By Errol Gregory, ContributorLAST week the Bank of Jamaica (BoJ) reversed the pattern of decline in short term rates that had accelerated in the previous four weeks.
To understand the significance of this we have to review recent interest rate changes in the money market. Take the case of the LRS market. At the three-year LRS issued on August 17, 2000, the average yield came out at 19.60 per cent. By September 21, having remained stable for some time, the rate fell by a near 1 percentage point to 18.92 per cent.
In the case of the seven-year LRS Instrument, the decline was even more dramatic as the average yield in mid August was 20.86 per cent but by September 21, the average yield fell to 15.81 per cent, a full two percentage points decline. It is this fairly rapid decline in rates, facilitated largely by BoJ reductions in its Benchmark Repo rates, that the central bank halted with its intervention last Thursday. On that day, The Central Bank hiked its 270 repo rate (repurchase agreements) from 17.60 per cent to 20 per cent and increased the rate on its 365 days repos to 22 per cent up from 18 per cent.
What is noticeable about this intervention is that, only days before, the Bank of Jamaica held a LRS offer at which it paid an average 18.41 per cent on its three-year LRS issues, 18.41 per cent on its seven-year instruments and 18.96 per cent on its 10-year instrument. Yields therefore averaged less than 19 per cent. Medium to long term investors must have definitely pulled out their hair when they saw the attractive yields that their lucky counterparts got at the short end of the market.
Of course the Central Bank's hike in repo rates was meant to shock the system. The authorities were apparently bent on taking up all the excess liquidity in the financial system to prevent these funds stimulating demand for US dollars. Additionally, the move was also designed to restore the attractiveness of local instruments, that had received a body blow, with the relatively attractive 13.125 per cent yield that obtained on government's tax free US Bond.
But even though BoJ's concern about excess liquidity in the system was understandable as a total of $5 billion ended up chasing its $1.8 billion LRS offer, its method of intervention has come in for much criticism.
Financial analyst John Jackson, speaking on a radio programme argued that it was incomprehensible that the monetary authorities would have jacked up rates to that extent, knowing that the increased rates would impact negatively on their fiscal deficit targets. According to Jackson, since long term investors were willing to part with their funds at less than 19 per cent, it was silly to give investors such high premiums.
Speaking on the same radio programme mentioned above, Lisa Gomes, investment and treasury manager of Guardian Life Ltd., argued that the slide in the value of the currency and the eventual intervention by the monetary authorities were predictable as the rates and had fallen at too fast a pace. In her view the narrowing of the differential in the interest rate paid on local instruments versus Government's US Bond was a precipitating factor to the crisis that triggered BoJ's intervention.
But whatever might have been BoJ's motivation for pulling up rates steeply, its action will have tremendous impact on the financial system and ultimately the economy. For one thing, its actions are likely to herald a renewed focus on short term investments. BoJ's recent success in floating its 10-year LRS had raised hopes that investors would be refocusing their investment horizons to the long term. The latest hike in rates will halt this process.
Secondly, we are witnessing the return of an inverted yield curve. As you no doubt remember, this means that those investors who decide to park their funds with BoJ for short periods (nine months or 1 year) are getting higher rates than those who part with their funds for longer periods (5,7 or 10 years). It is of course long term funds that are critical to an economy's dynamism.
A third point is that the upward climb in rates, even if only temporary, means that rates in the broader financial system are likely to move in tandem with BoJ's repo rates. This means that any hope of reduced rates to stimulate economic activity will be pushed back even further.
An even more fundamental point concerning the latest hike in repo rates, is that they indicate the predictable circular nature of government's monetary policies. For some time now, we have remain locked into a high interest rate regime with intermittent periods of declines.
