The Reserve Bank of India (RBI) on Tuesday released the report of the Working Group on the Operating Procedure of the Monetary Policy.
The group was set up with the objective of reviewing the current monetary policy mechanism operated by the RBI through its liquidity adjustment facility (LAF), which has two policy rates — reverse repo and repo — with the difference between the two defining the policy rate “corridor”.
In order to improve the efficiency in the transmission of monetary policy signals — ensure that the rates in the banking system move in tandem with the policy rates more swiftly — the group has made some significant recommendations for modifying the way the LAF operates.
The key recommendations on modified LAF are as follows:
1. The modified LAF should operate in a “deficit liquidity” mode and the liquidity level should be contained around (+) / (-) 1% of net demand and time liabilities (NDTL) of banks’ for optimal monetary transmission.
This implies that the RBI, under the modified LAF regime, will look to keep the banking system liquidity in a “deficit” mode on a continuous basis.
Under the current LAF, the RBI provides and absorbs liquidity at the same time. In the new regime, the RBI would maintain liquidity conditions such that banks would be borrowing from the RBI at the repo rate on a regular basis.
This will help in ensuring that any change in the repo rate is reflected in changes in bank lending and deposit rates much more swiftly and effectively. This also ties in with the introduction of the base rate methodology of bank loan pricing introduced last year, which also aimed at improving the monetary policy transmission.
2. The repo rate should be the single policy rate to signal the stance of monetary policy. It will operate within a corridor set by the bank rate and the reverse repo rate.
As the repo rate changes, the bank rate and the reverse repo rate should change automatically.
This is in line with current international practices where most central banks have only one policy rate and that helps in clearer communication of the policy stance, as against maintaining a policy rate band and allowing short-term rates to move around that band depending on the liquidity conditions in the banking system.
The approach of managing short-term money market and call money rates within a band has not been working effectively. Under conditions of excess liquidity, call money rate tends to be lower than the reverse repo rate and under conditions of tight liquidity, call money rate remains above the repo rate.
This policy rate band is therefore not operational most of the time and as a result is not as effective in guiding interest rates in line with the monetary policy stance of the RBI.
One single policy rate combined with deficit liquidity conditions would make rates in the banking system more responsive to RBI monetary policy actions, which is important in achieving the objectives of price stability and stable growth.
3. The reverse repo rate will constitute the lower bound of the corridor and the bank rate will constitute the upper bound of the corridor. The optimal width of the policy corridor should be fixed at 150 basis points and should not be changed under normal circumstances.
A defined corridor for the movement of policy rates would help curb volatility in the call money and other money market rates and help stabilise these rates.
Under the existing LAF, the corridor has ranged from 100 to 300 bps leaving room for wide volatility in rates. Depending on the inflationary pressures, growth scenario and liquidity conditions, the RBI focused on one policy rate only.
A defined corridor will also help banks’ in managing liquidity more efficiently.
4. The corridor should be asymmetric with the spread between the policy repo rate and reverse repo rate twice as much as the spread between the repo rate and the Bank Rate.
With a corridor of 150 bps, the Bank Rate could be fixed at repo rate plus 50 basis points and the reverse repo rate at repo rate minus 100 bps.
The reverse repo rate will have a negative spread on the repo rate and it will be the rate at which the RBI will absorb liquidity under the LAF.
This would ensure that the cost incurred by the RBI in mopping up excess liquidity from the banking system during conditions of surplus liquidity remains low and manageable.
Under conditions of surplus liquidity and rising policy rates, the cost of absorbing liquidity goes up every time the reverse repo rate is increased.
A lower reverse repo rate would also dissuade banks to park excess cash with the central bank on a continuous basis. The RBI’s endeavour however, would be to maintain deficit liquidity conditions in the banking system.
5. The RBI will provide liquidity at the bank rate under a new collateralised Exceptional Standing Facility (ESF) up to 1% of NDTL of banks to be carved out of the required statutory liquidity ratio (SLR) portfolio.
Such a facility has been given from time to time to banks to deal with exceptionally tight liquidity conditions. This proposed liquidity facility will now be a “standing” facility and will help banks’ to borrow funds from the RBI, at the bank rate (which will be higher than the repo rate), in conditions of acute liquidity tightness.
This measure will be particularly helpful in a preventing a persistent spike in call money rates above the repo rate and thus help keep call money rate anchored around the repo rate.
6. Persistent liquidity in excess of (+) / (-) 1% of the NDTL should be managed through other instruments such as outright open market operations (OMO), cash reserve ratio (CRR) and market stabilisation scheme (MSS).
This is a significant recommendation and will make it easier for banks to manage liquidity, as at any point in time the RBI would try and manage liquidity between (+) / (-) 1% of the NDTL.
To effectively manage liquidity however, the RBI will have to take recourse of the OMO route for injecting or taking liquidity out of the system, as there are limitations on using the CRR and MSS.
Open market purchases of government bonds by the RBI have had limited success, as banks in a rising interest rate environment are reluctant to sell their bonds kept in Held to Maturity (HTM) category, as that exposes them to mark to market losses.
In order to make these OMOs more effective, the working group has urged banks to move to mark to market accounting of their SLR bond portfolio.
7. Another significant recommendation of the working group is regarding auctioning of government’s surplus cash balances held by the RBI.
As has been the experience this fiscal year, central government’s excess cash balances with the RBI have created significant and persistent liquidity shortage in the banking system due to a lag in government spending.
Auctioning of these surplus balances for a short period of time would further help in injecting liquidity during times of tight liquidity and help in stabilizing short-term rates. This is a practice widely followed in other economies including Australia.
Overall, it appears that the modified LAF with a single policy rate, specific objective of maintaining deficit liquidity conditions and a defined liquidity management band would help in making monetary policy transmission more effective.
It would also help banks to manage liquidity more efficiently, thereby stabilising the short-term money market rates. Both these outcomes are desirable for supporting growth and controlling inflation.
The writer is senior economist, Royal Bank of Scotland NV, and can be reached at gaurav.kapur@rbs.com. Views are personal.
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