Development of Monetary Policy Initiatives by RBI over the years Part: 3
[An Overview of the Discussion Papers Submitted by the Basel Policy Group - Dr.Y.V.Reddy, Dy Governor, RBI,
Representing India - The Original Article may be referred at - URL http://www.bis.org/publ/plcy05.htm]

4. Operating procedures and instruments Contd.

Short-term liquidity management was undertaken by repos on a regular basis. Usually, the Reserve Bank engages in repos for a maturity of up to 14 days, which is the cycle for reserve requirements. Recently, the Reserve Bank has been performing three to four-day repos to absorb very short-term liquidity and even out money market rates. During 1993/94, repo auctions were conducted on as many as 36 occasions in the interest rate range of 5 - 11-1/2%. Although the frequency of repo auctions was reduced in the subsequent two years on account of tight liquidity conditions⁶, during 1997/98, repos were carried out on as many as 176 occasions (Table 2). The repo operations have become a firm fixture, with the Reserve Bank offering daily fixed rate repos for a maturity of three to four days since November 1997.

The repo rates and the amounts tendered in the repo auctions, apart from reflecting liquidity conditions, provide a floor for the overnight call-money rates. In the event of tight liquidity conditions, the Reserve Bank provides liquidity support to primary dealers in the form of a reverse repo facility in government dated securities. The conduct of such reverse repos enables the Reserve Bank to indirectly intervene in the market, alleviating undue pressure on overnight call-money rates. In addition to the repo rates, in April 1997 the Reserve Bank also reactivated the bank rate, which is now used as a signalling rate to reflect the stance of monetary policy. The interest rates on all accommodations from the Reserve Bank, including refinance, are linked to the bank rate. The use of the bank rate as an active instrument of policy can be gauged from the fact that it was changed on as many as five occasions during 1997/98, the most often so far in any financial year.

The refinance window of the Reserve Bank provides an additional source of reserves. The Reserve Bank currently provides two types of refinance facility to banks - export credit refinance and general refinance⁷. While the former facility is formula-based and extended to banks against their outstanding export credit eligible for refinance, the latter facility is provided to tide banks over their temporary liquidity shortages. Banks are eligible for export credit refinance to the extent of 100% of the increase in outstanding export credit eligible for refinance over the level of such credit in mid-February 1996, and the rate of interest on the facility is equal to the bank rate⁸. The Reserve Bank provides a general refinance facility to banks which is equal to 0.25% of each bank's fortnightly average outstanding aggregate deposits in 1996/97. This refinance is provided for two blocks of four weeks each. The rate on this refinance for the first block of four weeks is the bank rate, and for the next four weeks it is the bank rate plus 1 percentage point.

Although there is no formal corridor for interest rates, the bank rate provides an upper bound to the overnight interest rates, thereby creating an informal corridor for interest rate determination. Moreover, the spread between repo rates and the bank rate has narrowed considerably, which would imply that short-term interest rates could fluctuate in a narrow band, thereby minimising interest rate volatility. However, short-term interest rates are allowed to rise in periods of exchange rate volatility. For example, in the second half of 1995/96, the foreign exchange market experienced considerable volatility, requiring the Reserve Bank to actively intervene in the market. A panic demand for cover by importers and cancellations of forward contracts by exporters created persistent mismatches of supply and demand in both the spot and forward segments of the market. Forward premia rose sharply in October 1995, far out of alignment with interest rate differentials. The prohibitive cost of foreign exchange cover prevented banks from mobilising foreign currency assets and employing them to fund domestic assets. The exchange market intervention (net sales) by the Reserve Bank in the spot market led to a withdrawal of liquidity, causing a sharp increase in call rates given the buoyant demand for credit. Intervention, in turn, was supported by measures such as the imposition of an interest surcharge on import finance and the tightening of concessionality in export credit for a longer period. As the exchange rate stabilised, money market support was provided by the Reserve Bank, mainly through reverse repos conducted with primary dealers and an easing of the reserve requirements. As a result, call-money rates moved downwards to more realistic levels. In the backwash of the Asian currency turmoil, the foreign exchange market in India once again came under severe pressure during the second half of 1997/98, obliging the Reserve Bank to undertake strong monetary policy measures in January 1998, leading to a withdrawal of liquidity and a temporary sharp increase in short-term interest rates. Once orderly conditions were restored in the foreign exchange market, the overnight interest rates reverted to the corridor provided by the repo rates and the bank rate (Chart 1).

Although there has been no explicit interest rate target, in recent years a great reliance has been placed on interest rates and exchange rates in the day-to-day conduct of monetary policy. The movements in the interest rates and exchange rate also increasingly reflect the integration of the money market and the foreign exchange market on the one hand, and various money market segments on the other hand. The interest rates on major money market instruments (91- and 364-day Treasury bills, CP and CDs) in the recent period show a cointegrating movement with a very high speed of adjustment, reflecting a convergence of money market rates which augurs well for the prospective targeting of interest rates in the conduct of monetary policy.