First Capital Research believes that the Central Bank of Sri Lanka is yet again in a vulnerable position and the possibility of a policy rate cut is on the cards in order to push banks to consider the lending opportunities.

The research firm allocates a policy rate cut expectation of 100bps bringing the SDFR and SLFR to 4.50% and 5.50%, respectively.

“Despite prevailing the low interest rate environment it will have a ripple effect on the overall economy,” the research firm said in its latest report.

According to First Capital Research, the Central Bank presumes the excess liquidity may factor in as a stimulus for LCB’s to lend to businesses in support of the government’s efforts to revive the economy.

“On the contrary, LCB’s may expedite this as an opportunity to position in either short term treasury instruments or under SDF facility interest rate deriving a substantial interest on the deposit.”

“Thereby, the possibility exists that bulk of the money may not move into the revival of businesses via credit schemes, therefore, the intention of CBSL may not materialize,” the research firm said.

On 16th Jun 2020 CBSL has reduced SSR by 200bps from 4% to 2%. The reduction is expected to release over LKR 115Bn of liquidity into the banking system, allowing banks to accelerate credit flows into the economy, while reducing cost of funds.

“We expect LKR 100Bn top-up, in the existing refinance scheme which may enhance additional liquidity to the domestic money market above LKR 250Bn,” First Capital Research said.

At the current level of LKR 221Bn (17th Jun) excess liquidity is already at a 16-year high. Further top-up in existing refinance scheme may push CBSL Holding (printed money) closer to LKR 500Bn from current LKR 317Bn.

Moreover, the research arm stated that with the liquidity position surging over LKR 200Bn and bulk of the excess liquidity likely to be parked in short term Government Securities, they expect a significant downward pressure on the Yield curve Considering the possibility of a major rate cut to discourage using of the SDFR facility, we expect an accelerated downward pressure on the yield curve.

Further, the Government has decided to expand its quasi-fiscal re-financing facility from LKR 50Bn to LKR 150Bn requiring additional LKR 100Bn funding for planned disbursement.

“The remedial action to revive the economy may further boost liquidity in the system which as mentioned prior may push CBSL Holdings closer to LKR 500Bn,” it said.

In their previous recommendation First Capital Research expected a further surge in liquidity in 2Q3Q which may bring yields by 25-50bps.

“However, the current SRR cut, possible policy rate cut, and additional LKR 100Bn funding may bring the yields further down, thereby we bring down their bond yield bands by 125-150 bps,” the research firm said.

Further, the First Capital Research believes that Lacklustre 2Q & 3Q & CBSL intentions may push short term rates down for a limited period

With the Government’s intention to open up the economy and CBSL’s push to lower interest rates, there are caps being imposed on the recent Bill & Bond auctions which illustrates the intention of the CBSL to maintain lower rates in order boost economic activity and growth.

Considering the risks in the system and the worsening macro indicators First Capital Research prefers to maintain our bond yield bands at the mentioned levels in the previous slide

“However, with the lacklustre 2Q & 3Q, possible further increase in CBSL Holdings while also considering the intentions and the new rules of the CBSL to push rates lower, we would like to highlight that short-mid term yields may decline by 25-50bps for a very limited period,” the research firm said.