II. Monetary Operations, Liquidity Management and Money Market Development1
Over the past six years, Bank Indonesia (BI) has taken a series of measures to improve its liquidity management and monetary operations, and to promote the development of the interbank money market. However, it continues to face difficulties in reducing excess liquidity arising from capital inflows, achieving its interest rate target, strengthening the transmission from short-term rates to bank deposit and lending rates, and improving the functioning of the money market. These issues are highly interlinked, and therefore must be examined and addressed jointly. Key measures include establishing the infrastructure for the interbank repo market, restructuring BI’s balance sheet and monetary operations to remove excess liquidity and expand the supply of collateral for repo transactions, and providing incentives for banks to take the lead in money market development. Implementing a comprehensive program to address these issues can only be achieved in the medium term, but ultimately should improve the effectiveness of monetary policy, increase financial stability, and support capital market development.
1. The framework for monetary operations, the management of system liquidity by the central bank, and money market development are all interlinked, and all contribute to the effectiveness of monetary policy. The proper design and use of monetary instruments can allow the central bank to maintain stable liquidity conditions, and keep short-term interest rates at or near its operational target. This in turn can provide banks with incentives to manage their liquidity more tightly by participating in the money market, using some of the instruments issued by the central bank. A virtuous cycle may develop, where the credibility of the central bank is enhanced, transmission from short-term rates to deposit and lending rates is strengthened, and the overall effectiveness of monetary policy is improved.
Figure II.1.Money Market Reforms and Financial Market Development
2. A well-functioning money market can provide broader benefits for financial development. Short-term rates will provide a better indication of monetary policy expectations. Financial stability and efficiency will also be enhanced, because banks will have more instruments to manage their liquidity, and yields will better reflect underlying liquidity and credit risk. A liquid money market can support capital market development, especially the government securities market, by improving the ability of dealers to fund their market-making activities.
3. In 2005, as part of its adoption of an inflation targeting framework, Bank Indonesia (BI) introduced a new framework for its monetary operations.2 This was based on having an operational target for the one-month central bank bill rate that would be adjusted as BI’s forward-looking assessment of inflationary pressures changed. In 2008, the operational target was changed to overnight interbank rates and was to be achieved using open market operations in combination with standing facilities. Since then, BI has continued to refine the use of its monetary operations. From 2010 onwards, most of these changes were aimed at managing rising foreign inflows and reducing their impact on domestic liquidity conditions.
4. This paper proceeds by providing a brief overview of BI’s operational framework and recent reforms, and goes on to outline the development of the Indonesia interbank money market. It discusses issues arising from the inter-linkages between BI’s operations and money market functioning, and concludes with some recommendations for a comprehensive approach for improvements to both.
B. Evolution of Bank Indonesia’s Operational Framework
5. While BI has a wide range of monetary instruments, up to mid-2010 open market operations were primarily implemented by auctioning 1- and 3-month central bank bills (SBIs). While only banks could participate in the primary auction, these instruments were freely tradable in the secondary market, and potentially could have served as collateral for secured lending. SBIs were also attractive to foreign investors seeking exposure to relatively high local nominal rates and expectations of rupiah appreciation. In an effort to sterilize its mounting foreign exchange purchases from mid-2009 onwards, BI expanded the supply of SBIs, but these were increasingly purchased by foreigners. This raised concerns that BI’s sterilization efforts were themselves leading to more portfolio inflows.
6. BI has made some major changes to the framework for its monetary operations over the past 15 months, in part to reduce foreign demand for their sterilization instruments. Starting in July 2010, BI imposed a one-month holding period on SBIs and began lengthening the tenor of securities it auctioned from 1–3 months to the 9 months now on offer. It also has introduced nontradable term deposits available only to banks and up to six months tenor. BI increased the primary reserve requirements on both foreign and local currency deposits to 8 percent, from previous levels of 1 percent and 5 percent, respectively, and introduced a supplementary reserve requirement for banks with loan to deposit ratios above or below defined limits. In May 2011, it lengthened the SBI holding period to six months. In September 2011, it lowered the rate on its overnight deposit facility to 150 bps below its policy rate, making its interest rate corridor asymmetric. The current status of BI’s liquidity management framework is summarized in Box II.1.
7. The announced BI rate is the operational target, which is expected to be reflected in interbank overnight rates.3 However, historically the BI rate was interpreted as the target for the 1-month SBI auction rate. From end-2005 to early 2010, the 1-month SBI rate tracked the BI Rate more closely than overnight rates. However, as BI began lengthening the tenor of its SBI auctions from March 2010 onwards, the BI rate became the anchor for the longer tenor SBIs.
Figure II.2.Bank Indonesia Monetary Operations and Interbank Rates
Source: Bloomberg LP., CEIC Data Co. and IMF Staff estimates.
Box II.1.Summary of Bank Indonesia’s Current Framework for Liquidity Management
Announced operational target. BI Rate, which until recently was expected to be reflected in interbank overnight rates. However, BI currently seeks to steer overnight rates near the bottom of its interest rate corridor.
Interest rate corridor. Deposit and lending standing facilities available to banks and brokers have been effective in containing overnight rates within an asymmetric band around the BI Rate (currently +100 bps/-150 bps). The tenor of both deposit and lending facilities are overnight, and are available to the close of the interbank market.
Reserve requirements (RR). Local currency third party funds (TPF, deposits excluding interbank borrowing) attract a primary RR of 8 percent, which must be fulfilled on a lagged daily basis. The first five percentage points of the RR are unremunerated, and the remaining 3 percentage points are remunerated at 2.5 percent p.a. A secondary RR of 2.5 percent can be fulfilled by holdings of SBIs. Foreign currency third party funds face a RR of 5 percent (which will be raised to 8 percent in June 2011). In both cases, there is no averaging of the RR. Shortfalls attract a penalty rate of 100 bps over the BI rate. Since March 1, 2011, BI has imposed higher RRs on banks that have loan to deposit ratios (LDR) below 78 percent or above 100 percent. Banks with LDRs outside the range of 78–100 percent will need to add RR according to the following formula:
(i) If LDR is below 78%, the additional RR = 0.1 × (78%–LDR%) × rupiah TPF.
(ii) If LDR is above 100% and CAR below 14%, additional RR = 0.2 × (LDR%–100%) × Rupiah TPF.
(iii) If LDR is above 100% but CAR is above 14%, no additional RR required.
Open market operations. The main liquidity withdrawing instruments are:
The monthly variable rate auction of SBIs, currently of 9-months tenor. Only banks may bid at the primary auction. There is a 6-month holding period, during which the SBI cannot traded or repoed. However, the SBI can be used as collateral to access BI’s lending facilities.
Daily variable rate auctions of term deposits of varying maturities up to six months. Typically, three maturities are offered, a short tenor of up to 14 days, another around three months and the six month.
Outright sales of government securities.
Foreign exchange sales and swaps.
Shariah-compliant instruments: BI has a range of shariah-compliant facilities that allow Islamic banks and Islamic units of conventional banks to manage their liquidity. However, the amounts outstanding are relatively small.
C. Indonesian Money Market
8. Despite the growth of the banking system and improvements to BI’s liquidity management, money market activity remains low. Transaction volumes in the rupiah call money market rose steadily in the three years leading up to the global financial crisis, but fell sharply during 2008 as banks cut interbank credit limits and hoarded liquidity. Volumes have since recovered but remain below the peak levels of 2007. Most trading is in overnight lending, with little activity beyond two weeks. Moreover, banks are deploying less of their funds into the interbank market, choosing instead to place more of their liquidity with the central bank.
9. Persistent excess liquidity is a major impediment to money market development in Indonesia. Banks’ placements in BI’s overnight deposit facility have been trending upward, and are the equivalent of over 10 percent of the monetary base. Further, at least some part of banks’ holdings of term deposits could also be considered excess liquidity, given their relatively low yields. This means on many days that most banks have excess liquidity, and few banks, if any, have liquidity shortfalls. As a result, interbank money market volumes have remained low. This excess liquidity will need to be absorbed before interbank activity can take off, driven by liquidity mismatches among banks.
10. Concerns about counterparty risk, and a lack of market pressure have also limited interbank activity. Smaller banks that are considered to involve higher credit risk have little or no access to credit limits from larger banks with surplus liquidity. Therefore, these banks are forced to bid aggressively for deposits to secure funding, leading to a wide dispersion of deposit rates among banks. In addition to their reluctance to take unsecured exposures to smaller banks, some of the banks with large deposit bases have not taken the lead in promoting the interbank market, because their lending and trading businesses are highly profitable and they see little need to provide their competitors with cheaper funding.
11. The interbank repo market remains small, due to the scarcity and cost of eligible collateral and some structural impediments. In the eight months to August 2011, interbank repo transactions totaled just under 19 trillion rupiah, down from nearly 30 trillion rupiah in the same period of 2010. Some of the decline in repo volumes was due to the extension of the holding period for SBIs to six months; this effectively removed these securities as eligible collateral for repos of less than six months tenor. This left government securities as the only eligible collateral for interbank repo transactions.
12. The current low yields on government securities have also reduced their attractiveness to banks as a part of their liquid asset portfolio. The longer holding period for SBIs has channeled demand from offshore investors looking for rupiah exposure to short-term government bonds and the much smaller treasury bill market. As a result, rates at the near end of the government yield curve fell well below money market rates, with the 12-month treasury bill yield falling to 4.0 percent in September, or 275 bps below the policy rate. This meant that banks faced the choice of making a negative carry if they held treasury bills and short-term bonds as collateral for any interbank borrowing they undertook, or bearing increased duration risk if they bought long-term bonds to raise the return on their portfolio of liquid assets.
13. Bank Indonesia has taken several measures in the past year to promote interbank market development. It has improved the calculation of JIBOR reference rates by restricting membership of the banks providing quotations to those active in the money market, and disseminating individual and average rate quotations electronically on a daily basis. It has expanded the volume of reserve repo operations it conducts to promote interbank repo usage. Finally, it is pressing forward with the adoption of a proposed Global Master Repurchase Agreement that was developed in coordination with the Ministry of Finance, Bapepam-LK and market participants.
D. Challenges for Money Market Development and Monetary Policy Implementation
14. Bank Indonesia’s control over overnight interbank rates has weakened since 2009. Overnight rates are now 145 bps below the announced BI target. Money market rates have remained persistently lower than the BI rate because:
There is significant excess liquidity in the banking system, as evidenced by the high level of overnight and short-term deposits held by banks at BI. Even though the recorded level of excess reserves are low, the high volume of BI liabilities maturing within a month represent a liquidity overhang that will continue to put downward pressure on interbank rates.
There may be confusion in the market about BI’s operational target. BI has signaled that it will allow overnight rates to remain near the bottom of its interest corridor. The auction rate of the 9-month SBI has converged to the BI rate. Given broad expectations for further monetary policy tightening in 2011, and more general term premia, the 9-month SBI rate should be trading maybe 30–50 bps higher than the cash rate. In addition, the rates prevailing on the 6-month term deposit auctions had been generally higher than the BI rate until September 2011, but are now around 100 bps lower. This has also contributed to confusion about the target interest rate. Treasury bill rates have been depressed by demand from foreign investors expecting further exchange rate appreciation.
Liquidity forecasts provided by BI may not be that useful in guiding market expectations. Further detail regarding autonomous flows and projections for longer horizons would improve banks’ ability to manage their liquidity with longer-tenor instruments.
15. While recent changes to SBIs and term deposits have been somewhat successful in stemming the growth in foreign holdings of SBIs, they have not improved the conditions for liquidity management and money market development. SBIs can no longer be used in repo operations, and the increasing use of term deposits by BI is limiting the supply of instruments that can be traded in the interbank market. Further, BI is no longer actively managing system liquidity, since the term deposit auctions effectively function as a standing facility. BI is now providing many different instruments, with tenors ranging from overnight to 9 months and varying constraints on early termination and tradability. The resulting wide range of rates that BI is transacting its open market operations results in market confusion over its operational target, and increases uncertainty over the future path of short-term rates. This uncertainty in turn inhibits the development of the money market for tenors beyond one month, and weakens the transmission of short-term interbank rates into deposit and lending rates.
16. The growing overlap in maturities of government treasury bills and BI open market operations could complicate the coordination of BI’s liquidity management and public debt management. There have been cases in some countries where relations between the central bank and public debt manager have become strained due to the perceived competition between their issuance programs.
E. Policy Options
Improving Monetary Operations and Liquidity Management
17. The structure of BI’s OMOs should be simplified, and nontradeable instruments phased out. Nontradable term deposits and SBIs should be phased out, because their illiquidity affects their pricing, complicates banks’ liquidity management, and impedes money market development. Instead, BI should expand its use of reverse repos to manage liquidity. This would supply securities to banks that would be eligible collateral for interbank repo transactions. Structural operations should be conducted using variable rate auctions on a regular calendar and preannounced volumes. For example, 3- and 6-month auctions could be conducted each month. One-month repos could be auctioned each week. Eventually these rates will serve as useful benchmarks and provide indications of market expectations regarding the policy rate. Fine tuning operations of less than one month tenor could be conducted more frequently, even daily, at the policy rate. Open market operations should be used more aggressively to bring overnight rates in line with the BI rate.
18. Bank Indonesia’s holdings of nontradable government securities should be replaced as soon as possible with tradable government securities bearing a market rate of interest. The existing government obligations, which total 250 trillion rupiah, could be swapped for long-term government bonds and then used by BI as collateral for reverse repo transactions. This could double the level of eligible collateral available to banks. It would also alleviate the need for banks to hold long-term government bonds for liquidity purposes, and thus reduce the interest rate risk borne by banks.
19. A large part of the structural liquidity excess could be withdrawn by raising reserve requirements. This would allow BI to lower the volume of its other liquidity-absorbing positions, thereby reducing the potential for interest rate volatility associated with the rollover of these positions. Given that the remuneration on required reserves is below market rates, higher reserve requirements will increase the implicit tax on deposits, and potentially raise the spread between deposit and lending rates. Therefore, any decision to increase reserve requirements should weigh the impact on financial intermediation, and adjusting reserve remuneration closer to market rates should be considered.
20. Bank Indonesia should provide more detailed projections of system liquidity, with longer horizons and indications of the expected volume of future operations. This would allow banks to better plan their own liquidity management, and provide more certainty regarding the supply of longer-term central bank instruments, allowing banks to commit to extending the tenor of their transactions with the central bank and other market participants. Longer rates would become responsive to monetary policy expectations, strengthening the transmission of the policy rate to banking rates and credit growth.
Fostering Money Market Development
21. A strong interbank repo market could be the cornerstone of future money market development. The eventual replacement of SBIs and term deposits with repos as the primary monetary operations instruments will increase the amount of eligible collateral and directly promote the use of repos by commercials banks for managing their liquidity. In the meantime, the proposed Global Master Repurchase Agreement should be adopted as soon as possible.
22. The authorities should consider establishing a central clearinghouse for treasury security transactions that could also provide dealing systems and other market infrastructure. This would mitigate counterparty risk and allow for anonymous trading by providing a central counterparty for repurchase and outright transactions in the bond market. This could overcome the current reluctance of some banks to participate in the repo market. A good example of the benefits of a central counterparty for money market development was the success of the Clearing Corporation of India Limited (CCIL). In 2003, the CCIL introduced its Collateralized Borrowing and Lending Obligation (CBLO), which is similar to a General Collateral Repo. This instrument has provided a benchmark for overnight rates and increased liquidity by improving the ability of market participants to unwind their positions. By 2009–2010, trading in CBLOs, and other money market instruments handled by CCIL reached six times annual GDP, up from 69 percent of GDP five years earlier. The CCIL also supports trading in other markets, including foreign exchange and derivatives.
Prepared by Geoffrey Heenan.
For more detail regarding BI’s monetary policy framework, see http://www.bi.go.id/web/en/Moneter/Kerangka+Kebijakan+Moneter/.