efficient instruments to manage their balance sheet mismatches, such as precautionary funds in the form of excess reserves at the Central Bank and buy-and-hold investments in long-term debt. This worsens price formation across all the maturity spectrum of the yield curve. It is also the source of multiple inefficiencies in the other segments of debt markets, including the lack of secondary market trading and near captive demand for domestic debt because of lack of other investment alternatives.

**Relatively high reserve requirements, remunerated or unremunerated, are used in all MENA countries as a first recourse to absorb excess structural liquidity.** As it is widely acknowledged, the main drawback of this instrument is its cost on banks and the fact that it generally feeds into higher intermediation spreads. However, in the context of high sterilization needs it is a critical instrument that complements other tools such as auctioned bills or time deposits that are shorter term and bear a higher cost. Also, in the context of most MENA banking sectors, with low credit to deposit ratios, the opportunity cost of higher reserve requirements may be outweighed by the gains of more effective and less costly sterilization, and hence more efficient financial markets. For example, with higher reserve requirements the Central Bank would have to issue lower amounts of remunerated bills or time deposits or may even use repos to regulate liquidity. This would generally reduce interference with the Government’s issuance policy. Depending on the country, further analysis may be relevant to assess the benefits of higher reserve requirements for sterilization purposes.

**Excess structural liquidity is not sterilized fully and on a timely basis because of inaccurate forecasting of autonomous factors**<sup>**19**</sup> **and high costs related to the use of remunerated Central Bank debt or deposits.** MENA-5 countries are in the process of improving their liquidity forecasting capacity with Morocco taking the lead followed by Egypt and Tunisia. However, this is a long process involving complex institutional changes across all Government spending units, as well as capacity building at Central Banks.

**The choice of sterilization instruments, aside from reserve requirements, mainly based on short-term auctioned deposits and overnight “standing facilities”, is inadequate to support effective liquidity draining therefore hinders market efficiency.** These instruments are used in advanced economies for fine tuning operations or when forecasting errors are smaller 20. By using them to sterilize the bulk of structural excess liquidity, Central Banks in MENA countries face rolling over large volumes of liabilities in very short term maturities (e.g. seven day and overnight deposits, Table 3). This makes liquidity management more complex for both Central Banks and market participants and supports a _“de facto”_ accommodative monetary policy. Morocco is an

> 19 Government’s balances at the Central Bank and foreign exchange flows.

> 20 The choice of sterilization instruments should depend on the nature of excess liquidity to ensure effectiveness and minimum market disruptions: regular operations for changes in autonomous factors, fine tuning operations for unanticipated changes in forecasted liquidity, and standing facilities for the smaller forecasting errors after fine tuning operations (See in FSAP for Tunisia (2008) for further details on the operational framework for sterilization that applies to all MENA countries).

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