Banks slower in cutting lending rates; faster on deposits

• MSMEs insist cost of finance still remains high; CBSL’s next monetary policy review tomorrow
• Between October last year and March this year policy rates cut by 250 basis points
• Average Weighted Lending Rate declined by only 3.2% so far this year and Average Weighted New Lending Rate by 6.8%
• Several deposit interest rates have seen 30% drop
• First Capital Research opines 80% probability for CBSL to maintain rates at current levels; Charts.lk tips 50 basis point cut

Commercial banks have been slower in reducing lending rates as opposed to on deposits, latest data reveal whilst despite perceived softening of rates and a pick-up in economic activity, private sector credit hadn’t gathered pace.

Whilst latest monetary policy review scheduled for tomorrow, between last year October and March this year, policy rates have been reduced by 250 basis points. However, barring the Average Weighted Prime Lending Rate (AWPR) which has declined by 18.4% from 11.87 in January and to 9.68% last week benefitting the best clients, rest of the key lending rates haven’t dropped significantly. 

The Average Weighted Lending Rate (AWLR) has declined by only 3.2% so far this year and Average Weighted New Lending Rate (AWNLR) by 6.8%. On the other hand deposit rates have plunged with commercial banks being snappy. The Average Weighted Fixed Deposit Rate (AWFDR) has declined by 15% and the Average Weighted New Deposit Rate (AWNDR) and Average Weighted New Fixed Deposit Rate (AWNFDR) have plunged by 30%.

Following the March 2024 monetary policy review, the Monetary Policy Board underscored the need for a swift and full pass-through of monetary easing measures to market interest rates, particularly lending rates, by the financial institutions, thereby accelerating the normalisation of market interest rates in the period ahead.

It acknowledged that the overall market interest rate structure has adjusted downwards in response to the monetary policy easing measures implemented thus far and the reduction of risk premia attached to yields on Government securities following the implementation of the domestic debt optimisation (DDO) operation. 

“However, the pace of reduction of market interest rates, particularly lending rates, slowed in recent months, and yields on Government securities, which recorded a notable downward adjustment in the first two months of the year, have shown some reversal,” it said in March. 

Credit extended to the private sector by Licenced Commercial Banks (LCBs), which was in an expansionary phase since June 2023, witnessed a contraction of outstanding credit in January 2024, partly due to the valuation effects arising from the appreciation of the Sri Lanka rupee against the US dollar and possible post-festive season settlements.

“The prevailing accommodative monetary policy stance along with the reduction of policy interest rates affected are expected to induce a further reduction in market lending rates and encourage the expansion of credit to the private sector by LCBs in the period ahead,” the Monetary Policy Board said in late March.

Outstanding private sector credit peaked to Rs. 7.366 trillion in December last year from Rs. 7.263 trillion in November and Rs. 7.109 trillion in April last year. However it declined to Rs. 7.314 trillion in January this year and grew marginally to Rs. 7.321 trillion in February before increasing sharply by Rs. 72 billion to Rs. 7.393 trillion in March. The latter is likely to be seasonal ahead of the Sinhala-Hindu New Year in April. 

Most Micro, Small and Medium (MSM) enterprises and entrepreneurs view the cost of finance remains high as banks haven’t been proactive in reducing lending rates in tandem with CBSL moves. Lending data for April and May is not out yet and once made public it could reinforce March trend or otherwise. 

The next policy review is scheduled for tomorrow (28 May) and MSMEs are anticipating a further reduction in rates. 

Charts.lk predicts a 50 basis point cut in policy rates tomorrow.

First Capital Research’s forecast on tomorrow’s monetary policy review 

First Capital Research (FCR) said at the upcoming policy meeting, there is an 80% probability for CBSL to maintain rates at the current levels, allowing further strengthening of key economic indicators. However, there is a 20% probability for CBSL to relax the policy rates, with a probability of 15% for a rate cut of 50 bps and a lower level of 5% for 100 bps rate cut in order to further reduce rates and Government security yields to facilitate the strengthening of the economy. Further, there is 70% probability to keep SRR unchanged; while considering the improved liquidity levels in the system, we consider a 30% probability for a SRR hike of 100 bps.

In its pre-policy analysis, FCR said the uptick in private sector credit in March aligns with declining interest rates and the recovery of business activities. Moreover, the AWPLR experienced a robust continuous decline, reaching single digit in May-24 at 9.65%.

“With lending rates plummeting, further growth in private sector credit is anticipated. However, exercising caution is prudent to avoid potential implications of excessive borrowing and spending, which could lead to economic overheating. Therefore, refraining from policy relaxation is advised to maintain stability and balance in the economy,” FCR said in support of the view of policy rates being kept unchanged tomorrow. 

FCR said since the onset of 2024, the overall rupee liquidity in the domestic money market has shown consistent improvement, notably maintaining positivity since Mar-24. Followed by the relaxation of borrowing limits for Licensed Commercial Banks (LCBs) by the CBSL in Feb-24.

The decision, made after reviewing prevailing market conditions and enhanced liquidity, is expected to stimulate interbank lending and borrowing, thereby facilitating a decline in market interest rates in alignment with the CBSL’s monetary policy objectives. 

Consequently, this relaxation is anticipated to bolster banks’ borrowing capacity and enhance lending activities, potentially strengthening liquidity within the financial system in the forthcoming months. As a result, a gradual decline in interest rates is expected. Therefore, considering the current rate adjustments as sufficient to provide the necessary momentum to the economy in the short term, an immediate monetary easing is deemed unnecessary, FCR argued. 

It also said following the 50 bps rate cut in the latest monetary policy meeting held in Mar-24, lending rates, auction yields, and secondary bond market rates have notably decreased across the board, indicating a swift pass-through of the rate cut to market rates. Notably, the weighted average yields at the T-Bill auction hit a two-year low of below 10.00% in May-24, propelled by progress in the External Debt Restructuring (EDR) talks with the Steering Committee members of the Ad Hoc Group of Bondholders. Moreover, the GoSL is optimistic on achieving a resolution regarding debt restructuring by Jun-24. Upon agreement on EDR, Sri Lanka stands to potentially receive a rating upgrade, enhancing foreign activity in the market. This could further lower yields and bolster economic recovery. As a result, we advocate that further monetary easing measures are unwarranted at present.

GDP displayed a YoY growth of 1.6% in the 3Q2023, a notable reversal from the previous contraction experienced since the 1Q2022. This positive trajectory continued with a substantial growth rate of 4.5% in the 4Q2023, witnessing improvements across all sectors, including Agriculture, Industrial, and Services. FCR anticipates this favourable momentum to carry into 2024, projecting a GDP growth of 2.0%-3.0% for the year. Moreover, the Purchasing Managers’ Index (PMI) in Mar-24 indicated a sustained expansion in both the Manufacturing and Services sectors, signalling further signs of recovery. In Mar-24, the Services sector demonstrated improvement with an index value of 67.7, driven by increased new business activities particularly in financial services, wholesale, and retail trade segments.

Meanwhile, the Manufacturing segment recorded an index value of 62.5 in Mar-24 (compared to 51.4 in Mar-23), attributed to the uptick in new orders and production, notably in food and beverages, and textiles and apparel. Given these positive economic developments, it’s deemed inappropriate to adopt a dovish policy stance as it could lead to an overheating of the economy.

In the analysis of arguments for relaxation in monetary policy, First Capital said in the 2024 annual policy statement, the Governor of the CBSL unveiled a strategic change by moving towards a single policy interest rate mechanism, departing from the current dual policy rates. This shift is intended to bolster the effectiveness of monetary policy transmission and amplify the signalling impact of the overall monetary policy stance. The decision to pursue this modification arises from the constraints within the existing system, which encompasses both the SDFR and the SLFR. Therefore, we anticipate a potential reduction in the SLFR, which is currently standing at 9.50%.

Amidst significant improvements in economic indicators surpassing expectations, both reserves and inflation have outperformed targets set by FCR.

Inflation, in line with FCR projections, has shown a consistent deceleration since the start of 2024, and slightly picked up in Apr-24 amidst seasonality, reaching 1.5%, exceeding the FCR target.

Notably, YoY inflation in the Food group decreased to 2.9%, while the Non-food group increased to 0.9%, indicating that tight monetary conditions have effectively subdued demand pressures. Concurrently, the official reserves of the CBSL soared to a 3½ year high of $ 5.4 billion by the end of Apr-24, driven by increased earnings from tourism and worker remittances. This surge in reserve position along with the BOP expansion has led to a sharp appreciation of the rupee since the beginning of 2024. With these promising indicators, it is believed that the CBSL is well-positioned to consider another prudent rate cut, which would not only support the ongoing economic recovery but also foster an environment conducive to sustained growth and stability.

As per the GDP estimates published by the Department of Census and Statistics (DCS), the economy is estimated to have grown by 4.5%, year-on-year, in the fourth quarter of 2023, following the moderate expansion of 1.6% (year-on-year) recorded in the third quarter of 2023. Favourable growth outcomes recorded in the second half of the year helped limit the overall contraction of the economy to 2.3% in 2023, compared to the contraction of 7.3% (revised) recorded in 2022. 

The CBSL predicts a 3% economic growth this year.