March 19, 2011
Monetary Policy Operating Procedures in India
Reserve Bank of India's working group on Operating procedure of Monetary Policy report was released by the RBI on its website on 16-Mar-2011. My comments on the report are:
A. I find the following positives in this report:
1. Structural liquidity deficit mode would normally be attempted and hence the Repo rate would be the unambiguous policy rate (unlike the present case).
2. Extension of permissible collateral list (for accessing repo facility) to Oil bonds (these are issued by Government of India as a compensation to Oil companies for selling Oil at lower than market prices). I hope that in future corporate bonds issued by State-owned companies and bonds issued by Municipal Corporations are also included in the permissible collateral list.
3. Supporting longer term liquidity through variable rate auctions will serve the purpose of providing liquidity and as desired it is done without conveying an interest rate. This can prove to be a great move if this is institutionalized for tenors of say 3 months as it could lead to the development of a liquid market-based floating rate benchmark in India (currently non-existent in India as there are almost negligible money market transaction for tenor longer than 1 day).
4. A scheme of auctioning of government surplus cash balance at the discretion of the RBI to be put in place in consultation with the Government. I hope that if successful, such auctions are institutionalized over a period of time. It would be useful to allow highly rated corporate bonds to be allowed as collateral.
5. Paragraph 4.31 "The Group, therefore, recommends that information on government cash balances should also be placed in the public domain with a minimum time lag as part of the daily morning press release under “Money Market Operations” and published in the Weekly Statistical Supplement of the RBI Bulletin as is being done in the case of banks’ cash balances with the RBI."
6. The T+0 transactions for short-term money market segments [collateralised borrowing and lending obligations (CBLO) and market repo] should be extended up to the cut-off timing for
customers in real time gross settlement (RTGS) (i.e., 4.30 PM) so that the banking system could square off their CRR position efficiently.
B. I find the following negatives in the report:
1."the maturity period of repo and reverse repo operations" was an important part of the terms of reference of the working group. But, there is no discussion of the same. While it is generally accepted that the policy rate ought to be a short-tenor rate, it is NOT accepted wisdom that it ought to be a 1 day rate(The ECB main policy rate is NOT a one-day rate.) Further, Paragraph 4.32: "An area of uncertainty in liquidity forecast is the pattern of CRR maintenance by banks. At present, banks, on average, are required to maintain 100 per cent of the required CRR during the fortnight with a daily minimum maintenance of 70 per cent. However, banks frontload their CRR balances with the RBI in the first week of the reporting Friday, the front loading being higher in deficit liquidity situations (Chart IV.3). This accentuates the liquidity stress. But at the system level, banks tend to maintain over 80 per cent of their required balance throughout the maintenance period." This actually makes a strong case for a fortnightly fixed rate repo (or variable rate where the minimum bid rate has been announced) rather than using an overnight repo rate as the main policy rate. This will then mean greater certainty within the period for which reserves are to be maintained on an average basis. This is very different from the pure variable rate fortnightly repo operated by RBI from April-2004 to Nov-2004. Further, measures like the minimum daily CRR requirement (at 70% or any other level) should be primarily based on the stability of the banking system and then on the convenience of the banks. The minimum level does not seem to be an appropriate tool for improving monetary policy transmission as a higher level (80%) may bring with unintended consequences of unnecessary curtailing of the flexibility of the banks.
2. Paragraph 4.21: "Given the reduced share of the call money market in the overnight money market, the Group examined the relative merits of the overnight call money rate vis-à-vis the overnight money market rate, computed as the weighted average of call money, CBLO and market repo rates as the operating target. The empirical evidence suggests that the transmission of policy rate to the overnight call money rate is stronger than the overnight money market rate. Further, the stability properties of these two rates are not significantly different. Moreover, the correlation between the overnight call money rate and the collaterallised money market rate was high at 0.9." The CBLO rate is much closer to the Repo rate since both of them are collateralized with government securities. From a risk perspective the only difference is that the CBLO market operates with a centralized counterparty (namely the Clearing Corporation of India Ltd) while the repo of course has the central bank as a counterparty. As is acknowledged in the report the move towards CBLO has been a preference of central bank itself. The CBLO market is more transparent (screen based anonymous trading is used unlike Call money market) And fundamentally, should monetary policy be targeting the call money market just because it is easier even if it is less consequential and less relevant for risk based pricing than the CBLO market.
3. Paragraph 4.12 "The Group also examined the effect of corridor width on weighted average call money rate volatility using a GARCH model which indicated that a corridor width in the range of 150–175 bps could be optimal (Technical Appendix IV)." It would have been better to consider the CBLO rate instead of the overnight rate considering that the CBLO market is much larger than the call money market (the CBLO market was almost thrice the size of the call money market on 18-Mar-2011; for latest numbers pl see this).
4. Paragraph 4.25 "In fact, market participants preferred to access the RBI’s LAF window rather than meet their liquidity needs through the OMO. One of the considerations in banks’ inadequate response to OMO purchases by the RBI was the possibility of valuation losses as the bulk of the securities are held under HTM category. The Group, therefore, recommends that the RBI should incentivise banks to progressively mark-to-market their SLR portfolio to improve the effectiveness of OMO as an instrument of liquidity management."
Marking-to-market will introduce volatility in the balance sheets of banks. It may not always desirable and less so for the purpose of monetary policy transmission. So RBI should not engage in such incentivization. Issuing a larger proportion of floating rate bonds could yield the effect desired by RBI (since FRBs have lower price volatility compared to fixed rate bonds).
5. Paragraph 4.9:"it is not feasible to establish a standing uncollateralised deposit facility which will be treated as uncollateralised borrowing by the RBI and this is not permitted under
Section 17(4) of the Reserve Bank of India Act, 1934." Acceptance of non-government collateral would have helped.
6. Paragraph 2.5: "The Group, therefore, felt that the guiding principle in the determination of the width of the corridor should be such that it should stabilise the overnight money market interest rate while facilitating the development of the money market so that the reliance of banks on RBI facilities comes down over time." Some clarity on what is the expected proportion of the money market that RBI expects to occupy would be useful.
Note-1: You may like to read my earlier post "Monetary Policy Operating Procedures in India" (28-Nov-2010).
Note-2: I found it interesting to note that on 25-Apr-1987 (Cash Reserve Ratio+Statutory Liquidty Ratio)was at 53.5% !
Note-3: The working group's recommendations are only recomendations.
Posted by amgodbole at 08:28 AM
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March 16, 2011
A review of the recent books by Y.V. Reddy and Raghuram Rajan
Former Reserve Bank of India Governor Y.V. Reddy's book "Global Crisis, Recession and Uneven Recovery (Jan 2011)" and University of Chicago's Professor Raghuram G. Rajan's book "Fault Lines: How Hidden Fractures Still Threaten the World Economy" (May 2010) were released in the last twelve months. Here is my humble opinion of both of these must-read books.
A. Dr. Y.V. Reddy's book :The author suggests taking a re-look at Taxation of Financial Sector; de-financializing commodity markets and allowing financial sector globalization to move in sync with trade liberalization. Unfortunately, very little is articulated in concrete terms in the case of the first two points (i.e. proposing a definitive alternative).
The author does say that the financial sector ought to serve the real sector better especially in the area of housing.
The author enumerates various steps that RBI took (and he certainly deserves a lot of praise like increasing risk weights, inceasing standard provisioning,...) during the financial crisis.
The author also explains why in the times of crisis the Finance Ministry ought to play a central role...he also explains the rationale for RBI taking FinMin's approval for the sterilization of currency interventions (since it entails fiscal costs).
The author suggests that developing bond markets in not necessary (at least for infrastructure development) and suggest surveilance of usurious interest rates charged by for-profit MFIs. In some ways the former seems like a defence of the report card rather than a forward looking approach while the latter (although well-intentioned) seems like a suggestion without an alternative proposal for addressing microfinance.
At times, the author emphasises the importance of financing productive uses (as against consumption).
The author also points out the conflict of intererts in the Mutual Fund industry in India----serving large investors rather than retail investors; and that some of them are sponsored by corporate houses.
The discussion on the Global Financial Architecture is interesting.
The author seems to be largely in favour of gradual reform (except perhaps in the case of housing finance). And this might be the reason that there seems to be no appreciation of western financial sector (surely all of it is not hollow...).
Unfortnately, the format does not do justice to the book. It could have been 250 pages less (it is 410+ pages long!). It is very repititive (to be fair the reader is warned about this in the initial pages).
On the whole, it is well worth the time, because of the educated opinion and food for thought offered by Dr. Y.V. Reddy. And it seems to be a case of the country's misfortune that he was not retained for another term.
B. Professor Raghuram G. Rajan's book: The author clearly explains the drivers of financial stability i.e. the fault lines. He does this by analyzing the role of the government, central bank, the private sector and the voter. The structural changes in the US economy are discussed. So far the micro-level analysis is superb. The resulting interaction between various players is also well-explained. The rationale for the adoption of the export-oriented growth model adopted by Japan, Germany, China is discussed and so also are the problems associated with such a strategy. The discussion on the incentives for undertaking tail-risk; the discussion on the Philips curve; the reason for foreign banks lending to companies largely indirectly (through local banks) in East Asia (prior to the East Asian crisis), the example of the annuities issued by the French monarchy, the debt owed by the German Weimar Republic are all very interesting.
There are three shortcomings:
1. The solution for the US economy is relatively more detailed, while the solution for China, Germany and Japan seems much more macro.
2. The role of decreasing post-cold war defence expenditure in the US, in promoting economic growth is not discussed.
3. The relationship between the store of money and value of money functions is not discussed---with reference to the recent financial crisis.
On the whole this a superb analytical book and provides clues for solutions too although it falls short on micro-level solutions.
DO YOU AGREE WITH MY THOUGHTS?
Posted by amgodbole at 07:25 PM
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March 12, 2011
Political pressure and (un)easy credit...
A sub-committee of the Reserve Bank of India's Board submitted a report to Study Issues and Concerns in the MFI sector. It is available here. This report was submitted in January 2011.
This report mostly (with a few exceptions) is a good example of how NOT to regulate (this is a prescriptive report and not yet a list of new regulations).
WHY?
This is because this well-intentioned report is NOT customer (borrower) centric. Let me explain. Most of the poor in India are dependent on moneylenders for credit---and these moneylenders are generally a part of the informal unregulated economy. These well-intentioned regulations may push the poor towards moneylenders---who the central bank does not control in any case.
While the central bank clearly says (a week after the report was released to the public) that it is not possible for it or the banks to monitor the end-use of credit (i.e. differentiation between use of credit for "production" and "consumption" is not possible; you can listen to the audio available here starting from 5 minutes and 30 seconds---an application to play the MP3 file would be required) the report recommends limiting credit for "mainly income-generating activities" (see Pg 7). That too with inadequate justification for the different view on something very fundamental to banking and finance (see Pg9).
You may also like to read Microfinance: misunderstood, Malegamed by M.S. Sriram (Mint, 20-Jan-2011).
It is interesting to look at how other central banks have reacted to political pressure in democracies. While other central banks---most notable in US, UK and Spain in recent times--- have directly or indirectly encouraged easy credit to persons with poor repayment capacity in an attempt to postpone the effects of stable/falling real incomes for the poorer sections of the population, the RBI and the political system (led by the Government of Andhra Pradesh---one of India's largest States---and the Central Government)seem to be trying to (unwittingly?) prepone the misery of the poor in India by making them even more dependent on the unreformed moneylender.
WHAT DO YOU THINK?
Note-1: The views expressed here (and on other posts on my weblog) are my personal opinion.
Note-2: In case you have a problem in accessing the audio file mentioned above pl write to me. Or you could see the edited transcript here.
Posted by amgodbole at 07:11 PM
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