State Bank of Pakistan's policy of frequent intervention in the market is achieving the objective of bringing short-term inter-bank market rates close to the discount rate.
On Saturday, SBP through its open market operation (OMO) auction provided Rs 9.7 billion to the banks at 8.87 percent, via six-day reverse-repo transaction. In the previous OMO, SBP had injected Rs 6.75 billion for five days at 8.72 percent. The gap with the discount rate at 9 percent is now 13 basis points.
The accommodative monetary policy followed for five years was reversed in April 2005 as the inflation rate touched 11.1 percent. Allowing private sector credit to grow from Rs 18.3 billion in FY2000 to Rs 438 billion by the end of FY 2005 fuelled aggregate demand pressures.
Consequently, broad money growth exceeded nominal GDP growth for three consecutive years. Anticipating continued further build-up of these pressures, SBP raised the discount rate by 1.5 percent. But domestic demand pressures remained high as both the private sector credit and government borrowings continue to remain strung.
However, monetary tightening by SBP did upset the pro-growth government policy makers as well as other speculators dealing in real estate and the bourses. It was argued that high oil prices and food shortages were fuelling inflation, and monetary tightening could not counter it.
Governmental efforts to improve the supply side through higher imports, coupled with the tighter monetary stance, did weaken inflationary pressures (built since March 2004) with CPI headline declining from 9.3 percent year-on-year end June FY05-October FY05 to 6.9 percent in March FY06; and core CPI coming down from range of 7 to 8 percent during June FY04-October FY05 to 6.7 percent by end-March FY06. SBP expects CPI inflation rate would be in the range of 7.7 to 8.3 percent in FY06.
The higher inter-bank market rate, tight liquidity conditions and demand for credit together enhanced the weighted average lending rate by close to 200 basis points in FY06.
The private sector credit has remained robust 18 percent relative to over 25 percent in the preceding year. Had the government borrowings for budgetary support behaved as planned the impact of monetary tightening would have been more visible, say knowledgeable economists. Furthermore, it is argued that the fiscal dependence on SBP generates inflationary pressures and deters growth of the long-term government securities market priced in line with the prevailing yield curve.
Discontinuing the buy-sell dollar swap mechanism and liquidating this portfolio (which had grown to $450 million) has also resulted in withdrawal of rupee liquidity. Now, SBP is buying export dollars from future inflows to banks to meet the oil imports and reduce the reliance on meeting these payments from forex reserves.
The International Monetary Fund is pushing SBP to raise the discount rate to hike the interest rate structure. However, the government fears that any such move would stifle growth. SBP wants to fully gauge the effectiveness of its transmission mechanism and the time lag the interest rate adjustments entail before making any further move.
OMO: The State Bank of Pakistan has further tightened its grooves by injecting Rs 9.7 billion against market demand of Rs 24.4 billion at 8.87 percent through 6-day reverse repo transaction. Last time, it had injected Rs 6.75 billion for 5 days at 8.82 percent. The central bank's discount rate is 9 percent.
On Saturday, banks approached the SBP for 6-day reverse repo for Rs 24.4 billion, but SBP did not entertain the request. There could be two possibilities, first, it could be that market demand was to square their original position, but this is a less likely case, as banks, on Saturday did not approach the central bank's discount window for discounting, which was zero. The other possibility could be that the market was demanding excess liquidity, intentionally, knowing that tighter conditions would prevail. Hence, by obtaining funds from its discount window, the gap with corporate lending still provides good arbitrage opportunity.
Though it is impossible to ascertain exact liquidity of the banking system, since there are no details of daily liquidity position made available to the market. However, treasurers feel that the market is currently short by Rs 10-15 billion.
Banks have to maintain 5 percent SLR. During the week they are allowed to hold up to a minimum of 4 percent, but by the end of week they have to maintain a weekly average of 5 percent. One percent average SLR of banks is roughly Rs 22 billion.
Another factor that weighs on the market liquidity is the central bank's recent positive stances that instead of doing a Buy/Sell Dollar swap it is purchasing outright forward dollars from the inter-bank Fx market. When doing a Buy/Sell swap, SBP injects Rupee in the banking system against ready purchase of Dollar resulting future commitment of Dollar to be paid by the central bank at the time of maturity. Since, the central bank is refraining from forward B/S swap, which creates artificial liquidity in the market, banks are now left with long NOSTRO position, thus draining the artificial liquidity.
However, there are plenty of distortions in the rates. One-year T/bills cut-off yield is 8.7907 percent, one-year KIBOR averages 9.75 percent. One-year call ranges between 9.75 percent and 10 percent because 1 percent security is added in call lending. One-year clean lending is roughly averaged around 11 percent, because it is part of both Advances & Deposit of the bank. Some banks are even offering above 11 percent to sizeable deposits, while banks, taking risk in the equity market, are enjoying lending between 16 percent and 18 percent.
Meanwhile, some activity was seen last week after the announcement of Rs 10 billion PIB auction. When issued PIB script was traded at discount, 3-year deal was at a yield of 9.40 percent and 10-year PIB was traded at a yield of 9.75 percent. The coupon rates have been revised: for 3 years to 9.10 percent, 5 years to 9.30 percent, and for 10 years to 9.6 percent.
As per PD rules, all issued sales are subject to issuance of SBP. In case the auction is scrapped, all issued sales would stand null and void. Similarly, in case of issuance of any short-sell not covered through auction will be honoured by the central bank at a price at its discretion, which in the past was based on the weighted cut-off yield.
The central bank has invited application for new PDs. It makes no sense to have 14 PDs in a dead market, say bankers. The market activity has been dead, with occasional activity seen during the week. It has been a complete failure. SBP should seriously consider cutting down the number of PDs to five and asking all the five PDs to make sure that bond activity takes place on regular basis.
Ministry of Finance has been gloating about the success of Euro bond and Sukkok bond, but when it comes to domestic bond activity, there is not much to write about. They must be aware of the fact that the strength of financial sector comes from an active domestic bond market and therefore should realise the importance of the domestic debt market.
It would be interesting to see the coming PIB auction on May 18. Bond dealers say that they would be keenly watching the PIB auction, as the central bank's stance clearly suggests it would be targeting the amount and not the yield, while the Ministry of Finance priority would be targeting cut-off yield and not the amount. A compromise approach would certainly benefit the market, ie let the market determine the yield.
Bankers expect the SBP to announce a T-bill auction target in the range of Rs 3 to 5 billion on Monday.
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