By Janak Raj, Senior Fellow, Centre for Social and Economic Progress (CSEP)
The Reserve Bank of India (RBI) recently released the Report of the Internal Working Group (IWG) to Review the Liquidity Management Framework. Liquidity management operations are the nuts and bolts of monetary policy and, therefore, it is important that the framework is robust.
The report rightly suggests the discontinuation of a 14-day variable rate repo/reverse repo (VRR/VRRR) as the main operation. Banks, as the IWG report observes, are reluctant to park surplus liquidity for this duration. In addition, it is hard to make a precise liquidity forecast for 14 days as government cash balances maintained with the RBI are intrinsically volatile. Currency movements are unpredictable too, though they have predictable seasonal patterns. The main operation conducted at a weekly interval instead of 14 days, combined with the fine-tuning operations of varying tenors as and when needed as recommended by the IWG, should help smooth liquidity management.
The IWG’s recommendation on the retention of the weighted average call rate (WACR) as the operating target is also appropriate. However, a reduction in the activity for the overnight call money segment, from where the WACR emerges, raises concern, as this decreases the central bank’s control over short-term interest rates.
Why has activity in the call money market declined? The width of the corridor is essentially a trade-off between volatility in short-term interest rates and activity in the overnight inter-bank market. The narrower the corridor, the greater the possibility of banks dealing with the central bank than among themselves. In other words, the reduced volatility in short-term interest rates is at the expense of lower inter-bank activity. The IWG report observes that the narrowing of the corridor coincided with the declining share of call money in the total overnight money market volume. Thus, a proper balance needs to be struck between the two. Significantly, not many emerging economy central banks have such a narrow corridor width (50 bps). Therefore, it would have been ideal if the IWG conducted a detailed empirical investigation of this critical issue and weighed the pros and cons of continuing with the current width of the corridor.
In a corridor system, the minimum reserve requirement and the averaging help stabilise interest rates in the call money market through smoothing inter-temporal shocks to autonomous factors such as government cash balances and currency. For instance, banks can defer borrowings when interest rates in the call money market are high till later in the maintenance period. Likewise, they can advance their borrowings early in the maintenance period, when call rates are low. Thus, averaging is an effective instrument for diminishing the volatility of short-term interest rates. However, it seems that this mechanism has almost ceased to operate in India. This is also corroborated by an observation in the IWG report—banks rarely maintain daily reserve balances below 95% of the prescribed cash reserve ratio as against the requirement of 90%. This makes a strong case for lowering the daily minimum reserve requirement so that banks have enough room to arbitrage. This will not only help stabilise short-term interest rates but also limit the need for fine-tuning operations. What should be the minimum daily reserve requirement? It is again a matter of detailed examination.
The IWG has aptly rejected the demand to provide access of the marginal standing facility (MSF) to standalone primary dealers (SPDs). However, their participation in the call money market should be reviewed urgently. SPD operations in the call money market impart considerable volatility to call rates. There have been numerous instances when borrowings by SPDs have exerted significant pressure on call rates, pushing them at times above the upper bound of the corridor. This is not surprising as SPDs, according to the IWG report, constitute three-fourths of the total borrowing from the call money market. Therefore, in tight liquidity conditions, there is always a risk of the upper bound of the corridor being breached, especially because they do not have access to the MSF. Likewise, in the face of large surplus liquidity, there is also a risk of the lower bound of the corridor getting violated in the absence of an access to the SDF, though this risk is less serious as the limit to lend by SPDs in the call money market is far lower than the one on borrowing. Since operations of SPDs in the call money market hamper effective control over the operating target, they must be gradually phased out from the call money market. As SPDs play an important role in the government securities market, other appropriate borrowing and lending facilities could be provided to them for their smooth operations.
Large structural surplus liquidity in a corridor system also makes it challenging to achieve the operating target. Even in a floor system, central banks have struggled to have a tight control over the operating target, though in theory any amount of surplus liquidity under it is consistent with an effective control over the operating target. Therefore, while liquidity provided needs to be in consonance with the the monetary policy’s stance, it should be ensured that it does not impinge on the operating target.
The WACR in recent years has often significantly deviated from the policy rate and on several occasions, it has hovered close to the lower/upper bound of the target. At times, the WACR has even breached the lower and upper bounds of the corridor. An ultimate test of the effectiveness of the liquidity management framework is whether it is able to align the operating target with the policy rate. If call rates are not aligned with the operating target, it creates uncertainty among market participants, thereby hampering monetary transmission.
The central bank needs to have a tight control over the operating target for monetary policy impulses to transmit smoothly across the interest rate spectrum and asset classes. It is, therefore, important to examine some of the key issues which have impacted the efficacy of the liquidity management framework and address them suitably in the revised framework.