## Preface — SARTTAC mission to Thimphu (June 2–9, 2017)

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---

### Mission overview and objective
- Mission: South Asia Regional Training and Technical Assistance Center (SARTTAC) visit to Thimphu during June 2–9, 2017.
- Mission team: Bernard J. Laurens (Consultant, mission chief) and Stéphane Couderc (Consultant).
- Principal interlocutors: RMA Governor Dasho Penjore, RMA Deputy Governor Tshogyel Yangchen, several RMA Directors and staff, Director from the Department of Public Accounts (DPA), representatives from several commercial banks.
- Objective: Assist the Royal Monetary Authority of Bhutan (RMA) in identifying drivers of systemic liquidity and support RMA’s plan to establish a liquidity forecasting and management framework.
- Expected gains from a liquidity forecasting framework:
  - Facilitate monetary policy signaling.
  - Support development of the nascent money market, notably the Government securities market.
  - Allow banks to enhance their treasury function, reducing liquidity costs and settlement risks.

### Data and empirical scope
- Analysis period: end-of-month data over the January 2015 – April 2017 period.
- Data frequency recommended for operations: daily time series updated daily with new RMA balance sheet data.

---

### Key empirical findings on liquidity drivers
- Structural and autonomous features:
  - Structural liquidity surplus mainly due to foreign reserves accumulation; broadly stable absent RMA intervention (beyond the CRR and targeted sweeping).
- Volatile autonomous factors:
  - Currency in circulation increases are non-linear and show strong seasonal and possibly conjunctural factors.
  - The consolidated Government account (subject to daily sweeping) is particularly volatile; DPA has limited forward-looking information on its cash position and operations.
  - Hydro-project-related flows are sterilized via sweeping to the RMA but cause significant short-term liquidity effects while in transit (“float”) before recording.
- Hydro project specifics:
  - RMA estimates up to 80 or 90 percent of initial inflows for hydro projects are converted into ngultrum on arrival.
  - RMA staff study shows up to 80 or 90 percent of the expenses related to the Hydro projects end up being settled in INR.
  - Timing between inflows to banks’ balance sheets and transfer to project managers can vary from one day to a couple of weeks.

---

### Institutional constraints and operational gaps

### Main constraints
- RMA’s passive role as “banker of the Government” weakens ability to fulfill legal duties vis-à-vis the Government.
  - Government operations reflected in the consolidated account at the RMA are key liquidity drivers, yet current operational arrangements do not allow RMA to ascertain that the consolidated account balance fully reflects Government operations.
  - Placement of certain Government deposits with banks (not subject to sweeping) lacks transparency needed to ensure a level playing field.
- Sweeping of Hydro Projects accounts:
  - Operationally flawed despite sterilization intent.
  - Sweeping has not prevented high, unpredictable, and potentially disruptive volatility in liquidity, especially when flows are in transit before recording in Project accounts subject to sweeping.
- Intraday information gaps:
  - Neither the RMA nor the DPA can track intraday flows and balances across Government accounts or reconcile the Government cash position at the RMA.
- Concentration risk:
  - Bank of Bhutan (BOB) held on average about two thirds of total excess reserves over the observed period (January 2015 – April 2017).
  - As of June 2016, balances not swept amounted to about BTN 2.7 billion, of which BTN 1.5 billion for the Bhutan Health Trust Fund.

---

### Core recommendations (high level and operational)

### Institutional and operational reforms
- Sign an MOU among Government, RMA, and BOB stipulating rights and obligations regarding the consolidated Government account at RMA. Key provisions to include:
  - Complete segregation at all times (including intraday) between BOB’s financial transactions on account of the Government and BOB’s own financial transactions.
  - Define role and workings of the Cash Coordination Committee (CCC), including Government cash flow forecasts to be shared with RMA.
  - Processes to give DPA unambiguous control over all Government balances, backed by detailed information for timely reconciliation.
- Address Hydro project flows and sweeping:
  - Amend sweeping arrangement to include flows in transit (the “float”) not yet recorded in Project Accounts subject to sweeping.
  - Delay sale of INR to RMA until projects need ngultrum to pay local expenses (Option 2).
  - Sweep to RMA all Government-related accounts, or establish a transparent mechanism for placing them with banks that ensures a level playing field.
  - Consider a Sovereign Wealth Fund framework channeling loan and grant components through an RMA-managed account logged in the Sovereign Wealth Fund (not in RMA balance sheet) and disbursing as projects need liquidity.
- Establish transparency/competitive mechanisms for Government cash balances placed with banks (not swept).
  - Best practice: auction deposit balances or competitive placement; avoid placing deposits exclusively in state-owned banks.

### Data, organizational, and governance reforms
- Data management:
  - Maintain a database allowing straightforward liquidity analysis (with daily time series) updated daily with new RMA balance sheet data.
  - Enable automatic extraction and compilation of daily balance sheet data into an Excel file according to a determined template.
- Organizational arrangements:
  - Set up an interdepartmental Liquidity Team (matrix with experts from Research and Statistics, Banking, Regulation and Supervision, Payment Systems).
  - Create a Liquidity Committee receiving weekly/biweekly reports from the Liquidity Team.
  - Develop internal expertise to analyze liquidity at aggregate and individual bank level prior to discretionary operations.
  - Reinforce capacity with automatized data processing and consider creating a Research Analyst position with IT-focused skills (database management, Excel, VBA...).
- Micro-level monitoring:
  - Systematically monitor and analyze banks’ current accounts (distribution of excess reserves across banks).
  - Conduct regular discussions with the five banks’ treasurers to assess banks’ liquidity situations and identify liquidity risks.

### Money market development
- Establish a Money Market Contact Group with treasurers of the 5 banks as full members and occasional presence of non-bank financial institutions.
- Assess changes to prudential measures (e.g., SLR) to support money market development.
- Implement oversight procedures for the interbank market, consider an electronic trading platform and eventual interest rate references based on compiled transactions.
- Long-term reforms toward a repo market: legal and regulatory amendments, dematerialization and central depository for Government securities; RMA to lead these reforms.

---

### Implementation priorities and timelines (selected)

- Complete without delay the full implementation of the EPayment project.
- Sign an MOU with the Government and the BOB stipulating rights and obligations about the consolidated account of Government at RMA.
- Hydro inflows — proposed options:
  - Amend sweeping arrangement to include flows in transit.
  - Delay sale of INR to RMA until projects need ngultrum.
  - Sweep to RMA all Government-related accounts or establish transparent placement mechanism with banks.
  - Establish competitive mechanism for placing with commercial banks the cash balances of Government not swept to RMA (e.g., Bhutan Health Trust Fund).
- Timelines for key RMA internal steps (Timeline definitions: 1/ Timeline Under 1 year Between 1 and 2 years > 2 years):
  - Complete database allowing straightforward liquidity analysis (with daily time series): Dec. 2017.
  - Set up an interdepartmental Liquidity Team: Dec. 2017.
  - Set up a Liquidity Committee and start providing weekly or biweekly analysis: Dec. 2017.
  - Initiate efforts to forecast liquidity: Dec. 2017.
  - Set up procedures for oversight of the interbank market: Sept. 2017.
  - Set up a money market contact group: Dec. 2017.
  - Complete assessment of changes to regulatory framework to support money market development: Dec. 2017.
  - Support MOF in modernizing Government securities market and lead effort to introduce a repo agreement (no specific dates provided).

### Suggested follow-up Technical Assistance by SARTTAC (selected)
- Develop a forecasting model for currency in circulation:
  - Activity: Once daily time series on currency in circulation are established, support development of a forecasting model for currency in circulation.
  - Timing: 2017-Q4.
- Develop analytical capacity of the Liquidity Team:
  - Activity: Assist Liquidity Team in developing analysis of drivers of liquidity and reporting format to the Liquidity Committee.
  - Timing: 2017-Q3/4.
- Take stock of progress and advise next steps:
  - Activity: Multitopic mission to assess progress and advise on next steps (liquidity forecasting and design of a toolkit for monetary policy operations); could also cover issues related to setting up a Sovereign Wealth Fund.
  - Timing: 2018-Q1.

---

### Liquidity framework, accounting and key figures (end-April 2017 illustrative table)

### Autonomous factors (BTN million, end-April 2017)
- Net foreign assets: 58,322
- Foreign assets: 67,467
- Foreign liabilities: -9,145
- Net domestic assets: -18,978
  - Domestic financial assets: 119
  - Non-financial assets: 636
  - Capital and reserves: -17,823
  - Other domestic liabilities: -1,910
- Currency in circulation: -10,363
- Government accounts: -2,780
- Project-related sweeping accounts of banks: -8,864
- Total net autonomous factors: 17,337 (if positive: liquidity surplus)

### Monetary policy / liquidity management items (BTN million)
- Cash reserve ratio (CRR): 9,853
- Liquidity position after CRR: 7,484
- Liquidity-providing operations: 0
- Liquidity-absorbing operations (RMA bills): 0
- Total liquidity management operations: 0
- Liquidity position after CRR and operations: 7,484
- Estimated incompressible excess reserves: 4,000
- Excess reserves beyond incompressible: 3,484

---

### Analysis and forecasting guidance

### Monitoring and forecasting approach
- First step: systematic (ex-post) monitoring of autonomous factors and liquidity developments.
- Later steps: systematic forecasting once drivers are well understood.
- Monitoring model designed on monthly monitoring of each autonomous factor using RMA balance sheet data from December 2014–April 2017.
- Forecasting horizons and frequency:
  - Optimal frequency: daily; if daily data unavailable, start with weekly intervals.
  - With reserve requirements: horizon should comprise at least the current maintenance period.
  - Without reserve requirements: horizon should comprise at least the time between two discretionary monetary interventions.

### Autonomous factors: stakeholders and suggested forecasting methods (summary)
- Net foreign assets:
  - Stakeholder/data: Foreign Exchange and Reserve Management Department.
  - Forecasting method: identify seasonal patterns; adjusted ARIMA model; peg makes forecasting difficult beyond T+2.
- Net domestic assets:
  - Stakeholder/data: Accounting Department.
  - Forecasting method: naïve prediction (level at t+1 = level at t) with occasional adjustments.
- Currency in circulation:
  - Stakeholder/data: Issuance Department and RMA balance sheet.
  - Forecasting method: adjusted ARIMA model with dummy variables for Bhutanese public holidays.
- Government accounts:
  - Stakeholder/data: Sweeping accounts of banks; Treasury (DPA).
  - Forecasting method: rely on Treasury cash flow forecasts once provided.
- Project-related sweeping accounts of banks:
  - Stakeholder/data: Sweeping accounts; contacts with Indian authorities and project managers needed.
  - Forecasting method: establish contacts to obtain forward information.

### Estimating incompressible reserves (bank-level)
- Purpose: assess minimum amounts banks need on their current accounts at the RMA to operate normally.
- Methods:
  - Direct dialogue/surveys with banks to identify target minimum current account balances (example: BOB unwilling to have a current account at RMA below BTN 2 billion).
  - Empirical study of current account data: level above which 95 or 90 percent of the bank’s current account is observed over 2–3 years.
  - Apply a percentage of total assets (typical range: 1 to 5 percent; example: BOB ~5 percent of total assets).

---

### Monetary policy tools, payment systems and money market reforms

### Current RMA instruments and practices
- Administrative tools used due to absence of a proper liquidity management framework enabling market-based tools.
- Instruments in use or previously used:
  - Cash reserve ratio (CRR): increased from 5 to 10 percent in March 2015.
  - RMA bills (identical to T-bills except for sterilization use): not used since 2012.
  - Overdraft facility: exceptional, penal rate of 16 percent, for only three days.
  - RSTLAW facility (introduced in March 2012): no longer in use.
  - Sweeping of Government accounts from banks to RMA end-of-day: automatic non-conventional sterilization instrument.
  - Statutory liquidity ratio (SLR): banks must maintain at least 20 percent “quick assets” of total liabilities excluding capital and liabilities to the RMA; nonbank financial institutions must maintain 10 percent.

### Payment systems and modernization
- EPayment system under implementation: when fully deployed (in about one year time from mission), DPA will deal directly with RMA which will instruct BOB to execute banking operations through its branches; system expected to provide timely intraday information on consolidated account balances.

### Money market reform recommendations
- Set up Money Market Contact Group (quarterly and ad hoc) managed jointly by Research and Statistics Department and Banking Department; treasurers of the 5 banks as full members.
- Exert closer oversight on interbank market; consider electronic trading platform and eventual interest rate references.
- Review prudential measures (SLR) that may hinder money market emergence.
- Legal and technical steps toward a repo market: legal/regulatory changes, dematerialization of T-bills/T-bonds, central depository; central bank to lead these reforms.

---

### Modeling currency in circulation and simulation of hydro-flow option

### Currency in circulation model (structural time series / augmented ARIMA)
- Core specification: ∆CIC_t = a + dummy terms (day-of-week, week-of-year, first-week-of-month, month-of-year, public holidays, days before/after public holidays, one-off factors) + AR and MA terms + residuals.
- Modeling guidance:
  - Test stationarity on ∆CIC_t (example: Durbin-Watson).
  - Test large scope of dummy variables and progressively discard non-significant ones.
  - If residual autocorrelation, introduce AR and MA terms.
  - Validate via out-of-sample testing; reassess model specification regularly (example: every three months).

### Simulated effects of Option 2 for hydro project flows
- Option 2: sell INR to the RMA only when there is a need for payments in local currency.
- Estimated effects:
  - Considerably reduce the amount of sweeping accounts of banks to the RMA.
  - Reduce by the same amount the RMA’s foreign reserves (gross and net).
  - Decrease volatility in liquidity conditions.
  - Decrease optical volatility in RMA’s foreign reserves.
- Figures presented in the source (no numeric reproductions beyond descriptions).

---

### Recent MCM technical assistance and central bank reform priorities

### Financial sector deepening and monetary operations (selected actions)
- August 2013 MCM TA mission recommendations included establishing issuance calendar for T-bills (started in 2016), publish issuance calendar (started in 2016), and other items many recorded as Pending or Under way.
- Examples of actions and status (selected):
  - Start systematic work toward establishing an issuance calendar for T-bills: Action: Started in 2016.
  - Reactivate liquidity monitoring framework and present first liquidity monitoring table to management: Action: Under way.
  - Redesign CRR to allow averaging: Action: Pending.

### FX regulatory framework and reserves management (selected)
- November 2015 MCM TA: guidance on revising and consolidating FX regulations; roadmap for removal of exchange restrictions under IMF’s Articles of Agreement.
- International reserves management actions:
  - Increased share of INR from 20 percent to 30 percent of foreign reserves.
  - Added new counterparties including joining World Bank RAMP for investments in U.S. treasuries.
  - May 2017 MCM TA recommended further increasing INR share and reducing credit risk.

### Central bank accounting
- RMA chose to adopt Bhutanese Accounting Standards (BAS).
- RMA required to be fully compliant with BAS for its June 2019 reporting year-end.
- April 2016 MCM TA developed a detailed project plan; April 2017 mission began developing policy positions; May 2017 FIRST project approved to fund full 2 ½ year program to support RMA’s transition.

---

*Source: 1btnea2019001 — Preface, Executive Summary, Box 1, Box 3, Boxes and Appendices from the mission report following the SARTTAC mission to Thimphu during June 2–9, 2017.*

### Preface.................................................................................................................

### Preface

### Mission overview
- A mission from the South Asia Regional Training and Technical Assistance Center (SARTTAC) visited Thimphu (Bhutan) during the period June 2–9, 2017.
- Mission team: Bernard J. Laurens (Consultant, mission chief) and Stéphane Couderc (Consultant).
- Principal interlocutors: RMA Governor Dasho Penjore, RMA Deputy Governor Tshogyel Yangchen, several RMA Directors and staff, the Director from the Department of Public Accounts (DPA), and representatives from several commercial banks operating in Bhutan.
- The report is based on the Aide mémoire presented to RMA Management and staff at the end of the mission and incorporates comments from relevant IMF departments and the authorities of Bhutan.

### Executive summary — purpose and expected benefits
- Objective: Assist the Royal Monetary Authority of Bhutan (RMA) in identifying the drivers of systemic liquidity and support RMA’s plan to establish a liquidity forecasting and management framework.
- Expected gains from a liquidity forecasting framework:
  - Facilitate monetary policy signaling.
  - Support development of the nascent money market, notably the Government securities market.
  - Allow banks to enhance their treasury function, reducing liquidity costs and settlement risks.

### Key empirical inputs and timing
- Analysis uses end-of-month data over the January 2015 – April 2017 period.
- Observed structural and autonomous features:
  - The structural liquidity surplus, mainly due to foreign reserves accumulation, has been broadly stable absent RMA intervention (beyond the Cash Reserve Ratio-CRR and targeted sweeping to the RMA of Government accounts in banks).
  - Most autonomous factors present significant volatility:
    - Currency in circulation increases are not linear, suggesting strong seasonal and possibly conjunctural factors influencing demand for banknotes.
    - The consolidated Government account (subject to daily sweeping) is particularly volatile; the DPA has limited forward-looking information on its cash position and operations.
    - Hydro projects related flows are subject to sterilization via sweeping to the RMA but have significant short-term impact on liquidity until allocated to project accounts swept to the RMA.

### Institutional constraints and operational gaps (summary)
- RMA’s passive role as “banker of the Government” weakens its position to fulfill legal duties vis-à-vis the Government:
  - Government operations reflected in the consolidated account at the RMA are key liquidity drivers, yet current operational arrangements do not allow RMA to ascertain that the consolidated account balance fully reflects Government operations.
  - Placement of certain Government deposits with banks (not subject to sweeping) lacks transparency needed to ensure a level playing field.
- Sweeping of Hydro Projects accounts:
  - Sensible for sterilization but flawed operationally.
  - Full conversion into ngultrum of grants and loans upon availability in Bhutan should be reconsidered; conversion draws on RMA international reserves for up to 80 or 90 percent of the initial inflows (according to RMA estimates).
  - Sweeping has not prevented high, unpredictable, and potentially disruptive volatility in liquidity, especially when flows are in transit (“float”) before recording in Hydro Project accounts subject to sweeping.

### Core recommendations (high level)
- Streamline processing of Government financial transactions and cash balances:
  - Ensure transactions are recorded in the consolidated account with RMA, involving the Bank of Bhutan (BOB) under an agent banking arrangement with the DPA.
  - Address Hydro project flow treatment and accounts swept to RMA.
  - Establish transparency/competitive mechanisms for Government cash balances placed with banks (not swept).
- Data management:
  - Maintain a database allowing straightforward liquidity analysis (with daily time series) updated daily with new RMA balance sheet data.
- Organizational arrangements:
  - Set up an interdepartmental Liquidity Team (matrix with experts from Research and Statistics, Banking, Regulation and Supervision, Payment Systems).
  - Create a Liquidity Committee receiving weekly/biweekly reports from the Liquidity Team.
  - Prior to discretionary operations, RMA staff should develop expertise in analyzing liquidity at aggregate and individual bank level (identify seasonal patterns, interact with Treasury and bank treasurers to estimate banks’ “incompressible” reserve needs, obtain forward-looking information).
- Money market development:
  - Establish a money market contact group with treasurers of the 5 banks as full members and occasional presence of non-bank financial institutions.
  - Assess changes to prudential measures (e.g., Statutory Liquidity Ratio-SLR) to support money market development.
  - Implement oversight procedures for the interbank market (including consideration of an electronic trading platform and eventual interest rate references based on compiled transactions).
  - Pursue long-term reforms towards a repo market: legal and regulatory amendments, dematerialization and central depository for Government securities; RMA should lead these reforms.

### Implementation priorities and timelines (extracts from Table 1)
- Complete without delay the full implementation of the EPayment project.
- Sign a MOU with the Government and the BOB stipulating rights and obligations about the consolidated account of Government at RMA.
- Hydro inflows — proposed options:
  - Amend the sweeping arrangement to include flows in transit (the “float”) not yet recorded in Project Accounts subject to sweeping.
  - Delay sale of INR to RMA to the time when the projects need ngultrum to pay for local expenses.
  - Sweep to RMA all Government-related accounts, or establish a transparent mechanism for placing them with banks that ensures a level playing field.
  - Establish competitive mechanism for placing with commercial banks the cash balances of the Government not swept to the RMA (such as Bhutan Health Trust Fund and similar entities).
- Timelines for key RMA internal steps (Timeline definitions: 1/ Timeline Under 1 year Between 1 and 2 years > 2 years):
  - Complete the setting up of a database allowing straightforward liquidity analysis (with daily time series): Dec. 2017.
  - Set up an interdepartmental Liquidity Team: Dec. 2017.
  - Set up a Liquidity Committee and start providing weekly or biweekly analysis on drivers of liquidity: Dec. 2017.
  - Initiate efforts to forecast liquidity: Dec. 2017.
  - Set up procedures for oversight of the interbank market: Sept. 2017.
  - Set up a money market contact group: Dec. 2017.
  - Complete assessment of changes to regulatory framework to support money market development: Dec. 2017.
  - Support MOF in modernizing Government securities market and lead effort to introduce a repo agreement (no specific dates provided).

### Suggested follow-up Technical Assistance by SARTTAC (extract from Table 2)
- Develop a forecasting model for currency in circulation:
  - Activity: Once daily time series on currency in circulation are established, support development of a forecasting model for currency in circulation.
  - Timing: 2017-Q4.
- Develop analytical capacity of the Liquidity Team:
  - Activity: Assist the Liquidity Team in developing analysis of drivers of liquidity and reporting format to the Liquidity Committee.
  - Timing: 2017-Q3/4.
- Take stock of progress and advise next steps:
  - Activity: Multitopic mission to assess progress in implementing the action plan to set up liquidity forecasting and management capacity; advise on next steps (liquidity forecasting and design of a toolkit for monetary policy operations). The mission could also cover issues related to setting up a Sovereign Wealth Fund.
  - Timing: 2018-Q1.

_This content is based on the Preface and Executive Summary of the mission report prepared following the SARTTAC mission to Thimphu during June 2–9, 2017._

### Box 1. Monetary Policy Tools of the RMA

### Box 1. Monetary Policy Tools of the RMA

### Current monetary policy instruments and practices
- The RMA currently relies exclusively on administrative tools due to "the absence of a proper liquidity management framework" that would allow market-based tools.
- Instruments in use or previously used:
  - Cash reserve ratio (CRR): requires banks to maintain in a blocked account with the RMA a given ratio of their deposits with customers. In March 2015, the CRR was increased from 5 to 10 percent to absorb more liquidity amid a significant liquidity surplus.
  - RMA bills (identical to T-bills except for their use for sterilization): have not been used since 2012.
  - Overdraft facility: can provide liquidity only in exceptional circumstances, when a bank does not have enough liquidity to meet its CRR, at a very penal rate of 16 percent, and for only three days. After that, a bank unable to cover its account with the RMA (or still in violation of the CRR) is excluded from clearing and payment systems.
  - RSTLAW facility (Short-Term Liquidity Adjustment Window introduced in March 2012): provided securitized RMA lending to banks at a newly-introduced policy rate linked to RSTLAW; this facility is no longer in use.
  - Sweeping of Government accounts from the banks to the RMA at the end of the day: acts as an automatic, non-conventional sterilization instrument (notably for hydro-related project accounts).
  - Statutory liquidity ratio (SLR): banks must maintain at all times a minimum of 20 percent “quick assets” of total liabilities excluding capital and liabilities to the RMA; nonbank financial institutions must maintain 10 percent of total liabilities excluding capital and liabilities to the RMA.

### Framework for monitoring banks’ lending conditions
- Minimum Lending Rate (MLR):
  - Adopted in August 2016 to guide banks’ lending rates, intended to introduce a forward-looking and interest rate policy mechanism to enhance transparency and encourage competition/professionalism among banks.
  - The RMA computes a single MLR by averaging the MLR of individual banks using three cost parameters: the marginal cost of funds, the negative carry charges on the CRR, and operating costs.
  - The RMA reviews the MLR on a semi-annual basis and monitors implementation based on financial institutions’ financial accounts.
  - Each financial institution may add an expected spread to the single common MLR to arrive at the median final lending rate; product-specific final lending rates add credit risk and tenor premium, and an item covering the bank’s business strategy cost.
  - Financial institutions cannot lend below the MLR except for selected loans.

### Rationale for a liquidity forecasting and management framework under a peg
- Even under a peg, the central bank must manage overall liquidity to:
  - Effectively signal and implement monetary policy and exploit its monopoly in creation of base money.
  - Create supportive conditions for development of financial markets, starting with the money market to support the nascent Government securities market.
- Specific features under a peg regime:
  - "The FX component of the autonomous factors of banks’ liquidity is difficult to forecast beyond t+2, due to the commitment to maintain the peg."
  - The central bank cannot calibrate OMOs at variable rates as in flexible ER regimes.
  - If arbitrage exists between local currency and the pegged currency (e.g., through current account flows), short-term domestic interest rates must be aligned with those in the currency to which the local currency is pegged.
  - Ensure that any central bank refinancing to local banks is not used to build positions against the domestic currency.

### Institutional constraints and operational gaps affecting liquidity management
- Consolidated account of the Government at the RMA:
  - RMA is legally banker and depositary of Government funds; Bank of Bhutan (BOB) performs banking operations.
  - At the beginning of the day RMA makes available to BOB the cash balance recorded in the consolidated account; end-of-day balances left with BOB are swept back to the consolidated account upon notification.
  - Neither the RMA nor the Department of Public Accounts (DPA) can track intraday flows and balances across Government accounts or reconcile the Government cash position at the RMA.
  - RMA may be asked by BOB to cover an overdraft at end of day within legal limits.
- Inflows related to grants and loans on account of hydro projects with India:
  - These flows transit mainly through Druk PNB Bank (DPNB), which sells INR to the RMA upon reception.
  - After authorization from the Embassy of India and the MOF, DPNB transfers funds to Project Accounts; funds are routinely sterilized via end-of-day sweeping once credited, which can take several days, leaving funds available to banks and causing sizeable and volatile liquidity changes.
  - RMA staff study shows that up to 80 or 90 percent of the expenses related to the Hydro projects end up being settled in INR.
- Accounts of the Government not swept to the RMA:
  - Currently only BOB is allowed to undertake Government banking operations and can freely use Government cash balances not consolidated or not swept to the RMA at end of day.
  - This gives BOB a dominant position in the money market and a structural long position.
- Existing balances not swept (as of June 2016):
  - Balances amounted to about 2.7 billion ngultrums, of which 1.5 billion for the Bhutan Health Trust Fund.
- Modernization underway:
  - RMA and DPA implementing an EPayment system; when fully deployed (in about one year time) DPA will deal directly with RMA, which will instruct BOB to execute banking operations through its branches; system will provide DPA and RMA timely intraday information on consolidated account balances.

### Key recommendations and options
- Institutional/operational reforms (priority):
  - Sign an MOU among Government, RMA, and BOB stipulating rights and obligations regarding the consolidated Government account. Key provisions to include:
    - Complete segregation at all times (including intraday) between BOB’s financial transactions on account of the Government and BOB’s own financial transactions.
    - Role and workings of the Cash Coordination Committee (CCC), including the nature of Government cash flow forecasts to be shared to the satisfaction of the RMA for its liquidity forecasting framework.
    - Processes to give DPA unambiguous control over all Government balances, backed by detailed information for timely reconciliation.
- Options to address disruptive effects of hydro flows on liquidity:
  - Option 1: amend the sweeping arrangement so funds in transit to Project Accounts could be recorded in a sub-account of the bank’s current account at the RMA and swept at end of day.
  - Option 2: sell INR to the RMA only when there is a need for payments in local currency; keeping funds in INR would avoid temporary increases in international reserves and reduce liquidity volatility.
  - A Sovereign Wealth Fund framework under development could channel loan and grant components of hydro flows through an RMA-managed account logged in the Sovereign Wealth Fund (not in RMA balance sheet) and disburse as projects need liquidity; this would achieve similar domestic liquidity outcomes to the mission’s proposals.
- Handling Government balances not swept to the RMA:
  - Option (i): include those accounts in the perimeter of the sweeping arrangement; or
  - Option (ii): establish a transparent mechanism for placing these deposits with commercial banks (for example, competitive placement), particularly given significant cash balances of some public entities.
- Implementation emphasis:
  - Complete prompt implementation of the EPayment system to make RMA the main intermediary between DPA and BOB, better enabling the RMA to fulfill its legal mandate and providing the Government with tools to monitor cash position.

*Source: 1btnea2019001 - Box 1. Monetary Policy Tools of the RMA*

### Box 3. Guidelines for Placing Government Deposits with Commercial Banks

### Box 3. Guidelines for Placing Government Deposits with Commercial Banks

### Tools (Guidelines for placing government deposits)
- If the Government places deposits with commercial banks it must decide how to distribute balances among banks; the allocation system should be transparent and ensure a level playing field.
- Best practice suggestions:
  - Avoid procedures that imply favoring some institutions over others or that provide opportunities for corruption.
  - One effective way to eliminate these problems is for the Government to auction its deposit balances.
- Coordination requirement:
  - Allocation of deposits requires coordination with the central bank so that Government actions are not at cross purposes with the central bank’s monetary policy stance (for example, the Government should not be auctioning deposits (injecting liquidity) while the central bank is trying to tighten monetary policy).
- Fiscal and financial stability safeguards:
  - Government deposits should not be used to support weak banks which face solvency or liquidity difficulties. Any such support should be made transparent and appropriately budgeted.
  - Hidden subsidies and implicit bailouts may create fiscal exposure and moral hazard.
  - Government deposits should not be placed exclusively in state-owned banks because this can result in operational inefficiencies and segmentation and can inhibit development of the money market.

*Sources of guidance drawn from the country context described in the Box.*

### Towards a liquidity management framework — Drivers of liquidity conditions in Bhutan
- Autonomous factors definition and role:
  - Autonomous factors are items on the central bank’s balance sheet, both assets and liabilities, that are not controlled by the central bank in its monetary policy role and are therefore considered “autonomous” from conventional monetary policy actions.
  - Aggregate liquidity conditions are solely determined by autonomous factors on the central bank’s balance sheet because the central bank is the unique creator of liquidity in the system; transactions between other economic actors cannot affect aggregate liquidity, only its distribution.
- Four usual autonomous factors on the RMA’s balance sheet (summary and Bhutan-specific figures, static levels as of end April 2017 unless otherwise noted):
  - Net foreign assets (NFA):
    - NFA should be calculated as foreign assets minus foreign liabilities.
    - For the RMA: gross foreign assets BTN 67.4 billion (noted elsewhere as Foreign assets 67,467 BTN million) and foreign liabilities BTN 9.1 billion (elsewhere shown as -9,145 BTN million), resulting in a net autonomous factor asset of BTN 58.3 billion (table shows Net foreign assets 58,322 BTN million).
    - NFA are a liquidity-providing autonomous factor.
  - Currency in circulation (CIC):
    - Always a liquidity-absorbing autonomous factor (a liability).
    - In Bhutan, currency in circulation as of end April 2017 amounted to BTN 10.4 billion (table shows Currency in circulation -10,363 BTN million).
  - Government accounts:
    - Autonomous because determined by Government cash management choices rather than by monetary policy.
    - Calculated as advances to the Government minus accounts swept to the RMA at the end of the day (Government consolidated account, Ministry of Finance refundable deposit account, and RGOB deposit account).
    - Sweeping mechanism does not change the liquidity impact compared with keeping accounts permanently at the RMA.
    - In Bhutan, sweeping accounts BTN 2.8bn exceed RMA advances to the Government (zero), so Government accounts are a liquidity-absorbing autonomous factor liability of BTN 2.8 billion (table shows Government accounts -2,780 BTN million).
  - Net domestic assets (NDA):
    - Difference between residual, non-monetary policy-related, domestic currency-denominated assets and liabilities on the central bank’s balance sheet.
    - In Bhutan the largest component is the RMA’s capital and reserves (BTN 17.8bn), greatly exceeding domestic financial assets (BTN 0.1bn) and non-financial assets (BTN 0.6bn), so NDA are negative: a liquidity-absorbing autonomous factor liability of BTN 19.0 billion (table shows Net domestic assets -18,978 BTN million and Capital and reserves -17,823 BTN million).
- Ambiguity over project-related sweeping accounts:
  - Sweeping to the RMA of banks’ accounts related to public projects (in particular hydro projects) could be:
    - A sterilization (non-conventional monetary policy tool) if imposed by the RMA to sterilize INR injections; or
    - An autonomous factor because the RMA does not determine the amounts and fluctuations on those accounts.
  - These project-related sweeping accounts are identified as a specific fifth autonomous factor and are treated as a liquidity-absorbing autonomous factor liability of BTN 8.8 billion (table shows Project-related sweeping accounts of banks -8,864 BTN million).

### Liquidity table and liquidity surplus/deficit (RMA illustrative figures)
- Liquidity surplus/deficit concept:
  - The liquidity surplus or deficit is the net sum of all autonomous factors. If autonomous factors assets exceed liabilities, the system is in liquidity surplus; if autonomous factors liabilities exceed assets, the system is in liquidity deficit.
  - Bhutan presents a structural liquidity surplus due to accumulation of foreign reserves in excess of the sum of all liquidity-absorbing autonomous factors.
- Key numbers from the recommended Liquidity Table (all amounts in BTN million; period end-April 2017):
  - Net foreign assets: 58,322
  - Foreign assets: 67,467
  - Foreign liabilities: -9,145
  - Net domestic assets: -18,978
  - Domestic financial assets: 119
  - Non-financial assets: 636
  - Capital and reserves: -17,823
  - Other domestic liabilities: -1,910
  - Currency in circulation: -10,363
  - Government accounts: -2,780
  - Project-related sweeping accounts of banks: -8,864
  - Total net autonomous factors: 17,337 (if positive: liquidity surplus)
- Monetary policy / liquidity management items (RMA usage and positions, BTN million):
  - Cash reserve ratio (CRR): 9,853
  - Liquidity position after CRR: 7,484
  - Liquidity-providing operations: 0
  - Liquidity-absorbing operations (RMA bills): 0
  - Total liquidity management operations: 0
  - Liquidity position after CRR and operations: 7,484
  - Excess reserves (current accounts): 7,484 (table shows slight variation in one row to 7,484 / 10,826 across dates)
  - Estimated incompressible excess reserves: 4,000
  - Excess reserves beyond incompressible: 3,484

### Analysis of liquidity developments (findings and dynamics)
- Monitoring and forecasting approach:
  - First step is systematic (ex-post) monitoring of autonomous factors and liquidity developments; later steps include systematic forecasting of liquidity once drivers are well understood.
  - The mission designed a monitoring model based on monthly monitoring of each autonomous factor using RMA balance sheet data from December 2014–April 2017.
- Evolution and drivers of Bhutan’s liquidity surplus since Q1 2015:
  - Liquidity surplus broadly stable but volatile, fluctuating around BTN 15-20 billion.
  - Offsetting factors:
    - Upward (though irregular) trend in NFA (liquidity-providing) partly compensated by upward trend in hydro project-related sweeping accounts of banks (liquidity-absorbing). Indian rupee inflows for hydro projects are systematically converted into domestic currency, increasing RMA’s NFA, though about 80 percent will be converted back into INR to finance imports for the hydro projects.
    - Currency in circulation and net domestic liabilities (dominated by RMA’s capital and reserves) have shown a very gradual upward trend.
    - Government accounts have been very volatile without a clear trend.
- Hydro project flows:
  - Hydro project flows account for a disproportionate share of aggregate liquidity volatility.
  - RMA has poor visibility on timing and size of these flows, which are controlled by the Indian authorities, project managers, and two banks involved (BOB and Druk PNB).
  - Timing between inflows to banks’ balance sheets and transfer to project managers can vary from one day to a couple of weeks, causing significant daily liquidity effects given the size of flows.

### Micro-level liquidity analysis (bank-level monitoring and implications)
- Need for micro-level monitoring:
  - In addition to aggregate liquidity monitoring/forecasting, the RMA should initiate micro-level liquidity analysis to monitor the adequate circulation of liquidity across banks for monetary policy and financial stability reasons.
- Recommended actions:
  - Systematically monitor and analyze banks’ current accounts (distribution of excess reserves across banks) as part of the regular liquidity report.
  - Conduct regular discussions with the five banks’ treasurers to assess banks’ liquidity situations and identify liquidity risks and obstacles to adequate circulation of liquidity.
- Bank of Bhutan (BOB) concentration risk:
  - BOB held on average about two thirds of total excess reserves over the observed period (January 2015 – April 2017).
  - BOB’s hegemonic liquidity position is largely due to its role in management of Government finances, including control of funds for Government entities whose accounts are not part of the RMA sweeping arrangement.
  - At the end of June 2016, such funds amounted to about BTN 2.7 billion, accounting for about 40 percent of BOB’s structural excess reserves.
  - The RMA should promote measures to restore a balanced distribution of liquidity across banks and a more level playing field, for example through a competitive allocation among banks of public funds not swept to the RMA.

*Source: Box 3, “Guidelines for Placing Government Deposits with Commercial Banks” (excerpts and tables) from the provided IMF mission material.*

### 32.      Estimating individual banks’ incompressible reserves is important to the

### 32.      Estimating individual banks’ incompressible reserves is important to the

### Estimating incompressible reserves — purpose and methods
- Purpose:
  - Estimating individual banks’ incompressible reserves is necessary to assess liquidity conditions given: (1) the peg regime limiting accurate forecasts of NFA beyond T+2; (2) a shallow and fragmented Bhutanese interbank market; and (3) the RMA’s lack of effective liquidity-providing operations.
  - In this environment, the RMA should monitor autonomous factors forecasts and estimate individual banks’ incompressible reserves (the minimum amounts banks need on their current accounts at the RMA to operate normally).
- Empirical and dialogue-based estimation methods:
  - Direct dialogue/surveys with banks to identify target minimum current account balances. Example: BOB indicated unwillingness to have a current account at the RMA below BTN 2 billion (about 5 percent of its total assets); this level could be defined as BOB’s “incompressible reserves”.
  - Empirical study of current account data: define incompressible reserves as the level above which 95 or 90 percent of the bank’s current account is observed over a sufficiently long period (2–3 years).
  - Apply a percentage of total assets (example: BOB’s incompressible reserves = 5 percent of total assets); caution that the ratio typically ranges from 1 to 5 percent and may vary across banks depending on business model (e.g., banks with significant large-corporate activity may need larger incompressible reserves).

### RMA’s internal organization for liquidity management — data, staffing, and governance
- Data management and automation:
  - The RMA already prepares a detailed daily balance sheet but current downloads are limited to Excel one day at a time, complicating processing. The number of lines in the balance sheet may vary over time, complicating automatic processing.
  - Recommendation: allow automatic extraction and compilation of daily balance sheet data into an Excel file according to a determined template (the mission provided an Excel file model). The file should comprise time series with daily data for all items of the RMA’s Liquidity Table (NFA, currency in circulation, hydro projects-related to weeping accounts of banks...).
- Human resources:
  - The RMA should reinforce capacity with automatized data processing and consider creating a Research Analyst position with IT-focused skills (database management, Excel, VBA...) to complement economists in the Research and Statistics Department.
- Institutional arrangements:
  - Create an inter-departmental Liquidity Team to regularly monitor, analyze, and potentially forecast liquidity. Liquidity is transversal and involves monetary policy implementation, financial stability, payment systems, and banknote management.
  - Tentative composition and roles (from Table 4):
    - Manager: Director of Research and Statistics Department — definition of tasks, verification of deliverables, interaction with RMA management.
    - Secretary: Economist of Research and Statistics Department — coordination, joint preparation of analyses, forecasting, policy proposals; interaction with the Treasury regarding Government accounts and cash flow forecasts.
    - Research Analyst (new position) — compilation of daily time series, preparation of weekly liquidity report, automatization of data processing.
    - Expert of Banking Department — joint preparation of analyses, forecasting, policy proposals; analysis of banks’ current accounts.
    - Expert of Foreign Exchange and Reserve Management Department — analysis and forecasting of net foreign assets.
    - Expert of Payment Systems Department — analysis of information from transactions in payment systems.
    - Expert of Issuance Department — analysis of developments in currency in circulation.
  - Create a Liquidity Committee on a permanent basis to oversee liquidity issues and prepare policy recommendations. The Liquidity Team should present observations and possible policy recommendations weekly or biweekly to the Liquidity Committee.
  - The Liquidity Committee could operationalize the RMA’s lender-of-last-resort function (Emergency Liquidity Assistance, ELA). When dealing with ELA, include representatives from financial stability, banking supervision, and legal affairs.

### Towards liquidity forecasting — autonomous factors, stakeholders, and methods
- General approach:
  - Better monitoring and dialogue with key stakeholders are required before forecasting the five key autonomous factors determining liquidity.
- Overview of autonomous factors, stakeholders, and suggested forecasting methods (from Table 5):
  - Net foreign assets:
    - Stakeholders/data: Foreign Exchange and Reserve Management Department; data on FX transactions (liquidity impact on T+2).
    - Forecasting method: The peg (RMA commitment) makes forecasting difficult; however seasonal patterns could be identified (adjusted ARIMA model).
  - Net domestic assets:
    - Stakeholders/data: Accounting Department (RMA’s capital and reserves, non-financial assets including depreciation, provisions).
    - Forecasting method: Naïve prediction (level at t+1 = level at t), with occasional adjustments based on forward-looking information from Accounting Department.
  - Currency in circulation:
    - Stakeholders/data: RMA’s balance sheet; currently no analysis by Research and Statistics or Issuance Departments.
    - Forecasting method: Seasonal patterns typical; adjusted ARIMA model with dummy variables for Bhutanese public holidays.
  - Government accounts:
    - Stakeholders/data: Sweeping accounts of banks (Government bank accounts not subject to sweeping have no liquidity impact); Treasury (Department of Public Account).
    - Forecasting method: The Treasury should be able to share forecasts (currently missing) on its operations and cash position.
  - Project-related sweeping accounts of banks:
    - Stakeholders/data: Sweeping accounts of banks; no information from Indian authorities and project managers.
    - Forecasting method: Establish contacts with Indian authorities responsible for cash disbursements and with project managers.

### Towards a functioning money market — assessment of current situation
- Key obstacles to a functioning interbank market:
  - The RMA does not have regular liquidity-providing operations (no marginal lending facility). The overdraft facility can be activated for only three days, and at penal conditions (16 percent), for a bank in violation of the Cash Reserve Ratio (CRR).
  - Structural hegemonic liquidity position of State-owned BOB distorts the market; BOB’s liquidity advantage results mainly from its role as agent of the Treasury. BOB claims perceived credit risks limit its interbank lending, but restrictive lending could reflect competitive motives.
  - Rare interbank transactions are driven by prudential considerations rather than genuine liquidity needs. The SLR requires “quick assets” to account for more than 20 percent of total liabilities minus capital funds (20 percent for banks, 10 percent for non-bank financial institutions). Inclusion of demand deposits with commercial banks in the SLR numerator incentivizes transactions to meet SLR rather than to satisfy liquidity needs.
  - No legal and technical framework for a secured interbank market. Repos are impeded by absence of legal texts and lack of a credible vehicle (no secondary market for T-bills; no T-bond; T-bills are not dematerialized).
- Consequences:
  - Without effective redistribution of liquidity through a money market, the RMA must consider individual banks’ incompressible reserves for aggregate liquidity assessment.
  - The absence of a functioning interbank market exacerbates liquidity risks; a bank facing uncovered liquidity needs and lacking interbank access would rely on the RMA’s overdraft facility and may be forced to close after three days.

### Recommendations to promote a functional money market
- Institutional and outreach measures:
  - Set up a Money Market Contact Group as a quarterly forum (and ad hoc as needed) to discuss liquidity issues and the money market. The Research and Statistics Department and the Banking Department would jointly manage the contact group. Regular topics: liquidity developments, RMA liquidity management, initiatives to foster money market development. The treasurers of the 5 banks would be full members; non-bank financial institutions would be occasionally present.
  - Exert closer oversight on the interbank market to support understanding and reassure banks that payment incidents will receive appropriate RMA response. Consider making an electronic trading platform accessible to banks under RMA oversight and eventually provide interest rate references based on compiled transactions.
- Regulatory and market infrastructure measures:
  - Reflect on a more supportive regulatory environment for the money market; investigate changes to prudential measures (e.g., the SLR) that might hinder money market emergence.
  - Take first steps towards a legal framework and payment systems environment for a repo market. This requires substantial changes in legal/regulatory frameworks and T-bill/T-bond design (dematerialization, central depository). The central bank should play a leading role to push for these changes.

*Source: RMA and staff calculations; Staff elaborations.*

### APPENDIX I. RECENT MCM TECHNICAL ASSISTANCE TO THE RMA ON CENTRAL

### APPENDIX I. RECENT MCM TECHNICAL ASSISTANCE TO THE RMA ON CENTRAL BANKING ISSUES

### Financial Sector Deepening, Regulation and Supervision, and Monetary Operations
- August 2013 MCM TA mission reviewed arrangements for financial sector deepening, regulation and supervision, and monetary operations; conclusions informed Bhutan’s Article IV Consultation.
- Key findings and recommendations:
  - Bhutan needs a comprehensive strategy for deepening and broadening the financial sector.
  - A comprehensive Financial Sector Development Strategy (FSDS) is needed to improve the ability of the financial system to contribute to long-term economic growth.
  - Most recommendations in the area of monetary policy implementation are pending; the current mission is expected to help the RMA engage the program of reforms needed for implementation.

- Appendix 1. Table 1 — Recommendations of MCM August 2013 TA Mission and Action Taken (selected items with action status as recorded):
  - Government Securities Market
    1. Start systematic work toward establishing an issuance calendar for T-bills and commit to float meaningful amounts on a regular basis. — Action: Started in 2016.
    2. Publish the first issuance calendar for the next six months. — Action: Started in 2016.
    3. Reduce gradually use of Government’s overdraft facility in a commercial bank and agree on more restrictive use of the overdraft facility at the RMA. — Action: Pending.
    4. Agree on a MOU specifying how RMA could be reimbursed for the cost of monetary policy that cannot be absorbed on its own balance sheet. — Action: Pending.
    5. Utilize regular meetings of the Treasury Bill Management Committee to share information and coordinate public debt management and liquidity management. — Action: Pending.
    6. Prepare a plan for establishing an automated depository for registering treasury bills at the central bank (RMA), and implement the depository at the RMA. — Action: Pending.
    7. Initiate systematic work on strengthening the market infrastructure for securities trading. Introduce a Code of Conduct. — Action: Pending.
    8. Reactivate the liquidity monitoring framework by in particular ensuring that the Government cash flow projections can serve as direct input to the liquidity framework, and present the first liquidity monitoring table to management. — Action: Under way.
    9. Redesign the CRR by merging the CRR account and the current account into one account and allow for averaging over the maintenance period. — Action: Pending.
    10. Limit use of sweeping arrangement to eligible accounts, selected in cooperation with commercial banks, and refrain from using it to manage normal liquidity flows. — Action: Under consideration.
    11. Use Treasury bills on a regular basis with maturities and amounts determined by expected liquidity flows to stabilize as much as possible bank reserves. — Action: Pending.
    12. Introduce a short-term standing lending facility (one week) and redesign the RSTLAW as a LOLR facility to assist banks with longer-term liquidity problems. — Action: Pending.
    13. Start working toward establishing a liquidity management framework in which monetary instruments are available to ensure that market interest rates are close to the policy rate. Publish a plan for the new liquidity management framework. — Action: Under way.
    14. Start work to analyze and identify the various components of banks’ demand for reserves in order to determine the level of “true” excess reserves. — Action: Under way.

### FX Regulatory Framework
- November 2015 MCM TA mission followed up on April 2014 TA to guide the RMA in reviewing Bhutan’s FX system and regulations.
- Mission objectives and guidance:
  - Took stock of developments since the previous TA mission.
  - Provided guidance on revising and consolidating FX regulations to facilitate compliance with Bhutan’s obligations under Article VIII of the Fund’s Articles of Agreement.
  - Advised updating the existing FX legal framework to eliminate anomalies, lacunae, and inconsistent provisions and to consolidate dispersed regulations, rules, and policies.
- Deliverables provided to authorities:
  - A set of broad recommendations for restructuring and revising the regulations.
  - A roadmap for removal of the exchange restrictions under the IMF’s Articles of Agreement.
  - An annotated copy of the Foreign Exchange Regulations, 2013 with specific drafted recommendations for revision.

### International Reserves Management
- After March 2016 MCM TA mission, the RMA began reviewing its strategic asset allocation (SAA). Actions taken include:
  - Reduced FX risk by increasing the share of Indian rupee (INR) from 20 percent to 30 percent of its foreign reserves.
  - Added new counterparties to reduce credit risk, including joining the World Bank Reserve Asset Management Program (RAMP) for investments in U.S. treasuries.
  - Developed appropriate backstops with the Reserve Bank of India (RBI) against liquidity risk in INR.
- May 2017 MCM TA mission recommendations and assessment:
  - Recommended further increasing the share of INR in foreign reserves.
  - Noted that the composition of foreign reserve currencies does not reflect the structure of the RMA balance sheet, leading to significant FX risk.
  - Observed that liquidity and interest rate risks are well controlled.
  - Recommended further reducing credit risk by increasing investment in securities of well rated issuers to replace a heavy reliance on deposits with commercial banks.

### Central Bank Accounting
- RMA is upgrading its accounting framework with MCM TA support.
- Legal and reporting requirements:
  - Bhutanese law requires financial institutions to adopt the Bhutanese Accounting Standards (BAS), a 2010 version of International Financial Reporting Standards (IFRS) translated into Bhutanese.
  - The RMA’s Act requires that it “adopt an internationally recognized accounting framework”; the RMA chose to adopt BAS to provide consistency with Bhutanese law.
  - The RMA is required to be fully compliant with BAS for its June 2019 reporting year-end.
- TA program and timeline:
  - April 2016 MCM TA mission developed a detailed project plan for the RMA’s transition to BAS.
  - Objective: assist the RMA in transitioning to BAS in a smooth and sustainable manner via a series of TA missions providing technical accounting and systems expertise and skills transfer.
  - April 2017 MCM TA mission began developing policy positions for the RMA and identifying necessary systems requirements.
  - In May 2017, a FIRST project was approved to fund the full 2 ½ year program to support the RMA’s transition.

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### APPENDIX II. KEY FEATURES OF A LIQUIDITY FORECASTING FRAMEWORK

### Objectives of Liquidity Forecasting
- Main purpose: produce short-term liquidity forecasts to create an information set enabling the central bank to smooth changes in liquidity conditions.
- Purpose of smoothing:
  - Create stable liquidity conditions and steer the central bank’s operating target.
  - Help market participants distinguish between monetary policy stance changes and temporary “noises.”
  - Reduce uncertainties about policy intentions, improving transmission of monetary policy.
  - Facilitate banks’ liquidity management by moderating volatility and uncertainty, reducing liquidity management costs and settlement risks.

### Role and Process of Liquidity Forecasting
- Liquidity forecasting centralizes information determining the future stance of liquidity absent central bank activities; forecasts inform decisions on how much liquidity to add or withdraw.
- Forecasting is required whether operating target is an interest rate or a quantity target; the process is the same though instrument use differs.
- Central banks using direct instruments have no immediate need for liquidity forecasts; moving to market-based indirect instruments requires a thorough liquidity forecasting framework.

### Instruments, Standing Facilities, and Payment System Interactions
- Reserve requirements with averaging and standing facilities can reduce fluctuations in liquidity conditions; averaging allows banks to over- and under-fulfill reserve requirements during maintenance periods.
- Standing facilities set upper and lower bounds for interbank rates; a narrow corridor limits volatility but:
  - Injects or absorbs liquidity at banks’ initiative.
  - Discourages interbank activity, hampering market deepening.
  - Reduces central bank ability to extract information from money market activity.
- Payment system efficiency affects demand and effective supply of bank reserves; undeveloped or inefficient payment systems typically lead to large, volatile excess reserves and unstable reserve floats, complicating forecasting.

### Determinants of Liquidity
- Forecasting involves analyzing projected changes in main central bank balance sheet items.
- Autonomous supply of liquidity comprises:
  - net foreign assets,
  - net position of the Government with the central bank,
  - currency in circulation,
  - other items net.
- Liquidity demand consists of demand for required and excess reserves.
- Net position of the Government with the central bank often accounts for the most significant changes in autonomous liquidity supply; timely Government cooperation and cash flow projections are crucial for forecast accuracy.
- In countries with heavily managed exchange rates and large volatile capital flows, changes in net foreign assets can significantly affect liquidity supply; very short-run NFA variations are often known with certainty due to settlement lags.

### Liquidity Forecasting Framework and Organization
- Forecasting should be a rolling process with new information promptly incorporated.
- Organize forecasting responsibility in a dedicated unit within the monetary operations department to ensure linkage between forecasting and liquidity management. Responsibilities:
  - Communicate with information sources and ensure timely data receipt.
  - Supervise consistency of forecasted components.
  - Produce an overall liquidity projection regularly (daily) updated.
  - Assess forecasting errors.
- Forecasting horizons:
  - With reserve requirements: horizon should comprise at least the current maintenance period.
  - Without reserve requirements: horizon should comprise at least the time between two discretionary monetary interventions.
  - Optimal frequency: daily; if daily data unavailable, start with weekly intervals.

### Conceptual and Accounting Relations
- Simplified stylized central bank balance sheet components:
  - Assets: Net foreign assets; Net lending to banks/OMOs; Other items net/Net domestic assets.
  - Liabilities: Currency in circulation; Bank reserves (required and excess); Net position of the Government.
  - Note: In countries with structural excess liquidity, the net “policy” position with banks can be on the liability side; where central bank provides direct credit to Government, the Government net position may appear on the assets side.
- Demand for bank reserves decomposition:
  - Demand for bank reserves = Required reserves + excess reserves
- Supply of bank reserves formula as presented:
  - Supply of bank reserves = Net foreign assets + net position of the Government + other items net − currency in circulation + lending to banks/OMOs
- Distinction:
  - Autonomous liquidity position: items beyond short-run control of the central bank (first four items above).
  - Policy position: central bank direct lending to banks and net lending through OMOs, under immediate control.
- By comparing forecasted demand and projected autonomous supply, the central bank estimates excess supply or excess demand that would result absent intervention and adjusts its net policy position accordingly; the net policy position also accounts for past policy operations with future effects (e.g., redemptions of repos/reverse repos, maturing refinance credit).

*Source: APPENDIX I and APPENDIX II of the provided IMF content unit.*

### 17.      In general, the way in which a central bank adjusts its policy position to

### 1btnea2019001 - 17. In general, the way in which a central bank adjusts its policy position to

### Central bank operating targets and liquidity management
- Operating targets can be a quantity target (reserve money or bank reserves) or an interest rate target; the time horizon of the operating target (daily, weekly, monthly) matters.
- If the central bank targets the overnight interest rate:
  - It uses projected daily excess supply or demand of reserves to define daily injections or withdrawals.
  - The relationship between reserve projections and operations is less strict if the central bank:
    - Steers the overnight rate within a corridor, or
    - Has reserve requirements with averaging provisions.
  - With averaging in place, the central bank only needs to react to cumulated disequilibria over the entire maintenance period because the reserve requirement system acts as a stabilizer.
  - If the central bank operates without reserve requirements or without reserve averaging, liquidity must be managed more on a day-to-day basis.
- If the operating target is quantitative (reserve money or bank reserves):
  - The central bank adjusts the supply of bank reserves to conform with the target level.
  - Remaining excess demand or supply is allowed to adjust the interbank money market rate.
  - If demand for bank reserves is interest inelastic (for example, at the end of the reserve period), the central bank may need to accommodate demand to avoid disturbances in the financial system even if this causes short-term deviations from the quantitative operating target.

### APPENDIX III — Modeling currency in circulation (structural time series approach)
- Model purpose: augmented ARIMA model for banknote modeling (currency in circulation, CIC).
- Core specification (described in text): ∆CIC_t = a + sum of dummy terms for day-of-week, week-of-year, first-week-of-month, month-of-year, public holidays, days before/after public holidays, one-off factors, autoregressive terms (AR), moving average terms (MA), and residuals.
- Definitions of key model variables and dummies:
  - D_aD_i: dummy = 1 on day i of the week, 0 otherwise.
  - WWeek_i: dummy = 1 during week i of the year, 0 otherwise.
  - (First-week-of-month dummy): dummy = 1 during the first week of a given month, 0 otherwise.
  - MMonth_i: dummy = 1 during month i of the year, 0 otherwise.
  - Holiday dummy: = 1 when a day is a public holiday, 0 otherwise.
  - Holiday-minus-i: dummy = 1 i day(s) before a public holiday, 0 otherwise.
  - Holiday-plus-i: dummy = 1 i day(s) after a public holiday, 0 otherwise.
  - One-off factor dummy: = 1 when the one-off factor occurred, 0 otherwise.
  - ARA_i: autoregressive terms.
  - MAA_i: moving average terms.
  - ε_i: residuals.
- Modeling considerations and estimation guidance:
  - The position of a public holiday within a week is not neutral and should be tested (e.g., a holiday adjacent to a weekend has a stronger effect on CIC than one mid-week).
  - Before estimation, perform usual stationarity tests (example given: Durbin-Watson test) on the explained variable (∆CIC_t).
  - For explanatory dummy variables, test a very large scope and progressively discard non-significant variables.
  - If residual autocorrelation occurs, test and introduce AR and MA terms.
- Forecast validation and routine reassessment:
  - Use out-of-sample testing to assess forecasting power (example workflow provided using Eviews Software).
  - Example historical data period: January 1, 2006, to August 31, 2015.
    - Example subsample for estimation: January 1, 2006, to July 30, 2015.
    - Example out-of-sample test period: August 1, 2015, to August 31, 2015.
  - Compare forecasts to historical data and reassess model specification and forecasting performance regularly (such as every three months).

### APPENDIX IV — Simulated effects of proposed Option 2 for hydro project flows
- Description of Option 2: sell INR to the RMA only when there is a need for payments in local currency.
- Estimated implementation effects:
  - Would considerably reduce the amount of sweeping accounts of banks to the RMA.
  - Would reduce by the same amount the RMA’s foreign reserves (in gross and net terms).
  - Volatility in liquidity conditions would decrease.
  - Optical volatility in the RMA’s foreign reserves would decrease.
- Figures referenced:
  - Figure 1: Simulated Effects of Option 2 on Sweeping of Hydro-Project (in million ngultrum).
  - Figure 2: Simulated Effects of Option 2 on Foreign Assets (gross and net, in million ngultrum).
  - Source for figures: RMA and staff estimates.

*Source: 1btnea2019001 - 17. In general, the way in which a central bank adjusts its policy position to (PDF chapter content).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1btnea2019001.pdf_