106
Restricted 1 Workshop: Indirect Tools for Monetary Operations – Open Market Operations Jhuvesh Sobrun Monetary & Economic Department Research & Policy Analysis Bank for International Settlements (BIS) [email protected] Maputo, Mozambique 5 August 2009 The views expressed are those of the presenter and not necessarily those of the BIS

Monetary policy and monetary policy instruments

Embed Size (px)

DESCRIPTION

Direct and indirect instruments of monetary policyReserve requirementsStanding facilitiesOpen Market OperationsLiquidity supply & bank balance sheetFinancial crisis - different stagesUnconventional Monetary PoliciesImplications for Emerging markets

Citation preview

Page 1: Monetary policy and monetary policy instruments

Restricted

1

Workshop: Indirect Tools for Monetary Operations – Open Market Operations

Jhuvesh SobrunMonetary & Economic DepartmentResearch & Policy AnalysisBank for International Settlements (BIS)[email protected]

Maputo, Mozambique5 August 2009

The views expressed are those of the presenter and not necessarily those of the BIS

Page 2: Monetary policy and monetary policy instruments

Restricted

2

Part I - Role of the Central Bank & Monetary Policy framework/scope

- Short-term interest rates as operating target: implications

- Rules-based instruments: direct instruments - advantages v/s disadvantages

- Market-based instruments: indirect instruments - Advantages over direct instruments - Transition from direct to indirect instruments: conditions & phases

- Reserve requirements - Demand for reserves (required (RR), settlement & voluntary reserves) - Features (RR ratios, eligible assets, maintenance periods, lagged accounting) - Remuneration v/s non-remuneration - Reserves averaging (description & use) - Functions & main problems

- Conclusion to Part I

Page 3: Monetary policy and monetary policy instruments

Restricted

3

Main roles of the Central Bank in the financial system

Evaluate channels of monetary policy

Plan scenarios, set

the policy rate and communicate

with other market players

Monopoly supplier of local currency

Control

liquidity & credit conditions (by using RRs, SFs

& OMO)

Carry out FX intervention

to control relative value of local currency

Lender of last resort

to the banking sector

Fiscal agent

of the central government in the primary securities market

Supervises banks (thru legal frameworks, regulatory ratios & sanctions)

Page 4: Monetary policy and monetary policy instruments

Restricted

4

Monetary policy framework and implementation

Instruments Goal(s)Operating target(s)

Intermediate target(s)

Direct instruments

Indirect instruments:

Lending/deposit facilities

Reserve requirements

Disc. Mon. op.

Financial stability

Inflation stability

Growth

Full employment

Competitiveness

etc

Base money

Market interest rates

Exchange rate

etc

Money supply

Inflation rate

Exchange rate

Etc

Page 5: Monetary policy and monetary policy instruments

Restricted

5

Monetary policy framework and implementation (cont.)

To achieve its monetary policy goals (price stability, exchange rate stability, growth, full employment, financial stability), the CB:

-sets its policy rate and

-uses instruments that it can directly control to

indirectly influence its operating targets (exchange rate, monetary base, market interest rates).

-These are often supplemented by data on intermediate targets (money supply, inflation and exchange rate) for more visibility and timeliness (due to lags in transmission channels

(interest rate, credit, wealth, exchange

rate)

-Nowadays, most CBs rely on the money market to distribute liquidity among banks at market interest rates

Page 6: Monetary policy and monetary policy instruments

Restricted

6

The scope of monetary policy

Nowadays, most CBs

conduct monetary policy via ST interest rates

Well-functioning money market

vital

as formation of interest rates in interbank

market constitutes 1st

step in transmission of monetary policy

to financial markets & real economy

Exchange rate targets

used by small open economies

(HK, SG)

Quantity targets

(monetary base) used in some less developed countries

Commonly-used operating target

Page 7: Monetary policy and monetary policy instruments

Restricted

7

Implications of ST interest rates as operating target

Advantages:•

They signal

desired policy stance via the Policy Rate

fluctuations in interest rates (pre-condition: transmission mostly through interest rates

and developed + efficient

interbank

markets)

Can be used for

Liquidity management operations

Liquidity management operations

are either:

Supportive

influence ONLY the specific market rate

targeted by policy to keep it consistent with the policy rate

Active

influence the specific market rate targeted by policy over and above the impact of the policy rate –also called Balance sheet policy (BSP)

BSP implementable

whatever

the prevailing interest rate level

Active liquidity management operations

influence asset prices, yields &

funding conditions => substantial ∆

in size, composition and risk profile

of the CB’s balance sheet (more details in Part II & III)

Page 8: Monetary policy and monetary policy instruments

Restricted

8

Direct policy instruments (used in the good old times?)

Rules-based: CB has regulatory power to set or limit prices (interest rate) or quantities (credit)

Aimed at

balance sheet of banks

They are:

Interest rate controls

Bank-to-bank credit ceilings

Statutory liquidity ratios (hold % of bank’s liabilities as govt securities)

Directed credits

Bank-to-bank rediscount quotasUse of direct instruments – 1998 to 2004

Page 9: Monetary policy and monetary policy instruments

Restricted

9

Case for direct instruments

Best or only possible solution when:•

information is

scarce (used to limit adverse selection)

bank supervision & legal structures weak•

financial markets underdeveloped or at

early stages of development

Low market participation•

transmission mechanism

of monetary policy is uncertain

Relatively easy to implement & explain

to politicians and the public

Low direct fiscal costs (Statutory liquidity ratios)

Easy to link with a monetary targeting policy

(BUT monetary targeting relies on strong & stable relationship

over time between demand for money and supply of

money –

not the case in reality)

CB can more easily control flow of credit to banks or targeted sectors

Supplemental instrument (to RRs) in transition periods

or severe financial crisis (help more distressed sectors)

Page 10: Monetary policy and monetary policy instruments

Restricted

10

Case against direct instruments

Disintermediation (to circumvent them) => ↓

policy effectiveness

& ↑

evasion

Financial repression => ↓

bank-based savings & shifts from formal to

informal markets => Distortions

Discourage development of interbank markets & secondary markets for securities

Hamper & distort competition => ↑

costs

in resource allocation

Credit ceilings tend to ossify credit distribution & act as barrier to entry of new players

Over time, policies become less effective => multiplication of controls (↓

credibility) => complex, multi-tiered structures of interest rates and credit controls which make situation worse

Page 11: Monetary policy and monetary policy instruments

Restricted

11

Indirect instruments of monetary policy

Market-based instruments: they ∆

supply of banks reserves at

market-related prices

CB

determines overall systemic liquidity and

market distributes it

Roots: CB as monopoly supplier of high-powered money (i.e, monetary base (M0),i.e, the MOST liquid

and narrowest measure of

money supply)

Aimed at the balance sheet of the central bank

They are:•

reserve requirements

Standing facilities•

discretionary monetary operations (OMOs, OMO-type operations)

Page 12: Monetary policy and monetary policy instruments

Restricted

12

Greater flexibility

and larger choice of targets

than direct instruments

Encourage development and deepening of formal interbank

markets

=> ↓

disintermediation

=> Financial innovation & technological developments => ↓

information & transaction costs

Allow small, frequent changes in instruments

& hence quick responses

to shocks

& possibility to quickly correct errors

Reliance on market forces => reinforce CB independence & credibility

Improvement in investment

and ↑

financial savings

Indirect instruments & a well-functioning interbank

market mutually

reinforce

each other

Advantages of indirect instruments

Page 13: Monetary policy and monetary policy instruments

Restricted

13

Transition to indirect instruments: the conditions

Stable macroeconomic environment, reduction of barriers to entry & elimination of regulations restricting competition

Sound and competitive financial system•

Otherwise, segmentation and heterogeneity => systemic crisis

Well functioning interbank

market & healthy banks assets => rapid transmission of ∆

instruments to the banking system

Modernized clearing & payment systems

(to avoid volatility in reserves supply)

Adequate supervisory and legal frameworks•

To foster prudent behaviour

Requirements WITH proper enforcement on information disclosure

CB autonomy (vital for its credibility) & sound fiscal policies•

Government should refrain from pressuring CB to keep interest rates low to minimize fiscal costs

Page 14: Monetary policy and monetary policy instruments

Restricted

14

Transition to indirect instruments: the phases

Phase 1•

a. Absorb any liquidity overhang

(by using reserve requirements (RR))

b. CB to help individual banks

(to meet interbank

settlement obligations)•

c. Creation of a credit facility

to inject desired amounts of funds

Phase 2•

Characterised

by reduction of reliance on RR

for sterilisation

Introduction of primary market issuance (eg, OMO-type operations)•

Foundation stone for development of securities secondary market

Adequate collateral important as: •

CB has to protect itself from incurring losses on its credit operations

Without collateral, CB counterparties cannot obtain liquidity•

Combination with freer interest rates

to facilitate money market development

Phase 3•

Secondary market operations

(OMO), use of standing facilities & further

refinements…

Page 15: Monetary policy and monetary policy instruments

Restricted

15

Demand for Reserves (notes & reserve requirements)Stylised

CB balance sheet

Reserve demand = Currency + {required + voluntary + free (or settlement) reserves}

Excess reserves = Settlement + voluntary reserves

Voluntary (precautionary) reserves >0, if reserves are remunerated

Free bank reserves = net foreign assets + net lending to government + lending to banks + other items (net) – notes – required or contractual (voluntary) reserves – liquidity draining operations

Reserve money or

Base money or

Monetary Base

Page 16: Monetary policy and monetary policy instruments

Restricted

16

Reserve requirements

Required reserves

(generally fixed by CB & binding (compulsory))•

Defined as requirement for a bank to hold minimum current account balances with

CB (usually a % of its unsecured cash deposits)

• Only INDIRECT

influence of ∆

interest rates

(i) on required reserves•

i => ↓

demand for deposits

as economic activity slows down => ↓ the

base

used to calculate required reserves

Enforcement thru

penalty interest rate

(usually the lending SF rate) or restricted access

to CB lending facilities

Excess reserves

(non-binding; settlement + voluntary reserves)• Opportunity Cost: no interest return or banks earn interest < market rates•

Size

= fn (uncertainty on payment outflows (+), institutional characteristics of payment system (+ or -), expected costs of overdrafts (+), market interest rates (-), uncertainty about OMO (+), expensive standing facilities (+))• Higher excess reserves ↓

impact of changes in RR

Page 17: Monetary policy and monetary policy instruments

Restricted

17

Settlement (free) reserves: NON-binding reserve req

Exist as interbank

payments

usually settled via accounts at CB

Better CB technical capacity

& payment & settlement systems => ↓

free

reserves

Liquidity mgt problems

& high overdraft penalties

=> ↑

free reserves

If not remunerated

(opportunity cost) => banks keep minimum free reserves

Remunerated free reserves

(usually at deposit SF rate, normally < policy rate)

=> ↓

opportunity cost => free reserves ↑

free reserves => liquidity surplus

=> trigger CB to↑

policy rate

Free reserves usually high

when CB’s balance sheet

asset-driven

(eg, when

govt

borrows abroad and sells FX to CB; when CB makes net purchases of FX to manage a fixed exchange rate regime and capital flows)

Page 18: Monetary policy and monetary policy instruments

Restricted

18

Features of reserve requirements

RR with Uniform or differentiated ratios•

Applicable to domestic and foreign currency

(FC) liabilities with different

maturities•

Differentiation –

to attract or to discourage FC deposit inflows

(v/s

LC

deposits) or ST v/s

LT

deposits•

Countries (among which many African) using differentiated ratios

have in

general higher RR ratios

=> ↑

risks of disintermediation•

Uniform ratios (CB neutral with respect to currency / maturity of deposits)

Equitable, easier to calculate RR & to monitor•

Avoid shifts in deposits, ST capital flows & exchange rate pressures

Eligible assets?•

Include: usually, deposits with CB (demand, time, FC), vault cash (debatable –

estimation problems)

Exclude: government securities & OMO eligible instruments

=>to avoid ↓ efficiency of monetary policy thru increased complexity

Page 19: Monetary policy and monetary policy instruments

Restricted

19

Implications of using FC deposits as eligible assets for RR

RR on FC deposits: •

Reflects balance sheet structure of banks, hence of customer preferences

and even distrust in local currency

the bias on LC deposits & exposure to capital flows•

If exchange rate unstable

=> reserves demand unstable & unpredictable

FC deposits

(% of total deposits) very big

in many EMEs

(esp. Africa)

Common practice: RR on FX deposits in the LC, while corresponding liabilities are in FC => ↑

exposition to currency risk

LC depreciation

=> Banks have to ↑

reserve balances at CB => demand for

liquidity ↑

as banks forced to sell FC for LC or borrow liquidity from CB (at high penalty rates) => CB has to carry out policy expansion

(for eg, by ↓

policy rate) to counter liquidity shortage problems•

policy rate

may => more depreciation

(vicious circle!)

Page 20: Monetary policy and monetary policy instruments

Restricted

20

Features of reserve requirements (cont.)

Maintenance period (MP) –

period over which banks’

average holdings of

reserves

are assessed relative to requirements (US: 2 weeks, JP: 1 month; ECB: 28-35 days)•

Function of CB’s passivity/activity

in intervention to monitor liquidity

Long MP => ease

requirement conditions

=> ↓

excess reserves•

For determination of end-dates

of MP:

avoid days of high liquidity uncertainty

(eg, tax payment dates)•

avoid speculation & volatility: alignment with policy decision

announcement dates

Lagged reserve accounting•

Calculation of RR for next MP can be done before end-date of MP

=>

helps banks plan reserve holding pattern in advance & build-up confidence

Carrying over excess reserve holdings

into next MP

=> more smoothing,

esp. last day of MP (when O/N rate volatility is higher)

Page 21: Monetary policy and monetary policy instruments

Restricted

21

No Remuneration or RR remunerated below policy rate

Income source for the CB

= tax on the financial system => disintermediation

Less income for banks

=> banks

may ↑

spreads between deposit & lending rates

to clients to compensate for loss

Remuneration rate

= usually the policy rate for RR

and deposit SF rate for excess RR

High remuneration

=> ↑

excess (voluntary) reserves

No remuneration

but high RR

=> ↑

comparative disadvantage of banks

relative to non-banks (who are not subject to RR)

No remuneration, high inflation & lower interest rate differential with other countries

=> ↑

real opportunity cost (ie, implicit tax burden) on FX deposits =>

disintermediation & capital flight

domestic interest rates

=> ↓

interest rate differential => partial compensation (deposits earn higher returns), but ↑

opportunity cost of “non

remunerated”

deposits subject to RR v/s

deposits not subject to RR

Page 22: Monetary policy and monetary policy instruments

Restricted

22

Reserves averaging (cushion effect)

Banks can postpone reserves accumulation

to a later date of the MP, except

last day of the MP => binding RR ONLY on the last day of MP=> banks are indifferent between holding liquidity on different days of MP (before last day)

Averaging acts as Buffer

to stabilize cash flows & limit O/N int. rate volatility

Buffer effect more effective

if :

Longer MP•

RR binding enough

to affect marginal reserves demand

Combined with frontloading (ie, CB injects surplus liquidity early in the MP to mop up excess later on) => ↓

funding liquidity risk for banks

Contributes to ↓

excess reserves

by acting as an indirect liquidity injection

Critique:

By offering Greater flexibility => poorer liquidity mgt

=> prudential

issues

Page 23: Monetary policy and monetary policy instruments

Restricted

23

Features of reserve requirements (cont.)

Reserve requirement with averaging Varying elasticity over maintenance period

Start of maintenance period

During maintenance period

End of maintenance period

Rmin

<= RR <= Rmax

Maximum elasticity of Reserves demand

Reserves demand still very elastic

Reserves demand inelastic

Page 24: Monetary policy and monetary policy instruments

Restricted

24

Features of reserve requirements (cont.) Buffer function of reserves averaging

under calm market conditions

DT

= inverse aggregate demand for reserves; ST

= supply of reserves; R

= daily average RR

Flat part of DT

curve

(highly interest-elastic), ie, supply shocks do not affect ST interest rate =>

RR varies without affecting ST int

rate

Non-flat part of DT

curve

= reduced interest-elasticity of DT

“With averaging, before last day of MP” No averaging or “With averaging, last day of MP”

Page 25: Monetary policy and monetary policy instruments

Restricted

25

Functions of reserve requirements

Buffer –

stabilize cash flows & limit O/N int. rate volatility

Liquidity management (when averaged & lagged) –

facilitate interbank settlements

Monetary control: as reserve market management tool

& built-in stabilizer

Unremunerated RR

=> Introduce a wedge

bet. SFd

and SFc

to discourage over- lending => ↓

too fast credit growth

-

not much used (tax => disintermediation)

Income source for CB

(if unremunerated or remuneration < market rates)

Supportive role for OMOs

(“crude”

liquidity draining/injection device)

Prudential instrument in developing countries –

ensure that banks have sufficient liquidity in case of withdrawal of deposits –

prevent bank runs

Provide “automaticity”

when financial markets shallow

(& secondary markets inexistent) competition still too poor

for more flexible operations (like OMOs)

Page 26: Monetary policy and monetary policy instruments

Restricted

26

Main problems with reserve requirements

Unremunerated RR

=> tax on banking system => disintermediation

High RR

put banks under pressure

(penalty attached to non-fulfilment

& comparative disadvantage relative to non-banks)

IF liquidity uncertainty

↑, banks tighten targets on their daily accounts => weaken RR averaging

=> liquidity effects emerge on other days of MP

=>

“flat part”

of demand curve disappears

Blunt measure to control liquidity, esp. in the medium term:•

RR when liquidity shortage: too low RR => buffering

effect too small to

be still significant•

RR when liquidity surplus

=> high RR => ↑

tax on banking system (if

not remunerated) => cost of liquidity draining ultimately supported by the economy

Frequent changes in RR

=> disruptive

& ↑

costs for banks (may affect client rates on deposits/borrowings)

Page 27: Monetary policy and monetary policy instruments

Restricted

27

Reserve requirements in selected countries

RR on FC

are actually maintained in local currency in most countries

Less developed countries do not remunerate excess reserves

– tax! => disintermediation

RRs

are much higher

-

income for CB Other indirect insts

less effective -

inexistent or shallow secondary markets

High RR with no remuneration

can be dangerous (disintermediation)

Averag-ing Carry-over Accounting MP

RR on domestic currency

RR on foreign

currency

Remuneration of excess reserves

China No No Lagged 10 days 0.1 0.04 YesIndia Yes No Lagged 2 weeks 0.06 0.06 Yes (for > 3%)Korea Yes No Half-lagged 1/2 month 0-7% 0-7% NoBrazil Yes No Lagged 2 weeks 0-45% 0-45% YesKenya 0.05 0.05 NoTanzania 0.1 0.1 NoMauritius Yes No 2 weeks 0.04 0.04 NoSouth Africa Yes 0.025 0.025 NoEurosystem Yes No Lagged 28-35 days 0.02 0.02 YesJapan Yes No Half-Lagged 1 month 0.05-1.3% 0.15-0.25% NoUK Yes No Lagged 1 MPC month Voluntary Yes (within + - 1%)US Yes Yes Lagged 2 weeks 0-10% NoSource: Central Banks.

Page 28: Monetary policy and monetary policy instruments

Restricted

28

Conclusion to Part IRules-based instruments

(=> disintermediation, distortions in the

allocation of bank resources and loss of effectiveness by the monetary authorities) incompatible

with today’s developed financial markets,

international trade and and

liberalised

capital markets.

Reserve requirements, when averaging

is possible, are a good but not best way

to smooth

fluctuations in short-term interest rates, and by

spillover, to the rest of the yield curve. Their effects are however not clear over the medium-term.

Recommended for CB to use flexible, market-based

instruments of monetary policy that allow CB to control the supply of liquidity quickly and on day-to-day basis. This is best achieved through the combined use of standing facilities and discretionary monetary operations….

Page 29: Monetary policy and monetary policy instruments

Restricted

29

Part II - Liquidity supply & CB balance sheet

- Autonomous factors & importance of liquidity management - Problems with liquidity surpluses

- Standing Facilities - Definitions & uses - Credit and deposit facilities - Features (maturity, collaterization, eligible instruments) - Corridor system & stigma

- Discretionary monetary operations - Definitions & uses - Conduct & implementation - Types: primary & secondary market issuance, repos - Permanent v/s temporary liquidity injection/absorption - Features (maturity, frequency of operations, auction techniques) - Associated risk control measures

- Conclusion to Part II

Page 30: Monetary policy and monetary policy instruments

Restricted

30

Supply of liquidity

Net supply of reserves or liquidity

influenced by:•

Autonomous factors, ie,

Uncontrollable changes to the CB’s balance

sheet NOT the result of its domestic liquidity operations•

Policy factors

– its controllable

domestic liquidity operations

A Central Bank’s Balance sheetAssets Liabilities

Net foreign assetsNet securities

Outright•

Under repo

Lending to banksCredit to governmentOther items net

CurrencyBank reserves

Required reserves•

Excess reserves

Government depositsLiquidity draining operationsCapital and reserves

Autonomous liquidity position

= net sum of autonomous factors

=

Net foreign assets +

Credit to Government

+

Other net assets–

Government

deposits

Currency

Net policy position (+ means inject, -

means withdraw)=

Bank reserves –

Autonomous liquidity position

Page 31: Monetary policy and monetary policy instruments

Restricted

31

Importance of liquidity management

Good liquidity forecasting smooth undesirable liquidity fluctuations -

vital for efficiency

of OMO and SFs

By adjusting level of reserves balances, CB can offset or support

permanent, seasonal or cyclical shifts

in supply of reserve balances => effect on ST interest

rates &

rest of yield curve

Excess liquidity => ST int. rates ↓•

if ST interest rates too low, banks tempted to make riskier loans in search of yield

or refuse to take customer interest-bearing deposits => ↓

savings,↑

consumption & ↑

inflation

If liquidity level ∆

a lot => ST interest rate volatility

=> this impedes on devlt

of LT end of mkt

=> risk-aversion ↑

& banks reluctant to take positions

Both shortage & surplus liquidity

=> weak secondary market

for securities

Page 32: Monetary policy and monetary policy instruments

Restricted

32

CB as LOLR & liquidity surplus

Liquidity surplus

usually characterised

by:•

Large amounts of OMO & SF liabilities, but little or no OMO & SF lending

Excess reserves

in banks’

current accounts•

ST interest rates

( => ↑

inflation)

Weakening exchange rate

(if speculating banks seek higher FX returns or think that domestic inflation will rise soon)

Central Bank’s Balance sheet

Assets LiabilitiesNet FX reservesNet lending to govtLending to banks

OMO•

SFsLOLR & lending to

“priority” sectorsOther items

Currency in circulationReserve requirements (RR)Banks’ current accts excl. RRDeposits, CB bills (OMO)Deposits (SFs)Capital & ReservesOther items

Page 33: Monetary policy and monetary policy instruments

Restricted

33

Why is structural liquidity SURPLUS not preferable?

Liquidity-draining is costly

to CB => ↓

CB profitability & independence

CB carry out liquidity-draining by ↑

policy rate => -ve

effect on credit growth

Interference with transmission mechanism

of monetary policy => liquidity forecasting & monetary policy implementation complicated & imprecise

Market segmentation

big banks attract all deposits

while small banks are short of liquidity

Collusion

between big banks to ↑

pressure on small banks => ↑

risks of losses for CB => ↓

CB independence

EMES: weak market infrastructure, lack of competition & insufficient voluntary participation

=> CB unable to carry out efficient liquidity-draining

Issuance of same securities by both CB & govt

(to drain liquidity) => confusion & competition

bet. them => ↓

CB independence

in case of losses

Page 34: Monetary policy and monetary policy instruments

Restricted

34

Main sources of surplus liquidity

Net FX reserves•

Commodity exports

Foreign borrowing by govt

(who sells FX to CB to obtain local currency)•

FDI (FX receipts sold to CB for local currency)

Donor Funds

(esp. in Africa: Ethiopia, Ghana, Malawi, Mozambique, Uganda, etc)

Remittances (esp. countries with large emigrated citizens)

Main source in fixed or managed exchange rate regimes, as:•

FX stability perceived as key anchor for low inflation expectations

Export-competitiveness

important

Page 35: Monetary policy and monetary policy instruments

Restricted

35

Main sources of surplus liquidity (cont)

Monetary financing (= lending to government)•

May be detrimental to CB independence

=> coordination is needed

Better be in the form of marketable securities

as then CB can sell them in the market to drain liquidity

Reduction in reserve requirements•

Crude measure of liquidity management (costly & disintermediation)

Bank rescue (LOLR) – the case with the recent financial crisis ?•

Crisis

=> ↑

demand for liquidity as:

Banks want to ↑

precautionary reserves•

Banks are

reluctant to lend to each other

If CB bails out

a bank =>↑

CB assets

=> surplus liquidity•

If CB makes losses => may endanger

CB’s independence

Page 36: Monetary policy and monetary policy instruments

Restricted

36

Standing facilities (SF)

Usually come

after

use of discretionary monetary operations, in liquidity mgt plans

At initiative of the banking system

=> CB does not enjoy full control

SFs

are bilateral

(v/s

most OMOs

are multilateral)

INDIRECT form of liquidity

management (OMOs: direct approach)

When SF rates

low => SFs

used as permanent LOLR facility (ie, => over-reliance)•

Over-reliance =>

moral hazard =>

danger to development of

interbank

markets (CB’s SFs

acts as rough substitute to interbank

markets)•

Need for penalty rate

& regulation

However, Penalty rate may lead indirect stigma & discourage use when appropriate (eg, the US at beginning of current financial crisis)

Functions & Use•

Enhance CB credibility

(bears a pre-specified interest rate –

a commitment)

Safety valve

or

back-stop: ↓

volatility of ST int

rates around

the policy rate•

Rate-setting

or rate-stabilising: keep ST interest rate close

to policy rate

Used more often

when other indirect instruments not very effective

Page 37: Monetary policy and monetary policy instruments

Restricted

37

Credit Standing Facilities (SFc; also called Lending facility)

Form of liquidity injection

Help meet reserve deficiencies

& avoid end-of-day overdrafts

=> limit pressures on overnight rates

SFc > Market rates => market-ceiling

rate for market rates•

if market rates threaten to rise above SFc, banks tend to borrow more from SFc

than from the market=> limit rise in market rates

High SFc

= signal of tightening monetary policy

Often used as the penalty rate on unfulfilled RR

commitments at end of MP

Use of SFc

↑:•

When current accounts are not monitored properly

=> banks don’t meet

their RR, esp

on last day of MP due to liquidity forecasting errors•

With credit rationing, market segmentation, liquidity hoarding (during crises); ECB (1st

week Oct 08: daily avg

use of SFc

went from 0.5 bil euros to 21 bil

euros)

Page 38: Monetary policy and monetary policy instruments

Restricted

38

Deposit Standing Facilities (SFd)

Form of liquidity absoption

Facility for banks to deposit remunerated

funds at CB

SFd

< market rates

=> floor-setting

for market rates

SFd

> O/N interest

rate = signal of illiquid interbank

market

(less dev. countries)

Less widely used than SFc

(esp

in developed countries –

more often characterised

by liquidity shortages)

When market-wide liquidity surplus

=> SFd

policy rate

Often used as the remuneration rate on remunerated excess RR

Frontloading (ECB since Aug 2007) => liquidity surplus at beginning of MP => ↑ use of SFd; ECB (1st

week Oct 08: daily avg

use of SFd

went from 1.5 bil

euros to 43 bil

euros)

Page 39: Monetary policy and monetary policy instruments

Restricted

39

Standing facilities (SF) – cont.

Sometimes, Credit available at subsidised rates, ie, SFc < Market rates•

May lead to

Speculation on devaluation of LC =>

banks borrow funds (via

SFc) to purchase FX from CB, betting on speculative profits after devaluation •

May need additional supportive measures: rationing & CB close scrutiny

Types of eligible instruments•

Short-term, mainly O/N (loans/deposits; repos/reverse repos, FX swaps, outright sales/purchases of short-term securities or FX)

Recent trends marked by broadening of eligible instruments

Maturity of SFs•

O/N in most countries

serves “safety-valve”

function

Recent trends

(financial crisis): ↑

maturity to ↓

rollover risks

in interbank markets

Page 40: Monetary policy and monetary policy instruments

Restricted

40

Standing facilities (SF) – cont.Quick overview of money market instruments & their uses

Page 41: Monetary policy and monetary policy instruments

Restricted

41

Collaterisation of SFs: floors & ceilings

Hard floor:

(no collateral needed) => SFd

available to all banks without any limit => (SFd

< O/N rate)

Soft ceiling:

collateral needed for SFc

=> banks with non-eligible collateral forced to borrow from the market => may cause market rates to ↑=> (SFc

< = O/N rate) –

may pose problems during financial crises

Physical location of collateral

important as rapid access & transfer needed

– many SF settlements are “same-day”

Use of collateral denominated in foreign currencies

=> micro-

and macro- prudential

implications for > 1 country –

need international cooperation

Recent trends

(financial crisis): broadening range

of eligible collateral and wider set of counterparties

to facilitate effective distribution of CB funds

=> changes portfolio composition of CB’s balance sheet=> CB more exposed to illiquid assets –

risk control measures to protect

CB’s balance sheet against financial risks (haircuts, etc)

Page 42: Monetary policy and monetary policy instruments

Restricted

42

The Corridor Approach (SFc – SFd)

Provides automaticity -

CB can deal at both upper & lower bound

Narrow corridor•

Use of SFd

more attractive

v/s

interbank

market for excess liquidity depositing

Minimises

interest rate volatility; best if stigma low or zero => ↓

need for further fine-tuning operations

Serves the rate-setting or rate-stabilising

function•

Implies higher

importance of RR averaging

to contain rates within bounds

Too narrow

=> ↓

incentive for banks to manage their liquidity via interbank market & hamper its development

Too narrow => moral hazard (no penalty) => over-reliance•

Necessary

in financial crises

with severely impaired interbank

funding markets

Wide corridor•

Safety valve: prob

(market rates under-/over-shooting SF rates) ↓

Encourage banks to fund themselves via interbank

market instead of CB•

More room for interest rate volatility

=> ↑

need of fine-tuning operations

=> Lower use of SF

as spreads between SFc

and market rates ↑=> ↑

holdings of voluntary reserves

Page 43: Monetary policy and monetary policy instruments

Restricted

43

Stigma negatively affects the effectiveness of SFs

Banks go to interbank

market even if more costly

than to use SFs

External: borrowing from CB is an adverse signal

about creditworthiness as SFs

tend be associated with Emergency Liquidity (eg, US)

Internal: if CB credit requires additional administrative procedures

as SF seen as deviation from normal routine

High stigma & narrow corridor => ↑

prob

market rates under-/over-shooting SF rates

Important for CB to communicate its actions clearly (eg, announcements about liquidity operations should be separated from those about policy rate) => ↓

stigma => SFs

more effective

Page 44: Monetary policy and monetary policy instruments

Restricted

44

As of March 2007 Lending SF Deposit SF Ceiling Floor

Euro area Repo

or collaterised

credit Deposit Policy rate + 75 bp

(since 13/05/09)

Policy rate -

75bp (since 13/05/09)

Indonesia Repo Deposit Policy rate + 300 bp Policy rate -

500 bpMalaysia Repo

or collaterised

credit Direct borrowing Policy rate + 25 bp Policy rate -

25bp

New Zealand Repo Deposit Policy rate + 50 bp Policy rate

Singapore Collaterised

credit Deposit O/N cash rate + 50 bp O/N cash rate -

50 bp

Taiwan Fixed rate loan Discount rate + 37.5 bp

UK Repo Deposit Policy rate + 25 bp

(since Oct 2008)

Policy rate -

25 bp

(since Oct 2008)

Page 45: Monetary policy and monetary policy instruments

Restricted

45

Discretionary monetary operations

Done at the initiative of CB with

Voluntary participation

of the banking

system

Most flexible & widely-used

tool by CB for liquidity management

Can be used

regularly or irregularly

and

in any quantity

Influence interbank

rates to ↓

volatility

of ST rates, or to steer interbank

rates

towards levels considered appropriate with the desired stance of monetary policy

& consistent with macroeconomic policies.

Require a certain number of conditions to be effective

Come with large choice

of instrument-types, maturities, frequency of use

Available thru various auction/tender formats

Used in both primary markets

(first-time instrument issue) and secondary

markets

(trading of already issued instruments)

Page 46: Monetary policy and monetary policy instruments

Restricted

46

Conduct of discretionary monetary operations

2 ways:•

Can be actively aimed at a given quantity of reserves, letting the price of reserves fluctuate

freely along with fluctuations in the

pressure on banks’

liquidity.

Can be aimed at a particular market interest rate, letting the amount of reserves

provided at the central bank’s own initiative to be

determined passively as a function of demand at that price.

Well functioning interbank

market

& Liberalized interest rates

No interbank

market = NO issuance of securities & CB paper = no discretionary monetary operation

Interest rate controls => disintermediation

Conditions for implementation

Page 47: Monetary policy and monetary policy instruments

Restricted

47

Conditions for implementation (cont.)

Sound, competitive banks

for rapid and efficient transmission mechanism

Adequate book-entry, payment and settlement systems

to build up confidence

& increase flexibility of operations

Technical capacity of central bank

liquidity forecasting

If a bank doubts quality of forecast, it will be reluctant to participate in an OMO

Effective banking supervision & CB autonomy

(capital standards, doubtful

loans provisioning, collateral requirements, enforcement, financial reporting, etc)

Prudent fiscal policy: conflicts with debt management goals•

Monetary policy MUST be insulated

from deficit financing & needs fiscal

discipline

on the part of the government to be effective

Page 48: Monetary policy and monetary policy instruments

Restricted

48

Types of discretionary monetary operations

Open Market-Type Operations (OMO-type) •

Issuance of CB paper

or government securities

in primary market => this

absorbs excess liquidity•

Direct borrowing/lending in interbank

market with underlying assets as

collateral: eg, auctioning CB credit => this injects liquidity•

Difference with SFs

which are at initiative of banking system

(not CB)

Transfer

of fixed-term public entity

deposits

Open Market Operations (OMO)•

Outright

purchases/sales of domestic currency assets in secondary market

permanent (sales = excess liquidity absorption)•

Reversed

purchases/sales of domestic currency

assets (repos

and reverse

repos) & foreign currency

assets (FX swaps) →

temporary (purchases = liquidity injection)

Page 49: Monetary policy and monetary policy instruments

Restricted

49

Primary market issuance of CB paper & Govt. securities

Risk-free => highly sought-after; Issuance to withdraw excess liquidity

Most commonly-used OMO in developing countries

and at initial transition stages

to use of indirect instruments –

foundation for secondary markets

Rough-tuning liquidity management•

Securities issued tend to have long maturities

=> not suitable for ST

interest-rate setting•

Banks may bid for liquidity management reasons not in line with CB’s plans

Issuance of CB paper •

CB independence•

but in case of loss, may ultimately => ↓

CB independence

Used when:•

separation needed

bet. Monetary & fiscal policy goals

CB more creditworthy

than government or govt securities not available •

Coordination

with Treasury needed to protect CB independence

May be detrimental to development of active govt securities market

Page 50: Monetary policy and monetary policy instruments

Restricted

50

Primary market issuance of CB paper & Govt. securities (cont)

Issuing government securities-

coordination with govt debt manager necessary as govt securities also used in fiscal policy•

Reserve neutral: CB reinvests

proceeds of maturing securities into new

securities•

Reserve draining: CB redeems

maturing securities

Coordination with government debt issuance•

1 possible coordination solution: govt issues for structural liquidity purposes & CB for temporary liquidity purposes, with pre-agreed limits

If CB engages on LT structural issuance, advanced planning

rather than ad-hoc better (avoid uncertainties & disruptions)

Makes sense to harmonise securities’

specification

(same registry, discount yield, collateral, etc)

Page 51: Monetary policy and monetary policy instruments

Restricted

51

Open Market Operations (OMO): Secondary market operations

More flexible

and larger choice

of operations/instruments than primary market operations•

permanent (outright sales/purchases of securities & foreign exchange)

temporary (repos/reverse repos, FX swaps, deposits & collaterised

lending)•

Final impact on liquidity depends on

depth

of secondary market & CB has to

have adequate stock of marketable assets

Even If No govt

securities

available or held by LT investors => secondary mkts still allow CB to carry out OMOs

by using private sector paper, CB bills and FC

Permanent operations: best for basic/structural liquidity

needs & if CB seeks to impact on market price of specific asset

=> permanent ∆

in reserve balances

Outright transactions: assets are bought or sold up to their maturity•

May hinder market development when secondary market thin

Page 52: Monetary policy and monetary policy instruments

Restricted

52

Open Market Operations (OMO): Secondary market operations (cont.)

Foreign exchange outright transactions•

Widely used in developing & transition economies

Problem: spillover

effects

=> better use repos

of FX swaps instead•

In dollarised

countries: FX transactions (permanent) may affect exchange

rate while FX swaps

will not•

CB more exposed to settlement risk

Temporary operations

(reversible and more flexible): best for fine-tuning & if CB does not want to influence market price of specific asset

Collateral in reversed operations•

CBs tend to accept long lists of collateral

to avoid endangering monetary

policy => risk control measures needed

(more later)

Page 53: Monetary policy and monetary policy instruments

Restricted

53

Repurchase agreements (repos)

Defined as ST collaterised

loans

(usually < 2 weeks & often O/N) arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date => no aggregate impact on price of individual securities

Difference with collateralised

borrowing: ownership

of the securities is not retained by the seller

Repo = liquidity injection; reverse-repo = liquidity-draining

Most flexible and common

OMO

Good for offsetting seasonal/cyclical fluctuations

& when immediacy of response necessary

Play crucial role in reallocation of liquidity among banks

(during normal times)

Act as a safety net for smoothing interbank

cashflows

(in turbulent times)

Page 54: Monetary policy and monetary policy instruments

Restricted

54

Liquidity management options for the CB

Permanent Liquidity Shortage (Surplus)•

Buy CB bills or government securities

before they expire in the primary

market (issue new government securities or CB bills)•

Outright purchase

(sale) of foreign exchange

in the secondary market

Temporary Liquidity Shortage (Surplus)•

Provide short-term collaterised

loans (SFc)

to banks (invite banks to deposit

short-term remunerated deposits; SFd)•

Purchase

(sell) short-dated outright bills or foreign exchange

Offer repo

(reverse repo) transactions where the CB BUYS

(SELLS) securities from banks

Purchase (sell)

FX from banks

and sells (buys) domestic currency to swap them at a specified price at a given date (FX swaps) in the near

future

Page 55: Monetary policy and monetary policy instruments

Restricted

55

Maturity of discretionary monetary instruments

Short-term

operations best if CB wants to affect ST interest rates or

the exchange rate and help liquidity management (market needs cash!)

Long-term

operations best (outright transactions) if CB wishes to

adjust market’s structural liquidity position

LT operations not suitable to influence interest rates, as they can:•

Dilute the impact of monetary policy decisions

=> speculation•

Confuse the yield curve

=> pivoting, i.e, ST rates ↓

=> distortions in yield curve•

if CB wants to drain liquidity => banks reluctant to participate

Page 56: Monetary policy and monetary policy instruments

Restricted

56

Frequency: Regular and irregular operations

Regular (Eg: ECB’s

MROs

& LTROs)

Operations conducted according to an indicative calendar•

Steer interest rates & signal policy stance

Function of

: Reserve averaging, OMO maturity, volatility & size of flows of autonomous factors v/s

size of RR, CB’s commitment to interest rate

stability•

Eg: ECB: weekly Main Refinancing Operations (MRO)

Irregular: at short notice

& to react to unexpected shocks, with usually

much smaller group of banks

(sometimes 1-to-1)•

Operations much faster than regular OMO; eg, fine-tuning operations

To smooth effects on interest rates

caused by unexpected liquidity ƥ

No standardised

maturity; no indicative calendar

Freq of use has ↑

significantly during recent financial crisis

Page 57: Monetary policy and monetary policy instruments

Restricted

57

Frequency: Regular and irregular operations (cont.)

Frontloading and fine-tuning operations (FTOs) during the MP•

Frontloading: CB allots above benchmark

(creates surplus liquidity) at

beginning of MP

& gradually withdraws surplus until end of MP.•

Goal: generate expectations of interest target close to Policy rate

on last day

of MP

because:•

prob

(banks would have to borrow in unsecured market at high rates if

they cannot use SFs)•

prob

(banks fulfill their RR early in the MP)

Problem: more volatility of ST interest rates on other days of MP

Problems with irregular bilateral operations•

May not be visible, equitable and not distribute liquidity efficiently

Signaling effect: 1 counterparty knows about the CB’s actions –

competitive advantage over other banks who might be less willing to participate

as they

judge situation unfair

Page 58: Monetary policy and monetary policy instruments

Restricted

58

Auction techniques

All discretionary monetary operations are conducted via auctions

Standard tenders•

Regular; publicly announced

by means of wire services; eg

ECB’s

MRO &

LTRO

Quick tenders•

Irregular; fine-tuning; little counterparties; may not be announced publicly in advance

Most auctions characterized by allotment uncertainty; exception = full allotment tenders (ECB since Oct 2008)

Fixed rate or Volume tenders•

CB acts as signal receiver

banks bid only for volumes

supplied by CB at a pre-set interest rate•

If the aggregate amount bids received exceeds total amount of liquidity to be allotted, submitted bids satisfied pro-rata

=> overbidding by banks which expect their bids to be pro-rated

Page 59: Monetary policy and monetary policy instruments

Restricted

59

Auction techniques (cont.)

Variable rate or Interest rate tenders (Eg: ECB’s

weekly MROs)•

CB acts as signal transmitter

banks bid for amount and rate.•

CB charges the rates offered

(multiple-rate auction) or the cutoff rate

(single-rate auction). •

Bids listed in descending order of offered interest rates. Bids with

highest

interest rate levels are

satisfied first

Single rate auction (Dutch auction)•

Same rate

applied for all successful bids –

the

last winning offer’s rate

becomes the current interest rate of auction•

Allotment interest rate commonly called the stop-out rate

Multiple rate auction (American auction),•

Allotment interest rate is equal to the interest rate offered for each individual bid => different rates

on allotted bids

Page 60: Monetary policy and monetary policy instruments

Restricted

60

Auction techniques (cont.)

Bid-to-cover ratio: number of bids accepted

/ number of bids that were properly submitted

in relation to the auction

Gauge of the current level of desirability

for the issue auctioned •

High ratio

=> high level of investor desire for the issue => high likelihood

that another similar auction would have good results•

In a full allotment tender

(eg, ECB since Oct 08) => ratio =1

Feature of full allotment tender: aggregate liquidity purely demand-driven (no longer determined by CB)

Initial margins (used frequently with reversed transactions)•

Initial Margin = a % of the theoretical value of underlying assets

Counterparties have to provide underlying assets with a value >=

to liquidity provided by the CB + value of the initial margin

Risk control measures with SFs & discretionary monetary operations

Page 61: Monetary policy and monetary policy instruments

Restricted

61

Risk control measures with SFs & discretionary monetary operations

Valuation haircuts•

Underlying asset value = market value of asset -

a certain % (haircut)

Variation margins (used for marking-to-market)•

haircut-adjusted market value of underlying assets

used in liquidity-

providing reverse transactions have to be maintained over time, via margin calls

Valuation markdown•

CB applies a reduction of the theoretical market value of the assets

by

a certain % before applying any valuation haircut

Separate tranches of OMO for different classes of collateral (Fed)

Limits in relation to issuers/debtors or guarantors and Exclusion•

To mitigate correlation risks

Page 62: Monetary policy and monetary policy instruments

Restricted

62

Use of discretionary operations in selected countries (up to March 2007)

Page 63: Monetary policy and monetary policy instruments

Restricted

63

Conclusion to Part IIToday, most CBs use some sort of OMO and to a lesser extent SFs

in the

conduct of monetary policy. Differences are more on type & maturity of instruments used, collateral used and frequency of operations. These are influenced by the regime, the economic structure & openness, degree of development of primary and secondary markets for securities, credibility & independence of the CB

as well as its’

expertise in managing liquidity

and

the accuracy of its’

liquidity forecasts.

The current financial crisis

has shown that having highly developed & liberalised

interbank

markets and being able to use all sorts of instruments of

monetary policy available do not guarantee success. Enforcement

through regulation and cooperation with government debt management

policy are

crucial, together with the need for the CB to make good forecasts of autonomous factors

and take necessary measures early enough to counter

any adverse shocks…

Page 64: Monetary policy and monetary policy instruments

Restricted

64

Part III

Financial crisis development stages

Major CB operations in advanced countries

Unconventional Monetary Policies (UMP)

Effects on Emerging markets

Effects on African countries

Page 65: Monetary policy and monetary policy instruments

Restricted

Main features of the current financial crisis

Unprecedented

in its global reach

(main difference with past banking crises) and Reactions of CBs

(monetary policy easing to provide ample liquidity) & by

govts

(fiscal stimulus and bank rescue packages)

Consequences:•

Many advanced economies CBs have used up the usual tools of mon

pol

(like policy rate cuts (cut to almost 0 in US & UK)) –

had to resort to unconventional monetary policies

to provide liquidity => huge ↑

in size of

balance sheets & ∆

in composition

(=> ↑

risks of losses for CB)•

Government interventions

to restore confidence in banking systems &

safeguard flows of credit have affected public finances & raised

questions on their sustainability => large ↑

in sovereign credit risk, fiscal debt &

deficits

Exit strategies

(timing & scale), adequate

legal & institutional frameworks, disclosure of information by involved parties

& differentiated resolution (to

minimize moral hazard) VITAL

for success of interventions•

Success => direct effect on confidence & future credibility of policies

Page 66: Monetary policy and monetary policy instruments

Restricted

66

Development of the crisis (Aug 07 to mid-July 2009)Stage 1 (8/07 – 3/08): funding liquidity shortage, bank losses & writedowns

US subprime

mortgage problems=> Loss of confidence & investor retrenchment => ↑

uncertainty => ↑

concerns about counterparty & credit risk => ↑

volatility

=>

Libor –

OIS spreads (measure of liquidity risk)

=> 1st CB coordinated action & introduction of USD swap lines

Mounting writedowns

& fears of downgrades

=> forced sale of assets

in thin markets => ↑

deleveraging

& insolvency

Stage 2 (3/08 – 15/09/08): insolvency concerns & Lehman failure

insolvency

concerns => ↑

liquidity hoarding

& more concerns over counterparty risks => further ↑

in CDS spreads (meas. of counterparty risk)

& ↓

equity markets

Tightening collateral conditions => ↑

pressure on investment banks => failure of Lehman Brothers

(15/09/2008)

=> Turning Point

(until then, CBs were concerned

with persistently high inflation

& thus resisted cutting policy rates

(except Fed)) => sudden escalation of fears of disinflation => drastic policy rate cuts to almost 0 by May 09 in many industrialized countries

Page 67: Monetary policy and monetary policy instruments

Restricted

67

Development of the crisis (Aug 07 to mid-July 2009, cont.)Stage 3 (15/09/08 – 10/08): market turmoil becomes a global crisis

Lehman failure (LF) => crisis of confidence

& ↑

mutual funds’

exposure

to LF- issued notes => forced liquidation

of assets => ↑

demand for USD interbank

funds

LF => Use of Unconventional Monetary Policies by CBs &

massive govt intervention

(guarantees, recapitalisation/nationalisation, asset purchases)

Stage 4 (10/08 – 03/09): Global economic downturn

Questions arising about scope of govt

intervention

& impact on debt holdings

=> big pricing differences across capital structure => ↑

sovereign CDS spreads

Fiscal stimulus

plans to stimulate demand & growth

Stage 5 (since mid-March 09): signs of improving situation

Unprecedented policy actions =>

stabilization of financial conditions & ↓

in systemic risks

optimism; ↓

volatility; ↑

asset prices; ↓

LT ylds; equity prices ↑

=> ↓

Libor-OIS spreads & CDS spreads

Lending conditions still very tight, esp, cross-border lending

Page 68: Monetary policy and monetary policy instruments

Restricted

68

Spreads, equity prices and distressed conditions

LF => large ↑

in Libor-OIS spreads, writedowns

& CDS spreads; big ↓

in equity pricesLF=> ↑

capital injections (esp. Q4 08 & Q1 09); ↑

govt

share in Q4 08

Deteriorating credit quality => ↑

writedowns

=> ↑

deleveraging

=> ↓

credit growthDomestic official support (=> ↑

Home bias) & FX swap market impairment =>

cross-border funding => ↑

cross-border deleveraging

affecting EMEs

a lotConcern over fiscal sustainability & tight lending conditions =>

CDS spreads still higher

than pre-crisis levels

Page 69: Monetary policy and monetary policy instruments

Restricted

69

Credit standards and bank loan growth

“Too”

accommodative conditions from 04 to mid-07 (negative)Severe liquidity hoarding but recently loosening lending conditions but still tight compared to pre-crisis periodSignificant slowdown in loan growth (US & XM) –

signs that confidence still wary &

after-effects of deleveraging

& home bias affecting cross-border lendingJP exception –

helped by cheap cost of capital (almost 0 interest rates)

Page 70: Monetary policy and monetary policy instruments

Restricted

70

Volatility indicators

Significant ↓

in equity & exch

rate volatility after all-time highs after LF

(Sep 08); levels almost back to pre-crisis levels

Bond volatility still high => effects of aggressive government intervention (purchases of securities)

Page 71: Monetary policy and monetary policy instruments

Restricted

71

Major CB operations to counter the crisis (industrial countries)

So far, 3 kinds of CB responses, by targeted objective:•

Achieve official stance of monetary policy (conventional liquidity easing)

Influence wholesale interbank

market

conditions (conventional liquidity easing, but unconventional in range & magnitude)

Influence credit market and broader financial conditions

(UMP)•

Credit (CE) –

growth of asset side of CB balance sheet

Quantitative easing (QE) –

growth of

liability side of CB balance sheet (∆ in bank reserves)

(UMP = Unconventional Monetary Policy)

Results:•

Improvement recently (lower spreads & volatility & ↑

asset prices)

huge ↑

in CB’s balance sheet & ∆

in composition•

=> greater risk exposure for CB => ↑

threats to CB independence

=> ↑

importance of more coordination with fiscal authorities

Page 72: Monetary policy and monetary policy instruments

Restricted

72

Main characteristics of CB actions during the crisis

Higher

freq of fine-tuning operations

(for more sensitive responses)

More favourable

SF lending

facilities (help cap ST interest rates)

Increased supply of LT funds

(accommodate demand for term funds)

Wider range of collateral

& set of counterparties

(improve access &

distribution of CB funds)

Increased securities lending

(underpin market liquidity)

Increased reserves cushion

(dampen fluctuations in reserves demand by

remuneration of RR & increasing tolerance range around target RR)

Increased international cooperation

(facilitate cross-border distribution of

liquidity, eg. FX swap lines)

Direct funding & purchases

(reduce systemic risks from impaired to

unimpaired markets)

Page 73: Monetary policy and monetary policy instruments

Restricted

73

Achieve the official stance of monetary policy (conventional MP)

instability

of reserves demand =>↑

flexibility (& volatility) in supply

of

reserves

Narrower corridorNarrower corridor

=> ↓

interest rate volatility

& ↑

use of SFs

safety valve

Liquidity-draining operations:

issuance of CB bills

(BoE, SNB)•

Accept more ST deposits & Treasury deposits

remuneration rate on RR

to ↑

their attractiveness

In line with CB’s LOLR to banks; difference on range & magnitude

Page 74: Monetary policy and monetary policy instruments

Restricted

74

Influence wholesale interbank market conditions (conventional MP)

In line with CB’s LOLR fn; diff

on wider range

& magnitude v/s

trad. levels

Main goal: ↓

interbank

market spreads to:•

Provide more term funding

& Smooth distribution of reserves

FX swap lines = facilitate FC provision; main balance sheet expansion factor

Lending highly liquid securities against less liquid

assets & doubtful collateral => ↑

credit & market risk for CB

Page 75: Monetary policy and monetary policy instruments

Restricted

75

Influence credit market and broader financial conditions (UMP)

Main goal: alleviate tightening non-bank

credit conditions –

CB as LOLR Mostly at stages 3, 4 & 5

(intensification before better conditions)

Securities purchases –

quasi-fiscal element

=> need more careful coordination with debt mgt operations!!!

QE when CB cannot ↓

int

rates further as they are at 0!!! –

assets purchase => ↑ deposits at CB => ↑

excess reserves

that could be used for lending purposes

CE

focuses on mix of loans & securities

held by CB => ∆

asset composition

Page 76: Monetary policy and monetary policy instruments

Restricted

76

How do UMPs feed into the real economy?

Communication:

conditional CB statements

on future path of policy

& objectives => ∆

inflation expectations

& risk premia

To avoid misinterpretations,

CB to give broad info also in normal times

about factors expected to influence upcoming OMOs

=>

familiarisation

Quantitative easing

(QE):

reserves via pre-specified

outright purchases

of government or government-guaranteed

securities

from banks

Kicks in when policy rates = or close to 0 –

instrument of mon. policy shifts towards the quantity of money

provided

rather than int. rate

Goal:

↓longer-term int. rate independently of risk & control inflation

Affect market for risk free assets, typically longer-term govt

bonds

Problem:

LT yields are already very low!!! Why lower them more?

Example:

Japan (03/01 to 03/06) –

flood the market with excess yen liquidity to ↑

inflation to +ve

levels, while committing to zero int. rates.

Page 77: Monetary policy and monetary policy instruments

Restricted

77

How do UMPs feed into the real economy? (cont.)

Credit easing

(CE):

credit flows

via purchases of private

assets

in

specific sectors/markets or direct financing to corporate borrowers•

Problems:

Credit risk & resource reallocation issues => “blurring”

of

line between fiscal & monetary policy => danger to CB independence

CE

affects risk spread across assets between well-functioning markets

and those that are impaired

Many CBs don’t distinguish QE from CE

Endogenous credit easing

(ECE):

lending to banks at longer maturities,

against collateral that includes assets whose markets are temporarily impaired via

fixed rate tender procedures with full allotment (ECB)

Page 78: Monetary policy and monetary policy instruments

Restricted

78

Quantitative easing in Japan (March 01 – March 06)

19/03/01: shift of operating target

from O/N call rate to level of current acct balances

(reserves) at banks (changed 9 times until 09/03/06)

Accompanied by outright purchases of LT JP govt

securities

Results: •

in BOJ’s

balance sheet

Lowering of term-structure of govt

securities•

uncertainty about future funding & pickup in economic activity

Inflation (Y/Y % change) CAB (tr. Yen) Policy rates

Page 79: Monetary policy and monetary policy instruments

Restricted

79

Risks and challenges posed by UMP

Inadvertent credit allocation to inefficient markets

=> constrain financial

sector restructuring in ST=> impair future economic growth

Replacement of high-quality liquid assets with illiquid claims

on CB

balance sheets => constrain monetary management

Quasi-fiscal nature

blurs distinction

between monetary and fiscal policies

=> potentially compromise central bank independence

Inflation potential

of ↑

reserve money

=> ↑

inflation expectations in

response to some announcements of UMP•

Ongoing and detailed communication can help to reduce the risks

Page 80: Monetary policy and monetary policy instruments

Restricted

80

Effects on CB assets and repos

UMP => large ↑

in CB balance sheet (Fed’s & BoE’s

assets

almost X3, by end-08)

Reflection of aggressiveness of easing

& nature of financial system

Liquidity injection X4

for BoE & more than tenfold for Fed

Highly volatile use of LT repos

(from 0 to 100 %) –

reflects high freq of LT fine- tuning operations

and their irregular nature

Page 81: Monetary policy and monetary policy instruments

Restricted

81

Effects on Central Bank asset composition (billions of national currency)

Fed & BOJ more active in buying govt

& private

securities

than BoE & ECB

Stigma attached to use of discount window in US

(before end-08) limited use until then. TAF => increase in use of lending facilities

ECB & BoE use lending facilities more intensively

than securities’

purchases (more temporary v/s

permanent liq

mgt)

Use of FC ↓

compared to end-08, esp

with BoE –

replaced by direct lending

Page 82: Monetary policy and monetary policy instruments

Restricted

82

Effects on interest rates & OMO in the US

Policy rate almost 0

Improving signs… TAF has helped

in

easing money market conditions…

Massive liquidity injections

=> Funding

spreads

now very low at all maturities & less volatile

=> sign

of improving funding conditions

Bid-to-cover ratio ↓ => urgent need to

borrow ↓

Stop-out rate no longer > min. bid rate –

growing investor

confidence

Page 83: Monetary policy and monetary policy instruments

Restricted

83

Effects on interest rates & OMO in the euro area

Fixed-rate MRO with full allotment period

Unlike US, policy rate > 0

(1% on 22/07/09)

Funding spreads very low

at all maturities, but

still high volatility

Fixed-rate MRO

with full allotment

(since

15/10/08) to restore confidence

7 May 09: plan to purchase covered bonds

=> ↓

spreads & encourage LT funding

Problem:

instead of lending, banks ↑

use of

deposit facilities…

Page 84: Monetary policy and monetary policy instruments

Restricted

84

Effects of government bank-rescue packages on 5-year CDS spreads Unweighted average; in basis points

Spreads have ↓

from peaks, everywhere

Banks with govt

support not doing better

than those without support (Europe & UK)

Consistency of govt

guarantees important as lack of clarity slows banks’

efforts to secure funding & dampen investor interest

Page 85: Monetary policy and monetary policy instruments

Restricted

85

Performance of major banks until late July 2009

Mixed feelings, but on the whole still in negative

Uk

and esp. US banks in very bad shape, in spite of gov

& private

support (except GS)

Asia-based banks globally in better shape

Still high CDS spreads –

threat to

investors’

viability

Page 86: Monetary policy and monetary policy instruments

Restricted

86

Going forward: difficulty with assessing real impact of UMPs

New “untested”

environment (lack of experience) => calibration

problems

Assumptions based on past experience

may not be a good guide for the future

Transmission channels are impaired & unconventional: directed measures => distortions & interactions between standard & non-standard elements

Lags &

Durability of impact

is it going to last? How to unwind positions smoothly? When to do so?

Communication:

misunderstood decisions => negative effects on economic agents

Success depends on design & magnitude

of the measures but also on the willingness and ability

of creditors to lend & of borrowers to borrow

Density of different measures & international dimension

of certain measures (FX swaps lines) => uncertainty on which effects

attributable to which measure?

Page 87: Monetary policy and monetary policy instruments

Restricted

87

Going forward: exit strategies

Needed to give borrowers an incentive to return to interbank

markets

Should include retightening of funding conditions, traditional liquidity-draining operations

& RR readjustment

Liquidity-draining options:•

Sale of securities outright; reverse repos

;↑

attractivity

of bank

reserves holdings; Issue CB bills

ST operations CAN be allowed to expire

and rising interest rates

will

act as a disincentive to continue to use the CB as counterparty

LT assets-

more difficult to offload

More important for exit:

TIMING of exit & NOT the unwinding of

balance sheet size

Page 88: Monetary policy and monetary policy instruments

Restricted

88

Going forward: exit strategies (cont.)

Why? Because:•

Tightening “too early”

=> with low inflation, ↑

interest rates => ↓

inflation, investment & consumption •

Tightening “too late”

=> high inflation

=> large imbalances =>

another cycle of ↑

leverage & ballooning asset prices (base of current crisis)

Communication & clear explanation of policy decisions•

Very important for CB credibility

Bad communication

=> ambiguous reaction to news & stigma•

Clear separation of monetary & fiscal policies

to maintain

operational independence of CB

Page 89: Monetary policy and monetary policy instruments

Restricted

89

What about emerging markets?

Pretty resilient until late 2008

(less developed financial markets, banks

with lower leverage ratios, strong domestic demand, high level of FX reserves, lags in contagion effects)

Downside risks

materialize in early 2009

trade volumes (& receipts) & ↓

commodity prices

=> ↓

macroeconomic

growth

Deleveraging

(=> sale of EME subsidiaries & net capital outflows (home

bias

& higher regulatory capital charges

due to currency risks) => ↓

FDI & credit-rationing

=> ↑

refinancing problems & insolvency pressures

High external debt refinancing needs

=> EMEs

very exposed to financial

distress

Strong & coordinated policy actions needed from EME policymakers

Page 90: Monetary policy and monetary policy instruments

Restricted

90

EME asset classes’ Heat map

Pretty resilient until late 2008

consumption in earlier-hit advanced economies

=> ↓

exports, production & sales as revenues in EMEs

Spillover effects

creeping in through the financial system (banks and corporates facing funding problems)

Downgrades & crowding-out effects

affecting Sovereign spreads

Growing uncertainty & loss of investor confidence

affecting equity markets as domestic conditions worsen

Page 91: Monetary policy and monetary policy instruments

Restricted

91

Emerging market high-frequency indicators

Financial markets take full toll in Q4 08 => large depreciations

to support exports

Liquidity hoarding & fiscal stimulus sustainability uncertainty => ↑

sovereign spreads

equity prices & CDS spreads ↑

as confidence drops

Bond yields ∆

a lot as uncertainty grows over authorities’

actions

Page 92: Monetary policy and monetary policy instruments

Restricted

92

Emerging market exposure to spillover risks from advanced countries and CB balance sheet

EMEs’

dependence on advanced economies ↑

in recent years –

more exposed to spillover effects due to lower demand in advanced countries (=> falling prices and trade flows), liquidity hoarding, home bias, capital retrenchment (=>lower FDI), lower donor and remittance revenues

Large policy rate cut impact mitigated by ↓

inflation (=> real int

rates constant) + tighter funding conditions (more cautious banks & ↑

risk premiums)=> ↓

private

credit growth => need for UMP (=> ↑

CB assets)

Page 93: Monetary policy and monetary policy instruments

Restricted

93

Policy actions

policy rates, RR and SFc↓

=>

expand liquidity provisioning

OMO:

repos

=> inject liquidity; OMO-type: US$ swaps or outright sales of FC to local banks to counter ↓

cross-border bank funding

Establishment of swap lines

with advanced country CBs for some EME CBs

International lending facilities

(IMF’s

Flexible Credit Line, modernization of conditionality & simplification of lending terms)

UMP: Directed private sector credit support (purchase of LT corp

bonds & deposit insurance schemes) => ↓

LT yields & ↑

confidence in local banks

Govt

support: guarantees to bank lending & spending on infrastructure (less on personal tax reliefs)

Problem: most packages currently programmed to wind down in 2010

& levels below model-based baseline scenarios

Page 94: Monetary policy and monetary policy instruments

Restricted

94

Policy actions (cont)

Limited effects so far: still tepid flows into EME assets & severely strained funding & credit markets => deteriorating credit quality

EME CB balance sheets have not ↑

like those of advanced countries•

reflection of tighter constraints on EME liquidity easing

(higher external

vulnerability, shallower financial markets, conflicts between macroeconomic and systemic stability objectives, and less firm CB independence)

Firmer govt

commitments on fiscal stimulus needed

as EMEs

do not have extensive “automatic stabilizers”

like in advanced countries (like unemployment

insurance, etc)

Road ahead:•

More policy rate cuts & UMP

(liquidity injection & credit flow support measures)

more govt

commitment

to support banks & corporates

(for liquidity and credit needs), regulatory measures to facilitate creditor coordination

Rely less on exports

& promote domestic consumption/demand

while avoiding protectionist behaviors

Page 95: Monetary policy and monetary policy instruments

Restricted

95

Characteristics of Sub-Saharan African financial markets

Shallow or undeveloped financial markets

(CBs do not have many alternative means

to counter liquidity squeezes) => significant exposure to counterparty

risk, lack of collateral, deficiencies in the payment system,

etc; this feature has also limited contagion thru interbank

markets & lower liquidity pressures

Substantial liquidity buffers: large share of T-Bills & other liquid assets in CB balance sheet

Certain direct instruments & RR

still widely used

compared to other indirect instruments & other regions

RRs

generally high, uniform across maturities & unremunerated

Differentiated RR ratios between LC & FC deposits

& Large share of FC deposits as % of total deposits => destabilizing shocks on the money multiplier are amplified => complicate CB liquidity management

Weak & unstable domestic currencies; High & volatile interest rates & inflation

High corruption, weak or non-existent CB independence

& Heavy reliance

on revenues from export of commodities & raw materials, remittances, donor funds & FDI

from developed countries governments

Page 96: Monetary policy and monetary policy instruments

Restricted

96

Effect of the crisis on African countries (cont)

So far, pretty resilient-

limited integration with global fin markets, relatively high bank liquidity, low leverage & limited reliance on foreign funding

Like other EMEs,

Africa exposed to spillover effects of financial crisis to real economy

& deleveraging

from developed countries

Oil exporters &

financially more developed countries

hardest hit initially

Main concerns:

Tightening of global credit

=> Capital & FDI inflow, tourism, textiles & remittances revenues ↓; too thin domestic markets may not be able to accommodate demand for credit =>↑

credit & liquidity risks

Last hour:

Outlook slowing improving

(recovery in commodity prices & growth prospects + return of risk appetite =>resumption of foreign portfolio inflows) –

Africa will benefit from these with delays, though…

Risks remain:

confidence still fragile, weak bank balance sheets, lower than expected

global growth, constrained international bank lending & questions on

fiscal sustainability of public sector support & exit strategies adopted in developed countries that may have

adverse effects on EMEs

& Africa…

Page 97: Monetary policy and monetary policy instruments

Restricted

97

Sub-Saharan Africa : easing monetary & fiscal policies

SSA countries have fewer & less effective policy instruments: fiscal multipliers are lower, financing constraints more binding, debt sustainability issues more pressing, monetary policy options limited by currency arrangements

Countercyclical monetary policies:

1st

half: high commodity prices => tightening of monetary policies

Since 2nd

half: ↓

commodity prices => loosening of monetary policies

Exchange rate depreciations may ↑

export-competitiveness, but may ↑

inflation

Page 98: Monetary policy and monetary policy instruments

Restricted

98

Effect of the crisis on African countries

Less developed fin. markets

=> delayed crisis effects

via ↓

commodity prices, liquidity hoarding & capital repatriation by foreign banks & investors

in commodity prices

& demand and lower capital

& FDI and remittances

=> ↓ trade flows => ↑

current account deficit & fiscal deficit & ↓

GDP

Tighter global funding conditions

=> spillover effects => ↓

money supply

Sovereign spreads

back to pre-crisis levels after peaking around end-08

Conditions in equity markets

improving, but still a long way to go

Page 99: Monetary policy and monetary policy instruments

Restricted

99

Policy challenges within Africa

No single recipe -

circumstances differ so much across countries

Priority

for all countries : protect the hard-won improvements in

economic fundamentals

-

more sustainable debt levels, lower inflation, liberalized trade and structural reforms & ST preventive measures to minimize contagion

ST priorities should not detract govts

from the need for LT reforms to

build & diversify financial systems

Fiscal stimulus

MUST be used judiciously for countries enjoying

macroeconomic stability & sustainable debt levels

Countries with deteriorated terms of trade: depreciate real exchange rates to preserve macroeconomic stability

while keeping fiscal and

monetary policies sufficiently tight to avoid a devaluation-inflation spiral

Page 100: Monetary policy and monetary policy instruments

Restricted

Policy challenges within Africa (cont)

Early risk detection measures (stress-testing of banks)

Closely monitor the balance sheets of financial institutions

and be

prepared to act promptly if necessary

Strengthen banking sector regulation, recapitalization of banks

and

pursue prudent capital flow management

Contingency plans => ↓

potential runs on banks & cross-border crisis

management

Regional cooperation: implement emergency assistance programmes

(AfDB

-

Emergency Liquidity Facility, the Trade Finance Initiative and other ways of support to low-income countries)

Page 101: Monetary policy and monetary policy instruments

Restricted

101

Conclusion to Part III

Signs of improving situations

indicate that unprecedented monetary easing

conditions & massive govt

intervention are being successful in restoring confidence & normalizing interbank

transactions, although credit conditions

still remain largely impaired, esp, LT

Current financial crisis has shed light on importance of:

Good liquidity management by the CB, both in calm & turbulent times –

good & timely forecasting

+ ability to carry out operations with the necessary tools independently

& to communicate clearly

its intentions (esp

on UMP &

exit strategies)

Need of close coordination between monetary & fiscal policies

& the role of

govt

support

& UMP when conventional monetary policies reach their limits

CBs to understand better asset-price & credit boom formation

& associated

risks & take necessary measures to counter them in a timely & smooth manner

Page 102: Monetary policy and monetary policy instruments

Restricted

Conclusion to Part III (cont)

Supervision & legal frameworks

that prevent build-up of excessive leverage

Contagion & spillover effects

of crises stemming from developed financial

markets to EMEs

Need for monetary & fiscal authorities in

EMEs

to come up with measures

to support local financial markets & corporates

shifts in production patterns from export-

& leverage-led growth models to more balanced &

diversified ones

Strong policy commitments that resist protectionism

& encourage an orderly

adjustment, by striking a balance bet. ST stimulus & exit strategies

that ensure LT sustainability

System-wide macroprudential

policies

able to tackle procyclicality

inherent

in the financial system

& identify all risk sources & having the means to counter/reduce them to ensure global financial stability

Page 103: Monetary policy and monetary policy instruments

Restricted

103

Thank you….

Page 104: Monetary policy and monetary policy instruments

Restricted

Supportive charts…

Page 105: Monetary policy and monetary policy instruments

Restricted

Investors confidence up: global risk appetite returning…. (based on survey data on risk appetite, investment time horizon,

and cash position)

Source: Merrill Lynch.

Page 106: Monetary policy and monetary policy instruments

Restricted

Indicator of liquidity conditions (eg, depth of markets, narrowness of bid-offer spreads, ease of execution, etc) = back to normal?

Source: Merrill Lynch.