In India, the paradox of monetary policy is that when the central bank changes its policy interest rates, it generally does not result in a corresponding change in bank lending interest rates. Last month, the Reserve Bank of India (RBI) set up a panel to review its existing monetary policy operating procedures.
India’s central bank currently operates a liquidity adjustment facility (LAF). Under it, the overnight repo rate is the one at which banks borrow from the central bank for one day, while the overnight reverse repo rate is the rate at which banks lend to the central bank for one day. This system is, in some ways, well suited for managing daily mismatches between a bank’s cash inflows and cash outflows: It can help banks tide over daily liquidity deficit or surplus situations. But that’s not how the financial system works in developed countries.
Major central banks such as the European Central Bank, the US Federal Reserve, the Bank of Japan and even most members of the South East Asian Central Banks are similar in their attempt to achieve a structural liquidity deficit at most times—unlike in India, where banks actually hold surplus cash often. As a result, the banking system in the euro zone or the US is generally required to borrow from the central bank. As the central bank becomes the monopolist supplier of liquidity, this state of structural liquidity deficit ensures that the policy interest rate becomes the marginal cost of funds.
RBI needs its policy rate to matter for banks’ funding. If India is to make its policy transmission as effective as, say, the euro zone’s, it may follow a six-point approach:
First, the cash reserve ratio (CRR) should be retooled. Generally, a bank is required to set aside a portion of its deposits (with a few exclusions) to meet CRR (currently Rs.6 for Rs100 of deposits). But the bank’s borrowings from the central bank are not counted as deposits. This borrowing is at the heart of the money creation process and important for setting the price of money—the interest rate. That’s why CRR must target these borrowings.
Here, it must be recognized that banks need to maintain cash balances with RBI for their daily interbank settlement needs. Only when CRR is higher than the level of balances required by banks for their interbank settlement needs, will banks be sensitive to the rate at which it can borrow from the central bank. Then this borrowing interest rate would determine the marginal cost of funding for the bank. This approach, called borrowed reserves targeting, would mean that one unambiguous main policy interest rate would suffice.
Second, RBI’s main policy rate should be the minimum bid interest rate for a 14-day repo held every fortnight, prior to the beginning of a banking fortnight. Currently, our overnight money market rates vary significantly within a banking fortnight: This is essentially the time period over which CRR needs to be maintained on an average daily basis. The tenor of a fortnight for the policy rate will bring more clarity to funds management by banks, which seek to meet their CRR partly by borrowing from the central bank. Banks could bid for the interest rates at which they are willing to borrow from the central bank. The minimum bid rate acceptable to the central bank would be pre-announced, with the bank bidding the highest winning.
Third, RBI should offer a three-month refinancing operation. The central bank would be a price taker in such an auction (i.e. no minimum or maximum bid levels would be pre-announced). The objective of this is to provide liquidity to the three-month money market, currently non-existent in India. But the objective is not to set the price—interest rate—of three-month money. With a three-month interest rate discovered in the auction, it will be possible to develop a three-month floating rate interbank benchmark, on which bonds, loans and derivatives can be based.
Fourth, a standing facility such as LAF should be meant for addressing only temporary daily mismatches. Its width—the “corridor” between the repo and reverse repo rate—could continue to be 1 percentage point: the repo rate at, say, 0.5 percentage point above the minimum bid rate for 14-day repo operations and the reverse repo rate at, say, 0.5 percentage point below that same minimum bid rate.
Fifth, currently only government securities are eligible as collateral for repo operations. If RBI included highly rated non-government bonds as collateral, it would bring liquidity and, hence, improve transmission for non-sovereign interest rates, too.
Sixth, RBI is a banker to the government. The cash balances the government maintains with RBI keeps fluctuating—with, say, advance tax collections or higher government expenditures—affecting interbank liquidity. If RBI arranges to sweep in balances from its account directly to commercial banks, it can help address seasonal liquidity squeezes.
Any alternative to the above six-point approach should at least address the link between the policy interest rate and cost of funding; it should develop a floating rate benchmark; and enable the liquidity of non-sovereign instruments. Else, monetary policy operating procedures in India will remain wanting.
Aniruddha Godbole is an adviser with AV Rajwade & Co. Pvt. Ltd, a risk management consulting firm.
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