Thursday, 12 April 2012

Major Monetary Policy Tools and Operating Procedure

The Call Money Market
The call money market is an important segment of the money market where uncollateralized borrowing and lending of funds take place on overnight basis. This offers the banks an avenue for adjusting their cash reserve requirements, i.e. to even out their day-to-day deficits and cash surpluses.The interest rates are market determined.
Participants in the call money market in India currently include scheduled commercial banks (SCBs) (excluding regional rural banks), cooperative banks (other than land development banks), and primary dealers, both as borrowers and lenders (RBI's Master Circular dated 1 July 2011). Thus it is a purely inter-bank market.
Borrowers and lenders are required to have current accounts with RBI to participate in the call money market. Prudential limits in respect of both outstanding borrowing and lending transactions for each of these entities are specified by the RBI.
[Note: Primary dealers are firms that buy government securities directly from the RBI with an intention of reselling to others.] 1.

Open Market Operations
OMOs are conducted by the RBI via the sale/purchase of government securities to/from the market with the primary aim of modulating rupee liquidity conditions in the market. OMOs are an effective quantitative policy tool in the armoury of the RBI, but are constrained by the stock of government securities available with it at a point in time.

The Liquidity Adjustment Facility
The LAF is the key element in the monetary policy operating framework of the RBI. On daily basis, the RBI stands ready to  lend to or borrow money from the banking system, as per the latter's requirement, at fixed interest rates. The primary aim of such an operation is to assist banks to adjust to their day-to-day mismatches in liquidity, via repo and reverse repo operations.
Under the repo or repurchase option, banks borrow money from the RBI via the sale of securities with an agreement to purchase the securities back at a fixed rate at a future date. The rate charged by the RBI to aid this process of liquidity injection is termed as the repo rate. Under the reverse repo operation, the RBI borrows money from the banks, draining liquidity out from the system. The rate at which the RBI borrows money is the reverse repo rate.
The interest rate on the LAF is fixed by the RBI from time to time (with crucial changes introduced recently in the operating procedure of Monetary Policy detailed in the next paragraph). LAF operations help the RBI effectively transmit interest rate signals to the market.

Changes in the Operating Procedure of Monetary Policy
Effective 3 May 2011, based on the recommendations of the Working Group on Operating Procedure of Monetary Policy, the operating framework of monetary policy has been refined.

  • The repo rate has been made the only independently varying policy rate.
  • A new marginal standing facility (MSF) has been instituted, under which SCBs have been allowed to borrow overnight at their discretion, at 100 basis points(bps) above the repo rate.
  • The reverse repo rate has been placed 100 bps below repo rate and the MSF rate 100 bps above the repo rate. [So if repo rate is 5.5, then reverse repo rate will be 4.5 and MSF will be 6.5]

It is expected that the fixed interest rate corridor, set by the MSF rate and reverse repo rate, by reducing uncertainty and avoiding difficulties in communication associated with a variable corridor, will help in keeping the overnight average call money rate close to the repo rate.

Reproduced from:
Economic Survey 2012, Box 4.7, pg 96.
2. CSAT Economy Special, 2011, Arihant Publishers.

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