Liquidity management tool: RBI may have to balance old norms with the new

There shouldn't be room for interpretation in new framework, say experts

The Reserve Bank of India’s (RBI's) internal committee on liquidity management framework may have to choose between traditional and radically new ideas while upgrading the way the present framework works, say experts.

The present framework says that liquidity should be determined based on a single rate approach, which is currently the policy repo rate. 

The indication of liquidity would be weighted average call money rate, or the overnight rate that banks use to lend and borrow among themselves. 

The approach is that the weighted average call money rate must ‘hug’ the policy repo rate. The present approach also says that liquidity should ideally be in deficit mode.

The problem is that under Urjit Patel, the central bank refused to acknowledge there was a liquidity problem, as it saw the weighted average call money rates remaining below the repo rate.

It mainly happened because banking system liquidity was highly skewed, with larger banks being in surplus mode, while the smaller ones struggled for immediate money. 

But the larger banks, sitting on a huge surplus of liquidity, did not let the call money rates reflect the reality of the smaller banks, say experts.

The traditional approach has been that the call rates can move between the corridor of reverse repo rate and repo rate. The operative policy rate used to become the reverse repo rate when in times of liquidity surplus, and repo rate at the time of deficit.

Reverse repo is the rate at which banks put their money with the central bank and repo is the one paid by the banks to borrow money from the RBI. The central bank was fine as long as liquidity in the system supported the call rates to move in the corridor. 

When it consistently breached the upper band, the central bank infused durable liquidity and vice versa.

“I won’t be surprised if the central bank introduces some kind of corridor approach,” said Ramkamal Samanta, head of debt and fund manager at Star Union Dai-ichi Life.

The aim of the framework is to put the central bank and market participants on the same page in terms of interpretation of liquidity.

The RBI said the aim would be to “clearly communicate the objectives, quantitative measures and toolkit of liquidity management by the Reserve Bank.”

According to Soumyajit Niyogi, associate director of India Ratings and Research, communication itself has become a liquidity tool.

Experts say the new framework must be grounded in reality and not based on theoretical concepts. There should not be much of a room for interpretation.

For example, depending on the banking system liquidity being in surplus, neutral, or deficit mode, it should be reflected in the stance, which should be accommodative, neutral, or tightening respectively, according to Ananth Narayan, associate professor, SP Jain Institute of Management and Research. 

This would mean that the historical measure of the weighted average call rate should be replaced by a quantity target on banking liquidity.

“There should be review and guidance around what instrument should be used for achieving liquidity objectives under what circumstances, with minimal and acceptable side effects. Each of the instruments at the disposal of the RBI to manage liquidity – such as CRR (cash reserve ratio), repo, OMO (open market operations), foreign exchange spot operations and forex forward – impacts one or more markets,” Narayan said.

Traditionally, the RBI has been using the OMO route, or buying or selling bonds from the secondary market to infuse or remove durable liquidity from the system. But from March this year, the central bank introduced another tool – foreign exchange swaps.

The central bank has so far swapped $10 billion with banks, infusing about Rs 70,000 crore of durable liquidity into the system. But this mode of liquidity crashed the forward rate.

The market participants, therefore, want the framework to spell out in clear terms what could be the acceptable impact to other instruments in the market if such liquidity tools are used.

“Actually, no new tool is needed. But the communication around the usage of existing tools should be clear,” Niyogi said.