The monetary policy instruments of the Magyar Nemzeti Bank MNB, Financial analysis May 2012

Topics The place of the instruments within the inflation targeting regime The structure of the instruments Determinants of interbank liquidity on the aggregate level Shocks to the liquidity of the banking system and their management

The goals of monetary policy Final target achievement of price stability: inflation around 3% inflation target continuously since 2007: 3%+/-1% Intermediate target inflation forecast to be close to the inflation target latest forecast: 5.6% for 2012; 3% for 2013 Direct, operational target: short term market interest rates to be consistent with the central bank base rate and with the expectations of it short term: 3-6 months

The system of monetary policy instruments of the MNB Final target: Price stability Intermediate target: Inflation forecast = = medium term inflation target Operational target: Short term interest rate = expected base rate Main policy instrument: 2-week MNB-bill

Decision making mechanism of the MNB Financial stability analysis Monetary Council (MC): Decision on the level of interest rate Money market analysis Information Inflation and real economy forecast Effects of the transmission channels originating from the change in the interest rate Monetary instruments Short term interest rates adjust to the base rate

Transmission channels: how the monetary policy decisions affect output and inflation Source: Monetary policy in Hungary (2012)

Topics The place of the instruments within the inflation targeting regime The structure of the instruments Determinants of interbank liquidity on the aggregate level Shocks to the liquidity of the banking system and their management

The goal and basic principles of the monetary policy instruments On the basis of the real economy and inflation forecast, on the money market situation and on financial stability issues decision makers decide on which level of interest rate they think the inflation target achievable. The task of the instruments is to ‘adjust’ the money market yields to the level of the base rate To reflect the actual level and the expectations on changes in the rate. Not to depend on the liquidity situation, on interbank market processes. The basic principles of the instruments Market conform structure (indirect tools) Transparent, secure and cost efficient structure Equal treatment of market counterparties Support of market building

What are the instruments and who are the counterparties of the MNB? Monetary policy instruments: all the forint and FX market operations of the central bank Counterparties: credit institutions subject to reserve requirements who accomplish certain technical conditions Membership in the Hungarian real-time gross settlement system (VIBER) or in the Interbank Clearing System (BKR) Securities account with the central securities depository and security settlement system (KELER Zrt.) Different scope of counterparties possible according to the aims of the various instruments (e.g. in case of instruments aimed at quick intervention) In case of certain FX market instruments non-residents included In case of quick tenders only banks

The forint market instruments The design of it is determined by the fact that the liquidity of domestic banks is permanently higher than what is needed to fulfil reserve requirements The cause of the permanent liquidity surplus: former intervention at the strong edge of the crawling pegged exchange rate mechanism FX inflow of privatisations and of FX debt securities issuances of the Sovereign Debt Management Centre (ÁKK) exchanged to forint at the MNB conversion of EU funds at the MNB The banking system holds the permanent surplus liquidity in the form of MNB-bills The MNB passively drains out, sterilizes the surplus liquidity As a result, the main policy instrument of the MNB is on the deposit side (and not on the lending side as e.g. at the ECB)

The standard forint market instruments OBJECTIVE INSTRUMENT FORM EFFECT Monetary policy management Base rate Two-week bill Influence of short term yields Smoothing the volatility of interbank interest rates Interest rate corridor Overnight deposit Limiting fluctuations of interest rates Overnight collateralized loan Reserve requirements Averaging mechanism Reduces the volatility of interest rates Quick tender Deposit or collateralized loan Management of unexpected liquidity shocks

The main instrument of the central bank Two-week bill Credit institutions can buy it without upper limit on a weekly basis The MC determines the interest rate of it (key policy rate, base rate) Its aim: management of the money market interest rates in a way considered optimal by the central bank Directly affects short term interest rates (operatioiinal target) Change in the base rate has a signalling effect, it influences the expectations of market participants

Interest rate corridor Corridor between the interest rates of the central bank overnight (O/N) lending and deposit facilities Standing facilities at interest rates less favourable than the key policy rate (currently at +/-1%) Aim: moderate the volatility of money market interest rates, small differences from the key policy rate In case of temporary liquidity need: overnight loan opportunity against security collateral; in case of temporary liquidity surplus: deposit opportunity In the interbank market overnight rates fluctuate between the two edges of the interest rate corridor Cautious liquidity management in banks since the crisis, which results in accumulation of O/N deposits and in interbank interest rates close to the lower bound of the interest rate corridor

Overnight market interest rates within the central bank interest rate corridor

The role of the reserve requirement system Banks must deposit a part (2-5% of less than 2-year maturity liabilities subject to reserve requirement) of their liabilities with the central bank Its aim: reduction of the volatility of money market interest rates Averaging mechanism: monthly average of end-of-day reserve account balances should equal the reserve requirements In case of temporary liquidity deficit reserve account balances can be lower, in case of temporary liquidity surplus they can be higher No implicit taxation already, reserves are remunerated at market interest rates Since the crisis front-loaded reserve holding

Other and unconventional central bank instruments Tenders, open market operations Longer term loan tenders (2-week, 6-month, 2-year) FX-swap instruments (overnight, 3-month, until 2010 also 6- month) Mortgage bond program (2010) Government bond sell and purchase on the secondary market, rarely used instrument (e.g. during the government bond market turbulence of Autumn 2008) Quick tender In case of temporary liquidity problem of the banking system, rarely used instrument (e.g. Autumn 2001)

Acceptable collaterals Central bank credit can be granted only against collateral Acceptable securities: government bonds, mortgage bonds, appropriately rated bonds (of banks, of corporates), municipal bonds Collateral management in practice Lombard loan and not classical repo Pooling (one security portfolio serves for all central bank loans) Haircut dependent on the type and maturity of collateral Daily revaluation, in case of need additional collateral placement

Topics The place of the instruments within the inflation targeting regime The structure of the instruments Determinants of interbank liquidity on the aggregate level Shocks to the liquidity of the banking system and their management

The MNB is the bank of banks, thus changes in the liquidity position of the banking system are tracked in the MNB’s balance sheet Change of the monthly average statistical balance sheet of the MNB, January 2008-January 2012, HUF billion

In the last 3,5 years along with the increase in FX reserves the liquidity surplus of the banking system has increased (the amount of two-week bills has climbed) Cumulated change in the main balance sheet items of the MNB since January 2008 (monthly averages)

Changes in the liquidity surplus of the banking system on the long run go along with changes in MNB-bills The amount of MNB-bills increase when some asset side item of the central bank balance sheet increases: Amount of loans granted to banks increase FX reserves (the central bank buys foreign exchange on the market) Securities portfolio increases (the central bank buys government bond, mortgage bond on the market) or some liability side item of the central bank balance sheet decreases: Government account balance decreases (e.g. pension payments) => the current account balance of the banking system increases, resulting in the increase in two-week bills Current account balance of banks decreases (e.g. reduction in the required reserve ratio) => excess reserves are tied down in two-week bills

The government finances itself in forint: The amount of MNB-bills has increased since 2008 due to FX borrowing instead of issuing forint government bonds Balance sheet of the MNB The government finances itself in forint: Positive net forint government bond issuance Treasury account ↑ MNB-bill ↓ At the end of the day MNB-bills of banks decrease. Total assets of the balance sheet does not change, only the structure of liabilities changes. The government finances itself in foreign exchange: Balance sheet of the MNB FX borrowing FX reserves ↑ Government account ↑ Balance sheet of the MNB Redemption of government bond Government account ↓ MNB-bill↑ At the end of the day total assets of the MNB increase, FX reserves and two-week bills also increase.

Topics The place of the instruments within the inflation targeting regime The structure of the instruments Determinants of interbank liquidity on the aggregate level Shocks to the liquidity of the banking system and their management

Liquidity shocks of the banking system There is fundamental difference between liquidity shocks of individual banks and of the banking system as a whole: On the individual level risk takes the form of unpredictable customer transactions (inflows and outflows as well) Individual liquidity shocks are manageable in the interbank money market in general Shocks to the banking system as a whole reach all individual banks at the same time (though to different extent). Autonomous liquidity factors: transactions of treasury account, currency in circulation, Transactions of the MNB: FX transactions, interest payment Central bank instruments support the management of system wide liquidity shocks (reserve requirements, interest rate corridor, intraday and longer term loans)

A source of liquidity shocks to the banking system is the variability of the treasury account Government purchases increase, incomes decrease the liquidity surplus of the banking system: The majority of government expenditures (e.g. salary payments of the public sector, pension payments) arrive to current accounts held at banks, thus increase the liquidity of banks through payment systems (the structure of the liability side of the balance sheet of the MNB changes) In case of tax income (the largest item is the value added tax) companies transfer money from their bank accounts to the treasury account, while reducing the liquidity of the banking system. Debt financing items have a similar effect to the liquidity of the banking system: interest payments and redemptions are government expenditures to bank customers, thus increase the liquidity, while issuance of government bonds decreases the liquidity of banks.

The volatility of treasury accounts is the most important autonomous liquidity factor The daily movements of the treasury account are hardly predictable and have a significant liquidity effect (200 HUF bn a day in some cases). The smoothing of the treasury account supports the reduction of the volatility of money market yields: When the free liquidity of the banking system increases and the treasury account balance decreases due to government expenditures (e.g. pension payments), borrowing of the ÁKK (reverse repo) elevates the balance of the treasury account and decreases the liquidity surplus of the banking system at the same time. When government income (e.g. VAT) increases the treasury account balance and the liquidity surplus of banks decreases, equilibrium is achieved by money market lending (repo) of the ÁKK.

The other source of shocks to the aggregate liquidity of the banking system is the change in demand for currency Changes in the demand for currency cause smaller liquidity shocks (daily 10-20 HUF bn maximum) and are better predictable. The demand for currency of the economy is driven on the one hand by seasonal factors: Weekly seasonality: demand for currency decreasing in the first half of the week and increasing in the second half Yearly seasonal patterns: hike in the demand for currency holding before end-of-the-year and midyear holidays, while decrease after holidays On the other hand economic growth and inflation also affects the demand for money. As a non-interest bearing instrument the opportunity cost of holding currency changes with inflation. The decrease (increase) in inflation usually has been followed by the increase (decrease) in the growth rate of currency holding of the public.

Year-on-year growth rate of currency holding of the public and the inflation

Opportunities of interbank liquidity management Weekly average expected liquidity surplus Banks can manage optimally their liquidity surplus by quotation of MNB-bills (available once a week) The MNB publishes a liquidity forecast every week, just before the auction of the MNB-bills Management of the effects of intraweek liquidity shocks Change of current account balance (averaging mechanism of the reserve requirement system) Interbank (O/N) lending or borrowing Recourse to the interest rate corridor of the MNB (O/N deposit or loan)

Literature Monetary policy in Hungary (2006, 2012) Detailed monetary policy instruments (2009) Komáromi, András: The effect of the monetary base on money supply – Does the quantity of central bank money carry any information? MNB Bulletin (June 2007) Balogh, Csaba: The role of MNB bills in domestic financial markets. What is the connection between the large volume of MNB bills, bank lending and demand in the government securities markets? MNB Bulletin (October 2009) Varga, Lóránt: Introducing optional reserve ratios in Hungary MNB Bulletin (October 2010) Molnár, Zoltán: About the interbank HUF liquidity - what does the MNB’s new liquidity forecast show? MNB Bulletin (December 2010)