Chapter

II Monetary Operations and Government Securities Markets

Author(s):
Malcolm Knight
Published Date:
February 1998
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Recent Developments

Under the umbrella of central bank laws enacted since 1992, most central banks of the Baltic countries, Russia, and the other countries of the former Soviet Union have gained considerable formal autonomy to carry out an independent monetary policy (Belarus and Uzbekistan are notable exceptions). Monetary control is exercised through a variety of instruments, including reserve requirements; credit auctions, and refinance facilities that are mainly market-based; interventions in the foreign exchange markets; auctions of treasury bills; and, to a limited extent, open market operations.

Except in Belarus, Turkmenistan, and Uzbekistan, central banks have broad autonomy from political authorities to formulate and implement monetary policies and to pursue price stability (Table Al). The recently enacted laws of the Azerbaijan National Bank, the National Bank of Georgia, the Central Bank of Russia, the National Bank of Tajikistan, and the Central Bank of Uzbekistan all emphasize price stability. However, the Azerbaijan National Bank has an additional mandate to develop and strengthen the banking system, and the Bank of Uzbekistan’s autonomy could be restricted by the need for parliamentary approval for its financing of the government, which has no formal limit. New draft laws that enhance central bank independence have also been submitted to parliaments in the Kyrgyz Republic and Ukraine. The National Bank of Belarus may have lost the limited independence it had earlier, because of the outcome of a constitutional referendum that assigned a shared responsibility for monetary and exchange policy to the government and the central bank. The Central Bank of Turkmenistan suffered a setback when directed credits subject to presidential decree were reintroduced in December 1996.

Direct instruments for controlling net domestic assets have been phased out in most of the countries under review (Table A2). Tajikistan is the only country that continues to avail itself of bank-by-bank credit ceilings; together with Uzbekistan, it also continues to impose limits on cash withdrawals. Only Belarus and Turkmenistan continue to use directed credits as an element of their monetary policy, with subsidized interest rates set at below their refinance rates. Two other countries extend directed credits for crop financing on an ad hoc basis (Azerbaijan and Uzbekistan).

In most of the countries surveyed, medium-term operating frameworks and targets for monetary policy are geared to performance criteria for central bank balance sheets established under macroeconomic adjustment programs supported by the IMF.4 However, there remains a need to develop further the capacities for short-term forecasting and monitoring of financial flows and for coordination of instruments as central banks move toward more sophisticated and frequent monetary operations. Day-to-day implementation has encountered a number of problems, including limited coordination between monetary and foreign exchange operations (Belarus, Russia, Turkmenistan, and Ukraine) and difficulties in forecasting certain balance sheet items, such as government positions (Georgia, Kazakhstan, and Latvia) and residual assets and liabilities. These deficiencies have hampered the determination of central bank interventions consistent with monetary policy targets and have thus inhibited more active liquidity management. Nevertheless, many of the countries are making strong efforts in this area, and some have achieved substantial progress (Belarus, Kazakhstan, Kyrgyz Republic, and Russia).

Most countries have established interbank money markets. These operate freely, but their role in redistributing bank liquidity is still in its infancy. The development of the interbank money market has demonstrated sensitivity to general financial market disturbances and has suffered recurrent setbacks owing to banking crises. Further development of the interbank market continues to be hampered by risks in lending to unsound banks, a shortage of collateral, and inadequate collateral legislation.5 Also, the unavailability of accurate information on banks’ near-final settlement balances (Armenia, Georgia, Kazakhstan, Russia, Tajikistan, and Turkmenistan) has prevented them from using the market for end-of-day funding operations.6 Sometimes, the limited availability of collateral has impeded the interbank market (Kyrgyz Republic). Nevertheless, in a few countries—notably Estonia, Latvia, and Russia—banks now use the interbank market actively for their cash management.

A primary market for government securities is active in all of the countries in this evaluation, except Estonia, Georgia, Tajikistan, and Turkmenistan.7 In primary issues, the central bank usually acts as the government agent, and the ministry of finance determines timing, volumes, and cut-off prices. Two countries (Azerbaijan and Uzbekistan) only began to issue treasury bills in 1996. In the more established markets, the maturity of the securities issued has been lengthened as inflation has declined. Purchases by resident nonbank investors are generally limited. As a new development, significant purchases of government securities by nonresident investors have recently taken place in Armenia, Latvia, Lithuania, Moldova, Russia, and Ukraine.

With the exception of the Kyrgyz Republic, treasury bills have been issued into the primary market for public debt management and not for monetary control purposes.8 For this reason, a few central banks temporarily in need of a monetary instrument to absorb liquidity have issued central bank securities (Belarus, Estonia, Kazakhstan, and Uzbekistan) or have offered central bank deposits (Armenia, Latvia, and Russia).9

Some central banks have begun to conduct transactions in the secondary market for government securities (Belarus, Kazakhstan, Latvia, and Russia). A well-developed secondary market exists in Russia, where its central bank, in cooperation with the Ministry of Finance, intervenes actively, mostly to achieve an interest rate rather than a liquidity effect. In the Kyrgyz Republic, market activity is increasing following the streamlining of trading procedures, and in Moldova trading is getting under way. In the other countries in this study, secondary markets are small—in large part because the move to a market-based monetary policy is too recent (Armenia and Azerbaijan) or because of the absence of a meaningful primary treasury bill market (Turkmenistan). Also limiting market development are the absence of adequate payments systems, book entry, and information linking market participants, as well as uneven tax treatment of earnings from securities portfolios (for example, in Armenia and Lithuania, the tax laws discriminate against selling treasury bills before maturity).10 For effective liquidity management through operations backed by government securities, the central bank and other market participants must have adequate stocks of these assets, especially at the short end of the market—conditions not yet present in most countries.

Deposit and lending rates are market-determined in most countries in this analysis. In 1996, Kazakhstan eliminated its remaining indirect control on interest rates.11 In Ukraine, the mandatory link between lending rates and the refinance rate that had been introduced by the National Bank of Ukraine in 1995 was abolished, and Georgia liberalized prudential limits on the mobilization of household deposits in January 1997. However, in Belarus lending rates on loans using central bank funds cannot exceed the refinance rate plus a preset margin, and in Turkmenistan credits to selected industries and agriculture were extended by presidential decree at rates below the central bank refinance rate. Some countries have linked the rate charged on the use of central bank standing facilities (refinance) to market-based interest rates. In Azerbaijan and Moldova, the refinance rate is linked to the credit auction rate, and in the Kyrgyz Republic, to the treasury bill rate. In Kazakhstan, Tajikistan, Ukraine, and Uzbekistan, the refinance rate is set in relation to the inflation rate, with a view to keeping it above anticipated inflation. This approach is followed in Belarus, but has relatively little impact because most credit (almost 90 percent) is extended at a subsidized rate that is below the refinance rate.

Reserve requirements play an important role in monetary control, and compliance has on the whole improved (Belarus, Georgia, Kazakhstan, and Russia), as can be seen in Table A3.12 Except in Armenia, Belarus, Russia, and Uzbekistan, required reserve ratios are uniform for different maturities and currencies, varying from 8 percent in Latvia and Moldova to 20 percent in the Kyrgyz Republic (Table A3). Countries with nonuniform requirements typically have lower ratios for foreign currency deposits. In Russia, the difference is 8 percentage points, and in Uzbekistan, 25 percentage points.13 Most countries stipulate that reserve requirements on foreign currency deposits must be met in domestic currency. The exceptions are Armenia, Azerbaijan, and Kazakhstan, which allow the reserve requirements to be met in either domestic or foreign currency.14 Reserve averaging is becoming more common, but Azerbaijan, Belarus, Georgia, Russia, Turkmenistan, and Uzbekistan keep reserve balances blocked throughout the compliance period.15 Estonia, Kazakhstan, the Kyrgyz Republic, and Moldova remunerate reserve requirements.

Some central banks have overdraft facilities that provide uncollateralized short-term credits at penalty rates (Belarus, Russia, and Tajikistan). In Turkmenistan, the central bank has introduced an auxiliary credit facility to provide banks with short-term credits at a penalty rate that is linked to the refinance rate, so that overnight overdrafts can be avoided.

Other central banks have established, or are establishing, collateralized standing facilities, such as a Lombard window, to reduce the central bank’s credit risk (Table A3). Lending through this facility carries a penalty rate, has a short maturity, and is usually collateralized with treasury bills (Armenia, Kazakhstan, Kyrgyz Republic, Latvia, Moldova, and Ukraine).16 The Kyrgyz Republic and Latvia also have lending facilities designed to provide credit to problem banks. In the Kyrgyz Republic, the central bank has provided medium-term funding to those banks that have agreed to a restructuring plan and are put under enhanced supervision, and in Latvia in early 1995, the central bank provided limited credit to banks with financial difficulties.17 In countries with a currency board (Estonia and Lithuania), extension of central bank credit to commercial banks is limited to the amount of foreign exchange reserves in excess of those needed to provide full backing of base money. However, within the limits imposed, the Bank of Estonia and the Bank of Lithuania have provided emergency credit to commercial banks.18

Most central banks in the Baltics, Russia, and the other countries of the former Soviet Union have introduced credit auctions as a step toward market-based instruments of monetary control. Credit auctions exist in all countries except Tajikistan and the two countries with a currency board (Estonia and Lithuania). However, as alternative funding sources have developed, credit auctions are now used actively only in Moldova.19 In Russia, participation in the auction has dissipated, particularly in the Moscow region, because interbank market rates have been substantially lower than credit auction rates, largely reflecting tighter conditions in regional markets outside Moscow. In Armenia, the Kyrgyz Republic, and Latvia, the interbank money market began to play a larger role in bank financing in 1996, although its growth has been hindered by bank solvency problems. Few auctions have taken place in Belarus, because of the authorities’ emphasis on directed credits. Insufficient transparency of Azerbaijan’s auction procedures may have hampered the development of auctions in that country.

As the volume of treasury bills and other government securities in the market has risen, the rate of collateralization required for credit received in the credit auction has been increased, gradually transforming the uncollateralized credit auctions into the equivalent of tenders for repurchase agreements. This has occurred in Armenia, the Kyrgyz Republic, Latvia, and Russia. In addition, most countries have broadened the range of admissible collateral beyond treasury bills to include foreign exchange holdings, promissory notes, and some less liquid assets.

Country Rankings

In Table 2, three stages of development (limited, moderate, and substantial progress) of monetary operations and the government securities market were identified on the basis of advances in three major areas: central bank facilities and the range of instruments, the operating framework for monetary policy, and government debt management and securities market development.20

Table 2.Country Rankings in Monetary Operations and Government Securities Markets
RankingsI

Limited

Progress
II

Moderate

Progress
III

Substantial

Progress
Central bank facilities
Standing (Lombard, refinance, overdraft) and discretionary (open market operations, credit and deposit auctions)Belarus

Georgia

Tajikistan

Turkmenistan

Uzbekistan
Armenia

Azerbaijan

Moldova

Ukraine

Kazakhstan

Kyrgyz Republic

Latvia

Russia
Operating framework
Use of short-term liquidity forecasting and availability of a domestic debt forecasting program such as a treasury bill auction calendarGeorgia

Tajikistan

Turkmenistan

Uzbekistan

Armenia

Azerbaijan

Kazakhstan

Latvia

Moldova

Ukraine
Belarus

Kyrgyz Republic

Russia
Market development
Interbank money market and secondary market for government securitiesArmenia

Azerbaijan

Georgia

Moldova

Tajikistan

Turkmenistan

Uzbekistan
Belarus

Kyrgyz Republic

Ukraine
Kazakhstan

Russia

Latvia
Overall rankingGeorgia

Tajikistan

Turkmenistan

Uzbekistan
Armenia

Azerbaijan

Belarus

Moldova

Ukraine
Kazakhstan

Kyrgyz Republic

Latvia

Russia

The first criterion for the country ranking in this section was based on the quality of central bank facilities used for bank liquidity management. A central bank should have the resources to inject and absorb liquidity at its own discretion and should also have in place collateralized standing facilities to allow the banks, at their initiative, to come to the central bank for liquidity (at a penalty rate) if they are unable to borrow in the interbank money market. In the countries reviewed, a central bank was ranked as having achieved substantial progress if it had a well-designed Lombard facility with clear rules of access and a facility using repos and reverse repos, or the ability to undertake outright purchases or sales of securities (Kazakhstan, Kyrgyz Republic, Latvia, and Russia). A central bank received a ranking of moderate progress if it had those facilities but they presented significant shortcomings (Armenia, Azerbaijan, Moldova, and Ukraine). The remaining central banks received a ranking of limited progress (Belarus, Georgia, Tajikistan, Turkmenistan, and Uzbekistan).

The second criterion was based on the quality of the operating framework employed by the central bank to carry out monetary policy, including aspects of government debt management. A central bank received a ranking of substantial progress if it had been using monetary management and coordinating the use of the various monetary instruments to achieve its monetary policy objectives (Belarus, Kyrgyz Republic, and Russia). A ranking of moderate progress indicates that the operating framework was limited to a quarterly or annual monetary program and that a regular calendar of securities issues was not yet well developed (Armenia, Azerbaijan, Kazakhstan, Latvia, Moldova, and Ukraine). The remaining countries received a ranking of limited progress (Georgia, Tajikistan, Turkmenistan, and Uzbekistan).

The third criterion related to interbank and secondary market development. A central bank received a ranking of substantial progress in this category if there was an active interbank money market and an active secondary market in government securities (Kazakhstan, Latvia, and Russia). It received a ranking of moderate progress if either market was inactive (Belarus, Kyrgyz Republic, and Ukraine). The remaining countries receive a ranking of limited progress (Armenia, Azerbaijan, Georgia, Moldova, Tajikistan, Turkmenistan, and Uzbekistan).

To arrive at the overall rankings for progress in monetary operations, the following assumptions were made. To qualify for the overall ranking of substantial progress, a country had to rank at that level in two of the three categories (central bank facilities, operating framework, and market development). Moderate progress involved ranking at that level (or better) in at least two of the three categories, while the remaining countries received the limited progress ranking.

Priorities for Reforms

Despite significant progress, substantial work remains for the 15 central banks to improve their lending facilities and the operating framework for monetary policy and to facilitate the development of financial markets suitable for monetary operations. In particular, further reforms are needed toward establishing Lombard windows to help banks cope with unexpected end-of-day clearing imbalances that payments system weaknesses tend to make frequent. In the context of increased credit risks associated with systemic banking weaknesses, access to central bank credit should be collateralized and credit auctions should be transformed into repurchase auctions. Not only will these developments help to protect the quality of the central bank’s assets, but they will also enhance financial discipline in the system.

In most countries, the coordination of indirect instruments of monetary policy through a short-term programming framework as a condition for more active liquidity management remains weak and in some cases is not yet in place. At the institutional level, coordination within central banks and between them and other government bodies responsible for financial policies needs to be strengthened.

Much also remains to be done to improve the functioning of the interbank money market, which is critical to the development of indirect monetary control. However, in an environment of poor information on the financial condition of individual banks, widespread bank unsoundness, and, sometimes, a lack of collateral, development of the inter-bank money market will be a difficult and extended process. The central bank can play an active role by making the interbank money market the focus of its liquidity operations. Collateralization of monetary operations can promote the development of interbank money markets by containing credit risk and market segmentation. In addition, an efficient interbank clearing and settlement system and timely information on correspondent account balances will allow banks to trade their liquidity positions daily, fostering the development of interbank markets.

Similarly, the further development of secondary markets for government securities will facilitate monetary management in all countries. Few of the central banks being evaluated currently have the capacity for open market operations in government paper, although several have started experimenting in this area. As markets develop, adjustments may be needed in certain elements of the market microstructure—including trading arrangements, the regulatory environment, and clearing and settlement procedures. Most countries must still develop the institutional framework to conduct repurchase agreements, setting guidelines on these operations and providing the lender with a clear title to the security used as collateral in the event of default.

Of the 15 countries in the region, only Belarus and Turkmenistan did not have programs supported by the IMF in May 1997.

Collateralization of interbank loans could enhance the market’s role in redistributing liquidity when interbank credit lines have been used up.

In Russia, lack of settlement balance information hindered end-of-day interbank activity until the central bank introduced multiple clearings in February 1997, which markedly improved the situation.

Georgia introduced such a market in August 1997, and Tajikistan plans to do so in 1998. Turkmenistan has issued a limited amount of treasury bills, but not in an auction format.

Although until late 1994 the Kyrgyz Republic used treasury bills purely as a monetary policy instrument, more recently it has used issues of bills mainly to finance the government deficit.

In Belarus, the central bank began issuing short-term paper in the summer of 1995, primarily to manage monetary aggregates so as to meet targets under a program supported by a Stand-By Arrangement with the IMF. The Bank of Estonia issued certificates of deposit in 1996, which were used for money market development rather than for monetary control. In Russia, the central bank plans to securitize its claims on the government as an additional means of absorbing liquidity.

Such a discrimination also existed in Russia until January 1997, but it had a limited effect on the development of the secondary market.

Previously, borrowers that paid interest rates more than 1.5 times the refinance rate of the National Bank of Kazakhstan were not permitted to account for the extra interest payments as a cost item in their profit and loss statements.

In Russia, compliance was particularly weak until 1995, but improved in 1996 as a result of regulations allowing the central bank to unilaterally transfer balances of delinquent banks from their correspondent accounts to reserve accounts.

In Belarus, a differentiated reserve ratio of 5–15 percent applies to domestic and foreign currency deposits. Armenia reintroduced uniform reserve ratios in August 1997.

In 1996, Lithuania allowed banks to use treasury bills to meet the temporarily lower reserve requirement, but is phasing out this policy.

In Georgia, reserve balances (up to 90 percent) may be used as collateral for credit auctions; therefore, they are essentially not averaged. In Russia, there exists a restrictive reserve averaging regime, and banks do not use this facility.

Russia has introduced a collateralized lending facility that is not a Lombard window in the usual sense because banks cannot access it to cover end-of-day imbalances.

In Latvia, the credits have a maturity of one month and may not be rolled over. In the Kyrgyz Republic, emergency credits have a maturity of six months and may be rolled over.

In 1996, Lithuania reduced reserve requirements temporarily to provide liquidity to banks.

Tajikistan plans to introduce credit auctions in the near future to replace bank-by-bank credit ceilings.

Because Estonia and Lithuania have currency board arrangements and thus limited scope for monetary policy and operations, they have been excluded from this exercise.

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