KARACHI, Dec 2: The State Bank has seemingly realised that raising the treasury bills rates alone is not enough to tighten the interest rates if the banking system is allowed to wallow in excess liquidity.

That is why the central bank has lately become more aggressive in mopping up excess liquidity from the inter-bank market through its open market operations or OMOs.

Senior central bankers say that a gradual hiking of T-bills rates supported by frequent drainage of surplus liquidity from the banking system would result in faster increase in the banks' own lending rates, thus fulfilling the objective of the tightening of the monetary policy aimed at containing inflation.

On Thursday also, the central bank conducted an OMO to suck in Rs27.7 billion from a fairly liquid inter-bank market through repo sale of one-week treasury bills at 2.5 per cent.

Senior bankers said the OMO was conducted to offset the impact of an inflow of Rs19.4 billion through maturity of previously sold T-bills. But the market was fairly surplus in liquidity even after the OMO.

This was one of the several OMOs the State Bank has conducted since the banks started working after the Eid holidays. Even before that the central bank was conducting OMOs more frequently than in the past.

The purpose was not only to soak liquidity from the banking system that was receiving inflows through maturity of T-bills or because of other reasons, but also to let KIBOR or Karachi Inter bank Offered Rate rise and make KIBOR-based lending dearer for the private sector.

While the SBP continued to signal tightening of monetary policy by increasing the T-bills cut-off rates after June 2004, the interest rates in the secondary market (including KIBOR) did not increase until end-August 2004.

"This suggests that liquidity drain (through regular auctions of T-bills) from the inter-bank market was insufficient to put upward pressure on interest rates; in other words, the SBP's monetary tightening was initially not very effective," concedes an SBP report on money market.

"Since most of the banks' credit to corporate sector is now linked to KIBOR (for which inter-bank liquidity is a main driving force), the transmission of monetary policy to banks' lending rates remained weak. Hence, increasing the T-bills cut-offs alone, while leaving the market liquid impairs the effectiveness of monetary policy," remarks the report.

Six-month KIBOR shot up to 5.72 per cent at the end of November, from 3.23 per cent at the end of August, showing a big rise of 249 basis points in the past three months. Earlier in July-August it had increased by only 26bps, rising to 3.23 per cent at end-August from 2.97 per cent at end-June 2004.

The frequent use of OMOs as an effective tool for supporting the monetary policy is a welcome move by the State Bank both for the market as well as for the economy at large.

With the economy set to exceed the growth target of 6.6 per cent during this fiscal year ending in June, up from 6.4 per cent in the last fiscal, keeping inflation at a low level has become all the more difficult. Inflation in July-November rose by 9.06 per cent year on year against full fiscal year target of 5 per cent.

The IMF, while welcoming Pakistan's decision to end the three-year Poverty Reduction and Growth Facility or PRGF ahead of time has advised the country's economic managers to keep the monetary policy focused on maintaining low inflation and avoiding the entrenchment of inflationary expectations.

The IMF board of executive directors that met on December 1 advised Pakistan to continue "the implementation of sound macroeconomic policies, with monetary policy focussing on maintaining low inflation and avoiding the entrenchment of inflationary expectations, as well as structural reforms," according to a press release posted on the IMF website. This advice, according to the IMF press release, is for ensuring that the country maintains a high rate of economic growth.