CB’s recent policy rate hike and its impact

By CT Smith Stockbrokers

CBSL tightens its monetary policy for the second time in 2012

In its Monetary Policy Review for April, the Central Bank of Sri Lanka (CBSL) increased its repurchase rate and reverse repurchase rate by 25bps and 75bps to 7.75% and 9.75% respectively (w.e.f. end 5th April 2012) in order to further decelerate credit growth and anchor inflation expectations. The CBSL had previously increased its policy rates in early February 2012 (for the first time in almost five years, having last tightened its policy rates on 23 February 2007), in order to reduce the external pressure on the LKR, and also to arrest the higher than expected credit growth and consequent future demand side pressures in the economy.

A point to note is that the CBSL has increased the width of its policy rate corridor through its recent policy revision by 50bps to 2.0% as at 5 April 2012. The CBSL maintains the Inter-Bank Call Money Rate (CMR) within the policy rate corridor. Increasing the width of the policy rate corridor means that CBSL can let the CMR to float freely with minimal interventions in the money market.

Near term interest rate expectations

With the three-month,  six-month and 12-month T-bill yields rising 57bps, 59bps and 37bps to 11.62%, 11.65% and 11.69% during the week ended 13 April 2012, the benchmark 12-month T-bill has risen 239bps in 2012YTD.

The Sri Lankan Rupee (LKR) exhibited increased volatility during February and March 2012 (refer annexure on the recent exchange rate policy revisions). However, consequent to recent Forex inflows and monetary tightening, the LKR also has shown signs of stability. We nonetheless expect the benchmark 12-month T-bill yield to rise a further 150bps and then stabilize by end 3Q2012.

While the recent policy measures (refer annexure) together with the policy rate revision done in April 2012 are expected to bring in stability to the economy, economic growth will however likely be sacrificed in the near term. Our sectoral economic impact analysis on the April policy revision is as follows:

Industry wise impact (of the policy move)

1. Impact on financial institutions

The finance sector companies are likely to go through a tighter economic period as the general consumer debt servicing capacity is expected to deteriorate in the short to medium term. As a result we expect a slight deterioration in the finance sector NPAs during FY2012E.

We however do not expect Licensed Commercial Bank (LCB) Net Interest Margins (NIMs) to come under severe pressure, as the Asset-Liability Mismatch (ALM) of LCBs is highly regulated compared to Registered Finance Companies (RFCs) and Specialised Leasing Companies (SLCs). However, we expect the LCB sector Current And Saving Account (CASA) ratio to slightly deteriorate during FY2012E due to the rising interest rate scenario.

On the other hand, we expect NIMs of RFCs and SLC to come under pressure during 2012E, as the general business practice is to borrow short term to fund their relatively fixed long term investments.

Nonetheless, we expect the recent policy measures to improve stability in the banking sector, though at the cost of growth (which we have already factored into our forecasts).

While the CBSL directed the LCBs to limit credit expansion to 18% in 2012E (as opposed to 34.5% in FY2011), this is consequently likely to limit financial sector fund growth resulting in a slowdown in sector core income growth. However, if LCBs manage to obtain foreign Tier II funding, the said growth in credit is allowed to reach a maximum of 23%, which is also expected to increase foreign fund flows to the economy. We maintain our top line growth forecasts for our banking sector stocks as we have already taken effected revisions to our LCB top line growth targets to factor the aforementioned criteria.

2. Impact on the non Financial Sector companies

While highly geared companies are likely to have a negative impact owing to increased finance costs, the following are also expected to be negatively impacted owing to CBSL’s policy move.

1. Businesses which depend on (low cost) debt capital to promote sales, i.e. land and property, motor vehicles and consumer durables

2. Companies engaged in (credit driven) import related businesses

3. Impact on the broader stock market

The increase in policy rates should meanwhile impact the stock market negatively owing to the following reasons:

1. Reduce interest in equities while encouraging a switch from equities to fixed income instruments

2. Reduce corporate profit expectations (especially for highly geared companies)

3. Relatively expensive stock valuations (owing to higher cost of capital) compared to regional stock markets

4. Higher costs on margin facilities