[I think this article clarifies that what is open market operations. So, I would like to publish this most important article about Transformations to Open Market Operations written by Stephen H. Axilrod in 1997. – Chandra S. Stha]
– Stephen H. Axilrod©1997 International Monetary Fund
The following paper draws on material originally contained in IMF Working Paper 95/146, “Transformation of Markets and Policy Instruments for Open Market Operations” by Stephen H. Axilrod, who was a consultant with the Fund in 1995. Neil Wilson collaborated in the preparation of the present version. Readers interested in the original Working Paper may purchase a copy from IMF Publication Services.
Open market operations are the major instrument of monetary control in industrial countries and are becoming important to developing countries and economies in transition. Open market operations allow central banks great flexibility in the timing and volume of monetary operations at their own initiative, encourage an impersonal, businesslike relationship with participants in the marketplace, and provide a means of avoiding the inefficiencies of direct controls. Developing indirect controls is important to the process of economic development because, as a country’s markets expand, direct controls tend to become less effective, and markets eventually find a way around them, especially in a global world economy. With more countries seeking to deregulate and unleash the potential of market forces, many policymakers and central bankers are grappling with ways to realize the full benefits of open market operations.
For such operations to become part of monetary policy, however, other monetary instruments now in place need to be adjusted and the market infrastructure must be transformed. This paper assesses the options available to a central bank for addressing these matters and designing instruments for implementing open market operations. First, it provides a brief review of the connection between open market operations and other monetary operations. Then, it discusses how the central bank can encourage development of the necessary financial market architecture. Finally, it reviews the advantages and limitations of specific approaches to open market operations.
If open market operations are to become the principal policy instrument, other monetary instruments obviously need to be given less importance, particularly the central bank’s discount window, where the banking system can obtain reserves on its own initiative simply by borrowing from the central bank. Other adjustments may also be needed, depending in part on the particular strategy adopted for conducting day-to-day open market operations.
Restrictions on the discount window need, however, to be handled with care. If a penalty rate is set well above current market conditions, the system might not react quickly enough to unanticipated liquidity demands. Guidelines that restrict access to the window ought to permit smooth adjustment when reserve shortages occur. In a tight money period, borrowing from the central bank for very limited periods allows banks to make more orderly portfolio adjustments. Such short-term borrowing at the discount window should be differentiated from longer-term structural borrowing at the window, which, among other things, allows emergency long-term advances to institutions in severe operating difficulties.
A minimum binding level of reserve requirements may be useful in helping to gauge the impact of open market operations on interest rates and the money supply. The experience of some countries that do not impose reserve ratios, such as the United Kingdom, may suggest that they are not really necessary. On the other hand, the financial crisis at the end of 1994 in Mexico, which had abolished reserve requirements, raises questions about whether such requirements–and the ability to vary them–could still play a useful role. They may be particularly useful in circumstances where bank liquidity needs to be adjusted rapidly in markets that are thin, and where the central bank needs to give clear, swift, and unambiguous signals on the need for expansion or contraction of the money supply. Even in the United States, with its highly developed money market, reserve requirements remain binding on transaction deposits. The ability to make relatively predictable estimates of required reserves seems to be particularly useful to the Federal Reserve in its decisions on the timing and size of open market operations.
The markets most suitable for flexible open market operations are normally those where short-term instruments are traded, though it should be possible–and may sometimes be desirable–to trade in instruments with various maturities. Well-developed markets are characterized by a large and continuous volume of trading by a variety of participants, including government, financial institutions, and other businesses.
Three sectors present the best opportunities for effective open market operations. These are the markets for government and central bank securities, for interbank debt, and for short-term instruments issued by financial institutions and other corporate entities, including commercial paper, finance company paper, and bank certificates of deposit.
Given the government’s ability to raise taxes, the government securities market is generally regarded to be free of credit risk and therefore the best medium for open market operations. Unstable political and economic conditions, however, may make it impossible to maintain a viable market for issuing debt. Political stability and a sustained government record of meeting interest payments and redemption schedules are therefore essential to the use of open market operations. Apart from a failure to meet such contractual obligations, a government securities market can also dry up if the central bank pursues an inflationary policy that drives investors out of the market by eroding the real value of outstanding debt. Thus, keeping inflation within acceptable bounds is also a vital precondition.
Short-term private debt, including interbank debt, is less suitable for open market operations not only because of its inherent credit risks but because it leaves the central bank with some awkward choices. If the central bank is willing to buy this debt, commercial concerns may take the opportunity to off-load riskier paper. And if the central bank suddenly refuses, the market may turn away from such paper entirely, possibly precipitating a crisis. One way to resolve this type of quandary is for the central bank to restrict its operations to paper that carries a suitable credit rating, as established by an independent rating agency. In circumstances in which the amount of government debt is low or fast declining, central banks can find that open market operations are necessarily restricted to private money market instruments. When this occurs, operations in commercial bank instruments or interbank debt may raise fewer difficult credit risk issues than in other private instruments given the ongoing relationships between banks and the central bank. If a significant government debt market does not exist, a central bank may decide to create a similar balance sheet effect by developing debt instruments of its own, or through the use of a special government issue employed only for monetary policy purposes. These could serve as a permanent and liquid addition to the central bank balance sheet, substituting for private assets.
The central bank may not wish to go beyond these functions by assuming direct regulatory and oversight responsibilities, which may unduly tax its limited personnel resources and expose the central bank to a loss of stature and credibility should scandals erupt in the government securities market–as they sometimes do. A division of labor between monetary policy operations (the responsibility of the central bank) and regulatory authority (the responsibility of some other agency or, if within the central bank, of a department separate from open market operations) may serve a nation’s interest better. This said, the public will tend to look to the central bank as bearing some responsibility for markets in which it operates, whatever its precise role. For this reason alone, the central bank’s market group should take steps that help rationalize the market’s architecture and enhance its performance.
An active interbank market is particularly important because it helps clarify the timing and volume of open market operations. Many countries have developed such a market by adjusting policy instruments. The more successful have also used discount window policies that discourage, penalize, or forbid short-term borrowing at the central bank. The central bank can also encourage interbank trading through more technical measures, such as using its transfer and settlement mechanism to assure the integrity of interbank flows.
The central bank should take the lead, along with the Treasury, in encouraging market practices conducive to competitive trading. It could, for instance, encourage a computerized system of bids and offers for securities that protects anonymity. To foster market transparency, it should also discourage trading from taking place outside the established markets. The Treasury should have equal or greater interest in competitive trading, given that the cost of national debt should fall as government securities become more liquid.
Prior to the emergence of an active interbank and money market, the availability of an official financing facility can be particularly helpful at the early stages of market development. It can encourage market-makers to take positions and carry an adequate inventory, a necessary condition for a liquid market.
Many countries have been moving toward use of repurchase agreements (repos) as the most flexible and convenient form of financing. Repos, by which market participants buy or sell securities in return for cash with an agreement to reverse the transaction at a later point, are seen as an effective instrument for increasing market liquidity and helping to smooth the way to broader market development. They are usually short term, but may have longer maturities.
The central bank should make it clear that the availability of such financing depends primarily on monetary policy rather than strictly market considerations. Nonetheless, it may give a little more consideration to market needs at early stages of development. It may consider, for instance, whether a relatively favorable financing rate should be offered to encourage the emergence of active market-makers. In doing so, however, it should also take into account the political problems that often accompany subsidies and the inconsistency of treating some market participants favorably when it is trying to encourage competition. Indeed, in most cases, official financing should be provided at a competitive rather than favorable rate, even for a transitional period.
The central bank can also encourage market development by setting down ground rules for parties with which it deals. Criteria for a business relationship with the central bank may include membership in a group of primary dealers. A number of countries conduct open market operations through such primary dealers, who have an obligation to make reasonable bids and offers when the central bank enters the market, as well as in Treasury auctions. Brazil, the Czech Republic, India, Malaysia, the Philippines, Poland, and Russia, for example, have all introduced, or are introducing, such primary dealer systems. To perform their function more effectively, dealers would also have to seek retail customers, and would thereby help develop a broader and more liquid market.
In smaller countries, the creation of a primary dealer system where the number of participants may be few may be more problematic and impractical. When a market becomes large enough, however, there is much to be said for confining operations to a group of dealers, perhaps by designating a minimum level of capital. In order to avoid charges of favoritism, the group may have to be quite large. But, by establishing such a group, the central bank will be in a stronger position to encourage dealers to establish better market-making standards, such as minimum transaction sizes for dealing at quoted prices. Of course, ongoing rapid technological changes will also influence the best approach for the central bank to take toward market structure and its own counterparties.
The central bank is the natural focus for collection and dissemination of market statistics. The process of data collection, including daily figures on positions, transactions volume, and financing by type of issue, should begin at the very earliest stages of development. These figures provide the basis for surveillance. Later, when the number of participants is sufficient so that individual firm data cannot be deduced, the central bank should be able to publish aggregate data on market activity, something it should do as quickly as possible in order to enhance market transparency. Publication should be timed with sufficient lag, perhaps a week or a month, depending on the instrument, to avoid market overreaction.
The central bank should also take the lead at an early stage in encouraging the market to set delivery and payment standards. No market functions effectively without reasonable assurance that securities will be delivered on time and paid for as agreed. Although the speed and reliability of the clearing and payments systems obviously depend on the market’s technical capacity and institutional arrangements, the central bank can play a powerful role in galvanizing such efforts because of its leverage as lender of last resort. It can also work together with the Treasury to introduce up-to-date technology in the government securities market, such as a book-entry system to record security ownership and a simultaneous delivery-versus-payment procedure through the central bank’s deposit accounts. The monetary authority should ensure that clearing institutions obtain adequate credit lines from banks to act as a backstop in the event of delivery and payment failures.
In practice, the accuracy of reserve estimates needs to judged against incoming evidence on interest rates from the interbank or money market and what that reveals about liquidity pressures. Interpretation of this information should be aided by continuing contacts with the market. Traders from the central bank’s open market function should be continually speaking with other traders in an effort to understand the factors influencing market conditions, enabling policymakers to better assess market psychology.
A short-term market rate, in particular an overnight interbank rate (interest charges on funds borrowed to meet the day-to-day residual need for funds in the banking system) may usefully serve as the primary guide for open market operations. Using such a rate does not, however, lessen the need for prompt collection of statistics on basic factors affecting the demand and supply of reserves. An inadequate statistical base would greatly hamper the central bank in its ability to judge whether daily money market rate movements are merely temporary.
Many countries use such day-to-day operating guides as a matter of tactics in pursuing the measures that they use as intermediate policy guides. For example, net domestic assets have been used as an intermediate guide in Poland and Mexico, base money in the Philippines and Brazil, M3 in India and Malaysia, and the foreign exchange rate in Egypt. In many emerging markets, it seems that central banks have generally decided to conduct open market operations on a passive basis, leaving themselves with more flexibility to determine the degree of day-to-day pressure on the banking system and the basic cost of liquidity.
If the central bank offers a new Treasury security to absorb reserves, it should be considered as a monetary operation only if the incoming funds are not available to government for spending. The cleanest approach is to set the funds aside in a special account created purely for purposes of monetary policy. Such an account would ensure that bank reserves are reduced “permanently” by the operation, at least until policy is adjusted. In cases where the central bank finds that it overestimated the surplus of reserves, it can buy back the securities before maturity, leaving the special account balance unchanged. Such repurchases before maturity, perhaps followed by subsequent resales as policy is further adjusted, can have the ancillary advantage of helping to develop a secondary market.
Issuing central bank securities should be no more or less costly than offering special Treasury issues created especially for purposes of monetary policy. Choosing between the two types of instruments therefore depends mostly on institutional and market considerations. Central bank issues may be useful, if not necessary, to conduct open market operations in a country, such as Indonesia, where domestic government debt is not allowed. In the Philippines, as noted, the central bank took the same course in the early 1980s because it did not have access to sufficient government debt. Its experience, however, illustrates some of the problems that can occur in a market in which both government and central bank instruments coexist. In particular, the development of an active government securities market appears to have been retarded, rather than stimulated, by large-scale issues of the central bank’s own bills. The government thus came to view central bank issues as complicating its policies on interest rates and debt management because they were segmenting what was already a thin market. At the same time, the central bank was taking large losses from operations in foreign exchange and in the restructuring of weak commercial banks, thus putting its credibility into question. By 1993, the central bank was restructured and received a broad portfolio of Treasury securities to facilitate open market operations.
Problems like those in the Philippines may not be inevitable. In Brazil, for instance, where there is a relatively broad overall market, central bank issues have traded well alongside government securities. Open market operations in which special securities are issued for purposes of monetary policy are of most practical use when excess liquidity is flooding the banking system. Because these securities can be bought back before maturity and resold, they can also be employed to adjust to the ebb and flow of liquidity pressure. But they do not provide the same flexibility as open market operations in the secondary market. In the absence of an active money and interbank market, the central bank is deprived of ongoing information about actual and emerging liquidity conditions, which makes planning the timing and size of operations more difficult. The outcome of open market operations may thus be more subject to the vagaries of primary market bidding than to the central bank’s prior intentions.
In the absence of an active market for government securities, a special Treasury issue might also be considered as a means of adding to bank reserves needed for long-term growth. This would involve giving the central bank authority to auction a special Treasury deposit that would be created along with the debt issue. Such a special issue, guaranteed by the government, may help strengthen and diversify the central bank’s balance sheet.
Repos and reverse repos are ideally suited for offsetting short-term fluctuations that affect bank reserves. They are also useful for offsetting large shifts in liquidity caused, for instance, by a wave of capital inflows or outflows. For these reasons, repos can be expected to become the dominant tool for open market operations, as experience in various countries suggests. Repos can be used in various maturities, although short-term operations tend to dominate. In Brazil, where repos have become the main instrument of policy control, operations are undertaken through informal auctions on a daily basis, with maturities generally overnight. Mexico and Poland also undertake frequent operations with short maturities. Thailand employs an elaborate auction process twice a day, with maturities ranging from overnight out to six months. Maturities appear longest in the Philippines, where reverse repos are used to absorb liquidity, with maturities commonly between one week and one month and with a maximum out to one year.
Outright purchases and sales of Treasury securities in the secondary market are also used in many of these countries. In Brazil they are used to provide or absorb reserves on a more permanent basis. In India and the Philippines, they are considered an important instrument of monetary control and are undertaken on a daily basis. When secondary markets are still comparatively thin, however, outright transactions run a high risk of dominating the market and impeding further development, especially in longer-term sectors.
Whatever the relationship, open market operations will be most effective where the central bank has control over factors that affect the reserve base of the banking system. To help maintain a clear separation between monetary and fiscal policies, it is most desirable if the government debt issued to meet fiscal needs is sold directly into the market by the Treasury, avoiding any potential conflict between debt management and monetary policy needs. Such sales should be in the form of auctions, helping to develop a competitive, deregulated market system. This also avoids pressure on the central bank to facilitate primary market issues at a predetermined rate.
For open market operations, it is particularly important for the central bank to be able to influence, if not control, the Treasury’s operating balance with the bank, fluctuations in which affect the supply of bank reserves. It is unusual for the central bank to be given substantial discretionary power over government deposits, but there are exceptions. The Bank of Canada, for instance, has the right to transfer government deposits between itself and commercial banks. Bank Negara Malaysia auctions such deposits as an instrument of policy. Germany’s Bundesbank has a veto over the government’s ability to hold deposits outside the central bank.
In general, open market operations will function most effectively when the government abides by, and the public believes in, a clear division between debt management and monetary policy operations. In practice, this usually involves an agreement to neutralize the monetary effect of the Treasury’s balance or to delegate substantial control over it to the central bank. In virtually all countries, debt management decisions are made with ongoing input from the central bank, both informally and through formal committee structures.
Most countries have begun making complementary adjustments in reserve requirements consistent with the growing importance of open market operations. They have also been restricting access to the discount window, which has nevertheless remained open as a safety valve. Still, for most emerging markets and transitional economies, which are prone to surges in liquidity and sudden capital flows and with markets at varying stages of development, a complementary mix of all monetary instruments may be the best solution. Transformation of markets usually occurs in two stages: the establishment of a primary market followed by development of a secondary market. The initial transition is much easier to accomplish. Well-functioning secondary markets, however, must develop largely within the private sector, although the central bank can exert some influence through the legal, regulatory, and payments infrastructure. It is difficult for the central bank to accelerate development through transactions alone, as this risks dominating the market. Repos and reverse repos would appear to be the most effective instruments for encouraging such development. It is crucial, however, to develop an interbank market, which can then provide signals for policy. There are risks if the central bank relies excessively on operations in private paper, which can become illiquid. In the absence of an active government securities market, the use of the central bank’s own issues, or of special Treasury issues designated for monetary policy purposes, might be considered as a supplement.