Seychelles: Selected Issues
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International Monetary Fund. African Dept.
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Selected Issues

Abstract

Selected Issues

Modernizing Seychelles Monetary Policy Framework1

This note examines Seychelles’ current monetary policy framework, its challenges and reforms under consideration. Modernizing Seychelles monetary policy framework into one based on interest rates should enhance monetary policy transmission mechanisms and encourage further financial deepening, laying the foundation for a more effective monetary policy implementation.

A. Current Monetary Policy Framework

1. The CBS’s objective, intermediate and operational targets are similar to those adopted by many African countries and may be described as a standard reserve money targeting framework. The CBS’s main policy objectives are to promote domestic price stability and maintain a sound financial system. The price stability objective is to be achieved by influencing the intermediate target, broad money (M3) growth, with reserve money being the operational target.

2. In operational terms, reserve money serves as the anchor for domestic price stability. Between 2008 and 2013 the CBS targeted the quarterly end-period reserve money, but meeting the target failed to prevent the inflationary outburst of 2012 and did not allow guidance for day-to-day operations. As a result, a quarterly target on daily average reserve money was adopted in April 2014 and monetary operations have since been conducted to ensure that the arithmetic daily average of reserve money over the quarter does not exceed the upper bound of a symmetrical band of three percent around the quarterly reserve money target2.

uA08fig01

Reserve Money (in mln SCR)

Citation: IMF Staff Country Reports 2017, 161; 10.5089/9781484304792.002.A008

Sources: CBS and IMF staff estimates.

3. The CBS views exchange rate stability as an important policy objective in the context of the floating exchange rate regime3. Because Seychelles is a very small open economy, inflation is driven mainly by increases in food and non-food imported items, which results in inflation expectations strongly based on the exchange rate and the risk of currency depreciation. However, only (for brief period) in 2012 did the CBS intervene in the foreign exchange market to stabilize the exchange rate. The CBS intervenes in the FX market mainly for spot purchase of foreign currency against rupees with the objective to build international reserves.

  • Minimum reserve requirement (MRR). Minimum reserve requirement ratios stipulate the minimum percentage of deposit liabilities that financial institutions are required to hold as cash with the CBS. The ratios are currently at 13 percent of total deposit liabilities, with liable deposit including foreign currency deposits of residents and the primary purpose of the MRR’s is to manage liquidity. Minimum reserve requirements are held in Rupee and in foreign currency (USD and EUR) and are not remunerated.

  • Standing facilities. Standing facilities aim at managing overnight liquidity he financial system. There are two types of standing facilities, the standing credit facility (SCF) and the standing deposit facility (SDF). The SCF is an overnight collateralized loan facility that provides funds to the commercial banks at a predetermined interest rate to cover temporary end-of-day shortfalls that can arise in the daily settlement of payments. The SDF is an overnight deposit made with the CBS at a pre-determined interest rate for the banks to place any overnight excess reserves. The rate is 0.25 percent and 1.75 percent respectively for the deposit facility and credit facility.

  • Emergency lending facility. Emergency lending facility supports banks with severe and persistent liquidity problems. This facility is not used for monetary policy purposes but aims at safeguarding against systemic risk and financial instability.

  • T-bills auction. T-bills with maturities of 91, 182, and 364 days are the main open market instruments for managing structural liquidity over the longer horizon. They are auctioned twice every week, on Tuesday for monetary policy purpose and on Friday for fiscal needs. While open to all investors (including households) commercial banks dominate the primary market. There is currently no secondary market for T-bills.

  • Deposit/Credit auction arrangement (DAA/CAA). The CBS also uses its own instruments for open market operations. The DAAs have been used to mop up excess liquidity through daily operations since 2014. They are issued through a quantity auction (briefly changed to a price auction in August 2014) where banks place one bid per maturity. The most common maturities are the 7 and 14 day. CAAs are lending facilities with the interest rate generated from an auction process similarly to the DAA’s. The CBS’s use of this facility will depend on liquidity needs on the financial market and on the CBS’s prevailing monetary policy stance. CAAs have not been used since its creation in 2009, given the structural excess liquidity in the banking system.

  • Foreign Exchange auctions (FEA). The FEA allows for the purchase and sale of foreign currency and the CBS uses those for both external FX reserve and liquidity management

  • Medium-term and long-term bonds. In 2014, as liquidity surged, the CBS issued for the first time medium-term bonds. The treasury bonds have maturities of 3-, 5-, and 7-years, and the issuance of these medium to long-term bonds aim at dealing with structural liquidity.

B. Challenges Arising from The Current Monetary Policy Framework

4. Seychelles’ banking system is prone to structural excess liquidity, largely built-up by the accumulation of net foreign assets (NFA). For example, in 2009, NFA increased significantly, forcing the CBS to mop-up excess liquidity. Then again in the fall of 2013, a massive excess liquidity resulting from opportunistic CBS purchases of foreign exchange occurred. However, this time the CBS was unable to mop-up excess liquidity without undermining its capital position, consequently driving short-term interest rates down. In 2014, the government issued medium-term rupee-denominated bonds as well as weekly T-bills, which considerably reduced excess liquidity. Because excessive liquidity represents a risk to macro stability, it is important that the government continues to provide all the T-bills needed to achieve the country’s monetary policy goals, even if that means a higher debt burden. Macro stability is a public good and as such, should be a priority.

5. After a brief introduction in 2014, the authorities are considering the reintroduction of an interest rate corridor. The signaling of the monetary stance has been confusing for the markets. The CBS regularly influences the auction outcomes by eliminating bids whenever it believes those are out of line from its views on the appropriate interest rate level or to avoid interest rate volatility. This has led to confusion in the markets as to what rate to bid and what rate would be accepted. Lack of understanding of the CBS’s auction directions s by market participants have thus contributed to a weak signaling of the preferred monetary policy stance.

6. Structural excess liquidity may have contributed to an underdeveloped money and interbank market. Interbank rates are quoted rather than transacted rates, and the pricing of interbank transactions is mainly the result of bilateral negotiations, longstanding relationships or credit lines between counterparties. The T-bill rates and the standing facilities’ rates play a marginal role in the interbank pricing mechanism. The lack of market infrastructure including a trading platform, cumbersome procedures for ownership transfer, and a still-pending legislation for master repurchase agreements, have all contributed to the absence of a secondary market.

C. Reforms Under Consideration

7. Improving liquidity forecasting. The CBS is receiving TA to help strengthen its analysis of the banking system’s liquidity position and the size of its precautionary liquidity buffer. In this regard, training additional staff for continued liquidity forecasting would be helpful. In addition, forecast on foreign exchange auctions for reserve management purposes could be conducted for the medium-term, and the currency composition of required reserves could be better monitored. These measures would reduce liquidity risk but call for more coordination within the CBS and between the CBS, the Ministry of Finance and the Treasury.

8. Modernizing liquidity management operations and finding alternative instruments. The issuance of T-bills and government bonds is constrained by the government’s debt reduction strategy. Accordingly, alternative instruments which would not compromise the CBS’ capital position might be needed to manage liquidity. In this regard, the CBS should clarify and accelerate to the extent possible the resolution of the legal issues related to repurchase operations and the introduction of a master repurchase of agreement4; so that over the medium term, repurchase operations can substitute for CAAs and DAAs as primary open market instruments. This will also allow the CBS to leverage the current government securities it has on its balance sheet for monetary purposes.

9. Reinforcing the interest rate corridor. Having a functioning interest rate corridor would support the development of the interbank market, and give incentive for banks to more actively manage liquidity. The CBS could introduce a new monetary framework focused on an implicit monetary policy rate (MPR) that would fluctuate within a corridor formed by the SCF and SDF rates. The reintroduction of the interest rate corridor, currently scheduled to be approved by June 2017 and implemented by July 2017, would help reduce short-term interest rate volatility and at the same time, provide guidance short-term interest rates. The implicit MPR and hence the interest rate corridor should be set consistently with the RM target and adjusted up or down to achieve the medium-term inflation target.

10. As the interest rate corridor strengthens, the money market and interbank market should further develop, reducing the need to issue more monetary debt. The interbank market has been inactive because of structural liquidity and pricing difficulties. A better liquidity management and a functional interest rate corridor, should therefore support the development of the interbank market. Interbank and secondary markets are essential to an effective financial system. In the absence of such markets, even a short-term financial instrument can be rendered illiquid. The development of these markets will also eliminate the incentive for banks’ liquidity hoarding. Better communication with market participants will also support well-functioning financial markets and promote effective monetary policy implementation.

11. Discussions are still on-going. Based on the latest discussions with recent TA missions and the authorities. the following issues are under consideration: (i) how much focus needs to be put on interest rates; (ii) the width of the corridor; (iii) whether the corridor should be symmetric or asymmetric; (iv) access to standing facilities; (v) auction frequency and maturities; (vi) the implementation date of the new framework; and (vii) the sequencing of communication events.

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1.

Prepared by Arina Viseth (AFR)

2.

The upper bound is a performance criterion under the current IMF program.

3.

At the time of the writing, discussions on Seychelles’ de facto exchange rate classification as a floating regime are on-going, and reassessment will be conducted for the next AREAER chapter.

4.

Currently scheduled for mid-2018.

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