Papua New Guinea
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Will restructure of the open market effectively address excess liquidity?

The International Monetary Fund (IMF) approved Papua New Guinea (PNG) government’s request for US$918 million loan under the Extended Credit Facility and the Extended Fund Facility program on March 22, 2023.

The program aims to protect the domestic economy against shocks and promote inclusive growth over a period of 38 months.

Specifically, the program focuses on the following three policy reforms:

This article focuses on the second policy reform, specifically the buildup of excess liquidity in the banking system. Excess liquidity protects commercial banks against liquidity risk.

However, persistent excess liquidity may have undesired implications on inflation, monetary policy transmission, private sector lending, bank profitability and sterilisation cost.

In PNG, the banking system has a chronic problem of excess liquidity and it undermines the effectiveness of monetary policy transmission.

This implies that when the Bank of PNG (BPNG) raises the policy rate, the intended outcomes such as low inflation may not be achieved because high level of liquidity in the system naturally exerts downward pressure on domestic interest rates.

Hence, BPNG has responded by introducing the central bank bills and raising the cash reserve requirement to mop up excess liquidity. Despite these monetary policy efforts, excess liquidity remains a concern in the banking system.

To improve the sterilisation efforts, the IMF program aims to restructure BPNG’s open market operations (OMO) framework by introducing a new short-term liquidity management instrument and reviewing the terms of the central bank bills by the end of August 2023.

OMO is a monetary policy instrument that involves buying and selling of government and central bank securities such as treasury bills, central bank bills, treasury bonds and inscribed stocks to support the monetary policy stance.

The new instrument will come with full allotment and have a fixed rate to limit interest rate volatility in the market.

The review of central bank bills will focus on reducing its current minimum tenure of 28 days to two weeks or below.

Furthermore, the rate of central bank bills will be linked to the Kina facility rate to ensure that changes in the policy rate can effectively transmit to the market rates. The purpose of the reform is to intensify efforts to sterilise excess liquidity using the short-term monetary policy instruments.

The new instrument will directly compete with the existing products in the OMO. Since its rate is fixed, commercial banks, as the main clients, may use their oligopolistic market power to bid for high rates in other instruments or participate in other investment opportunities that yield greater return or abstain from investing in the new product.

Hence, the opportunity to effectively sterilise excess liquidity using the new instrument is slim and costly.

Furthermore, with structural excess liquidity in the system, linking the central bank bills rate to the policy rate on a short-term basis is costly and should not necessarily be the stance of monetary policy.

The primary role of central bank bills to mop up excess liquidity must be maintained. Although BPNG has issued large volumes of short-term securities, the level of excess liquidity remains high.

Clearly, there is a need to improve the terms of existing securities for medium and long-term liquidity management.