‘RBI Clears The Air On Liquidity’
Through its communication and steps, RBI has made liquidity management more predictable: Soumyajit Niyogi.
One of the key tasks ahead of the Monetary Policy Committee (MPC) this time was tackling the liquidity situation.
Liquidity has been sloshing around in the system, and this had pushed down short term rates. Bringing short term rates back to near the policy rate and clearing the air on liquidity management was a key objective.
The MPC has handled this objective well.
Firstly, the RBI has ensured its objective of keeping overnight rates close to policy rate by narrowing the interest rate corridor to 50 basis points (bps). To do this, the reverse repo rate was hiked by 25 bps while the Marginal Standing Facility rate was cut by 25 bps. This removes the uncertainty quotient from the market.
To add to this, the RBI has articulated potential strategies and tools that it intends to employ to tackle various levels and types (durable and non-durable) of liquidity. For instance, the RBI said that temporary liquidity mismatches would be managed through instruments like cash management bills, while more permanent liquidity would be tackled through tools like open market operations (OMO). However, in the press conference held after the policy announcement, the RBI assured that OMOs would be used sparingly as they tend to distort bond markets by adding excess supply.
What Good Are Low Short Term Rates?
Ahead of the policy, there was an expectation that the RBI may allow short term rates to remain at levels below the policy rate as it may help the economy by allowing the private sector to borrow at lower rates.
This, however, could have had a detrimental impact on the currency in the future.
Here’s why.
The Rupee has performed extremely well in recent months but this does not insulate the currency from future volatility. Globally, further monetary policy tightening from advanced economy central banks is very much on the cards. Markets are unsure about the timing and quantum of the rate movements.
Should global markets turn volatile, India has to ensure that it can avoid a repeat of the 2013 taper tantrum. This is where short term rates come in.
Back in 2013, part of the currency carnage was linked to low short term rates that existed in the markets at that time. The low rates meant that exporters had no incentive to bring back foreign proceeds to India as they could borrow in the domestic markets at cheaper rates. The situation had to be tackled through an abrupt change in the monetary policy strategy.
The lesson learnt from that experience was that pressure on the Rupee, in the event of global volatility, can get amplified if short term rates are low.
Besides, there is no reason to believe that low short-term rates are enough to spur lending as these rates are largely associated with working capital requirements rather than long term borrowing. Also demand for working capital is dependent on the level of capacity utilization, which has been stubbornly low for quite some time. Anecdotal evidence also suggests that low rates did not propel issuance of commercial paper over the last few months.
Given all this, the RBI has done well to nudge short term rates higher.
Moving Towards A Standing Deposit Facility
Under its current liquidity framework, the RBI has moved towards targeting the overnight rates. The required liquidity then becomes the enabler rather than the primary target.
In such a scenario, the regular fine tuning of liquidity will be managed through the repo, reverse repo and MSF windows. For an extreme situation, where liquidity is far in excess of what is considered optimal, another floor rate could be introduced through the Standing Deposit Facility (SDF).
Once this is in place, the RBI may eventually move away from open market operations (OMOs) and the Market Stabilization Scheme (MSS). Instead they may manage liquidity through repo, reverse repo, MSF and SDF - the pillar of the liquidity adjustment facility offered by the RBI.
In this regard, this comment below by Ulrich Bindseil and Juliusz Jabłecki of the European Central Bank in a 2011 paper seems appropriate to quote:
It is not exaggerated to say that the width of the corridor problem is at the center of understanding monetary policy implementation techniques. The question why going for the complex to steer short term interest rates (namely through the sporadic conduct of open market operations) instead of the simple and effective (through standing facilities at the target interest rate), has to be addressed before discussing in a meaningful way further details of monetary policy implementation.Ulrich Bindseil and Juliusz Jabłecki, European Central Bank (2011 Paper)
Soumyajit Niyogi is Associate Director at India Ratings & Research - a Fitch Group Company. The views expressed here are his own and do not reflect those of his organisation.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.