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.
