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RBI’s Liquidity Management: A Technical Analysis

Ranjit Kumar Pattnaik

Author: Ranjit Kumar Pattnaik

Date: Mon, 2017-05-08 11:20

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. 




Thank you sir for giving such a detailed and helpful description of First bi-monthly monetary policy(April 06,2017 monetary policy) I would like to add few more points about April 06,2017 monetary policy. We all noticed that RBI kept repo rate on hold and shifted focus to excess liquidity in the economy which was the result of demonetisation. RBI raised the reverse repo rate by 25 basis points to 6 percent to remove excess liquidity. One more reason because of which RBI kept repo rate on hold is challenging inflation outlook. Central bank has kept its policy rate unchanged at 6.25 per cent from last three successive quarterly review. The RBI’s decision on the policy rate was widely expected as it works towards achieving the medium-term target for target for consumer price index (CPI) inflation of 4 per cent, with an upper and lower tolerance level of 6 per cent and 2 per cent, respectively, while supporting growth. RBI Governor Urjit Patel, said that “further scope for a more complete transmission of policy impulses remains, including for small savings/administered rates.” Corporate were not very happy about RBI’s position on the policy rates. “From the industry’s perspective, greater transmission of previous policy rate cuts and a further softening of the lending rates of banks are important as this would encourage both consumption and investment demand,” said Pankaj Patel, President, FICCI.

The article brings good clarity about the liquidity surplus and action initiated by RBI. The challenges of surplus due to demonetization and the near term impact on the various financial instruments. The RBI is fine tuning the variable rate repo and reverse repo auction. Despite taking action the liquidity will remain surplus in the year 2017-18. The overarching goals of RBI to absorb post demonetization the surplus liquidity by increasing CRR and NDTL of banks. The downside risk of reducing surplus liquidity management announced in april policy like magnitude of fueling fiscal deficit and revenue deficit which may derail the plan to keep fiscal deficit under check as per the set goals.Since there is no budgeted provision for the absorption of surplus it depicts the lack of coordination between RBI and Government policy. How reverse repo will share the major burden of absorbing surplus liquidity. The increase outgo of interest (net) of RBI will have less profit to share with government and it can null the course correction through reverse repo. There should be regular meeting with RBI and GOI to resolve the lacuna and work out an amicable solution. Our development plan and fiscal deficit target should not be derail otherwise it can have detrimental effect on the over rating of India.

The economy of India is the sixth largest in the world measured by nominal GDP & the third largest by purchasing power parity. The Reserve Bank of India is entrusted with an onerous task of overseeing the monetary policy of India apart from issuing currency, managing foreign exchange, working as a bank of government and as banker of scheduled commercial banks. The Monetary Policy decision taken by RBI in consultation with the Monetary Policy Committee is the widely sought after data by economists in India as well as abroad. The Policy statement spelt out by the RBI has a major impact on the economy of India. In line with the Urjit Patel committee recommendations, the monetary policy committee is given a target of keeping the inflation levels within the limits set by the Central Government. In wake of the demonetization exercise carried out by the Government of India a huge void was created in the liquid cash available. Though the government of India maintains that there has been no major impact of the demonetization exercise on the growth, the numbers indicate a different thing altogether. The Growth rate has indeed come down. The IMF & World Bank have downgraded the growth forecast for India post the demonetization exercise. However, RBI needs to be commended in the way it has handled the monetary policy post demonetization as it was effective in bringing back the growth forecast to over 7%. The IMF has in its biannual World Economic Outlook (WEO), increased India’s growth estimate for 2016-17 to 6.8%, from 6.6% estimated in January; The World Bank has projected a strong 7.2 per cent growth rate for India this year against 6.8 per cent growth in 2016. The Asian Development Bank (ADB) earlier this month said India’s economy is set to grow at 7.4% in financial year 2017-18 against 7.1% the previous year. India is now the fastest growing economy in the world. RBI in its second bimonthly statement released on 07th June, 2017 has kept the policy rate under LAF unchanged at 6.25% & projected the headline inflation to be in the range of 2.0-3.5 per cent in the first half of the year and 3.5-4.5 per cent in the second half. It however has to be seen how RBI implements the Urjit Patel committee recommendation on liquidity management for phase II.

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