What is monetary policy?

Series preface

In light of recent criticism of economic policy in South Africa, particularly the role and responsibilities of the South African Reserve Bank, this series of briefs will provide background and discuss the issues.

The series will cover the following:

1. The South African Reserve Bank currently
2. Monetary policy
   
   
   1. and  the provision of liquidity
   2. and inflation targeting
   3. and the promotion of economic growth and employment
   4. versus fiscal policy and the budget deficit
3. Exchange rate intervention, eg to stimulate exports
4. Monitoring of asset prices
5. Promotion of Johannesburg as a financial centre

This second brief looks at the implementation of monetary policy function and  the provision of liquidity at the Bank.

Introduction

The main reason for the operations of the South African Reserve Bank (the Bank) in the money market is to implement the Bank's interest rate policy as determined by the Monetary Policy Committee (MPC), with the aim of achieving the Bank's inflation target. In its monetary operations, the Bank endeavours to promote financial stability by managing the liquidity needs of the banking system as a whole. It also contributes to the development and efficiency of the domestic financial markets, in particular the interbank market.

The monetary policy implementation framework

The Bank's refinancing system is the main mechanism that the Bank uses for implementing its monetary policy. Through its refinancing system, the Bank provides liquidity to banks enabling them to meet their daily liquidity requirements. "Liquidity" in this context refers to the banks' balances at the central bank that are available to settle their transactions with one another, over and above the minimum statutory level of reserves that they have to hold. In terms of its monetary policy implementation framework, the Bank creates a liquidity requirement (or shortage) in the money market, which it then refinances at the repurchase (repo) rate – a fixed interest rate determined by the MPC.


The Bank's repo rate influences the interest rates charged by banks, the general level of interest rates in the economy and, consequently, other economic aggregates such as money supply, bank credit extension and, ultimately, the rate of inflation. The monetary policy implementation framework of the Bank can be simplified as follows:

The repo rate influences market rates in two ways: Firstly, it directly influences the marginal cost of funding of the banks and, secondly, it reflects the Reserve Bank's stance on monetary policy. Therefore, even the interest rates of banks which do not participate in the repo auctions are adjusted when the repo rate is increased or decreased. Money-market interest rates are determined by a combination of market forces and the repo rate.

To ensure that its repo rate remains effective, the Bank has to compel the banks to borrow a substantial amount (i.e. the liquidity requirement) from the Bank. The Bank therefore has to transact regularly in the money market to create such a shortage, that is, it has to drain excess liquidity from the money market. In addition to levying a cash reserve requirement on banks, the Bank also uses various types of open-market instruments, such as Reserve Bank debentures, longer-term reverse repos and foreign exchange swaps to drain excess liquidity.

The cash reserve requirement

Banks are required to hold a prescribed percentage of their total liabilities, as adjusted, in cash on their cash-reserve accounts at the Bank. The amount of cash reserves held at the Bank is referred to as the structural liquidity requirement. This is the amount that the liquidity requirement would have been if all the other factors influencing liquidity in the money market had a combined zero balance.

Open-market operations

In addition to the cash-reserve requirement, the Bank conducts open-market operations to drain any excess liquidity in order to ensure an appropriate liquidity requirement in the market.

The instruments that the Bank uses for draining excess liquidity are:

• Issuing its own debentures.
• Longer-term reverse repos. The Bank sells bonds from its monetary policy portfolio in terms of repurchase agreements, and pays the interest rates tendered by the counterparties (mostly banks) on the cash that it withdraws from the market.
• Foreign-exchange swap transactions (i.e. swapping US dollars for rand) to drain rand liquidity from the market on a temporary basis.

Estimating the daily liquidity requirement

The Bank estimates the banks' overall liquidity requirement on a daily, weekly and monthly basis.

The Bank is in the best position to estimate the daily liquidity requirement, firstly, because it is the sole creator and destroyer of liquidity and, secondly, because it has the best overall market information about the factors influencing liquidity.

Refinancing the liquidity requirement

When the Bank has drained sufficient liquidity from the money market, the overall market position should reveal a significant shortage of liquidity. This liquidity requirement is funded at the main refinancing repo auctions. At these auctions, the Bank provides liquidity to the banks by means of repurchase agreements (repos) involving different categories of securities.

Banks sell these securities to the Reserve Bank for a period of one week, in return for cash, while paying a specified rate (the repo rate) on the cash they receive. The transaction is reversed at maturity, when the banks return the cash to the Bank in exchange for the securities.

Although the main repo auctions provide the market's estimated liquidity needs for a week, deviations may occur on a daily basis, leaving the market in either a long or a short liquidity position. Further refinancing would be provided either through a supplementary repo auction. The difference between supplementary tenders and standing facilities is that the former are conducted at the prevailing repo rate, while the latter are conducted at penalty rates, either 50 points above (standing facility repo) or below (standing facility reverse repo) the prevailing repo rate.

In addition to the supplementary auctions and standing facilities mentioned above, banks have access to their cash-reserve balances at the Bank for liquidity management purposes, provided that they adhere to the requirement on an average basis over the full maintenance period. This implies that if a bank uses some of its cash reserves for a day or two (thus falling below the required amount) it has to hold additional reserves for the rest of the maintenance period in order to comply, on average, with the statutory reserve requirement.

Access to cash reserves has been introduced as an additional mechanism for banks to manage their short-term liquidity needs. However, the averaging requirement prevents banks from using this facility for an extended period. If a bank continues to have a liquidity shortage for some time, it has to obtain liquidity either in the interbank market or through the Bank’s refinancing facilities.

Refinancing can be employed by the Bank when it acts as lender-of-last-resort (LOLR) to assist banks which are illiquid but solvent. The Bank has discretion in granting LOLR assistance but only against collateral (this assistance has, at times, been supplied by the authorities at virtually zero cost). As in the UK, the Bank has to look for financial assistance from the Treasury if it wants to bail out an insolvent financial institution.

Source: South African Reserve Bank, Fact Sheet #9