Challenges Facing Central Bank in Conducting Monetary Operation under Excess Liquidity Dr. Atchana Waiquamdee Deputy Governor Bank of Thailand 1 Nov 2007.

Challenges Facing Central Bank in

Conducting Monetary Operation under Excess Liquidity

Dr. Atchana WaiquamdeeDeputy Governor Bank of Thailand

1 Nov 2007

Presented at the Workshop on Developing Government Bond Market:

The Challenges towards a Sound Monetary Management

2

Outline

I. Sources of excess liquidity

II. Implications on monetary management– Monetary policy framework: Inflation Targeting– Monetary operation: Sterilization

III. Implications on financial market development– Choosing monetary instruments to further market development– Side effects of taming surges in inflows

IV. Challenges & risks– Effectiveness of Monetary policy – Central bank’s balance sheet risk – Practical Limits to sterilization– Finding optimal balance on policies responses in face of large

inflows

3

I. Sources of Excess Liquidity

4

Foreign exchange inflows have been large and persistent, from both current account surpluses and non-bank capital inflows…

Billion USD 2005 20062007

Q1 Q2 H1

Current A/C -7.9 3.2 4.9 1.3 6.2

Net capital movement 12.6 7.9 -3.5 0.5 1/ -3.0 2/

Of which: Non-Bank 11.0 16.8 2.6 2.6 1/ 5.2 2/

- FDI 7.4 10.5 2.1 1.8 1/ 3.9 2/

- Portfolio 2.6 4.5 0.9 0.7 1/ 1.6 2/

- Other Loans -1.3 2.9 0.3 -0.4 1/ -0.1 2/

- Trade credit 2.3 -0.3 -0.5 0.8 1/ 0.3 2/

- Other -0.1 -0.7 -0.1 -0.3 1/ -0.4 2/

Overall balance 5.4 12.7 3.3 2.3 5.7

Reserves 52.1 67.0 70.9 73.0 73.0

Note : 1/ Apr-May 07 2/ Jan-May 07Source: Compiled by Bank of Thailand

5

…causing Thai baht to appreciate rapidly.

2006YTD

(End Sep07)

THB 14.9 4.2

IDR 9.3 -1.6

SGD 8.5 3.2

KRW 8.4 1.6

PHP 8.1 8.7

MYR 7.1 3.6

CNY 3.3 4.1

INR 1.8 11.2

TWD 0.7 -0.2

HKD -0.3 0.2

% change in exchange rate against USD1 Jan 06 = 1

0.80

0.85

0.90

0.95

1.00

1.05

1/1/2006 1/4/2006 1/7/2006 1/10/2006 1/1/2007 1/4/2007 1/7/2007 1/10/2007

THB

INR

PHP

HKD

CNY

TWD

IDR

MYRSGD

KRW

6

The appreciation momentum, especially in 2006, hardly reflected our economic fundamental

5

5.5

7.9

5

5.5

5.9

11.1

9.1

4.7

6.8

-14.9

-9.3

-8.5

-8.4

-8.1

-7.1

-3.3

-1.8

-0.7

-15 -10 -5 0 5 10 15

TH

ID

SG

KR

PH

MY

CH

IN

TW

HK

FX appreciation 2006 GDP growth 2006

Thailand

Indonesia

Singapore

Korea

Philippines

Malaysia

China

India

Taiwan

Hong Kong

Source: CEIC and Bloomberg

0.3

7

Foreign exchange intervention to prevent excessive exchange rate volatility resulted in reserves accumulation

Source : BOT

8

II. Implications on monetary management

9

Strategy Implementation

Framework

Ultimatetarget

Intermediatetarget

Operatingtarget

Instruments

Price stability

Sustainablegrowth

Expected inflation

(Core inflation of 0-3.5% quarterly

average)

Policy interest rate

(1-day RP rate)

Reserve requirement

Open MarketOperations

(OMOs)

Standing facilities

Thailand adopts inflation targeting framework (since May 2000)

10

Thus far, inflation developments have been well contained

-2

0

2

4

6

8

10

12

14

Jan

1995

Ju

l

Jan

1996

Ju

l

Jan

1997

Ju

l

Jan

1998

Ju

l

Jan

1999

Ju

l

Jan

2000

Ju

l

Jan

2001

Ju

l

Jan

2002

Ju

l

Jan

2003

Ju

l

Jan

2004

Ju

l

Jan

2005

Ju

l

Jan

2006

Ju

l

Jan

2007

Ju

l

Core Inflation

Annual percentage change

Headline Inflation

Target: 0 – 3.5%

FX targetMonetary target

Inflation target

Source : BOT

11

Monetary Operations Framework

BOT is responsible for maintaining money market liquidity at a level consistent with the policy interest rate set by the MPC.

Monetary operations comprises 3 main components:

1. Reserve requirements– 1% of which is in the form of non-remunerated deposits

at the BOT

2. Open market operations– Repo– Outright buy/sell of government securities– Issuance of BOT Bills/bonds– FX Swap

3. Standing facilities– Interest rate corridor of +/- 50 bps.

12The BOT sterilized mainly via issuance of BOT bonds,

FX swap and repurchase operations

-1400

-1200

-1000

-800

-600

-400

-200

0

Ja

n-0

6

Fe

b-0

6

Ma

r-0

6

Ap

r-0

6

Ma

y-0

6

Ju

n-0

6

Ju

l-0

6

Au

g-0

6

Se

p-0

6

Oc

t-0

6

No

v-0

6

De

c-0

6

Ja

n-0

7

Fe

b-0

7

Ma

r-0

7

Ap

r-0

7

Ma

y-0

7

Ju

n-0

7

Ju

l-0

7

Au

g-0

7

Se

p-0

7

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

Bln Baht Mln USD

RP

FX Swap Outstanding (RHS)

BOT Bills/Bonds

Source : BOT

13

3.00

3.50

4.00

4.50

5.00

5.50

Jan-06 Mar-06 Jul-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07

1D RP

14D RP

Interbank O/N

The BOT has been able to keep the policy rate at its target with very little volatilities

%

Source : BOT

14

III. Implications on financial market development

15

0

20

40

60

80

100

120

140

1994 1995 1996 1997 1998 1999 2000 2001  2002 2003 2004 2005 2006

Banking sector Domestic Bond Stock market

Thai Financial System

% of GDP

The increased role of domestic bond market in Thailand facilitates the use of debt securities as a monetary instrument

Source: ThaiBMA

16

Monetary operations can and do play an important role in enhancing development of financial market

Markets in which central banks operate normally gain more depth and breadth– E.g. the rapid growth in Australian repo market since

1990s when the RBA started using repo.

17

The BOT has consciously chosen its monetary operations to also further market development

Repurchase operations Plan for BOT RP closure

is in place Bilateral RP operations

between the BOT and PDs are designed to help promote the private RP market

0

5000

10000

15000

20000

25000

30000

35000

May-04 Nov-04 May-05 Nov-05 May-06 Nov-06 May-07

Trading volume in private RP marketMln Baht

Source : BOT

18

Composition of OMOs Used (Liquidity Withdrawal)

BOT bills/bonds are playing increasingly larger role

as monetary instruments

FX Swap48%

BoT Bills/Bo

nds43%

RP9%

End -2003Total 415 bil. Baht

FX Swap19%

BoT Bills/Bo

nds71%

RP10%

End -2006Total 1,270 bil. Baht

Source : BOT

19BOT bonds/bills outstanding has risen steadily,

corresponded to the rise in international reserves accumulation

Source : BOT

20

Issuance of BOT bonds/bills are similarly designed to also further market development

BOT bonds/bills issuance Requires MOF approval on overall outstanding (stipulated in

the BOT Act) Admittedly, the presence of two “risk-free” issuers (BOT &

MOF) could lead to market fragmentation, but the Public Debt Management Act does not allow MOF to issue for BOT)

Thus, BOT coordinates closely with MOF on issuance schedule with market development objective in mind

provide regular and predictable supply reduced auction frequency and consolidation to reduce

number of issues to facilitate secondary market trading Introduce new products such as FRN

21BOT bonds have a wide investor base and contributed

to the growth of mutual funds industry

Source : BOT Source : AIMC

22

Source : ThaiBMA

Outstanding Value Daily Trading Volume

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2000 2001  2002 2003 2004 2005 2006

Bln. Baht

Government Bonds T-Bills State Enterprise Bonds BOT Bonds Corporate Bonds

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2000 2001 2002 2003 2004 2005 2006

Bln. Baht

BOT papers have become the most actively traded instruments

23

IV. Challenges & risks

24

Challenges & Risks

1. Effectiveness of monetary policy

2. BOT’s balance sheet risk

3. Practical limit to prolonged sterilization

4. Finding optimal balance on policies responses in face of large inflows

25

1. Effectiveness of monetary policy

Excess liquidity could impair transmission mechanism

weaken interest rate channel could lead to a reduction in short-term interest rates

and have consequences for inflation

Two implications of excess liquidity at the ‘macro’ level

may provide unwanted stimulus and create excessive inflationary pressure

central banks’ ability to effectively manage liquidity may be constrained relative to a liquidity shortage situation.

26

2. BOT’s balance sheet risk

Both size and composition of the BOT balance sheet has changed substantially reflecting large-scale sterilized FX intervention.

Large currency mismatch led to large FX revaluation losses last year.

Effective communication is the key to preserve credibility.

27

3. Practical limit to sterilization

The BOT Act limits instrument flexibility The BOT cannot pay interest on any deposits placed at the

central bank

Stage of market development may constrain operations under-developed market for interest rate hedging tools could

compromise large sales of central banks’ papers With ever-larger scale of sterilization needed, the challenge is

to keep all operations market-friendly

Insufficient participation in monetary operations may result in failure to achieve the operational target

Prolonged sterilization may not be possible without causing upward pressure on interest rates

284. Finding optimal balance on policies responses

in face of large inflows

Challenges to macroeconomic management as well as financial stability

Macroeconomic management Combining policies of sterilised FX intervention,

restriction inflows while encouraging outflows Proper risk management is crucial

29

Financial stability issue– Will excess liquidity lead to asset price bubbles?– Deal with potential buildup of imbalances early

Ongoing balancing act between managing financial integration and managing exchange rates– The need to have sound fundamentals, transparent

regulatory and legal frameworks, robust market infrastructures, efficient risk management system

4. Finding optimal balance on policies responses in face of large inflows