Money Markets, Monetary Policy
Framework, & Government Securities
Market Development
Mark Zelmer
Bank of Canada
SEACEN-World Bank-IMF Seminar
June 2004
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
2
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)
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INTERBANK MARKET
Initial impact of Indirect
Monetary Policy Instruments
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.
PRIMARY MARKET
Initial sale of T-bills by the
Government’s agent, usually the
CB. Sold by auction or tap issue.
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.
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.
PRIMARY GOVERNMENT
BOND MARKET
Initial sale of government bonds by
Government’s agent, usually the
CB. Sold by auction or tap issue.
BOND MARKET
Market for paper of over 1 year remaining
to maturity. Banks and other financial and
institutional investors participate.
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1. What are Money Markets?
• A word about repos
– “Buyer” agrees to buy securities from the “seller” for a prespecified 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
5
2. Benefits of Money Markets
• More effective monetary policy
• Promote financial stability & market development
• Reduce cost of government borrowing
6
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
7
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
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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)
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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
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4. Role of Monetary Policy Framework
• Role of exchange rate regime / monetary framework
• Stability oriented monetary policy
• Well-designed monetary policy operating procedures
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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
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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
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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
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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
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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
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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
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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
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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
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5. Coordinating Monetary Operations with
Government Cash & Debt Management
Stylized balance sheet of the central bank
Assets
•
•
•
•
Liabilities
• Currency (C)
Net position of the govt. (NPG) • Bank reserves (R)
Lending to banks (L)
• Central bank bills (if any) (B)
Net foreign assets (NFA)
Other items net (OIN)
Supply of bank reserves = [NFA + NPG + OIN – C] + [L-B]
Autonomous position
Policy
position
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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)
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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)
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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
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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
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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
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