New vistas in monetary policy

The Mohanty Working Group Report (March 2011) is a landmark Report which will greatly facilitate the operating procedures in monetary policy The merit of the Report is that it provides a consistent framework within which day-to-day monetary policy operations can be conducted efficiently.

The Report recommends that the Liquidity Adjustment Facility (LAF) should be the key element in the operating framework of the RBI. The LAF should be contained around plus/minus one per cent of the net demand and time liabilities (NDTL), which would, at present, translate to plus/minus Rs 45,000 crore. In the recent period the extent of the LAF has been significantly higher than recommended by the Group.

Recognising that the liquidity swings present a major problem, the Group recommends that persistently high usage of the LAF would call for alternative instruments.

It is conceivable that the LAF deficit could be very large and credit expansion could also be way ahead of the desired trajectory. This would, no doubt, call for other measures, such as increase in the cash reserve ratio (CRR), but this would increase the liquidity shortage. The moral of this is that early policy action has to be taken before the situation gets out of hand and paralyses monetary policy. These are problems arising from concerns that pre-emptive monetary policy could abort growth. These are hard macro-policy choices which have to be made.

The Group favours operating the LAF in a deficit mode and recommends a single policy rate while the operating target would be to keep the overnight interest movement within a narrow informal bound of the repo rate.

SLR waiver

The Group recommends the reactivation of the instrument of the Bank Rate with a fixed spread over the repo rate and recommends the introduction of a collaterised Exceptional Standing Facility (ESF) at Bank Rate up to one per cent of the NDTL which could be carved out from the statutory liquidity ratio (SLR) portfolio. As against the present ad hoc waivers for SLR shortfalls there should be a general waiver of SLR shortfalls up to the stipulated borrowings.

The Group recommends an asymmetrical corridor with the Bank Rate at one- half of one percentage point above the repo facility and a reverse repo rate of one percentage point below the repo rate. Thus, the corridor would be 150 basis points which, according to the Group, should normally not be altered. Given the present repo rate of 6.75 per cent, the Bank Rate would need to be raised by 1.25 percentage points, which would be a tall order in the present milieu of “baby steps”.

Given the historical difficulties in frequent changes in the Bank Rate it would be best to iron out these rigidities before linking the Bank Rate and the repo rate. There should be a policy decision that all facilities linked to the Bank Rate would face automatic changes when the repo rate is changed.

Unintended rigidities

A word of caution is raised as the State Government Ways and Means Advances and Overdrafts as also certain long-term refinance facilities are linked to Bank Rate and the link between the repo rate and the Bank Rate should not have the unintended effect of rigidities developing in the repo rate. If the rigidities of the Bank Rate cannot be overcome, the ESF could be provided at one half of one percentage point above the repo rate.

Although the fixed rate repo and reverse rate repo operations are called auctions, there is no real auction as unlimited liquidity is injected or withdrawn at fixed rates. Again, when having an overall surplus/deficit limit of one per cent of the NDTL, it would be best to fix bank-wise quotas in relation to their NDTL. In the absence of this there could be imprudent borrowing by individual banks.

With bank-wise quotas, there would be some discipline as additional recourse to the RBI beyond the repo quota would require these banks to pay a higher interest rate while seeking access to the ESF. Bank-wise quotas would not disrupt day-to-day operations as banks would be able to borrow and on-lend to other banks and as such the system would equilibrate.

The dilution, of mark-to market valuation norms for government and other approved securities was unfortunate. This was done, ostensibly, to shore up bank profitability but in the event it restricts the banks' ability to trade in securities. The Group recommends that the entire SLR portfolio should be progressively marked to market.

The Group recommends that a scheme for auctioning government surplus cash balances should be devised but banks should not get access to these funds at sub-repo rates of interest.

The Mohanty Working Group deserves to be commended for its efforts. To start with, the RBI should not hesitate to implement as many of its recommendations as possible in its May 3 Monetary Policy Review.

(The author is an economist. >blfeedback@thehindu.co.in )

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