The April 06, 2017 monetary policy committee resolution while keeping the policy repo rate unchanged at 6.25 per cent, increased the reverse repo rate under LAF to 6 per cent and marginal standing facility rate (MSF) to 6.50 per cent, focusing on the further narrowing of LAF corridor to bring the operating target of the monetary policy i.e. Weighted Average Call Rate (WACR) in alignment with the policy repo rate.
Thus, the focus of the liquidity management stance of RBI in the April policy has been directed towards three aspects viz; (a) surplus liquidity management, (b) narrowing of monetary policy rate corridor and (c) substitution of collateral under LAF term repos. It may be noted that the liquidity management policy stance of the RBI has been guided by the recommendations of the Urjit Patel Committee Report, January 2014. While the narrowing of policy repo rate corridor and substitution of collateral under LAF term repos are welcome, the approach and effectiveness of instruments pose some moral hazard and adverse selection problems.
In the above context, it is important to note that post demonetisation period, the overarching goal of RBI was to absorb the large structural surplus liquidity from the banking system in an undisruptive manner in order to bring the system closer to neutral position. In this situation, RBI engaged reverse repo which is the floor of the LAF corridor very frequently with variable rates and longer duration.
In the liquidity management guidance observed in the April 06, 2017 policy, the RBI has observed that for management of structural surplus liquidity, three instruments will be used viz; Market Stabilisation Scheme (MSS), Open Market Operations (OMOs) and Cash Management Bills (CMB) apart from fine tuning operations through variable rate repo and reverse repo auctions. As further observed by RBI, the liquidity conditions are expected to remain in surplus mode and may persist in 2017-18.
In the above context, it is pertinent to note that one of the important features under the new regime of MPC is the calibrated shift in the policy stance from accommodative to neutral. Accordingly, during the pre-demonetisation period (April 2016-November 08 2016), RBI proactively injected durable liquidity of Rs. 2.1 trillion in the form of OMO purchases, forex market operations and buy back of government securities. This resulted in a shift to a Rs. 64 billion liquidity surplus in Q3 of 2016-17 from a liquidity deficit of Rs. 813 billion.
After demonetisation, currency in circulation declined by Rs. 8,997 billion up to January 06, 2017. Therefore, during the post demonetisation period, the overarching goal of RBI was to absorb the large structural surplus liquidity from the banking system with the following measures viz; temporary application of Incremental CRR (ICRR) of 100 per cent on the increase in Net Demand & Time Liabilities (NDTL) of banks between September 2016 and November 11 2016, open market sales of cash management bills (CMBs) issued under the Market Stabilisation Scheme and variable reverse repos.
The absorption of excess liquidity through ICCR was to the tune of about Rs. 4000 trillion. The scheme ended on December 09, 2016 with the enhancement of issuance of securities under MSS from Rs. 300 billion to Rs. 6,000 billion. The surplus liquidity was then managed through MSS and fine tuning of reverse repo. This reduced the liquidity surplus in the system to Rs. 3,141 billion. Thus, RBI absorbed a daily average surplus of liquidity of Rs. 4,024 billion ( post-demonitisation) in Q3 and Rs. 5,932 billion in Q4.
A few downside risks of surplus liquidity management as announced in the April policy are in order.
Higher magnitude of absorption of liquidity through MSS and CMB has adverse implications for the government budget in terms of interest outgo there by fueling the magnitude of revenue deficit and fiscal deficit. Besides, the government has not taken any budget approval for MSS amount for fiscal 2017-18. This development is a pointer to the lack of policy coordination between the government and the RBI with regard to addressing surplus liquidity resulting out of demonetisation.
OMO is an important indirect instrument of monetary policy. However, past experience suggests that there is a lack of interest on the part of banks to actively participate in the market as while taking a decision on the OMO purchase/sale, they have to in fact take a decision on the interest rate while bidding.
More importantly, the government will also borrow from the market as part of the market borrowing programme for fiscal 2017-18. As indicated in the calendar released by RBI, the government will enter the market on an average in every week with an average magnitude of around Rs.40,000 – Rs. 50,000 crore. This has implications for OMO sales and also moral hazard problems for RBI, balancing the act of debt manger and monetary authority.
In view of the foregoing, in effect, the reverse repo will share the major burden of absorbing surplus liquidity. There are two associated problems viz; (a) the expenditure on interest outgo (net) of RBI will be higher, which in effect will impact the surplus position of RBI and may translate to lower profit transfer to government and (b) with frequent recourse to reverse repo with higher magnitude, the fine tuning nature of this instrument will be jeopardised.
It may be noted that there is still unfinished agenda with RBI in terms of full implementation of the Patel Committee recommendations in respect of Phase II. One important paradigm shift is to move to a 14-day term repo as the operating target in place of WACR. It is appropriate that RBI should bring out a medium term timeframe for implementation of the Patel committee recommendation on liquidity management for phase II.