Debt on net India- RBI LAF results

Schedule for Issuance of Treasury Bills/ Bonds under Market Stabilisation Scheme (MSS)
With a view to providing transparency and stability in the financial markets, it has been decided to release an indicative schedule for issuance of Treasury Bills/dated securities under MSS covering period from April 1, 2004 to June 30, 2004. The schedule is as under:

The issuance of Treasury Bills under MSS will be undertaken by increasing the notified amount for the regular auction of 91-day and 364-day Treasury Bills. Thus, the issuances covered by the indicative schedule will be undertaken in addition to the regular issuances of Treasury Bills and dated securities.

The indicative schedule is subject to variations depending on market conditions and other relevant factors. In addition to the proposed issuances indicated in the schedule, the Reserve Bank will also have the flexibility for additional issuances of Treasury Bills and dated securities depending upon the liquidity condition and other relevant factors.

The Government of India and the Reserve Bank of India have today formally signed a Memorandum of Understanding (MoU) detailing the rationale and operational modalities of the Market Stabilisation Scheme (MSS).
The scheme would be effective from April 2004. An advance schedule for the borrowings under the MSS for the first quarter of 2004-05 is being announced separately. The main features of the MoU are:

1. The Government would issue Treasury Bills and/or dated securities under the MSS in addition to the normal borrowing requirements, for absorbing liquidity from the system.

2. The Treasury Bills/dated securities issued under the MSS would have all the attributes of existing Treasury Bills and dated securities; specifically, these would be issued and serviced like any other marketable government securities and will thus be eligible securities for Statutory Liquidity Ratio (SLR), repo and Liquidity Adjustment Facility (LAF).

3. The Treasury Bills and dated securities will be issued by way of auctions to be conducted by the Reserve Bank.

4. The Government, in consultation with the Reserve Bank, will fix an annual aggregate ceiling for Treasury Bills and / or dated securities under the MSS. This ceiling will hold good till further revision during the course of the year. For 2004-05, the ceiling shall be Rs.60,000 crore.

5. The actual outstandings under the MSS would not exceed the ceiling or the revised ceiling at any point of time.

6. The amounts raised under the MSS would be held in a separate identifiable cash account titled the Market Stabilisation Scheme Account (MSS Account) to be maintained and operated by the Reserve Bank.

7. The amounts credited into the MSS Account would be appropriated only for the purpose of redemption and / or buy back of the Treasury Bills and / or dated securities issued under the MSS.

8. The payments for interest and discount will not be made from the MSS Account. The receipts due to premium and/or accrued interest will not be credited to the MSS Account. Such receipts and payments towards interest, premium and discount would be shown in the budget and other related documents as distinct components under separate sub-heads.

The Treasury Bills and dated securities issued for the purpose of the MSS would be matched by an equivalent cash balance held by the Government with the Reserve Bank. Thus, there will only be a marginal impact on revenue and fiscal balances of the Government to the extent of interest payment on Treasury Bills and/or dated securities outstanding under the MSS.

It may be recalled that an Internal Working Group on Instruments of Sterilisation had submitted its Report in December 2003. Following the recommendations contained in the Report, the Government of India had confirmed its intention to strengthen the Reserve Bank in its ability to conduct exchange rate and monetary management operations in a manner that would maintain stability in the foreign exchange market and enable it to conduct monetary policy in accordance with its stated objectives. On February 23, 2004, the Reserve Bank had announced the launching of the Market Stabilisation Scheme.

Alpana Killawala
Chief General Manager

Following the recommendations contained in the Report of the Reserve Bank of India (RBI) Working Group on Instruments of Sterilisation submitted in December 2003, the Government of India has confirmed its intention to strengthen the Reserve Bank in its ability to conduct exchange rate and monetary management operations in a manner that would maintain stability in the foreign exchange market and enable it to conduct monetary policy in accordance with its stated objectives.

In this regard the Reserve Bank has proposed to the Government of India to authorise issuance of existing debt instruments, viz., Treasury Bills and dated securities up to a specified ceiling to be mutually agreed upon between the Government and the Reserve Bank by way of a Memorandum of Understanding (MoU) under the Market Stabilisation Scheme (MSS). The bills/bonds issued under MSS would have all the attributes of the existing Treasury Bills and dated securities. The bills and securities will be issued by way of auctions to be conducted by the Reserve Bank. The Reserve Bank will decide and notify the amount, tenure and timing of issuance of such treasury bills and dated securities. Whenever such securities are issued by the Reserve Bank for the purpose of market stabilisation and sterilisation, a press release at the time of issue would indicate such purpose. For the present, the total outstanding obligations of the Government by way of bills/securities thus issued under the MSS from time to time would not exceed Rs. 60,000 crore.

The bills and securities issued for the purpose of MSS would be matched by an equivalent cash balance held by the Government with the Reserve Bank. Thus, there will only be a marginal impact on revenue and fiscal deficits of the Government to the extent of interest payment on bills/securities outstanding under the MSS. Further, the cost would be shown separately in the Budget. This would add transparency to the cost of sterilisation.

It may be noted that, as mentioned in the Reserve Bank's Report of the Internal Group on Liquidity Adjustment Facility (LAF), the intention of introducing MSS is essentially to differentiate the liquidity absorption of a more enduring nature by way of sterilisation from the day-to-day normal liquidity management operations. The total absorption of liquidity from the system by the Reserve Bank will continue to be in line with the monetary policy stance from time to time and accordingly, the liquidity absorption will get apportioned among the instruments of LAF, MSS and normal open market operations (OMOs).

P. V. Sadanandan
Manager
Press Release: 2003-2004/1014

The following is the full text of the executive summary of the report of the Reserve Bank of India's working group on instruments of sterilization released on December 2, 2003.

1.The mid-term Review of Monetary and Credit Policy for 2003-04 released on November 3, 2003 indicated that an Internal Group reviewed the operations of the Liquidity Adjustment Facility in a cross-country perspective keeping in view recent developments in the financial market as well as in technology.

The draft Report of the Internal Group was discussed both in the Technical Advisory Committee on Money and Government Securities Markets (TAC) and the Financial Markets Committee (FMC) of RBI.

Taking into account the comments made by TAC and FMC members; the Report has been revised and is now placed in the public domain for wider comment and debate.

2. The operations of the LAF need to be seen in the context of changes in the transmission channels of monetary policy. Since the early 1990s, the monetary targeting approach in the conduct of monetary policy came under stress with increasing interplay of market forces in the determination of interest rates and exchange rate as a consequence of deregulation.

In addition, the excess liquidity engendered by capital flows imparted an upward pressure on money supply. There was also increasing evidence on changes in the underlying transmission mechanism of monetary policy.

The Third Working Group on Money Supply (Chairman: Dr.Y.V.Reddy) which submitted its Report in June 1998, found that the output response to monetary policy operating through the interest rate tends to be stronger and more persistent than that through the credit channel.

With pricing decisions left increasingly to market forces, the interest rate and exchange rate gained in importance vis-à-vis quantity variables. Accordingly, on a review of the monetary policy framework, RBI gradually switched over to a more broad-based multiple indicator approach.

3. In a quantity based monetary targeting framework, Reserve Money (RM) was used as the operating target and bank reserves as the operating instrument with broad money (M3) being the intermediate target.

In the current monetary operating framework, reliance on direct instruments of monetary policy has been reduced and the liquidity management in the system is carried out through open market operations (OMO) in the form of outright purchases/sales of government securities and repo and reverse repo operations under Liquidity Adjustment Facility (LAF).

The OMO are supplemented by access to the Reserve Bank's standing facilities combined with direct interest rate signals through changes in the Bank Rate/repo rate. In this direction, the LAF introduced in June 2000 has now emerged as the principal operating instrument of monetary policy.

The LAF enables the Reserve Bank to modulate short-term liquidity under varied financial market conditions in order to ensure stable conditions in the overnight (call) money market.

The LAF operates through daily repo and reverse repo auctions thereby setting a corridor for the short-term interest rate consistent with policy objectives.

Although there is no formal targeting of overnight interest rates, LAF operation has enabled the Reserve Bank to de-emphasize the targeting of bank reserves and focus increasingly on interest rates.

4. While the LAF has emerged as the principal instrument in the monetary policy operating framework of the Reserve Bank, its operation in the present form in conjunction with other supporting instruments has given rise to certain conceptual and operational issues which need to be addressed to enhance the efficacy of monetary operations.

The Group identified a number of major issues. First, is the issue concerning the role of the Bank Rate and the repo rate in signaling the stance of monetary policy.

While the Bank Rate was envisaged to provide the medium-term signal and the repo rate as the marginal liquidity management rate, there is an increasing market acceptance of the repo rate as the signalling rate.

Thus, there is a need to clarify the relative role of the Bank Rate and the repo rate to impart transparency to monetary operations.

Second, at present, there is a multiplicity of rates at which liquidity is absorbed/injected.

In an interest rate corridor framework, with the system being in surplus mode, it is generally witnessed that there are normally two rates through which liquidity is absorbed and one rate through which liquidity is injected, and vice versa when the system is in deficit mode.

Keeping this perspective in view, there is a need to rationalize the existing corridor.

Third, since the repo rate has emerged as the policy signaling rate, its relative position within the corridor becomes important.

Normally, cross-country experiences show that the policy signaling rate is placed in the middle of the corridor. However, in the present framework, the repo rate has been acting as both the policy rate as well as the rate for passive sterilization of excess liquidity emanating from capital flows.

Hence, the LAF repo rate is placed at the bottom of the corridor which compromises its role as an exclusive policy signaling rate.

Fourth, there is merit in conceptually, though not operationally, distinguishing the Sterilization objectives of the LAF repo facility which is supposed to sterilize surplus funds of a "temporary" nature as opposed to a facility which should be capable of handling surplus funds of a somewhat "enduring" nature. Keeping this in view, it would be desirable to de-emphasize the passive sterilization attribute of the LAF repo facility so that it could emerge as the exclusive policy signaling rate. There is, therefore, a need for adequate instruments of Sterilization in addition to the liquidity management facilities.

Fifth, placement of funds under the LAF repo window should normally take place as a matter of last resort. However, with persistence of excess liquidity the LAF window is treated as an absorber of funds of the first resort by market participants, thereby affecting adversely the balanced development of various segments of the money market as also the emergence of a proper rupee yield curve.

Sixth, normally central banks have a standing deposit facility that provides the floor to the interest rate corridor and acts as the absorber of funds of the last resort. Such a facility is not available with Reserve Bank at present. In such a scenario, the remuneration of eligible cash balances under cash reserve ratio (CRR) at the Bank Rate is not compatible with the institution of a standing deposit facility.

Thus, there is a need to rationalize the interest rate on eligible cash balances under CRR. In principle, no remuneration is appropriate to make CRR most effective. When remuneration is given, it should be at the rate at which liquidity is intended to be absorbed, either through LAF operations or through the standing deposit facility.

5. The monetary policy operating framework on the basis of a cross-country analysis shows that there are normally two standing facilities: (i) an unlimited collateralized marginal lending facility available throughout the day at a premium over the repo rate that provides the upper bound to the corridor, and (ii) a standing uncollateralized unlimited deposit facility available towards the closure of the market hours at a discount to the official repo rate that provides the lower bound.

Within this corridor, the repo rate (equivalent to the reverse repo rate in India) as a discretionary instrument for providing liquidity is generally placed in the middle of the corridor in major developed countries so that both the floor rate and the ceiling rates are linked with the repo rate in a well defined and transparent manner.

6. In order to address the set of issues listed above, the Group reviewed the present LAF framework drawing upon experiences in a cross-country perspective. While in the current market conditions, there is surplus liquidity, the Group examined the operations of LAF under alternate scenarios of the system for both surplus and deficit modes. The major recommendations of the Group both in respect of day to day liquidity management and in the context of sterilization are as follows:

I. Proposed Modifications in LAF in the Context of day to day Liquidity Management

-- In the light of substantial technological developments, the objective of conducting LAF operation on real-time basis, particularly operationalisation of Negotiated Dealing System (NDS) (i.e., minimum time lag between the auction and communication of results to market participants) on LAF need to be pursued further.

-- With a view to achieving balanced development of various segments of the money market, introduction of a deposit facility becomes essential to afford more flexibility to RBI in using the repo facility as a signaling device while not sacrificing the objective of the provision of a floor to the movement of short-term interest rates.

The deposit facility would also be useful in mopping up any surplus funds emanating from settlement balances of banks in an RTGS environment.

Currently, the repo rate provides the lower bound to the interest rate corridor as the Bank Rate at which eligible cash balances under CRR is remunerated is higher than the repo rate.

As the repo rate has emerged as the policy signaling rate, there is a need to have a lower rate linked to the repo rate which could provide a lower bound to the interest rate corridor.

In this context, the Group explored the feasibility of instituting a standing deposit facility. However, the Reserve Bank of India Act, 1934 in its present form does not permit RBI to borrow on clean basis from banks and pay interest thereon.

Therefore, institution of such a deposit facility distinct from CRR for banks would necessitate a suitable amendment to the RBI Act.

The Group learnt that the Reserve Bank has already made proposals to the Government to have the flexibility to change CRR even below the current statutory minimum of 3.0 per cent as also to pay interest on such balances actually maintained with it by scheduled banks.

The Group noted that such amendments are required in the light of the evolving monetary policy framework.

-- The Group felt that pending amendments to the RBI Act, the Reserve Bank should explore possibilities of modifying the current CRR provision to accommodate a standing deposit type facility for scheduled banks within its ambit which could achieve the same objective as a standing deposit facility.

The Group recommends that banks may be permitted to place deposits with the Reserve Bank at their discretion over and above the required CRR deposits.

Such deposits may be treated as being placed under standing deposit type facility and be deemed as a part of CRR with a flexible interpretation of the extant provisions of the RBI Act.

The distinguishing feature of the proposed standing deposit type facility is that the placement of deposits under this facility is at the discretion of banks unlike CRR which is applicable to all banks irrespective of their liquidity position.

Thus, the standing deposit type facility as a tool for residual liquidity management is more efficient as it distinguishes between banks having surplus cash balances from those that are in deficit.

-- In the context of LAF, the remuneration of cash balances maintained by banks with the Reserve Bank under the standing deposit type facility becomes an important issue. Since the interest rate on standing deposit type facility is designed to provide a floor to the interest rate corridor, the remuneration of such deposits should be at a rate lower than the repo rate.

A related issue is remuneration of eligible cash balances maintained under required CRR for all scheduled banks. It is felt that with substantial scaling down of CRR coupled with marked decline in overall interest rate structure in the economy and increasing liquidity needs of participants in the wake of higher interlinkages among different segments of the market, the degree to which CRR had been impacting banks as an implicit taxation earlier is considerably less in recent period.

On balance, the Group, therefore, recommends that in principle, the interest rate on CRR may be aligned with the desired interest rate on the proposed standing deposit type facility.

Accordingly, the Group felt that remuneration of eligible cash balances at the Bank Rate is no longer justifiable and hence, recommends that the remuneration of CRR, if any, be delinked from the Bank Rate and placed at a rate lower than the repo rate.

-- The minimum tenor of the repo/reverse repo operations under 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.

To facilitate a smooth transition to a system of 7-day LAF repo, both the overnight and 7-day repo auctions may be conducted on daily basis for a period. Even when the overnight repo is phased out, the Reserve Bank should have the option of conducting overnight repo if the situation so warrants.

-- As regards the method of LAF auction, it needs to be appreciated that though the LAF repo rate emerges from a variable price auction, experience so far indicates that the LAF has turned out to be a de facto fixed rate auction as market participants do not tend to bid at different rates.

As a result, the Reserve Bank had to conduct fixed rate LAF auctions as and when the repo rate was to be changed. In the proposed framework, the Group recommends that the LAF auction could be a fixed rate auction enhancing its policy signaling rate. However, the Reserve Bank should have the flexibility to use the variable price auction format if the situation so warrants.

-- If in future the underlying situation changes from the existing surplus mode to a shortage mode on a more enduring basis, the LAF corridor would need to be redefined within the basic parameters.

In such a scenario, there would be two rates at which liquidity would need to be injected and a single rate at which liquidity would be absorbed. Accordingly, the reverse repo rate would be placed within the corridor around which the overnight interest rates are expected to fluctuate.

As a result, the reverse repo rate (i.e., repo rate by international parlance) would become the policy signaling rate.

The standing deposit facility would continue to remain as the window for absorbing residual liquidity. However, the interest rate on the standing deposit facility would have to be determined at a rate lower than the reverse repo policy rate and would continue to give the lower bound to the interest rate corridor.

The upper bound to the corridor would be provided by a marginal lending facility in the nature of our existing standing refinance facility at a rate higher than the reverse repo rate. In essence, while the shape of the corridor would not change, reverse repo rate would replace the repo rate and would become the policy signalling rate around which the overnight call money rates would be expected to fluctuate in the event the financial market turns into a shortage mode.

In such a scenario, the Bank Rate should under normal circumstance be aligned to the marginal lending rate (i.e., standing refinance rate).

-- In the international parlance, while "repo" denotes injection of liquidity by the central bank against eligible collateral, "reverse repo" denotes absorption of liquidity by the central bank against eligible collateral. On the contrary, in the Indian context, "repo" denotes liquidity absorption by the Reserve Bank and "reverse repo" denotes liquidity injection. In order to achieve uniformity and facilitate international comparison, it would be useful to follow international practice in the usage of the terms "repo" and "reverse repo".

-- The current practice of the minimum bid amount of Rs.5 crore and multiples thereof may continue.

-- In the recent period, with the economy remaining in surplus mode coupled with discretionary liquidity being provided at the reverse repo rate as and when required, the importance of the Bank Rate as a signaling rate seems to have reduced. It would be desirable that liquidity injection should take place at a single rate. Accordingly, it would be desirable that the Bank Rate is under normal circumstance aligned to the reverse repo rate and, therefore, the entire liquidity support including refinance should be made available at the reverse repo rate/Bank Rate. The Bank Rate/reverse repo rate would, therefore, provide the upper bound to the interest rate corridor. The Group, however, recommends that the Reserve Bank may continue to announce the Bank Rate independently as at present, but the Bank Rate should under normal circumstances stay aligned to the reverse repo 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 longer time in an environment of RTGS system and low CRR before coming on to RBI's repo window.

-- To take care of unforeseen contingencies in mismatches, RBI may consider discretionary announcement of timing of both repo auctions and reverse repo auctions at late hours. RBI should not hold any regular reverse repo auction under LAF towards late hours so as to prevent participants to fund themselves under this window to extinguish their liability towards IDL availed earlier during the course of the day from RBI.

RBI should, however, keep the deposit facility open towards the end of RTGS system operating hours to absorb any excess fund remaining in the system.

-- RBI should strengthen its liquidity forecasting model so as to provide a more scientific basis to the decision making process for LAF operations.

-- In order for the LAF to function as the principal monetary policy instrument for signaling the Reserve Bank's stance on interest rates, it is desirable that LAF operates to primarily manage liquidity at the margin on a day-to-day basis.

However, in the recent period, the LAF repo facility has also operated as an instrument of Sterilization. While operationally it is difficult to distinguish between the Sterilization operations and liquidity management operations under LAF, conceptually there is need to distinguish surplus liquidity of "temporary" nature from surplus liquidity of a somewhat "enduring" nature.

In order to enhance the effectiveness of LAF, the Group recommends that additional instruments of Sterilization may be explored so as to reduce the liquidity pressure on the LAF window.

The Group proposes that as and when the RBI Act is amended, the Standing Deposit Facility could provide an additional instrument of Sterilization. In the meantime, the Group proposes that a "Standing Deposit Type Facility" could be explored within the extant provisions of the Act, without prejudice to the proposed amendment.

As proposed by the RBI Working Group on Instruments of Sterilization, setting up of a Market Stabilization Fund (MSF) will be useful as an option which can be operationalised whenever considered necessary.

-- In view of the finite stock of government securities available with the Reserve Bank for Sterilization, particularly, as the option of issuing central bank securities is neither permissible under the Act nor considered desirable by the RBI Working Group on Instruments of Sterilization, the Government may consider setting up of a Market Stabilization Fund (MSF) to be created in the Public Account.

This Fund could issue a new instrument called Market Stabilization Bills/Bonds (MSBs) for mopping up enduring surplus liquidity from the system over and above the amount that could be absorbed under the day to day repo operations of LAF. MSBs may be raised through auctions and permitted to be actively traded in the secondary market.

The amounts raised would be credited to the Market Stabilization Fund (MSF). The Fund account would be maintained with and managed by the Reserve Bank. 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 Sterilization of such inflows.