The Working Group on Operating Procedure of Monetary Policy constituted by the Reserve Bank of India last October, in pursuance of the First Quarter Review of Monetary Policy for 2010-11 announced in July, submitted its report a fortnight ago.

The members of the working group were drawn from financial markets, academia and the RBI. In line with the terms of reference, the working group has submitted its recommendations to the RBI. At the outset, it may be said that the report is well drafted, with keen academic insights. The underlying technical works presented in the Appendix to support the recommendations is a praiseworthy effort.

The core recommendations are:

The repo rate should be the policy rate, and should operate within a corridor defined 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;

the bank rate should be reactivated as a discount rate, as envisaged in the Reserve Bank of India Act, 1934 and it will be the rate at which the Reserve Bank will provide liquidity under a new collateralised Exceptional Standing Facility (ESF) up to one per cent of NDTL (net demand and time liabilities) carved out of the statutory liquidity ratio (SLR) portfolio of banks;

the bank rate will constitute the upper bound of the corridor;

the reverse repo rate will have a negative spread on the repo rate and will be the rate at which the Reserve Bank will absorb liquidity under the LAF (Liquidity Adjustment Facility);

the reverse repo rate will constitute the lower bound of the corridor;

the optimal width of the policy corridor should be fixed at 150 basis points and should remain unchanged in the normal circumstances;

with a corridor of 150 basis points, the Bank Rate should be fixed at repo rate plus 50 basis points and the reverse repo rate at repo rate minus 100 basis points;

the weighted average overnight call money rate should be the operating target of the Reserve Bank. The operating objective should be to contain this rate around the repo rate within the corridor;

banks should be incentivised to progressively mark-to-market their SLR portfolio to fine-tune open market operations (OMO) as an instrument of liquidity management; and

introduce, in consultation with the Government, the auction of government surplus cash balance at the discretion of the Reserve Bank.

In theory only, or pragmatic?

The recommendations, by and large, are not disruptive from the market point of view, as the width of corridor between the repo rate and reverse repo rate is currently maintained at 100 basis points. There are, however, some apprehensions that keeping the repo rate as policy rate with bank rate as upper bound and reverse repo rate as lower bound may appear theoretically sound but the implementation may be difficult, particularly in a surplus liquidity mode, given market participants' hesitancy towards pricing securities for open market operations (OMO). Thus, the conduct of OMO remains a challenge for the RBI. The working group suggests incentivising banks to mark to market their SLR portfolio to fine-tune OMO. It, however, has not specified any incentive scheme, leaving that to the RBI.

The system inter alia will enter into a large surplus mode if capital inflows exceed the volume required for monetary and liquidity management consistent with the money supply, deposit and credit growth assumed at the announcement of monetary policy. The working group recommends the use of other instruments such asCash Reserve Ratio (CRR) and Market Stabilisation Scheme (MSS) as the case may be. Thus, the recommendation of repo rate as policy rate, with bank rate and reverse repo rate as upper bound and lower bound, respectively, is pragmatic and not theoretical.

Problem of surplus cash

It must be noted that the RBI faces deficit liquidity mode mainly due to surplus cash balance by the Government. The group suggests publishing cash surplus data and auctioning government surplus cash balance at the discretion of the Reserve Bank and in consultation with the Government. This recommendation should be seen in conjunction with the present institutional arrangement for the Government's cash and debt management. The Committee on cash and debt management should consider this recommendation at the earliest.

A large and persistent cash surplus not only indicates inefficient cash management by the Government but also brings pressure on monetary, liquidity and debt management. The RBI should discourage the Central and State Government's from maintaining large surplus for longer duration. The State governments may be discouraged first, as these surpluses create cash management trouble at the Centre. Similar to the Ways and Means Advance (WMA) scheme, there should be a scheme for surplus maintenance. The group recommends price discovery for surplus cash balance.

It, however, does not suggest that the Government should discourage surplus cash at the cost of prudent fiscal management, efficient debt management and effective monetary and liquidity management.

Now, the cash and debt management committee should play a proactive role in the implementation of the recommendations and in addressing the origin of surplus cash. Otherwise, fiscal inefficiency in the form of a large cash surplus will make liquidity and monetary management difficult, notwithstanding the credible and pragmatic recommendations of the group.

(The author is Professor of Economics, K. J. Somaiya Institute of Management Studies and Research, Mumbai.)

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