Aworking group set up by the Reserve Bank of India (RBI) has recommended important changes to the way monetary policy is conducted. The key to monetary policy is that changes in the policy rate should be immediately transmitted to bank lending rates. This can best be done when liquidity is scarce. Hence, the committee’s key recommendation is that RBI should keep the money markets in a deficit liquidity situation, with a deficit of around 1% of bank deposits. This will force the banks to borrow from RBI at the repo rate, ensuring that it becomes the single policy rate.
RBI’s policy rate has fluctuated between the repo rate in times of scarce liquidity and the reverse repo rate, or the rate at which banks park their overnight surpluses with RBI, under conditions of excess liquidity. This has led to uncertainty, which has been exacerbated because the gap between the two rates has fluctuated. The committee now recommends the gap between the repo and reverse repo rates be kept constant at 100 basis points—the reverse repo rate will move automatically with changes in the repo rate. The committee also says the now moribund bank rate should be revived, as the rate under an exceptional facility at which RBI lends to banks that do not have the excess government securities over and above the statutory requirements to offer as collateral to avail of repo borrowing. This bank rate is proposed to be fixed at 50 basis points above the repo rate, which means the gap between the upper and lower bounds of the corridor will be fixed at 150 basis points. Liquidity will be managed through open market operations, or RBI’s buying and selling bonds. Another important suggestion is to auction off the government’s unutilized cash balances with RBI—this will infuse liquidity at a time when it is very scarce.
In short, the committee’s recommendations are aimed at improving transparency and reducing uncertainty. The challenge will be to implement them, in particular the key recommendation of keeping the money markets always in a deficit mode.
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