A. Introduction

1. A structural liquidity surplus is a common characteristic in countries experiencing sustained foreign currency inflows such as Qatar.² Particularly, if the exchange rate is pegged, the central bank will have to purchase foreign exchange and sell domestic currency. When the supply of domestic liquidity persistently exceeds demand, a structural liquidity surplus will develop. Depending on the central bank’s ability to absorb the surplus, liquidity will either accumulate at the central bank or leak out into the economy through the banking system.

2. Liquidity surplus is a concern from both a macroeconomic and a financial stability prospective. It may initially be reflected in the accumulation of excess reserves with the central bank. Over time, however, as banks look for higher returns, credit growth is likely to rise and contribute to inflationary pressure. Banks may also relax lending standards, which could increase systemic risk in the banking sector. Moreover, surplus liquidity has the potential to cause the demand for real and financial assets to increase and thus contribute to asset price inflation. Hence, managing surplus liquidity is of interest not only from a monetary policy perspective (e.g., price stability) but also from a financial stability perspective. It is important to point out, however, that in countries that have an exchange rate peg and where there are limited restrictions on cross-border capital flows, the primary responsibility of macroeconomic stability falls on the fiscal authorities while the main task of liquidity management is to smooth volatility in money markets and prevent the build-up of structural liquidity.

3. A number of central banks facing structural liquidity surpluses operate a so-called floor-rate system. A floor-rate system is an interest rate corridor consisting of a lending and deposit facility, but where the central bank does not actively guide the interbank rate within the corridor. Instead, the deposit rate (i.e., the floor-rate) is used as the policy rate. This is especially convenient when there is a structural liquidity surplus as the interbank rate is naturally pushed to the floor of the corridor.³ One potential drawback of such passive liquidity management approach is that the central bank becomes the main counterparty for commercial banks when managing their liquidity and therefore depresses interbank activity.

4. This chapter reviews the liquidity management framework in Qatar and assesses the progress made towards a more active and more market oriented liquidity management framework. Section B discuses the underlying sources of liquidity surplus in the Qatari economy and the realized consequences; section C and D describe the country’s current liquidity management framework and the authorities’ efforts to move towards more market based instruments; and section E discusses the basics of liquidity forecasting in the context of Qatar. Finally, section F concludes and discusses potential ways on how to strengthen the liquidity management framework going forward.

B. The Hydrocarbon Boom, Surplus Liquidity and Asset Price Inflation

5. Since the mid-2000s, surging hydrocarbon export revenues have supported a ramp-up in fiscal spending, which has caused a persistent liquidity surplus in the economy. With rising global oil prices and a more than doubling of hydrocarbon production since 2004, export revenues have surged. The windfall has partly helped fund a massive investment effort by the government to diversify the domestic economy, and partly invested in external assets held by the sovereign wealth fund. Although the rise in fiscal spending has boosted outflows of foreign currency through higher remittances and imports, part of the spending has been monetized in order to maintain the peg to the U.S. dollar. As a result, the balance sheet of the QCB expanded five-fold between 2004 and 2011, and its international reserves rose from $3 billion to $17 billion. The injection of liquidity resulted in a significant pick up in broad money and credit growth, and inflation rose to 16 percent by mid 2008 (see Table II 1). In addition, imported loose monetary policy from the U.S. further contributed to the growth of money aggregates. Although hydrocarbon export revenues fell in 2009 due to the global financial crisis, fiscal spending growth remained positive and growth in credit and monetary aggregates regained momentum in 2011.

Table II.1.

Hydrocarbon Boom, 2004–11

(Percent)

Source: Country authorities.

Table II.1.

Hydrocarbon Boom, 2004–11

(Percent)

	2004	2005	2006	2007	2008	2009	2010	2011
Growth in hydrocarbon export revenue	33.8	40.6	36.5	27.5	55.1	-31.4	71.6	45.2
Growth in fiscal spending	43.2	40.6	32.3	28.4	15.9	21.7	18.2	18.2
Money growth (M3)	18.6	39.2	40.9	35.6	21.9	12.7	23.2	27.5
Credit growth	11.4	39.5	40.7	54.4	50.9	14.1	16.7	28.2
Inflation	6.8	8.8	11.8	13.8	15.0	-4.9	0.4	1.9

Source: Country authorities.

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Table II.1.

Hydrocarbon Boom, 2004–11

(Percent)

	2004	2005	2006	2007	2008	2009	2010	2011
Growth in hydrocarbon export revenue	33.8	40.6	36.5	27.5	55.1	-31.4	71.6	45.2
Growth in fiscal spending	43.2	40.6	32.3	28.4	15.9	21.7	18.2	18.2
Money growth (M3)	18.6	39.2	40.9	35.6	21.9	12.7	23.2	27.5
Credit growth	11.4	39.5	40.7	54.4	50.9	14.1	16.7	28.2
Inflation	6.8	8.8	11.8	13.8	15.0	-4.9	0.4	1.9

Source: Country authorities.

6. The build-up of liquidity surplus was a contributing factor to both the equity boom (2003–06) and the real estate boom (2007–08). The strong growth in monetary aggregates not only spurred price inflation of goods and services, but also contributed to asset price inflation.

• Stock market boom (2003–06): Stock prices quadrupled between early 2003 and the third quarter of 2005, only to fall by over 50 percent by the end of 2006 (Figure II.1). Although many factors contributed to the rise in stock prices—such as the small number of listed companies, low free float, and limited alternative investment opportunities—the demand for equity was to a large extent driven by strong economic growth and abundant liquidity.⁴ Furthermore, relaxed lending standards by commercial banks made it possible for investors to leverage their investments as consumer credit was redirected to equity investments.

• Real estate boom (2007–08): According to the QCB, real estate prices rose by about 140 percent between early 2007 and September 2008.⁵ Part of the reason for the rise in real estate prices was the rapidly growing population, which doubled between 2003 and 2008, coupled with strong economic growth. However, the excess liquidity provided easy access to finance while imported low interest rates and high inflation resulted in negative real interest rates. Real estate credit grew by 137 percent between January 2007 and September 2008. It all came to an abrupt end when the global financial crisis hit the region in late 2008. Consumer and investment confidence fell in tandem with oil prices, banks became more risk averse, and global capital markets tightened. By mid 2009 real estate prices had fallen by over 50 percent. To assure financial stability, the government intervened to purchase a part of the real estate and domestic equity investment portfolios of local banks.

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Figure SHUAA Capital Qatar Index, 2003–07

(Index, Dec. 2003 = 100)

Citation: IMF Staff Country Reports 2013, 015; 10.5089/9781475571455.002.A002

Source: Haver.

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C. Liquidity Management in Qatar

7. With an open capital account and a strong commitment to the U.S. dollar peg, the QCB is constrained in its ability to manage liquidity. As any sizable deviations between the domestic policy and international U.S. dollar rates encourage speculative capital flows, the QCB’s ability to use its policy rate to actively manage liquidity is limited. Furthermore, with a structural liquidity surplus and underdeveloped money markets, QCB has found it convenient to take a passive approach to liquidity management.

8. As a result, the QCB has primarily relied on non-market based liquidity management instruments.⁶

• Reserve requirement ratio (RR): The reserve requirement ratio is defined over the average of commercial banks’ foreign and domestic deposit held during the previous month. The required reserves are unremunerated and must be maintained on a daily basis. Banks will be penalized if they fail to fulfill the reserve requirement. The QCB has in the past used the RR ratio as an instrument to absorb liquidity. The RR was raised in several steps between September 2007 to April 2008 from 2.75 to 4.75 percent with the explicit motivation of absorbing liquidity and moderating credit growth.

• Qatar Money Market Rate (QMR) standing facility: This is the main instrument used by QCB to manage liquidity. The facility consists of an overnight deposit and a lending facility. Prior to July 2005, the interest rate corridor (i.e., spread between the QMR lending and deposit rates) was kept narrow and tightly followed the London Interbank Offering Rate (LIBOR). However, with the loosening of U.S. monetary policy in September 2007, the interest rate corridor widened sharply as the QCB lowered the deposit rate in line with LIBOR but kept the lending rate constant. As the global financial crisis hit the world economy in the third quarter of 2008, LIBOR fell sharply, but unlike most of its neighboring central banks, the QCB did not follow suit and kept its deposit rate substantially higher than LIBOR (Figure II.2).

• Certificates of deposits (CD): The QCB introduced non-negotiable CDs in 2008 with maturities varying between 14 to 273 days.⁷ The purpose was to absorb excess liquidity. However, following the introduction of treasury bills (T-bills) in 2011, the QCB terminated the issuance of CDs. At its peak, the outstanding amount of CDs reached approximately 3 percent of commercial bank deposits.

• Repurchase agreements (Repos): The QCB enters into repurchase agreements with commercial banks—backed by government securities—but does not conduct reverse repos. Consequently, this instrument is only designed to inject and not absorb liquidity. The repos have maturities of 2 weeks to one month. As there is no active repo market, banks typically initiate the transaction at a predetermined rate set by the QCB. The repo rate is currently equal to that of the QMR credit rate.

• Public deposit management: The government and semi-government institutions account for almost 40 percent of total residential deposits in Qatar. However, as public deposits are not under direct control of the QCB, they are generally not part of the QCB’s liquidity management framework. Nevertheless, during the global financial crisis in 2008–09, the government, in coordination with the QCB, increased its deposits in commercial bank to inject liquidity in the banking system.

• Macroprudential instruments (MaP): The QCB also considers macro-prudential tools as an indirect channel to manage liquidity through the credit creation process. The primary macro prudential tools are the loan-to-deposit ratio and the liquidity ratio.

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QMR Standing Facility and Interbank Rates, 2002–12

(Percent)

Citation: IMF Staff Country Reports 2013, 015; 10.5089/9781475571455.002.A002

Sources: Qatar Central Bank; and Haver.

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9. The large speculative capital inflows between 2008 and 2011 illustrate the difficulty of actively using the standing facility to absorb liquidity. With the spread between the LIBOR and QCB’s deposit rate widening in 2008, commercial banks quickly began to take advantage of the arbitrage opportunity by borrowing from abroad and depositing at the QCB (Figure II.3). Net foreign liabilities of banks increased sharply by QR 55 billon by the end of 2010 and deposit at the QCB rose by an almost identical amount of QR 57 billion. In 2011, to prevent further speculative flows the QCB limited the amount commercial banks could deposit at QCB and lowered the QMR deposit rate, resulting in a sharp drop of deposit holdings of commercial banks.

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Deposit Rate-LIBOR Spread and International Arbitrage, 2006–11

Citation: IMF Staff Country Reports 2013, 015; 10.5089/9781475571455.002.A002

Sources: Country authorities; and IMF staff calculations.

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D. Recent Reforms to the Liquidity Management Framework

10. The QCB is moving towards market based instruments in order to align the liquidity management framework with efforts to develop domestic capital markets. Since 2011, the authorities have made a concerted effort to develop domestic capital markets. To align the liquidity management framework with the objective of developing capital and money markets, the QCB implemented a series of measures

• On 17 January 2011, the QCB imposed a ceiling on the QMR deposit facility. To reduce speculative capital inflows, the QCB reduced the interest rate on its deposit facility and imposed a quantity ceiling on the amount that banks could deposit with the central bank.⁸

• On 10 May 2011, the government began to issue T-bills. The issuance of T-bills was motivated by a number for factors. According to the QCB, the main objectives were to (i) provide the government with a source of funding in local currency that could be used for domestic current expenditure, (ii) develop a benchmark yield curve of risk-free rates for pricing of financial instruments, (iii) provide an instrument to QCB for managing structural liquidity, and (iv) develop a high-quality, liquid asset for banks in local currency.” The T-bill auctions are conducted monthly and at a fixed amount of QR 4 billion.

• On May 6, 2012, the QCB released, together with Bloomberg, the Qatar Interbank Offer Rate (QIBOR). The initiative was part of a general effort to encouraging a more active interbank market in Qatar by making market activity more transparent. QIBOR is constructed on offer rates provided by nine banks and is published on QCB’s website as well as distributed through Bloomberg. The initiative started in August 2010 and the quoted maturities range from overnight to one-year.

11. The QMR deposit ceiling resulted in a build-up of excess reserves and a persistent disconnect between the deposit and the interbank rate. With the ceiling on QMR deposits, banks found themselves with a significant amount of excess reserves with the QCB. Not surprisingly, the volume and number of interbank transactions fell markedly in the first couple of months following the policy initiative, and the overnight interbank rate fell from 1.5 per cent on January 17 to 0.28 percent on July 4-well below the current QMR deposit rate of 0.75 percent (Figures II.4 and II.5).⁹ To absorb the liquidity surplus, the government issued bonds amounting to QR50 billion to banks at an interest of 5 percent. However, as the proceeds from the bonds were gradually transferred from the QCB to government accounts, it is unclear how much liquidity was actually drained. The combination of a pick-up in credit demand and an outflow of speculative cross-border capital appear to have tightened liquidity conditions in mid-2011. The QIBOR began to rise in tandem with interbank activity in the second part of 2011 and by early 2012 it had converged to the QMR deposit rate.

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Impact of Liquidity Management Reforms on the Qatar Interbank Rate, 2010–12

(QIBOR)

Citation: IMF Staff Country Reports 2013, 015; 10.5089/9781475571455.002.A002

Source: Bloomberg.

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Interbank Market Activity, 2010–12

Citation: IMF Staff Country Reports 2013, 015; 10.5089/9781475571455.002.A002

Source: Qatar Central Bank.

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12. The effectiveness of T-bills to absorb liquidity will depend on the institutional arrangement between the QCB and the MoEF. The approval to issue government securities, including T-bills, was obtained from the Supreme Council of Economic Affairs and Investment, which is chaired by the Emir. By end of 2011, the outstanding amount of T-bills reached over QR14 billion, and by end October 2012, it had risen to QR21 billion. Currently, the debt stock remains constant as the monthly issued debt exactly covers maturing amount. The proceeds from both the T-bills and T-bonds appear to be first deposited with the QCB but then transferred to government accounts. However, since early 2012, the government has transferred approximately QR4 billion monthly to the QCB to back up the issuance of government debt and make sure that it stays in a blocked account with the QCB.

E. Liquidity Forecasting

13. As the QCB transitions to a market-based liquidity management, it will be essential to develop a strong liquidity forecasting framework. In the past, when the QCB primarily relied on its standing facility to passively absorb liquidity surplus, forecasting may have been less of an issue. However, if the QCB intends to move to a more market-based liquidity management approach, forecasting the liquidity needs of the banking system becomes imperative as it help guide the size and timing of liquidity operations. Without good liquidity forecasts the QCB runs the risk of draining too much or too little liquidity, resulting in excess swings in interbank rates. Thus, having reasonably accurate short-term forecasts of liquidity will help reduce interest rate volatility and strengthen the monetary transmission mechanism. Moreover, if the central bank consistently fails to absorb excess liquidity due to poor liquidity forecasting or the lack thereof, more systemic problems may develop (e.g., asset price bubbles and lax lending standards).

14. The first step towards building a liquidity forecasting model is to reconstruct the balance sheet of the central bank into demand and supply components of reserves. The supply of reserves is decomposed into factors beyond the control of the central banks (so-called autonomous supply factors) and those directly managed by the central banks through its liquidity instruments (i.e., policy position). The demand for reserves is decomposed into required reserves and excess reserves (Table II.2). By forecasting the autonomous supply factors and the demand for reserves, the central bank can project the ex-ante demand-supply imbalance. By adjusting its liquidity management operations, the central bank can then decide how much liquidity to drain or absorb in order to smooth interbank rates. Table II.2 shows a reconstruction of the QCB balance sheet before the QMR deposit ceiling was implemented.

Table II. 2.

Simplified QCB’s Balance Sheet, December 2010

(QR millions)

Sources: Qatar Central Bank; and IMF calculations.

Table II. 2.

Simplified QCB’s Balance Sheet, December 2010

(QR millions)

Assets	116,502	Liabilities	116,502
Net Foreign Assets (NFA)	113,262	Currency in circulation	7,974		Autonomous supply factors
		Government deposits	668
		Other items net	20,015
		Required reserves	14,611		Demand for reserves
		Excess reserves	5,177
QMR Standing facility Credit	3,240	QMR Standing facility Deposits	64,046		Policy position
		Certificates of deposits	4,010

Sources: Qatar Central Bank; and IMF calculations.

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Table II. 2.

Simplified QCB’s Balance Sheet, December 2010

(QR millions)

Assets	116,502	Liabilities	116,502
Net Foreign Assets (NFA)	113,262	Currency in circulation	7,974	View Expanded	Autonomous supply factors
		Government deposits	668
		Other items net	20,015
		Required reserves	14,611	View Expanded	Demand for reserves
		Excess reserves	5,177
QMR Standing facility Credit	3,240	QMR Standing facility Deposits	64,046	View Expanded	Policy position
		Certificates of deposits	4,010

Sources: Qatar Central Bank; and IMF calculations.

15. In order to forecast the change in the autonomous supply factors, it is important to understand their underlying determinants:

• Net foreign assets (NFA): The net foreign asset position is determined by the QCB’s foreign exchange sales and purchases with commercial banks. As a large share of the foreign currency denominated hydrocarbon export revenue goes to the government—some of the revenues are transferred to the sovereign wealth fund—the fiscal authorities become the main supplier of foreign exchange. On the other hand, imports and remittance payments constitute the main sources of demand for foreign exchange. Private cross-border capital flows also play an important role in determining the ultimate balance of payment surplus and the accumulation of NFA.

• Government deposits: In Qatar, the government primarily operates through commercial bank through a Multi Treasury Account (MTA) system. The government’s account with QCB is mainly used for the initial collection of proceeds from government securities issuance. Thus government’s cash management mostly affects the deposit base in commercial banks and hence indirectly the demand for reserves.

• Cash in circulation: This component is generally determined by transaction demand in the economy and thus likely to be highly seasonal. Over the long-term, however, currency demand should generally grow proportionally with economic activity. Another factor that can impact currency in circulation is technological and financial innovations (e.g., improvements in the payment system).

• Other items net (OIN): The capital, reserve and revaluation accounts are traditionally the largest components of OIN. Movements in the capital and reserve accounts should be well known to the central bank and the revaluation account should not influence liquidity as it is offset by changes in capital, although in Qatar, capital and reserve accounts have traditionally been driving OIN.

16. A reliable forecasting model would have to be built around a good understanding of underlying market trends as well as policy factors affecting the NFA position. As figure II.6 shows, the NFA is by far, the most important component of the 4autonomous supply factors, both in terms of relative size and volatility. To forecast changes in NFA, it is important to have a good understanding of public and private balance of payment transactions (e.g., government transfers in and out of the sovereign wealth fund; private net demand for foreign exchange based on import and remittance projections; and non-bank and bank cross-border capital flows). Uncovering seasonal patterns in NFA and strengthening balance of payment coverage—in particular with respect to private non-bank financial account transactions—would also help improve the accuracy of the forecast.

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Relative Importance of Autonomous Supply Factors, 2001–12

(QR billions)

Citation: IMF Staff Country Reports 2013, 015; 10.5089/9781475571455.002.A002

Sources: QCB; and IMF staff calculations.

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Box II.2.

An Illustration of the Usefulness of Liquidity Forecasting

The QMR deposit facility ceiling imposed in January of 2011 led to a build-up of excess reserves, causing the interbank rate to fall well below the deposit rate. It was not until early 2012 that the interbank rate realigned itself with the floor of the interest rate corridor again. Clearly, such interest rate volatility is undesirable. To illustrate the usefulness of liquidity forecasting, this box attempts to answer the following question: Based on a simple forecasting model, how much liquidity should the QCB have absorbed in January of 2011 to have kept the interbank rate close to the policy rate. To simplify matters the following assumptions were made:

Net foreign assets: The forecast is based on a regression with the oil price and the spread between the QIBOR and LIBOR as dependent variables. The basic premise is that NFA would be positively correlated with both variables. The forecast for January assumes that the interest spread remains constant. The oil price is forecast based on a simple ARMA (1,1) model.

Government deposits: The MOEF is assumed to perfectly inform the QCB about its transactions.

Currency in circulation: The forecast is based on an estimated long-run trend.

Other items net: Assumed to remain constant.

Required reserves: Due to the lagged calculation of the required reserves, the balance for the next month is assumed to be known.

Excess reserves: The forecasted value of excess reserves is based on past values and would thus reflect the average level of reserve that banks want to hold in excess of what is required.

QMR facility: The assumption is that the imposed ceiling is binding and that the QMR deposits of banks will amount to the sum of the required reserves and CDs. The change in credit is assumed to be zero.

Certificates of deposits: The QCB is assumed to know exactly the change in stock for January. The table above shows the forecasted changes in the QCB’s balance sheet for January 2011 and compares them to actual outcomes. The forecast suggest a liquidity deficit of QR23 billion due to a slight contraction in NFA and a significant increase in government deposits. The rise in government deposit was part of the proceeds from the QR50 billion bond issuance. Despite the deficit, the final position suggests the need to absorb QR24 billion due to the fall in QMR deposits (due to the implementation of the ceiling). The forecast would thus predict that without any active liquidity absorption, excess reserves would have increased by over QR24 billion. Comparing the ex-ante forecast to the ex-post outcome, one can indeed see that excess reserves increased by QR21 billion.¹ This example illustrates the importance of liquidity forecasting for the purpose of liquidity management. If the QCB would have had the instrument to absorb the projected liquidity injection, the sharp fall in the interbank rate could potentially have been avoided.

Liquidity Forecast for January 2011

Sources: Country authorities; and IMF estimates.

Liquidity Forecast for January 2011

				December 2010 balances	January 2011
					Forecast	Actual
1. Autonomous supply of reserves (A+B+C+D)				84,605	-22,674	-26,524
	A. Change in net foreign assets			113,262	-2,720	-6,708
	B. Change in government deposits			-668	-19,948	-19,948
	C. Change in currency in circulation			-7,974	-6	6
	D. Change in other items net			-20,015	0	127
2. Demand for bank reserves (E+F)				19,788	205	21,175
	E. Change in required reserves			14,611	82	82
	F. Change in excess reserves			5,177	123	21,094
3. Structural liquidity position, (1-2)
			Surplus (+)/deficit (-)	64,817	-22,879	-47,699
4. Policy Position				64,817	-47,313	-47,699
	G. Passive policy instruments
		QMR Standing facility		60,807	-46,328	-46,714
			Change in credit	3,240	0	706
			Change in deposit	64,046	-46,328	-47,421
	H. Active policy instruments
			Change in the stock of CDs	4,010	-985	-985
5. Final Position, (3-4)				0	24,434	0

Sources: Country authorities; and IMF estimates.

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Liquidity Forecast for January 2011

				December 2010 balances	January 2011
					Forecast	Actual
1. Autonomous supply of reserves (A+B+C+D)				84,605	-22,674	-26,524
	A. Change in net foreign assets			113,262	-2,720	-6,708
	B. Change in government deposits			-668	-19,948	-19,948
	C. Change in currency in circulation			-7,974	-6	6
	D. Change in other items net			-20,015	0	127
2. Demand for bank reserves (E+F)				19,788	205	21,175
	E. Change in required reserves			14,611	82	82
	F. Change in excess reserves			5,177	123	21,094
3. Structural liquidity position, (1-2)
			Surplus (+)/deficit (-)	64,817	-22,879	-47,699
4. Policy Position				64,817	-47,313	-47,699
	G. Passive policy instruments
		QMR Standing facility		60,807	-46,328	-46,714
			Change in credit	3,240	0	706
			Change in deposit	64,046	-46,328	-47,421
	H. Active policy instruments
			Change in the stock of CDs	4,010	-985	-985
5. Final Position, (3-4)				0	24,434	0

Sources: Country authorities; and IMF estimates.

¹ Notice that the NFA fell more sharply than projected. Part of the reason is the actual contraction in the interest rate spread as supposed to the forecast which assumed a constant spread.

17. Nevertheless, it would be helpful if the MOEF could share its cash flow projections with the QCB. As the government deposits accounts for a sizable share in the banking system, the QCB liquidity forecasting model would benefit from incorporating the MOEF’s projected cash transactions with commercial banks.

18. The challenge to forecast the demand for reserves lies in predicting banks’ need to hold excess reserve. Since required reserves are calculated based on the previous month’s deposit balances and maintained on a daily basis, forecasting the short-run demand for required reserves should be fairly straight forward. However, forecasting excess reserves can be complex as it depends on a multitude of factors, including the opportunity cost of holding non-interest bearing balances with the central bank as well as characteristics of the payments system. For instance, if the central bank requires a minimum settlement balance on top of the required reserves, as is the case in Qatar, it creates a regulatory demand for excess reserves. Historically, excess reserves have averaged around 1–2 percent of the total deposit base in Qatar.

F. Considerations for Further Enhancement of the QCB’s Liquidity Management Framework

19. There are at least three key factors influencing the effectiveness of a liquidity management framework. First, the central bank must have the appropriate tools to effectively manage liquidity. The availability of instruments will depend to a large degree on the state of financial development and the overall monetary policy framework. Second, the central bank must have a reliable liquidity forecasting framework to determine the size and timing of its liquidity operations both in the very short term as well as over a longer term horizon. Finally, the framework needs to be transparent and well understood by market participants to reduce uncertainties and minimize excess market volatility.

20. The objective of the QCB’s liquidity management should be to smooth volatility in interbank markets, absorb structural surplus liquidity, and promote market development. As there is limited scope for independent monetary policy, using the deposit rate to absorb or drain liquidity is likely to trigger offsetting cross-border capital flows. Hence, to avoid a repeat of the speculative inflows in 2008-11, the QCB should ensure that the policy rate is consistent with the exchange rate peg. The QCB could also revisit the appropriateness of the QMR deposit ceiling as it limits the function of the facility as an automatic liquidity absorber.

21. Absorbing the structural surplus liquidity is crucial, if the QCB wants to move towards OMO. Structural liquidity surpluses are likely to reduce activity in the interbank market since most banks will be in a net lending position. Hence, mopping up the structural liquidity surplus should help tighten liquidity and encourage interbank activity. The T-bill issuances could help in this regard to the extent the proceeds are impounded with the central bank. A stable and sufficient stock of government securities should also help develop the repo and reverse repo markets through which the QCB could conduct OMO to manage liquidity on a short-term basis. The government could potentially also align its public deposit management with efforts to absorb surplus liquidity if needed.

22. The issuance of T-bills to absorb liquidity surplus is encouraging, but greater transparency in the operational framework would help market development. The specifics of the agreement between the Supreme Economic Council and the QCB regarding the issuance of government securities remain unclear to market participants. The operational framework needs to be more clearly formulated and communicated to market participants. Increasing transparency of T-bill operations by reporting through the QCB’s balance sheet and improving communication with respect to the QCB’s liquidity operations would allow banks to better anticipate liquidity conditions in the interbank market and strengthen their liquidity management.

23. Developing a liquidity forecasting framework will be imperative to enhance liquidity management. Effective monitoring and reliable forecasts of liquidity conditions will help guide liquidity operations, smooth interest rate volatility and encourage interbank trading. Initially, the QCB can make monthly forecast on a daily basis to help guide liquidity operations aimed at absorbing structural liquidity. For instance, the forecasts can be used to determine how much of the proceeds from the monthly T-bill auctions should be used to absorb liquidity surplus. Should the QCB decide to move to OMO on weekly or daily basis, shorter horizon liquidity forecasting needs to be developed.

24. Developing the interbank market is a prerequisite for effective liquidity management through OMO. Currently, interbank market activity is low, attributable not only to a general liquidity surplus in the banking system, but also to the dominance of a few large banks with excess funds and only a few small banks with liquidity deficits. While absorbing structural liquidity surplus is important, activity in the interbank market will remain constrained as long as the relative dominance of a few banks persists.

25. A next potential step towards a market-based liquidity management framework would be to move to a mid-rate corridor. Recently, several emerging market countries have transitioned from a floor-rate to a mid-rate corridor as their liquidity surplus turned into a deficit (See Box II.3). A precondition would be for the QCB to continue absorbing the current structural liquidity surplus through T-bills. The QCB can then set up the interest rate corridor with the midpoint representing the policy rate consistent with exchange rate target, and use OMO to keep the interbank rate close to the policy rate. To this end, it would be useful to not only have a repo instrument to inject liquidity but also a reverse repo instrument to absorb liquidity.