## _wp1240

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### Executive Summary — Main argument and operational guidance
- Central question: whether central banks should use government securities or their own securities when draining liquidity from the market.
- Main argument: treasury bills are the first best option because they:
  - shield central banks from potential financial losses associated with issuance of own securities;
  - reduce likely threats to central bank autonomy in the conduct of monetary policy.
- Advocacy for treasury bills premised on:
  - (i) an integrated view of public sector finance;
  - (ii) the public policy argument for developing money markets;
  - (iii) the advantages of inherent features that enable government securities to generate positive externalities for other financial instruments and the rest of the economy in a way that cannot easily be replicated by other instruments.
- Operational guidance:
  - Treasury bill markets should be designed to sterilize structural liquidity of the banking sector in the cheapest possible way and contribute to financial market development.
  - Where both central bank and treasury bills are used, priority factors are:
    - (i) ensuring operational independence for the central bank;
    - (ii) fostering development of liquid markets;
    - (iii) strengthening transmission of monetary impulses.
  - Additional operational recommendations:
    - Primary issuance should not be overburdened with both fine-tuning operations and structural excess liquidity.
    - Fine-tuning should be addressed by short-term instruments such as repos (using government securities as underlying collateral).
    - Proceeds from government securities used for liquidity management should be placed in blocked account at the central bank.
    - The cost of sterilization is a charge on the consolidated public finances and should ideally be explicitly recognized and provided for in the government budget; some governments may prefer to reflect this on the central bank balance sheet instead.

### I. Use of government securities vs central bank bills — Evidence and country practice
- Data source: ISIMP database of IMF/MCM; latest survey conducted in 2008.
- 2008 survey results (responses from 83 countries; exact table/text excerpts preserved):
  - The 2008 survey results, which are based on responses from 83 countries show that the extent of use of treasury bills and central bank bills among the respondents is almost the same (Table 1 and Figure 2).
  - Table 1. Summary Information on Use of Treasury Bills and Central Bank Bills
    - Sample of Countries 84 100.0
    - Countries using treasury bills only 29 34.5
    - Countries using central bank bills 28 33.3
    - Countries using both treasury bills and Central bank bills 27 32.2
    - Total use of Treasury Bills 56 50.5
    - Total Use of Central Bank Bills 55 49.5
- Country practices and examples:
  - Developing and emerging economies tend to use both securities frequently, reflecting reluctance by some governments to have treasury bills used for liquidity management.
  - Example: Brazil
    - Before May 2002 both treasury and central bank issued paper.
    - From May 2002 to July 2004, the volume of outstanding government securities increased from 395 billion to 736 billion while the volume of outstanding central bank bills decreased from 126 billion to 22 billion.
    - The central bank stopped issuing own bills and the treasury issued equivalent amounts of government securities; proceeds were placed in a special account and could only be used to augment foreign reserves or retire foreign debts.
- Maturity profile and market structure:
  - Securities used for liquidity management concentrate on short end (less than 12 months); debt management ideally focuses on the long end.
  - Short-term debt increases refinancing risk and can contribute to macroeconomic instability.
  - Data on half of the countries in the 2008 ISIMP survey show central bank bills for liquidity management generally have maturities of up to 12 months (Table 2).
  - Exceptions with maturities longer than 12 months include: Armenia, Costa Rica, Dominican Rep, Jordan, Macedonia, Malaysia, Tajikistan, Thailand, Russia, and Uzbekistan.
  - Most bills sold through multiple price auction formats and have weekly frequencies.
  - BIS (2000) finding: public sector accounted for about half of outstanding domestic debt securities; corporate sector about a quarter; financial sector including central banks about 30 percent; central bank securities alone accounted for 15 percent of issuances at end of 2000. In Chile, central bank securities accounted for 55 percent of total domestic debt issuance (reflecting use to sterilize large capital inflows).

### II. Desirable features and market infrastructure
- Central bank operational needs for securities:
  - manage the demand and supply of bank reserves;
  - serve as underlying collateral for repos; and
  - support the payment and settlement systems.
- Desirable attributes of securities used by central banks:
  - under the control of the central bank;
  - avoid fragmenting the market for securities;
  - available in sufficient amounts and in key maturities;
  - accord operational independence to the central bank;
  - enhance the transmission mechanisms of monetary policy;
  - liquid and have minimal credit risk (qualities shared by government securities and central bank bills).
- Important infrastructure arrangements:
  - auction formats, trading platforms, price determination and settlement arrangements;
  - design and operation of payment systems;
  - design of monetary policy instruments and procedures for money and exchange market operations;
  - public debt and foreign exchange reserves management.
- Market liquidity — definitions and dimensions:
  - liquidity as the ease with which a financial instrument can be exchanged for cash without a loss in value;
  - market liquidity: ability to trade a given volume of assets without significantly affecting their prices;
  - Main elements: width, depth, immediacy and resilience.
    - Width: size of bid-ask spreads reflecting the cost of providing liquidity.
    - Depth: volume of transactions at particular bid-ask spreads effected without price changes.
    - Immediacy: speed with which transactions are effected and whether there are price changes.
    - Resilience: speed with which price fluctuations caused by orders peter out.
- Policy implication: short end addresses monetary policy; long end addresses government financing. Public sector involvement justified to capture positive externalities and properly price costs and benefits of liquidity.

### III. Central bank bills — motivations, risks, and trade-offs
- Reasons central banks issue own securities:
  - inadequacy of volumes of government securities for open market operations;
  - reluctance of some governments to issue government securities beyond financing needs and lack of commitment to market development;
  - desire for operational flexibility in monetary operations;
  - attempts to separate monetary management from debt management.
- Financial risks and historical loss examples from central bank issuance/sterilization:
  - National Bank of Poland: losses amounting to about 0.8 percent of GDP in 1998–99.
  - Chile: 1.4 percent of GDP (early 1990s).
  - Colombia: 0.5 percent to 0.7 percent of GDP (early 1990s).
  - Mexico: 0.2 percent to 0.4 percent of GDP (early 1990s).
  - Evidence of general decline in return on assets: Stella and Lonnberg (2008) — 1.66 percent during 1995–99 to 1.25 percent during 2000–04 (sample of 91 central banks).
- Advantages of central bank paper:
  - substitute for treasury bills where government securities unavailable; useful in post-conflict or regional arrangements.
- Disadvantages and systemic risks:
  - potential weakening of central bank balance sheet and threats to central bank credibility;
  - limited externalities for broader money market development (participation often limited to banks);
  - market segmentation if central bank and government paper maturities overlap;
  - interest costs borne by central bank can be large; may require government recapitalization.
- Institutional mitigants:
  - explicit rules on distribution of profits and recapitalization procedures;
  - Memoranda of Understanding (MOUs) between central bank and finance ministry to guide interaction.

### IV. Alternatives, coordination mechanisms, and operational design
- Alternatives to traditional central bank securities:
  - Private paper: surged over time but limited use for monetary policy; not used for liquidity draining operations.
  - Auctioned interest-bearing deposits: not marketable; do not contribute to market development; impose direct burden on central bank balance sheet.
- Options to avoid market fragmentation and provide central bank access to government securities:
  - Government add-ons to normal treasury bill auctions (issuances over and above budgetary financing needs) with proceeds sterilized in a special/blocked account.
    - Increase central bank access to securities for market intervention.
    - Foster market development.
    - Raise additional budget costs and require sterilization and coordination between liquidity and debt management policies.
  - Transparency measures: announce central bank add-ons; limit securities for monetary policy to the short end; proceeds held in blocked account unavailable to the government.
  - Other methods: conversion of existing central bank loans to securities; recapitalization of the central bank (examples cited: Philippines in 1993 and Uganda in 1999).
- Operational guidance for instruments:
  - Treasury bills:
    - Effective for management of structural excess liquidity and debt management.
    - Should not be used for fine-tuning; overuse can introduce volatility into the yield curve.
  - Short-term instruments (repos):
    - Repos with maturities of one to two weeks should be used to fine-tune short-term liquidity.
    - Forecasting errors feed directly only into short-term money market rates, limiting spillovers to longer rates.

### V. Benchmarks, market development, and public-good rationale
- Government securities function as:
  - benchmarks for commercial paper, asset-backed securities, corporate bonds;
  - anchors to the notion of a riskless asset;
  - sources of information on inflation expectations and term premiums;
  - underlying collateral supporting repo, derivatives and hedging markets.
- Benefits of deep and liquid government securities markets:
  - lower funding costs for governments;
  - improved monetary policy transmission;
  - reduced welfare losses associated with absence of markets;
  - wider set of instruments for savers and investors; enhanced risk management.
- Risks of absent markets:
  - diminished asset choices for savers; potential financial disintermediation; loss of pricing information; dominance by banks with low deposit rates; vulnerability to crisis.
- Policy implication: development of liquid debt markets is a public good; benefits can outweigh costs.

### VI. Policy recommendations and institutional arrangements
- Main findings and recommendations:
  - Treasury bills are the "first best option" security for both debt and liquidity management, subject to country circumstances.
  - For liquidity-absorbing operations using treasury bills, proceeds should be kept in a frozen/blocked account and not available for government expenditure.
  - Effective use of treasury bills requires a commitment to a regular issuance schedule at appropriate maturities.
- Guiding criteria for instrument choice:
  - Instruments should:
    - (i) facilitate transmission of monetary impulses;
    - (ii) assist development of liquid markets;
    - (iii) ensure operational independence for the central bank.
- Institutional arrangements and coordination mechanisms (roles preserved as in source):
  - Auction Management Unit (Central Bank)
  - Liquidity Projection Unit (Central Bank)
  - Government Cash Balance Unit (Central Bank and/or Ministry of Finance)
  - Joint Monetary and Debt Management Coordination Committee (Ministry of Finance and Central Bank)
  - Debt Management Committee (Ministry of Finance/Treasury)
  - Monetary Management Committee (Central Bank)
  - Monetary Operations Unit/Committee (Central Bank)
  - Treasury/Ministry of Finance: Monitor fiscal position
- Consolidation option:
  - Bringing all public debt under one obligor can eliminate competition and market fragmentation and ensure maturity profiles meet debt management and liquidity management needs.
- Transparency and formal agreements:
  - MOUs between central bank and ministry of finance can clarify accounting, profit transfer, loss coverage, and recapitalization procedures.
  - Central bank purchases of treasury bills to build an income-generating portfolio should be transparent and pre-announced.

### VII. Integrated budget identity and macro linkages (core equation and variables)
- Integrated budget identity (core equation preserved exactly as in source):
  - ΔRM + (ΔGDD + ΔCBB – ΔGNFA  – ΔCBNFA) = GOE + CBOE  – T) + rdGDD + rbCBB – GNFA – CBNFA – GONA – CBONA – reCBCE + ΔCBCE + ΔGONA + ΔCBONA
- Definitions provided in the source for variables (preserved exactly as in source), including:
  - ΔRM, ΔGDD, ΔCBB, ΔGNFA, ΔCBNFA, GOE, T, rd, rdGDD, rb, rbCBB, , GNFA, , CBNFA, , GONA, GONA, , CBONA, CBONA, re, CBCE, reCBCE, ΔCBCE, ΔGONA, ΔCBONA
- Note: adapted from Leone (1991); highlights macroeconomic imbalances associated with deficits (printing money → inflation; excessive reserve use → balance of payments crises; high foreign borrowing → debt crisis; excessive domestic borrowing → high real interest rates and crowding out).

*Italic source: Excerpted material from IMF Working Paper _wp1240 (ISIMP-based analysis; 2008 survey results and related discussion).*

### Executive Summary ......................................................................................................

### _wp1240 - Executive Summary ......................................................................................................

### Executive Summary
- Central question: whether central banks should use government securities or their own securities when draining liquidity from the market.
- Main argument: treasury bills are the first best option because they:
  - shield central banks from potential financial losses associated with issuance of own securities;
  - reduce likely threats to central bank autonomy in the conduct of monetary policy.
- Advocacy for treasury bills premised on:
  - (i) an integrated view of public sector finance;
  - (ii) the public policy argument for developing money markets;
  - (iii) the advantages of inherent features that enable government securities to generate positive externalities for other financial instruments and the rest of the economy in a way that cannot easily be replicated by other instruments.
- Operational guidance:
  - Treasury bill markets should be designed to sterilize structural liquidity of the banking sector in the cheapest possible way and contribute to financial market development.
  - Where both central bank and treasury bills are used, priority factors are:
    - (i) ensuring operational independence for the central bank;
    - (ii) fostering development of liquid markets;
    - (iii) strengthening transmission of monetary impulses.
- Additional operational recommendations:
  - Primary issuance should not be overburdened with both fine-tuning operations and structural excess liquidity.
  - Fine-tuning should be addressed by short-term instruments such as repos (using government securities as underlying collateral).
  - Proceeds from government securities used for liquidity management should be placed in blocked account at the central bank.
  - The cost of sterilization is a charge on the consolidated public finances and should ideally be explicitly recognized and provided for in the government budget; some governments may prefer to reflect this on the central bank balance sheet instead.

### I. Introduction
- Role of OMOs: open market operations (outright transactions, repos, issuance of debt certificates, foreign exchange swaps and fixed-term deposits) are main mechanisms to provide/withdraw liquidity, steer short-term interest rates and signal monetary stance.
- Focus of the paper: draining surplus liquidity using government securities or central bank bills, with attention to maturities of less than a year for monetary policy and liquidity management.
- Context:
  - Builds on Quintyn (1996) and later developments: many countries have moved from direct to indirect instruments; MCM developed in-house databases on use of government and central bank securities and on legal provisions on losses/profits and capital.
- Key observations:
  - Both government securities (treasury bills) and central bank bills have low credit risk (virtually zero credit risk) and occupy the bottom end of the risk/return spectrum.
  - Central banks often resort to own securities where government securities markets are undeveloped or governments are reluctant to issue sufficient amounts.
  - Three elements give an edge to government securities: (i) integrated public sector finance; (ii) government role in fostering money markets; (iii) ability to generate positive externalities.
  - Central bank losses and threats to autonomy argue against central bank securities unless adequate arrangements (loss treatment, recapitalization procedures) exist.
  - Paper concurs with Quintyn (1996) that no definitive preference can be universally applied, but makes a stronger case for government securities on the three-element basis cited above.

### II. Country Use Of Government Securities and Central Bank Bills
- Data source: ISIMP (Information System Instruments of Monetary Policy) database of IMF/MCM; latest survey conducted in 2008.
- 2008 survey results (text and table excerpts preserved exactly):
  - The 2008 survey results, which are based on responses from 83 countries show that the extent of use of treasury bills and central bank bills among the respondents is almost the same (Table 1 and Figure 2).
  - Table 1. Summary Information on Use of Treasury Bills and Central Bank Bills
    - Sample of Countries 84 100.0
    - Countries using treasury bills only 29 34.5
    - Countries using central bank bills 28 33.3
    - Countries using both treasury bills and Central bank bills 27 32.2
    - Total use of Treasury Bills 56 50.5
    - Total Use of Central Bank Bills 55 49.5
- Country practices and examples:
  - Developing and emerging economies tend to use both securities frequently, reflecting reluctance by some governments to have treasury bills used for liquidity management.
  - Example: Brazil
    - Before May 2002 both treasury and central bank issued paper.
    - From May 2002 to July 2004, the volume of outstanding government securities increased from 395 billion to 736 billion while the volume of outstanding central bank bills decreased from 126 billion to 22 billion.
    - The central bank stopped issuing own bills and the treasury issued equivalent amounts of government securities; proceeds were placed in a special account and could only be used to augment foreign reserves or retire foreign debts.
- Legal/institutional arrangements:
  - Many central bank statutes clearly state whether the central bank can use treasury bills or its own securities for monetary operations.
  - Statutes also commonly include provisions on distribution of central bank profits and procedures for recapitalization, with varying specificity.

- Maturity profile and market structure:
  - Securities used for liquidity management concentrate on short end (less than 12 months); debt management ideally focuses on the long end.
  - Short-term debt increases refinancing risk and can contribute to macroeconomic instability.
  - Data on half of the countries in the 2008 ISIMP survey show central bank bills for liquidity management generally have maturities of up to 12 months (Table 2).
  - Exceptions with maturities longer than 12 months include: Armenia, Costa Rica, Dominican Rep, Jordan, Macedonia, Malaysia, Tajikistan, Thailand, Russia, and Uzbekistan.
  - Most bills sold through multiple price auction formats and have weekly frequencies.
  - In less developed financial markets, the short end tends to have both treasury and central bank securities; more developed markets may include private paper (bills of exchange, commercial paper, certificates of deposit).
  - BIS (2000) finding cited: public sector accounted for about half of outstanding domestic debt securities; corporate sector about a quarter; financial sector including central banks about 30 percent; central bank securities alone accounted for 15 percent of issuances at end of 2000. In Chile, central bank securities accounted for 55 percent of total domestic debt issuance (reflecting use to sterilize large capital inflows).

### III. Desirable Features of Securities Used in Liquidity Management
- Papers notes the importance of matching instruments to roles:
  - Primary issuance should not be used for both fine-tuning and structural liquidity; fine-tuning better handled by short-term operations such as repos using government securities as collateral.
- Balance sheet and fiscal transparency considerations:
  - Proceeds from government securities used for liquidity management should be kept in blocked central bank account.
  - Sterilization costs are ultimately a charge on consolidated public finances and should ideally be reflected in the government budget; alternative is to record on the central bank balance sheet, per government preference.
- Institutional and market development considerations:
  - Coordination between debt management and monetary operations is necessary to avoid market fragmentation and to support central bank independence.
  - Developing liquid government securities markets generates positive externalities for wider financial market development and monetary policy transmission.
- Risks from central bank issuance:
  - Potential threats to central bank balance sheets and autonomy are compelling reasons to prefer government securities where feasible, absent adequate arrangements for loss treatment and recapitalization.

*Italic source: IMF Working Paper _wp1240 - Executive Summary (ISIMP-based analysis; 2008 survey results and related discussion).*

### 17.      Central banks need securities to enable them to: manage the demand and supply

### 17.      Central banks need securities to enable them to: manage the demand and supply of bank reserves; serve as underlying collateral for repos and support the payment and settlement systems

### Role and desirable features of securities for central banks
- Central banks need securities to:
  - manage the demand and supply of bank reserves;
  - serve as underlying collateral for repos; and
  - support the payment and settlement systems.
- Desirable attributes of securities used by central banks:
  - under the control of the central bank;
  - avoid fragmenting the market for securities;
  - available in sufficient amounts and in key maturities;
  - accord operational independence to the central bank;
  - enhance the transmission mechanisms of monetary policy;
  - liquid and have minimal credit risk (qualities shared by government securities and central bank bills) to avoid financial losses.
- Important infrastructure arrangements:
  - auction formats, trading platforms, price determination and settlement arrangements;
  - design and operation of payment systems;
  - design of monetary policy instruments and procedures for money and exchange market operations;
  - public debt and foreign exchange reserves management.
- These infrastructure elements contribute to effective implementation of monetary and fiscal policy and have important implications for efficient functioning of financial markets and overall financial sector stability.

### Market liquidity: importance and dimensions
- Market liquidity is an increasingly important public policy issue for central banks and policy makers.
- For market development, the maturity spectrum of securities should be viewed as a continuum:
  - the short end generally addresses monetary policy needs;
  - the long end addresses government financing needs.
- Short-term treasury bills may be required for active cash management in government.
- Definitions and dimensions of liquidity:
  - liquidity as the ease with which a financial instrument can be exchanged for cash without a loss in value;
  - market liquidity: ability to trade a given volume of assets without significantly affecting their prices;
  - monetary liquidity: monetary aggregates.
- Widely accepted definition: a market in which large and fast transactions can be executed with minimal impact on prices.
- Main elements of market liquidity: width, depth, immediacy and resilience.
  - Width: size of bid-ask spreads reflecting the cost of providing liquidity.
  - Depth: volume of transactions at particular bid-ask spreads effected without price changes.
  - Immediacy: speed with which transactions are effected and whether there are price changes.
  - Resilience: speed with which price fluctuations caused by orders peter out.
- Deep and liquid securities markets are important for public debt management, monetary policy, financial stability, pricing of financial instruments and market development.
- Securities provide indicators for inflation and output outlooks through pricing data, serve as risk-free investment vehicles, collateral, benchmarks for pricing fixed income securities, and for hedging interest rate risks.
- Public sector involvement is justified to ensure that costs and benefits of liquidity are properly priced and to capture positive externalities for debt management and monetary policies.

### Central bank bills: features, uses, and motivations for issuance
- Central bank bills are considered free from credit risk (reflecting assumed strength of central banks’ financial position and underwriting of central bank losses of capital by governments) and share many features with treasury bills.
- Central bank bills have generally tended to operate on the short end of the money market (maturities that are less than 12 months).
- Many countries use central bank bills in conjunction with or as an alternative to government securities for liquidity management.
- Reasons central banks have issued their own securities:
  - inadequacy of volumes of government securities for open market operations;
  - reluctance of some governments to issue government securities beyond financing needs and lack of commitment to market development;
  - desire for operational flexibility in monetary operations;
  - attempts to separate monetary management from debt management.
- In transition economies, central bank bills were used when government securities were unavailable in sufficient volumes; examples include experiences documented for the Czech Republic, Hungary, Poland, Slovakia and Slovenia.
- Examples where capital inflows led to defensive issuances of central bank bills to sterilize FX purchases: China, Guatemala, Indonesia, Lebanon and Serbia.
- Some central banks, especially in emerging and developing countries, have not built up significant portfolios of government securities and are often not permitted to do so by respective governments.

### Financial risks, losses, and implications for central bank balance sheets
- Central banks need sufficient resources to carry out mandates without undermining balance sheets and autonomy.
- Many central banks have experienced chronic losses which may interfere with implementation of monetary policy and other mandates.
- Examples of losses from sterilization operations and own-paper issuances:
  - National Bank of Poland: losses amounting to about 0.8 percent of GDP in 1998–99.
  - Chile: 1.4 percent of GDP (early 1990s).
  - Colombia: 0.5 percent to 0.7 percent of GDP (early 1990s).
  - Mexico: 0.2 percent to 0.4 percent of GDP (early 1990s).
  - Other significant losses: Indonesia, Malaysia, Sri Lanka.
- Stella and Lonnberg (2008) evidence: general decline in return on assets of a sample of 91 central banks from 1.66 percent during the period 1995–99 to 1.25 percent during the period 2000–04.
- Some central banks have been subject to fiscal abuse through quasi-fiscal operations.
- Central bank financial problems have arisen from issuance of debt by central banks; preference to use treasury bills instead of central bank securities is consistent with aversion to accumulation of unsustainable central bank debt.
- Financial difficulties in central bank balance sheets have also appeared in some industrial and emerging market countries due to:
  - provision of central bank credit to ailing banking systems;
  - increased exposure to revaluation losses in large foreign exchange reserve holdings;
  - issuance of central bank debt to resist exchange rate appreciation;
  - fiscal abuse through quasi-fiscal operations;
  - decreased revenue from inflation tax and seigniorage in an environment of low inflation;
  - increased transparency in reporting and accounting practices (e.g., adoption of IFRS affects treatment of valuation gains/losses and profit distribution).
- A central bank experiencing financial difficulties suffers a decline in financial independence, compromising overall independence.
- Persistent central bank losses may necessitate recapitalization, which is a charge on public finances.
- Views on the need and level of central bank recapitalization are varied; no universally accepted level of capital exists.
  - Some views suggest central bank capital need only be non-negative.
  - Four methods used to determine central bank capital: (i) an absolute nominal value; (ii) a target ratio to a selected central bank balance sheet item; (iii) a target ratio to some macroeconomic variable; and (iv) according to perceived risks to solvency of the central bank.

### Advantages, challenges, and market-fragmentation risks of central bank paper
- Advantages:
  - Central bank bills can substitute for treasury bills and be useful in post-conflict situations where the central bank may be the lone credible official institution.
  - Central bank paper can be convenient in regional monetary arrangements where a collective central bank can sell its own paper independent of individual governments’ issuance calendars.
- Challenges and risks:
  - Potential conflict with government debt management objectives.
  - Limited externalities for overall money market development as participation is often limited to banks.
  - Possible weakening of central bank balance sheet and threats to central bank credibility.
  - Potential for market segmentation, especially if maturities of central bank and government paper are similar.
  - Use of different paper for monetary policy, government financing and/or cash management risks market fragmentation and loss of liquidity, resulting in many series of small issuances that hinder development of benchmark securities.
  - Conflict of interest for issuing central banks: as monetary authorities they want market-determined interest rates; as issuers they wish to minimize costs and may interfere with price determination (example: prior to 2004 in Croatia discount for treasury bills was 8 percent while that for central bank bills was only 1 percent).

### Coordination mechanisms and options to avoid fragmentation and support market development
- Options to address fragmentation and provide central banks access to government securities:
  - Government add-ons to normal treasury bill auctions (issuances over and above budgetary financing needs) with proceeds sterilized in a special/blocked account:
    - increase central bank access to securities for market intervention;
    - foster market development;
    - raise additional budget costs and require sterilization and coordination between liquidity and debt management policies.
  - Transparency is critical: without transparency, add-ons could confuse the market about which portion of a tender finances the budget versus monetary policy.
    - Confusion can be eliminated by announcing central bank add-ons and limiting securities for monetary policy to the short end.
    - Transactions for monetary policy can be limited to a select group of financial institutions and proceeds held in a blocked account unavailable to the government.
    - Coordination challenges persist, illustrated by the Philippines example in the 1980s where the Treasury later resisted full add-ons despite initial agreement to freeze proceeds.
  - Other ways for a central bank to obtain government securities:
    - conversion of existing central bank loans to securities;
    - recapitalization of the central bank (examples: Philippines in 1993 and Uganda in 1999).
    - Challenges: converting loans may raise costs if existing loans are below market rates and governments may object.
- Coordination imperative:
  - Stylized scheme (Annex II) underscores imperative for effective collaboration between debt management and monetary operations.
  - Main objective of debt management (Bank Fund guidelines): ensure government’s financing needs and payment obligations are met at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk; consistency with monetary policy is also critical.
  - Using the same instrument for both debt management and monetary policy, with appropriate maturity structures and handling of proceeds, avoids market fragmentation and strengthens government securities as a tool for market development.

*Source: Excerpt from content unit "_wp1240 - 17.      Central banks need securities to enable them to: manage the demand and supply of bank reserves; serve as underlying collateral for repos and support the payment and settlement systems."*

### 38.      In a bid to separate debt management from liquidity management, consideration

### _wp1240 - 38.      In a bid to separate debt management from liquidity management, consideration

### Alternatives to traditional central bank securities
- Private paper:
  - Has surged over time but its use for monetary policy has been limited even among industrial countries.
  - Rare exception: Indonesia used its own debt instruments as well as private paper in open market operations (Quintyn (1994)).
  - Japan used private paper but experienced some problems of default in 1997 (Yaohan defaulted and several Japanese banks followed suit).
  - Private paper is not used for liquidity draining operations.
- Auctioned interest-bearing deposits:
  - Potentially serve the same purpose as central bank bills but are not marketable and thus do not contribute to market development.
  - Require coordination and impose a direct financial burden on the central bank’s balance sheet and indirectly on the overall government budget.
  - The extent to which such a financial burden can be imposed sets a limit to the amount available in this instrument.
  - When used for liquidity absorbing operations, rates tend to be the lower bound in the case of interest rate corridors.

### Central bank bills: conditions and trade-offs
- Design and market implications:
  - Must avoid fragmenting the market.
  - Should be on the short-end of the maturity spectrum.
  - Require close coordination with debt management objectives to avoid negating liquidity absorption (e.g., injections from redemptions).
  - Modalities identical to treasury bills can reduce market fragmentation.
  - One way to avoid fragmentation: central bank bills concentrate on the short end while treasury bills concentrate on the longer end.
- Advantages:
  - Provide autonomy for the central bank to control excess liquidity without relying on the government issuance program.
- Disadvantages:
  - Interest costs are borne by the central bank and can be large when there is a lot of liquidity to absorb and rates are high.
  - Can impair the central bank’s balance sheet, potentially necessitating government capital injection.

### Treasury bills and government securities: functions and strengths
- Stylized features of government securities:
  - Regarded as virtually free from credit risk.
  - Act as a tool for hedging interest rate risks and as underlying assets and collateral for related markets such as repo, futures and option markets.
  - Serve as a benchmark in pricing for other financial assets and for extracting information on inflation and output outlook.
  - Liquidity concentrated in a few key maturities.
- Unique attributes that support their role as core financial market instruments:
  - Perception of high creditworthiness and being virtually risk free.
  - Presence of high volumes of outstanding and fungible issues; on-the-run issues are more liquid than private paper.
  - Ability to cater for a wide range of risk appetites and maturity profiles.
  - Existence of well-developed repo and derivatives markets enabling short and long positions.
- Market development and issuance:
  - Government securities are natural candidates for core markets but not all features are present in all countries at all times; instances of near or actual defaults exist.
  - Experiences of Hong Kong, Singapore, and Australia show government securities markets can be created through accumulation of assets.
  - Treasury bills are preferred in shallow markets where secondary markets are not yet in place because large volumes facilitate market development and yield-curve formation.

### Repo markets and risk-free benchmarks
- Repo rates:
  - In major debt markets, general collateral repo rates are widely regarded as the most efficient proxy for risk-free rates at very short maturities [CGFS (1999)].
  - Repo markets are typically liquid out to about 3 months (12 months in the U.S.).
  - Repo rates have displaced government yields at the very short end of the yield curve.
  - Beyond the short-term, expectations from the term structure of repo rates may not be accurate for broader collateralized debt markets that extend out to 30 years or more.

### Institutional and fiscal considerations in instrument choice
- Financial autonomy of the central bank manifests in three broad ways:
  - (i) latitude to set the terms and conditions for items in its balance sheet;
  - (ii) resources to cover operational expenses and losses;
  - (iii) clear rules governing distribution of profits, and the accumulation of capital and reserves.
- Policy and institutional developments supporting autonomy:
  - Explicit prohibition on central bank lending to the government.
  - Elimination of explicit or implicit subsidies to the government.
  - Memoranda of Understanding (MOUs) developed between central banks and finance ministries to guide interactions.
- Cost-bearing and transparency:
  - Costs of sterilization can be borne directly and transparently through the government budget or indirectly through the central bank’s balance sheet.
  - In the consolidated public sector, government bears costs either directly (budget entry) or indirectly through reduced central bank profit transfers or increased budget outlays to meet central bank losses or inject capital.
- Guiding criteria for instrument choice:
  - The choice between government securities and central bank paper should be guided by the extent to which they:
    - (i) facilitate the transmission of monetary impulses;
    - (ii) assist in the development of liquid markets;
    - (iii) ensure operational independence for the central bank.
  - Relying on own debt instruments can weaken the central bank’s balance sheet, especially if government support frameworks/timings are unclear.
  - Development of liquid debt markets can be viewed as a public good whose benefits outweigh the costs.

### Operational guidance for liquidity management and fine-tuning
- Roles and appropriate instruments:
  - Treasury bills:
    - Effective for management of structural excess liquidity and for their traditional role in debt management.
    - Should not be overburdened with multiple objectives; poor for fine-tuning because liquidity forecasting errors would feed volatility into the entire yield curve.
  - Short-term instruments (repos):
    - Repos with maturities of one to two weeks should be used to fine-tune short-term liquidity in the banking sector.
    - Forecasting errors in this case feed directly only into short-term money market rates (one-week or two-week rates), limiting transmission of volatility to longer-term rates.
    - Volatility in short-term interest rates should normally not significantly influence longer-term money market rates or lending rates; longer-term rates should more reflect expectations about future short-term interest rates.

*Source: Excerpt from IMF Working Paper _wp1240.*

### 57.      As suggested above, government securities serve as benchmarks for other

### 57.      As suggested above, government securities serve as benchmarks for other

### Role of government securities in markets and monetary operations
- Government securities serve as benchmarks for commercial paper, asset-backed securities, and corporate bonds, and thereby strengthen financial intermediation and stability.
- Investors' demand for liquidity premiums tends to be high when markets are not liquid.
- The development of a liquid secondary market helps to lower funding costs for governments and mitigates conflicts between debt management and monetary operations.
- Government securities establish a benchmark yield curve across a continuum of maturities (including treasury bills with maturities of 12 months or less and medium and long-term notes and bonds).
- As benchmarks, government securities:
  - provide an anchor to the notion of a riskless asset;
  - disseminate information on inflation expectations and term premiums;
  - become the standard for valuation of other fixed-income contracts;
  - increase liquidity in related markets by serving as a hedge for illiquid securities.

### The case for treasury bills
- Treasury bills are helpful for:
  - insulating all sterilization operations from normal day-to-day liquidity management;
  - reducing and/or eliminating volatility that can contaminate the whole spectrum of interest rates;
  - making effective use of short-term instruments for fine-tuning;
  - developing benchmark issues to pave the way for a vibrant secondary market.
- The treasury bill market should be designed to sterilize structural banking-sector liquidity in the cheapest possible way while contributing to market development.
- Treasury bills are presented as a "first best option" for liquidity management within an integrated public finance perspective.

### Central bank bills, central bank balance sheets, and public-sector integration
- Where government securities are not available for monetary policy, the central bank needs a strong enough balance sheet to issue its own bills and service interest costs; this is rare in countries with weak fiscal positions.
- An exception is a central bank that owns international reserves and is independent enough to control earnings on these reserves.
- A case could be made for allowing a central bank to buy limited amounts of treasury bills at every government auction to build a stock from which it could derive income; such purchases should be transparent and announced in advance.
- Over time, the central bank holding a portfolio of bills of different maturities provides flexibility for OMO repo operations.
- Using both treasury bills and central bank bills can create coordination challenges: market fragmentation; determination of volumes, issuance procedures and terms; and maturity-profile conflicts.
- A case for consolidation: bringing all public debt under one obligor can eliminate competition and market fragmentation and ensure maturity profiles meet debt management and liquidity management needs.
- Central bank financial considerations:
  - Losses from issuing central bank debt may impair the central bank, potentially adding to public debt and hampering monetary policy.
  - An independent central bank should have clarity in accounting practices, transfer of profit, coverage of losses and recapitalization; arrangements may need to be formalized in an MOU between the central bank and the ministry of finance.
  - Bindseil et al (2004) model assumes a "liquidity unconstrained" central bank (right to issue legal tender over an infinite horizon) and suggests temporary negative capital shocks can reverse over time under restrictive assumptions.
  - The U.S. General Accounting Office found no widely accepted criteria for whether a central bank needs capital as a cushion against losses.
  - Stella and Lonnberg (2008), based on 135 central bank statutes, find divergent practices: a bimodal distribution where one group explicitly recognizes treasury responsibilities for central bank finances and the other group does not; practices on recapitalization and profit distribution vary across countries.
- Footnote evidence: Korea experienced differential pricing between a two–year monetary stabilization bond and a three-year treasury bond; the monetary stabilization bond traded nearly 20 basis points above the treasury bond despite the same explicit guarantee.

### Promoting money-market development and the wider economic externalities
- Deep and liquid financial markets reduce welfare losses associated with market absence; financial crises have increased focus on domestic securities markets.
- Market liquidity generates positive externalities for government, central banks, public entities, private entities and households.
- A well-functioning money market:
  - allows participants to transact meaningful amounts without large price changes;
  - provides reliable financing and investment opportunities;
  - is supported by market-determined interest rates and sound regulatory and institutional infrastructure;
  - lays the foundation for a liquid secondary market and enhances monetary policy transmission.
- Negative consequences of absent deep and liquid markets include:
  - a diminished range of assets for savers;
  - possible financial disintermediation;
  - welfare loss to savers who are less well-off;
  - loss of information contained in market-determined interest rates;
  - lack of a clear measure of the opportunity cost of funds, potentially leading to over- or underinvestment;
  - dominance by banks, enabling low deposit rates due to lack of competition;
  - vulnerability to crisis from excessive reliance on bank lending from highly leveraged institutions;
  - difficulty securitizing non-performing loans to redeploy resources for restructuring.
- Yields on fixed-income instruments can be conceptually decomposed into:
  - inflation premium (loss of purchasing power and uncertainty of future prices);
  - term premium (willingness to wait for payment);
  - credit spreads (issuer-specific risks).
- Government securities, with minimal credit-spread noise, provide the basic discount factor and support the development of derivatives markets and risk management by economic agents.

### Policy implications and coordination needs
- Public policy should support the development of market liquidity given its positive externalities for financial stability, monetary policy conduct, and debt management.
- Coordination between monetary authorities and debt managers is essential to avoid market fragmentation and conflicting issuance that can negate each other's objectives.
- Formal arrangements (for example, an MOU) between central bank and ministry of finance can clarify accounting, profit transfer, loss coverage, and recapitalization procedures, especially where institutional tensions exist.
- Where central banks purchase treasury bills to build an income-generating portfolio, such purchases should be transparent and pre-announced to markets.

_Excerpt from the provided IMF content (paragraphs 57–76)._

### 77.      On the whole, the choice between treasury bills or central bank bills should be

### 77.      On the whole, the choice between treasury bills or central bank bills should be

### Main findings and recommendations
- Treasury bills are identified as the "first best option" security to use for both debt and liquidity management, supported by:
  - an integrated view of public sector finance;
  - the public policy argument for the government’s role in fostering the development of money markets;
  - inherent features that enable government securities to generate positive externalities for other financial instruments and the rest of the economy in a way that is not easily replicable by other instruments.
- The choice between treasury bills and central bank bills depends on individual country circumstances despite the strong argument for government securities as first best.
- For liquidity-absorbing operations using treasury bills, proceeds should be kept in a frozen account and thus not available for government expenditure.
- Effective use of treasury bills requires a commitment to a regular issuance schedule at appropriate maturities.

### Practical considerations in emerging and developing countries
- Many countries, especially emerging and developing ones, use central bank bills and/or treasury bills to deal with chronic surplus liquidity.
- Key challenges include possible market fragmentation and the relationship between central banks and ministries of finance, particularly when central banks suffer operational losses and require recapitalization.
- Institutional arrangements, including memoranda of understanding, can support arrangements so that central bank securities function as well as government securities in absorbing excess liquidity.

### Operational design and coordination
- Liquidity management paper typically concentrates on the short end of the market and can take the form of add-ons or special issues over and above financing needs.
- The bidding process for such securities is typically limited to commercial banks or the central bank’s regular counterparties in open market operations.
- Critical requirement: overall issuances and redemptions must be coordinated so intended objectives are not negated.
- Close coordination between debt management and monetary policy — and thus between the central bank and the ministry of finance — is always needed, even when government securities are not used for monetary policy purposes.

### Advantages of using treasury bills (enumerated)
- Insulating all sterilization operations from normal day-to-day liquidity management.
- Reducing volatility, which can contaminate the whole spectrum of interest rates.
- Making effective use of short-term instruments for fine-tuning.
- Developing benchmark issues to pave the way for a vibrant secondary market.
- Design objective: structure the treasury bill market to sterilize structural liquidity of the banking sector in the cheapest possible way and to contribute to market development.

### Comparative table summary (Annex I, relative advantages and disadvantages)
- Government securities — Advantages:
  - Help develop a viable market and stimulate financial markets and monetary transmission.
  - Shift the cost of monetary tightening to government and make it transparent in the budget; may encourage fiscal discipline if direct central bank financing is discontinued.
  - Require high degree of coordination between central bank and treasury.
- Government securities — Disadvantages:
  - If not properly coordinated with treasury, central bank’s operational autonomy may not be guaranteed and primary market interventions may not be effective.
- Central bank securities — Advantages:
  - Facilitate central bank operational independence (provided issuance is coordinated with government securities).
  - Flexible instrument for liquidity management.
- Central bank securities — Disadvantages:
  - May reduce central bank profits or lead to central bank losses if issued in large amounts.
  - Requires some degree of coordination with treasury to avoid small and segmented markets.
- Auctions of central bank deposits — Advantages:
  - Guarantee central bank operational independence and avoid competition with treasury securities.
- Auctions of central bank deposits — Disadvantages:
  - Do not assist in developing securities markets (unless negotiable, in which case they resemble central bank securities).

### Integrated budget framework (Annex II) — key identity and variables
- Printing base money y = consolidated foreign and domestic net borrowing = consolidated budget deficit + interest payments on outstanding consolidated net debt + central bank credit to the economy + acquisition of foreign assets and other net assets by the government and central bank.
- Core equation presented (variables shown as in source):
  - ΔRM + (ΔGDD + ΔCBB – ΔGNFA  – ΔCBNFA) = GOE + CBOE  – T) + rdGDD + rbCBB – GNFA – CBNFA – GONA – CBONA – reCBCE + ΔCBCE + ΔGONA + ΔCBONA
- Definitions provided for variables (preserved exactly as in source), including:
  - ΔRM, ΔGDD, ΔCBB, ΔGNFA, ΔCBNFA, GOE, T, rd, rdGDD, rb, rbCBB, , GNFA, , CBNFA, , GONA, GONA, , CBONA, CBONA, re, CBCE, reCBCE, ΔCBCE, ΔGONA, ΔCBONA.
- Note: adapted from Leone (1991) and similar frameworks used by other analysts; highlights macroeconomic imbalances that deficits can cause (i) printing money shows up as inflation; (ii) excessive use of foreign reserves leads to crises in the balance of payments; (iii) high foreign borrowing leads to a debt crisis; (iv) too much domestic borrowing leads to high real interest rates and possible crowding out of private investment.

### Institutional arrangements for monetary and debt management (Annex III) — roles and coordination mechanisms
- Suggested units and committees (roles preserved as in source):
  - Auction Management Unit (Central Bank): Manage auction process, tenders, acceptances, etc.
  - Liquidity Projection Unit (Central Bank): Monitor changes in balance sheet of the central bank; project autonomous changes in the supply of liquidity.
  - Government Cash Balance Unit (Central Bank and/or Ministry of Finance): Monitor and project path of government cash balances.
  - Joint Monetary and Debt Management Coordination Committee (Ministry of Finance and Central Bank): Joint determination of auction program and parameters for size and rate determination to meet operating targets for monetary management and debt management objectives; government cash balances endogenous subject to upper and lower bounds.
  - Debt Management Committee (Ministry of Finance/Treasury): Formulate overall debt management program including instruments, size, timing; establish short-term auction program to meet debt management and maintain positive cash balances.
  - Monetary Management Committee (Central Bank): Formulate policy goals in relation to inflation, interest rates, balance of payments; establish short-term operating targets (e.g., reserve money).
  - Monetary Operations Unit/Committee (Central Bank): Analyze liquidity projections and money market developments with input from Ministry of Finance; determine stance of open market operations (buy/sell) and size of operations to meet operating targets set by the Joint Committee.
  - Treasury/Ministry of Finance: Monitor fiscal position.

### Interrelationships among bond and money markets and monetary policy (Annex IV) — core linkages
- Secondary bond market: mechanism for investors to sell instruments before maturity by providing liquidity; liquid secondary markets provide link with monetary policy and money market; active markets provide pricing information along yield curve for issuing new debt and reduce debt management costs.
- Monetary policy: central bank responsible for policy interest rate which acts as primary indicator of short term rates; policy implementation requires ability to affect levels of monetary liquidity; central bank may act as agent for issuance, payment and registry of government debt.
- Debt management: primarily for funding government debt; constant monitoring of risk and cost objectives (lowest cost/least risk); determine issuance levels.
- Money market: mechanism for banks to adjust intraday liquidity; efficient money markets provide key means of financing holdings of government debt; levels of liquidity can be affected by central bank open market operations.

*Source: “Monetary Policy Through Primary Market Issues: Government Securities or Central Bank Securities?” MAE Operational Paper, MAE OP/96/5, December 1996.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2012/_wp1240.pdf_