Oct 2014 Financial News

Mop up excess liquidity first. Financial analysts on repo rate hike…

Oct 06, 2014

On Friday, September 26, the Central Bank announced an increase in the repo rate by 25 basis points, bringing it up to 3.0 per cent. In an interview with chief editor-business, Anthony Wilson, the day before, Governor Jwala Rambarran explained the reasoning behind the move, saying the bank was signalling to the market it wanted interest rates to rise.

But the move was also calculated to get out ahead of the US Federal Reserve, which is scaling back on its programme of quantitative easing. The Fed’s decision would make US bonds more attractive investment instruments, relative to local ones, causing a movement of funds from here to there. 

According to the Central Bank in its release, raising the repo rate, therefore, was a move to protect the value of the TT dollar, prevent capital flight to the US and to keep inflation at manageable levels by taking up excess liquidity in the system. Given that inflation affects the potential long-term value of items such as pension plans and insurance policies, the Sunday BG wanted to know what influence, if any, an increase in the repo rate would have on them.

Repo rate rise: Little impact on interest rates and inflation
The repo rate is the overnight rate at which commercial banks borrow from the Central Bank. Financial analyst, Kurt Valley, said the way the repo rate works in the US is different from the way it works here. “In the US for example, when the Fed raises their rate, banks that day, borrow at a higher price or a lower price. In Trinidad, nothing happens, no one is lending at the repo rate, no one is selling at the repo rate.” 

Ian Narine, head of Guardian Asset Management Ltd, and regular BG contributor said, “A 25 basis point rise in the repo rate would not in and of itself impact any aspect of the market at this stage.” 

“As the governor pointed out, the rate move serves to signal that the Central Bank is seeking to bring the cycle of declining interest rates to the current record lows to an end. The rationale is simple: the economy is now out of recession and there seems to be sufficient evidence that there is no need for such an ultra-accommodative policy.”

In understanding why changes in the repo rate do not have the immediate effect, but are more in the mode of signalling the CB’s intentions as has been explained above, one has to understand the rate’s role in something called the “transmission mechanism.” In the transmission mechanism the repo rate, interest rates for loans, as well as savings and investments, the price of treasury bills and other government bonds, the foreign exchange rate and inflation are all connected. 

According to the Riksbank of Sweden’s Web site: “the transmission mechanism is actually not one but several different mechanisms that interact. Some of these have a more or less direct impact on inflation while others take longer to have an effect.” In markets like the US, as Valley observed, adjustments to the repo rate, result in strong, measurable and more immediate effects elsewhere in the system.

However, in T&T, the repo rate is not operating this way and, in essence, an increase in repo rate does not automatically translate into a rise in interest rates—either for loans or for savings or a reduction in inflation or is an accurate reflector of the price of T-bills. The IMF commented on this disconnect in a 2011 country report, where it said, “the repo rate does not seem to be an effective monetary policy instrument.”

According to the report, the lending rate is only moderately affected by an increase in the repo rate and “the repo rate affects the lending rate more through signaling rather than through the market channel. The current high liquidity makes the repo rate non binding, as banks have not tapped the repo window since February 2009.”

Because of the excess of funds in the financial system, commercial banks have no need to borrow money from Central Bank, which means that the ability of the repo rate to influence rate changes is limited. Narine and Yogendranath Ramsingh, CEO of Global Finance Ltd, one of the pensions experts the Sunday BG spoke with, predicted that if there is a rise in interest rates, it will be more gradual or “progressive” as opposed to immediate, just as Governor Rambarran said. 

However, Valley said interest on savings and investments will not rise at all, contrary to the hopes of the Governor, when the repo rate was raised. 

“All that will really happen is that banks will raise their prime rates. People who have loans tied to the prime will see interest rates go up, the spread of the banks will increase, but the funding costs in savings accounts, the checking accounts, the prime deposits, those are not going to be linked, there will be nothing to drive them up, except the Central Bank wanting them to go up,” said Valley.

The repo rate rise, in his opinion, will do very little to curb inflation, because the excess liquidity in the system does not respond to the repo rate something that the IMF noted in the 2011 report. 

“If it is harder for banks to now get savings accounts or get checking accounts or have enough money to meet their reserves, then rates will rise. But if you have huge amounts of liquidity, most banks have over and above what they need to meet their reserve requirement. If that is so large, what is the repo rate going to do to change that?”

The expansionary nature of the 2015 budget, moreover, will put even more liquidity into a system that is not adequately structured to absorb it and Valley said this could have dire consequences 

“When the Fed is doing their quantitative easing and there is too much liquidity in the US market, they are at the same time, putting money into the market and selling bonds, long bonds, so they can soak up that money again. The Central Bank of T&T has never done that, the money just keeps piling up like a huge iceberg and at some point and at some point it is going to have to be cleaned up, otherwise it will generally lead to inflation.”

As several Sunday BG articles have explored in the past, inflation is deadly to the aspirations of those hoping to retire in relative comfort, reducing the future purchasing power of dollars saved and invested today. Valley’s proposed solution to this problem is for the Central Bank to increase the number of T-bills or Treasury Bills and other Central Bank notes, such as bonds, issued to affect monetary policy to contain inflation.

According to the IMF 2011 report, “excess reserves drove down the interest rate on 30-day T-bills from 6.9 percent at end-2008 to 0.3 percent in November 2010.” As of 2013, Finance Minister Larry Howai, put excess liquidity in the system at $6 billion. (source:news.gov.tt) Valley said that the Central Bank needs to have several bond issues, both where they and the market play a role in setting the price.

“I think they should, instead of having a single price option, let them have a multi-price option, so that people who want to buy the bond, and want to get rid of liquidity, can buy the bond at the price they want and the market really clears. And that is how people with excess liquidity will eliminate that excess liquidity and then, we will really know where the price of bonds are and we will have a really market determined yield curve, instead of a yield curve that is highly influenced by the Central Bank.”
 
The T-bill’s connection to savings and investments
Valley explained that because interest rates for T-bills and other government bonds are more reflective of how the market actually functions than the repo rate, increases in these interest rates have the ability to carry up the interest rates of savings and investments, particularly in the case of items like money market and mutual funds. “That is more indicative of rising rates, than the government changing the repo rate. That signals that rates are rising.”

Effect on pensions and insurance
On this issue, Narine said, “Over the longer term if we get interest rates on a steady upward glide path then new bonds issued will have a higher coupon rate thus leading to increased cash flows for fixed income investors. This is good for long-term investors like pension plans and insurance companies.” 

The problem lies with interest rates on current bonds products. Both Narine and Ramsingh said because the relationship between interest rates and bonds is inverse, a higher interest rate on these, will eventually reduce their value. “The fund manager’s ability to adjust the portfolio mix will be required, depending on the sensitivity of the assets or liabilities to changes in interest rates,” said Ramsingh.

Based on this, Ramsingh said defined benefit pensions will be hard hit as increasing interest rates will have the effect of reducing their benefit obligations based on present versus future value computation. Meanwhile, he said future retirees with defined contribution pensions and deferred annuity plans may benefit from an increase in interest rates.

However, working with the assumption that the repo rate will be effective in raising interest rates on its own, Lloyd Ince, managing director of The Consulting Interface, said the measure would “ultimately benefit pensioners and pension plans”, by preserving pensioners’ purchasing power and improving “the out-look for long-term yields from subsequent bonds and income securities held by pension funds.”

He saw the increase in the repo rate working to reduce the money supply and thereby decreasing aggregate demand, forcing prices downward. Meanwhile, rising interest rates fuelled by a reduction in the money supply, “the price of money, or interest rates, will push upwards.”

“It reduces a perplexing problem that currently faces such funds, as the 20-year nominal bond yield-curve in many cases falls below certain base-returns guaranteed by certain pension products. This fact has been even more troubling, when the said curve is adjusted for inflation.” Ince said that the adjustment of the repo rate gave a sense of promise that this longstanding threat to long-term savings and investments is finally being dealt with.

 

Source:
Natalie Briggs
Trinidad Guardian
Sunday October 5, 2014

http://www.guardian.co.tt/business/2014-10-05/mop-excess-liquidity-first