Developing a domestic debt market would have large benefits in managing liquidity within the UAE’s financial system, according to the International Monetary Fund (IMF).
“A domestic debt market offers governments a domestic funding source to tap if needed. This would help them diversify sources of funding and reduce reliance on bank financing, external borrowing or withdrawals from sovereign wealth funds (SWFs),” the IMF said in a recent staff paper.
A domestic debt market also offer the central bank the flexibility of an additional instrument for managing liquidity by conducting open market operations in the context of the currency peg.
The IMF said a domestic debt market would make the supply of liquid assets less dependent on oil prices and the peg. “From the financial stability point of view, issuing domestic securities could increase the pool of domestic securities that qualify as high quality liquid assets (HQLA) for the Basel III liquidity requirements,” the IMF staff paper said.
From a pure banking system perspective, it [domestic debt instruments] would also provide banks with collateral that could be used for interbank operations and borrowing from the central bank, including under emergency liquidity provision. Issuing government securities would help create a yield curve at long-term tenors to provide a benchmark for bank lending.
Domestic government debt issuance could help develop a domestic corporate bond market and interbank repo market. It would provide a useful pricing benchmark. Firms would have an opportunity to diversify their finances. As the market develops, smaller companies could follow larger ones in issuing debt, supporting economic diversification. Finally, developing the domestic debt market could attract more foreign investors to stimulate domestic activity.
Unified overnight rates
According to IMF, standing facilities for providing liquidity to banks could be unified into one overnight lending rate. Currently, the existence of multiple standing facilities risks causing confusion in the market and potentially creating arbitrage opportunities. Using one standing facility may also help banks overcome any stigma associated with using standing facilities. In addition, introducing an overnight deposit rate would help the central bank steer interest rates in the context of the peg. At present, bank balances with the central are not remunerated. The deposit facility can serve as a floor for the interest rate policy rate corridor. Together, the deposit and lending rates would help the central bank to use short-term interest rates to guide the market.
The IMF paper recommends reforming the certificate of deposits (CDs) programme to provide benchmark short-term instruments. According to the IMF, CDs could be offered at regularly scheduled auctions rather than as a daily tap facility. Such auctions could be held weekly with the results published to facilitate price discovery by market participants. The auctions would be calendarised with CD maturity profile to match maturing tranches. CDs should be traded at fixed volume variable rate auctions to provide a price signal to the central bank and banks.
“CDs would be issued as transferable securities, which banks could trade with each other. Once CD auctions are well established, the early redemption feature could be removed from new CD issuances. This would incentivise banks to trade CDs with each other, fostering interbank market development, and to plan their liquidity needs better,” the IMF paper said.
The IMF said the central bank’s and governments’ plans regarding market development and liquidity management need to be accelerated. According to the IMF, the CBU’s current liquidity management framework has served the country well. However, the new challenges posed by the lower-for-longer oil prices and expected increases in US interest rates call for moving towards more active management of liquidity. Upgrading the CBU’s liquidity management framework, together with governments’ initiatives to develop domestic debt markets, would expand the range of liquid assets available to banks and the CBU, enabling them to manage liquidity better, consistent with the Basel III requirements.
“More active liquidity management by banks would increase their resilience to unexpected shocks. A more robust banking system would support healthy credit growth and contribute to further diversification of the UAE economy,” the IMF said.