Tuesday, August 3, 2010

Open Market Operations And The OPR

[This blog post is a primer for students and anybody else unfamiliar with the normal conduct of monetary policy. satD, you can skip to the end ;)]

Ever wonder how BNM “sets” interest rates across the whole economy? This past year has been a fascinating exercise in observing monetary policy being conducted across the globe, and Malaysia has not been an exception. I’ve certainly learned a lot, especially in bridging the gap between theory and practice.

In Malaysia, we use interest rate targeting to achieve the desired monetary conditions that both maintains stable prices as well as supports growth. That dual mandate can occasionally be at odds, though we don’t have that problem at the moment with inflation low despite an expanding economy.

BNM uses the Overnight Policy Rate (or OPR) as the target rate for the interbank overnight rate, also known as the Kuala Lumpur Inter-Bank Offered Rate (or KLIBOR). This is the rate at which banks borrow and lend to each other on the interbank market, and is generally used as the benchmark rate of interest for a whole range of other assets. That means movement in the KLIBOR will have knock-on effects on other interest rates and bond yields across the whole economy. BNM in theory allows a trading band of 50 basis points around the OPR target, though in practice I don’t think the overnight rate has much traded more than a few bp off the OPR at any given time.

But given that KLIBOR is market determined, and not set by administrative fiat, how does BNM ensure that banks trade at the overnight rate? Largely by buying or selling deposits or securities, which alter the demand and supply of money within the banking system. Since the interest rate is the “price” of money, changing the balance of supply and demand also changes the “price”. The exact instrument used may vary, but by and large, BNM uses its own securities (known as BNM bills) which have different maturities of between 1 month to 12 months.

The exact mechanics of it can be described as follows:

  1. BNM sets the OPR at a rate they think is consistent with the long term goals of stable prices (about 3% inflation in Malaysia’s case) and economic growth at full employment. Assuming the OPR is higher than before, than BNM needs to reduce the supply of money in the system. This relative scarcity will increase the market price for overnight deposits.
  2. To achieve this, BNM auctions BNM bills (typically in 3-month and 6-month maturities) to the banking system until enough money has been sucked out of the system that the “price” of overnight money equals the targeted OPR. Faced with a choice between choosing to deposit money at other banks and buying interest yielding securities from BNM, banks will always choose BNM because there is no counterparty risk (BNM can always print money if it has to, ordinary banks can’t).
  3. If the interbank rate starts wandering off the OPR target, then BNM will continue to offer or redeem BNM bills until the market price equals the OPR target.
If the change in the OPR is lower than before, than you just reverse the process, which results in BNM buying securities from the interbank market until the overnight rate falls to the OPR target.

From a balance sheet perspective, you’ll see a number of things happening when monetary policy is tightened (i.e. BNM targets an interest rate rise). First is that interbank deposits and deposit of banks with BNM will fall by the amount of securities that BNM has to issue, while BNM has increased its liabilities by the same amount (though they can, and often do, cancel out the implied balance sheet expansion by “destroying” money).

Second is that the banking system’s holdings of securities increases, which implies a drop in monetary aggregates (banks use their cash to buy BNM securities). Since deposits can be used to create new loans, while securities can not, BNM has effectively reduced the ability of banks to create credit and give out loans, and thus (hopefully) slow the economy down.

To illustrate this mechanism, here’s what happened in the first six months of this year (RM billions):

02_billsThere have been 3 consecutive increases in the OPR, the latest of which occurred in July (so isn’t full reflected here). You see BNM bills outstanding more than doubling between February and May (an increase of about RM44+ billion), and you’ll see a further increase for July when the statistics are released next month. Excess reserve deposits that the banking system keeps with Bank Negara decreased almost in tandem (RM billions):

03_depThe amounts don’t exactly match up, because economic activity in the economy is continuously creating more deposits in the banking system. But between February and June, you do see a significant drop of about RM35 billion, so money balances in the banking system dropped by about RM10 billion. Since BNM has been offering more securities for sale to the banking system, their price rose:

04_billsThe difference in yield between 3 month and 6 month maturities reflects the term risk premium, which essentially means that you want a higher return from the securities you hold the longer you have to hold them. Yields on debt securities (or equivalently the interest rate) such as these move in inverse proportion to the price of a security. Since BNM is increasing the supply of securities, the price they have to offer to get banks to buy them has to fall, which implies an increase in the interest rate.

Since this operation also reduces the relative amount of money in the banking system, the yield on interbank deposits also rose:

01_ibAnd that more or less completes the story. There’s a few nuances to the this simple tale as open market operations are really a continuous process, and not always in conjunction with changes in the OPR. For instance a higher or lower level of economic activity, which changes the amount of money in the banking system, also necessitate some intervention. Inflows or outflows of money from outside the country complicate the open market operations further, as we have to deal with foreign exchange and not just Ringgit denominated money and securities.

If anybody wants clarification on any of the points raised here, feel free to fire away in the comments. I promise I won’t bite.


  1. bro hishamh.....i took the long path...

    tambah sikit..on the contraction side..

    BNM also borrows from Institutional Investors via their Centralised Securities Borrowing program..the said securities will then be used as collateral in their Repo operations...

    this is more of technical "savings" Vs Direct Borrowing thru their Interbank Money market..

    this programs help the CB to build artificial inventory without having to buy the MGS outright into the market.....


  2. Thanks, bro. I'd been wondering about that issue.

  3. Hi Hisham H,
    Great post but why did private credit grow by double digits in and around the same time that BNM did their contractionary measures?

  4. Hi,

    The textbook answer is that monetary policy actions always act with a lag. You can come up with all sorts of rationalisations for this, including loan processing time, forward business planning, etc.

    But I think there are a couple of things going on here:

    1. The level of interest rates were too low relative to the country's growth trajectory and expectations of its future path - hence the hike in interest rates is lagging (and continues to lag) actual economic activity. If you're expecting a recovery in business prospects, or you feel more secure in your job and income prospects, an increase of 0.75% isn't going to put you off borrowing. I haven't found a long term relationship between the overnight rate and property sales for example.

    2. While wholesale cost of funding is rising, banks have access to a whole lot of cheaper funding (loan-deposit ratio is still just 87.8% in June). What BNM is doing is draining excess liquidity from the interbank market, but that doesn't mean a contraction in banks' current ability to lend. Basically, the banks are partly eating the higher cost of funding, and have not fully passed them on to borrowers.

    Note the middle chart in this post (there's still RM150 billion in excess reserves), and the second to last chart in my previous post (spread between interbank funding and lending rates has dropped 25bp this year).

    Interest rates moves are a blunt instrument, and it takes time for them to have an effect. This is especially true since we aren't talking about a drastic increase either - KLIBOR is only now getting back to the low end of its normal range for the past decade.

    I think BNM is really being proactive, and heading off potential trouble before it begins, because there's little sign that things are at all getting too frothy. In other words, you'll probably continue to see fairly high loan growth in the coming months.


    1. No they are not quite the same. The KLIBOR is the actual daily quoted rate for overnight deposits between banks. The OPR is the target that BNM wants the KLIBOR to be at.