Tools of Monetary Policy:
- Quantitative Tools
- Qualitative Tools
Quantitative tools can further be classified as:
- Open market Operation (OMO)
- Variable Reserve Ratios
- Interest Ratio
Open Market Operations:
These include both - outright purchase and sale of Government securities(G-Sec) in the secondary market, for injection and absorption of durable liquidity, respectively.
Government securities(G-Sec):
- Tradable sovereign instruments issued by RBI on behalf of the government through auctions conducted on the electronic platform E-kuber.
- Sale and purchase of G-Sec affects the balance sheet of RBI. Purchase of G-sec means more G-sec in the balance sheet of RBI as asset while vice versa in case of sale of G-sec.
- E-Kuber is the core banking solution platform of RBI. Retail investors, Commercial banks, Scheduled Urban cooperative banks, Primary dealers insurance companies, FPI’s and provident Fund are its members.
HOW OMO WORKS:
If there is liquidity in the market :
G-Sec are sold in the market resulting in absorption of liquidity from the market.
If there is no liquidity in the market :
G-Sec are purchased from the market resulting in injection of liquidity from the market.
SIGNIFICANCE OF OMO :
- OMO is prevalent prior to independence but with the increasing integration with global financial markets, OMOs gained additional prominence in sterilising the liquidity impact of large capital inflows.
- Consequent to the enactment of the FRBM Act, 2003, RBI’s withdrawal from the primary market for G-secs in 2006 also facilitated the emergence of OMOs as a key tool for monetary management.
Net Demand and Time Liabilities:
Demand Liabilities:
Liabilities of a bank which are payable on
demand like saving accounts, demand draft.
Time Liabilities:
Time Liabilities of a bank are those which are payable otherwise than on demand like Fixed deposits.
Other Demand and Time Liabilities (ODTL):
It includes interest accrued
on deposits, bills payable, unpaid dividends, suspense account.
The Net Demand and Time Liabilities or NDTL shows
the difference between the sum of demand and time liabilities (deposits) with a
bank and the deposits of bank in the form of assets held by the other bank.
Bank’s NDTL = Demand and time liabilities (deposits) +ODTL –
deposits with other banks
Example:
Total demand and time liabilities of a bank X (including the other bank deposit) :10,000.
Interbank deposits of the bank X: 1000 with the other bank
NDTL: 9,000 (10,000-1,000).
Variable Reserve Ratios (VRR):
Monetary policy tool which controls money supply by maintaining different types of assets like cash , gold , government securities as reserves. Ex: Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).
VRR is used to control credit in the market. By changing the ratio of reserves, the RBI influences the volume of credit that banks can advance. There are two components of VRR:
- Cash reserve ratio (CRR) and
- Statutory liquidity ratio (SLR).
Cash Reserve Ratio (CRR):-
- The average daily balance that a bank is required to maintain with the Reserve Bank of India to operate risk free.
- CRR is calculated on fortnightly basis and is calculated in terms of percentage of NDTL, notified by RBI from time to time .
- As per the RBI Act 1934, all Scheduled Commercial Banks are required to maintain a cash balance on average with the RBI on a fortnightly basis to cater to the CRR requirement.
DYNAMICS OF CRR:
The main purpose of CRR is to regulate money circulation in the economy to drive overall liquidity. It enables banks to keep a minimum cash reserve with RBI, so as to deal with any emergency situation. It helps keep inflation under control as the RBI use it as a tool to regulate liquidity in the economy.As on Nov 2024, CRR is 4.5 %.
If CRR increases, Liquidity with banks decreases, leading to less inflation in the market.
If CRR decreases, Liquidity with banks increases, leading to high liquidity in the market
****** The CRR limits were in the range of 3 -20 % prior to 2006 but 2006 onwards, the limits has been removed.
Statutory Liquidity Ratio (SLR):
The share of NDTL that all Scheduled Commercial Banks is required to maintain in safe and liquid assets, such as, government securities, cash and gold. The SLR is to be maintained with the bank itself.
DYNAMICS OF SLR :
- Changes in SLR often influence the availability of resources in the banking system for lending to the private sector and hence affect the liquidity in the economy.
- SLR has helped the government to sell its securities or debt instruments to banks.
- Most of the banks will be keeping their SLR in the form of government securities as it will earn them an interest income.
- Traditionally the amount to be held thus was stipulated to be no lower than 25 percent and not exceeding 40 percent of the bank’s total NDTL. SLR was 38.5 % during 1990’s while CRR was 15 % during 1990’s.
If SLR increases, Liquidity with banks decreases , leading to less inflation in the market.
If SLR decreases, Liquidity with banks increases, leading to high liquidity in the market .
**********From January-2007 the floor of 25 percent on the SLR was removed following an amendment of the Banking Regulation Act, 1949.
VRRR Rationale:
- CRR causes a huge strain on the financial resources of a bank as there is a huge opportunity cost as the money set aside for deposits with the RBI can be utilized by other sectors creating growth in the economy. Emerging economy like India cant afford to keep this money lying idle with RBI.
- The RBI does not pay any interest on the cash reserve it holds and it is a major lost opportunity for the Banks.
- Statutory Liquidity Ratio (SLR) is already in place and an instrument for the RBI to contain speculative spending by banks, indiscriminate lending and excess cash.
- CRR in addition to SLR is like taxing the bank for public deposits it has secured by sound banking practices. Additionally the CRR as a policy tool to control inflation in the economy has not also yielded the desired results. Price rise has always been an economic issue and will continue to be a cause of concern. Cash supply in the economy is not the sole cause of price rise but supply side factors are a major contributing factor.
- On the positive side, CRR along with SLR provide a buffer to banks so as to avoid aggression in providing loan and avoid any situation which is disastrous for a bank like bank run. Banks in India could survive crisis of 2008 due to VRR.
Liquidity Adjustment Facility:
Monetary policy tool, primarily
used by the RBI, to manage liquidity and provide economic stability by using
REPO and Reverse REPO as tool. RBI adopted in 1998 on recommendation of
Narasimham committee.
Repo Rate:
The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
REPO Rate is inversely
proportional to the liquidity with the banks. All other rates except REPO rate
are decided by RBI governor.
DYNAMICS OF REPO:
If REPO Rate increases ----------------funds will be costlier to consumers ---------------borrowing by people will be less resulting into-------- less Liquidity in the
economy
If REPO Rate decreases --------------- funds will be cheaper to consumers --------------- borrowing by people will be more resulting into ------more Liquidity in the
economy
Repo rate history :
- Since the inception of the Liquidity Adjustment Facility on June 5, 2000, the REPO rate is currently quite low.
- Repo rate was around 9 % during June 2000 and reached the peak during Aug. 2000 to 16 % in the wake of rising oil prices making oil imports more expensive and import inflation in the country.
- As of Nov 2024, it is in the range of 6.5 %.
Marginal Standing Facility (MSF):
- Monetary arrangement announced by the RBI in the year 2011-12, MSF is a penal rate at which banks can borrow money from the RBI over and above their borrowing capacity from the RBI under the LAF window.
- MSF is always fixed at a higher rate than the Repo rate.
- Banks can borrow funds under MSF by pledging government securities within the limits of the statutory liquidity ratio (banks cant pledge SLR securities while borrowing under REPO window).
- MSF has been introduced by RBI with the main aim of reducing volatility in the overnight lending rates in the inter-bank market and to enable smooth monetary transmission in the financial system .
- MSF (marginal standing facility) is available on all days of the week, throughout the year.
Reverse Repo Rate:
The interest rate at which the RBI borrows money from banks for the short term often overnight is defined as Reverse Repo Rate. It is done against the collateral of eligible government securities under the LAF. It is basically done to absorb the liquidity from the market. It is of two types ie
- Reverse Repo and
- Variable Reverse Repo.
If Reverse REPO Rate increases----------- the bank will park money
with RBI --------- Liquidity with banks will decrease ---------- loans will be costlier to the customers -----------less liquidity in the economy.
If Reverse REPO Rate decreases------------the bank will withdraw money from RBI--------Liquidity with banks will increase --------------- cheaper loans to the customers --------- more liquidity
in the economy.
Variable Rate Reverse Repo (VRRR) Auction:
- If the Economy is flush with liquidity, then RBI Since January 2021, had been absorbing money from the banking system via VRRR auctions.
- RBI ask banks to keep their deposit money with RBI and RBI will pay interest above reverse repo rate (and below repo rate) BUT the rate will be decided through auction.
- For example, RBI wants to absorb Rs. 50,000 crore liquidity then RBI will select those banks which quotes (asks for) minimum interest rate above reverse repo rate. This VRRR auction can be for overnight or for longer period. At present, VRRR auctions have tenors of 7, 14 and 28 days.
STANDING DEPOSIT FACILITY :
- The idea of an SDF was first mooted in the Urjit Patel Monetary Policy Committee report in 2014 but it could finally be implemented in April 2022.It is an additional tool of Monetary policy for absorbing liquidity without any RBI collateral.
- When there is huge liquidity in the system and the central bank has to absorb that huge amount of money from the banking system through the reverse repo window, it becomes difficult for it to provide the required volume of government securities in return.
- As the SDF is a collateral-free arrangement, RBI need not to give collateral for liquidity absorption .
- SDF rate is higher than Reverse Repo rate, it provides banks a greater incentive to use the SDF window to park their excess money.
- Though SDF is for overnight deposits but it retain the flexibility to absorb liquidity of longer tenors.
VRRR vs SDF :
- VRRR transactions sought for G-Sec as collaterals while there is no such requirement in case of SDF.
- SDF is active throughout the year while VRRR is discretionary of RBI and it is invoked as and when RBI thinks so because of liquidity in the market.
- The SDF will replace the fixed rate reverse repo (FRRR) as the floor of the liquidity adjustment facility corridor. Both the standing facilities — the MSF (marginal standing facility) and the SDF will be available on all days of the week, throughout the year.
Corridor:
- The Corridor in the monetary policy of the RBI refers to the area between MSF which is the emergency lending rate and SDF which is the liquidity absorption rate.
- Marginal Standing Facility is the upper ceiling of the Corridor, whereas the Standing Deposit Facility constitutes the lower floor.
- The repo rate is usually placed in the middle of the corridor.
Sterilization:
Monetary action in which a central bank limits the effect of inflows and outflows of foreign capital on the money supply. It involves open market operations undertaken by RBI to neutralize the impact of associated foreign exchange operations.
DYNAMICS OF STERLISATION :
BOP should be zero in the accounts of RBI.
When FDI and FPI increases
↓
BOP becomes positive.
↓
+ BOP should be neutralized
↓
RBI purchased extra Dollar
↓
Injection of Rupee in the economy
↓
Inflation in the economy and depreciation of Rupee.
↓
RBI sell G-Sec to absorb liquidity
↓
Economy gets stabilized
This whole process that starts with influx of foreign currency to the stabilization of Rupee is referred to as sterilization .
Market Stabilization Scheme (MSS):
- Monetary management tool used by the Reserve Bank of India to suck out sudden excess liquidity from the market through issue of securities like Treasury Bills, Dated Securities etc. on behalf of the government.
- Surplus liquidity arising from sudden large capital inflows is absorbed through sale of temporary short-dated government securities and treasury bills. The money raised under MSS is kept in a separate account called MSS Account and not used by the government and hence it does not have any impact on Budget deficit.
- The interest cost is shown separately in the Budget and interest payment liability against this scheme is called carrying cost.
- MSS was used in 2004 for the first time in the wake of inflow of dollar in India. It was also invoked during the times of demonetization.
Gradation of different rates :
SDF<Reverse Repo< Repo < MSF (Bank Rate)
