a. Countries that have used government securities from the onset

Pakistan, Kenya, The Gambia, Israel and Mexico are typical examples of countries that have used primary auctions of government securities as the main instrument of monetary policy in newly introduced indirect monetary policy environments. In all of these countries, some types of government securities were already in circulation prior to the introduction of indirect instruments of monetary policy. The relations between fiscal and monetary authorities, including the central banks’ role in public debt management at the time of the introduction of indirect monetary intervention, however, varied in each country, which influenced the initial success of the monetary operations.

The transition to indirect monetary policies in Pakistan was intended to start with central bank intervention in primary government securities markets (1991). ^1/ Thus far, the government has continued to maintain ultimate responsibility for determining auction volumes and cut-off rates in the primary market, often to the detriment of monetary management. No explicit coordinating arrangements have been established to ensure that monetary policy considerations are included in determining the terms of primary market issues.

In the other countries, the introduction of open market-type operations in government paper was supported explicitly by arrangements aimed at operational independence for monetary policy. In Kenya, the central bank had been actively involved in the management of government securities markets since 1985. ^1/ The central bank conducted weekly treasury bill auctions and was fully responsible for issuing and redeeming treasury bills. At the onset of the move to indirect monetary policies (1990), the Central Bank of Kenya was also given responsibility for determining the volume and terms of primary issues of government securities, in line with monetary policy requirements, thereby receiving a high degree of monetary policy autonomy.

In The Gambia, the central bank began to rely actively on treasury bill auctions to manage cash reserves in 1990. ^2/ As the government budget was close to balance, the central bank was given full autonomy to adjust auction volumes in line with its monetary policy requirements. The proceeds of the sales are credited to the government’s account with the central bank and the latter is not required to pay any interest on this account.

Open market interventions in Israel also take place in primary markets for government securities. ^3/ The Bank of Israel uses a specifically designed government security, the “Government Short-Term Loan”, which is issued at weekly tenders and available in six- and twelve-month maturities. The central bank has full autonomy in deciding on the volumes to be issued within a limit set by law. The proceeds from the sales of this paper are not used to finance the government deficit. Instead, they are deposited in a government account at the central bank. ^{4/ 5/}

The Central Bank of Mexico began open market-type operations through primary issues of government securities (Certificates of the Treasury (CETES)) in 1983–84, at a time when direct controls were still in place. In 1989, the central bank abandoned its direct controls and started open market operations in secondary markets for government securities in 1990. ^1/

Of the countries mentioned above, Mexico is the only one that has moved to genuine open market operations in the secondary market. The other central banks are still using primary issue of government securities as their main intervention tool, along with other instruments such as reserve requirements and central bank credit to the banks. ^2/

b. Countries that in the process switched to government securities

The Phillippines, Sri Lanka, Poland and Nepal are examples of countries where, early in the transition to indirect instruments, the central bank expressed a preference for using government securities in developing its open market operations. The government, however, showed some reluctance in allowing the central bank the use of its debt instruments, which forced the central bank to issue its own securities in an attempt to keep the transition to indirect instruments of monetary policy going. Later in the process, the governments agreed to the use of government securities for monetary management purposes and the issuance of central bank securities was discontinued. Nepal is a special case among these countries because, while treasury bills are the main instrument, the central bank also intervenes with its own securities to fine-tune the interventions.

The Philippines have gone through several arrangements since the early 1970’s. ^3/ At the time of the move to indirect monetary management (early 1980s), the volume of primary issues of government securities continued to be determined solely on the basis of the government’s borrowing requirements, leaving little room for the central bank to use these issues for monetary policy purposes; secondary government securities markets were not developed at the time. In light of these shortcomings, the central bank was forced to issue its own debt instrument to improve monetary control (1983).

Over time, however, there were complaints that competition with central bank securities pushed up interest rates in the government securities market, which was thought to be unnecessarily complicating domestic public debt management. At the same time, high interest costs associated with central bank securities were contributing to central bank losses, which complicated domestic liquidity management.

Given the above complications, by the mid-1980s, the Government and the Central Bank agreed to phase out central bank securities and use the issues of government securities for monetary management. To ensure that primary issues of government securities satisfied both fiscal and monetary objectives, a coordinating committee was established which determined the auction volumes of government securities on the basis of both deficit financing requirements and monetary policy considerations. Even then, the central bank was still required on occasion to issue its own securities to fine tune its monetary management.

In 1987, an additional and important arrangement was established between fiscal and monetary authorities allowing for the possibility of overfunding the fiscal deficit on account of monetary policy considerations. Proceeds from any excess sales of treasury bills are now placed in fixed-term deposit with the central bank. Remuneration of the deposits is determined during periodical meetings between the Ministry of Finance and the Central Bank. ^1/

The central bank of Sri Lanka had to issue its own securities in its first attempt at indirect monetary operations because the government was not prepared to develop a treasury bill market (1984). ^2/ In 1987 the authorities started concentrating on the development of a treasury bill market. Weekly auctions of treasury bills have since replaced central bank bills in the conduct of open market-type operations. Despite the existence of a joint forecasting committee, auction volumes were for a long time largely based on volumes of maturing bills, thereby subordinating monetary policy considerations to debt management requirements. In 1992 the authorities agreed on new operating procedures whereby the rates at auction are left to market forces and the quantities of treasury bills sold at auction are set according to a reserve money program, thereby greatly enhancing the central bank’s operational autonomy.

In Poland, at the time of the introduction of indirect instruments of monetary policy (1990), the Ministry of Finance was not prepared to allow the Central Bank to intervene in primary government securities markets for monetary operations, prompting the Central Bank to issue its own debt instruments. ^3/ The success of central bank securities, and their direct competition with treasury bills, however, eventually led the Government to agree in 1991 on the Central Bank using the primary treasury bill market for monetary management. Consequently, central bank bills were phased out. However, coordination between Central Bank and Treasury never proved solid enough for the central bank to meet its monetary management needs. The Central Bank therefore started as soon as feasible with repurchase operations as its main indirect intervention tool.

In Nepal, an auction system for treasury bills was introduced in 1988. However, this system did not assist the Central Bank in its transition to indirect monetary policies because the terms of the auctions, both volume and cut-off rates, were based solely on deficit financing requirements and initially, treasury bill auctions were held only infrequently. Therefore, the Central Bank started issuing its own securities to gain control over monetary developments (1991). Eventually, treasury bill auctions became more regular, and central bank bills are now issued, with identical terms and characteristics as treasury bills, in side-by-side auctions, with the Central Bank adjusting the combined volume at issue in line with monetary policy objectives. While both central bank and treasury bills carry identical terms, the Central Bank has shown greater tendency than the government to allow rates on its bills to move upward, and this primary rate differential has hampered market development in general.

a. Countries that in the process switched to central bank securities

Changes from government securities as the underlying intervention instrument for open market operations to central bank securities have mainly resulted from growing reluctance on the part of the government to further share its debt instruments with the central bank for monetary management, either because (a) the cost of the arrangement was deemed too high for the government (Mauritius), (b) a favorable fiscal situation reduced the need for issuing government debt instruments (Ghana, Chile), or (c) government and central bank wanted a clear separation between monetary and debt management (New Zealand).

Starting in 1988, the Bank of Mauritius began to remove its direct monetary instruments. At the same time, the banking system started facing significant liquidity injections through the external accounts. The Government began to issue on tap short-term, fixed-price government securities to sterilize this excess liquidity. The growing interest cost of this operation became a major concern and in 1991, the Government announced its intentions to discontinue the issue of treasury bills for liquidity sterilization purposes. Thus, beginning in July 1991, the Bank of Mauritius started issuing its own bills on tap and moved to auctions of these bills in November of the same year. Since then, the Central Bank decides on the amounts to be auctioned in close consultation with the Treasury. When the Treasury needs cash, treasury bills are issued and at other times, Bank of Mauritius bills are issued. Both securities have the same characteristics--so that there is in fact only one market--but they are never issued simultaneously.

In Ghana, the introduction of indirect monetary policies during 1988–89 took place against a background of excess domestic liquidity, forcing the Central Bank to intervene quickly and in vast amounts. ^1/ The concern to develop financial markets, combined with the reluctance of the Government to issue treasury bills in sufficient amounts to absorb the excess liquidity, prompted the Central Bank to issue its own debt instruments. Over time, central bank securities became the main instrument of monetary policy, primarily because of rigidities in the weekly treasury bill auction procedures. Furthermore, when fiscal conditions improved, the Government became increasingly reluctant to issue treasury bills, forcing increased reliance on central bank securities for monetary management. To stimulate market development in general, the Central Bank broadened both the maturity range of its own bills and the eligible holders. The concern to stimulate financial markets is further reflected in the fact that central bank bills have exactly the same features as treasury bills.

The experience of Chile bears some resemblance with Ghana. As early as 1975 the Central Bank of Chile moved to indirect monetary policy as part of broader financial reforms. The Central Bank started auctions of central bank promissory notes and treasury bills. Throughout the years the emphasis increasingly shifted to central bank paper. This move was accelerated by the fact that, as part of the financial sector rescue operation in the early 1980s, the Central Bank of Chile bought bad loans from the banks in exchange for central bank bills. By the end of the 1980s when the financial situation returned to normal, the Government lost its interest in issuing government paper because of the favorable fiscal position, so the Central Bank had to rely on its own securities for policy interventions and for market development. To foster markets, the Central Bank broadened the range of maturities of its promissory notes which are now up to 10 years. As in Ghana, these operations have had an unfavorable impact on the central bank’s profit and loss account.

Since 1988, Reserve Bank of New Zealand bills (RBNZ bills) have played a major part in the conduct of monetary policy in New Zealand. ^2/ The RBNZ targets the quantity of primary liquidity (defined as the sum of settlement cash and discountable RBNZ bills) by limiting the quantity of RBNZ bills available to the banks and targeting settlement cash. ^3/ Between 1985 (start of financial reform) and 1988, treasury bills were used instead of RBNZ bills. However, lack of central bank control over the supply of treasury bills in conjunction with the Government’s desire to achieve a clear separation between monetary policy and the Government’s debt management and banking operations, led to the introduction of RBNZ bills in 1988.

Under the present system, a change in primary liquidity--reflecting a change in monetary policy stance--is initiated by the RBNZ offering a greater or smaller quantity of its owns bills. These bills are issued solely to commercial banks through twice-weekly auctions. Secondary market interventions by the RBNZ take place only when settlement cash injections are required. A variety of techniques, including securitized, short-term loans (or sellbacks), repurchases of government bonds and, occasionally, outright purchases of government bonds or commercial paper are used to achieve this aim.

On the other hand, when the RBNZ intervenes to neutralize the impact of government cash flows on reserves (as opposed to changing the stance of monetary policy), it intervenes with a specific kind of treasury bill, “seasonal treasury bills”, solely designed for these purposes. The Central Bank autonomously determines the terms of these securities, taking into account forecast liquidity flows. ^{1/ 2/} It was thought that the use of a different type of security would improve the transparency of monetary policy actions and thus enable the market to clearly distinguish between neutralization operations and changes in the stance of monetary policy.

The features, terms and purpose of central bank securities differ from those of government securities. Furthermore, in its role as the government’s advisor in domestic debt management, the RBNZ makes recommendations on the structure, amount, and timing of issues and the coupon rate of government bonds, thereby ensuring consistency with monetary policy and reducing the potential for interference of debt management with monetary policy purposes to a minimum.

b. Countries that have used central bank securities from the onset

Central banks in Costa Rica, Indonesia and Korea, for various reasons, have always used central bank securities as the intervention instrument for open market (type) operations. Bank Indonesia, in addition, also uses private paper to enhance the flexibility of its interventions.

In Costa Rica, the central bank’s main monetary instrument is primary issues of its own securities. ^3/ By lack of coordinating arrangements, the Central Bank and the Treasury have been competing to place their respective securities and have experienced problems placing the desired amounts.

Government securities are not available in Indonesia, since, according to the “Balanced Budget” rule the Government is effectively prohibited from issuing any domestic debt instrument. ^1/ Therefore, since 1983, at the initiation of the transition to indirect instruments, central bank securities or SBI’s (Sertificat Bank Indonesia) have been the central bank’s main open market instrument. Because SBI’s mainly served liquidity draining purposes and could not be effectively used to inject liquidity, the Central Bank also created a market for SBPU’s (Surat Berhaga Pasar Uang--money market securities) to inject liquidity. ^2/ These SBPU instruments can be rediscounted at the initiative of commercial banks. ^3/ Issue procedures of SBI’s and maturities of both SBI’s and SBPU’s have been undergoing frequent adjustments to improve their effectiveness, depending on the prevailing macro monetary conditions.

In Korea, central bank securities (Monetary Stabilization Bonds or MSB’s) have been used since 1961 to deal with massive liquidity absorption. ^4/ Treasury bills were introduced a few years later and, officially, were also available for monetary policy purposes. For a long time, however, the central bank continued to rely on direct credit controls as its main monetary policy instrument, supplemented with MSB’s for absorbing excess liquidity. The dramatic expansion of the market for MSB’s, needed to absorb the liquidity overhang, at times hampered expansion of other money markets by draining away funds. More recently, steps are being taken to revise the terms and operating procedures of treasury bills to allow government securities markets to become the principle vehicle for a move to full indirect monetary operations in Korea.

a. General observations

In theory, the origin of the financial instrument used for market development and policy intervention seems irrelevant. What matters are the characteristics of the instrument. Irrespective of their origin, these instruments should be designed in such a way that they foster the development of a free, well-functioning market in this instrument which, in turn, would facilitate the development of money markets in general and market-based monetary policy operations in particular.

Important ingredients in this respect are: ^1/ (a) interest rates should be freely determined by the market; (b) holdership should be defined as broadly as possible to stimulate competition. More competition is likely to improve the process of interest rate setting. Broad holdership will also facilitate the transmission of monetary policy impulses; (c) the maturities of the paper should be such that they stimulate trading; (d) transfer of ownership of the instrument must be easy; (e) taxation should be simple and transparent to stimulate trading and holding ^1/; and (f) proper rules for rediscounting the financial instrument should be established. If access to the central bank’s rediscount window is automatic and easy, secondary market development will be hampered.

The above key features can in principle be adopted by both government and central bank paper. So, from this perspective, the choice between both instruments is indifferent. The next question is whether, based on country experience, there are other arguments in favor of or against either of these two instruments.

b. Central bank paper - specific arguments

The main advantage of the central bank using its own debt instruments for open market operations is that monetary management will be largely separated from debt management, thereby giving the central bank operational independence from the early stages of the transition onward.

On the other hand, country practices also reveal two types of problems--or limitations--with respect to the use of central bank paper. The first is the risk of central bank losses when solely relying on the issuance of central bank paper to absorb excess liquidity. The second is the lack of spill over to foster money market development in general.

• The risk for central bank losses. In economies in transition, one major danger that has been associated with the use of central bank bills is the risk for central bank losses. Given the adverse features common to many economies in transition, including situations of extreme liquidity overhang of a domestic origin, central banks often have to intervene in massive amounts to absorb the excess liquidity. If this is done by exclusively relying on central bank securities, these interventions may eventually affect the institution’s profit and loss account. Cases in point are the Philippines, Ghana, and Chile where the issuance of central bank paper has contributed to such losses, while in Indonesia and Korea central bank bills have a significant, negative impact on the profit and loss account.

Central bank losses lead to two major problems. First, they undermine the central bank’s prestige and autonomy and secondly, there is a danger that the huge interest payments due on the outstanding debt and, perhaps, the accompanying losses themselves, will undermine monetary policy effectiveness. In other words they neutralize the very effects sought by the issuance of central bank securities. ^1/

Admittedly, the issuance of central bank securities is just one of several factors that have an impact on central bank profits and may lead to losses. ^2/ Sales of central bank paper reduce central bank profits as much as the use of any other instrument on the central bank’s balance sheet to absorb liquidity from the markets, such as government paper held in the central bank’s portfolio (the exception being required reserves when they are non- or lowly remunerated). Also, if the authorities have agreed on an arrangement whereby the government budget deficit is allowed to be overfunded to meet monetary management requirements, and the central bank pays a market-related interest on these government deposits, the impact on the central bank’s profit and loss account will be similar to the case wherein the central bank replaces this overfunding with its own debt instruments.

The risk for central bank losses resulting from the use of central bank securities is the greatest in the initial stages of the transition to indirect monetary policies, because of the need to mop up large amounts of excess liquidity that have been building up under the direct monetary control regime.

In light of the risk for central bank losses, it would be recommended that any excess liquidity of a permanent nature be absorbed by not entirely relying on short-term central bank paper, but through a combined intervention of increasing reserve requirements and issuing medium- and long-term government bonds (which would also stimulate market development).

• Contribution to market development - mixed results. A second phenomenon is that markets for central bank securities often remain very thin, which may have implications for the flexible use of central bank bills for monetary policy intervention and for financial market development in general. Often, monetary authorities seem to have a tendency to design central bank securities by only focussing on those features that would serve their immediate monetary policy purposes (usually absorbing excess liquidity). The instrument often receives too much government support (eligibility for reserve requirements, liquid asset requirements, rediscountable) for a viable market to develop, and in addition, holdings are often restricted to a small group, e.g., banks. As a result, the market never widens and secondary market activity never materializes. Such design features are not conducive to money market development in general.

However, the seriousness of the above implications depends on the particular circumstances under which central bank paper is used. The implications seem most damaging in those cases where no government securities are in circulation. As long as government securities are in circulation (and these securities have the proper market-stimulating features), there is no real problem in a central bank bill market remaining small. The torch of financial market development can be carried by government securities and, in addition, the central bank can fully enjoy the benefits of a separation between debt and monetary management to gain operational independence. ^1/

The situation becomes more difficult when no government paper exists. Then, central bank securities also carry the weight of financial market development and should be designed accordingly. The degree of financial market development will ultimately have an influence on the efficiency and effectiveness of the central bank’s policy interventions.

A first, though perhaps minor problem in this regard, is that in the absence of a well developed central bank securities market, liquidity injections through this market are difficult because the market would dry up easily. However, central banks can overcome this limitation to one-way interventions (liquidity absorption) by introducing other instruments to inject liquidity, such as credit auctions (operations that most central banks already conduct). Bank Indonesia, for instance, introduced a separate instrument, the SBPU, (based on private paper) for injecting liquidity.

The second implication seems more serious in the long run. If the intervention market remains underdeveloped, it will often remain a nonintegrated part of the money market and therefore fail to stimulate money market development in general. A major drawback associated with segmented money markets is that transmission of monetary policy through the intervention market will remain imperfect, which tends to weaken the impact of the central bank’s policy actions and could force the authorities to delay abolishing their direct instruments of monetary control.

Two cases where the central bank bill market has (yet) failed to integrate in the rest of the financial market are Indonesia and Korea. These countries have respectively nonexistent and underdeveloped government securities markets. ^1/ In both countries, the intervention markets have developed significantly (although secondary market activity is still weak), but they have failed to play a leading role in money market integration because the respective central bank instruments did not bear the desirable features. In both cases, for a long time, interest rates on central bank securities were set by the central banks at lower than market clearing levels. By contrast, both countries have other money market segments that are well developed and function freely (e.g., in Indonesia, the unregulated CP market has grown independently from and in contrast with the SBI and SBPU market, while in Korea, CP and CD markets also developed successfully (Emery (1991)).

In Korea, the administratively set interest rate on MSBs has followed market trends with a lag, and as such there has been no spillover to those market segments where rates are market determined (Chart la). Despite the relatively low rates, the MSB market grew dramatically in the late 1980s--it became the largest money market segment in Korea--owing to its largely captive nature (Chart lb). Its size notwithstanding, secondary market activity is still very low. Both factors constrain the capacity of the central bank to conduct indirect monetary policy.

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Korea-Interest rate at issue on MSBs and corporate bonds

(quarterly data. 1986-12 - 1992-12)

Citation: IMF Working Papers 1994, 062; 10.5089/9781451848229.001.A001

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Korea—Outstanding Balances in the money market

(1980 - 1992, end of period)

Citation: IMF Working Papers 1994, 062; 10.5089/9781451848229.001.A001

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In Indonesia, financial markets have reached a fairly developed stage but the system is still plagued by several shortcomings. From the beginning, the central bank tried to promote the SBI interest rate as a benchmark rate for the system. However, its rigidity and the lack of stimulus that radiated from the SBI and SBPU markets to the other markets resulted in this objective foundering. Chart 2a compares the SBI rate with the interbank and CD rates. Although the chosen periodicity (quarters) does not always allow to obtain a precise idea of the leading/lagging character of the respective interest rates, there are instances (1985-IV, 1986-IV and 1988-III and IV) where the SBI rates lagged rather than led the money market or where the relationship was weak.

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Indonesia-SBI, CD and interbank interest rates

(1984-1990)

Citation: IMF Working Papers 1994, 062; 10.5089/9781451848229.001.A001

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Market development in general, and secondary market activity in particular has been hampered by the (very) short maturities of SBIs (to which Bank Indonesia was forced to increase the flexibility of its interventions in the absence of a secondary market) and the demand-determined nature of the volumes which led to large fluctuations in the outstanding SBI amounts (Chart 2b). The fact that only banks and NBFIs could buy directly from Bank Indonesia and that certain key features such as auction frequency and maturities frequently changed, also constrained the development of the SBI market.

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Indonesia-SBI and SBPU volumes outstanding and interbank transactions

Citation: IMF Working Papers 1994, 062; 10.5089/9781451848229.001.A001

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Some of the above measures also affected the SBPU market. In 1987 Bank Indonesia, in an effort to tighten monetary policy, moved to a system of daily auctions of seven-day SBIs. This, in conjunction with the withdrawal of central bank support for the SBPU market, led to a drying up of the SBPU market (Chart 2b). The chart also demonstrates that the creation of the SBPU market in 1985 had a negative impact on the developing rupiah interbank market. The features of SBPUs (short maturities, rediscount facilities, the proceeds of borrowing via SBPU were exempted from reserve requirements) made these securities very attractive. As a result, transactions in the rupiah interbank market diminished significantly after 1985. In 1988, when the SBPU market dried up, the interbank market revived.

The above problems have lately been recognized by the Indonesian and Korean authorities and in both countries plans have been devised to modify key features of the central bank bills to overcome these problems and improve the effectiveness of indirect monetary policy.

It is worth emphasizing that the above mentioned shortcomings should not be considered as inherent flaws in the use of central bank bills. What they reveal is that, particularly in those circumstances when no government securities markets exist, the proper design of central bank paper is a crucial element for the reform process to be successful.

c. Government securities- specific arguments

The main argument in favor of government securities as the underlying instruments for monetary management is their comparative advantage to act as catalysts for financial market development. Typically, government paper--when well designed--is generally accepted and is therefore a very reliable vehicle for financial market development. Usually, short-term instruments will be issued first, in an effort to foster money market development and gradually, the maturity spectrum will be extended to encourage capital market development.

The specific advantage of government paper over central bank paper in this regard is the potential of the government to issue large amounts of different maturities, given its typical debt funding problems. These large volumes will help in deepening markets in a minimum of time. In theory, a central bank could also issue paper of varying maturities, but it is not in the nature of its business and most likely would lead to financial problems, as the examples of Ghana and Chile to some extent illustrate.

When using primary issues of treasury bills, the central bank will accelerate a cumulative development process. The central bank contributes to the deepening of the market, allowing itself to move quickly to secondary market interventions. These interventions will enhance the liquidity of the market and thus stimulate its further development. In addition, the switch to secondary market interventions considerably reduces the need for coordinating arrangements to preserve the central bank’s operational independence.

The country survey indicates that in several cases the cost to the government, resulting from massive issues of government paper to absorb excess liquidity--particularly when these issues are not needed for deficit funding operations--reduces the government’s enthusiasm for further allowing the central bank to issue government securities for monetary management. In Mauritius, where large capital inflows forced the authorities to conduct massive absorption operations, the Treasury no longer allows the central bank to use government securities in its monetary operations. Excess liquidity is also an issue in Kenya, and the Treasury has shown some reluctance to issue treasury bills in amounts that meet monetary management needs, but has not changed its position. ^1/ In contrast, in The Gambia, the Treasury still allows the use of government securities for open market type operations, despite the government’s favorable fiscal position. ^2/

The cost-for-the-budget-argument as a deterrent for the government to allow the use of government securities in support of open-market type interventions needs to be considered carefully. Absorption of excess liquidity always involves a cost which ultimately needs to be borne by the government (the cost involved is mainly the interest to be paid on it). When government securities are used for the absorption, the cost will be directly visible in the government budget. When central bank securities are used, the operation will affect the central bank’s profits, and in the worst case lead to losses. Under the typical institutional arrangement whereby the larger part of the central bank’s profits are transferred to the government, the budget will be affected, either through foregone revenue or higher expenditures to bail out the central bank. So, in terms of cost for the government budget, both approaches are equivalent.

The true size of the cost of the absorption operation depends on the origin of the excess liquidity. If the excess liquidity had been building up under direct credit controls, there will inevitably be a cost for the authorities, whether government or central bank securities are used. If on the other hand, the authorities have to sterilize excess liquidity resulting from capital inflows, the interest cost from issuing treasury or central bank securities will largely be offset by the interest earned on the central bank’s holdings of foreign assets. The net cost to the government will be approximately the same, whether government or central bank securities are used. With government securities as the intervention instrument, the interest cost to the government budget will be partially compensated by higher central bank profits. When central bank paper is used, the higher interest revenue on foreign assets will partially compensate the interest paid on those liabilities.

Thus, the cost to the Government resulting from the use of treasury bills in open market (type) operations is not a valid argument against their use, because ultimately the government will always have to bear the cost of the absorption. On the contrary, reliance on government securities for absorption operations would improve the transparency of the operation. The use of government securities would make overt the cost of the exercise and put pressure on the authorities to address the underlying cost factors, which often are related to excessive fiscal deficits. In addition, the greater potential of government securities to stimulate financial market development is a strong argument in favor of using government securities in large absorption operations. Debt management considerations will dictate the proper maturity mix of these securities at each point in time. Finally, the use of government securities would take away the risk for central bank losses as discussed earlier.

d. Summary

While in principle the origin of the financial instrument used for open market (type) operations does not matter--provided the instrument is endowed with the proper characteristics to stimulate financial market development--this section argued that there is a preference for the use of government securities in monetary management. This preference is primarily motivated by the fact that government securities are better placed to play a catalyst role in financial market development and that their use increases the transparency of the operation.

The use of government securities in monetary management will assist in establishing a liquid and deep market in the intervention instrument. The expansion of the government securities markets (towards the longer end of the maturity spectrum) will also improve the transmission of policy impulses and thus the effectiveness of monetary policy. Also, by not using a separate instrument for monetary policy intervention, market segmentation and confusion will be avoided in the early stages of financial reform.

However, to be successful, the use of government securities does require good coordination, especially in its initial stages. This requirement may make both the central bank and government decide that it is better to introduce a separate instrument for monetary management. However, the introduction of a separate instrument does not relieve the authorities from coordinating their respective operations as will be illustrated and argued in the next section.

On those rare occasions where a government securities market is not established and no plans exist to develop such a market, the central bank debt instruments should be carefully designed so that they can contribute to financial market development in general.

Finally, siphoning off of large amounts of excess liquidity in the initial stages of financial reform should ideally take place before indirect instruments are introduced, through the issuance of certain medium- to long-term instruments, or a combination of monetary policy instruments.

Exclusive reliance on central bank securities is bound to lead to financial problems for the central bank under such circumstances.

a. case 1

There is no need for supporting arrangements in those situations where no government securities exist. Coordination between monetary and fiscal authorities is necessary for the impact of daily government cash flows on reserves, but that is not different from any of the other cases. Here, central bank bills are also the main vehicle for financial market development. Hence, proper design of the instrument is crucial.

b. case 2

Open market policy through secondary markets for government securities is the most common case in industrial countries with developed securities markets. As the danger for debt management interfering with monetary management is minimized under these circumstances--and thus the central bank’s operational independence largely guaranteed--the requirements for coordination at the operational level are minimal. ^1/

This type of arrangement is still exceptional in countries with developing financial markets because it requires the existence of sufficiently deep and wide securities markets, which can take considerable time to develop. The Central Bank of Mexico is the only one that mainly relies on genuine open market operations. Sporadic secondary market interventions have started in a few other countries.

c. case 3

The need for coordination at the operational level is equally low when the central bank conducts open market operations in the secondary market for central bank securities. Although this a feasible arrangement in theory, to date, in the countries under review a secondary market in central bank bills has not developed sufficiently to allow the central bank to conduct the larger part of its open market operations in that market.

d. case 4

A higher degree of coordination at the operational level is required when the central bank uses primary issues of its own debt instruments for monetary management, while treasury bill markets exist simultaneously. Coordinating arrangements between fiscal and monetary authorities are required to avoid mutual interference that would hamper the central bank’s operational independence and delay financial market development. Therefore, the arrangements should ensure that government securities stimulate financial market development and that a viable market develops in the intervention instrument, as an integrated part of the money market in general.

The country survey indicates that only a few countries have succeeded in elaborating solid arrangements that make the achievement of the above goals possible. This does not come as a surprise because quite often, failure on the part of the authorities to share primary issues of government securities for monetary and debt management is at the origin of the resort to central bank bills. In the aftermath of these events, both parties also fail to elaborate coordinating arrangements in the new environment, or are under the false impression that they do not need such coordination.

Problems that have emerged as a result of a lack of coordination are (i) competition between the two authorities to sell the (separately) planned amounts of securities, and (ii) segmentation of the markets in the early stages of the reform which hampers the growth of both markets.

To achieve a successful co-existence of both types of financial instruments, it is necessary to (a) coordinate the issues of both financial instruments and (b) arrive at an arrangement that avoids market segmentation in the early stages. Depending on the particular situation in each country, these conditions can be met through various arrangements.

For instance, market homogeneity could be preserved if central bank and government securities were endowed with exactly the same features (interest rate determination, maturity, eligible holders). This would be the preferred option when both markets, taken separately, are expected to remain thin for a long time, as it would add some volume to the market. The arrangements in Ghana and Mauritius are along these lines and, thus, meet conditions (a) and (b). In both countries, central bank and treasury instruments have identical characteristics, and the issues are coordinated. In Mauritius, for instance, the Treasury and Central Bank alternate issuance dates, depending on the Treasury’s needs for fresh funds.

However, success of the above type of arrangements depends to a large extent on the market’s perception of both instruments. In some countries, it turns out that the government has to pay a higher risk premium than the central bank on otherwise similar securities, which has led to segmented markets and caused confusion in the market. Such was the case in the Philippines in the early 1980s and Poland in 1990, and it still is the case in Costa Rica. In Nepal, the Central Bank has a tendency to pay higher interest rates on its bills than the Treasury (in side-by-side auctions). As a result of this practice, the markets remain also segmented. ^1/

Should the establishment of a homogeneous market prove to be impossible, both authorities should seek to clearly differentiate their instruments from one another. ^2/ In such a situation, the central bank securities should have shorter maturities at issue than the treasury bills with all the other features of the instruments being identical. Central banks always operate at the short end of the market to achieve the strongest feed-through to interest rates. Therefore, this option would increase the central bank’s intervention flexibility. In terms of remaining maturity, both types of instruments will eventually merge into one market.

The New Zealand arrangements stand out as a unique example. In New Zealand, the RBNZ bill market is limited to a key market of financial institutions but this market is well integrated in the rest of the money market so that the transmission of monetary impulses is ensured. The clear separation between government and RBNZ securities and the clear definition of their purposes ensures that there is no confusion in the market place that could possibly hamper financial market development. The main difference between New Zealand and most of the other countries discussed here is that the latter often do not have established government securities markets which will ensure financial market development. In the absence of such well-established markets, market segmentation should be avoided.

e. case 5

The most elaborate type of coordinating arrangement to ensure the central bank’s operational independence is needed when the same instrument and market is used for monetary and debt management. The country survey contains a number of typical examples, demonstrating good (or potentially good) arrangements as well as the kind of problems that may arise when arrangements are missing.

To safeguard (or achieve) the central bank’s operational autonomy, the coordinating arrangement supporting the use of primary issues of government paper for both debt and monetary management should contain the following ingredients: (a) the instrument should have the proper characteristics, as discussed earlier; more particularly, the government should allow the interest rate at auction to clear the market; (b) a mechanism should be established whereby the volume at issue incorporates the monetary management needs; and (c) an arrangement should also be established to “sterilize” the proceeds from securities sold over and above the debt management needs, and to determine the interest payments on these proceeds.

Developments in Pakistan (since 1991), Nepal (before 1992), and Sri Lanka (before 1992) point to problems in terms of monetary policy effectiveness and delays in the transition to indirect policies, when these requirements are not met. A common characteristic of these countries’ procedures was (or is) that the volumes at issue are determined by the government without due regard of monetary management objectives and the interest rates at auction were (are) not at market clearing levels, due to government interference.

Recent experience in Pakistan highlights the problems associated with a move to an indirect monetary control framework in the absence of clear coordinating arrangements between fiscal and monetary authorities regarding the use of government paper. From the introduction of the auction system, the volumes offered at issue did not reflect monetary management considerations but in general remained unchanged at each auction. Initially, interest rates at the auctions moved steadily higher, closer to market-clearing levels (although the government used post-action cut-off rates). In the wake of these developments, limited secondary market activity began (Charts 3a and 3b). Later on, however, there was some hesitation on the part of the Treasury to allow interest rates to move higher, which has been reflected in a slowing down of market expansion. In addition, there have been cases where all bids were rejected and the Government consistently forced the State Bank of Pakistan to buy the amounts rejected at auction.

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Pakistan—Average Rate at Treasury bill auctions

Citation: IMF Working Papers 1994, 062; 10.5089/9781451848229.001.A001

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Pakistan—Trading Volumes in the secondary Treasury bills market

(March 1991 - November 1992)

Citation: IMF Working Papers 1994, 062; 10.5089/9781451848229.001.A001

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The latter practices have rendered monetary management more complicated than before the introduction of the auction system for two reasons. First, the forced purchases by the State Bank significantly add to money creation and introduce additional variability in reserve money. Secondly, the central bank has to counteract the above mentioned liquidity fluctuations but has no developed secondary market to execute such transactions.

These distortions have also affected the development of other money market segments. ^1/ In particular, the uncertainty introduced by rejecting bids, not only has affected the bidding pattern at the auction and the trading activity in the secondary market (Charts 3a and 3b), but has also introduced a high degree of volatility in the interbank market as a consequence of the large and sudden fluctuations in domestic liquidity (Chart 4).

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Pakistan—Auctions results and interbank rate developments

(09/19/92 – 12/09/92)

Citation: IMF Working Papers 1994, 062; 10.5089/9781451848229.001.A001

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In contrast, the arrangements currently used in the Philippines, the Gambia and Israel seem to meet the above requirements. Kenya has also elaborated a potentially good arrangement, but other factors have lately been intervening.

The current arrangements in the Philippines--allowing for overfunding of the deficit--require a high degree of coordination between fiscal and monetary authorities. As part of the arrangement, the government has to commit itself to not using these funds, which in times of emergency financing needs has led to tensions or conflicts. ^1/ Under the current arrangements in the Philippines, the cost for the central bank is slightly smaller than the cost it would incur if it had to issue its own securities to supplement the issues of treasury bills, because the central bank does not pay interest on the entire deposit. In the Gambia, unlike in the Philippines, the Treasury bears the entire interest rate cost.

The arrangement in Kenya is different in the sense that the central bank was granted large autonomy as the Government’s debt manager. In principle, such an arrangement leads to a large degree of central bank autonomy in monetary management and requires less day-to-day coordination than a Philippine-type arrangement. While most central banks are fiscal agents of the government, the role of debt manager is only rarely given to central banks. ^2/ Yet, the fact that in general central banks are closer to the financial markets than ministries of finance is a valid argument for giving the central bank broad debt management responsibilities.

Against the assignment of the debt management function to the central bank stands the argument that this type of function is not really at the core of central banking, and therefore may distract the latter from its main tasks. ^3/ The validity of this argument is a practical matter because, in the circumstances of countries in transition, making the central bank the government’s debt manager may exactly give the central bank the operational autonomy it needs to pursue its main objective. Therefore, as part of reform programs, this type of arrangement deserves more attention. Such an arrangement may still require an additional mechanism to deal with overfunding of the budget.

Finally, an alternative that relies on government securities and yet has the added advantage of largely separating monetary from debt management, has been adopted in Israel. The Bank of Israel uses a specific government debt instrument that is not used by the government for debt funding purposes. This arrangement in fact bears a lot of resemblance with the use of central bank paper, but the cost is directly borne by the government. Such an arrangement also deserves more attention for reform programs because it is fairly easy to implement, gives monetary management its operational autonomy, only marginally interferes with debt management and requires no day-to-day coordination between both authorities.

When comparing the above arrangements, distribution of the cost of the arrangement comes out as a the distinguishing factor. Under the Gambian, Israeli, and Kenyan arrangements (and Mauritius before 1992), the government bears the interest cost of the operation. In the Philippines, the cost is shared, with the central bank bearing the larger part of it. However, as discussed earlier, on a consolidated basis, all solutions approximately yield the same results, provided all central bank profits are transferred to the government, and the central bank does not artificially depress profits to dampen the transfer.