The Reserve Bank of India (RBI) released the Internal Working Group (IWG) report to review the liquidity management framework. This step aims to strengthen the monetary policy operations amid evolving market dynamics. The report recommends key changes to improve liquidity forecasting and control short-term interest rates effectively.
Discontinuation of 14-Day Variable Rate Repo
The IWG suggests ending the 14-day variable rate repo/reverse repo as the main liquidity operation. Banks prefer shorter durations due to difficulties in forecasting liquidity over 14 days. Government cash balances and currency movements add volatility, making longer operations less effective. Weekly main operations combined with fine-tuning of varying tenors are proposed to smooth liquidity management.
Weighted Average Call Rate as Operating Target
The report supports retaining the weighted average call rate (WACR) as the operating target. However, declining activity in the overnight call money market, where WACR is derived, concerns the central bank’s control over short-term rates. This decline relates to the narrow corridor width between the repo and reverse repo rates, which reduces inter-bank activity but lowers volatility. A balance is needed between rate stability and market activity.
Role of Corridor Width and Reserve Requirements
The corridor system’s narrow width (50 basis points) is unusual among emerging economies. It encourages banks to deal with the RBI rather than with each other. Minimum reserve requirements and averaging help stabilise interest rates by allowing banks to time their borrowings. Yet, banks maintain daily reserve balances above the minimum, reducing this stabilising effect. Lowering the daily reserve requirement could increase market activity and reduce volatility.
Impact of Standalone Primary Dealers
Standalone primary dealers (SPDs) influence call money market volatility. They borrow heavily but lack access to the marginal standing facility (MSF), causing pressure on call rates and breaches of the corridor bounds. The IWG rejects MSF access for SPDs but recommends phasing out their call money market participation gradually. Alternative borrowing and lending facilities should support their role in government securities markets.
Challenges of Surplus Liquidity and Operating Target Alignment
Large structural surplus liquidity complicates achieving the operating target in the corridor system. The WACR often deviates from the policy rate and sometimes breaches corridor limits. Such misalignment creates uncertainty and weakens monetary transmission. Effective liquidity management must ensure close alignment between the operating target and policy rate for smooth transmission across markets.
Need for Empirical Analysis and Framework Revision
The IWG report marks the need for detailed empirical studies on corridor width and reserve requirements. A revised liquidity management framework should address these issues to enhance control over short-term interest rates and improve monetary policy effectiveness.
Questions for UPSC:
- Point out the challenges faced by central banks in managing liquidity under a corridor system and estimate their impact on monetary policy transmission.
- Underline the role of reserve requirements in stabilising short-term interest rates and critically analyse their effectiveness in emerging economies with examples.
- What is the significance of the weighted average call rate (WACR) in India’s monetary policy? How does the activity in the overnight call money market affect its reliability as an operating target?
- Critically analyse the impact of standalone primary dealers on the call money market liquidity and suggest alternative mechanisms to support their operations in government securities markets.
