The monetary policy must be made more responsive to the macroeconomic situation and to liquidity smoothing so that market expectations formation is sound.
The RBI's liquidity management is not led as much by the interest rate considerations, as commonly believed, as by the aim of providing adequate liquidity.
The concerns about liquidity management that came to the fore in a most forceful manner in March reflect the analytical problems that the monetary authorities are faced with in the given context of other macroeconomic policies. Liquidity management falls in the area of operating procedures of monetary policy and central bankers have to be sure that the operating procedures make sense and help to provide sufficient scope for formation of meaningful market expectations.
Most central banks in industrialised economies indulge in elaborate exercises to forecast liquidity requirements for each day and for a short period ahead (say, a week). These economies, one must note, are characterised by a high degree of financial integration and a well-evolved financial development. The forecasting exercises are conducted more than once on each working day whenever the liquidity supplies fall short of the expected liquidity requirements.
In India too such liquidity forecasting exercises are conducted on a daily basis. The exercises began with the introduction of the Liquidity Adjustment Facility in 1999. An internal and informal Financial Markets Committee (FMC) at the RBI meets early each day to examine the numbers that go into the forecasting exercise. The exercise is also forward looking in that the forecasting is done for a week ahead.
Depending on the FMC's assessment, the Reserve Bank of India decides upon the course of action to be taken during the day to either supplement or withdraw liquidity. The mechanism of repurchase agreements (repos) is triggered as part of such a course of action. On any day, when the liquidity supplies are not adequate to match the projected liquidity needs, the liquidity forecasts are reworked and the Committee meets again to consider the new forecasts.
Analytically speaking, liquidity determination is a technical exercise based on the assessment of the bank reserves position and the expected inflows and outflows from both domestic (fiscal and other) operations and foreign flows. It has direct impact on the quantity of funds for lending and investment and through it the short-term interest rates. There is, thus, a twin effect on both the quantity and rate variables. In industrialised economies, a significantly low provision of the expected liquidity requirement would indicate that the central bank might like to see the policy interest rate (say, the repo rate) move up. The magnitude of the gap in liquidity provision would be a signal to market participants of the extent of the upward movement in the policy rate that the central bank desires.
A full provision of daily liquidity requirements would mean that the central bank would be neutral in that it would not be uncomfortable with the current direction as well as the extent of market rates of interest.
CHANGE IN SMALL DOSES
Where financial integration is sharp, the short rates would influence the long rates, facilitating the evolution of a yield curve that would show long rates commanding a premium over the short rates. The authorities in industrialised economies attempt to influence the liquidity position by adjusting the policy rates and impact on the consumption-investment mix. But even in these economies, because of glorious uncertainties, the policy rates are changed smoothly by small margins, often in doses of 25 basis points. This happens even in countries where there is formal inflation targeting as an objective of monetary policy.
The above rudimentary description of the analytics underlying liquidity determination and the forecasting exercises as seen in most industrialised economies is applicable for the Indian economy as well. The Indian case, however, differs from the industrialised economies in several respects. First, the financial integration is not complete. Second, the interest sensitivity of investment needs to be established more forcefully. Third, the economy is characterised mainly by bank financing rather than market financing.
Fourth, there are some distortions such as the special schemes for export credit coexisting with the LAF. Fifth, the daily trial balance-sheet of the RBI is apparently not prepared and the daily liquidity forecasts depend perhaps on pro-rata allocation of numbers under various heads of the balance-sheet that is prepared on a weekly basis. Sixth, the objective of monetary policy is not one of inflation targeting but of duality of objectives that makes it difficult to have a clear policy on interest rate management. Finally, the liquidity policy, to be consistent with rate of interest signals (read, stance) that the RBI provides through monetary policy, should be such that changes in key policy rates would have a noticeable impact on short-term market rates of interest. In case the liquidity operations do not have effect on the money market rates, it would reflect lack of clarity about the interest rate signals.
The above features give an important clue. The RBI's liquidity management is not led as much by the interest rate considerations, as commonly believed, as by the aim of providing adequate liquidity. The underlying principle of the approach seems to be that through the quantity variable interest rates would be stabilised around the levels where investment intentions are perceived to be conducive to economic growth.
The success of this premise depends on avoidance of shifts in the direction of liquidity requirements from surplus to crunch and back. Liquidity smoothing is vital and would facilitate interest rate smoothing. It is to this end that the framework of monetary policy would require to be focused.
Monetary policy, as of now, is centralised: This has not changed by the establishment of the Technical Advisory Committee on Monetary Policy. One needs to strengthen the institutional set-up to make monetary policy much more responsive to macroeconomic situation and to liquidity smoothing so that market expectations formation would be sound.
A NEW SET-UP
Against this background, it would be essential to carve out a Monetary Policy Committee (MPC) from the present legal framework. The MPC could consist of the Governor (as Chairman), the Deputy Governor in charge of monetary policy, two members from the Central Board of Directors, and one senior representative of the government, preferably the Secretary in charge of the Department of Economic Affairs. Other RBI Deputy Governors could be invited for consultation at the meetings of the MPC. The representative of the government would be required because monetary policy without appropriate fiscal policy support would not have the requisite effect. Two members could be drawn from the Central Board of Directors on the basis of their knowledge of the economics of policy and, if possible, experience in policy-making. An external expert could be inducted at a later stage with a change in legislation.
The Committee would be in operation along with the Central Board of Directors, which, in the event, would focus on other issues relating to central banking. While the Central Board would meet regularly (as of now every week), the MPC would meet at least four times in a year. The MPC secretariat would have to be drawn from the Monetary Policy and Financial Markets Departments. The gist of the policy options and if possible of the policy papers placed before the MPC could be put on the RBI web site. Such an approach would be viewed as more transparent and credible.
(The author, a former Executive Director of the Reserve Bank of India, can be accessed at email@example.com)