Central bank bills

Central bank bills (CBBs) - also known as central bank securities or central bank bonds - are usually short-term (up to a year) financial instruments issued by a country's central bank or monetary authority to commercial banks. CBBs are primarily issued for a range of monetary policy purposes and exchange rate regulations, and are also used as a primary means of reducing excess liquidity (via reserves management).

While known to exist in various forms much earlier in monetary history, CBBs have found their widest application in developing and emerging markets in recent years, following a series of currency crises in the 1990s and most recently in the post-2008 crisis quantitative easing environment. CBBs may be used in conjunction with or in place of more typical liquid government securities (for instance Treasury bills, preferred in advanced economies) in a central bank's routine open-market operations. As such, CBBs are an increasingly important alternative monetary policy instrument.

The scope of CBBs is quite extensive, with both advanced and developing economies resorting to this instrument at different times (see, for example, Bank for International Settlements, 2009, 2013; Rule, 2011; Nyawata, 2012; and Yi, 2014), though advanced economies mostly rely on government-issued securities for their open-market opera- tions. A variant of CBBs can be used to finance a central bank's foreign reserves fund. For example, the Bank of England is known to have issued its own securities (euro and US dollar denominated) for such purposes. A similar approach, via a subsidiary, was adopted by Malaysia right after the 1997 Asian crisis. The Bank of Korea has used Monetary Stabilization Bonds (MSB) since 1961 as its primary means of absorbing excess capacity in the market (see Rule, 2011 for details).

As a liquidity management tool, the People's Bank of China (PBC), in 2003, started issuing short-term CBBs with up to a year in maturity. This policy has been maintained with successive reissuance, as a means to drain liquidity rather than monetary policy tightening. Importantly, targeted CBBs were issued for isolated commercial banks that saw high credit growth and liquidity levels on a relative scale. It is estimated that the PBC was able to sterilize up to 80 per cent of the liquidity increase between 2003 and 2007 (Bank for International Settlements, 2009).

In the post-2008 crisis quantitative easing policies' proliferation, Switzerland (in 2008) and Malaysia (in 2011) started issuing CBBs, used as eligible collateral by respective banks. At the same time, Argentina's central bank (in December 2013) started issuing 180-day maturity CBBs targeted at grain exporters in an effort to accumulate foreign reserves ahead of crop deliveries, with restrictions on resale and specific terms of bond redemption.

In principle, accumulated evidence suggests that CBBs have been used for open-market operations as a sterilization instrument and liquidity management, mainly in economies with limited volume or non-existent government securities markets. The latter's limited scope may be explained by smaller capacities and rudimentary fixed income markets (for instance, in post-socialist transition economies), perhaps even owing to governments' reluctance to issue debt in excess of immediate financing needs.

Therefore, lacking access to sufficiently robust short-term government securities markets, central banks rely on their own short-term fixed income paper for conduct of open-market operations. Yi (2014) cites the example of Brazil, where both the Treasury and the central bank issued individual bills up to 2002, when the central bank stopped the practice, thus allowing domestic sovereign bond market development. The Treasury continued issuing equivalent bills once original CBBs expired.

In another scenario, CBBs offer clear operational flexibility in conduct of monetary policy, distancing the central bank's involvement from sovereign debt management issues and focusing more on monetary management. The policy of using CBBs could also be linked to economic development efforts as liquidity initially expands artificially to stimu- late economic growth. With increased loan portfolios and expanding foreign exchange flows, which also have repercussions on competitive exchange rates, as the economy gradually opens up but with still limited government securities market, the use of CBBs as an open-market operations mechanism may be justified to alleviate the pressures and drain excess liquidity.

Yet, even with relative autonomy in the conduct of monetary policy, CBBs pose certain immediate risks that have far wider and deeper ramifications for the national economies in developing rather than advanced markets.

One of the key risk factors is the interest that central banks pay on CBBs depending on the exact security structure. Over the years, excessive reliance on CBBs has put significant weakening pressures on central banks' balance sheets, in some cases leading to sizeable losses. Nyawata (2012) estimates such central banks' losses to have occurred in Poland (up to 0.8 per cent of GDP), Chile (1.4 per cent), Colombia (up to 0.7 per cent), as well as in Mexico, Indonesia, Malaysia and other countries throughout the 1990s. Persistent losses may even require a central bank's recapitalization, which by definition is a hard hit on the national economy.

Often the simultaneous use of CBBs and Treasury bills, issued by entities with identical credit ratings (that is, the national central bank and the government), brings on undesired market fragmentation and potential conflicts with fiscal debt management. Two bills with the same maturity resulting in different yield curves could lead to securities markets price distortions and backfire with liquidity shortage (see Yi, 2014 for the example of South Korean MSB and Treasuries term structure of interest rates). This is evident from the central bank's dual role in the CBBs process: as a regulator allowing the market to determine the CBBs' interest rate, and as an issuer attempting to control the CBBs' price to minimize the costs.

In a situation of limited central bank reserves, reliance on CBBs in effect contributes to national debt levels, resulting in a real fiscal burden. In more complex scenarios, excessive CBBs lead to negative externalities on central banks via credit provisions to low-capitalized banks or significant exposure to currency revaluation risks via foreign- exchange fund maintenance or pegged exchange-rate policies.

Finally, in creating a new liquid asset (in this case, CBBs), a central bank may inadvert- ently cause liquidity to actually increase rather than decrease as intended. Such a scenario plays out if foreign (and domestic) investors consider the new security as an alternative risk-free investment and stimulate its secondary market (hence the restrictions on second- ary market transactions as cited above in Argentina).

More abstractly, CBBs help conceptualize monetary policy effectiveness in economic development.

See also:

Collateral; Financial crisis; Open-market operations; Quantitative easing; Reserve requirements; Sterilization; Yield curve.