Slow and steadyMore time needed to assess the efficacy of interest rate corridor framework to reduce volatility in interest rates and managing liquidity
An interest rate corridor (IRC) denotes the range within which the operating target of the monetary policy—a short term interest rate, for instance, the interbank rate—moves around the policy rate announced by the central bank. The IRC framework has been employed by central banks and in countries at all stages of development, as a tool to reduce the volatility of short-term market interest rates. IRCs also lessen the interest rate sensitivity of the commercial banks demand for central bank balances, and thus make the market less sensitive to liquidity forecasting errors.
In many countries, monetary policy is generally undertaken with a single policy rate which is fixed within a corridor plotted by: a) standing collateralized marginal lending facility at a rate exceeding the policy rate that provides the upper bound; and b) a standing uncollateralised deposit facility at a rate less than the policy rate that represents the lower bound.
Width of Corridor
Among central banks, the width of the corridor generally ranges from 50 basis points (bps) to 200 bps, though there are instances where the width of the corridor has surpassed 200 bps in many countries in the initial phase of the implementation of the IRC framework. Whether a corridor of 50 bps or 200 bps is optimal is governed basically by: a) the preferences of central banks regarding the core variables affected by the corridor width (interest rate volatility, leanness of the central bank’s balance sheet and interbank market activity) and b) by the structural parameters, including interbank transaction costs and extent of liquidity shocks affecting the banking system.
Frequent changing of the width of the corridor may create uncertainty and may make it arduous to maintain the target rate aligned to the policy rate. However, in exceptional cases, when it is required to incentivise or disincentivise market participants from accessing the standing lending facility or parking funds with the central banks, the width of the corridor could be changed.
A too-narrow corridor could increase the reliance of banks on the central bank and thus impede the growth of the money market. On the other hand, too wide a corridor could provide scope for volatility in the short term rate, hindering market development and the transmission of policy signals. The key principle in determining the width of the corridor is that it should stabilise the short term interest rate while facilitating the development of the money market so that the reliance of banks on central bank facilities comes down over time.
IRC was formally introduced in Nepal on 10 August 2016 to align the Nepal Rastriya Bank’s (NRB) short-term liquidity management framework for reducing volatility in short-term interest rates as well as providing incentives for interbank trading. Its launch provided the relevant stakeholders an opportunity to get acquainted with the concept. Introduced as some kind of a “floating” corridor under the standing liquidity facility (SLF), it was not very successful in lowering the volatility in short-term interest rates.
Against this perspective, to make the policy framework more effective and in line with the revision made in the Monetary Policy for 2017/18, NRB has recently introduced a more conventional and refined framework of IRC by fixing the floor, ceiling and policy rates to reduce the volatility of interbank interest rates. This step is also expected to: a) enhance the signalling of the monetary policy stance, b) support financial market development, especially with respect to the government securities market, and c) facilitate commercial banks’ liquidity management.
Experiences of countries that have successfully adopted the IRC framework reveal that steps need to be taken gradually and cautiously for its smooth implementation, based on market conditions. In India, for instance, the IRC system was introduced by the Reserve Bank of India (RBI) in 1999 on the basis of the recommendations of the Committee on Banking Sector Reforms, and subsequent improvements made based on the suggestions provided by the Working Group on Operating Procedure of Monetary Policy and the Expert Committee to Revise and Strengthen the Monetary Policy Framework. Fine-tuning with respect to the IRC is currently being undertaken during the course of RBI’s Bi-monthly Monetary Policy Review based on liquidity and market conditions. At present, the policy rate, that is the fixed repo rate announced by RBI for its overnight borrowing/lending operations through its mechanism for managing short term liquidity, stands at 6.0 percent. The upper bound of the IRC is served by the Marginal Standing Facility (MSF) rate, which stands at 6.25 percent and the lower bound by the reverse repo rate which is fixed at 5.75 percent. This implies that the width of the corridor is 50 bps. However, it should be recalled that the width of the corridor stood at 300 bps between July to October 2008. In India’s case, the objective of fulfilling short term liquidity needs is met through the provision of liquidity by the RBI under its regular facilities—variable rate 14-day/7-day repo auctions corresponding to 0.75 percent of banking system Net Demand and Time Liabilities (NDTL), and also complemented by daily overnight fixed rate repos corresponding to 0.25 percent of bank-wise NDTL.
The situation is different in Nepal, where only fixed rates are involved. The standing liquidity facility (SLF) rate, which forms the ceiling in the IRC, has been fixed at 7 percent, implying that the NRB lends funds to banks and financial institutions (BFIs) at this rate for a maximum period of one week whenever they face shortage of liquidity. On the other hand, the two-week term deposit rate, which forms the lower bound, has been fixed at 3 percent. Analogous to the SLF, this is the instrument through which BFIs borrow from the central bank for a relatively longer period, that is, two weeks. The two-week repo rate as a policy rate has been fixed at 5 percent. This all shows that the width of the corridor currently stands at 400 bps. However, the NRB could have the flexibility to narrow down the width of the corridor during its half-yearly or annual review of the monetary policy should monetary conditions warrant. Likewise, this framework would be gradually upgraded, in line with international practice, as policymakers and market participants gain more experience with it.
Though the immediate impact of the implementation of the revised IRC framework appears to be positive, it could take a quite a while, as witnessed in many countries, to make a clear assessment of the corridor system in terms of reducing the volatility in short-term interest rates as well as in facilitating liquidity management in the banking system.
Pant is with Nepal Rastra Bank; Views expressed are personal