A single policy rate may provide a stable signal to the money market but it might be a bit premature to give up the additional flexibility that the reverse repo gives
Regional Head of Research, India, Standard Chartered
This will not mean an abandonment of the multiple objectives approach but ensure that we do not see a repeat of 2010 in the money markets
The Reserve Bank of India (RBI) has traditionally followed an approach of multiple objectives, operating targets and instruments while designing monetary policy in India. This has generally worked well in the past. There were odd periods of volatility but they did not last long.
However, two policy challenges arose in 2010. One, transmission of monetary policy was slow, making it ineffective. Second, volatility of overnight rates made communication of the monetary policy stance difficult. To get the background right, both fiscal and monetary policy were loosened aggressively in 2008 and 2009 in response to the global financial crisis. Only from late 2009 did the RBI start withdrawing the monetary stimulus as inflationary pressures emerged.
This reversal in monetary stance initially did not have any impact on the short end of the curve. However, in June 2010 payments for the 3G spectrum auction sucked out more than Rs 1 trillion and the call rate jumped 150 basis points without any policy trigger from the RBI. Still, deposit and lending rates did not go up in tandem because there was hope that liquidity might come back to the system when the government spent its surplus cash. So, the inability to forecast government revenue expenditure patterns, uncertain banking system liquidity, volatile short-term rates and ineffective monetary policy transmission became the backdrop for instituting a committee to evaluate the operating procedure for monetary policy.
In totality the recommendations of the committee address the above issues adequately. Although the suggestion of moving to a single repo rate for signalling monetary policy stance is a crucial departure from current practice, there are equally important proposals with regard to liquidity management. The RBI’s endeavour will be to keep banking system liquidity primarily in deficit mode (one per cent of net demand and time liabilities, or NDTL) so that the repo rate is the operational rate and the call rate remains close to the repo rate. Under exceptional circumstances the RBI will be willing to absorb liquidity from the banking system at the reverse repo rate (100 basis points below the repo rate) and also inject liquidity at the bank rate, which will be 50 basis points higher than the repo rate. The width of the corridor between reverse repo and bank rate will be fixed at 150 basis points, obviating the need for the market to speculate on this issue.
The idea behind this framework is to provide a stable and less uncertain overnight rate without sacrificing the flexibility to deal with emergency liquidity situations. Also, the RBI hopes that monetary policy transmission will be more effective in a deficit liquidity mode. Its analysis shows that a change in the repo rate under deficit liquidity conditions is about three times more effective in pushing up the call rate than an equivalent change in the reverse repo rate in a surplus liquidity environment. The choice of one per cent of NDTL as a guidance for the targeted deficit in the system is driven by its finding that if the deficit moves above that threshold then the overnight rates might exceed repo rates by a significant margin, making the objective of stabilising short-term rates around the policy rate difficult to attain.
For this proposed mechanism to succeed, liquidity assessment and management will be key. Two suggestions stand out — one, government cash balances lying with the RBI can be auctioned if frictional liquidity shortage is high and, second, banks will be incentivised to mark-to-market the government securities in their held-to-maturity Statutory Liquidity Ratio portfolio. This is likely to improve banks’ participation in the RBI’s open market operations where valuation losses were suggested as one of the possible reasons for a lukewarm response from banks. Also, the RBI is considering putting out its own liquidity forecast in the public domain after fine-tuning its model. The only uncertainty seems to be how promptly the RBI will take action if the systemic liquidity is outside its target band of (+/-) one per cent of NDTL. It is important to appreciate that the single policy rate framework will not mean a complete abandonment of the overall monetary approach of multiple objectives, targets and instruments. It will just ensure that we do not see a repeat of 2010 in the money markets.
Chief Economist, Aditya Birla Group
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The quest for the holy grail of a single policy rate is admirable, but attaining it requires many other prerequisites to be met
A single policy rate to conduct monetary policy is a holy grail in the policy world. Most advanced countries are closer to this grail than India, because their money, credit and financial markets are much more integrated. Hence in those countries the monetary transmission, in normal times is predictable and swift. But even this mechanism broke down in the aftermath of Lehman’s bankruptcy, when credit markets froze, and policy action was rendered relatively impotent. The spectacle of a possible liquidity trap loomed large, and the US Federal Reserve Bank had to resort to unorthodox methods like buying non-sovereign assets from banks. Even today the danger of a liquidity trap has not receded, and more unusual tactics of the Fed are not ruled out. In India too, the RBI’s unorthodox action prevented a crisis for mutual funds in late 2008, an action possible due to policy flexibility.
The Deepak Mohanty committee was set up to review the operating procedure of monetary policy, most notably the working of the liquidity adjustment facility (LAF). The LAF came into existence in 2000 primarily as a tool to control volatility in short-term rates. Before the existence of the LAF corridor, readers may remember that inter-bank call money rates had zoomed to 120 per cent, albeit in extraordinary times. After LAF there has been more sanity. The Mohanty committee’s main recommendation are that (a) the repo rate be the only policy rate; (b) the LAF corridor width be fixed; (c ) repo loans should not exceed one per cent of Net Demand and Time Liabilities (NDTL); (d) above this limit, a higher bank rate be made operative.
The committee expects the banking system to be mostly in deficit mode. These recommendations raise the following questions. First, by giving up the flexibility of the corridor width, the use of reverse repo rate to absorb excess liquidity gets undermined. Our experience from 2007 and again in 2009 suggests that the Reserve Bank of India (RBI) needs extra tools to mop excess liquidity. Just relying on Market Stabilisation Schemes or Open Market Operations is not enough. Having flexibility on the reverse repo rate ensures that it can be made low enough occasionally to manage excess liquidity. Secondly, if the repo is to be determined by an auction, should it not vary from day to day? Ever since the beginning of LAF we have not really witnessed a genuine auction. Even if we have genuine daily auctions, how can we ensure that total demand is restricted to one per cent of NDTL (approximately Rs 50,000 crore)? If the repo is not allowed to vary, then we will have excess demand. The last few months have seen repo demand zoom all the way to nearly Rs 2 lakh crore! In such a case, how to ration? Will it be first come, first served? Or proportionate allocation based on bids? Any rationing scheme is likely to be seen as arbitrary. Thirdly, the committee’s recommendation implies a higher (penal?) rate for demand that exceeds one per cent of NDTL. It says this higher rate be 50 basis points above the repo rate and 150 basis points above the reverse repo. This (higher) bank rate would then change every time with policy changes. The fact is that the bank rate as it stands (being the refinance rate) has hardly changed in many years. The elevation of the repo’s status would mean that the bank rate would need to change frequently. Is that possible?
The quest for the holy grail of a single policy rate is admirable, but attaining it requires many other prerequisites to be met. Globalisation and integration are perhaps making it easier to use a single rate to signal monetary stance. India’s fiscal situation already reduces a lot of elbow room. But sometimes there are other anomalies too. Not too long ago the liquidity and inflation situation called for a simultaneous increase in repo and decrease in the cash reserve ratio! This awkward situation could have been prevented with proactive and stern anti-inflationary measures. But such situations certainly call for maximum instrumental flexibility. The world is moving away from inflexible paradigms like inflation targeting and single regulators. In such a scenario, it might be a bit premature to give up an additional degree of freedom that the reverse repo gives.