Revamping India Liquidity Management Framework, Challenges and Reforms

Revamping India Liquidity Management Framework, Challenges and Reforms

Why in News?

The Reserve Bank of India (RBI) recently released the Report of the Internal Working Group (IWG) to Review the Liquidity Management Framework, marking a significant step toward refining the operational mechanics of monetary policy in India. Liquidity management, often described as the nuts and bolts of monetary policy, ensures that short-term interest rates align with the policy rate, facilitating smooth monetary transmission across the economy. The IWG’s recommendations aim to address longstanding issues such as the volatility in call money rates, the role of stand-alone primary dealers (SPDs), and the structural surplus liquidity that has often disrupted the efficacy of the liquidity corridor system. This development is critical for financial stability, efficient credit allocation, and macroeconomic management, especially in a rapidly evolving economic landscape.

Introduction

Liquidity management is the cornerstone of modern monetary policy. It involves regulating the amount of money available in the banking system to ensure that short-term interest rates remain close to the policy rate, thereby enabling effective transmission of monetary policy signals to the broader economy. In India, the RBI employs a corridor system—with the Marginal Standing Facility (MSF) rate as the upper bound and the Standing Deposit Facility (SDF) rate as the lower bound—to manage liquidity. However, structural surpluses, volatile government cash balances, and the increasing dominance of non-bank participants in the money market have posed challenges to this framework. The IWG’s report seeks to tackle these issues by proposing reforms such as discontinuing the 14-day variable rate repo/reverse repo operations, reevaluating the width of the liquidity corridor, and phasing out stand-alone primary dealers from the call money market. This article delves into the intricacies of these recommendations, their implications, and the path forward for India’s liquidity management framework.

Key Issues and Background

1. The Liquidity Corridor System: An Overview
The RBI’s liquidity management framework operates through a corridor system where the policy repo rate serves as the target, with the MSF rate and SDF rate forming the upper and lower bounds, respectively. The weighted average call rate (WACR)—the interest rate at which banks lend to each other overnight—is the operating target. The corridor is designed to contain volatility in short-term rates while ensuring that the WACR aligns closely with the policy rate. However, structural surplus liquidity, unpredictable government cash flows, and external factors like currency movements have often caused the WACR to deviate from the policy rate, undermining monetary transmission.

2. Structural Surplus Liquidity: A Persistent Challenge
Since the demonetization exercise in 2016 and the subsequent influx of deposits into the banking system, India has grappled with structural surplus liquidity. The COVID-19 pandemic exacerbated this situation, as the RBI injected massive liquidity to support the economy. While surplus liquidity is necessary during crises, its persistence poses challenges:

• It dampens the effectiveness of the corridor system, as the WACR tends to hover near the lower bound (SDF rate), even dipping below it at times.

• It reduces inter-bank lending activity, as banks prefer parking excess funds with the RBI rather than lending to each other.

• It complicates liquidity forecasting, making it difficult for the RBI to conduct precise operations.

3. The 14-Day VRR/VRRR Operations: Inefficiencies and discontinuation
The IWG rightly recommends discontinuing the 14-day variable rate repo/reverse repo (VRR/VRRR) as the main liquidity operation. Banks have been reluctant to park funds for this duration due to the uncertainty in liquidity forecasts. Government cash balances, which are highly volatile, and unpredictable currency movements make it challenging to estimate liquidity needs accurately over a 14-day horizon. Replacing this with weekly operations and fine-tuning tools of varying tenors would enhance flexibility and precision.

4. The Width of the Corridor: Balancing Volatility and Activity
The current corridor width of 50 basis points (bps) is narrower than that of many emerging economies. While a narrow corridor reduces short-term rate volatility, it also diminishes activity in the call money market. Banks find it more convenient to deal with the RBI than with each other, leading to a decline in inter-bank transactions. The IWG report notes that the narrowing of the corridor coincided with a reduction in call money market volumes. A detailed empirical analysis is needed to determine the optimal corridor width that balances volatility control with market activity.

5. The Role of Stand-Alone Primary Dealers (SPDs)
SPDs, which play a crucial role in the government securities market, are significant borrowers in the call money market. They account for nearly three-fourths of total borrowings, and their operations often introduce volatility into call rates. During tight liquidity conditions, SPDs’ borrowing can push call rates above the upper bound of the corridor, as they lack access to the MSF. Similarly, in surplus conditions, their limited lending capacity (due to regulatory constraints) can cause rates to fall below the lower bound. The IWG recommends phasing out SPDs from the call money market and providing them with alternative facilities to ensure smooth operations without disrupting monetary policy.

6. Reserve Requirements and Averaging Mechanism
The averaging provision for cash reserve ratio (CRR) maintenance allows banks to smooth out daily liquidity shocks by borrowing or lending across the maintenance period. However, banks rarely utilize this flexibility, often maintaining reserves above the mandatory 90% threshold. This indicates that the averaging mechanism is underutilized, reducing its effectiveness in stabilizing call rates. Lowering the daily minimum reserve requirement could encourage banks to arbitrage across days, enhancing market activity and rate stability.

Specific Impacts or Effects

1. On Monetary Policy Transmission
A robust liquidity framework ensures that changes in the policy rate are swiftly transmitted to lending and deposit rates across the economy. The current deviations of WACR from the policy rate create uncertainty, hampering the transmission process. The IWG’s recommendations, if implemented, could improve alignment and strengthen the RBI’s control over short-term rates.

2. On Financial Market Stability
Volatility in call money rates can spill over to other segments of the money market, affecting yields on commercial paper, certificates of deposit, and government securities. By reducing volatility and enhancing the predictability of rates, the proposed reforms could foster stability in financial markets.

3. On Banking Sector Efficiency
Banks rely on the money market for short-term funding and investment. A well-functioning liquidity framework reduces their operational risks and costs. The phasing out of SPDs from the call money market could mitigate undue volatility, while the discontinuation of 14-day VRR/VRRR operations would allow for more efficient liquidity management.

4. On Economic Growth
Effective monetary transmission ensures that credit flows smoothly to productive sectors of the economy. By addressing the flaws in the liquidity framework, the RBI can better support growth, especially during periods of economic uncertainty.

Challenges and the Way Forward

Challenges

• Structural Surplus Liquidity: Managing persistent surplus liquidity without disrupting financial markets remains a complex task.

• Market Development: Encouraging greater activity in the call money market while containing volatility requires careful calibration.

• Regulatory Coordination: Implementing changes involving SPDs and reserve requirements demands coordination between the RBI and other stakeholders.

• Global Uncertainties: External factors, such as capital flows and geopolitical events, can complicate liquidity management.

Steps Forward

1. Adopt Flexible Liquidity Operations: Replace the 14-day VRR/VRRR with weekly operations and fine-tuning tools to enhance responsiveness.

2. Reevaluate Corridor Width: Conduct empirical studies to determine the optimal corridor width that balances volatility control and market activity.

3. Phase Out SPDs from Call Money Market: Provide SPDs with alternative borrowing and lending facilities to ensure their operations do not disrupt monetary policy.

4. Revamp Reserve Requirements: Lower the daily minimum CRR requirement to encourage banks to utilize the averaging mechanism effectively.

5. Enhance Liquidity Forecasting: Improve models for predicting government cash balances and currency movements to conduct more precise operations.

6. Promote Market Development: Encourage greater participation from banks in the call money market through incentives and regulatory support.

Conclusion

The IWG’s report on liquidity management is a timely and comprehensive effort to address the weaknesses in India’s monetary policy operating framework. By focusing on practical issues such as the discontinuation of inefficient operations, the reevaluation of the corridor width, and the phased exit of SPDs from the call money market, the recommendations aim to enhance the RBI’s ability to control short-term interest rates and ensure effective monetary transmission. However, the success of these reforms will depend on their meticulous implementation and the RBI’s adaptability to evolving economic conditions. As India navigates a complex global environment and domestic challenges, a robust liquidity management framework will be indispensable for sustaining financial stability and fostering inclusive growth.

5 Questions and Answers

Q1: What is the primary objective of the RBI’s liquidity management framework?
A: The primary objective is to ensure that short-term interest rates, particularly the weighted average call rate (WACR), align closely with the policy repo rate, enabling effective monetary policy transmission across the economy.

Q2: Why has the IWG recommended discontinuing the 14-day VRR/VRRR operations?
A: Banks are reluctant to park funds for 14 days due to uncertainties in liquidity forecasting caused by volatile government cash balances and unpredictable currency movements. Shorter-term operations offer greater flexibility and precision.

Q3: How do stand-alone primary dealers (SPDs) impact the call money market?
A: SPDs account for a significant portion of borrowings in the call money market, and their operations often introduce volatility, pushing rates beyond the corridor bounds during tight or surplus liquidity conditions.

Q4: What is the significance of the corridor width in liquidity management?
A: A narrower corridor reduces short-term rate volatility but also diminishes inter-bank lending activity. Finding the right balance is crucial for both stability and market development.

Q5: How can the averaging mechanism for CRR maintenance be improved?
A: Lowering the daily minimum reserve requirement could encourage banks to arbitrage across days, enhancing the effectiveness of the averaging mechanism in stabilizing call money rates.