monetary policy unchanged, the above position remains same.

Therefore, the readers are provided with the above technical information to make their own assessment on the usefulness of the present monetary operations to the general public and the economy in the present circumstances.

(The presentation in this article is based on the author’s hands-on experience on the relevant subject and targeted for students and teachers and professionals interested in Economics. The readers may also refer to two books of the author “Innovating Central Banks with New Mandate & Governance to Promote Safer Money and Banking in Open Economies” and “ මූල්‍ය ආර්ථික විද්‍යාව: මුදල්, වාණිජ බැංකු සහ මහ බැංකුව” (Sarasavi Bookshop) for technical discussions on the monetary policy and central banking.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka