Lessons in Monetary Policy Implementation & Using Government Bonds

1. Lessons in Monetary Policy Implementation & The Conduct of Monetary Operations Using Government Bonds Dato’ Ooi Sang Kuang Bank Negara Malaysia Workshop on Developing Government Bond Market 31 OCTOBER – 2 NOVEMBER 2007, Bali, Indonesia

2. Outline • Background • Lessons in Monetary Policy Implementation • Using Government Bond for Monetary Operations • Initial Roadblocks • Development Initiatives • The effectiveness of repo operations • Recap of key points

3. Background • Monetary policy aims at achieving sustainable growth in an environment of price stability • Monetary Policy Meeting is held 8 times a year and the statement is issued on the same day • The policy rate is Overnight Policy Rate, currently at 3.5% • Objective of monetary operations: • meet the overnight operating target; • reinforce monetary policy intention, and • manage liquidity in the interbank market. • Monetary operation focuses on managing liquidity in an excess liquidity environment

4. Overnight rate Lending facility Ceiling rate (+25 bps) 50 bps corridor on the overnight tenor Policy rate (3.50%) Floor rate (-25 bps) Deposit facility Time Overnight rates to gravitate around policy rate Background Overnightpolicy rate framework is guided within a corridor • Overnight rate as the policy rate and also the operating target • Operating band of 50 basis points to minimise extreme volatility • Standing facility available at the ceiling and floor rate • Overnight rate was chosen as the policy rate • high controllability • minimal expectation content • Market determined rates at other tenors. Liquidity is managed over the longer horizon using longer-term repo and money market tenders to ensure rates are not persistently too low or too high

5. Background Range of monetary instruments to sterilise liquidity has been diversified… 2001 vs 2007 Total liquidity: RM46.2 billion Total liquidity: RM284 billion Source: Bank Negara Malaysia Source: Bank Negara Malaysia

6. Background Initial challenges to monetary policy implementation.. • High dependence on uncollateralised interbank borrowing and lending through money market auction. • Large and volatile capital flows since 2000 into financial market – 2000 to 2004 net capital flows amounted to approximately 3.8% of GDP annually. • Growth of Islamic finance – 2000 to 2006 total asset of Islamic financial institutions as to compared to the banking system assets has increased from 2% - 7%. • Growth of domestic debt securities market –in Dec 2006 total market size amounted to USD146.88 billion or 94.8% of GDP. • Greater demand for transparency in monetary policy implementation process and operations ie: updates on market liquidity.

7. Outline • Background • Lessons in Monetary Policy Implementation • Using Government Bond for Monetary Operations • Initial Roadblocks • Development Initiatives • The effectiveness of repo operations • Recap of key points

8. Lessons learned in conducting monetary operations Amendments in Central Bank Act was undertaken proactively to overcome impediments to operations…

9. Lessons learned in conducting monetary operations The framework change in April 2004 & new monetary instruments have enhanced operational effectiveness… interbank rates track OPR closely & affects bank’s average lending rates directly… Correlation analysis on Average Lending Rate (ALR) and interbank rates Source: Bank Negara Malaysia

10. Lessons learned in conducting monetary operations Rapid development of global Islamic financial market leads to the introduction of new instruments… Source: Bank Negara Malaysia More information on these instruments can be obtained online at BNM’s Islamic Money Market website at http://iimm.bnm.gov.my/

11. Outline • Background • Lessons in Monetary Policy Implementation • Using Government Bond as Monetary Operations • Initial Roadblocks • Development Initiatives • The effectiveness of repo operations • Recap of key points

12. Initialroadblocks to the use of government securities for monetary operations…. Small BNM holdings of government securities initially impede wider use… • In December 2004, BNM began to purchase MGS from primary and secondary markets based on market prices. • The purchase of MGS at primary tenders will be based on the weighted average price of the tender and limited to a maximum of 10% of the issue size. • BNM also may purchase MGS from the secondary market, however subject to maximum limit of holding MGS to 10% of the total outstanding. Source: Bank Negara Malaysia

13. Initialroadblocks to the use of government securities for monetary operations…. Captive market of government bonds… 64% of total MGS were hold by “buy-and-hold investors”

14. Outline • Lessons in Monetary Policy Implementation • Using Government Bond as Monetary Operations • Initial Roadblocks • Development Initiatives • The effectiveness of repo operations • Recap of key points

15. Development initiatives Introduction of ISCAP to enable borrowing and lending of securities… • Institutional Securities Custodian Programme (ISCAP) was introduced in October 2004 to facilitate lending of debt securities by buy-and-hold investors • BNM act as a catalyst to free the captive holdings of MGS by institutional investors to market participants through its repo operations • Greater use of repo for sterilisation of surplus liquidity is facilitated through collateral availability from ISCAP • Regulated short-selling in MGS introduced in October 2005 as ISCAP facilitates sufficient availability of MGS to market participants for short-covering via securities borrowing and lending Institutional Lenders / FIs Lend securities Guarantee Securities lending fees Collateral via repo Funds Interbank Institutions More information on the ISCAP and Regulated Short-Selling of MGS may be obtained online at BNM’s Bond Infohub website at http://bondinfo.bnm.gov.my/

16. Outline • Lessons in Monetary Policy Implementation • Using Government Bond as Monetary Operations • Initial Roadblocks • Development Initiatives • The effectiveness of repo operations • Recap of key points

17. Effectiveness of repo operations Sterilisation of excess liquidity via repo… more effective, and enhances repo and debt market development

18. Effectiveness of repo operations Repo operations facilitate the smoothening of the yield curve…more bond trades at larger number of points along the government securities yield curve… Market snapshot of MGS trades from 16 Feb to 29 Feb 2000 Market snapshot of MGS trades from 16 Feb to 28 Feb 2007

19. Effectiveness of repo operations BNM as a catalyst to encourage market to actively use repo as alternative funding instruments… • On average, cash driven repo volume are triple the size of securities driven repo mainly due to current surplus liquidity in the market • Cash-driven repo are conducted mainly for managing liquidity • Securities-driven repo supply the market with current benchmarks MGS to market participants mainly for securities lending and regulated short-selling activities. Source: Bank Negara Malaysia

20. Effectiveness of repo operations Sterilisation costs is lower via repo…. • On average cost savings for cash driven and securities driven repo are around 3 bps to 50 bps respectively. • Main reasons for relatively lower borrowing rate via repo are :- • Lower risk due to collateral • Demand for specific securities ie: recently issued benchmark securities for secondary trading • The ability for repo buyers to short sell the MGS during the repo period for fund raising Source: Bank Negara Malaysia Note: Spread = 1-month interbank money market rate – 1-month repo rate

21. Outline • Lessons in Monetary Policy Implementation • Using Government Bond as Monetary Operations • Initial Roadblocks • Development Initiatives • The effectiveness of repo operations • Recap of key points

22. Recap of key points • Earlier impediments to effective sterilisation operations may be overcome through proactive legislative changes of central bank law • New monetary instruments were necessary due to the transformative changes in the domestic financial system especially growth of the debt securities market and international capital inflows • Development initiatives such as increasing the purchase of MGS for BNM own holdings and the introduction of ISCAP helped to increase the use of government bond for monetary operations. • Increased repo operations and the issuance of BNMNs have enhanced the monetary policy implementation process by :- • widening the impact of monetary policy actions to the repo and short-term debt securities market, in addition to the money market originally • reduces monetary policy costs relative to direct borrowings without affecting the signalling role of the Overnight Policy Rate (OPR) target • developed the market in repo & short-term debt securities