Today is a T-Bill auction. The fiscal financing needs are growing, while the avenues to finance are drying. SBP financing is totally a no-go area. External financing is absent without the IMF. The reliance is (almost) solely on domestic banking sources. Banks have too much exposure in government papers. They are not comfortable. SBP is offering reverse Open market operations (OMOs) to provide liquidity and premium to banks. This sums to Rs4 trillion.

There are reasons for banks to ask for higher returns and to be edgy when the probability of government default is growing. Then there are opportunists in the market as well. In such times, the SBP policy rate becomes irrelevant. That has been the case for the past few months, if not quarters. The policy rate is 12.25 percent while the last T-Bill auctions cut-offs were 14.8 to 15 percent.

Then the rates in the secondary markets went further up and reached by 15.4 percent by Monday. Yesterday SBP called some banking treasures to make them bid for less. The secondary market yields came down a bit as a result. But banks have another worry. With sharply rising rates, the mark-to-mark losses for banks are increasing on existing bills. They want higher term OMOs from SBP. The central bank may do so to club with upcoming monetary policy where rate hike ranges from 100 bps to some insane number. However, this requires political decision on petroleum pricing and other decisions.

If tough decisions are being taken, expect a moderate increase (around 100 bps), and market rates to come down as well. Otherwise, a bigger jump is expected in the policy rate to converge with the market rates. Similar is the argument for currency, and higher currency depreciation would entice SBP to increase more rates to curb the enthusiasm.

However, the tough decisions (at the time of writing) are pending, and if they remain pending, banks will go for higher rates in the upcoming auction. SBP is trying to calm banks; but without correcting fundamentals, market’s voice will prevail.

The solutions for brining market rates down are by enhancing liquidity and opening alternative avenues of financing. The liquidity crunch has one other reason of extremely high currency in circulation (CIC). The CIC stocks are standing at staggering Rs7.3 trillion which is 40 percent of banking deposits and 29 percent of the money supply (M2). Read it again, it is 40 percent and 29 percent. This is probably one of the highest ratios in the world. This shows how big the informal economy is growing.

The CIC’s flow just in this fiscal year so far is almost a trillion rupees. The number is high due to Ramzan and wheat harvesting seasons. A bit of it can come back; but not much. And to bring liquidity in the market and to lower rates, SBP should think of luring cash holders to bring these back to banks deposits.