Introduction to Liquidity Management
The Reserve Bank of India (RBI) has released a report by the Internal Working Group (IWG) to review the liquidity management framework. Liquidity management operations are crucial for monetary policy, and it’s essential to have a robust framework in place. The report suggests several changes to improve the existing framework.
Discontinuation of 14-Day Variable Rate Repo/Reverse Repo
The IWG report recommends discontinuing the 14-day variable rate repo/reverse repo (VRR/VRRR) as the main operation. Banks are hesitant to park surplus liquidity for this duration, and it’s challenging to make precise liquidity forecasts for 14 days. The report suggests conducting the main operation at a weekly interval, combined with fine-tuning operations of varying tenors as needed. This change should help smooth out liquidity management.
Retention of Weighted Average Call Rate (WACR)
The IWG recommends retaining the weighted average call rate (WACR) as the operating target. However, a reduction in activity in the overnight call money segment raises concerns, as it decreases the central bank’s control over short-term interest rates. The width of the corridor is a trade-off between volatility in short-term interest rates and activity in the overnight inter-bank market. A narrower corridor can lead to reduced volatility but also lower inter-bank activity.
Balancing Corridor Width and Inter-Bank Activity
The IWG report notes that the narrowing of the corridor coincided with a declining share of call money in the total overnight money market volume. It’s essential to strike a balance between the two. The current corridor width of 50 bps is narrower than many emerging economy central banks. A detailed empirical investigation is necessary to weigh the pros and cons of continuing with the current width.
Minimum Reserve Requirement and Averaging
In a corridor system, the minimum reserve requirement and averaging help stabilize interest rates in the call money market. However, this mechanism has almost ceased toreminder operate in India. Banks rarely maintain daily reserve balances below 95% of the prescribed cash reserve ratio, making a strong case for lowering the daily minimum reserve requirement. This would give banks enough room to arbitrage, stabilizing short-term interest rates and limiting the need for fine-tuning operations.
Participation of Standalone Primary Dealers (SPDs)
The IWG has rejected the demand to provide access to the marginal standing facility (MSF) to standalone primary dealers (SPDs). However, their participation in the call money market should be reviewed urgently. SPD operations in the call money market impart considerable volatility to call rates. They should be gradually phased out from the call money market, and other borrowing and lending facilities could be provided to them for their smooth operations.
Challenges in Achieving Operating Target
Large structural surplus liquidity in a corridor system can make it challenging to achieve the operating target. The WACR has often deviated from the policy rate and has hovered close to the lower/upper bound of the target. It’s essential to ensure that liquidity provided is in consonance with the monetary policy stance and does not impinge on the operating target.
Importance of Effective Liquidity Management
The central bank needs to have a tight control over the operating target for monetary policy impulses to transmit smoothly across the interest rate spectrum and asset classes. It’s crucial to examine the key issues that have impacted the efficacy of the liquidity management framework and address them suitably in the revised framework.
Conclusion
In conclusion, the IWG report provides valuable recommendations to improve the liquidity management framework. It’s essential to strike a balance between corridor width and inter-bank activity, lower the daily minimum reserve requirement, and phase out SPDs from the call money market. By addressing these issues, the RBI can develop a more effective liquidity management framework, ensuring smooth monetary policy transmission and maintaining financial stability.
