Appendix III. Enhancing Liquidity Management and Forecasting

Bernard Laurens
Published Date:
December 2005
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The central bank needs to develop a framework to monitor and forecast short-term liquidity developments in the system on a continuous basis, so that its discretionary operations are consistent with its ultimate and intermediate objectives. The main purpose of establishing a framework to monitor and forecast short-term liquidity developments is to create an information set which puts the central bank into a position to smooth changes in liquidity conditions (with a view toward creating stable liquidity conditions and limit market volatility) and to ensure that its monetary operations are consistent with the monetary program (Table A.3.1). By allowing the central bank to take well-informed monetary decisions, such a framework allows the central bank to communicate with the market in an effective manner and, through an appropriate communication policy, helps market participants to clearly distinguish between changes in the monetary policy stance and temporary “noises.”

Table A.3.1.Standardized Central Bank Balance Sheet
Liquidity providing OMO and/or OMO–type operationsBank’s holdings on current accounts (Required reserves and excess reserves)
Refinance standing facilityLiquidity-absorbing money market operations
Credit to the governmentDeposit standing facility
Net foreign assetsBanknotes in circulation
Net government deposits
Other factors (net)
Source: IMF’s Monetary and Exchange Affairs Department, or MAE (2000) (as of 2003 the Monetary and Financial Systems Department, or MFD), and European Central Bank (2001).
Can be rearranged as follows
“banknotes in circulations”
plus “government deposits”
minus “credit to the government”
minus “net foreign assets”
plus “other factors (net)”
“banks’ holdings on current accounts”
Source: IMF’s Monetary and Exchange Affairs Department, or MAE (2000) (as of 2003 the Monetary and Financial Systems Department, or MFD), and European Central Bank (2001).

The country experiences show that forecasting the effects of the government’s operations on liquidity poses the greatest difficulties. A lack of cooperation between the treasury department and the central bank and the specific organization of the spending procedures are often the main impediments to accurate projections of government cash flows. In addition, in countries with exchange rate pegs and large foreign exchange interventions, net foreign assets may be volatile and difficult to predict. However, since foreign exchange operations are typically settled with a lag of two days, there is some room for the central bank to adjust unwanted liquidity fluctuations. Similar challenges can be posed for currency projections, particularly when a country is on the path of remonetization after a period of high inflation. Overall, experience indicates that establishing a strong liquidity forecasting framework may be a lengthy process, in particular because this requires concomitant progress in establishing frameworks for forecasting government cash flows (a task which typically is carried out by the treasury), and for forecasting foreign assets and currency in circulation.

Appropriate arrangements are also needed to absorb unexpected liquidity shocks in the system. It is in this context that the buffer function of reserve requirements and standing facilities plays a critical role. In particular, averaging provisions for reserve requirements allow banks to smooth out daily liquidity fluctuations because transitory reserve imbalances can be offset by opposite reserve imbalances within the same maintenance period. This mechanism also works to the benefit of the central bank because it reduces the need for frequent intervention in the market which may otherwise be warranted due to deviations from liquidity forecasts.1 Similarly, standing facilities, by allowing banks at their own discretion (subject to a penalty in terms of cost/yield) to make deposits at the central bank, or to receive short-term liquidity from the central bank, play a stabilizing role and reduce the need for frequent central bank discretionary monetary operations.

The buffer function is important in the early stages of the implementation of a liquidity forecasting framework as the quality of the forecasts might be low at the beginning.

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