ELENA ILKOVA: Reserve Bank reforms of monetary policy framework set to hit a milestone

The Reserve Bank’s reforms to its monetary policy implementation framework (MPIF) will reach a new milestone on April 6 when the daily liquidity surplus in the monetary system climbs to its long-term target of R100bn. It will mark the conclusion of the second phase of the MPIF reform, during which the liquidity target has been lifted from R50bn at the end of the first phase. 

The 2022 reform of the MPIF fundamentally changed the way the Bank manages the transmission of its monetary policy decisions into the economy. It does this by managing the flow of liquidity in the money market. The reform caused it to switch from the traditional system, which relied on creating a money market shortage, to a modern system that relies on a permanent liquidity surplus.

This aimed to give the Bank a flexible framework that would insulate monetary policy transmission from interventions to maintain financial stability during crises such as the market disruptions early in the Covid-19 pandemic. A similar policy framework allowed the US Federal Reserve to hike interest rates in March, while simultaneously injecting liquidity to alleviate concerns about banking system stability after the recent niche bank failures.  

The Bank’s reform also aimed to eliminate market distortions that had built up after the start of the pandemic, in the expectation that key short-term market interest rates would move closer to the policy rate set by the Bank. Abundant liquidity and ample bank reserves imply a marketwide decrease in liquidity premiums, especially in the short end of the fixed-income market. This will reflect in money market rates, but it will take time and be felt more strongly once the interest rate hiking cycle turns. 

When the Bank initially proposed that the MPIF system move from the “classic” shortage to a surplus, it said it would target a liquidity surplus of about R50bn during the phasing-in period, but expected that further expansion would be necessary.  

Sterilisation deposit

Implementation of the MPIF began in June 2022 with a 12-week transition, during which the market switched from a R33bn shortage to a surplus of about R50bn. The Bank was able to inject about R80bn of liquidity into the system using two of the tools at its disposal: it reduced its foreign exchange (FX) swaps forward position, releasing R32.9bn; and moved R43.2bn of funds belonging to the Corporation for Public Deposits off the bank’s balance sheet and into the banking system.  

Managing market liquidity also has a third component: adjustments to the National Treasury sterilisation deposit account. As long as SA was using a liquidity shortage-based MPIF system it was necessary to sterilise incoming foreign exchange flows to prevent these causing inflationary pressure. This was executed mainly through foreign exchange swaps, but it was enabled by cash the government provided through deposits at the Bank that sterilised liquidity created from the build-up of foreign exchange reserves.  

During the 2021/22 fiscal year the Treasury used R26.1bn of the R67bn sterilisation deposits to fund Covid-19-related spending. The remaining R41bn was used during 2022/23 to finance part of the borrowing requirement. As the balance was drawn down during February/March, the funds injected liquidity into the market via the banking system. Though a larger liquidity surplus was always part of the plan, the drawdown of the sterilisation deposits may have accelerated the implementation timeline.  

To accommodate the increased market liquidity surplus, the Bank announced a plan to lift the daily liquidity target, which triggered an expansion of bank quotas — the excess reserves banks can deposit at the Bank at the policy rate. It also doubled the system’s liquidity buffer, designed to allow absorption of daily volatility, to R20bn, enabling banks to absorb shocks without resorting to Bank assistance.

Increasing quotas

The Bank also made two technical adjustments to the allocation of bank quotas, which are based on balance sheet size: a reclassification, and a modification of the rounding-off rules for quota allocation. This more than doubles the big five banks’ combined quota to R105bn. Medium-sized banks’ combined quota triples to R24bn, while small banks’ total increases to R11bn.

The total quotas increased from R67.2bn to R140bn in four stages over five weeks from February to April 6. These changes reduce the liquidity target from 74% of total quotas to 57%. The more than ample quotas are “expected to keep market rates close to the policy rate despite a larger liquidity surplus”, the Bank says. 

The result of the rapid quota expansion will be that banks will have adequate room to avoid situations in which they are forced to place excess reserves with the Bank at the punitive rate of repo less 100 basis points (applicable to deposits above the quota). This has been a persistent problem since the new surplus liquidity framework was implemented. 

The increase in the daily liquidity target reflects the higher liquidity supply into the market, which in turn reflects the change in market dynamics since the structural shift in implementation of the new monetary policy. It had been expected that abundant liquidity would reflect in short-term rates, with banks’ demand for wholesale funding declining as on-balance sheet deposits grew. In a system with abundant excess bank reserves, liquidity availability as a constraint practically falls away and banks are less willing to pay the traditional premium for reducing liquidity risk.  

The spreads between Johannesburg interbank average rates (Jibar) and the repurchase agreement (repo) rate were therefore expected to compress as liquidity premiums reduced. But while spreads have compressed, this has not been by as much as expected, nor across all tenors. The key reason is that the Bank has been on an aggressive interest rate hiking path since the MPIF transition began.

Rates on short-term money market instruments such as the Jibar inevitably reflect hiking expectations. And the premium of three-month Jibar over the repo rate is cyclical — it widens during a monetary policy hiking cycle and compresses in a cutting cycle. We believe however, that spreads will compress as the current hiking cycle comes to an end. 

The drawdown of sterilisation deposits might have accelerated the timetable for adjustments to the MPIF’s design, but the increased daily liquidity target and expansion of bank quotas are a natural progression in the development of SA’s financial system. There will be more tweaks as the system is refined further. 

• Ilkova is a research analyst at RMB.