Prepared for knowledge sharing program organized by the office of the GovernorInterest Rate Corridor Nara BahadurThapa Executive Director Nepal Rastra Bank 2075/8/6
Outline of presentation Concept of IRC IRC and concept of liquidity Theory of IRC Ways of managing IRC Types of IRC IRC in Nepal Issues in IRC
I. Concept of IRC • The concept of IRC refers to the band within which the operating target of monetary policy- the interbank rate moves around the policy rate of the central bank. • The framework of IRC is based on the assumption that interest rate is the effective channel of monetary policy to the real economy. • The IRC has four elements: • The interest rate cap, the upper bound interest rate • The interest rate floor, the floor • The policy rate, the repo rate • The operating target, the interbank rate
The IRC is a modern monetary tool for managing liquidity and interest rate. • The Bank of Canada was the first central bank to introduce the IRC in 1994. Now a number of countries have IRC in place. • The main objectives of IRC are: • limiting volatility in shot term interest rates • Managing liquidity of the system • Signaling the stance of monetary policy • The IRC involves injection and absorption of liquidity
II. IRC and the concept of liquidity As the IRC involves the injection and absorption of liquidity, we need to understand the concept of liquidity. The concept of liquidity refers to ease with which a range of assets can be converted into cash without a significant loss of their values. From the central bank perspective, there are three dimensions of liquidity. They are: • Central bank liquidity • Market liquidity • Funding liquidity
a) Central bank liquidity • Central bank liquidity refers to reserves of BFIs with the central bank. Liquidity management is the framework, the central bank follows in managing the amount of reserves so as to steer the short term interest rates in consistent with its ultimate goals, especially price stability. • Three components of central bank liquidity • Reserve requirements • Working balances • Excess balances • Such reserves are borrowed and lent in the inter bank money market • Important for domestic payment system • Related to inter bank money market rate • Money market rate is the macro-financial linkage- channel of monetary policy. • Open market operations and the corridor are the tools to mange central bank liquidity.
b) Market Liquidity Ease with which assets are bought and sold without significant changes in prices Lack of confidence and coordination failure causes market liquidity problem Leads to a breakdown of key financial markets Most destructive of all liquidity crisis The Lehman Brothers is the popular example Arises from a sharp rise in market participants’ uncertainty about assets values and financial strength of counterparties. Quantitative easing is the central bank response to market liquidity problem.
c)Funding liquidity Ease with which an individual institution can either borrow or raise cash through assets sales Borrowing problem of a specific institution Problem arises on account of solvency concerns of counterparties Flawed business strategy is the main cause Bridge financing is needed for fundamental restructuring of business strategy Fear of contagion is the justification for the central bank liquidity support Key criterion of liquidity support is whether the institution is systemically important or not. Qualitative easing is the central bank response to funding liquidity problem.
III. Theory of IRC The theory of corridor establishes a relationship between quantum of liquidity and overnight rate It takes the policy rate as the channel of communication. It is assumed that macroeconomic shocks do not affect the operating target Likewise, it is also assumed that supply of and demand for central bank money determine the over night rate Sources of central bank money are : • Autonomous factors: (i) change in NFA, (ii) change in treasury position with the central bank, (iii) change in bank notes in circulation and (iv) change in capital and other items, net. • Policy factors: liquidity provided through monetary operations. The demand for liquidity – Reserve requirements and working balances for settlement Central bank attempts to provide liquidity through OMOs so that counterparties fulfill their reserve requirements without recourse to standing facilities
IV. Ways of managing IRC Two ways of managing IRC As the focus of IRC is on stabilizing the short term interest rate, there are two ways of doing it. Open market operations Standing facilities Stabilizing the short term interest rate through open market operations entails the conduct of outright purchase auction, outright sale auction, repo auction and reverse repo auction. While outright purchase auction involves the injection of liquidity, outright sale auction entails the absorption of liquidity. Likewise, while liquidity is injected through repo auction, liquidity is absorbed through reverse repo auction.
The difference between outright and repo transactions is that while the former is used for managing secular liquidity, the latter is used for managing the short term liquidity. The similarity between outright and repo transactions is that both require underlying assets for their operations. Without collateral - eligible securities, open market operations can not take place. This is the major constraint. In countries with IRC, the bulk of liquidity is managed through OMOs. Only marginal liquidity is handled through IRC. .
V. Types of IRC The following versions of IRC are discussed in the literature. • Overnight standing facilities with two predetermined rates and has no policy rate Standing liquidity facility (SLF) Standing deposit facility (SDF) While the SLF rate acts as the ceiling, the SDF rate sets the floor. These two rates form a channel under which the short term interest rate moves. Transactions under these facilities take place at the initiative of the counterparties. These are passive monetary policy instruments . • Overnight standing facilities with the policy rate • Ceiling system • Floor system, e. g. ECB, BOJ, BOE, Bank of Canada, Norges Bank have moved to the floor system • Symmetrical (mid rate) system • Asymmetrical system, e.g. Riksbank (Swedish) has adopted this. • Term standing facilities with or no policy rate
VI. IRC in Nepal Hanging IRC The NRB in its monetary policy for 2016/17, for the first time, introduced the concept of IRC. Then was adopted the hanging IRC. The main features of the hanging (floating) corridor were: • The SLF rate as ceiling of the corridor. The SLF rate was fixed at 7 percent. • The moving deposit auction rate with two-week maturity acted as the floor of the corridor. • The moving repo rate with two-week maturity was the policy rate. • The repo rate and the interbank rate were to move within the corridor. • The repo rate used to be fixed at the interbank rate prevailing prior to two working days plus 200 basis points (bps) . The two –week repo auctions used to be conducted with the preannounced rates. Liquidity was injected through repo auctions. • The deposit collection auction rate used to be fixed at interbank rate prevailing prior to two working days minus 10 pbs. The two- week deposit auction used to be conducted with the preannounced rates. Liquidity was absorbed through deposit collection auctions. • Both two-week repo rate and two-week deposit collection auction rate would be moving as they would be based on interbank money market rate.
Graph 1: IRC in Nepal Upper bound SLF rate Two week repo rate = Interbank rate plus 200 bps Interbank rate Two-week deposit Collection rate = Interbank rate less 10 bps Lower bound
Fixed IRC The NRB in its monetary policy of 2017/18 adopted the concept of fixed IRC. Then the upper bound (the SLF rate) was fixed at 7%, the lower bound at 3% and the policy rate at 5%.. The SLF rate was the upper bound, the two week deposit rate, the lower bound and the repo rate was the policy rate. The spread of the corridor was of 400 bps. The operating target was the interbank rate.
Chart 2: IRC in Nepal r SLF rate 7% Upper bound Interbank rate Two-week repo rate 5% Two-week deposit Collection rate 3% Lower bound Liquidity
The fixed rate corridor performed well in 2017/18. It was introduced towards the end of November 2017 and the interbank rate lay within the targeted range between November 2017 and July 2018. Under the fixed rate corridor, expenses incurred on deposit collection amounted to Rs 41.3 million and interest income earned on repo amounted to Rs 113.6 million, resulting in net income of Rs 72.3 million. The NRB in its monetary policy of 2018/19 has reduced the band of the corridor to 300 bps with the upper bound fixed at 6.5% and the lower bound at 3.5%, with no change in the policy rate of 5%. Currently, the IRC is on hold.
Chart 2: IRC in Nepal r SLF rate 6.5 % Upper bound Interbank rate Two-week repo rate 5% Two-week deposit Collection rate 3.5 % Lower bound Liquidity
VII. Issues in IRC The operating band: wider or narrower The wider band helps develop interbank market. It does not incentivize banks to park their funds with the central bank. The objective of wider band is also to discourage the counterparties to place their funds with the central bank. The wider band provides the role for other monetary policy tools. It is said that wider the width, the greater the interbank turnover, the leaner the central bank’s balance sheet. The wider band reduces the central bank balance sheet and increases interbank transactions.
(ii) The narrower band helps contain the short term interest rate volatility. The narrower band is quite useful in managing liquidity especially excess liquidity in a situation where other tools of monetary policy are insufficient and inadequate. Likewise, the narrower band helps make transmission of policy signals effective. It is difficult to determine the optimal band. The country circumstances are the best way to define the optimal width. International practice is to keep it between 50 to 200 bps.
(b) Symmetrical vs. asymmetrical corridor: spread of the corridor around the policy rate Traditionally, IRC is defined as a symmetric and a narrow band around the policy rate, and is used to ensure that the short term market rates are reasonably close to the policy rate. The symmetric one has a passive role for monetary policy. Asymmetric interest rate corridor can be used to smooth the business cycle fluctuations by mitigating the excessive volatility in the risk appetite of financial intermediaries. Asymmetric corridor has the potential to be used as a macro-prudential policy instrument.
(c) Ways of operating an IRC One issue is to use it with or without the policy rate. It is used without the policy rate when (a) liquidity forecasting capability is weak, (b) financial market is not well developed and ( c ) the functioning of interbank market is weak. On the other hand, it is quite useful to use it with the policy rate to communicate the stance of monetary policy. The choice depends on the focus of the corridor on liquidity management or signaling the stance.
d) Standing vs. adhoc type corridor Standing type is suitable where money and capital markets are well developed. Banks are in loaned up situation. Ad-hoc type is more suitable where excess liquidity is the problem. (e) Overnight vs term IRC Overnight type works well if money market is well-developed. Term IRC is suitable in a country where money market is not well developed. Nepal has adopted a term type IRC.