Money & Banking

Why the RBI focusses on liquidity management

Radhika Merwin BL Research Bureau | Updated on January 15, 2018 Published on April 06, 2017


Last year, in the April policy, the RBI made substantial changes in liquidity management — moving from deficit to neutral liquidity

It was only in April last year that the RBI, taking note of banks’ plea, had announced a slew of measures to ease liquidity. The objective then was to help banks transmit the RBI’s rate cut to borrowers more quickly. One year on, banks are dealing with just the opposite — the problem of plenty. And the RBI too has reversed its policy stance from accommodative to neutral.

In either situation of tight liquidity or excess liquidity, the RBI’s objective remains the same — to ensure that the key policy rate (repo) is the operational rate.

Then and now

Liquidity always plays an important role in transmission of policy rates. In a falling rate cycle, pass-through of rate cuts will happen quickly if there is sufficient liquidity in the system, as banks will be able to lower deposit rates comfortably. Hence, last year, in the April policy, the RBI made substantial changes in liquidity management — moving from deficit to neutral liquidity. Aside from assuring ‘durable liquidity’ through open market operations (OMOs), the RBI also lowered the rate corridor between the repo, reverse repo and marginal standing facility (MSF) rate to 50 basis points from 100 basis points earlier.

Repo rate is the rate at which banks borrow short-term funds from the RBI, and reverse repo, the rate at which banks lend surplus money to RBI. If banks exhaust their limits under the repo window, they can borrow under the MSF at higher rate.

The underlying purpose of narrowing the rate differential between the three, was to ensure quicker transmission of policy rates to borrowers. The overnight rate that hovered between the repo and the MSF, moved lower, ranging between the repo and the reverse repo instead. Since the Centre’s demonetisation move, the tables have turned. Despite lifting of the various caps on withdrawal, banks are still flush with funds.

Fallout of excess liquidity

The immediate fallout of excess liquidity over the past few months has been the sharp cuts in deposit rates by banks.

The other outcome has been the call money rate falling below the repo rate. The three-month T-bill rate, for instance, has been trading at 5.7 per cent, way below the repo rate at 6.25 per cent. The CBLO overnight call rate too has been trading at these levels.

In a bid to align the call rate close to the repo rate, the RBI has raised the reverse repo rate from 5.75 per cent to 6 per cent. This will have two implications. One, the overnight rate will now move closer to the repo rate at 6.25 per cent. The three-month T-bill rate has already inched up to 5.8 per cent.

Two, this further narrows the rate corridor from 50 basis points to 25 basis points, better aligning the operational rate with the policy repo rate.

The RBI is likely to introduce the standing deposit facility soon. This will have the advantage of sucking out liquidity, without requiring collateral. This tool recommended in the Urjit Patel Committee report of 2014, may replace the reverse repo.

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Published on April 06, 2017
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