By Paneetha Ameresekere Courtesy Ceylon Today

Three reasons are causing foreign funds of significant value to exit from the Treasury (T) Bond and T-Bill market as was reflected in the movement of such outflows in the week ended 19 October 2016, a banker told this reporter. Those are the prevalence of a weak rupee, artificially shored up by the Central Bank of Sri Lanka (CBSL) and expectations that it will collapse at anytime once that prop is gone. Thereby foreigners being left with too fewer US dollars when they do exit.

Secondly, the possibility of the Federal Reserve System (Fed.) raising its benchmark Fed. Funds rate (FFR) at its December policy setting meeting becoming a possibility, where a Bloomberg survey had pointed out that there is a 68 per cent chance that the FFR will be increased, thereby making investments in the USA more attractive.

And thirdly, that CBSL will raise its policy rates either this month, when these flows will once more return, if such an outcome does take place, to take advantage of the higher interest rates prevailing in the local market then.

EPF

The banker who didn’t want to be named also said foreign funds seeking to exit from the market currently are however, finding it difficult to do so because there are ‘no’ local buyers! The only fund that could match those values is the EPF which is administered by CBSL. However, the authorities have suspended the EPF from trading in the T-Bond and T-Bill market these days due to an alleged scandal involving EPF monies, he said. The alleged scandal is currently being investigated by the authorities.

When there are ‘no’ buyers to accommodate foreign exits, the net effect is that foreigners will exit at any cost, driving up the yield curve, which graphically displays the movement of interest rates over time (tenures), vis-à-vis the T-Bill and T-Bond market.

When there is an inordinate spike on such a graph, the message translated to investors is that there is room for interest rates to go up. Currently CBSL’s lending rate, known as the standing lending facility rate, is 8.5 per cent, while its deposit rate, known as the standing deposit facility rate is 7 per cent.

Meanwhile, in the week ended 19 October 2016; the T-Bill and T-Bond market, suffered a net foreign outflow (NFO) of Rs 8,792.3 million, according to CBSL data. (Ceylon Today of 22 October 2016).
The T-Bond and T-Bill market last suffered a net outflow six weeks ago, when on 7 September 2016 it suffered a NFO of a nominal Rs 862.5 million. In the interim, it had been enjoying net foreign inflows (NFIs) totalling
Rs 9,915.46 million in the immediately following five weeks. CBSL gives such summaries weekly, in general, covering the week ending on a Wednesday.

Wiped out

Meanwhile, on an overall basis, in the calendar year to date, this market has enjoyed an NFI of Rs 11,520.2 million. Nonetheless, according to the growing trend, it may not be surprising if this net surplus, in the coming weeks is wiped out, turning the T-Bill and T-Bond market to a net deficit market.

The consequences of such a move are that such a situation will cause further depreciating pressure on the rupee.
Total foreign investments in T-Bill and T-Bond outstanding as at 19 October 2016 stood at Rs 307,930.59 million comprising a mere 6.6 per cent of total investments in that market, which was a figure of Rs 4,665,652.65 million as at that date. Foreigners are permitted to invest up to a maximum of 11.5 per cent in such outstanding, still leaving a deficit of 4.9 per cent or Rs 228,616.98 million open for foreign investments.

Prior to Budget 2016 presented in November 2015, foreigners were permitted to invest up to 12.5 per cent in such outstanding. But this was reduced to 11.5 per cent probably because there were no takers, especially after foreign outflows from this market began in earnest since September 2014, coinciding with advent of the announcement of a presidential election which was subsequently held on 8 January 2015, due to uncertainty created in the minds of such foreign investors in respect of Sri Lanka’s political stability in particular.

For instance, as at 27 August 2014; i.e. during the Mahinda Rajapaksa regime, foreign investments in T-Bonds and T-Bills comprised a massive 12.9 per cent of such outstanding, with the total outstanding amount comprising Rs 3,887,132.81 million and foreign investments in such securities at
Rs 501,418.74 million.

It was the Rajapaksa regime which allowed foreign investments in T-Bonds and T-Bills in the first place, to stave off a balance of payments crisis, at the beginning by allowing such investments up to 10 per cent of outstanding, in a genesis that started in 2008, which was gradually increased to 12.5 per cent, before the present government reined it to 11.5 per cent.

Meanwhile, when CBSL’s current policy lending rate is at 8.50 per cent and the one year T-Bill yield in the secondary market is 10½ per cent (at the primary auction of 19 October 2016, this tenure fetched a weighted average yield of 10.19 per cent), a registered bank or a primary dealer may borrow at 8.5 per cent from this window by giving risk free government securities (such as T-Bonds and T-Bills) as securities to CBSL and invest such low cost borrowed money from CBSL in treasuries (T-Bills and T-Bonds) at the prevailing high yields (the longer the tenure, the higher the yield), thereby being able to make good money from the interest rate differential, the banker said.

CBSL this year has raised its policy rates twice thus far, i.e. in February and July, on each occasion these rates were raised by 50 basis points (bps) each.

Stable

With a seemingly stable coalition government in power after its victory at the 17 August 2015 parliamentary polls, thereby apparently buttressing Maithripala Sirisena’s presidential election win of 8 January 2016; the movement of foreign investments in Sri Lanka’s T-Bond and T-Bill market since are mainly governed by economic interest and not necessarily political interest, which, however, may have had been the latter case in the 12 months from September 2014 to 17 August 2015.

Foreign investments in T-Bills and T-Bonds are important, due to their direct correlation with the rupee and interest rates. The importance of the movement of the rupee is twofold. First, the island is an import dependent economy. Therefore, a weak rupee will make prices to go sky high, hitting the poor and the fixed wage earner the hardest. Such a scenario may lead to social unrest, thereby threatening the political stability in the country.

Secondly, because the Treasury is bereft of dollars, which is the case, more often than not in general, to service Sri Lanka’s huge foreign debt, the required dollars are purchased from CBSL’s foreign reserves and not from the foreign exchange market, in order to prevent further depreciating pressure on the rupee. However, if the rupee is weak, more rupees will be needed to buy the required dollars, thereby increasing the government’s rupee debt, while at the same time causing upward pressure on local interest rates due to demand.

Therefore, in Sri Lanka’s case in particular, due to the paucity of exports and foreign direct investments, the movement of foreign investments in the T-Bill and T-Bond market, plays a key role in determining the fate of the rupee.
For instance, in May 2013, when the then Federal Reserve System ((Fed.) US Central Bank Chairman Ben Bernanke announced the possibility of the Fed. Stopping its bond buying programme amounting to some $ 85 billion (more than the size of Sri Lanka’s $ 82.3 billion economy) monthly, in stages, by September 2013, the rupee took a massive hit due to the withdrawal of foreign funds from the T-Bill and T-Bond market, to US. markets on the impression that that would cause a hike in US interest rates.

This may have been a contributory factor leading to Rajapaksa’s polls defeat a few months later, on 8 January 2015. Similarly, when around September 2014 it was made known that Rajapaksa was going for a snap presidential election, such foreign exits from the T-Bond and T-Bill market once more took place.

Another recourse which governments adopt to prevent depreciation of the rupee in such instances is to drawdown from its foreign reserves by selling dollars at discounted prices to buying banks. But such an action is unsustainable.
Therefore, in order to once more attract foreign investments to the T-Bill and T-Bond market, in order to prevent such a calamity, CBSL may be compelled to raise its policy rates steeply in the near future.