How the OPR can affect the economic climate

As mentioned earlier, Bank Negara signals their monetary policy stance by changing the Overnight Policy Rate (OPR). How can this change affect the economic climate in the country?

Well, we are awared that the OPR serves as the primary reference rate in determining other market rates, such as the Overnight Interbank Rate (OIR), Base Lending Rate (BLR), deposit rate, etc.

If the OPR increases, so do the other rates. This will cause borrowing cost to increase as interest expenses become higher. Business and investment activities might become less aggressive, investment institutions might allocate more funds in the money market than in the stock market. People are more encouraged to deposit their money with bank and earn interest. Cost of ownership of house and car will increase as the interest rate increased.

Higher interest rate could also attract short term foreign fund (hot money) to flow in, as the multi-national institutions can earn more interest by putting their fund in countries with higher interest rate. This will in turn strengtern the currency exchange rate of the country. When the currency rate is strong, cost of imports goods will be lower.

Theoritically, all these chain reactions will eventually slow down the inflation rate in the country.

If the OPR decreases, the opposite will happen. As interest rate decreases, borrowing cost will be lower, and this encourages more aggressive business and investment activities by leveraging on liabilities. Banking instittutions need to be more aggressive and competitive in order to maintain their profit with the lowered interest rate, and this will cause getting loan from bank become easier. People are discouraged to leave their money with the bank as interest earned become too little, and they are more tending to use their money in buying properties, insurances, unit trusts, shares, etc. The automotive industry will also be benefited with the lower interest rate.

If the interest rate is comparatively lower than other countries, this could cause short term foreign fund to flow out, as the multi-national institutions can earn more interest by putting their fund in countries with higher interest rate. This will in turn weakening the currency exchange rate of the country. When the currency rate is weak, cost of imports goods will be higher.

Theoritically, all these chain reactions will eventually accelerate the inflation rate in the country.

Therefore, Bank Negara need to be extremely careful in changing the OPR, as a wrong move will be disasterous to the economy of the country, and a good move will be benefitial to the economy of the country.

About the Overnight Interbank Rate (OIR)

I mentioned about the Overnight Interbank Rate (OIR) in the article about the Overnight Policy Rate (OPR). Let's see what is actually meant by OIR.

Everyday, the banking institutions will transfer money to each other on behalf of their clients as well as on their own account. At the end of each working day, a bank may have a surplus or shortage of funds. Banks that have surplus funds may lend them to or deposit them with other banks, who borrow from them in the interbank market. The banks can also borrow this short term fund from Bank Negara as well.

The OIR is the overnight interest charged by the lending banks or Bank Negara to the borrowing banks.

About the Overnight Policy Rate (OPR)

Yesterday night, the Monetary Policy Committee (MPC) of Bank Negara Malaysia (BNM, central bank of Malaysia) has again decided to keep the Overnight Policy Rate (OPR) unchanged at 3.50%. This position has been maintained since 26 April 2006 after rising by 25 basis points from the previous 3.25%.

You might want to know exactly what is OPR? Why is it important? How does it affect us?

On 23 April 2004, BNM introduced a New Monetary Operating Procedures with a new interest rate framework. Under this New Monetary Operating Procedures, the Overnight Policy Rate (OPR) will be the indicator of the monetary policy stance of Bank Negara. The OPR will have a dual role:

• As a signalling device to indicate the monetary policy stance;
• As a target rate for the day-to-day liquidity operations of the Central Bank.

Any change in the monetary policy stance would be signalled by a change in the OPR. It will serve as the primary reference rate in determining other market rates, such as the Overnight Interbank Rate (OIR), Base Lending Rate (BLR), deposit rate, etc.

Liquidity management of Bank Negara will aim at ensuring the appropriate level of liquidity that would influence the OIR to move close to the OPR. Liquidity operations will also be conducted at other maturities but without targeting a specific interest rate level as well. Therefore, interbank interest rates at other maturities would be market determined, reflecting overall demand and supply conditions in the money market as well as interest rate expectations.

To minimize excessive volatility in the overnight rate, Bank Negara specifies a corridor around the OPR, which set at ± 25 basis points around the OPR. A standing facility is introduced to ensure that the overnight interbank rate fluctuates within this corridor by providing a lending facility at the upper limit of the operating band and a deposit facility at the lower limit of the operating band. The MPC will announce the OPR on a quarterly basis, unless there is emergency change in the monetary policy stance, whereby additional OPR statement will be issued.

With the OPR set at 3.50%, the upper limit will be 3.75% and lower limit will be 3.25%. Interestingly, you might have noticed that the BLR of banks is set 3% more than this upper limit, and short term fixed deposit rate is set close to the lower limit, while long term fixed deposit rate (1 year or above) is set close to the upper limit.

In fact, under the new framework, each banking institution can announce its own BLR based on its cost structure and business strategies. Banking institutions are also no longer be subject to the maximum spread of 2.5 percentage points above BLR. As a result, you might have noticed that the BLR of certain bank is a little bit different from the majority counterparties.

In summary, the OIR will move in accordance to the OPR. As a result, the banks' BLR and deposit rates are also expected to move accordingly.

When the OPR is low, more money is released to flow into the market, and expected to stimulate the economic activities. On the other hand, when the OPR is high, more money will flow back to Bank Negara, and expected to slow down the economic activities. This is seen as a way to control the inflation rate.