Moneta ry policy.

August 22

2011
LAF perspective .

MEMBERS
1.

Mahalaxmi Krishnan Email id: mhlxm.k@gmail.com Contact no. 9892374856

2.

Ankit Solanki Email id: ankit.solanki21@yahoo.in Contact no. 9833618280

DECLARATION

This is to certify that the research paper is original and is not published anywhere.

ABSTARCT

On the global front, the sovereign debt problems that have beset the Euro area over the past year re-emerged on the back of Greeces deteriorating fiscal position, downgrading of Portugals sovereign debt rating, and most significantly, signs of stress in Italy's sovereign debt.now. In the US, concerns over a Sovereign default loomed over financial markets, with potentially disruptive consequences for global capital flows. Japan is dealing with the challenges of recovering from the impact of the Tsunami amidst deeper recessionary tendencies. In striking contrast to the advanced economies, emerging market economies (EMEs) have generally been dealing with rising inflation, caused by a combination of elevated commodity prices and robust domestic demand. Overall, the current balance of global and domestic factors suggests that monetary policy needs to persist with a firm anti-inflationary stance. Moreover, moderating domestic growth will certainly help ease the inflationary pressures.

In advanced countries, and especially in Europe targeting one rate and keeping the system short on reserves works because the external sector and the capital account is not controlled which is not the case in developing countries like India.

In India, the LAF (Monetary policy) framework was such that the operating policy rate alternated between the repo rate and the reverse repo rate, depending on the

prevailing liquidity condition. In a surplus liquidity condition, the reverse repo rate becomes the operating policy rate. In a deficit liquidity situation, the repo rate becomes the policy rate. the shift in the policy rate from one rate to another does create confusion in the minds of market participants.

In order to review the prevailing operating procedure of monetary policy in India, in particular, the Liquidity Adjustment Facility (LAF), the Reserve Bank of India (RBI) constituted a Working Group led by Shri Deepak Mohanty, Executive Director, RBI and based on its recommendations, revised the operating procedure for LAF(Annexure 1). It announced that there will be only one independently varying policy rate henceforth and that will be the repo rate. The reverse repo rate will be pegged 100 basis points below the repo rate and that will no longer be an independent variable.

This Research paper will provide the reader with an overview of the system of Monetary Policy, with an emphasis on the framework with respect to the Indian context. Also, the paper will provide an in depth analysis of the Liquidity Adjustment Facility (LAF), which has emerged as the key element of the present operating procedure of monetary policy. The paper will also provide an insight into the role of LAF in the Money market transmission mechanism.

CHAPTERISATION

Chapter I will explain the concept of Monetary policy and the prevelant scenario in India. Chapter II will outline the Importance Of Financial Markets In The Transmission Mechanism specially the Money Markets. Chapter III will cover Indias journey of Transition from a Pre- LAF to a Post-LAF Economy. Chapter IV wil provide an insight into the Future Challenges confronting the Indian Economy.

CHAPTER I: CONCEPT OF MONETARY POLICY

The idea of monetary policy as independent of executive action began to be established with the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold. The term Monetary Policy is also known as the 'credit policy' or called 'RBI's money management policy' in India. A monetary policy is related to the availability and cost of money supply in the economy in order to attain certain broad objectives. According to Prof. Harry Johnson, "A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy.. The Central Bank of a nation keeps control on the supply of money to attain the objectives of its monetary policy, often targeting a rate of interest for the purpose of promoting economic growth and stability. It is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, & contractionary policy expands the money supply more slowly than usual or even shrinks it. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting distortions and deterioration of asset values. There are several monetary policy tools available to achieve these ends: increasing interest rates; reducing the monetary base; and increasing reserve requirements.

Monetary policy is one of the tools that a national Government uses to influence its economy. Using its monetary authority to control the supply and availability of money, a government attempts to influence the overall level of economic activity in line with its political objectives. According to Milton Freidman, If all factors having an impact on output and inflation were completely known in advance, it would make no difference whether the central bank conducts policy by fixing the supply of reserves or by setting an interest rate. However, since many factors that impact the central banks policy priorities are unpredictable, the choice of the operating instrument matters for the effectiveness of monetary policy. Monetary Policy can be implemented by changing the size of the monetary base. Central banks use open market operations to change the monetary base. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies. It can also be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. By changing the proportion of total assets to be held as liquid cash, the RBI changes the availability of loanable funds. This acts as a change in the money supply. Another way to implement monetary policy Discount window lending, where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), thereby affecting the money supply. The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. This rate has significant effect on other market interest rates

(Chart 1). The main transmission channel is the commercial interest rate channel whereby change in the policy interest rate impacts deposits and lending rates of financial institutions, and alters the spending & investment decisions of households and businesses (Annexure 2). Monetary policy framework is a continuously evolving process contingent upon the level of development of financial markets and institutions, and the degree of global integration [Speech by Deepak Mohanty, Executive Director, Reserve Bank of India, delivered at the Indian Institute of Management (IIM), Lucknow on 12th August 2011.] Traditionally, four key channels of monetary policy transmission are identified, viz., interest rate, credit aggregates asset prices and exchange rate channels. The interest rate channel emerges as the dominant transmission mechanism of monetary policy. In the recent period, a fifth channel expectations has assumed prominence in the conduct of forward-looking monetary policy in view of its influence on the traditional four channels. For example, the link between short- and long-term real rates is widely believed to follow from the expectational hypothesis of the term structure of interest rates. In a generalized context, the expectations channel of monetary policy postulates that the beliefs of economic agents about future shocks to the economy as also the central banks reactions can affect the variables that are determined in a forward-looking manner. Thus, "open-mouth operation" by the central bank, i.e., an announcement of future central bank policy influences expectations in financial markets and leads to changes in output and inflation.

MONETARY POLICY IN INDIA

The Reserve Bank of India Act, 1934 sets out one of the objectives of the Bank: to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage. With regards to achieving the said objective, the twin objectives of monetary policy in India are widely regarded as (i) price stability and (ii) provision of adequate credit to productive sectors of the economy so as to support aggregate demand and ensure high and sustained growth. The Reserve Bank has explicit multiple objectives of monetary policy with changing relative emphasis. It also follows a multiple indicator approach, which has been reasonably effective. In India, the current operating procedures of monetary policy using the three major instruments of policy, namely, repo rate and reverse repo rate setting the corridor for short term interest rates and the cash reserve ratio operating through the quantum channel, were initiated since early 2001. While all these three rates move in conjunction, repo rate is the most significant, the other two rates playing a complementary role. The key element of the framework at present is the flexibility enjoyed by the Reserve Bank while going about its assigned task of maintaining the monetary stability of India. In India, the objectives of monetary policy evolved as maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy. With progressive liberalisation and increasing globalisation of the economy, maintaining orderly conditions in the financial markets emerged as an additional policy objective.

Thus, monetary policy in India endeavors to maintain a judicious balance between price stability, economic growth and financial stability. [Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the Bankers Club, Bhubaneswar, 15 March 2010]. The operating framework of monetary policy has been the maintenance of overnight market rates within an interest rate corridor defined by the floor of the reverse repo (absorption) rate and ceiling of the repo (injection) rate (Chart 3).

One can trace the development of the monetary policy in India by looking at its history

In the formative years during 1935-1950, the focus of monetary policy was to regulate the supply of and demand for credit in the economy through the Bank Rate, reserve requirements and OMO.

During the development phase during 1951-1970, the need to support plan financing through accommodation of government deficit financing by the RBI began to significantly influence the conduct of monetary policy.

During 1971-90, the focus of monetary policy was on credit planning. However, the dominance of fiscal policy over monetary policy accentuated and continued through the 1980s.

The 1980s saw the adoption of monetary targeting framework based on the recommendations of Chakravarty Committee (1985). Under this framework, reserve money was used as operating target and broad money (M3) as an intermediate target.

Structural reforms and financial liberalisation in the 1990s led to a shift in the financing paradigm for the government and commercial sectors with increasingly market-determined interest rates and exchange rate.

The monetary policy operating procedure also underwent a change following the recommendation of Narasimham Committee II (1998). The RBI introduced the Interim Liquidity Adjustment Facility (ILAF) in April 1999 which was gradually transited into a full-fledged Liquidity Adjustment Facility (LAF).

Current Situation
As per the Monetary Policy Statement 2011-12 by the RBI Governor, throughout the year, the goal of monetary policy will be to nurture the growth in the face of persistent global uncertainty while trying to contain the spillover of supply-side inflation. Three factors have shaped the outlook and monetary strategy for 2011-12: 1) Firm & increasing global commodity prices;
2) High headline and core inflation, which have significantly overshot even the most

pessimistic projections over the past few months; and 3) The likely moderation in demand, which should help reduce pricing power and the extent of pass-through of commodity prices. Against this backdrop, the stance of monetary policy of the Reserve Bank will be:

Maintaining an interest rate environment that moderates inflation. Fostering an environment of price stability that is conducive to sustaining growth in the medium-term coupled with financial stability.

Managing liquidity to ensure that it remains broadly in balance, with neither a large surplus diluting monetary transmission nor a large deficit choking off fund flows.

CHAPTER II: IMPORTANCE OF FINANCIAL MARKETS IN THE TRANSMISSION MECHANISM.

The basic aim of financial market development must be to aid economic growth and development. The primary roles of financial markets is to intermediate resources from savers to investors, and allocate them in an efficient manner among competing uses in the economy, thereby contributing to growth both through increased investment and through enhanced efficiency in resource use.

Developed financial markets are critical for effective transmission of monetary policy impulses to the rest of the economy. Monetary transmission cannot take place without efficient price discovery, particularly with respect to interest rates and exchange rates. Deep and liquid financial markets contribute to efficient price discovery in various segments of the financial market. Well-integrated markets improve efficacy of policy impulses by enabling quick transmission of changes in the central banks short-term policy rate to the entire spectrum of market rates, both short and long-term, in the money, the credit and the bond markets. However, various benefits emanating from the functioning of the financial markets depend critically upon the resilience of various segments of the market to withstand shocks and the strength of the risk management systems in place. In view of the critical role played by the financial markets in financing

the growing needs of various sectors of the economy, it is important that financial markets are developed further and well-integrated. [Address by Deputy Governor, Rakesh Mohan, Reserve Bank of India at the First Indian-French Financial Forum] It is through the financial markets that monetary policy affects the real economy. The monetary policy instrument is a financial market price, which is directly set or closely controlled by the central bank.

The Reserve Bank has accorded prime attention to the development of the money market as it is the key link in the transmission mechanism of monetary policy to financial markets and finally, to the real economy. With the initiation of reforms and the transition to indirect, market-based instruments of monetary policy in the 1990s, the Reserve Bank made conscious efforts to develop an efficient, stable and liquid money market by creating a favourable policy environment through appropriate institutional changes, instruments, technologies and market practices. Accordingly, the call money market was developed into primarily an interbank market, while encouraging other market participants to migrate towards collateralised segments of the market, thereby increasing overall market integrity.

With the increased market orientation of monetary policy along with greater global integration of domestic markets, the Reserve Banks emphasis has been on setting prudential limits on borrowing and lending in the call money market, encouraging migration towards the collateralised segments and developing derivative instruments for hedging market risks.

This has been complemented by the institutionalisation of the Clearing Corporation of India Limited (CCIL) as a central counterparty. The upgradation of payment system technologies has also enabled market participants to improve their asset liability management. All these measures have widened and deepened the money market in terms of instruments and participants, enhanced transparency and improved the signaling mechanism of monetary policy while ensuring financial stability.

MONEY MARKET
The money market is a subsection of the fixed income market. The money market specializes in debt securities that mature in less than one year. It is an important channel for monetary policy transmission. It exists to facilitate efficient transfer of short-term funds between holders and borrowers of cash assets. It is that part of financial market where instruments with high liquidity and very short term maturities are traded. One of the primary functions of money market is to provide focal point for RBIs intervention for influencing liquidity and general levels of interest rates in the economy. RBI being the main constituent in the money market aims at ensuring that liquidity and short term interest rates are consistent with the monetary policy objectives. RBI has an important presence in the money market through the liquidity adjustment facility (LAF) window. A gradual shift towards a collateralised inter-bank market, phasing out of non-bank participants from the call and notice money market, policy direction towards reductions in cash reserve requirements, the introduction of new instruments, such as,

Collateralised Borrowing and Lending Obligation (CBLO), implementation of Real Time Gross Settlement (RTGS), significant transformation of monetary operations framework towards market-based arrangements and facilitating trading through Negotiated Dealing System Call Money (NDS-CALL) are some of the reform measures that have contributed to the development of a relatively vibrant and liquid money market in India.

CHAPTER III: TRANSITION FROM PRE- LAF TO POST-LAF ECONOMY

PRE-LAF PERIOD
Financial markets in India in the period before the early 1990s were marked by administered interest rates, quantitative ceilings, statutory pre-emption, captive market for government securities, and excessive reliance on central bank financing, pegged exchange rate, and current and capital account restrictions.

M3 broad money emerged as intermediate target of monetary policy and RBI formally announced the monetary target as nominal anchor for inflation. Scope of open market operations was limited as yields related to government securities were low and administered. The demand for them was created through periodic hikes in the Statutory Liquidity Ratio (SLR) for banks.

As interest rates were regulated, monetary management was undertaken mainly through changes in the cash reserve ratio (CRR), which was used to influence indirectly the marginal cost of borrowing by having an initial impact on the call money market. The task before the Reserve Bank was, therefore, to develop the financial markets to prepare the ground for indirect operations. The Indian money market was characterised by paucity of instruments, lack of depth and dichotomy in the market structure. As a result of inadequate depth and liquidity in the organised money market, the sectoral financing were met by the unorganized market. The money market during this period could not provide an equilibrating market mechanism for meeting short-term liquidity needs for banks. The prevalence of administered structure in the money market did not permit interest rates to reflect the actual extent of scarcity of funds. Owing to limited participation, money market liquidity was highly skewed, characterised by a few dominant lenders and a large number of chronic borrowers. Faced with these impediments, together with limited Reserve Banks refinance, banks often faced either short-term liquidity problems for meeting the statutory reserve requirements or remained saddled with excess liquidity. The money market increasingly reflected the spillover impact of monetary policy operations through direct instruments. The process of financial liberalization introduced in the early 1990s, as part of the overall economic reforms programme, led to a structural shift in the financing paradigm for the government and the commercial sectors. The volatility in call rates, however, continued, necessitating some instruments for managing liquidity. For analyzing the conditions & suggesting improvements, the RBI set up the Committee on Banking Sector Reforms (Narasimham Committee II, 1998)

INTRODUCTION OF LAF
The Narasimham committee, constituted by RBI, recommended further liberalisation of money market through withdrawal of ceiling in money market interest rate, auction of treasury bills, abolition of Adhoc T-bills, gradual movement from cash credit system to loan system, more participation in the market, & development of the secondary market. CRR which had already been brought down from 15 percent of NDTL in 1989-1993 was reduced to 9.5 per cent by November 1997 & further to 4.5 percent in June 2003. While SLR reduced to 25 percent in October 1997 and is currently 24 percent. The Narsimham Committee (1998) noted that the money market, inspite of various reforms continued to remain lopsided, thin and volatile and the Reserve Bank also had no effective presence in the market. Therefore, it reiterated the need to transform the call money market into a pure inter-bank market and recommended the Reserve Banks operations to be market-based. Following these recommendations, the Reserve Bank introduced the liquidity adjustment facility (LAF) in June 2000 to manage market liquidity on a daily basis and also to transmit interest rate signals to the market. Under the LAF, the Reserve Banks policy reverse repo and repo rates set the corridor for overnight market interest rates. Thus, OMO including LAF emerged as the dominant instrument of monetary policy, though CRR continued to be used as an additional instrument of policy. And subsequently the Interim Liquidity Adjustment facility ( ILAF) was introduced in April 1999 with the purpose of modulating market liquidity on a daily basis and also to transmit interest rate signals.

The transition from ILAF to LAF commenced in June 2000 and progressed gradually in three stages:
(1) The replacement of Additional Collateralised Lending Facility(ACLF) by variable rate

repo auction with same day settlement;

(2) Collateralised Lending facility was replaced by variable rate repo; and (3) Adoption of international best practices of repo and reverse repo, computerisation of

public debt office , onset of RTGS(Real Time gross settlement) and introduction of Second LAF(SLAF) in November 2005.

The Scheme

Under the LAF, the Reserve Bank sets its policy rates, i.e., repo and reverse repo rates and carries out repo/reverse repo operations, thereby providing a corridor for overnight money market rates (Chart 3). The weighted average overnight rate largely moves within the corridor set by LAF rates.

Under the scheme, (i) Repo auctions (for absorption of liquidity) and (ii) Reverse Repo auctions (for injection of liquidity) will be conducted on a daily basis (except Saturdays). But for the intervening holidays and Fridays, the Repo tenor will be one day. On Fridays, the auctions will be held for three days maturity to cover the following Saturday and Sunday. The funds under LAF are expected to be used by the banks for their dayto-day mismatches in liquidity.

Initially, auctions under LAF were conducted on ''uniform price'' basis. It had been decided to introduce ''multiple price'' auction, on an experimental basis for one month period during May 2001. Also Interest rates in respect of both Repos and Reverse Repos were to be, accordingly, based on the bids quoted by participants and subject to the cut-off rates as decided by the Reserve Bank of India, at Mumbai.

Objectives of LAF:
Amongst its many functions, Reserve Bank of India also acts as the banker of last resort. In this role, the central bank has to ensure that it can inject funds into the system to help participants tide over temporary mismatches of funds. Refinance, as it used to happen earlier was at a fixed rate which was largely divorced from the cost of equivalent short-term funds in the market. This gave rise to a non-egalitarian distribution of interest rates in the short end of the curve. Further, the amounts that could be borrowed were determined by a preset limit. To do away with the deficiencies, RBI moved to an auction system of repos and reverse repos to suck-out and inject liquidity to the market. The three broad objectives of LAF are as follows: To give RBI greater flexibility in determining both the quantum of adjustment as also the rates by responding to the system on a daily basis. To help RBI ensure that the injected funds are being used to fund day-to-day liquidity mismatches and not to finance more permanent assets.

To help RBI set a corridor for short-term rates, which should ideally be governed by the reverse-repo (top band), and repo (lower band) rates. This would impart greater stability in the markets.

The chief advantage of the system in India is the quantum of adjustment and also the rates of interest would be flexible depending upon the needs of the system. It made possible the transition from direct instruments of monetary control to indirect instruments. It is designed to tolerate frictional liquidity. But, as is true with a new system, the LAF too has attracted a fair amount of criticism about the way it worked: 1) LAF discriminates between the lending banks and PDs RBI, or for that matter any central bank is not there to present unlimited liquidity through the reverse repo auctions. While setting cut-off rates and the quantum in reverse repos, RBI keeps in mind the overall liquidity condition of the market and not bank-wise liquidity positions. RBI can monitor the bids submitted by the banks to identify the chronic borrowers and whether the reverse repo is being used as a "backdoor" refinance for other more permanent assets.

2) The uniform price auction should be replaced with a discriminatory price auction The main argument in favour of this being that given a uniform price auction which eliminates the "winners curse", the tendency is to submit higher bids to ensure success. This in turn leads to higher cut-off rates. The argument can be countered by the proposition that the uniform price auction leads to a single clearing rate, which sets a benchmark for the market. Also RBI feels that this form of auction is better for the

post-auction market.

3) LAF has increased interest rates, as call rates tend to follow the reverse repo cut-off. This would inevitably happen as the market players read from the actions of the central bank. The ultimate objective of the LAF is to adjust short-term liquidity situation to the overall policy stance. The LAF is still in the early protean stages of development and further fine-tuning is bound to improve the system. 4) PDs argue that they should be given assured liquidity at reasonable rates Higher cost of carry for PDs gets transmitted to the market by higher bond yields. Also PDs face uncertainty that all bids might get rejected and they are left with nothing. It is important to remember that Level I refinance is still available to the PDs and that the LAF currently operates at the margin in replacement of Level II refinance. Thus to view the impact of the LAF on PDs, the reverse repo cut-off rate has to be seen in conjunction with the liquidity availed under Level I refinance and a weighted average will have a far greater relevance. As has been stated earlier, the objective of the LAF is with overall liquidity and not with the needs of individual market players. The Liquidity Adjustment Facility (LAF) over the past years has served as the primary means for day-to-day liquidity management through the absorption or injection of liquidity by way of sale or purchase of securities followed by their repurchase or resale under the repo/reverse repo operations. These operations have the added advantage that sale of securities does not require the financial system to take the market risk involved in such purchase of securities. Further, the access to this facility is at the

discretion of market participants enabling them to undertake their own liquidity management. The LAF has also effectively acted as an instrument of sterilization. However, if the LAF is excessively used as an instrument of sterilisation, it loses its character as a day-to-day liquidity adjustment tool operating at the margin

The LAF has helped to develop interest rate as an instrument of monetary transmission. In the process, two major weaknesses came to the fore. First was the lack of a single policy rate. The operating policy rate alternated between repo and reverse repo rates depending upon the prevailing liquidity condition. In a surplus liquidity condition, the operating policy rate was the reverse repo rate, while in a deficit liquidity situation it was the repo rate. Second was the lack of a 10 firm corridor. The effective overnight interest rates dipped below the reverse repo rate in surplus conditions and rose above the repo rate in deficit conditions. Moreover, overnight call rates became unbounded under occasional liquidity stress.

LAF has emerged as the principal operating instrument of Monetary Policy. It has helped to stabilise the regular liquidity cycle, and volatility of call rates by allowing banks to fine tune their liquidity needs as per the averaging requirements of CRR over the reporting period. LAF operates through repo and reverse repo auctions and provide a corridor for short-term interest rate.

LAF has emerged as the tool for both liquidity management and also signalling device for interest rates in the overnight market. It is also a move towards international best

practices in the context of convergence of Indian Accounting Standards with the International Financial Reporting Standards (IFRSs).

POST-LAF
The LAF allows the Reserve Bank to have a strong grip on systems liquidity, on a day to day basis, and consequently helps in achieving its goals of policy more successfully. Volatility in call rates has declined over the years. (Chart 4)

A recent noteworthy development is the substantial migration of money market activity from the uncollateralised call money segment to the collateralised market repo and CBLO markets (Chart 5). Thus, uncollateralised overnight transactions are now limited to banks and primary dealers in the interest of financial stability.

The overnight rates have an important contributory role in terms of managing day to day liquidity and as a point of origin for building expectations on the term structure of interest rates. Domestically, while the overnight rates have more or less remained around the corridor in the recent past, the daily cash maintained by the banking system

with RBI one of the most important determinants of the overnight rates - have remained highly volatile as compared to the required CRR balances. Hence, despite the daily overnight rates remaining around the interest rate corridor, the daily absolute changes in the weighted average rates have not been smooth.

CURRENT SCENARIO
Monetary conditions remained tight during Q1 of 2011-12 with interest rates firming, deposit growth picking up and credit growth decelerating. The Reserve Bank persisted with its anti-inflationary monetary policy stance during Q1 of 2011-12. As inflation became increasingly generalised, the Reserve Bank raised policy repo rate by 50 bps in May, followed by another 25 bps in June. The Reserve Bank has thus raised the reverse repo rate, repo rate and the CRR by 325 basis points (bps), 275 bps and 25 bps respectively since March 2010.

Following a shift from absorption mode to injection mode in the liquidity adjustment facility (LAF), there has been, in effect, a rise in policy rates by 425 bps since February 2010 till date as the money market rate started hovering around the upper bound from the lower bound of the LAF corridor (Chart 6). As per data on July 22, the average daily

net injection of liquidity through the LAF window during this year was around Rs.48,000 crore, which was within one per cent of net demand and time liabilities (NDTL). Liquidity conditions eased significantly during Q1 of 2011-12.

The liquidity tightness in the system was evident from the rising money market rates and continued injection of funds by RBI in its liquidity adjustment facility (LAF) window. The operating framework of monetary policy has been the maintenance of overnight market rates within an interest rate corridor defined by the floor of the reverse repo (absorption) rate and ceiling of the repo (injection) rate. During periods of system wide excess liquidity, overnight rates tend to hug the bottom of the corridor, while touching the ceiling during other periods of liquidity shortage, as might be expected. Increased volatility in capital flows, tending to inject excess liquidity into the system, and in government cash balances resulting from bunching of tax payments that absorb liquidity out of the system, have made the task of liquidity management somewhat more difficult over the recent years.

The Reserve Bank in its Monetary Policy Statement for 2011-12 effected the following changes to the operating procedure of monetary policy as per the recommendations of the Working Committee set up by the RBI and led by Shri Deepak Mohanty, Executive Director, RBI:
1. The weighted average overnight call money rate has become the operating target of

monetary policy;
2. The repo rate has become the only independently varying policy rate;

3. The reverse repo rate, pegged at 100 bps below the repo rate, provides the lower

bound to the corridor of overnight interest rate and; 4. A new Marginal Standing Facility (MSF) has been instituted at 100 bps above the repo rate that provides the upper bound to the corridor. Banks can borrow overnight from the MSF up to one per cent of their respective net demand and time liabilities (NDTL). The new operating procedure became operational in May 2011. 5. The Bank Rate should be reactivated as the discount rate as envisaged in the RBI Act, 1934. 6. To improve liquidity management, a scheme of auctioning of government surplus cash balance at the discretion of the RBI to be put in place in consultation with the Government.

FUTURE CHALLENGES
The monetary policy framework in India has undergone significant shifts from a monetary targeting regime to a multiple indicators regime. Such a transition was conditioned by the developments of financial markets, increasing integration of the Indian economy with the global economy and changing transmission of monetary policy. There has been a shift from quantitative intermediate targets to interest rates, as the development of financial markets enabled transmission of policy signals through the interest rate channel. At the same time, availability of multiple instruments such as

CRR, OMO including LAF and MSS has provided necessary flexibility to monetary operations. Three major considerations that have guided rationalisation of the structure in the money market are: (i) ensuring balanced development of various constituents of the money market, especially the growth of the collateralised market vis-a-vis the uncollateralised market; (ii) preserving integrity and transparency of the money market by ensuring better disclosure of information; and (iii) rationalising various classes of participants across different market segments in order to strengthen the efficacy of the LAF of the Reserve Bank. [Speech by Deepak Mohanty, Executive Director, Reserve Bank of India, delivered at the Indian Institute of Management (IIM), Lucknow on 12th August 2011] But the Indian economy has to be well equipped to face a number of challenges in the future. Some of which are broadly discussed as follows:

International best practices and our own empirical evidence suggest that the transmission of policy signals to the operating target and other short-term market interest rates is most effective under deficit liquidity conditions. The challenge is to keep the systemic liquidity in a deficit mode consistently. This needs an accurate forecasting of liquidity.

Even if uncertainties of sudden swings in liquidity are not there, there could be prolonged phases of autonomous liquidity infusion due to sustained capital inflows or liquidity drain due to persistent surplus of government cash balances (Chart 7)

The challenge in this case, however, is in having the capacity to conduct longer term liquidity management operation through instruments such as long-term and outright OMO, MSS and CRR.

Effective transmission of policy signals to the operating target, while necessary, is not a sufficient condition for the success of monetary policy. Needless to say, the success lies in the achievement of the ultimate objective of sustained growth with price and financial stability. This entails improved transmission of short-term interest rates to other long-term commercial interest rates. This will require further deepening of financial markets and removal of structural rigidities coming in the way of market determination of interest rates.

The development of the term money market is vital for strengthening proper linkages between the foreign exchange market and the domestic currency market, which, in turn, would provide an impetus to the derivative segment.

During periods of abundant liquidity, the LAF window becomes a first resort for parking surplus funds by banks.

While the Reserve Bank now holds LAF auctions twice on each working day to facilitate intra-day liquidity, a moral hazard issue arises as some market participants may not be actively managing their own liquidity in the wake of the Reserve Banks market operations.

Market participants prefer to access the RBIs LAF window rather than meet their liquidity needs through the OMO. One of the considerations in banks inadequate response to OMO purchases by the RBI was the possibility of valuation losses as the bulk of the securities are held under HTM category. It is therefore recommended

that the RBI should incentivise banks to progressively mark-to-market their SLR portfolio to improve the effectiveness of OMO as an instrument of liquidity management.

Annexure 1

Annexure 2

Annexure 3

Annexure 4

Annexure 5 Chart 1

Chart 2

Chart 3: LAF CORRIDOR & CALL RATE

Chart 4

Chart 5

Chart 6

Chart 7

Table 1

Current Rates Repo Reverse Repo) MSF rate(100 BP above Repo) Bank Rate CRR repo(100 BP

In % 7.25 below 6.25

8.25 6 6

SLR

24

REFERENCES
Research Reports by Agencies: 1. Money Market Review February 2011by EPW Research Foundation,Feb 2011. 2. CCIL Market Review- 2010-2011

Other References:
First Quarter Review of Monetary Policy 2011 by Dr. D.Subarao, Governor, RBI. Report on Currency and Finance 2010-2011, RBI. Report Of The Working Group On Operating Procedure Of Monetary Policy,

RBI, March 2011. How does the Reserve Bank of India Conduct its Monetary Policy? Speech by Deepak Mohanty, Executive Director, Reserve Bank of India at IIM-L on 12th August 2011.
Implementation of monetary policy in India, Deepak Mohanty, Executive

Director, RBI at the Bankers Club, Bhubaneswar, 15 March 2010.

Paper presented by Dr. Rakesh Mohan, Deputy Governor, RBI, on "Transmission

Mechanisms for Monetary Policy in Emerging Market Economies - What is New?" at Bank for International Settlements, Basel on December 7-8, 2006. Monetary Policy Transmission in India. RBI Bulletin, April, 2007.
Development of Financial Markets in India, Rakesh Mohan (2007).

Scheme of Liquidity Adjustment Facility: 2001-2002.

WEBSITES:

www.rbi.org www.investopedia.com www.ccilindia.com