As per a CBI notice placed on its website, lenders can manage their need for liquidity or offer their surplus liquidity in the interbank market within the new CBI monetary framework.
The OMO and creating an interest rate corridor (IRC) are the main components of the central bank’s new monetary policy, the CBI said.
Under the IRC framework, the CBI sets the floor and ceiling of policy rates and lets other money market rates, such as interbank rate, move within this setup.
OMO is a financial instrument through which central banks buy and sell securities in the open market to expand or reduce money supply.
Within this framework, central banks can buy government bonds to increase the money base (cash reserves) and by extension curb inter-banking lending rates. By the same token, selling government bonds reduces the base money and raises interbank rates.
It constitutes a key instrument of monetary policy under the market based system of monetary management. Essentially, it is used by monetary authorities to regulate the cost and availability of credit in the banking system and influence the level of money supply.
In addition, within the framework, banks can hold bonds as collateral to borrow from the CBI.
According to the notice, the “operating instruments” to inject liquidity into the interbank market include trading in government securities, repurchase agreements backed by foreign currency and government bonds, giving credit in return for collateral (gold, currency and bonds) and lenders’ parking liquidity in deposits with the central bank.
A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys it back the following day at a slightly higher price.
CBI has asked lenders to allocate a portion of their assets to trade in bonds. “Given that in the new framework the CBI manages liquidity of banks and non-bank credit institutions based on the issued Islamic bonds… they need to allot a portion of their assets to [buying] bonds,” the CBI said.
The policy is also backed by the provisions of the next fiscal budget (March 2020-21). In Note 5 of budget bill for the forthcoming fiscal year, the government has envisioned the launch of OMO for “implementing monetary policy, managing interest rates and controlling inflation”.
Accordingly, the CBI is allowed to collateralize banks’ debts over a gradual process in a way that at least 50% of banks and credit institutions’ debts to the CBI are collateralized by debt bonds issued by the treasury.
CBI Governor Abdolnasser Hemmati earlier said that the bank is committed to control inflation and improve macroeconomic variables, particularly trough policies that could be realized by regulating trade in the bond market and role of the OMO in regulating interest rates in the interbank market.
Hemmati said the CBI has focused attention on the OMO in the hope that the new monetary policy would help curb inflationary effects of the ballooning liquidity because previous measures had failed to produce the desired results.
The key monetary policy was approved by the Money and Credit Council – the major monetary decision-making body – in April 2019.