Monetary and Foreign Exchange Operations Instruments and Effectiveness

The prevailing monetary operations framework is based on monetary policy instruments and operating procedures, money and foreign exchange markets, and payment settlement system. Its design bears directly on banks' ability to manage short-term liquidity. The three structural components are closely interlinked, and they strongly influence and reinforce each other so that the design and framework of one will affect the characteristics that need to be given to the others.

The design features of monetary policy instruments affect liquidity management by banks. First, rules on averaging and maintaining reserve requirements and the rules of access, as well as volume, maturity, and rates of interest on standing facilities, all affect demand and supply of reserves and liquid assets by commercial banks. Second, those and other policy instruments influence and sometimes restrict banks' asset and liability management. Third, central banks' operating procedures in money markets can influence liquidity and efficiency of the markets in which they operate and of other related markets.

Usually banks operate in more than one currency and must, therefore, include foreign exchange considerations in their liquidity management. Access to liquidity in foreign exchange is affected by a number of factors that are different from those affecting liquidity in domestic currency. In this regard, banks operating in highly dollarized economies are faced with particular challenges. For example, deposits in domestic currency may prove less stable than those denominated in dollars. In addition, specific market and institutional factors affecting foreign exchange liquidity include (a) efficiency and liquidity of local foreign exchange markets, (b) foreign exchange intervention procedures of central banks, and (c) linkages between local and external financial markets, which will also have an important effect on liquidity in the local foreign exchange market.

Technical and institutional characteristics of payment and settlement arrangements strongly influence short-run liquidity management by commercial banks. For example, at least three factors help reduce the need for precautionary balances (Borio 1997): design of settlement procedures, access to money markets, and access to central bank facilities. First, if settlement procedures are designed to allow banks to borrow and lend among themselves toward the end of the day after settlement positions are known or can be estimated with a comparatively small margin of error, then the need for precautionary holdings of reserves is reduced. Second, provided the inter-bank market among participants works smoothly, the institutions can be reasonably confident of obtaining funds at the going market rate, and this expectation of being able to finance imbalances at a rate with no penalty also reduces demand for excess reserves. Finally, both the central bank operating procedures, including practices that discourage banks from turning to the central bank, and the market operations that smooth liquidity will encourage the development of inter-bank markets.

The ability of financial institutions to access liquid funding markets and their use of effective techniques for liquidity management will contribute to financial sector resilience. Without ready access to markets that recycle liquidity, market participants would

Box 11.4 Liquidity Forecasting Frameworks

Liquidity forecasting enables a central bank to decide on how much liquidity to provide to or withdraw from the market with the objective of smoothing undesirable fluctuations that could distort the implementation of monetary policy and could result in excessive market volatility. Liquidity forecasting involves the centralization of a wide range of information on financial transactions that affect the main items of the central bank's balance sheet, including the sources of base money creation that are not under the control of the central bank (autonomous factors), and those that are under its direct control (policy position). The supply of bank reserves can be derived as

Supply of bank reserves = Net foreign assets 1 Autonomous

+ Net credit to the government J factors + Other items net - Currency in circulation + Lendmg to brnks }

Note: Further details can be found in Schaechter (2000).

The first four items are beyond the control of the central bank in the very short run or—more generally—not related to monetary policy actions (autonomous factors). When the central bank acts as a banker to the government, the ability of the government to prepare accurate cash-flow projections and to share them with the central bank is vital for liquidity forecasts, because variations in the net position of the government often account for the most significant changes in liquidity supply.

In contrast, the policy position consists of central bank lending to banks through a standing facility, and net lending through discretionary money market operations.

be severely constrained in managing payments, transforming maturities, and managing interest rate risk, hence undermining prudent intermediation. Sound arrangements provide confidence to the market that liquidity can be mobilized and repaid on demand in a predictable and transparent manner.

Effective liquidity management by central banks—management that is based on anticipating liquidity conditions in money markets and acting at their own initiative to smooth liquidity—is essential both for monetary policy implementation and for a well-functioning money market that provides access to liquid funds. Forecasting the banking system's liquidity situation is a key element of a central bank's liquidity management framework (box 11.4). The main purpose of the framework is to create an information set that puts the central bank in a position to decide on the size of the central bank's operations in the money market, and to smooth changes in liquidity conditions in the money market at its own initiative to create stable liquidity conditions and to steer the central bank's operating target effectively.

For effective liquidity management, central banks rely on a wide range of monetary and foreign exchange instruments, in accord with the legal provisions governing the conduct of monetary policy. The mix of instruments that a central bank relies on varies from country to country and from time to time, depending on the state of development of financial market and monetary policy objectives (see box 11.5). The central bank may choose to regulate monetary and credit expansion by using administrative measures that set limits on the price (interest rate controls) or the quantity (credit ceilings) of bank borrowing and lending operations. Alternatively, it may seek to exploit its monopoly in the creation of base money to regulate overall liquidity conditions in the economy

Box 11.5 Monetary Policy Instruments

Rules-Based Instruments

Rules-based instruments include reserve requirements (RRs), liquid asset ratios (LARs), and standing facilities. Unlike money market instruments (which are market-based), rules-based instruments are based on the regulatory power of the central bank.

RRs are requirements for a bank to hold minimum reserves with the central bank, typically as a percentage of its liabilities. When averaging provisions are allowed, banks can fulfill RRs on the basis of average reserve holdings during the maintenance period. RRs serve the following functions: a buffer function for short-term money market rates when averaging provisions apply, a liquidity management function, and a seignorage function when they are not remunerated or remunerated at below-market rates. Efficient cash management requires that sufficient liquid assets are held to meet normal business requirements. Where this voluntary demand for liquid assets coincides with the requirement for reserve holdings, the requirement does not constitute a problem for banks if they are generally able to mobilize these RRs for liquidity management purposes. If RRs are set very low, banks have less leeway through averaging to manipulate their reserve positions without the risk of incurring the penalty of noncompliance. In such cases, banks would have to voluntarily maintain higher levels of reserves.

LARs require a bank to hold minimum amounts of specified liquid assets, typically as a percentage of the bank's liabilities. Where government securities qualify as the main eligible asset, the restrictions (if binding) limit the volume of securities that can be readily used to realize liquidity in the short run. Some countries impose restrictions on banks' loan portfolios by stipulating proportions to be lent to particular sectors or by setting absolute quantitative ceilings on outstanding credit. In the former case, the restriction limits the ability of banks to sell loans affected by the stipulation, while in the latter case, income is constrained and so reduces the incentive to sell those assets in the event that liquidity is needed. Ceilings on loan rates or interest spreads reduce the flexibility to price loan assets for sale.

Standing facilities are policy instruments that may be used at the initiative of banks and that bear a pre-specified interest rate. Refinance standing facilities allow banks to borrow from the central bank; deposit standing facilities allow banks to deposit funds with the central bank. In settlement facilities and in some rediscount arrangements, credit is provided at mar ket or below-market rates. In the latter case, many central banks establish volume limits on access to this window or alternately limit usage through moral suasion. For commercial bank liquidity, the management, the rules of access, the volume of credit allowed, and the maturity and rates of interest on the credit available are all relevant design features. In this regard, many countries operate standing credit facilities, most often with unlimited volumes of credit at market or above-market rates. In the case of rediscount operations, the bulk of credit is restrained by penalty rates of interest rather than volume restrictions. Some countries restrict the number of banks that can access the overnight standing facilities, the frequency of access, and the intervals between access.

Money Market Operations

These operations are transactions in money market instruments initiated by the central bank and operated through a competitive mechanism that aims at adding (liquidity providing operations) or withdrawing (liquidity absorbing operations) reserves to and from the system, respectively. Money market operations include the following:

• Open market operations (OMO). Those operations are conducted by the central bank as a participant in regular markets. They involve (a) buying and selling assets outright on the secondary market, and (b) buying and selling assets under a repurchase agreement in the repo market or foreign exchange swaps.

• OMO-type operations. Those operations are conducted using a specific central bank instrument. OMO-type operations involve (a) lending and borrowing against underlying assets as collateral, (b) primary market issuance of central bank securities or government securities for monetary policy purposes, (c) accepting fixed-term deposits, and (d) auctions of foreign exchange (as a tool for both foreign exchange and liquidity management).

• In their market operations, central banks may use various auction techniques. With volume tenders, banks bid only for volumes supplied by the central bank at a preset interest rate. With interest rate tenders, banks bid for the amount and the rate; the central bank charges the rates offered (multiple-rate auction) or the cutoff rate (uniform-rate auction).

Note: Further details can be found in Balino and Zamalloa (1997).

by influencing the underlying demand and supply conditions for central bank money. It does so by exchanging financial assets (domestic assets or foreign exchange) for its own liabilities (hereafter referred to as money market operations), or by requiring banks to maintain minimum balances with the central bank (reserve requirements). All of those measures are aimed at influencing the balance sheet of the commercial banks, either directly (through administrative measures) or indirectly (through the balance sheet of the central bank and its money market operations and reserve requirements). The operations, in turn, allow the central bank to influence the liquidity of money and financial markets and to facilitate the achievement of its objectives.

Industrial countries started moving from reliance on credit or interest rate controls toward reliance on money market operations in the 1970s, in view of the increasing inefficiency of the former controls in a context where financial markets had become more integrated both domestically and internationally. In addition, allowing market forces to distribute financial resources was associated with increased economic efficiency and growth. While the instruments used have varied on the basis of country circumstances, the following common trends can be observed: (a) lesser recourse to open-ended or standing facilities that banks may use at their discretion to place funds with, or borrow funds from, the central bank under certain pre-established conditions; (b) increased use of market-based operations conducted at the discretion of the central bank to add or withdraw liquidity from the system; and (c) reduced reliance on reserve requirements. Concomitantly, governments have ceased to rely on the central bank to finance their needs, relying more on the markets to fund their operations.

Central banks in emerging market economies and developing countries have also moved toward reliance on money market operations. At the same time, they have maintained a high reliance on reserve requirements and, at times, liquid asset ratios, which create a captive demand for qualifying assets (typically government securities). Frequently, the central bank has continued to act as banker to the government. The move toward money market operations was the counterpart in the monetary area to the trend toward enhancing the role of price signals in the economy. It has involved reducing direct government intervention in the economy, improving the capacity of financial institutions to mobilize domestic savings, and strengthening the role of market forces in the allocation of financial resources.

As one carries out financial sector assessments, therefore, it is important to assess the functioning of money and foreign exchange markets and to evaluate central banks' monetary operating procedures from the perspective of systemic liquidity management. One objective of assessing systemic liquidity infrastructure is to provide an input in formulating recommendations that will enhance the liquidity of funding markets and will improve access to such markets, thereby helping increase financial sector resilience. Another key objective of assessments is (a) to examine whether monetary operating procedures are efficient and adequate to foster efficient and liquid markets and (b) to help contain interest rate and exchange rate volatility along with the associated risks and vulnerabilities in the system.

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