A dovish twist from the CBSL

Wednesday, 21 May 2014 01:26 - - {{hitsCtrl.values.hits}}

Policy rates remain unchanged in May; the CBSL is a tad more dovish than usual
The inflation trajectory is not yet a threat
CBSL wants to enable better transmission of monetary easing; will launch a credit-guarantee scheme
We expect CBSL to keep rates on hold; Q4 will likely be the earliest it will consider a policy rate change
We maintain a Neutral outlook on T-bonds and revise lower our H2-2014 yield forecasts

Economic Alert by Standard Chartered Bank Global Research The Central Bank of Sri Lanka (CBSL) kept policy rates unchanged – the Standing Deposit Facility Rate (SDFR) at 6.5% and the Standing Lending Facility Rate (SLFR) at 8.0% on 20 May, as we had expected. We believe the tone of its statement was a tad more dovish than usual, with the CBSL looking through any weather-related potential food price inflation, while introducing a credit-guarantee scheme to boost private credit.

The CBSL cited a favourable inflation outlook as a key reason for maintaining its status quo. Favourable base effects on non-food inflation should keep the headline inflation rate below 5.0% at least until September, as we had highlighted in Economic Alert, 21 April 2014, ‘Sri Lanka – weather woes’, despite our expectation of a weather-induced increase in food inflation over the summer months of May and June. The CBSL is focused on reducing lending rates further. Following a 125bps and 175bps reduction in the SDFR and the SLFR, respectively, since end-2012, the prime lending rate has come down 570bps from its peak. Credit-guarantee scheme To reduce lending rates further, i.e., to enable better transmission of monetary easing to bank lending rates, the CBSL intends to implement a credit-guarantee scheme on pawning advances on behalf of the Government. We do not have the details on this scheme as yet, but in the past, Sri Lanka has introduced various partial credit-guarantee schemes focused on the small and medium-sized enterprise (SME) sector. In past schemes, the extent of government liability has ranged from 50-90% of the loan loss, and against a premium charge of 0.0-1.5%.

This sort of scheme is presumably being introduced to prevent any further spill-over effect of a contraction in pawning advances (c.14% of total bank loans) on both the quantity and price of loans directed to the corporate sector. Contraction in pawning loans A sharp contraction in pawning loans (14% y/y as of end-2013) has been a major reason for the fall in private credit growth – of the 28 percentage point fall in private credit growth since early 2012, 40% is attributable to a contraction in consumer loan growth. The c.30% fall in gold prices (on which most pawning loans are based) since end-2012 has led to a higher gross NPA ratio within the banking system (6.0% at end-2013, the highest since 2009), and is likely having a negative impact on loan growth to other sectors.We expect the CBSL to keep rates on hold for now, as it will likely want to assess the impact of its credit-guarantee scheme on lending for at least a few months. We now think Q4 will be the earliest that it will consider a policy rate change – a policy rate cut may be on the cards if private credit growth fails to pick up by end-Q3 and inflation remains low. However, the Central Bank may keep rates on hold even if these two conditions are met, if GDP growth remains strong, as in Q4-2013. Dovish policy tone to support T-bonds The Central Bank’s decision to maintain its status quo on policy rates is in line with market expectations. However, the implementation of a credit-guarantee scheme and the CBSL’s emphasis on lower lending rates for private-sector borrowers suggests its dovish bias towards promoting growth. We expect T-bond yields to remain range-bound and maintain a neutral outlook on T-bonds. We revise lower our yield forecasts for H2-2014. We now expect the 5Y T-bond yield at 9.00% (versus 9.50%) by Q3-2014 and 9.50% (versus 10.00%) by Q4-2014. Our previous forecasts for H2-2014 were premised on a pick-up in private-sector credit growth, expectations of monetary policy tightening, and deterioration in global risk sentiment towards emerging markets. However, the pick-up in private-sector credit growth has been below the Central Bank’s expectations. Today’s policy announcements to further promote credit growth imply that the Central Bank is unlikely to reverse its monetary policy stance soon. We think the markets will also build expectations of a policy rate cut during late Q3-2014 or in Q4-2014. This should be supportive of the T-bill and T-bond markets. Global risk sentiment towards emerging markets has been supportive, and the rise in US Treasury (UST) yields has been limited. On the back of our below-consensus US growth forecasts for 2014-15 and an ongoing lack of upside inflation pressure in the US, we have lowered our UST yield forecast by 50bps. We now expect the 10Y UST yield at 3.00% (versus 3.50% earlier) by end-2014. The recent pick-up in foreign inflows to T-bills and T-bonds may be attributed to supportive global risk sentiment. Foreign holdings of T-bills and T-bonds have increased by $ 46mn ($ 177mn YTD in 2014) during the past month.