Money Markets, Monetary Policy Framework, & Government Securities Market Development Mark Zelmer Bank of Canada SEACEN-World Bank-IMF Seminar June 2004

2 Overview of Presentation 1.What are money markets? 2.Benefits of money markets 3.Conditions for money market development 4.Role of monetary policy framework in money market development 5.Coordinating monetary operations and government cash & debt management 6.Other steps central banks can take to foster debt market development 7.Concluding remarks: Pitfalls to avoid

3 1. What are Money Markets? Money markets trade instruments with maturities < 1 year Market segments include –Interbank market (clearing or settlement balances) –Overnight market (secured/unsecured call loans & repos) –Term market (Treasury bills, bankers acceptances, commercial paper, asset-backed commercial paper, term repos, etc.) Cornerstone for developing government debt markets (see chart)

4 INTERBANK MARKET Funds held immediately prior to final settlement to enable banks to meet obligations to each other and to the central bank. Only institutions with accounts at the CB & the CB participate. CALL LOAN or REPO MARKET Market for funds with overnight maturity. Transactions take place during the day. Banks and large organizations participate. TERM MONEY MARKET Market for funds with maturities >1 day and <1 year. Includes secondary market in T-bills & other paper. Banks & large financial organizations participate. Initial impact of Indirect Monetary Policy Instruments BOND MARKET Market for paper of over 1 year remaining to maturity. Banks and other financial and institutional investors participate. PRIMARY MARKET Initial sale of T-bills by the Government’s agent, usually the CB. Sold by auction or tap issue. PRIMARY GOVERNMENT BOND MARKET Initial sale of government bonds by Government’s agent, usually the CB. Sold by auction or tap issue. FOREIGN EXCHANGE MARKET Liquidity of the Money Market affects the functioning of the Foreign Exchange Market. Money Market liquidity and stability affects the liquidity of the Bond Market.

5 1. What are Money Markets? A word about repos –“Buyer” agrees to buy securities from the “seller” for a pre- specified period of time, with an agreement upfront to resell them back to the “seller” at the pre-specified future date at a pre-agreed resale price. –Difference between initial price and resale price reflects interest rate paid by “seller” for use of cash received. –In effect, repos are equivalent to a collateralized loan –Most transactions conducted under a single legal agreement between two parties—Master Repurchase Agreement

6 2. Benefits of Money Markets More effective monetary policy Promote financial stability & market development Reduce cost of government borrowing

7 2. Benefits of Money Markets More effective monetary policy –Desired liquidity settings can be achieved without distorting prevailing market prices –First step of transmission of monetary actions to economy –Money market interest rates are a useful indicator of market expectations regarding future monetary actions

8 2. Benefits of Money Markets Promote financial stability & market development –Help financial institutions manage their short-term liquidity flows –Facilitate development of well-functioning debt, equity, and foreign exchange markets Money markets enable market makers in other markets to fund their holdings of securities and foreign exchange so they can trade with other participants

9 2. Benefits of Money Markets Reduce cost of government borrowing –Existence of liquid debt markets  Reduce risk of auction failure (more certainty in funding)  Lower borrowing costs (government captures liquidity premia)

10 3. Conditions for Money Market Development Conditions for developing a well-functioning money market –Banks and other investors should be commercially motivated to actively manage risk and maximize profits –Sound banks and other financial institutions Repos can help foster trading between institutions because transactions are fully collateralized –Shift from direct to indirect monetary policy instruments –Sound government cash & debt management and coordination with monetary policy

11 4. Role of Monetary Policy Framework Role of exchange rate regime / monetary framework Stability oriented monetary policy Well-designed monetary policy operating procedures

12 4. Role of Monetary Policy Framework Choice of exchange rate regime / monetary framework can help determine role of central bank in money market –Exchange rate target & open K account Monetary policy mainly relies on unsterilized FX intervention –Exchange rate target & K controls Some scope for setting domestic liquidity conditions in money market –Floating exchange rate & inflation targeting Well-functioning money market critical to minimize uncertainty surrounding monetary operations

13 4. Role of Monetary Policy Framework Monetary policy objectives also influence development of the money market –Market participants more willing to invest in and trade securities if they are confident that investment returns will not be eroded by unexpected inflation –Important to have a nominal anchor for monetary policy i.e. transparent exchange rate or inflation target for monetary policy

14 4. Role of Monetary Policy Framework Monetary policy operating procedures –Affect the stability of the money market and –Provide incentives for banks & other investors to use the money market to manage risk Trade-off between –Encouraging active trading in the money market vs. –Inducing excessive volatility in short-term interest rates

15 4. Role of Monetary Policy Framework Standing facilities –Penalty rates (i.e. wide corridor between central bank lending and deposit rates) to provide incentives for money market trading before accessing central bank facilities –Collateralized lending by central bank to protect it & ensure credit extended is used by FIs to manage liquidity rather than solvency deficiencies

16 4. Role of Monetary Policy Framework Repo and outright open market operations –Foster the development of secondary markets in the underlying securities  Central bank bills can be a useful instrument when there is no working T-bill market or the central bank is perceived more creditworthy than the government  But: central bank bills may fragment the money market & can undermine the financial condition of the central bank –Foster collateralized money markets (collateralized call loans,repos, buy/sell backs) –High frequency operations by the central bank may discourage money market trading

17 4. Role of Monetary Policy Framework Reserve requirements Trading activity in interbank & overnight markets will be determined by –Length of reserve maintenance period –Averaging provisions for meeting reserve requirements –Treatment of interbank transactions for reserve purposes –Penalties for accessing central bank lending and deposit facilities

18 5. Coordinating Monetary Operations with Government Cash & Debt Management Importance of accurate liquidity forecasts –Monetary operations are based on liquidity forecasts Good liquidity forecasts contribute to more accurate monetary policy settings This make it easier for the market to understand signals in monetary operations –Items in the “autonomous supply component” that are most difficult to predict are government cash receipts and payments

19 5. Coordinating Monetary Operations with Government Cash & Debt Management Government cash flows –can be a major source of uncertainty in central bank liquidity management –affects the autonomous component of liquidity supply

20 Stylized balance sheet of the central bank Supply of bank reserves = [NFA + NPG + OIN – C] + [L-B] AssetsLiabilities Net foreign assets (NFA) Currency (C) Net position of the govt. (NPG) Bank reserves (R) Lending to banks (L) Central bank bills (if any) (B) Other items net (OIN) 5. Coordinating Monetary Operations with Government Cash & Debt Management Autonomous position Policy position

21 5. Coordinating Monetary Operations with Government Cash & Debt Management Consequently – Need sound management of government cash flows and debt stock – Important to have good information-sharing between those responsible for implementing monetary policy & those managing the government’s cash balances and debt stock (see Guidelines for Public Debt Management)

22 5. Coordinating Monetary Operations with Government Cash & Debt Management Examples of ways to coordinate –Government shares cash flow projections with central bank on a daily basis and promptly informs when new information arrives –Coordinate monetary and cash/debt management market operations so that they do not act at cross-purposes –Down the road, consider limiting government access to central bank credit & investing government deposits in the banking system rather than with the central bank (UK approach)

23 6. Other Steps that Central Bank Can Take Examples of other steps that central banks can take to help develop domestic debt markets –Work with government debt managers to ensure that government securities are issued in an efficient transparent manner –Work with market participants to introduce a code of good conduct for ethical trading practices, as well as efficient & sound clearing and settlement systems –Work with financial sector supervisors to develop sound frameworks for prudential supervision and market regulation –When circumstances permit, work with policymakers to gradually remove K controls so that domestic markets can benefit from the participation of foreign investors

24 7. Concluding Remarks: Pitfalls to Avoid Some pitfalls to avoid when developing debt markets –Lenient monetary policy operating procedures that make it easy for market participants to deal with central bank rather than with one another –Weak controls in market operations, which expose the central bank to the risk of financial loss –Poorly designed clearing & settlement systems that are costly to operate and not sufficiently risk-proofed –Insufficient consultation with market participants & other stakeholders when introducing market reforms –Liberalizing K controls too quickly, leaving the financial system vulnerable to the ebbs & flows of foreign K flows

25 Further Information Further information can be found in the following publications –Alexander and others, The Adoption of Indirect Instruments of Monetary Policy (IMF Occasional Paper) –Carare, Schaechter, Stone, and Zelmer, “Establishing Initial Conditions in Support of Inflation Targeting (IMF Working Paper) –IMF/World Bank, Guidelines for Public Debt Management –Mehran, Laurens, and Quintyn, Interest Rate Liberalization and Money Market Development: Selected Country Experiences (IMF Publication) –Sundararajan, Dattels, and Blommestein, Coordinating Public debt and Monetary Management (IMF Publication) –Van’t dack, Monetary Policy Operating Procedures in Emerging Market Economies (BIS Policy Paper) –Wheeler, Sound Practice in Government Debt Management (World Bank Publication) –World Bank/IMF, Developing Government Bond Markets: A Handbook