First Capital forecasts substantial policy rate cut

• Sees 90% chance for policy rate cut with 40% probability for 100bps cut
• Says substantial rate cut may dissuade banks from keeping excess liquidity with CB
• CB has already reduced policy rates by 100bps in 3 occasions since March
• Next Monetary Policy Review scheduled for July 20

First Capital Research sees a higher probability for a substantial policy rate cut by the Central Bank at its upcoming Monetary Policy Review scheduled for July 20 to discourage banks’ utilisation of Standing Deposit Facility Rate (SDFR)‎ to park their excess liquidity in order to accelerate lending to COVID-19 hit businesses and individuals. 

“To dissuade banks from keeping excess money with the CB without lending, we believe that the CB has to reduce its policy rates substantially—both, SDFR, the rate at which commercial banks can keep overnight liquidity with the CB, and the SLFR, as a stimulus to boost credit growth,” First Capital Research stated in its pre-policy analysis report.

Accordingly, the Colombo-based research house predicts a 90 percent chance for a policy rate cut with 40 percent probability for a 100bps cut.

As a COVID-19 relief measure, the CB has already reduced policy rates by 100bps in 3 emergency instances since March, reducing the SDFR and SLFR rate to 5.50 percent and
6.50 percent.

Most recently, the CB also cut the SRR by two percent, which injected Rs. 115 billion of liquidity into the banking system.

In addition, the CB also launched Rs. 150 billion refinance scheme for the banking sector.

These measures are aimed at allowing banks to accelerate credit flows into the economy, while reducing cost of funds.

Despite these measures, First Capital noted that private credit remains muted while the excess liquidity is already at a 16 -year high at the current levels. 

Further, it also expects the CB to increase the refinance scheme by another Rs.100 billion which may increase additional liquidity in the domestic money market beyond Rs.250 billion. As a result, the printed money is expected to reach Rs.500 billion from the current Rs. 311 billion.

Indentifying the reluctance of most banks to lend due to credit risks, the CB announced a credit guarantee scheme on June 28. However, First Capital Research believes that CB would have to either implement a substantial policy rate cut or restrictions on CB’s liquidity window discouraging banks parking their excess funds at this liquidity window, in order to support rates to sustain for a longer period.

“We believe that there is a higher probability for a 100bps rate cut to ensure that SDFR rate is closer towards the 4 percent special working capital lending rate,” it stated. 

However, the research house noted that CB may consider options such as limiting the frequency of access to the SDFR liquidity window or limiting the amount that can be parked through the liquidity window to discourage banks parking their additional funds with this facility, instead of a rate cut. 

Further, First Capital pointed out that the credit guarantee scheme announced needs to be included in the budget (the current year or subsequent years) of the government, where the Treasury acts as the guarantor for the loans given by banks.  

However, this move is expected to further increase the budget deficit, which is predicted to move closer 10 percent of GDP this year.