The expected rate hikes apart, Reserve Bank of India’s (RBI) first six-weekly monetary policy review carries an underlying message of macroeconomic significance and operational relevance: convergence in the policy rate spectrum. There are two ways to look at this. First, the interest rate corridor (the spread between the repo rate, or rate at which RBI infuses liquidity, and the reverse repo rate, or the rate at which it drains out liquidity) is now reduced to 100 basis points—less than half of what it was a year ago and one-third of what it was two years ago.
This indicates a reduced level of systemic uncertainty, and the central bank’s growing confidence in the economic situation as well as its ability to manage monetary policy and liquidity. Second is the convergence of the repo rate with the defunct base rate. For the first time since 2002, the two are the same. In this sense, it could be the beginning of a new phase in monetary policy management.
The focus now has to be on improving the transmission of interest rate signals from RBI to the financial sector. One factor that weakens the transmission mechanism is the plethora of rates: There are the policy rates, the market rates, the regulated rates and some anachronistic administered rates. With so many rate categories and rates within each category, the result is a fragmented money and debt market. This forms a barrier to smooth and quick transmission of monetary policy signals.
By introducing a new pricing regime for the base rate, RBI has nudged the system such that the range of rates has come down across the banking sector. A similar initiative now needs to be taken for the whole gamut of existent policy, regulated and administered rates.
It might be worthwhile here to look at the possibility and implications of having one policy rate rather than two. The dual policy rate system—repo and reverse repo—was introduced in 2000 as a part of the liquidity adjustment facility.
The two-rate system has a policy rationale in economies where the central bank sets an interest rate target. For instance, in the US, when the actual Federal funds rate is higher than the target, the money supply is usually increased through a repo. When the actual Fed funds rate is less than the target, the money supply is decreased through a reverse repo.
With no such explicit targeting, it is illogical to continue with two rates, let alone three: bank rate, repo rate and reverse repo rate.
In an earlier era, the bank rate was used to signal interest rate changes over the medium and long terms, while the repo and reverse repo were the short-term rate tools.
Since then the repo has dislodged the bank rate as an indicative rate. Earlier, changes in repo rate followed shifts in the bank rate, but in recent times, the repo has moved without any reference to the latter. In fact, the bank rate has remained unchanged since April 2003.
This means the policy rate—the repo, for instance—has also become the rate at which commercial operations are transacted.
The logic that during surplus liquidity conditions it is the reverse repo and during tight liquidity situations it is the repo that is the effective policy rate doesn’t hold much analytical merit. It not only presumes the lack of effective monetary policy measures and/or tools to allow such wide variations in liquidity conditions, but also makes the central bank hold commercial, as distinct from statutory, deposits of banks.
By moving to a single policy rate, and not using it to lend or borrow, RBI will strengthen the system structurally; the inter-bank market, once RBI abandons its dual policy rates, will become deeper, wider and more competitive. This will hold the key to the smooth transmission of rates across the system.
If RBI feels an interim arrangement is required on the road to a single policy, a special deposit facility can be introduced. This facility, with a sunset clause, should yield less than the policy rate.
This could be in the nature of an uncollateralized standing facility. There will be limited chances of misusing this for the kind of lazy banking that we have seen (placing large amounts of funds with RBI, thereby dampening lending activities). Under the new system, there would be an incentive for market participants to deploy resources first in the market on account of the higher returns, and come to RBI only when they would not be in a position to deploy funds around the policy rate.
In the case of tight liquidity conditions, the special deposit facility will not be used; no bank will place funds in this facility during times of monetary tightness.
In the interim, the special deposit facility rate could provide a firm floor to the behaviour of call rates, while the policy rate would continue to provide the signalling stance from RBI and also bear linkages to certain specific operations such as credit reserve ratio/standard liquidity ratio defaults and the general line of credit to National Bank for Agriculture and Rural Development.
Haseeb A. Drabu is former chairman and chief executive of Jammu and Kashmir Bank. He writes on monetary and macroeconomic matters from the perspective of policy and practice. Comment at email@example.com
To read Haseeb A. Drabu’s previous articles, go to www.livemint.com/methodandmanner