Policy Rate Setting
The Bangko Sentral ng Pilipinas (BSP) formally adopted inflation targeting as the framework for monetary policy in January 2002. This policy move is aimed at providing the BSP with a more focused and forward-looking approach in the pursuit of its primary mandate, which is to ensure price stability. Two intrinsic features of the approach—transparency and accountability in monetary policy—is expected to enhance the credibility of the BSP in helping create a stable macroeconomic environment in which vital economic reforms to raise the growth potentials of the economy can continue.
This approach involves the announcement of an explicit inflation target that the BSP promises to achieve over a given time period. The target inflation rate is set and announced jointly by the BSP and the government through an inter-agency body. Although the responsibility of achieving the target rests primarily with the BSP, this joint announcement reflects active government participation in achieving the goal of price stability and government ownership of the inflation target.
In the Philippines, the interest rates applied on the overnight RP/RRP signals the stance of BSP’s monetary policy. The BSP created an Advisory Committee which deliberates, discusses and recommends to the Monetary Board the appropriate monetary policy stance that will enable the BSP to achieve the desired inflation target. The Advisory Committee meets every six weeks and in between regular meetings, whenever it is deemed necessary.
The BSP implements monetary policy using various instruments to influence the level of liquidity in the market and thereby steer inflation towards thetarget level. These instruments can be classified into two types:
- Direct instruments enable the BSP to control directly certain items in banks’ balance sheets which may be in the form of financial prices or quantities. Direct instruments have a strong coercive element as in the case of reserve requirements and directed lending requirements.
- Indirect instruments work through the market to influence the behavior of financial institutions, usually through the pricing of central bank facilities. Indirect instruments include adjustments in short-term policy interest rates and the conduct of open market operations (OMO).
Mechanics of OMO
OMO is a monetary tool which involves the BSP publicly buying or selling government securities from banks and financial institutions in order to expand or contract the supply of money. By controlling the money supply, the BSP is able to exert some influence on the prices of goods and services and achieve its inflation objectives.
When the BSP buys securities, it pays for them by directly crediting its counterparty’s Demand Deposit Account that is being maintained with the BSP. Effectively, the transaction increases the buyer’s level of reserves and on an aggregate level, expands the system’s money supply. Conversely, when the BSP sells the securities, the buyer’s payment (via direct debit against the buyer’s Demand Deposit Account with the BSP) reduces his reserve account causing money supply to contract.
In conducting OMO, the BSP uses two instruments: (1) repurchase (repo)/reverse repurchase (reverse repo) agreements and (2) outright purchases and sales of securities.
- Repurchase (repo) / reverse repurchase (reverse repo) agreements. The BSP purchases government securities from a bank with a commitment to sell it back at a specified future date at a predetermined rate. In effect, a repo transaction expands the level of money supply as it increases the bank’s level of reserves. Under a reverse repo, the BSP acts as the seller of government securities, thus, the bank’s payment reduces its reserve account resulting in a contraction in the system’s money supply. For both repos, the BSP can only affect the level of money supply temporarily, given that the parties involved commit to reverse the transaction at an agreed future date. At present, the BSP enters into repo agreements for a minimum of one (1) day (overnight) for both repos and a maximum of 91 days and 364 days for repo and reverse repo agreements, respectively.
- Outright purchases and sales of securities. An outright contract involves direct purchase/sale of government security by the BSP from/to the market for the purpose of increasing/decreasing money supply on a more permanent basis. In such a transaction, the parties do not commit to reverse the transaction in the future, creating a more permanent effect on the banking system’s level of money supply.
The BSP may also use other monetary policy tools such as reserve requirements and rediscounting to expand or contract money supply. The BSP may also grant loans and advances to banking institutions to influence the volume of credit consistent with the objective of price stability. In addition, the BSP can employ moral suasion as a last resort when existing market mechanisms cannot adequately and promptly ensure the attainment of specific monetary objectives.
Advantages of Open Market Operations
However, among the tools available to the BSP, OMO offers advantages and continues to be the most practical tool for the following reasons:
- First, it works within the BSP’s initiative and control. Having the authority to steer market interest rates, the BSP can influence money supply by changing the monetary policy rates. Consequently, OMO gives the BSP greater flexibility in terms of the amount and timing of intervention.
- Secondly, it is fast to implement and gives quick results. Any change in the policy rates is readily implemented, i.e., on the same day that the Monetary Board makes the resolution. Thus, any effect on the market is evident right after the overnight trading for the day.
Call Loans and the Interbank Call Loan Market
Call money are amounts traded in the interbank call loan market that correspond to the excess or deficiency of each bank in terms of reserves. These can be overnight placements.
IBCL transactions among banks are done primarily to correct reserve requirements. The reserve position of each bank or quasi-bank is calculated daily on the basis of the amount of the institution’s reserves at the close of business for the day and the amount of its liability accounts against which reserves are required to be maintained. The reserve positions of banks are normally known after the check clearing results have been transmitted. As the check clearing results are known only by late afternoon, interbank call loans are currently done from 4:45 PM to 5:30 PM.
The interbank market can either be securitized (collateralized) or unsecuritized (clean) lendings/borrowings, as well as repurchase agreements. Repurchase Agreements (RPs) are generally short-term sale of government securities with an agreement to repurchase on the agreed maturity date. Repurchase agreements are extensively used as a means of short-term financing by government securities dealers and by banks.
Banks establish credit lines with its counterparties for these transactions.
Managing Risks in OMO Transactions
A valuation scheme for securities used in repos is adopted by the BSP to help manage the credit risk inherent in OMO transactions. Eligible securities are valued based on their current market yields as well as the applicable cut based on remaining life of securities involved.
To avoid exposing the BSP to undue risks arising from purchases of securities, Section 91, Article V of RA 7653 (The New Central Bank Act) sets the type of securities that can be bought or sold by the BSP for its own domestic portfolio, as follows:
- Evidences of indebtedness issued directly by the Government of the Philippines or by its political subdivisions; and
- Evidences of indebtedness issued by government instrumentalities and fully guaranteed by the Government.
Section 92 of the same article also provides the BSP with effective instruments for OMO, that is, it may, subject to such rules and regulations as the Monetary Board may prescribe and in accordance with the principles stated in Section 90, issue, place, buy and sell freely negotiable evidences of indebtedness of the BSP, provided that such issuance shall be made only in cases of extraordinary movement in price levels. Said evidences of indebtedness may be issued directly against the international reserves of the BSP or against securities, which it has acquired under the provisions of Section 91 or may be issued without relation to specific types of assets of the BSP.