Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 2 - Monetary Policy Framework In India

Liquidity Adjustment Facility

The Reserve Bank is now able to influence short-term interest rates by modulating the liquidity in the system through repo operations under the Liquidity Adjustment Facility, reinforced by interest rate signals. The Reserve Bank has been largely able to enforce the interest rate corridor defined by the reverse repo rate, the price at which it absorbs liquidity and the repo rate/Bank Rate, the price at which it injects liquidity⁹.

The Liquidity Adjustment Facility (LAF), introduced in June 2000, allows the Reserve Bank to manage market liquidity on a daily basis and also transmit interest rate signals to the market. The LAF, initially recommended by the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham), was introduced in stages in consonance with the level of market development and technological advances in payment and settlement systems. The first challenge was to combine the various sources of liquidity available from the Reserve Bank into a single comprehensive window, with a common price. An Interim Liquidity Adjustment Facility (ILAF), introduced in April 1999 as a mechanism for liquidity management through a combination of repo operations, export credit refinance facilities and collateralised lending facilities supported by open market operations at set rates of interest, was upgraded into a full-fledged LAF. Most of the alternate provisions of primary liquidity have been gradually phased out and even though export credit refinance is still available, it is linked to the repo rate since March 2004. Accordingly, the LAF has now emerged as the principal operating instrument of monetary policy.

Analytically, the LAF experience with market stabilisation can be partitioned into multiple sets of roles.

1. First, the LAF stabilises regular liquidity cycles, by allowing banks to tune their liquidity requirements to the averaging requirements over the reporting fortnight and smoothening liquidity positions between beginning-of-the-month drawdown of salary accounts to fund household spending and end-of-the-month post-sales bulge in business current accounts.

2. Second, it irons out seasonal fluctuations. It injects liquidity during quarterly advance tax outflows or at end-March, when banks avoid lending on call, which adds to their Capital to Risk-Weighted-Assets Ratio (CRAR) requirements. It mops up liquidity in April to counter the typically large ways and means advances drawn by the Government prior to the inception of its borrowing programme.

3. Third, it modulates sudden liquidity shocks, by injecting liquidity on account of say, temporary mismatches arising out of timing differences between outflows on account of Government auctions and inflows on account of redemptions.

4. Fourth, the LAF has emerged as an effective instrument for maintaining orderly conditions in the financial markets in the face of sudden capital outflows to ward off the possibility of speculative attacks in the foreign exchange market.

5. Fifth, by funding the Government through private placements and mopping up the liquidity by aggressive reverse repo operations at attractive rates, the LAF helps to minimise the impact of market volatility on the cost of public debt.

6. Sixth, the LAF bore much of the burden of sterilisation in the face of sustained capital flows, especially since November 2000, by mopping up bank liquidity through reverse repos and at the same time, gradually reducing reverse repo rates to enable a softening of the interest rate structure.

7. Finally, the Reserve Bank tailors monetary policy action through both quantum and rate channels of transmission. The LAF accords the Reserve Bank the operational flexibility to alter the liquidity in the system (by rejecting bids) as well as adjusting the structure of interest rates (through fixed rate operations) in response to evolving market circumstances.

Persistent capital inflows that India experienced since 2001-02 posed a challenge to the LAF operations. In view of large capital flows, the LAF emerged as the key instrument of managing capital flows through sterilisation. This was reflected in the outstanding reverse repo amount which increased from Rs.2,415 crore as at end-March 2003 to Rs. 62,995 crore by late March 2004 and further to Rs. 89,435 crore by mid-April 2004. Thus, instead of absorbing liquidity of a short-term and temporary nature, the LAF window was absorbing funds of a relatively more enduring nature. In order to address these issues, an Internal Group of the Reserve Bank reviewed the operations of the LAF in a cross-country perspective, keeping in view recent developments in the financial markets as well as in technology. The Group noted that it is difficult to distinguish operationally between the sterilisation operations and liquidity management operations under the LAF. Nonetheless, it emphasised the need to conceptually distinguish surplus liquidity of "temporary" nature arising from banks' cash management practices from surplus liquidity of a somewhat "enduring" nature arising from sustained capital inflows. The Group also added that it would be desirable to de-emphasise the passive sterilisation attribute of the LAF-reverse repo facility so that it could emerge as the exclusive policy signalling rate. Accordingly, it felt a need for adequate instruments of sterilisation in addition to the liquidity management facilities and, recommended, inter alia, introduction of a standing deposit facility.

Pursuant to the recommendations of the Internal Working Group on LAF as well as the Internal Working Group on Instruments for Sterilisation (RBI, 2003b), a Market Stabilisation Scheme (MSS) was introduced in April 2004. Under this scheme, Government of India dated securities of a maturity of less than two years (so far) and Treasury Bills are being issued to absorb liquidity (see Module: 3). As on December 10, 2004, the outstanding issuances under the MSS were Rs.51,334 crore, the pressure on the LAF window has gradually come down. The outstanding reverse repo amount, therefore, fell from Rs. 89,435 crore (mid-April 2004) to only Rs. 15,820 crore by December 10, 2004. The issuance of securities under the MSS enables the Reserve Bank to improve liquidity management in the system, to maintain stability in the foreign exchange market and to conduct monetary policy in accordance with the stated objectives.

The Indian experience underscores the need for constant innovation in terms of instruments and operating procedures for effective monetary management. Apart from introduction of innovative instruments such as the MSS, the policy framework has evolved in response to the changing environment. Illustratively, the interest rates in the LAF auctions were initially allowed to emerge from the bids, with the Reserve Bank holding occasional fixed rate auctions to transmit interest rate signals. As market players began to bid at the prices signalled by the Reserve Bank, the de jure market-determined LAF rates began to turn into de facto fixed rates. It is in this context that the Reserve Bank switched to a fixed auction format in March 2004. Second, while the reverse repo rate, acted as the floor, the practice of supplying liquidity at multiple rates, e.g., the Bank Rate and the repo rate, implied that there was no unique ceiling. It is in this context that the Reserve Bank has increasingly been resorting to pricing its liquidity at the repo rate, in recent years. Apart from WMA which are still at the Bank Rate, all other forms of liquidity support are at the repo rate.

In the light of substantial technological developments, the objective of conducting LAF operation on real-time basis needs to be pursued further.

Introduction of a deposit facility to afford more flexibility to the Reserve Bank in using the reverse repo facility as a signalling device while not sacrificing the objective of the provision of a floor to the movement of short-term interest rates. As the Reserve Bank of India Act, 1934 in its present form does not permit the Reserve Bank to borrow on a clean basis from banks and pay interest thereon, this would necessitate a suitable amendment to the Reserve Bank Act.

Pending amendments to the Reserve Bank Act, the Reserve Bank should explore possibilities of modifying the current CRR provision to accommodate a standing deposit type facility - placement of deposits at the discretion of banks unlike CRR which is applicable to all banks irrespective of their liquidity position.

The remuneration of CRR, if any, could be delinked from the Bank Rate and placed at a rate lower than the reverse repo rate.

The minimum tenor of the repo/reverse repo operations under the LAF facility should be changed from overnight to 7 days to be conducted on daily basis to enable balanced development of various segments of money market.

The LAF auction could be a fixed rate auction enhancing its policy signalling rate, with the flexibility to revert to variable price auction format.

The Bank Rate under normal circumstances should be aligned to the repo rate and, therefore, the entire liquidity support including refinance should be made available at the repo rate/Bank Rate.

With intra-day liquidity (IDL) available under the RTGS system, the timing of LAF could be shifted to the middle of the day, say, 12 noon to ensure that marginal liquidity is kept in the system for a longer time. To take care of unforeseen contingencies, the Reserve Bank may consider discretionary announcement of timing of both repo auctions and reverse repo auctions at late hours.

As proposed by the Reserve Bank's Working Group on Instruments of Sterilisation, Market Stabilisation Bills/ Bonds (MSBs) could be issued for mopping up enduring surplus liquidity from the system over and above the amount that could be absorbed under the day-to-day reverse repo operations of the LAF. The maturity, amount, and timing of issue of MSBs may be decided by the Reserve Bank in consultation with the Government depending inter alia, on the expected duration and quantum of capital inflows, and the extent of sterilisation of such inflows.

The changes in the operating procedure of Reserve Bank's monetary policy in tune with financial sector reforms during the 1990s have impacted its balance sheet in terms of size and composition and sources of income and expenditure. In consonance with the international experience, the programme of financial liberalisation was accompanied by several measures to further strengthen the health of the Reserve Bank balance sheet, especially as monetary policy emerged as the principal instrument of macroeconomic stabilisation.

⁹With effect from October 29, 2004, the nomenclature of repo and reverse repo has been interchanged as per international usage. Prior to that date, repo indicated absorption of liquidity while reverse repo implied injection of liquidity. The nomenclature in this module is based on the new use of terms even for the period prior to October 29, 2004 for comparability purposes. )]