Challenge of managing liquidity

One of the significant moves made by the Reserve Bank in the post-reform period was to strengthen transparency through effective communication, better disclosure of policy framework and operating procedures.

If a complex situation called for a departure from prevailing practices, the change would be made after extensive consultations with market participants, industry and trade associations. The setting up of working groups from time to time has facilitated this process.

The liquidity adjustment facility and sterilisation of excessive inflows were reviewed in 2004; the context was the difficulty in managing liquidity after the opening up of the financial sector and the consequent volatility in capital flows. This led to the birth of a new instrument of market stabilisation through MSS securities.

Since then, a combination of open market operations, cash reserve ratio along with LAF has served the system well. But the recent phenomenon of liquidity crunch created by sharp fluctuations in government cash balances gives rise to a new set of problems.

The constitution of the Mohanty working group last year to undertake a comprehensive review of operating procedures of monetary policy was timely.

The recommendations of the report, released on March 15, are worth implementing to the last word, though some teething problems in the initial stages cannot be ruled out.

The Working Group's report is a significant milestone in the journey towards streamlining the operating procedures of monetary policy.

The repo rate should be the single signal policy rate and all other rates should align automatically with the repo rate; this will provide some certainty to market expectations.

STREAMLINE POLICY RATE

Transparency will be enhanced because of well-defined boundaries for the money market corridor and the use of the weighted overnight call money rate as the target for operations. Nobody can then complain that there is no firm anchor for monetary operations of the central bank.

The revival of the Bank Rate, assigning it a specific and respectable role, also improves flexibility in liquidity management operations, especially when the system is in liquidity deficit mode. It is an innovative step to use one percentage point of SLR ‘to enhance the liquidity attribute of the SLR portfolio without compromising its prudential nature'.

The standing facility at the Bank Rate above the repo rate would relieve the system from stress when the liquidity position of banks is otherwise sound.

The LAF should operate on a deficit mode to the extent possible. In any case it should not operate beyond the limit of one percentage point, plus or minus, of net demand and time liabilities of the banking system; that will legitimise LAF as purely an equilibrating mechanism under normal conditions, without overburdening it with excessive injection or absorption of liquidity.

SOME GAPS

Without undermining the value-addition by the Working Group, it is also important to take note of unaddressed concerns. First, the Group could have laid down implementation deadlines. Second, the Group could have re-examined the role of cash reserve ratio, since the policy seems to have taken a U-turn in the past few years. It remains a significant tax, particularly on rural banks and small banks with limited profitability. It is another matter that the Working Group's terms of reference did not include such a review.

Third, it could have taken into account the possibility of teething problems in implementation and alternative ways of handling different scenarios.

Fourth, the way in which LAF operates at present makes the operation very passive. Repo itself can be viewed as part of open market operations, and in a combined way the RBI can attempt to peg the weighted average overnight call money rate, the target rate, within the corridor. Repo operations by RBI should be through dealing rooms, as in the case of forex operations. Such operations will incentivise banks to operate more on the term money market.

MODIFY BANK RATE

The forthcoming annual policy should come out with concrete proposals for implementation. In the meantime, some leads can be taken. The Bank Rate can be reset as per the defining corridor, since the band between repo and reverse repo rates already fulfils the requirement of the WG.

The standing facility at the revised Bank Rate can also be announced, since banks are already being exempted from time to time from the requirement of SLR to the extent of one percentage point.

Rough calculations show that 1 per cent of NDTL currently is around Rs. 45,000 crore. Ever since October 2010, the liquidity injection at the LAF window is far in excess of this limit. The introduction of the standing facility may help in shifting a part of this to the new facility.

(The author is Director, EPW Research Foundation. The views are personal. blfeedback@thehindu.co.in )