RBI Signals Surplus Liquidity Only If Financial Conditions Warrant

The Reserve Bank of India has released its new liquidity framework, signalling an easier liquidity stance but only if financial conditions warrant.

The framework comes at a time when government borrowings from the market are expected to remain high and bond yields are elevated. Against this backdrop, the central bank’s signal of permitting easy liquidity is likely to come as a small relief to the markets. The central bank has, however, stayed away from a wider review of its approach towards liquidity, which some in the markets were hoping for.

As per the new framework:

• The call money rate will remain the target rate.
• While the corridor system would normally require the system liquidity to be in a small deficit, if financial conditions warrant a situation of liquidity surplus, the framework should be adaptable.
• The current provision of assured liquidity—up to 1 percent of net demand and time liabilities—is no longer necessary since the proposed liquidity framework would entirely meet the system’s liquidity needs.
• The liquidity framework should entirely meet the liquidity needs of the system. Consequently, a separate provision of assured liquidity is no longer necessary, the RBI said.
• There should be ideally one single overnight variable rate operation in a day.
• Build-up of a large deficit or surplus, if expected to persist, should be offset through open market operations, forex swaps, long-term repo operations at market rates.

The review had been initiated due to concerns raised over the conflict between the central bank’s liquidity framework and its monetary policy stance. This, according to market participants, was preventing complete transmission of policy rate changes, particularly via the bond markets.

In particular, market participants argued that interest rate cuts and an accommodative monetary policy stance must go together with surplus liquidity. In contrast, the central bank should maintain liquidity in deficit if it is raising rates and has a tightening bias.

While the RBI’s new framework opens a window for surplus liquidity, it believes that maintaining a small deficit is important to the conduct of monetary policy.

Evolution Of The Liquidity Framework

India’s liquidity framework has gone through many iterations over the years.

In recent times, among the significant changes has been a move away from the dual signalling rate regime to a single rate. Till 2011, both the repo rate and the reverse repo rate acted as signalling rates, depending on whether liquidity was in deficit or in surplus.

The repo rate is the rate at which the RBI injects liquidity and, hence, acted as the signalling rate when liquidity was in a deficit. The reverse repo rate, being the rate at which the RBI absorbs liquidity, was seen as the benchmark rate when liquidity was in deficit.

In May 2011, the repo rate was made the single independently varying policy rate, on the premise of keeping the system in a deficit mode, was essential for efficient transmission of monetary policy impulses. The reverse repo rate was linked to the repo rate and a corridor of interest rates was created.

In 2014, fresh adjustments were made to the liquidity framework, following the report of a committee headed by former Governor Urjit Patel.

The weighted average call rate was used as the benchmark for determining liquidity needs. Direct borrowings from the fixed rate repo window were restricted to 0.25 percent of bank deposits (net demand and time liabilities). Instead it introduced term repos of different tenors to manage liquidity.

What Changes; What Doesn’t

The latest review of the liquidity framework continues with many of the already existing principles.

The central bank will continue to use the weighted average call rate as the benchmark to determine the liquidity needs of the banking system. It will also continue with a corridor approach to rates, where the reverse repo rate acts as the floor and the repo rate acts at the ceiling for rates.

The RBI also continues to believe that the weighted average call rate should be close to the policy rate, or the repo rate, set by the Monetary Policy Committee.

Where the RBI has eased its stance marginally is in its approach towards liquidity. It says it surplus liquidity may be permitted if financial conditions warrant.

The central bank, however, rejected arguments from money market participants that liquidity conditions should move in conjunction with the monetary policy stance. Instead, the RBI has signaled that liquidity will remain in a small deficit unless financial conditions warrant.

“The banking liquidity being kept in deficit or in surplus mode is a design feature of the liquidity management framework – whether it is the corridor system or the floor system, or, analogously, whether the policy rate is the repo rate or the reverse-repo rate,” the central bank explained. “It does not reflect, or depend upon, the monetary policy stance (neutral, tightening or accommodative), because monetary policy stance, under an inflation targeting framework conducted through changes in interest rate, hinges on the direction of policy rate.”