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HARMONIZING EFFECTIVE POLICY
RATE MANAGEMENT FOR ECONOMIC
PROSPERITY
AN EMPIRICAL ANALYSIS ON SRI LANKA
Niroshana Seneviratne
Deputy General Manager/Chief Internal Auditor Hatton National Bank PLC
Abstract
The Central Bank of Sri Lanka (CBSL) is responsible for the management of the monetary policy of the country so as to achieve its basic economic objectives. In general, interest rate is a key channel of the monetary policy transmission mechanism. During the past two decades, interest rate has become the most important policy instrument used by the CBSL. Since 2003, through managing the policy rates (SDFR) and (SLFR), CBSL attempts to influence Interbank Call Money Market Interest Rate (CALLWA) and through this means expects the interest rate adjustments to be reflected in commercial bank retail (lending and deposit) interest rates. Undoubtedly, the efficient transfer of the monetary policy impulses to the retail deposit and lending rates is important to achieve the ultimate goal of the monetary policy. The first stage of the process of interest rate transmission is related to the pass-through from Central Bank policy rates to CALLWA. The second stage is the pass-through from CALLWA to commercial bank retail lending and deposit interest rates. The aim of this paper is to assess through an empirical estimation and use of statistical tools, the effectiveness of managing the policy rates in influencing the commercial bank lending and deposit interest rates. Interestingly Granger Causality test illustrates that SLFR has followed the behaviour of Money Market Interest Rates when the reverse was expected. This result suggests that it was the Money Market Interest Rates that has influenced CBSL policy rates and not the policy rate that has influenced Money Market Interest Rates as expected. It could also be interpreted that the policy maker may not have been prompt in adjusting policy rates in effective discharge of its responsibility in Monetary Policy Management. Accordingly, the study concludes that the interest rate pass-through process in Sri Lanka is considered to be incomplete as supported by the empirical results of the current study since the proxy rate which is the Money Market Interest Rates is not totally dependent on the policy rates imposed by the Central bank.
Interest Rate Management – Theoretical Background
The interest rate management in the economy was intensively studied by many economists. Two of the most influential theories are Irving Fisher’s classical approach, extended to loanable funds theory, and liquidity preference theory, developed by John M. Keynes. Both economists advocated against the direct management of the interest rates and favoured it to be managed through the market forces. However McKinnon and Shaw (1973) presented a strong case for deliberately set high interest rates and Market failure school of economists strongly advocated direct involvement of the government or the policy makers in active management of the interest rates. In classical theories of economics, interest rate is one of the major economic policy tools. According to classical thinking, domestic savings and investments are interest rate sensitive. In essence, as per the classical theories, savings are positively related to interest rates and investments are negatively related. According to Keynesian theories, low interest rate regimes are encouraged for higher income and economic growth. Most of the developing economies prefer to adopt Keynesian theories for economic grown, including Sri Lanka. However, McKinnon and Shaw (1973) presented a strong case against the low interest rate policy which was advocated by Keynesian policies. The central argument of the McKinnon- Shaw (1973) hypothesis was that, an increase in the real interest rate may induce the savers to save more, which enable more investment. As advocated by McKinnon and Shaw, savings are encouraged by high interest rates thereby the lending banker may get more lendable funds so that the investments are encouraged. Therefore they proposed removing interest rate ceilings and deliberately setting the interest rates high. Market failure school of economists strongly argued that market malpractices should be corrected through government interventions. Therefore, market failure school of economists suggests having a government intervention in determining interest rates and efficient allocation of resources.
Interest Rate Management - Context of Sri Lanka
That said, prior to 2003, the main policy instruments of the Central Bank of Sri Lanka were the Bank Rate (at which rate the Central Bank would lend to Banks if they need to borrow), Statutory Reserve Requirement (SRR) (portion of the deposits that the banks should maintain with Central Bank as a security), and moral suasion (indirect communication by Central Bank). None of these instruments had direct intervention with the interest rates quoted by the commercial banks for their deposits and lending (retail interest rates). During the past few decades, interest rate has become the most important policy instrument used by the CBSL in its monetary operations. Adopting this policy instrument, by influencing Interbank Call Money Market Interest Rate (CALLWA) at the short end of the market, the CBSL expects the interest rate adjustments to be reflected in the commercial bank retail interest rates (lending and deposit
short term interest rates, particularly the Interbank Call Money Market Rate or average weighted call money rate (CALLWA) as the operating target (CBSL Annual Report 2017). Accordingly, instead of reserve money, Central Bank currently uses CALLWA as its operating target under its enhanced monetary policy framework. The Central Bank of Sri Lanka being the regulator of the commercial banks, does not directly set the deposit and lending rates of the commercial banks, but expects the commercial banks to get guided by the money market interest rates. On the other hand, commercial bank interest rate is the premium paid by commercial banks to attract deposits and the price set by them for the borrowing customers. As with any other company, one of the primary objectives of a commercial bank also could be to maximize profits, irrespective of whether it helps to achieve economic targets of the country or not. In this context, would it be reasonable to expect the commercial banks to get guided by the CALLWA fully. If so, would the expectation of the Central Bank in impacting domestic savings, domestic borrowings, inflation and level of unemployment through influencing the commercial bank lending and deposit rate be met? This paper is an attempt to study the effectiveness of the policy rate management adopted by the CBSL, in influencing the commercial bank lending and deposit interest rates in Sri Lanka.
Recent Monetary Policy Measures
As stated in highlights of 2017 and prospects for 2018, a CBSL publication in 2017, “the Central Bank continued to maintain a tight monetary policy stance in the first nine months of 2017 in view of the developments in inflation as well as monetary and credit aggregates. With a view to containing the build-up of adverse inflation expectations and in the excessive expansion of money supply, the Central Bank further tightened its monetary policy by raising policy interest rates by 25 basis points in March 2017. The Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank stood at 7.25 per cent and 8.75 per cent, respectively, since then.” In response to the monetary policy stance maintained by the Central Bank and the high financing requirement of the government budget, most market interest rates moved upwards during the first nine months of 2017, although short term rates adjusted downwards with liquidity improvements in the domestic money market since July 2017. The Average Weighted Call Money Rate (CALLWA) moved around the upper bound of the policy rate corridor during the first seven months of 2017, reflecting tight monetary conditions. However, with improved liquidity conditions since July 2017, the CALLWA adjusted downwards towards the middle of the policy rate corridor by end September 2017. Meanwhile, Sri Lanka Inter Bank Offered Rates (SLIBOR) adjusted in line with movements in the CALLWA. The deposit interest rates of commercial banks increased particularly during the first seven months of 2017, reflecting the increased funding costs of commercial banks. Lending rates of commercial banks also increased further and stabilized at high levels by end September 2017. (Central Bank Annual Report 2017)
Table 01: Recent Monetary Policy Measures Date Measure 10-May-2013 Repurchase rate and Reverse Repurchase rate reduced by 50 basis points to 7.00% and 9.00%, respectively. 26-Jun-2013 Statutory Reserve Requirement (SRR) reduced by 2 percentage points to 6% with effect from 1-Jul-2013. 15-Oct-2013 Repurchase rate and Reverse Repurchase rate reduced by 50 basis points to 6.50% and 8.50%, respectively 2-Jan-2014 The Policy Rate Corridor was renamed as the Standing Rate Corridor (SRC), and the Repurchase rate and the Reverse Repurchase rate of the Central Bank were renamed as the Standing Deposit Facility Rate (SDFR) and Standing Lending Facility Rate (SLFR), respectively. SLFR reduced by 50 basis points to 8.00%. The Standing Deposit Facility (SDF) uncollateralized with effect from 1-Feb-2014. 23-Sep-2014 Access to the SDF of the Central Bank by OMO participants at 6.50% was rationalized to a maximum of three times per calendar month. Any deposits at the SDF window exceeding three times by an OMO participant was accepted at a special interest rate of 5.00%. 2-Mar-2015 The 5.00% special SDF rate was withdrawn 15-Apr-2015 The SDFR and SLFR reduced by 50 basis points to 6.00% and 7.50%, respectively. 3-Sep-2015 The exchange rate was allowed to be determined based on demand and supply conditions in the foreign exchange market. 30-Dec-2015 SRR was increased by 1.50 percentage points to 7.50% to be effective from the reserve period commencing 16-Jan-2016. 19-Feb-2016 The SDFR and SLFR increased by 50 basis points to 6.50% and 8.00%, respectively. 28-Jul-2016 The SDFR and SLFR increased by 50 basis points to 7.00% and 8.50%, respectively. 24-Mar-2017 The SDFR and SLFR increased by 25 basis points to 7.25% and 8.75%, respectively. Source: Central Bank of Sri Lanka As per a recent article that appeared in Daily Mirror, 2nd August 2018, under the caption ‘Central Bank seen holding rates to spur growth’, “Sri Lanka’s Central Bank is expected to keep key interest rates steady at its policy review as it looks to spur faltering economic growth amid heavy downward pressure on the nation’s currency. The Central Bank unexpectedly cut
they concluded that the direct interest rate channel is often weak in developing countries. The strength of the channel depends on both the degree of pass-through from monetary policy actions to lending, deposit, and securities rates, and the interest rate sensitivity of investment and consumer spending decisions.
Previous Studies on Policy Rate Management in Sri Lanka
The results are somewhat mixed for studies done in countries such as China, Africa, Argentina, Euro market, Namibia, Austria and Central African countries. Some countries, the interest rate pass-through had been effective whereas most of the countries the second lag of the transmission had not been that effective. There were few previous studies focusing on Sri Lanka that mostly suggested policy rate management as a policy instrument in influencing commercial bank interest rates is not so effective. Amerasekera C. (2005), in his study on interest rate pass-through in Sri Lanka, attempted to assess whether there is one to one pass-through in policy instruments to call money market interest rate or at what rate a unit change in policy rate affect the call money market rate. Further his study attempted to measure the correlation between the call money market rate and the commercial bank deposit and lending rates. Having analyzed data from 1995 to 2004, his study revealed that although there is a rapid and almost complete pass-through from the Central Bank policy interest rates to call money market rates, the pass-through from call money market rates to commercial bank retail interest rates is sluggish and incomplete. With this conclusion he explained that the sluggish and incomplete pass-through poses a challenge to the Central Bank as it hinders the achievement of its monetary policy objectives as desired. His study suggested several possible reasons for sluggish adjustments in commercial bank retail interest rates. However, the writer feels that the assumptions used in the above study, especially the causality test conducted, need further justification to prove the effectiveness of the policy rates on the interbank call money rate. This is briefly discussed in this paper and the writer feels that this area should be further considered in future researches for effective discharge of Central Bank responsibilities. Abeygunawardana K and Thilakaratne C (2013), using a Vector Auto Regression (VAR) method, examined the impact of monetary policy instruments on output, prices, and interest rates in Sri Lanka during the period from 2003 to 2012. Their study indicated a strong transmission of policy rate onto the money market rates and the government securities market yields. However, they argued that banking sector interest rates exhibited a smaller and slower impact compared to money and government securities market rates. They concluded that the existence of a large informal economy, volatile excess market liquidity, shallowness of financial markets, relatively less flexible interest rates on deposit and loan products are identified as reasons for weak transmission. However, analysing the direction of the change, whether policy rate influence the call money rate or otherwise, was not within the scope of this study. Perera, A., (2016) in his study on monetary transmission mechanism in Sri Lanka provides
a comprehensive assessment of the transmission of monetary policy in Sri Lanka starting from changes to Central Bank policy to the response of final target variables-output and prices. His study provides estimates for interest rate pass-through and suggests that pass-through is yet to achieve the completeness except for prime lending rates. Based on the empirical estimates obtained employing both unrestricted and structural vector auto regressions, this study observed that monetary policy in Sri Lanka is quite ineffective to influence the target variables of the Central Bank. It also suggests that monetary policy changes affect target variables through different intermediate transmission channels such as bank credit, exchange rates as well as asset prices. Perera, A., (2016), in his conclusion argued that according to his findings, the interest rate pass-through in Sri Lanka is not complete. Despite the fact that short term lending rates, particularly prime lending rates show some speedy and complete adjustment, a majority of interest rates report sluggish and incomplete adjustments. This calls for the need for implementing policies to further develop the financial and banking sector in Sri Lanka while promoting competition among financial intermediaries. He further points out that prime lending rates and 3-months fixed deposit rate of commercial banks have a strong association with money market interest rates. It may therefore be argued that using short-term rates would be much appropriate when assessing the effectiveness of monetary policy. Pathberiya T., (2016), examined the transmission of monetary policy impulses to bank retail interest rates in Sri Lanka. Among other econometric techniques, the Error Correction Mechanism has been used in this study as a main technique to analyse the interest rate pass through mechanism empirically. The data used were for the 10-year period from 2003 to 2013. The key conclusion was, that there is no one for one interest rate pass-through to the long-run commercial bank rates from money market rate. Nevertheless, there is a sizable and satisfactory pass-through in the long-run in fixed deposit rates. In contrast, the long-run pass-through was not satisfactory with regard to retail loan interest rates. In the short-run, bank retail rates deviated from the equilibrium due to monetary policy shocks, but were adjusted to their equilibrium levels in the long-run. Also it was found that, on average, short-run adjustment speed of deposit rates is less compared with the lending rates. Further, the short-run adjustment speed is higher for shorter maturities. In general, there is no asymmetry in interest rate pass-through in Sri Lanka. In summary, the limited previous studies on the effectiveness of the interest rate pass- through in Sri Lanka referred to above collectively conclude that the process adopted by the Central Bank is quite ineffective to influence the target variables of the Central Bank. Abeygunawardana K and Thilakaratne C (2013) indicated a strong transmission of policy rate onto the money market rates but ineffective transmission from money market rates to commercial bank retail interest rates. Similar observations were made by Amerasekera C. (2005). That said, analyzing the direction of the change, whether policy rate influence the call money rate or otherwise, was not within the scope of these studies, which the writer believes to be a vital assessment to assess the effectiveness of the policy implementation. Hence this short paper in addition to assessing the effectiveness of the policy rate management is an attempt to study the direction of the influence, whether policy rates influence the money market rates or vise versa.
within the scope of this study. Similar view was expressed by Hemachandra W M (2010), where he argued that total investment has not been influenced by the changes in lending interest rates, yet the interest rates should not be ignored in assessing the financial deepening in Sri Lanka. Figure 03: Average Weighted Prime Lending Rate and Domestic Investment
Interest Rate Corridor and Call Money Rate Movement
As per the pure theoretical explanation, the call money rates should move within the interest rate corridor. Figure 4 below indicate how it has moved during January 2008 to December
- Contrary to what is expected, a closer look suggest that the call money market rate has been moving outside the range specified, during 2008,early 2009, 2012, 2014 and 2017. This challenges the argument whether the CBSL policy rates were effective in influencing the call money rates. Figure 04 CBSL Policy Rates and CALLWA – Monthly
Statistical Results
With an object to assess the effectiveness of the pass-through process of the policy rates to retail interest rates, the writer analysed the data gathered using SPSS statistical software version 20 and EViews. Monthly data were used covering the period from January 2008 to December
- All the data used in this paper have been extracted from the publications of Central Bank of Sri Lanka. Descriptive Statistics, Correlation, Regression analysis and Granger Causality test have been deployed as major techniques for data analysis. The analysis has been conducted under two sections. First section consists of the pass-through from the CBSL policy interest rates to the call money market interest rates and the second section deals with the pass-through from call money market interest rates to the commercial bank retail lending rates and deposit rates.
First Leg - Pass Through from Policy Interest Rates to Money Market
Rate
Descriptive statistics mean values indicate that the call money market rate (CALLWA) on average remained between standing deposit facility rate (SDFR) and standing lending facility rate (SLFR). Standard deviation indicates the volatility of the interest rates. Based on the above results it can be observed that there is a high volatility in call money rates since the standard deviation was nearly 2.62. When considering the minimum and maximum values of the call money rates, it can be recognized that the maximum value has exceeded the upper ceiling rate of the interest rate corridor which is SLFR and on the other hand minimum value of the call money rate has fallen below the lower limit of the corridor which is SDFR. Consequently, based on the correlation results of annual interest and monthly interest rates, it can be concluded that the policy interest rates and call money market rates are relatively highly correlated in the short run when comparing with the correlation in the long run. Coefficients of each independent variables indicate the number of units change in the dependent variable when the independent variable changes by one unit. Accordingly, when SDFR increases by one unit CALLWA increases nearly by 2.36 and vise versa. Considering the impact of SLFR to the CALLWA, it shows a negative impact with a unit change of 0.425. When applied regression analysis, T- statistics and probability levels show to which extent the independent variables can influence the dependent variable individually. Since t-statistics of SDFR was greater than 2 and probability level was less than 0.05, it can be concluded that Standing Deposit Facility Rate significantly and individually has impacted on the CALLWA. However, based on the above results, it can be seen that the Standing Lending Facility Rate is insignificant in influencing the CALLWA since the value of t-statistics is less than 2 and probability level is greater than 0.05.
average weighted lending rates and average weighted deposit rate are correlated with the call money rate. However, the AWPLR is highly correlated to CALLWA than the AWDR.
Conclusion
The Central Bank of Sri Lanka (CBSL) is responsible for the management of the monetary policy of the country so as to achieve its basic economic objectives. In general, interest rate is a key channel of the monetary policy transmission mechanism. During the past few decades, interest rate has become the most important policy instrument used by the CBSL. As with its regional counterparts, Central Bank of Sri Lanka has not been directly managing the commercial bank lending and deposit interest rates. Through managing the Policy rates (SDFR) and (SLFR), CBSL expect to influence money market interest rate in the short run and through this means expects the interest rate adjustments to be reflected in commercial bank retail (lending and deposit) interest rates. The efficient transfer of the monetary policy impulses to the retail deposit and lending rates is important to achieve the ultimate goal of the monetary policy. The aim of the study was to assess how effective this approach had been in managing the commercial bank lending and deposit interest rates through the policy rates. Through an empirical estimation, this study attempted to ascertain the effectiveness of policy rates in influencing Money Market Rates and in turn, the Money Market Rates on commercial bank lending and deposit interest rates. The first stage of the process of interest rate transmission is related to the pass-through from Central Bank policy rates to money market interest rates. The second stage is the pass- through from call money market interest rates to commercial bank retail lending rates and deposit rates. As followed by few previous studies referred to in this report, the writer too deployed various statistical tools to understand the relationships. As an additional step, having closely studied the behaviour of the interest rate movement, the writer felt it was important to analyse whether the CBSL has in fact set the direction for the behaviour of call money market rates or whether call money market rates have been behaving independently. The writer deployed Granger Causality test to analyse the relationship. Granger Causality test illustrates that SLFR has followed the behaviour of CALLWA when the reverse was expected. This result suggests that it was the call money rate that has influenced CBSL policy rates and not the policy rate that has influenced call money rates as expected. It could also be interpreted that the policy maker has not been prompt in adjusting policy rates in effective discharge of its responsibility in Monetary Policy Management. We have tested Granger Causality for different lags and the results of the tests irrespective of the number of lags were the same. To major extent the writer believes that this explains the reason for the fluctuations noted in Figure 4, wherein the call money market rate has been moving beyond the upper limit of the policy range specified, during 2008,early 2009, 2012, 2014 and 2017. Accordingly, the interest rate pass-through process in Sri Lanka is considered to be incomplete as supported by the empirical results of the current study since the proxy rate which is the call money market rate does not totally depend on the policy rates imposed by
the Central Bank and the same is insignificant in determining all the commercial bank retail deposit and lending rates.
Policy Recommendation
As part of this short study, the writer attempted to identify previous studies conducted in recognizing the sensitivity of the economic indicators to the commercial bank interest rates. However studies that concentrated on Sri Lanka were limited and also the availability of the historical data was limited. However, considering the regional studies, it was clear that economic indicators such as domestic savings, investment, informal markets, unemployment and inflation are highly sensitive to the movements in commercial bank interest rates across many countries and the visible active management of interest rates in some of the countries. Hence the writer believes that the policy makers shall encourage more studies on such areas and publish available statistics so that the data could be easily accessible to potential researchers. Policy makers for a long period have been using interest rate as a policy instrument to exercise open market operations. Writer feels that it is now opportune for the policy makers to analyse the effectiveness of the interest rate as a policy instrument in the above context.
References
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