Abstract
From January 2014, the Reserve Bank of India (RBI) initiated a regime change in the conduct of monetary policy. Under its revised liquidity management framework, the operating target - the weighted average call money rate -has moved in a tight range of +/−40 bps with the long-run coefficient on the effective policy rate close to unity. Autoregressive distributed lag model estimates indicate that 74 % of the deviation of the call rate from the policy rate is adjusted in just one day in the most recent period as against only 24 % in earlier periods. Various segments of the money market are getting increasingly integrated and confirm a martingale process. A marked reduction in volatility in the operating target is validated by an I-GARCH (1, 1) model, though volatility brought on by large exogenous shocks appears regime-insensitive.
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Notes
- 1.
Dr.Urjit Patel chaired the Expert Committee to Revise and Strengthen the Monetary Policy Framework. The case for inflation targeting in India had already been made by several committees in the past, notably the Percy Mistry Committee (GoI 2007), the Raghuram Rajan Committee (GoI 2009), and the B.N. Srikrishna Committee (GoI 2013). The Urjit Patel Committee was unique in setting out a complete operational “model” underpinning the regime, each element reinforcing the other in a mutually consistent manner. Reforms in liquidity management are an integral part of its recommended framework.
- 2.
The exchange rate predates the interest rate as an operating target of monetary policy. Although still in practice in small open economies such as Singapore, it faces diminishing practitioner appeal today as it entails a loss of independence of monetary policy and exposes the economy to external shocks (RBI 2014).
- 3.
27 countries target inflation explicitly (Hammond 2012). Some have an explicit numerical expression for a desirable rate of inflation as in the case of the USA.
- 4.
By contrast, Switzerland and Hungary explicitly target the 3-month rate and during September 2011 to January 2015, a floor on the exchange rate in the case of the former.
- 5.
As noted earlier, in the aftermath of the 2008–09 crisis, several central banks in advanced economies have preferred to operate a floor system with operating targets/deposit rates close to or at zero or even into negative territory.
- 6.
See RBI (2004) for a comprehensive, historical overview of monetary policy regimes in India.
- 7.
The Chakravarty Committee (1985) was the first to make comprehensive recommendations for the development of the Indian money market. In 1987, the Reserve Bank set up a Working Group on the Money Market (Chairman: Shri N.Vaghul) to specifically examine various aspects for widening and deepening the money market. Following the recommendations of these two committees, several new initiatives were undertaken.
- 8.
The Committee on Banking Sector Reforms, 1998 (Chairman: Shri M. Narasimham) (RBI 1998) recommended measures to facilitate the emergence of a proper interest rate structure reflecting the differences in liquidity, maturity and risk.
- 9.
In response to suggestions from market participants, the Reserve Bank introduced a second liquidity adjustment facility (SLAF) from November 28, 2005, enabling conduct of repos and reverse repos for fine-tuning operations.
- 10.
The MSS was an arrangement between the Government of India and the Reserve Bank to mop up the excess liquidity generated on account of the accretion to foreign exchange assets of the Bank and neutralize the monetary impact of capital flows.
- 11.
The corridor width was reduced to 100 bps, with reverse repo rate and MSF rate placed 50 bps below and above the policy rate, respectively, in April 2016. This was intended to ensure finer alignment of the WACR with the policy repo rate, drawing upon the success of the revised framework in keeping the WACR well within the earlier corridor of 200 bps.
- 12.
Cash credit facility is an arrangement under which banks lend money against securities. It runs like a current account, except that the money that can be withdrawn from this account is not restricted to the amount deposited in the account. Instead, the account holder is permitted to withdraw a certain sum called "limit" or "credit facility" in excess of the amount deposited in the account. Cash credits are, in theory, payable on demand.
- 13.
As noted in Sect. 4, the impact of liquidity movements resulted in the operative policy rate shifting between the LAF’s floor and ceiling. During episodes of excess liquidity (2008:4 to 2010:2), the reverse repo rate was the effective policy rate. On the other hand, during episodes of monetary tightening/liquidity shortage (2007:1 to 2008:3 and 2010:3 to 2011:4), the repo rate became the effective policy rate. The effective policy rate, thus defined, is used as the policy rate, following Patra and Kapur (2012).
- 14.
Dummies D3, D4, D5, D6, and D7 denote Monday, Tuesday, Wednesday, Thursday and Friday of the first week of the 14-day reserve maintenance period, while D10, D11, D12, and D14 denote Monday, Tuesday, Wednesday, and Friday of the second week of the reserve maintenance period. In order to avoid multicollinearity, we do not include a dummy (D13) for the Thursday in the second week.
- 15.
A martingale is a model of a fair game where knowledge of past events never helps predict the mean of the future outcomes. In particular, a martingale is a sequence of random variables i.e., a stochastic process for which, at any particular time in the realized sequence, the expectation of the next value in the sequence is equal to the present observed value even given knowledge of all prior observed values (Bartolini and Prati 2004).
- 16.
We also explored standard deviations over alternative time horizons of 15–90 days, but the results were qualitatively similar.
- 17.
The coefficient on the 30-day rolling standard deviation of the call rate is positive but significant at the 10 % level.
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Appendices
Annex 1
Annex 2
Annex 3: Money Market Microstructure
In India, the overnight money market comprises three segments, viz., the uncollateralised interbank call money market, collateralised Market Repo and Collateralised Borrowing and Lending Obligation (CBLO) . These segments differ in terms of their market operation timings, participants and instruments (Table A.14). In recent years, the share in the volume of the collateralized segment of the overnight money market has increased due to safety of settlement of trades on net basis (CCIL being counterparty for CBLO), and choice for borrower to rollover previous trade. Also, in the aftermath of the global financial crisis, the shift in lending and borrowing activities of foreign banks from uncollateralised market to collateralised markets as a global strategy have affected the call volumes.
The depth of market in the overnight segments varies markedly intra-day (Chart A.10). Foreign banks and primary dealers—major borrowers in market repo—meet around 80 % of their funding requirement for G-sec trading activities during 9–10 a.m., although the market is open up to 2:30 p.m. CBLO transactions of mutual funds, which are major lenders in CBLO, are routed through designated banks within banking hours (generally up to 2.30 p.m.). The CBLO market becomes thin thereafter, often resulting in spikes in call rates which is the only active segment in late trading hours. Call market volumes, therefore, exhibit an intra-day U-shaped pattern.
Intra-day activities in overnight markets. a Call market. b CBLO. c Market repo
Interestingly, intra-day, overnight interest rates open at an elevated level in the early session of the market as most players cover their estimated liquidity mismatches and with the competitive trading in deep markets around the morning hours the interest rate differentials across markets are at their minimum as also the volatility in the rates. Subsequently, as volumes dip and volatility rises, interest rates decline at differential pace across markets till about 2.30 p.m., reflecting market specific factors. For example, in case of call market, the participation is largely driven by lending by cooperative banks which typically lend at a rate lower than the prevailing rate in call market, leading to the higher call market volatility (Table 14).
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Patra, M.D., Kapur, M., Kavediya, R., Lokare, S.M. (2016). Liquidity Management and Monetary Policy: From Corridor Play to Marksmanship. In: Ghate, C., Kletzer, K. (eds) Monetary Policy in India. Springer, New Delhi. https://doi.org/10.1007/978-81-322-2840-0_9
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