Monday Dec 02, 2024
Monday Dec 02, 2024
Monday, 2 December 2024 00:45 - - {{hitsCtrl.values.hits}}
When the policy rate of the Central Bank is reduced, the banks immediately cut the deposit rates meaning that they are downward flexible
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Aseni, whiz kid in economics, has seen the viral news that the Central Bank has moved to a new monetary policy instrument called the Overnight Policy Rate, abbreviated as OPR. There has been a press release from the Central Bank, but it has been in technical jargons. As a result, it has been beyond the comprehension of the ordinary citizens. Aseni herself could not understand it. Hence, she turned to her grandpa, Sarath Mahatthaya, an ex-official of the Ministry of Finance, to elucidate this new instrument to her. This is the conversation between the two.
Aseni: Grandpa, did you see the announcement by the Central Bank that it has adopted a new monetary policy instrument called the Overnight Policy Rate or OPR which has been branded as its primary monetary policy tool1. The media has gone to town on this but failed to explain what it is. Even the Central Bank’s press release is incomprehensible by ordinary citizens because it is full of technical jargons. Why has the Central Bank done this?
Sarath: This is a single policy interest rate to give proper signal to the market. But this is not the first time the Bank has gone for a single rate. In the good old days, there was an interest rate applicable to the Central Bank called the Bank rate. But that rate was used by the Bank not as a monetary policy tool, but as a rate to provide funds to ailing commercial banks when they are in trouble and at the doorstep of bankruptcy. Therefore, it was used by the Bank to perform its function as the lender of last resort or help banks to fund themselves when all other funding sources have failed. Presently, this Bank rate is non-existent.
That is because under the Section 36 of the new Central Bank Act, the Bank can provide only liquidity financing to an illiquid financial institution for 91 days first, but could be extended for further 91 days later, under an irrevocable and unconditional government guarantee at an interest rate above the prevailing market rate. Therefore, Bank rate no longer applies. These are special arrangements and not related to the day-to-day monetary policy actions.
For monetary policy actions, there had been two interest rates. One is called the Standing Deposit Facility Rate or SDFR that applies to the surplus money deposited by commercial banks with the Central Bank. The other is called the Standing Lending Facility Rate or SLFR which relates to the borrowing made by commercial banks to meet their temporary liquidity problems. The Central Bank had been using these two rates as its policy interest rates to influence the market interest rates. SDFR should be fixed above SLFR to prevent commercial banks from borrowing from the central bank and deposit the same at a higher rate. The practice of buying from a low-priced market and selling at a high-priced market is known as arbitraging. Arbitraging is not a bad thing. But doing it at the expense of the Central Bank is unwarranted.
Aseni: Why did the Central Bank change from this dual interest rate system? Was it ineffective?
Sarath: When you have two rates, it is confusing. The market does not know which rate should be followed. To be effective, there should be a clearly identifiable interest rate. Therefore, there was the necessity for changing it. But the more relevant reason is that the Central Bank now uses inflation targeting as its more effective monetary policy framework.
In the previous system, the Central Bank controlled the reserve money or base money or monetary base to control money supply and through money supply, the inflation rate. But this was not very successful as also has been revealed by the performance of the Central Bank in the past. The Bank starts the year with a certain inflation target but at the end of the year, ends up in overshooting that target. As you know, subduing inflation is the final goal of a central bank. Hence, our central bank, like many other central banks in the world like the Bank of England, Bank of France, Bank of Thailand and so on, has now gone for inflation targeting as mandated to it by Part IV of the new Central Bank Act.
Under inflation targeting system, the Central Bank controls the interest rates and through interest rates, the expectations of the public about the future inflation, to keep the inflation to the target made. Therefore, the Central Bank should select a clear interest rate to give the proper signal to the market about its intention. For that purpose, having two rates like SDFR and SLFR is confusing. This was studied by an IMF Technical Assistance Team on Liquidity Monitoring and Monetary Operations in Sri Lanka and it released its report in September 20242.
In this report, the team has recommended that the Central Bank should start replacing the current two policy rates with a single policy rate to strengthen the signalling of monetary policy and improve the ability of the bank to steer market interest rates toward the level it wants to have in the system. Hence, the introduction of this OPR is in terms of this recommendation to make the inflation targeting of the Bank more effective.
Aseni: Oh I see. Has the Central Bank abolished the previous SDFR and SLFR to accommodate this single rate?
Sarath: No, because that would have been a shock to the market. Therefore, the Bank is working now with the dual system but for policy purposes, it recognises only OPR. Commercial banks can still use the deposit window to park their excess money temporarily with the Central Bank and lending window to fill up liquidity shortages. But those rates at 8.25% for SDFR and 9.25% for SLFR are a way apart from OPR set at 8% now and therefore, there is no incentive for commercial banks to heavily use these two windows.
Aseni: How does OPR operate? Does the Central Bank pick up OPR by guess work or is it linked to any market interest rate?
Sarath: The Central Bank says its OPR is linked to the weighted average of the call money rate within the banking system. As you are aware Aseni, the call money market is the market in which commercial banks lend to fellow banks to put the excess money to effective use or borrow from the fellow banks to meet urgent liquidity needs. The rate at which they do these transactions among themselves is called the call money rate. This rate varies from bank to bank depending on their excess positions and liquidity shortages. These are overnight lending operations not secured by any collateral. Hence, it is based on trust and credit worthiness of each bank.
The Central Bank collects the data on the amount of the transaction and the rate at which that transaction has taken place. For ease of understanding, it averages the rate but to reflect reality in the market, weighs each rate by the volume involved. The average rate so calculated by the Central Bank is called the average weighted call money rate or AWCMR. Aseni, it is a calculated average and does not tell us about the actual rate at which a given bank has lent or borrowed money. But it gives some indication of the level of interest rates in the call money market and is useful in that sense.
Aseni: So, OPR is connected to some market interest rate. What is the link between Central Bank’s policy determined OPR and this calculated AWCMR?
Sarath: The Central Bank will fix the OPR in such a way that commercial banks will have to revolve their call money rates around OPR. That is because the Central Bank uses AWCMR as its operating target to maintain the inflation at the targeted level. For instance, if OPR is fixed at, say 9%, call money rates too will be close to that rate. By the same token, if OPR is brought down to 5%, call money rates will also fall to around 5%. In this way, by changing OPR, the Central Bank can change the call money rates also. That call money rate will be the base rate for all other interest rates in the economy such as deposit rates and lending rates.
If call money rate falls, the deposit rates will also fall. If commercial banks maintain a fixed interest margin between the deposit rates and lending rates, the lending rates too will fall. The opposite will also take place if call money rates also go up. Therefore, by changing OPR, the Central Bank will influence the level of the call money rates and through the call money rates, all other interest rates in the system.
Aseni: Has it been a proven fact that call money rates will function as the base interest rate in the economy?
Sarath: There are structural problems in Sri Lanka for this mechanism to work perfectly. When the policy rate of the Central Bank is reduced, the banks immediately cut the deposit rates meaning that they are downward flexible. But it takes time for lending rates to get adjusted because banks operate with their borrowers on pre-determined loan agreements. Those agreements do not provide for immediate reduction in lending rates in response to a cut in the policy rate. Hence, lending rates are downward sticky. But with respect to increases in interest rates, deposit rates are upward sticky, and lending rates are upward flexible. Hence, whether this mechanism will work perfectly in Sri Lanka is questionable. But there is a clear one on one relationship between OPR and call money rates as shown by recent experiences. For instance, before OPR was set at 8%, AWCMR was 8.57%. But after it was set at 8%, AWCMR has fallen by about half a percent to 8.15%. But because of the structural problems, whether the other interest rates will get adjusted likewise is yet to be seen.
Aseni: Why did AWCMR fall in response to the level of OPR?
Sarath: That is again through a manipulation by the Central Bank. Simultaneously with this measure, the Central Bank has announced the rules on its daily monetary policy operations in the market known as Open Market Operations or OMO. They have been gazetted by the Central Bank in terms of the Central Bank Act3. These rules have outlined what commercial banks should do and what they should not do and how the Central Bank will make its decisions regarding the OMO transactions.
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Aseni: How has the Central Bank fixed those rules to control the behaviour of commercial banks?
Sarath: OMO is basically conducted through the REPO and Reverse-REPO transactions. The Central Bank has said that in REPO transactions, any bid by a bank at or above OPR will not be accepted meaning only bids below OPR are accepted. On the other side of the coin relating to Reverse-REPO transactions, it has said that any bid at or below OPR will not be accepted meaning that only bids above OPR will be accepted. This is a harsh rule which all commercial banks will have to oblige. When they do so, their call money rates will naturally revolve around the set OPR and SDFR and SLFR will become irrelevant.
Aseni: Can you explain how this REPO and Reverse-REPO transactions take place. It is a subject which I have not been able to understand.
Sarath: REPO stands for Repurchase Agreements and Reverse-REPO its opposite. REPOs and Reverse-REPOs can happen anywhere in the market for any good or asset. REPO means that I sell an asset which I have to you with a promise to repurchase it later at a given price. From my point, it is a REPO and from your point, the same transaction is a Reverse-REPO. Since it is the Central Bank which originates these transactions, we view them from the point of the Central Bank.
This is how the Central Bank does these transactions. Suppose the Central Bank has purchased a Treasury bill from the Government by lending to it. That Treasury bill is a part of the assets of the Bank. But its purchase has caused the Bank to increase the reserve money or base money which will be used by commercial banks to create bank money in multiple terms. That money in the hands of the people will chase after goods and services putting pressure for the prices to increase and hence causing inflation rate to rise. To put a stop to this process, the Central Bank should take that money back to the Bank and neutralise the same via a REPO auction.
In that auction, the Bank will sell the Treasury bill it has bought from the Government to commercial banks with a promise to buy it back later at a fixed price. Commercial banks will get the ownership for the Treasury bill but should part with the excess money they have. That money when it comes to the Central Bank is neutralised and removed from the reserve money. Therefore, REPO transactions are conducted by the Central Bank as a contractionary monetary policy.
The Reverse-REPO is the opposite operation. In that transaction, the Central Bank will buy a Treasury bill in the hands of commercial banks with a promise to sell it back on a later date. Here, the commercial bank exchanges its Treasury bill which is not money for money. The Reverse-REPO transactions will increase the level of reserve money and therefore, they are expansionary monetary policies. They are overnight transactions that should be settled the following day. But when they are done again and again, they become permanent withdrawal and injection of liquidity from and to commercial banks.
Since REPO bids should be below OPR and Reverse-REPO bids should be above OPR, they are synonymous with SDFR and SLFR, respectively. Since they should be around OPR, the earlier announced SDFR and SLFR become irrelevant. Also, commercial banks should fix their call rates around OPR. That is how call rates are manipulated by the Central Bank through rules and OPR practices.
Aseni: I now understand it fully. Thanks, Grandpa. But time will tell us whether OPR is a success or a failure given the structural bottlenecks which the financial systems has in Sri Lanka.
Footnotes:
1https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/press_20241126_the_cbsl_implements_a_single%20_policy_interest_rate_mechanism_ny_introducing_the_opr_e.pdf
2https://www.elibrary.imf.org/view/journals/019/2024/078/article-A001-en.xml
3http://documents.gov.lk/files/egz/2024/11/2412-09_E.pdf
(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)
Since REPO bids should be below OPR and Reverse-REPO bids should be above OPR, they are synonymous with SDFR and SLFR, respectively. Since they should be around OPR, the earlier announced SDFR and SLFR become irrelevant. Also, commercial banks should fix their call rates around OPR. That is how call rates are manipulated by the Central Bank through rules and OPR practices