The initiative is part of the proposed budget that says “in order to implement the monetary policy and control interest rates and inflation, the CBI will launch the OMO and trade in Islamic bonds issued by government, Banks can hold the bonds as collateral to borrow from the CBI.”
OMO is a financial instrument through which central banks buy and sell securities in the open market to expand or reduce the supply of money. Within OMO, the CBI buys government bonds to increase the money base (cash reserves), thereby reducing the inter-banking lending rates.
On the other hand, selling government bonds decreases the base money and raises interbank rates, Financial Tribune reported.
However, the current procedure doesn’t oblige lenders, which are in need of liquidity, to keep collateral with CBI for inter-bank debt settlement, a “wrong practice” which the MRC says must end.
“Binding the banks to keep collateral for borrowing from the central bank is normal in many countries that also helps CBI regulate lending” MRC said.
An increase in the volume of bonds is tantamount to increase in the volume of borrowing which in turn causes the interest rate on bonds to rise.
When the interest rate of government bonds is higher than the interbank rate, banks with surplus cash reserves prefer to buy bonds instead of parking their money in the interbank market. This is a point where central banks come in and play their role as the main purchaser of bonds in the secondary market.
According to the parliamentary think tank, due to current religious jurisprudential prohibitions, except for treasury bills, the CBI is not legally allowed to trade in other types of Islamic bonds.
However, the budget bill is construed in a way that grants permission for trading Islamic bonds within open the market operation framework.
Launching the OMO and purchasing bonds by CBI will naturally increase demand for such bonds that in turn reduce the yield of such bonds and bring them closer to interbank borrowing rates. “The procedure ultimately reduces the borrowing cost and, thereby, facilitates the borrowing process,” the MRC says.
A Warranted Move
MRC argues that decreasing borrowing costs and facilitating the borrowing process is a must for the government as it seeks to plug the budget hole by borrowing, adding that because the budget deficit for next year is predicted to be bigger, launching open market operation is more warranted.
The report points to average interbank rate in the period covering March 22 -Sept. 22 which stood at 19.59% and contrasts it with the interest rate registered for Islamic bonds by the August 22, saying that the bond rate was 10.5% higher than the interbank rate during the period.
However, the research wing of the parliament says for the mechanism to work optimally, some groundwork should be in place.
It says optimal implementation of OMO requires sufficient “depth” of the Islamic securities market. In other words, “there should be enough bonds in the market to create maneuverability for the CBI to trade bonds for controlling interest rates.”
Adding up the bonds which mature next year (270 trillion rials / $2.3 billion) and the total bonds to be issued next year (910 trillion rials / $7.9 billion), as seen in the budget bill, the MRC says there will be enough bonds in the market for the effective implementation of OMO.
However, it links this to an important factor i.e. is the demand for government bonds. “Increased demand for government bonds leads to decline in their interest rates. As such, less interference on the part of the CBI is needed to draw rates closer to desired point,” the MRC claimed.
It added that as lenders are the main applicants of CBI loans, the existence of crisis-plagued banks means a huge decline in demand for bonds.
The think tank believes that the presence of bad banks in the bond market impede CBI open market operations to obtain its desired results as “these banks seek resources from the CBI at any cost to settle their debts to other lenders… because essentially they barely have any reserve to be able to buy bonds and keep them as collateral with the CBI. ”
It warns that if the CBI keeps compromising with lenders’ malfunctions and hangs on to faulty former procedures, the market won’t see any progress over time.
Therefore, the MRC recommends banking reforms and closing poorly performing banks, asking the regulator to enforce appropriate penalties for borrowers who fail to put up collateral.