Open Market Operations and the Treasury Bills Auction. Ivy Aryee. Centre for Policy Analysis. CEPA, Accra. June 2001

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1 Open Market Operations and the Treasury Bills Auction Ivy Aryee Centre for Policy Analysis CEPA, Accra June 2001 Introduction Every Friday the Bank of Ghana (BOG) conducts an auction of T-bills on behalf of government in respect of the Government of Ghana s (GOG) Public Sector Borrowing Requirement (PSBR) and of itself as an instrument of monetary policy. It is a wholesale auction with only primary dealers as participants. Primary dealers comprise Domestic Banks (DMBs) and some non-bank financial institutions like discount houses and brokerage firms. The primary dealers participate by submitting competitive tenders at the auction. The BOG pays a commission fee of 0.25 percent of the face value for securities purchased by the primary dealers on behalf of their customers. After the auction, tap sales are used to supply customers outside Accra through the BOG s branches in Kumasi, Takoradi, Hohoe, Tamale and Sunyani. Securities for the tap sales are purchased by the BOG in a non-competitive tender and sent to the regional branches. The Auction Committee The Auction Committee comprises representatives from the BOG, Ministry of Finance (MOF) and Controller and Accountant General s Department (CAGD). It meets every Friday. It has a two-fold purpose: To determine the lowest acceptable price for each T-bill that will be accepted from the bids submitted, and hence the highest interest rate that will be allowed that week; and To determine the total value of T-bills that will be offered at the next auction, based on the PSBR and the BOG s desired level of OMO. The OMO Committee

2 There is an OMO Committee that meets every Thursday to determine the size and direction of the weekly OMO. That is whether reserves need to be added or drained from the banking system. The size of OMO arrived at is governed by the difference between actual reserves and the weekly reserve money target. Quarterly targets are agreed with the IMF (as benchmarks or performance criteria under the PRGF formerly ESAF Arrangement). These are broken down into weekly targets using straight-line projections by the Research Department of the BOG. The DMBs submit formal reports on their reserve positions every Wednesday. In practice, the BOG canvasses DMBs daily to determine their overall reserve position. Thus, even though formal reports on reserves are submitted by the DMBs once a week, the BOG has a reasonably good idea of the level of reserves in the banking system on a continuous basis. The OMO Committee weighs current and potential changes in all sources of change in Reserve Money namely, BOG s holdings of GOG securities, Net Foreign Assets, Net Claims on GOG and Net Claims on the Rest of the Economy (including the financial sector). This enables the Committee to make an informed judgement of how the monetary base, that is Reserve Money, is likely to behave in the near term. Based upon these considerations the Committee presumably decides on the volume of OMO that would be undertaken from week to week. The BOG is thus, in a position to know whether it has met the targets set for itself or even more critically those agreed with IMF. The target for the week thus determined by the OMO Committee is a key input in the determination of the total value of T-bills that the Auction Committee would offer at the subsequent auction the other determining component being the PSBR from the cash flow of the GOG prepared by the MOF. Fully Subscribed Outcome The GOG has first claim on the OMO proceeds, which it uses to meet its PSBR. The Bank of Ghana Law (1992) among other things specifies the BOG s obligations as the government s banker and fiscal agent. Part I, Section 3(c) enjoins the BOG to regulate and direct credit of the banking system in accordance with the economic policy of the Government. This clearly subordinates the regulation of credit to the economic priorities of the government priorities which may conflict with the broader objectives of achieving and maintaining macroeconomic stability, specifically low rates of inflation. Consequently it is the residual proceeds that constitute the means of draining reserves from the banking system to meet the Reserve Money target. It is these residual (after the GOG s claims for meeting PSBR has been met) proceeds, if any that constitutes the BOG s OMO in government securities. The BOG could and does resort to Foreign Exchange Market Operations (FEMO) i.e. sale of foreign exchange as additional means of achieving the reserve money target. The total value of GOG securities sold at the auction becomes a claim on the GOG in the balance sheet of the BOG. The gross assets of the BOG are unaffected by the OMO.

3 Instead, changes in bank reserves (a BOG liability) are offset by an increase in the value of a blocked account of the GOG held by the BOG. In other words, the component of the auction proceeds earmarked to meet the PSBR is recycled back into the system and if the auction is fully subscribed, has no significant effect on the balance sheet of the BOG. The residual proceeds, (technically the OMO component), are deposited into a GOG blocked account. The effect of this is a reduction in bank reserves (and hence reserve money) but with a corresponding reduction in the net claims on the GOG as the blocked account rises. Undersubscribed Auction As depicted in Figure 1, the auction is more often that not undersubscribed sale/offer ratio less than unity. Undersubscription, given the first claim of the GOG, means that the OMO fails to achieve its objective and the reserve money target for the week cannot be fully met through the T-bills auction. FEMO or reverse REPO or both may therefore be needed. If the extent of undersubscription reaches the point where the PSBR cannot be met, a serious problem of macroeconomic stability arises. Various courses of action include: BOG purchase of enough T-bills to meet the PSBR. This granting of credit to government by the BOG creates money as the financing of the PSBR means payments for goods and services by government and or the redemption of maturing securities. The BOG is not only unable to conduct its OMO, but also directly violates its reserve money target. Table 1 presents a bar chart frequency distribution of subscription rates for the period 1995 to mid The overall average is 74.1% with a median of 85.6% and a modal class of 81-90%. It is clear that on average the BOG s OMOs have failed because the T-bill auctions have been persistently undersubscribed. Furthermore the BOG has often extended credit to government, offsetting the potentially, inflationary effects of such monetary injection by running down its holdings of international reserves. When this latter route proves infeasible, payment arrears have resulted. It is estimated by CEPA that as at end-december 2000 the stock of payments arrears amounted to about 3% of GDP contributing to the emergence of the domestic debt as the most difficult challenge policy facing the Kufuour administration. Debt repudiation or cancellation, as the HIPC Initiative demonstrates, is possible (even if at some cost) but in the context of the domestic debt can only spell disaster. Table 1: Frequency Distribution of Subscription rates for the period 95 Mid 2001

4 Frequency Mean Median Under 20% % % % % % % % % Source: Calculated from BOG Auction data Undersubscription could occur for seasonal reasons such as when income taxes are due and around major festivals like the X mas and New Year period. The primary reason by far, however, is that interest rates are not free to equilibrate the quantity of securities supplied with the quantity demanded. As Figure 2 shows for example over the first five months of the year nominal interest rates remained stable even in the face of large swings in subscription rates. Unofficially it is alleged that a critical consideration in the setting of interest rates is the debt servicing cost to government. There is an additional consideration believed to have been important in a politically sensitive period like election year This is the political cost of the high lending rates of DMBs. More generally it appears that interest rates are changed when reserve money targets cannot be met through the use of alternative instruments or when other considerations dominate. For example, beginning in the last quarter of 1999 interest rates were raised incrementally to over 45% in an attempt to rein in the fast depreciating cedi. It has indeed been claimed that the current relative stability of the cedi in the foreign exchanges is due to the raising of interest rates. An undersubscribed auction renders the BOG unable to drain the desired level of reserves from the banking system. The historical record shows that BOG cannot exercise the degree of control over the monetary base through the use of its primary monetary policy instrument

5 the OMO in the prevailing circumstances. This situation at least in the past is due to an institutional weakness that is the underdevelopment of a secondary market for T-bills where the BOG can freely buy or sell exactly the amount of T-bills it wants to (as obtains for example in the US). The BOG has made some progress in this direction converting the auction from retail to a wholesale market by selling to only primary dealers. The latter are in turn supposed to rediscount the securities to retail purchasers. It may be worth recalling that originally, the discount houses were intended to underwrite the T-bill issues and then resell them to the rest of the market. It soon became apparent that the discount houses were not financially strong enough to do this so the BOG was forced to move to the primary dealer system. The important point to emphasize is that a well-functioning secondary market can never develop as long as the need to intervene in the market to constrain the interest rate remains strong. DMBs are apparently notified by the BOG when it deems it desirable that they raise bid prices to lower interest rates. The BOG reportedly also uses dummy bids to signal when it deems it acceptable for dealers to offer lower prices demand higher interest yields for T-bills. Copyright CEPA 2002