Group No -38 110451 - Md.

Zohair Zobairi 110571 Ashok Pandey PGCBM-21 Patna Center

Liquidity Management Facility in Indian Financial System

Prof Purna Chandra Padhan

Liquidity Management Facility in Indian Financial System

IntroductionIn the macroeconomic context, liquidity management refers to overall monetary conditions, reflecting the extent of mismatch between demand and supply of overall monetary resources, for a central bank, the concept of liquidity management typically refers to the framework and set of instruments that the central bank follows in steering the amount of bank reserves in order to control its price, consistent with the ultimate goals of monetary policy . What is the price of bank reserves? The price of bank reserves is fixed in terms of short term interest rates. This is set in terms of overnight inter-bank borrowing and lending rates either secured or unsecured which affect the reserves that the banks keep. As markets do not clear often on their own the central bank itself steps in by influencing the short-term interest rates by affecting short-term repurchase obligations with banks. Need Of Liquidity Management The need for liquidity management arises from central banks concept of liquidity measured in terms of the monetary base, of which it is the monopoly supplier. The supply of monetary base by the central bank depends on (i) the public's demand for currency, as determined by the size of monetary transactions and the opportunity cost of holding money and, (ii) the banking systems need for reserves to settle or discharge payment obligations. Importance Of Liquidity Management The importance of central bank liquidity management lies in its ability to exercise considerable influence and control over short-term interest rates by small money market operations. Central bank liquidity management has short-term effects in financial markets. However, the long-term implications for the real sector and on price level are more important. By operating on the current account balances that the commercial banks maintain with the central bank or by directly operating on the short-term money market rate, central banks attempt to influence money market liquidity in order to exercise control over the short-term interest rate. The central bank may directly set at least one of the short-term interest rates that acts as its policy rate. By controlling the short-term interest rate while letting markets determine the rest of the yield curve,

the central bank attempts to transmit monetary policy impulses across the yield curve. The sovereign yield curve in turn influences the lending and deposit rates in the economy. Mortgage rates are found to be particularly sensitive to the policy rate changes through the interest rate as well as the credit channel. Once bank lending gets affected, interest rates impact real variables such as consumption and investment, which in turn impact output and inflation levels. So active liquidity management has a localised objective of keeping short-term interest rates range bound, it also has a long-term meta objective of implementing monetary policy goals of inflation and output. Liquidity Management Facility in India through Direct & Indirect Instruments Before the advent of repos, market operations by the RBI almost invariably focused on open market operations through outright transactions in government securities. The scope of open market operations in the earlier period was limited as yields were repressed by an administered interest rate regime, including auctions of T-bills on tap at fixed coupon of 4.6 per cent. The move towards a market determined system of interest rates began by development of the secondary market by increasing coupons and decreasing maturity of government debt1. The yields were made substantially market determined by introduction of auctions since the mid1980s2. The Reserve Bank introduced reverse repos for absorption from December 19923. With the objective of improving short-term management of liquidity in the system and to smoothen out interest rates in the call/notice money market, the Reserve Bank began absorbing excess liquidity through auctions of reverse repos (then called repos). With the activation of bank rate as a policy instrument, reverse repos helped in creating an informal corridor in the money market, with the reverse repo rate as floor and the Bank Rate as the ceiling. The use of these two instruments enabled RBI to keep the call rate by and large within this informal corridor. Liquidity Adjustment Facility As part of the financial sector reforms launched in mid-1991, India began to move away from direct instruments of monetary control to indirect ones. The transition of this kind involves considerable efforts to develop markets, institutions and practices. In order to facilitate such transition, India developed a Liquidity Adjustment Facility (LAF) in phases considering countryspecific features of the Indian financial system. LAF is based on repo / reverse repo operations by the central bank. In 1998 the Committee on Banking Sector Reforms (Narasimham Committee II) recommended the introduction of a Liquidity Adjustment Facility (LAF) under which the Reserve Bank would conduct auctions periodically, if not necessarily daily. The Reserve Bank could reset its Repo

and Reverse Repo rates which would in a sense provide a reasonable corridor for the call money market. In pursuance of these recommendations, a major change in the operating procedure became possible in April 1999 through the introduction of an Interim Liquidity Adjustment Facility (ILAF) under which repos and reverse repos were formalised. With the introduction of ILAF, the general refinance facility was withdrawn and replaced by a collateralised lending facility (CLF) up to 0.25 per cent of the fortnightly average outstanding of aggregate deposits in 1997-98 for two weeks at the Bank Rate. Additional collateralised lending facility (ACLF) for an equivalent amount of CLF was made available at the Bank Rate plus 2 per cent. CLF and ACLF availed for periods beyond two weeks were subjected to a penal rate of 2 per cent for an additional two week period. Export Credit refinance for scheduled commercial banks was retained and continued to be provided at the bank rate. Liquidity support to PDs against collateral of government securities at the bank rate was also provided for. ILAF was expected to promote stability of money market and ensure that the interest rates move within a reasonable range. The transition from ILAF to a full-fledged LAF began in June 2000 and was undertaken in three stages. In the first stage, beginning June 5, 2000, LAF was formally introduced and the Additional CLF and level II support to PDs was replaced by variable rate repo auctions with same day settlement. In the second stage, beginning May 2001 CLF and level I liquidity support for banks and PDs was also replaced by variable rate repo auctions. Some minimum liquidity support to PDs was continued but at interest rate linked to variable rate in the daily repos auctions as determined by RBI from time to time. In April 2003, the multiplicity of rates at which liquidity was being absorbed/injected under back-stop facility was rationalised and the back-stop interest rate was fixed at the reverse repo cut-off rate at the regular LAF auctions on that day. In case of no reverse repo in the LAF auctions, back-stop rate was fixed at 2.0 percentage point above the repo cut-off rate. It was also announced that on days when no repo/reverse repo bids are received/accepted, back-stop rate would be decided by the Reserve Bank on an ad-hoc basis. A revised LAF scheme was operationalised effective March 29, 2004 under which the reverse repo rate was reduced to 6.0 per cent and aligned with bank rate. Normal facility and backstop facility was merged into a single facility and made available at a single rate. The third stage of full-fledged LAF had begun with the full computerisation of Public Debt Office (PDO) and introduction of RTGS marked a big step forward in this phase. Repo operations today are mainly through electronic transfers. Fixed rate auctions have been reintroduced since April 2004. The introduction of LAF has been a process and the Indian experience shows that phased rather than a big bang approach is required for reforms in the financial sector and in monetary management. The introduction of LAF had several advantages. First and foremost, it helped the transition from direct instruments of monetary control to indirect and, in the process, certain dead weight loss for the system was saved. Second, it has provided monetary authorities with greater flexibility in determining both the quantum of adjustment as well as the rates by responding to the needs of the system on a daily basis. Third, it enabled the Reserve Bank to modulate the supply of funds on a daily basis to meet day-to-day liquidity mismatches. Fourth, it enabled the central bank to affect demand for funds through policy rate changes.

Fifth and most important, it helped stabilise short-term money market rates.

LAF has now emerged as the principal operating instrument of monetary policy. The LAF has enabled the Reserve Bank to de-emphasise targeting of bank reserves and focus increasingly on interest rates. This has helped in reducing the CRR without loss of monetary control. Market Stabilisation Scheme (MSS) The money markets operated in liquidity surplus mode since 2002 due to large capital inflows and current account surplus. The initial burden of sterilisation was borne by the outright transaction of dated securities and T-bills. However, due to the depletion in stock of government securities, the burden of liquidity adjustment shifted on LAF, which is essentially a tool of adjusting for marginal liquidity. Keeping in view the objective of absorbing the liquidity of enduring nature using instruments other than LAF, the Reserve Bank appointed a Working Group on Instruments of Sterilisation (Chairperson: Smt Usha Thorat). The Group recommended issue of T-bills and dated securities under Market Stabilisation Scheme (MSS) where the proceeds of MSS were to be held by the Government in a separate identifiable cash account maintained and operated by RBI. The amounts credited into the MSS Account would be appropriated only for the purpose of redemption and / or buy back of the Treasury Bills and / or dated securities issued under the MSS. In pursuance of the recommendation the Government of India and RBI signed a Memorandum of Understanding (MoU) on March 25, 2004. As part of the MoU, the scheme was made operational since April 2004. It was agreed that the Government would issue Treasury Bills and/or dated securities under the MSS in addition to the normal borrowing requirements, for absorbing liquidity from the system. These securities would be issued by way of auctions by the Reserve Bank and the instruments would have all the attributes of existing T-bills and dated securities. They were to be serviced like any other marketable government securities. MSS securities are being treated as eligible securities for Statutory Liquidity Ratio (SLR), repo and Liquidity Adjustment Facility (LAF). The payments for interest and discount on MSS securities are not made from the MSS Account. The receipts due to premium and/or accrued interest are also not credited to the MSS Account. Such receipts and payments towards interest, premium and discount are shown in the budget and other related documents as distinct components under separate sub-heads. The Tbills and dated securities issued for the purpose of the MSS are matched by an equivalent cash balance held by the Government with the Reserve Bank. Thus, they only have a marginal impact on revenue and fiscal balances of the Government to the extent of interest payment on the outstanding under the MSS. MSS has considerably strengthened the Reserve Bank's ability to conduct exchange rate and monetary management operations. It has allowed absorption of surplus liquidity by instruments of short term (91-day, 182-day and 364-day T-bills) and the medium-term (dated Government securities) maturity. Generally, the preference has been for the short-term instruments. This has given the monetary authorities a greater degree of freedom in liquidity management during transitions in liquidity situation. The evidence of this efficient liquidity management may be seen in the relatively orderly movement in both exchange rates and interest rates. During times of excess visible liquidity, the call rates have essentially hugged the reverse repo rate, as might be expected, whereas they are near or slightly higher than the repo rate in times of tighter visible liquidity. Referance

Alexander, W.E., T.J.T. Balino and C. Enoch (1995), The Adoption of Indirect Instruments of Monetary Policy, IMF Occasional Paper, No. 126, Washington, D.C. Bindseil, U. (2000), "Central Bank Liquidity Management: Theory and Practice", April, European Central Bank. Borio, C. (1997), The Implementation of Monetary Policy in Industrial Countries, BIS Economic Papers No. 47, Bank of International Settlements. Saggar, M (2006): "Monetary Policy and Operations in Countries with Surplus Liquidity", Economic and Political Weekly, March 18, pp. 1041-52. Coping With Liquidity Management in India: A Practitioner's View by Rakesh Mohan