IV. Fiscal Cost of Liquidity Management1
1. This note evaluates the fiscal cost of the reform of liquidity management in Belize. Currently, the Central Bank of Belize (CBB) lacks effective market-based instruments to control domestic liquidity. Existing instruments for liquidity management include reserve requirements, liquid asset requirements, and voluntary transfer of public institutions’ deposits from commercial banks to the CBB.
2. Two ceilings contribute to the rigidity of the monetary system:
BZ$100 million ceiling on outstanding T-bills, which led to the growing use of the overdraft facility by the government.
3.25 percent ceiling on T-bill rates, rendering them unattractive to commercial banks as evidenced by small portion of T-bills being held outside the Central Bank.
3. Reforms enabling more effective liquidity management involve removing the ceilings and moving to market-based interest rates. In particular, these include; (i) removing ceilings on outstanding domestic government securities and on interest rates; (ii) converting the CBB overdraft into marketable domestic government securities; (iii) converting all government securities to market-based interest rates; and (iv) drawing down the securities held by the CBB to sterilize the planned buildup of foreign exchange reserves. Subsequently, liquidity requirements for commercial banks could be lowered.
4. The evaluation of the fiscal cost of the aforementioned reform has involved three steps. First, the market-based cost of government domestic debt is estimated. Second, the income statement of the Central Bank is projected. Finally, the net fiscal cost is calculated taking into account the use of government securities for liquidity sterilization and profit transfers from the Central Bank. The costs were calculated using projections of the monetary aggregates and of the Central Bank income statement anchored by staff’s medium-term projections (Box 1).
Box 1.Belize: Key Assumptions for Medium-Term Projections
Real GDP growth— to gradually increase to 3¾ percent, in line with higher investment.
Inflation— to stabilize at 2.5 percent after 2009.
Fiscal Policy— the central government budget to be financed externally.
Reserve accumulation— tight financial policies and sustained private capital inflows to enable a reserve build-up to above 3 months of imports after 2016.
Gross fiscal cost of domestic financing by the banking sector is equal to 0.7 percent of GDP. It corresponds to the interest payments made on the outstanding government securities and overdraft. It is calculated under two different sets of interest rate assumptions. First, the current interest rates structure is applied. Next, the cost of debt is re-calculated applying market-based interest rates assumed to have a risk premium of 400 basis points, as which the restructured Belizean bond is traded in secondary markets, above United States Government T-bills and T-notes. It is assumed that all of the existing domestic debt stock is swapped with market rate securities. At this point, the gross fiscal cost would increase to 0.9 percent of GDP.
|Market rates 1/|
Long run values.
Long run values.
CBB profits transferred back to the government would cover the increase in the cost of domestic debt. At the time all government debt is converted into instruments with market-based interest rates, gross profits of the Central Bank would increase, as it holds most of the government debt.
Net fiscal cost of the reform is negligible in 2008. Although gross interest costs to the government would increase significantly at the time of the reform, the bulk of these payments would be owed to the Central Bank, and subsequently transferred back as profits.
The cost of new T-bill issuance for liquidity management will be largely associated with international reserves accumulation. Over time, the Central Bank would draw down its holding government securities to sterilize the build-up of reserves. With a gradual increase of commercial banks’ government security holdings, the government’s interest payments to them would increase. However, an external reserve accumulation assumed over the medium term would also raise the profitability of the Central Bank. This, in turn, would help reduce the net cost to the government, which nonetheless would reach 0.21 percent of GDP in 2018.
Distribution of Government Securities, millions of BZD
5. Overall, the net additional cost of the proposed monetary strategy would be low. This cost is estimated to be negligible in 2008, and it would increase to 0.21 percent by 2018 largely due to cover the cost of external reserves accumulation.
|(In millions of BZD)|
|Gross fiscal cost of domestic financing by the banking sector|
|Profits transferred back to the GoB|
|Net fiscal cost of domestic financing by the banking sector|
|(In percent of GDP)|
|Net additional cost of switching to market rates||(0.00)||0.00||0.02||0.03||0.04||0.07||0.11||0.15||0.18||0.20||0.21||0.20|
|Cost of new T-bill issuance for sterilization only||—||—||—||—||—||—||—||—||—||—|
Emine Boz is the principal author of this paper.