Liquidity management posers

The Reserve Bank of India (RBI) recently released the Report of the Internal Working Group (IWG) to Review the Liquidity Management Framework.

- JANAK RAJ

Liquidity management operations are the nuts and bolts of monetary policy and, therefore, it is important that the framework is robust.

The report rightly suggests the discontinuation of a 14-day variable rate repo/reverse repo (VRR/VRRR) as the main operation. Banks, as the IWG report observes, are reluctant to park surplus liquidity for this duration. In addition, it is hard to make a precise liquidity forecast for 14 days as government cash balances maintained with the RBI are intrinsically volatile. Currency movements are unpredictable too, though they have predictable seasonal patterns.

The main operation conducted at a weekly interval instead of 14 days, combined with the fine-tuning operations of varying tenors as and when needed as recommended by the IWG, should help smooth liquidity management.

The IWG's recommendation on the retention of the weighted average call rate (WACR) as the operating target is also appropriate. However, a reduction in the activity for the overnight call money segment, from where the WACR emerges, raises concern, as this decreases the central bank's control over short-term interest rates.

Why has activity in the call money market declined? The width of the corridor is essentially a trade-off between volatility in short-term interest rates and activity in the overnight inter-bank market. The narrower the corridor, the greater the possibility of banks dealing with the central bank than among themselves. In other words, the reduced volatility in short-term interest rates is at the expense of lower inter-bank activity. The IWG report observes that the narrowing of the corridor coincided with the declining share of call money in the total overnight money market volume. Thus, a proper balance needs to be struck between the two.