Drivers and Management of RBI’s Liquidity operations in 2018-19

In the earlier versions of India’s monetary policy, RBI used to release this useful Macroeconomic and Monetary Developments Report (MMDR).  This was discontinued after April-2014 policy, as RBI started releasing Monetary Policy Report. In the MMDR, the chapter on Monetary and Liquidity Conditions used to be very useful as it would tell us about ongoing changes in RBI’s liquidity management. This would tell us the drivers of market liquidity and how RBI managed the situation. Alongwith MMDR, this very useful input was also done away with.

In the recent RBI Bulletin (Feb-19), there is a nice research note bringing back both: memories and insights. The note is written by Indranil Bhattacharyya, Samir Ranjan Behera and Bhimappa Talwar of the Monetary and Liquidity Analysis Division, Monetary Policy Department, Reserve Bank of India.

They first summarise the broad history of RBI’s LAF framework since 1999 and changes which have happened overtime. Then they discuss the drivers and management of liquidity in Indian money markets in 2018-19.

Liquidity management was subjected to conflicting pulls during 2018-19 in an environment suffused with global spillovers, the rapid pace of remonetisation and frictional high tides of budgetary spending. As a consequence, liquidity in the system underwent sizable churns that vitiated patterns of the recent past and necessitated atypical responses from the RBI in terms of the choice of instrument mix and the timing of deployment – for the first time, pre-announced OMO notified amounts entered the RBI’s arsenal of liquidity management instruments. Another defining feature of the 2018-19 experience is that liquidity absorption was conducted through short-tenor (4-7 days) reverse repo whereas liquidity injection was mainly through longer-tenor (28-56 days) repo, indicating that episodes of liquidity surplus in the system were transient. In the event, the combination of one-sided OMOs (purchases) and long-duration repo imparted a downward bias to the WACR which trailed below the policy rate throughout the year, warranting careful review of the framework’s performance in terms of the marksmanship objective that has been pursued with the progressive narrowing of the LAF corridor.

The empirical results suggest that announcement effects tend to dominate over liquidity effects so that the market’s reactions to policy innovations are
stronger and faster than the responsiveness of actual cost of funds to system liquidity shifts engendered by the policy changes when they fully play out. The
results also underscore the need for assigning priority to reforms of the market microstructure if the full effects of the overhaul of the liquidity management framework are to be reaped in terms of marksmanship and efficiency of transmission. Significantly, however, the volatility of the WACR has reduced, stabilising
market expectations.

An unfinished agenda awaits the evolution of the liquidity framework. The 14-day repo, through which the bulk of primary liquidity is provided to satiate the 
demand for reserves, needs to replace the fixed rate overnight repo as the single policy rate. Two-way OMOs need to be conducted in a market-based framework so that quantity modulation occurs seamlessly rather than relying on announcement effects. The experience of 2018-19 also suggests that fine-tuning operations should be of short tenors and easily reversible, notoverwhelming the durable liquidity operations. A more accurate assessment of liquidity needs is critical, combining top-down methodologies and bottom-up approaches. A roadmap for liquidity management reforms has been laid out (RBI, 2014), and it is apposite to carry its implementation forward. The success of liquidity management in terms of its objectives hinges around clear and transparent communication of intent, content, time frame and target(s).

Superb bit. RBI should keep releasing these liquidity notes in its Bulletins..

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