In order to further strengthen the transmission of monetary policy and the desired effect on term structure of interest rate, State Bank of Pakistan (SBP) has announced that it will review its interest rate corridor framework. According to SBP, a main feature of this planned improvement is to introduce a "SBP target rate" for the money market overnight repo rate.
This rate will be in addition to SBP Reverse Repo Rate (ceiling rate) and the SBP Repo Rate (floor rate) of the corridor. Moreover, this rate will be specified within the corridor, ie, lower than ceiling rate and higher than floor rate.
In this context, the SBP has decided that a proposal will be submitted to the Advisory Committee on Monetary Policy (ACMP) in its March 2015 meeting, for review and its recommendations to the SBP Board. Later on, the SBP Board of Directors will make a final decision about needed improvements in interest rate corridor in its March 2015 meeting.
The SBP established an "Interest Rate Corridor" (IRC) in August 2009 with SBP reverse repo rate, the policy rate, as ceiling and SBP repo rate as floor. The main objective of introducing the corridor was to minimise volatility in the money market by ensuring the movement of short-term interest rates within a reasonable range. The width of IRC was initially set at 300 basis points (bps) and was later reduced to 250 bps in February 2013.
Before the introduction of the IRC, market interest rates, particularly the short-term rates, (overnight repo rates) witnessed considerable volatility. It was mainly due to uncertain flows in the system such as government related deposits, taxes, borrowing for commodity operations, borrowings from the SBP, etc.
While, the SBP reverse repo rate served to keep a lid on the upside movement of overnight rate, there was no instrument available with the SBP for providing a binding floor to limit its downward movement. As a result, repo rate used to drop very frequently and with high magnitudes. Such volatility diluted the SBP''s efforts to keep the weighted average money market overnight repo rate close to the policy rate that was essential to ensure effective transmission of monetary policy stance of the SBP.
As envisaged, IRC has helped reduce volatility in overnight money market repo rate. Though the volatility of short-term interest rates has come down sharply since August 2009, the present IRC framework is such that the overnight money market repo rate can alternate between the floor and the ceiling rates, depending on the prevailing liquidity situation. In Pakistan; however, short-term interest rates have remained mostly in the upper half, close to ceiling of the corridor.
Overnight rates close to the policy rate; however, made the ceiling rate less penal and increased the probability of banks availing SBP reverse repo facility (discount window) more frequently. In order to dissuade frequent usage of the SBP standing facilities, SBP introduced penal rates for accessing SBP standing facilities more than seven times in a quarter in 2012.
This measure has, however, allowed the overnight money market repo rate to go above the SBP''s reverse repo rate (policy rate) at times. Consequently, to enhance the effectiveness of monetary policy and better manage liquidity in the interbank market, the SBP has decided to gradually improve its interest rate corridor by setting the Target Rate (policy rate) between the floor and ceiling rates of the corridor. In accordance with the best international practices and to address the above issues, the SBP plans to align the operational target of overnight money market repo rate with the proposed Policy Rate.
The proposed overnight repo rate target would be a single policy rate to unambiguously signal the SBP''s stance of monetary policy to achieve macroeconomic objectives with price stability. The SBP Policy Rate will be set between the floor and ceiling of the interest rate corridor.
Specifically, using liquidity management tools, mainly OMOs and outright sale/purchase of government securities, the SBP will aim at keeping the money market weighted average overnight rate close to the SBP Target Rate. The existing SBP''s reverse repo and repo rates will be above and below the proposed policy rate, as ceiling and floor of the interest rate corridor, respectively.
Under the current practice, SBP is conducting OMOs mostly on a weekly basis to manage the liquidity in the interbank market. The reserve maintenance period in Pakistan is two weeks starting Friday and ending Thursday in the subsequent week. The SBP conducts at least two weekly OMOs during a given reserve maintenance period. Moreover, short-dated OMOs are also conducted as and when required. In order to ensure that overnight money market repo rate remains close to the target rate (ie Policy Rate), the SBP would increase the frequency of OMO repo operations of varying tenors including overnight.
In the absence of more frequent SBP intervention, unexpected liquidity shocks (especially those emanating from government flows) on any given day increase the likelihood of banks accessing the standing facility which eventually induces volatility in the overnight repo rate.
Thus, increase in the frequency of OMOs will sterilise the effect of any autonomous liquidity shock and would reduce the volatility in the overnight rates. This practice would facilitate in keeping the overnight repo rate close to the proposed ''Target Rate.''
The SBP will conduct short-term OMO repo operations to address temporary liquidity mismatches in the banking system and ensure adherence of the overnight repo rate to the policy rate; however, any permanent liquidity shortage/surplus will have to be addressed by the SBP conducting term repos or buying or selling outright government securities.