Realistic teist: Getting a grip on the new liquidity framework
The framework now has given a realistic twist to managing liquidity. If RBI feels at any time that liquidity is getting tighter, it can go in for longer tenure repos of maybe even up to one year, which is more durable than the regular 14-day term repos but less permanent than an OMO. The draft proposed liquidity management framework (LMF) of the Reserve Bank of India (RBI) is timely, and even though the basic approach has not really changed, it is significant for the market. It also does bring into focus the process of transmission of policy rates quite well and, in a way, defines better the missing link.
In fact, the LMF is quite independent from the monetary policy, which decides on what the policy rate should be. However, the LMF is critical in making the repo rate change effective without regulatory or government intervention, which is refreshing.
The focus, so far, has been to nudge or force banks to bring about transmission. This has been done by both RBI and the government by speaking to them on the necessity of lowering their lending rates, with the latest tool being fixing the lending rate on certain loans to a market benchmark that also includes the repo rate. Theoretically, the repo rate affects 1% of NDTL (net demand and time liabilities) and hence does not really add or subtract much in terms of cost for banks and, therefore, does not really get reflected significantly in either the base rate or MCLR (Marginal Cost of Funds-based Lending Rate) formula. But the liquidity framework works better through the market to ensure that the transmission takes place and the call market is the starting point. Let us see how this works out.
The call money market is an interbank market where banks lend and borrow funds on an overnight basis depending on their liquidity conditions and requirements. This rate is based purely on demand and supply conditions, and is not driven directly by RBI. Ideally, the call rate will move in a regulatory constructed corridor and be just above the repo rate as banks go to this market when the repo window is closed to them because the 1% liquidity support is exhausted. Therefore, the change in repo will affect the call rate almost immediately. The reverse repo rate acts as the other end of the corridor when there is surplus liquidity. Hence, the reverse repo and repo rates become the limits for the call money market.
RBI can influence the liquidity in the market directly to guide the call rate. Ideally, RBI would be happy to let the market decide the rates, and not deal with banks on a daily basis. However, if it is left to the market, the possibility of the call rate soaring to higher levels (it was above 20% in the 1990s) or crashing close to nil cannot be ruled out. This is more so when the market knows there is no benchmark against which the prevalent rate can be assessed. Therefore, there is a need for supports in the market like the repo rate so that there is reduction in volatility in the market.
There is now the issue of how much money can be transacted in the liquidity adjustment facility (LAF) market. The 1% norm today comprises 25 basis points in overnight repo and the balance in the term repo market. The Committee feels there should no such limit that will give more flexibility to RBI to keep liquidity stable. It is suggested that, ideally, the system should be in a deficit of 25-50bps, which will be non-distortionary. As a corollary, the market can take over beyond this level. However, assuming that such thresholds are breached on either side, RBI can bring in durable liquidity through OMOs (open market operations), which is what is done to ensure that volatility is eliminated. By not having a limit on how much can be transacted through LAF, there is more flexibility given to RBI in maintaining rates in the market.
The proposed framework now has given a realistic twist to managing liquidity. If RBI feels at any time that liquidity is getting tighter, it can go in for longer tenure repos of maybe even up to 1 year, which is more durable than the regular 14 days term repos but less permanent than an OMO. The advantage here is that by using longer-term repos to manage liquidity, the yields on securities do not get affected. Today, when there are OMOs being conducted, there are shifts in the demand and supply of securities of various tenures, which affect their prices and hence yields. This can be eschewed by using only the repos as liquidity management tools where the overnight repo without a limit is used to manage temporary mismatches while the term repos of longer duration come into the frame when it comes to durable liquidity.
OMOs would then be interpreted as a way to induce permanent liquidity as the securities are not pledged to get money but bought by RBI. The same story gets replicated for the reverse repo when there is surplus liquidity. Forex deals/swaps are supplements to OMOs in this scenario.
Intuitively, the operations in the call market have a better linkage with other interest rates and hence would tend to guide the transmission process of interest rates. Once the liquidity framework is in place and known to all, banks will be able to adjust their interest rates to the call rate as all other tenures get repriced. Hence, while the liquidity operations are distinct from monetary policy with the purpose being very different, closer alignment becomes almost immediate as the targeted rate, which is the call money rate, is linked to the repo rate through the LAF framework and the overall state of liquidity which then drives the interest rate determination process.
Besides being a market-oriented solution for rate transmission, the market requires to know this framework so as not to be caught unawares. The step-up process from overnight repos to term repos to OMOs is predictable, which will make it easier to manage funds for all the players. There will hence be better pricing of products in the market as the call rates feed into other prices of instruments that will reduce the element of noise, which will be beneficial. This approach is, therefore, definitely pragmatic.
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