Extensive Study of the Bond Market

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Have you ever asked yourself why interest rates increase when the number of people who need to borrow money increases?

The relevance of this question is particularly relevant now, as the nature of Sri Lanka’s bond yields, which are again on the rise, reflects growing borrowing needs among investors, inflation fears and uncertainty. The Loanable Funds (LFT) approach provides a simple and realistic description of how these interest rates are set not only by policy, but also by market forces in savings and borrowing.


What is happening in Sri Lanka’s bond market?

Sri Lankan government bond interest rates have increased in the past two weeks. Analysts say that two issues have contributed to this.

  1. Increased government borrowing due to fiscal policy and budget deficits

  2. Foreign investors withdrawing their investment from the market due to the discussions and excitement of debt restructuring.

When government increases, the government has to pay to borrow funds, and to do so, the government has to pay a higher interest rate on bonds to attract investors to buy bonds.

Loanable Funds Theory in Action

The Loanable Funds Theory is a great opportunity to explain this. According to this theory, interest rates are determined by loanable fund supply and loanable fund demand.
  • Loanable funds are supplied by parties such as Savers, the Central Bank, etc.
  • Loanable funds are demanded by parties such as the government and businesses


In Sri Lanka,

  • The demand for loanable funds has increased. This is because the government needs more funds to meet its budget.

  • Also, the supply of funds in the market has decreased. This has been partly due to foreign investors withdrawing their investments. Debt restructuring negotiations and inflation uncertainties have contributed to this withdrawal.

Therefore, the interest rate has to increase to reach the new demand-supply equilibrium. According to the loanable funds theory, when demand exceeds supply, interest rates increase. To this end, the central bank can respond to these situations by maintaining a stable monetary policy and participating in open market operations.

The Reason for Rising Bond Yield with Government Borrowing

The government must issue bonds to raise funds, and they must increase the interest rates to attract more investors. The low rates at the weekly bond auctions held by the Central Bank have reduced investor participation and therefore the government has had to postpone the raising of funds. Accordingly, the market for borrowing funds is responding to supply and demand.


Wider Implications to Economy

The increase in bond yields has several implications:

  • Government spending may increase in the future, and therefore government borrowing will increase. This can be addressed by reducing spending and raising taxes.

  • As interest rates rise, businesses will have to incur higher costs in funding their investments, which may slow down the pace of investment.

All this is what the Loanable Funds Theory would have us expect that the cost of borrowing (interest rate) is not only a factor in what the central bank does, but also a factor of the whole savings and borrowing framework within the economy.


The Central Bank in the Loanable Funds Model

The Central Bank of Sri Lanka still plays a significant role in providing funds, while instruments such as foreign exchange operations and reserve requirements are still in their infancy.

For example, when the central bank increases the policy rate, the cost of borrowing increases, which reduces the demand for funds. Similarly, easing monetary policy increases liquidity, increases the amount of money available, and lowers interest rates in the short term.


The Effect of Exchange Rates and the Outflow of Foreign Capital

Currently, due to uncertainties surrounding Sri Lanka's debt restructuring, foreign investors have been tempted to withdraw their investments, resulting in a decrease in funds available in the local bond market.

Also, inflation in Sri Lanka has increased due to the depreciation of the rupee, and investors need a higher interest rate to respond to this.


The Prospects of the Interest Rates and Bond Market in Sri Lanka

Future interest rates are determined by several factors.

  1. Development of IMF-sponsored structural adjustment Progress

  2. Fiscal deficit reduction

  3. Fine-tuning of internal tax raising Operating Performance 26 Improvement in domestic revenue collection

  4. Reentrance into the international capital markets

  5. Rebuilding the confidence of investors

If these activities are successful, the amount of funds that can be borrowed will increase and the interest rate will decrease. Therefore, the cost of borrowing will be minimized.


Written By - Harsha Jayaweera

Publication Date - 02/08/2025

Sources

https://economynext.com/sri-lanka-rupee-weaker-against-dollar-bonds-broadly-steady-233941/


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