POLICY RATE CORRIDOR IN INDIA

BY: R. VASHISTHA

An interest rate corridor or a policy corridor refers to the range within which the operating target of the monetary policy - a short term interest rate, say the weighted average call money market rate - moves around the policy rate announced by the central bank.

Generally a corridor should have a discount rate or standing lending facility at the upper bound and an uncollateralised deposit facility at the lower bound. The word standing facility means a facility to access funds at a specified rate from the Central Bank (or deposit funds with Central Bank) on a standing basis (i.e. non ad-hoc, operational throughout the year on a permanent basis). The idea of a standing lending facility is to enable banks to obtain funding from the central bank when all other options have been exhausted. Uncollateralised deposit facility (this is also a standing facility though in many economies generally the word “standing facility” is used only for indicating the permanent window for borrowing funds) provides an option for banks to park their excess funds, for which there are no takers in the market. Since the funds are parked with the central bank, there is generally no need to take securities as collateral.

The policy rate is the key lending rate of the central bank. It is generally the repo rate though the nomenclature varies from country to country. If a bank has faced shortage of liquidity, then it can approach the Central bank with acceptable collaterals to pledge and borrow funds at the repo rate. The spreads around the policy rate for determination of the corridor is generally fixed such that any change in the policy rate automatically gets translated into corresponding changes in the standing facility rates. Notwithstanding the width of the formal corridor charted by the two standing facilities, the overnight interest rate, in practice, varies around the policy rate in a narrow corridor.

Monetary policy is generally conducted with a single policy rate in many countries. The policy rate is set within a corridor charted by

§  A standing collateralised marginal lending facility available throughout the day at a rate higher than the Policy rate that provides the upper bound; and

§  A standing uncollateralised deposit facility at a rate lower than the Policy rate that provides the lower bound to the corridor.

The market logically has to operate within the interest rate corridor as a trader having excess cash would demand the minimum rate from a borrower of funds, which it can get from the Central Bank by depositing its excess cash. The maximum rate he can charge would be below the standing facility rate at which central bank gives liquidity to the participants at a penal rate.

The width of the corridor is generally based on the following two considerations.

§  First, it should not be so wide as to induce volatility in short-term money market rates.

§  Second, it should not be so narrow that it retards the development of the short-term money market by taking away the incentive from market participants to deal amongst themselves before approaching the central bank.

The width of the corridor fixed by countries generally varies from 50 basis points to 200 basis points.

Just as the spread between commercial banks deposit and lending rates is a measure of the cost of bank intermediation, the spread between the parameters of the corridor is measure of the cost of central bank intermediation.

For most countries, the policy rate is placed symmetrically at the centre of the corridor. Countries like New Zealand, have asymmetric spread around the policy rate.

The money market rates should ideally be in the middle of the corridor, hovering around the policy rate.

The overnight operations are generally conducted at a fixed rate tender at the Policy Rate to clearly signal the stance of monetary policy. The longer-term repo operations and fine-tuning operations are conducted at a variable rate tender essentially as liquidity management operations. The longer-term operations and fine tuning operations are viewed essentially as liquidity management operations.

By changing the repo rate, the central banks indicate the interest rate direction. A shift in monetary policy can be signaled by adjusting the interest rate corridor.

For instance, widening of the corridor may imply tighter monetary policy stance as borrowing from central bank is relatively costlier than placing money with the central bank.

Frequent changing of the width of the corridor may create uncertainty and may also make it difficult to keep the target rate aligned to the policy rate. However, in extraordinary situations, when there is a need to incentivise or disincentivise market participants from accessing the standing lending facility or parking funds with the central banks, the width of the corridor could be changed.

A too-narrow corridor could increase the reliance of banks on the central bank and thus hamper the growth of the money market. On the other hand, too wide a corridor could give scope for volatility in the overnight interest rate which could impair the transmission of monetary policy. The guiding principle in the determination of the width of the corridor is that it should stabilise the overnight money market interest rate while facilitating the development of the money market so that the reliance of banks on central bank facilities comes down over time.

There are a number of ways to operate an interest rate corridor, depending on the specific country circumstances, liquidity forecasting abilities, state of development of the financial markets etc. Some of the main alternative interest rate corridor and policy rate configurations include:

§  A corridor with no official central bank policy rate: The central bank may, or may not, have an internal target for the interbank rate.

§  A floor system where the rate on the central bank deposit facility that constitutes the floor of the corridor both serves as the target for the interbank rate and as the official central bank policy rate.

§  A mid-rate corridor system where the policy rate either is an announced target for the interbank rate-and a central bank commitment to use open market operations (OMOs) to steer interbank rates to the target-or the rate the central bank uses to transact with its counterparts (the “OMO rate”). Typically, the policy rate is positioned in the middle of the corridor with the standing facility rates that constitutes the floor and ceiling of the corridor set at a fixed margin above and below the policy rate so that they move in tandem with changes in the policy rate.

§  A ceiling system where the rate on the central bank lending facility that constitutes the ceiling of the corridor both serve as the target for the interbank rate and as the official central bank policy rate, somewhat similar to the "classical system" where the central bank discount rate, or Bank Rate, combined with OMOs were used to steer short-term market rates somewhat below the Bank Rate. Ceiling systems are not common anymore.

Interest Rate Corridor in India

In India, policy rate is the fixed repo rate announced by the central bank - Reserve Bank of India (RBI) - for its overnight borrowing/lending operations through its mechanism for managing short term liquidity - the Liquidity Adjustment Facility. The Repo Rate is an instrument for borrowing funds by selling securities of the Central Government or a State Government or of such securities of a local authority as may be specified in this behalf by the Central Government or foreign securities, with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed.

The upper bound of the interest rate corridor in India is served by the Marginal Standing Facility (MSF) rate, which is the penal rate at which banks borrow money from the central bank and lower bound is served by the reverse repo rate, the rate at which banks park their surplus with RBI by purchasing the securities from central bank^[3]. (For more details on marginal standing facility rate, repo and reverse repo rates and policy rate please see the respective concepts in Arthapedia)

Other interest rates in the system like, inter-bank overnight call money rate, 7 and 14 day market repo and Collateralized Borrowing and Lending Obligations (CBLO) rates, form the short term money market rates in India. These rates typically hover around the policy rates - at the time of excess liquidity in the system, the rates are around the reverse repo rate while at the time of shortage, the same hovers around repo rate. At extremely tight liquidity conditions, these rates hug near to the MSF rate. The actual movement of rates during the period May 2015 to April 2016 is shown in the graph below.

Source: RBI database

The typical corridor used by RBI had been 200 basis points (100 basis point (bps) = 1%) or +/- 100 bps around the policy rate. In April 2016, RBI narrowed the policy rate corridor from +/-100 basis points (bps) to +/- 50 bps. Thus, MSF will be fixed 50 basis points above repo rate and Reverse repo would be fixed 50 basis points below Repo rate. This was done with a view to ensure finer alignment of the weighted average call rate or the overnight money market rates with the repo rate (which essentially means more effective transmission of monetary policy).

At present, the objective of meeting short term liquidity needs is being accomplished through the provision of liquidity by the Reserve Bank under its regular facilities - variable rate 14-day/7-day repo auctions equivalent to 0.75 per cent of banking system Net demand and Time Liabilities (NDTL), supplemented by daily overnight fixed rate repos (at the repo rate) equivalent to 0.25 per cent of bank-wise NDTL. Frictional and seasonal mismatches that move the system away from normal liquidity provision are addressed through fine-tuning operations, including variable rate repo/reverse repo auctions of varying tenors. Under the Marginal Standing Facility, the eligible entities may borrow up to 2% of their respective NDTL.

History of Interest rate corridor in India

The operating procedure of monetary policy in India has evolved over the years from regulation and direction of credit to liquidity management in a market environment. The focus on liquidity management arose particularly after the liberalisation of the economy and inflow of capital. Setting of an interest rate corridor in a formal manner thus started in India with the introduction of Liquidity Adjustment Facility in 1999.

In 1998, the Committee on Banking Sector Reforms (Narasimham Committee II) recommended the introduction of a Liquidity Adjustment Facility (LAF) under which the RBI should conduct auctions periodically. Accordingly, the RBI introduced an Interim Liquidity Adjustment Facility (ILAF) in April 1999 to minimize volatility in the money market by ensuring the movement of short-term interest rates within a reasonable range. Under the ILAF, the Bank Rate acted as the refinance rate (i.e., the rate at which the liquidity was to be injected) and liquidity absorption was done through the fixed reverse repo rate announced on a day-to-day basis (At that point of time they were called as repo rate). An informal corridor of the call rate thus emerged with the Bank Rate as the ceiling and the reverse repo rate as the floor rate, thereby minimising the volatility in the money market. ILAF was expected to promote stability in money market activities and ensure that interest rates moved within a reasonable range.

With the introduction of revised LAF in 2004 (whereby the meaning of the hitherto used Repo and Reverse Repo rates were inter-changed), in effect from November 2004, all liquidity injections are made at the fixed repo rate and liquidity absorption at the fixed reverse repo rate, with the two rates intended to act as the upper and lower bound of the corridor, respectively.

The 2011 Report of the Working Group on Operating Procedure of Monetary Policy (RBI, March 15, 2011; Chairman: Shri Deepak Mohanty)) paved the way for the installation of the current framework of interest rate corridor. Both the corridors designed earlier worked without a single policy rate. Depending on the liquidity situation either bank rate or repo rate or reverse repo rate assumed the role of policy rate. The operation of the LAF during April 2001 to February 2011 indicated that the repo and reverse repo rates were changed either separately or together 39 times, leading to changes in the corridor width 26 times. Hence, the committee recommended the following with respect to interest rate corridor.

§  Idea of operating the monetary system in a deficit mode

The Working Group report stated that monetary transmission is substantially more effective in a deficit liquidity situation than in a surplus liquidity situation. If the banks have surplus funds, the commercial bank will have discretion as to whether they lend their surplus to the central bank at the policy rate or create more credit by lowering credit standard if the policy rate is not attractive and the banks have the risk appetite. In case of surplus, the central bank's ability to transmit its preferred interest rate structure (yield curve direction) into the market gets weakened. If the shortage is a continuing feature of the market, the central bank becomes a net creditor of the banking system and the effectiveness of the monetary policy is likely to be stronger. However, the level of acceptable shortage for effectiveness of the monetary policy is a debate in itself.

An empirical exercise carried out by the Group suggested that under deficit liquidity conditions, money market rates responded immediately to a policy rate shock. For example, a 100 basis points (bps) change in the repo rate caused around 80 bps change in the weighted average call rate over a month. However, the strength of the response is relatively small in a surplus liquidity situation: a 100 bps change in the reverse repo rate, which is the operational rate in a surplus liquidity situation, caused around 25 bps change in the weighted average call rate over a month. Given the substantially superior strength of monetary transmission in a deficit liquidity condition, the Group recommended that the RBI should operate the modified LAF in a deficit liquidity mode to the extent feasible.

A simulation exercise carried out by the Group showed that at a liquidity deficit of one per cent of NDTL, the weighted average of money market rates exceeded the repo rate, on average, by around 15 bps. Similarly, with a liquidity surplus of one per cent of NDTL, the weighted average of money market rates was lower by about 20 bps. But when the liquidity deficit increased beyond one per cent of NDTL, the impact on the weighted average of money market rates was non-linear. For example, for a deficit at 1.25 per cent of NDTL, the deviation in weighted average of money market rates was 40 bps which rose to 75 bps for deficits at 1.5 per cent of NDTL and became unbounded at higher deficit levels. The Group was of the view that the objective of the LAF should be to stabilize short-term interest rates around the chosen policy rate for the smooth transmission of monetary policy. The Group, therefore, recommended that the liquidity level in the LAF should be contained around (+)/ (-) one per cent of NDTL. If the liquidity surplus/deficit persists beyond (+)/ (-) one per cent of NDTL, the RBI should use alternative instruments to supplement the LAF operations for effective monetary transmission.

§  Setting a single policy rate

However, it poses a major communication challenge to clearly articulate the stance of monetary policy, particularly in a situation when liquidity alternates between the surplus mode and the deficit mode in quick succession. World over central banks generally follow a corridor approach and they have a single policy rate as the system mostly operates in a deficit mode. As the Working Group suggested that the RBI operate the LAF in a deficit mode, it also recommended that the repo rate be the single policy rate.

§  Bank Rate and Reverse Repo rates acting as the ceiling of the Corridor

Further, the Group recommended that the repo rate should operate within a corridor so that the overnight interest rate moves around the repo rate in a narrow informal bound by redesigning the corridor. The Group recommended that the Bank Rate be re-activated as a discount rate with a spread over the repo rate. Once the policy rate changes, the Bank Rate should change automatically with a fixed spread over the repo rate.

The Group recommended that the reverse repo facility at which the RBI absorbs liquidity from the system should constitute the lower bound of the corridor. However, the reverse repo rate should not act as a policy rate as at present and should be determined as a negative spread over the repo rate. Moreover, as the Group envisaged the reverse repo facility more in the nature of a standing deposit facility, it suggested that the reverse repo rate should be such that it does not incentivise market participants to place their funds with the RBI and this needs to be kept in view while designing width of the corridor.

§  Creation of an Exceptional standing facility at the Bank Rate

The Group recommended the institution of a collateralised Exceptional Standing Facility (ESF) at the Bank Rate up to one per cent of the NDTL of banks carved out of their required SLR portfolio. Under sub-section (8) of Section 24 of the Banking Regulation Act, 1949, the RBI is allowed to waive payment of the penal interest on account of default in the maintenance of the SLR by a bank. The idea of liquidity facility up to one per cent of NDTL by waiving the penalty for the SLR default is to ensure that interest rates in the overnight inter-bank market do not spike for want of eligible collateral with some banks. The Group, therefore, recommended that the RBI should grant general exemption from payment of penal interest rate for the proposed ESF.

§  Suitable corridor width

An empirical exercise carried out by the Working Group showed a positive significant correlation of corridor width with weighted average overnight call rate. Controlling for liquidity, a wider corridor was associated with greater volatility in the overnight interest rate. In India, the corridor width has varied between 100 and 300 bps. An international survey suggests a corridor width of 50 to 200 bps. The Group also examined the effect of corridor width on weighted average call money rate volatility which indicated that a corridor width in the range of 150–175 bps could be optimal. Considering these estimates and keeping in view the optimality at containing liquidity within (+)/(-) one per cent of NDTL, the Group recommended 150 bps for the corridor width.

§  Spread of the corridor around the policy rate

Assuming a liquidity surplus scenario (due to capital flows and growth prospects) Group recommended an asymmetric corridor with the spread between the policy repo rate and reverse repo rate twice as much as the spread between the policy repo rate and the Bank Rate. That is, with a corridor width of 150 bps, the Bank Rate should be at ‘repo rate plus 50 bps’ and the reverse repo rate should be at ‘repo rate minus 100 bps’. This will ensure that market participants have an incentive to deal among themselves before approaching the RBI.

Accordingly, an operating framework of monetary policy was implemented on 3 May 2011 on the basis of recommendations of the Working Group on Operating Procedure of Monetary Policy (RBI, 2011). The framework had the following distinguishing features^[4]:

§  The weighted average overnight call money rate will be the operating target of monetary policy.

§  There will henceforth be only one independently varying policy rate and that will be the repo rate.

§  The reverse repo rate will continue to be operative but it will be pegged at a fixed 100 basis points below the repo rate. Hence, it will no longer be an independent rate.

§  A new Marginal Standing Facility (MSF) will be instituted from which Scheduled Commercial Banks (SCBs) can borrow overnight up to one per cent of their respective NDTL. The rate of interest on amount accessed from this facility will be 100 basis points above the repo rate. This facility is expected to contain volatility in the overnight inter-bank market.

§  As per the above scheme, the revised corridor will have a fixed width of 200 basis points. The repo rate will be in the middle. The reverse repo rate will be 100 basis points below it and the MSF rate 100 basis points above it.

§  While the width of the corridor is fixed at 200 basis points, the Reserve Bank will have the flexibility to change the corridor, should monetary conditions so warrant.

Thus, till the monetary policy statement of 3.5.2011, LAF Repo and reverse repo rates were being fixed separately. In this 2011 monetary policy statement, based on the working group report, it was decided that the reverse repo rate would not be announced separately but will be linked to repo rate. The reverse repo rate was proposed to be kept at 100 basis points below repo rate (100 basis points = 1%). Thus, reverse repo ceased to exist as an independent rate.

The +/- 100 basis points system with MSF and Reverse Repo as the upper and lower bounds continued till April 2016, with the width of the corridor remaining at 200 basis points, except for some brief periods in between.

The Reserve Bank’s liquidity framework was changed significantly in September 2014 in order to implement key recommendations of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Chairman: Dr. Urjit R Patel), RBI, January 2014). Based on the committee report, it was decided that RBI would adopt inflation targeting using repo rate as the policy rate and by maintaining a tight grip on the other interest rates.

Urjit Patel Committee, while recommending inflation targeting regime for the central bank advised continuing with the above operating framework in a broad manner. In the first or transitional phase, the weighted average call rate will remain the operating target, and the overnight LAF repo rate will continue as the single policy rate. The reverse repo rate and the MSF rate will be calibrated off the repo rate with a spread of (+/-) 100 basis points, setting the corridor around the repo rate. The repo rate will be decided by the Monetary Policy Committee (MPC) through voting. The MPC may change the spread, which however should be as infrequent as possible to avoid policy induced uncertainty for markets. Provision of liquidity by the RBI at the overnight repo rate will, however, be restricted to a specified ratio of bank-wise net demand and time liabilities (NDTL), that is consistent with the objective of price stability. As the 14-day term repo rate stabilizes, Committee suggested that, central bank liquidity should be increasingly provided at the 14-day term repo rate and through the introduction of 28-day, 56-day and 84-day variable rate auctioned term repos by further calibrating the availability of liquidity at the overnight repo rate as necessary. The objective should be to develop a spectrum of term repos of varying maturities with the 14-day term repo as the anchor.

Accordingly, in the April 2016 monetary policy RBI reviewed its monetary policy stance. It was stated by RBI that, it is possible for the Reserve Bank to keep the system closer to balance on average without the operational rate falling significantly, given that new instruments such as variable rate reverse repo auctions allow the Reserve Bank to suck out excess short term liquidity from the system without the excess liquidity being deposited with the Reserve Bank through overnight fixed rate reverse repo. Thus, RBI found that the past rationale for keeping the system in significant average liquidity deficit is no longer as compelling, especially when the policy stance is intended to be accommodative. Moreover, given that the Reserve Bank’s market operations rather than depositing or borrowing at standing facilities determine the operational interest rate, the policy rate corridor could be narrowed, as suggested by the Expert Committee.

Thus, in the April 2016 monetary policy statement, RBI narrowed the policy rate corridor from +/-100 basis points (bps) to +/- 50 bps. Thus, MSF will be fixed 50 basis points above repo rate and Reverse repo would be fixed 50 basis points below Repo rate; i.e., the width of the corridor came down from 200 bps to 100 bps. This was done with a view to ensure finer alignment of the weighted average call rate or the overnight money market rates with the repo rate (which essentially means more effective transmission of monetary policy). Also, RBI decided that it would continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from one per cent of NDTL to a position closer to neutrality. Further, it has been decided to:

§  Smooth the supply of durable liquidity over the year using asset purchases and sales as needed;

§  Ease liquidity management for banks without abandoning liquidity discipline by reducing the minimum daily maintenance of CRR from 95 per cent of the requirement to 90 per cent with effect from the fortnight beginning April 16, 2016;

§  Allow substitution of securities in market repo transactions in order to facilitate development of the term money market; and

§  Consult with the Government on how to moderate the build-up of cash balances with the Reserve Bank.

1. Refers to depositing funds with the central bank without receiving any collateral as security in return

2. It has also been argued recently that the constant width of the corridor is a waste of a good instrument. Goodhart, Charles (2009), "Liquidity Management". Paper prepared for the Federal Reserve Bank of Kansas City Symposium at Jackson Hole, August, 2009 as quoted in the Working Group Report.

3. "reverse repo" means an instrument for lending funds by purchasing securities of the Central Government or a State Government or of such securities of a local authority as may be specified in this behalf by the Central Government or foreign securities, with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.

4. The transition to the current framework in which the interest rate is the operating target, from the earlier regime based on reserve targeting – i.e., base money, borrowed reserves, non-borrowed reserves – was generally driven by two guiding considerations. First, financial sector reforms largely freed the interest rate from administrative prescriptions and setting, thereby enhancing its effectiveness as a transmission channel of monetary policy. Second, the erosion in stability and predictability in the relationship between money aggregates, output and prices with the proliferation of financial innovations, advances in technology and progressive global integration.