Central Bank of Oman Occasional Paper: 2019-1 Liquidity Management Framework and Interbank Overnight Interest Rate in Oman: An Empirical Investigation Amal Al Raisi, Sunil Kumar and Razan Al Humaidi* Abstract Oman’s overnight inter-bank rate generally follows the trends in federal fund rate due to currency peg with the US dollar and open capital account, albeit with some intermittent deviations. In our ARDL model, we find federal fund rate along with domestic liquidity conditions as drivers of the overnight inter-bank rate in Oman. Accordingly, intermittent deviations of Oman’s overnight inter-bank rate from the federal fund rate appears to have been caused by evolving domestic liquidity conditions and less than perfect arbitrage due to various prudential limits. Keywords: Overnight inter-bank rate, federal fund rate, monetary policy, liquidity conditions JEL Classification: E43, E52, E58 *Amal Al Raisi is a Manager, Sunil Kumar is an Economist, and Razan Al Humaidi is an Associate Research Analyst in Economic Research & Statistics Department of the Central Bank of Oman. The authors would like to express their sincere thanks to Dr. Mazin Al Ryami for his valuable comments/inputs on the paper. The views expressed in this paper and errors, if any, are strictly of the authors and do not belong the organization they work for. All the usual disclaimers apply. CONFIDENTIAL Central Bank of Oman Occasional Paper: 2019-1 Introduction The Central Banks across a large number of countries have shifted from monetary targeting to interest rate targeting as the main instrument of monetary policy. This shift was mainly necessitated by the weakening of relationship between the monetary aggregates and final objective(s) i.e. inflation and growth. Moreover, it was empirically observed that demand for money function had turned unstable in most of the jurisdictions. Under the interest rate targeting, the monetary policy framework comprises three main pillars, viz. policy rate, operating target, and final objective(s). The second pillar (operating target) is the starting point of the monetary policy transmission and therefore, its achievement becomes paramount for effective implementation of the monetary policy for any Central Bank. In most cases, the operating target is the overnight inter-bank rate, which is being achieved by implementing efficient liquidity management framework. Any misalignment of the operating target with the policy rate undermines the monetary policy transmission and hence, such an outcome is considered suboptimal and undesirable. In fact, sustained misalignment of the operating target from the policy rate could jeopardize the credibility of the monetary policy (Central Bank), thereby, warranting a review/ revision in the monetary and liquidity management frameworks. Oman has a fixed exchange rate, i.e. Rial Omani is pegged to USD and largely open capital account. Therefore, the monetary policy in Oman should not have much of independence theoretically (impossible trinity or macroeconomic trilemma problem), and the US monetary policy should get transmitted automatically that means interest rates in Oman should be at par with prevailing interest rates in the USA, assuming free arbitrage between assets of both countries. It has, however, been observed that although interest rates in Oman follow the trends prevailing in the interest rates of USA, they tend to vary somewhat from the latter at times. In this regard, Espinoza and Prasad (2012) also find that domestic interest rates in Oman 2 Central Bank of Oman Occasional Paper: 2019-1 are somewhat delinked from US FED policy rate. Some variance between two interest rates is expected on account of risk premia and transaction costs. Furthermore, the evolving domestic liquidity conditions and liquidity management operations coupled with some restrictions on free arbitrage due to prudential limits also provide scope for deviation in Oman’s interest rates from the USA interest rates. So the moot question that arises is whether Oman’s monetary policy enjoys some independence. Or such deviations, especially among short-term interest rates, suggest a need to have a relook at the liquidity management framework. It may be underlined that any large deviation of Oman’s interest rate from the USA interest rates for long-period could undermine internal and external balance. Against the above backdrop, this study makes an attempt to analyze the alignment of the inter-bank overnight rate with CBO’s policy rate and the US Fed Fund Rate as well as examine the factors driving the overnight inter-bank rate in Oman. We have not come across any such study in case of Oman. In fact, a few studies have touched upon this subject in GCC region. A related study by Hamdan, Pattaniak, and Yousuf (2007) examine the transmission mechanism of monetary policy in Oman. Chailloux and Hakura (2009) analyze the U.A.E.’s liquidity management framework in the context of the 2008 global financial crisis. Our study add to the scanty literature on the subject with respect to the GCC countries. The scheme of the study is as follows. The alignment of the overnight inter-bank rate is investigated in Section II, while Section III contains the contours of the current liquidity management framework. The studies on the similar topics are reviewed in Section III, while the factors deriving the overnight inter-bank rate are empirically examined in Section IV. Section V analyzes the impact of liquidity conditions on the interest rates in the economy. The concluding observations are furnished in Section VI. 3 Central Bank of Oman Occasional Paper: 2019-1 Section II: Alignment of Oman’s Interest Rates with that of USA In an environment of free capital mobility and fixed exchange rate, the interest rates in Oman must be closely aligned with the commensurate interest rates prevailing in the US keeping in view the free arbitrage opportunity. Accordingly, the overnight inter-bank rate in Oman should be closely aligned with the US’s overnight inter- bank rate even if the policy rate of Oman differs from that of USA. The monthly data shows that the overnight inter-bank rate in Oman largely follows the trends in the US overnight rate i.e. Effective Federal Fund Rate (EFFR). Notwithstanding following the similar trend, the overnight inter-bank rate in Oman have been found diverging from EFFR and such divergence was quite large at times (Chart 1). For example, Oman’s overnight inter-bank rate remained much lower than EFFR during the period January 2005-August 2008. But it was very closely aligned to EFFR during the subsequent period until December 2016. This is the period when the policy rate was largely sub-zero and liquidity was abundant in the USA due to quantitative easing. In Oman also, the liquidity was surplus largely during this period, reflecting large inflows of foreign exchange due to oil exports. Again Oman’s overnight inter-bank rate diverged downward from EFFR during the period January-May 2017. The large deviations of Oman’s overnight inter-bank rate from EFFR during intermittent periods suggested some decoupling of the former from the latter which could be attributed to domestic factors. On the other hand, Oman’s overnight inter-bank rate had been much lower than the CBO’ policy rate, i.e. repo rate at with banks avail liquidity from the CBO (Chart 1). In fact, misalignment of the overnight interbank-rate with policy rate is by construct as the latter is defined as 50 basis points spread over the monthly US$ LIBOR rate or 1 percent whichever is higher. 4 Central Bank of Oman Occasional Paper: 2019-1 Chart 1: Overnight Inter-bank Rate, Repo Rate and 7.00 Federal Fund Rate 6.00 Repo Rate 5.00 Overnight Rate 4.00 Effective Federal Fund Rate 3.00 Percent 2.00 1.00 0.00 Jul-07 Jul-12 Jul-17 Jan-15 Jan-05 Jan-10 Jun-05 Jun-10 Jun-15 Oct-08 Oct-13 Sep-06 Feb-07 Sep-11 Feb-12 Sep-16 Feb-17 Apr-06 Apr-11 Apr-16 Dec-07 Dec-12 Mar-09 Mar-14 Aug-14 Nov-05 Aug-09 Nov-10 Nov-15 May-13 May-08 Notwithstanding intermittent periods of divergence, one inference that could be drawn from the above chart is that Oman’s overnight inter-bank rate is anchored to the US EEFR and not to the policy rate (repo rate), which is quite logical being US$ as the anchor currency for Oman’s pegged exchange rate. It has, however, been noticed that the gap between Oman’s policy rate (repo rate) and the US FFER has narrowed down in the last few years and more so in the recent past. This pattern could also be observed in the narrowing of the gap between the spreads of Oman’s overnight inter-bank rate over the policy rate and over the US FFER (Chart 2). Chart 2: Spread of Overnight Rate over Repo Rate and Federal Fund Rate (a) Monthly (b) Daily 3.00 0.60 0.40 2.00 0.20 1.00 0.00 0.00 -0.20 -1.00 -0.40 -2.00 Percent -0.60 Percent -3.00 -0.80 -4.00 -1.00 -5.00 -1.20 Jul-07 Jul-12 Jan-05 Jan-10 Jan-15 Sep-06 Sep-11 Sep-16 Mar-09 Mar-14 Nov-05 Nov-10 Nov-15 May-08 May-13 8-Jun-15 9-Feb-15 1-Feb-17 10-Jul-13 7-Mar-16 6-Nov-13 8-May-13 20-Jan-16 4-May-16 15-Oct-14 10-Sep-13 21-Sep-15 13-Apr-15 28-Apr-16 13-Mar-14 10-Aug-15 17-Nov-15 11-Aug-16 29-Nov-16 Spread over Repo Rate Spread over EFFR Spread over Repo22-May-14 Rate Spread over EFFR 5 Central Bank of Oman Occasional Paper: 2019-1 The average monthly spread of the overnight rate over the US EFFR (absolute by ignoring sign) declined from 176 basis points during 2005-2008 to just 5 basis points during the period 2009-2016 but increased to 20 basis points in 2017 (up to October).