The Reserve Bank of India (RBI) is the monetary authority of the country. RBI sets the monetary policy with the objectives of price stability, economic growth and financial market stability. RBI uses its monetary tools for effective pass through of monetary policy. RBI sets its annual monetary policy for a fiscal year in April and then subjects the policy to reviews every quarter with mid quarter reviews held a month before the quarterly review.
RBI Policy tools
The tools used by the RBI for its monetary policy are:
1. Repo Rate
2. CRR (Cash Reserve Ratio)
3. SLR (Statutory Liquidity Ratio)
4. OMO (Open Market Operations)
5. MSS (Market Stabilization Scheme)
1. Repo (7.25% as of June 2015)
The repo rate is the benchmark policy rate. The repo rate is the rate at which the RBI lends money to banks. The lending operation is done through an auction called the LAF (Liquidity Adjustment Facility) auction. This auction is done on a daily basis and banks wanting to borrow funds from the RBI at the repo rate have to bid for funds in the auction. RBI lends successful bidders funds at the repo rate. The LAF is a collateralized lending platform where banks have to pledge government bonds or treasury bills with the RBI for borrowing money.
A rise in repo rate increases cost of funds for banks while a fall in repo rate reduces cost of funds for banks.
Rates linked to repo rates are the Reverse Repo rate and the Marginal Standing Facility (MSF). The reverse repo rate is the rate at which RBI borrows money from banks in the LAF auction. Banks with excess liquidity lends funds to RBI by bidding for reverse repo in the LAF auction. RBI gives government bonds or treasury bills as collateral to the banks.
The reverse repo rate is set at 1% below the repo rate.
The MSF is an emergency window for funds for banks. The MSF is set at 1% above the repo rate and banks in need of emergency funds borrow from the MSF window by bidding for funds at the MSF rate. Banks pledge government securities or treasury bills to borrow funds under MSF window. Under the Marginal Standing Facility (MSF), banks avail funds from the RBI on overnight basis against their excess SLR holdings. They can also avail funds on overnight basis below the stipulated SLR up to two per cent of their respective Net Demand and Time Liabilities (NDTL) outstanding at the end of second preceding fortnight.
2. CRR (4% as of June 2015)
Banks have to keep a percentage of their NDTL (Net Demand and Time Liabilities) as CRR with the RBI. RBI sets the CRR rate to reflect its monetary stance. The CRR rate is set higher if RBI wants banks to keep more money as CRR and lower if RBI wants banks to keep less money as CRR. The more money kept as CRR the less money banks have to lend and less money kept as CRR the more money banks have to lend
3. SLR (21.5% as of June 2015)
SLR is the percentage of NDTL that banks have to invest in government bonds. RBI sets the SLR rate to reflect its monetary stance. The higher the SLR rate the more money the banks should invest in government bonds and the less money they have to lend. The lower the SLR the less money banks should invest in government bonds and the more money they have to lend.
4. OMO (Open Market Operations)
RBI buys and sells government bonds directly in the bond market or through bond purchase and sale auctions. RBI buying government bonds adds liquidity into the system while RBI selling government bonds sucks out liquidity from the system. The higher the liquidity the more money banks have to lend and the lower the liquidity the less money banks have to lend.
MSS securities are special government securities and treasury bills that are used to suck out liquidity from the system. RBI sells MSS bonds through auctions to banks and other investors. The money paid for buying the MSS bonds by investors are then held by the RBI in a special account and does not come into the system. The act of issuing MSS securities is an act of sterilization of excess liquidity, when the liquidity is generated by excessive capital flows into the country.
How does MSS work? Take for example RBI buying USD 1 billion. RBI USD purchase would add around Rs 630 billion of liquidity into the system. RBI does not want this liquidity staying in the system and wants to take it away. RBI will ask the government to issue MSS bonds, which can either be treasury bills or dated government securities. Government will auction MSS bonds and the money collected from auctioning the MSS bonds will be kept in a separate MSS cash account, as the government cannot spend this money. Hence liquidity goes out of the system and stays out of the system until the MSS bonds mature or until the MSS cash balances are released through de-sequestering of the cash balances.