KARACHI: The State Bank has decided to restructure the interest rate corridor to minimise its volatility.

The central bank will also introduce a target rate that will remain between ceiling and flat rates.

The State Bank on Tuesday issued a detailed report about proposed changes in the next monetary policy which stated that the interest rate corridor framework was being reviewed by the bank to further strengthen the transmission of monetary policy for the desired effects.

The main feature of this planned improvement is the introduction of ‘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,” says the SBP.

Moreover, this rate will be specified within the corridor, lower than ceiling rate and higher than floor rate.

In this context, a proposal will be submitted to the Advisory Committee on Monetary Policy (ACMP) in its March 2015 meeting for a review and for its recommendations to the SBP Board.

Later on, the SBP board of directors will make a final decision in its meeting in the same month.

The SBP established an “Interest Rate Corridor” (IRC) in August 2009 with SBP reverse repo 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 the interest rate corridor 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 short-term rates (overnight repo rates) witnessed a considerable volatility.

It was mainly due to uncertain flow in the system, such as government related deposits, taxes, borrowing for commodity operations and borrowings from the SBP, etc.

While the SBP reverse repo rate (policy 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 an effective transmission of monetary policy stance of the SBP.

Though the volatility of short-term interest rates has come down sharply since August 2009, the 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, 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 order to dissuade frequent accesses to the SBP Overnight Reverse Repo and Repo facilities SBP imposed a spread of +/- 50bps over and above the SBP overnight reverse repo and repo rates respectively for the remaining quarter in case an eligible institution accesses either of the above facilities more than seven times during a given quarter.

“Changes Under Consideration in the Monetary Policy Operational Framework In accordance with the best international practices and to address the above issues, SBP plans to align the operational target of overnight money market repo rate with the proposed policy rate,” said the report.

This overnight repo rate target would be a single policy rate to unambiguously signal 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 and 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.

In order to ensure that overnight money market repo rate remains close to the target rate (i.e. policy rate), the SBP would increase the frequency of OMO repo operations of varying tenors including overnight.

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.

 

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