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RBI Working Group on Monetary Policy recommends a single policy rate with a
"deficit" liquidity regime
The Reserve Bank of India (RBI) has released the report of the Working Group on the
Operating Procedure of the Monetary Policy. The Group was set up to review the current
monetary policy mechanism operated by the RBI through its Liquidity Adjustment Facility
(LAF) with two policy rates – revrse repo and repo rates, with the difference in the policy
rates defining the policy rate “corridor”.
To improve the efficiency in the transmission of monetary policy signals, ie, ensure that the
rates in the banking system move in tandem with the policy rates, the group has made some
significant recommendations for modifying the way the LAF operates.
The key recommendations on modified LAF are:
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. In other words, banks’ would be borrowing
from the RBI at the repo rate on a regular basis. This will ensure that any change in the repo
rate is reflected in changes in bank lending and deposit rates much more swiftly. This ties in
with the introduction of the base rate methodology of loan pricing introduced last year.
2. The repo rate should be the single policy rate to unambiguously 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 international practice 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 move around the band depending on liquidity
conditions. In 2010, it was very clear that the approach of managing short-term money
market and call money rates within a band was not working effectively. As 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 remains above the repo rate. That has reduced the
effectiveness of the policy rate band for signalling the monetary policy stance of the RBI.
However, to maintain a single policy rate to make the monetary transmission more efficient,
the RBI will have to ensure deficit liquidity in the banking system.
3. The reverse repo rate will constitute the lower bound of the corridor and the bank
rate will constitute the upper. The optimal width of the policy corridor will be fixed at
150bp and should not be changed in normal circumstances.
A defined corridor for the movement of policy rates would help curb volatility in call money and
other money market rates. Under the existing LAF, the corridor has ranged from 100 to 300bp, as
the RBI did not define a corridor and depending on the inflationary and liquidity conditions, the
RBI focused on one policy rate. This was particularly so in 2008, when inflation touched double
digits on the back of strong demand conditions and the RBI raised the repo rate consistently to
signal its monetary policy stance along with maintaining tight liquidity conditions by raising the
CRR.
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 150bp, the bank rate could be fixed at repo rate plus 50bp and the
reverse repo rate at repo rate minus 100bp. 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 manageable and to dissuade banks
from parking funds with the RBI. However, the RBI’s endeavour 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 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. This measure will be
particularly helpful in preventing a persistent spike in call money rates above the repo rate and
thus help keep the 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 to
inject or take liquidity out of the system. 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 the held-to-maturity (HTM) category, as that exposes them to mark-to-market
losses. To make these OMOs more effective, the working group is urging banks to move to mark
to market of their SLR bond portfolio.
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 year, the central
government’s excess cash balances have created significant and persistent liquidity shortages in
the system due to a lag in government spending and large cash balances building up as a result
with the RBI. Auctioning of these surplus balances for a short period of time would further help in
injecting liquidity during tight liquidity conditions and help in stabilizing short-term rates.
Overall it appears that the modified LAF with a single policy rate with a specific objective of
maintaining deficit liquidity conditions and a defined liquidity band would help in making monetary
policy more effective. The modified LAF would also help banks to manage liquidity in a much
better manner, thereby stabilising short-term rates.
