Tuesday, December 16, 2008

Interest rate and risk

Kalpanakaranna! Why is it so obvious to me and so oblivious to the Central Bank, that there is something extremely serious going on. There is month on month deflation in Sri Lanka today that is if one takes, October vs November and November vs December. The current interest rate on 5 year T Bill rates is 20%, which is an effective real interest rate of 20%. Is it no wonder that there is a huge credit squeeze on the lines of the international crisis and no one seems to be doing anything about it?

What is so obvious is that when the risk free rate one can earn is 20% on one’s cash, why would one want to lend at anything less than 35% in an environment where there is such a huge degree of uncertainty. For a business to borrow at that rate and make a profit is almost impossible. So we are about to see companies crash. It is so simple to understand but why is it that no one seems to do anything about it?

Added to this dynamic, there are many wealthy people, including the pettah traders who hold cumulatively, more US$ both in cash and in accounts overseas, than the Sri Lanka Central Bank. I am sure the Central Bank does not realize that. I can transfer US$100M tomorrow to any account overseas I specify, if I have the SL currency to give today at the black market wire transfer rate of Rs118=US$1. This is one reason that the SL rupee has to tanked nor has the pressure on the rupee yet been high to devalue. That does not mean the pressure will not come shortly if other circumstances like a banking crisis suddenly takes hold when all hell will brake loose.

In previous blog articles I have proposed urgent solutions, none of which have yet been implemented and therefore the impending gloom will be more severe when it actually transpires. I do not think it is too late but time is running out and the signs of a disaster are now obvious. Firstly the fall in commodity prices, has not been fully reflected in local prices, as importers are over invoicing and stashing their cash in US$ overseas. We have screwed up in oil hedging not passing the full benefit to the country, and if the deals are nullified by the Supreme Court will never be able to hedge or borrow from overseas banks again. With the collapse of Tea, Rubber and Coconut, there are many people out of work or are earning much less than a few months previously, which directly affects their pocket books which then directly affect consumption, and therefore impact on local industry. I see this first hand as I have a village shop in my farm and have noticed this.
When there is less money in the consumer pockets, in a simplistic form these are the ramifications. People who have leased vehicles or white goods cannot make payments. They are then reposed by the lessor. Just look at the lease returns available for sale with no takers as there appears to be no one with money to buy these cheap. Then with less money from income they are dipping into savings. People are now cashing in their CD’s so Finance Companies are finding it harder to keep deposits. They cannot offer ever increasing rates, as the real interest rate is already high and they cannot lend at higher rates. Additionally as these companies are lending long, by way of cash stream over the period of a lease of say 4 years and depositors usually hold a maximum of one year CDs that some are not renewing on maturity, finance companies are strapped for cash and will imminently face a liquidity crisis.

The Liquidity crisis is exacerbated because the banks invest surplus cash in Treasury Bills which are risk free, and are reluctant to lend to finance companies as they are now considered very high risk, because of what I have shown above. The imminence of a run on Finance Company deposits cannot be more convincing, the rollover effect to a run on the banks is just the next step, and there is no guarantee by the Central Bank of a bailout of the Banks or Finance Companies if this happens. The guarantee MUST be given now before a crisis happens, as it will be too late after as the cost will be much greater and the resulting loss of confidence in the banking sector more devastating.

I have earlier recommended a Central Bank guarantee of about Rs1M per name per Bank of Finance Company to forestall a run on these institutions. The various institutions are led by novices and the professionals in their midst are biting their nails and preparing their exit strategies in case the house of cards crumbles. Those affected will no doubt be all the innocent citizenry of this country who will see their life savings devastated and the resulting lack of funds for consumption will immediately reduce demand, output, layoffs, and a depression with stagflation with no one able to do anything about it.

Then the rupee will depreciate by 100% in a flash and the only people who will benefit are those holding US$ realizable assets who can pounce in and buy every asset in Sri Lanka at fire sale prices, due to the desperation of people for cash as there is no availability of ready of ready cash to conduct economic activity. This is the law of the jungle capitalism at its worst!

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