ECONOMIC NOTES

EPW Research Foundation

RBIs Policy Stance

The Reserve Bank of India has in its attempt to control the exchange rate volatility of the rupee perplexed the market. The short-term measures announced to limit money market liquidity went against its accommodative medium-term stance, causing considerable uncertainty in the market. In hindsight, they seem to have hurt the nancial system as a whole.

Anita B Shetty, Bipin K Deokar and K Kanagasabapathy are with the EPW Research Foundation (epwrf.mumbai@gmail. com), Mumbai. They thank Vishakha G Tilak and Pravin S Jadhav for support with data and information.
Economic & Political Weekly EPW

he Reserve Bank of India (RBI) in its rst quarter review of the monetary policy for 2013-14, which was announced on 30 July, maintained the status quo, leaving policy rates and the cash reserve ratio (CRR) undisturbed. That would have generally indicated a continuation of its accommodative medium-term policy. But just a little earlier, in the same month, the RBI had surprised the market with a slew of measures to contain volatility in the exchange rate and arrest the depreciation of the rupee against the dollar. This made the RBIs short-term objectives and policy stance different from its medium-term position. Indeed, they were diametrically opposite. As evident, the focus on balancing ination and growth shifted to informal exchange-rate targeting, creating a fresh trilemma. The measures were intended to squeeze money market liquidity, especially the ows through RBI windows to make rupee funds costly in the shortterm so as to arrest the tendency to use them to take speculative positions in the foreign exchange market. What has come out about a month after these measures is that the liquidity-tightening measures have hurt the system as a whole. While the motive was to control speculative activities in the forex market, this has hardly been achieved as the rupee is once again volatile, moving above the presumptive target of Rs 60 per dollar. This note attempts to critically review the trends in overall liquidity conditions, and the money, foreign exchange, and government securities markets over the past one month to ascertain how far the objective of the RBI has been achieved and what distortions its measures have introduced in the markets.
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1 Medium-term Policy Stance The RBIs phase of tightening monetary policy continued from March 2010 to October 2011, when it raised the repo rate 13 times to contain ination that was hovering near double digits. In January 2012, the RBI signalled a shift in its policy stance by reducing the CRR by 50 basis points (bps), followed by 75 bps in March 2012, to ease liquidity (one bps is one hundredth of a percentage). Overall, during the period of easing, the CRR was cut by as much as 200 bps, or from 6% to 4%. In April 2012, for the rst time in three years, the RBI initiated easing the policy rate by reducing the repo rate by 50 bps, warning that there was limited scope for further rate cuts. After nine months, it cut the repo rate by 25 bps in January 2013. On the whole, the repo rate was cut by 125 bps during this easing phase. The RBI has after this maintained the status quo against the backdrop of multiple challenges such as depreciation of the rupee, a negative trade balance, depleting foreign exchange reserves, inationary pressures, and a widening of the current account decit (CAD) alongside a rising scal decit. 1.1 Exchange Rate Measures Quite contrary to its medium-term policy stance, the RBI announced a set of shortterm measures when its focus shifted to managing the exchange rate of the rupee. The measures were expected to tighten liquidity conditions, make rupee funds costlier, and have a sobering effect on the rupee exchange rate. However, the RBI claried that
the recent liquidity tightening measures are aimed at checking undue volatility in the foreign exchange market and will be rolled back in a calibrated manner as stability is restored to the foreign exchange market, enabling monetary policy to revert to supporting growth with continuing vigil on ination.

How far have these objectives been achieved? 2 Liquidity Conditions The RBIs recent effort to shore up the rupee exchange rate by draining liquidity from nancial markets is pushing up market interest rates. However, overall liquidity has not tightened. The RBIs restrictions on
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ECONOMIC NOTES

EPW Research Foundation

need of banks to meet a shortage of funds following 2,00,000 the RBIs liquidity-tighten1,75,000 ing measures (Graph B). 1,50,000 Repo During 2012-13, a degree 1,25,000 of stability was evident in 1,00,000 money market rates meas75,000 ured in terms of standard 50,000 MSF deviation (SD) across mon25,000 ey market instruments 0 2/4 13/4 24/4 5/5 16/5 27/5 7/6 18/6 29/6 10/7 21/7 1/8 12/8 (Table 1). The lower volaGraph B: Weighted Average Daily Money Market Rates (%) tility emphasised the out10.50 come of the informal cor9.50 ridor of repo and reverse 8.50 repo rates, which is in 7.50 consonance with the RBIs 6.50 focus on nancial stability, 5.50 a key consideration of 4.50 1/4 8/4 15/4 22/4 29/4 6/5 13/5 20/5 27/5 3/6 10/6 17/6 24/6 1/7 8/7 15/7 22/7 29/7 5/8 12/8 19/8 monetary policy. However, Call Money CBLO Market Repo Call Money CBLO Market Repo the restrictions imposed by the RBI in July 2013 saw short-term the liquidity adjustment facility (LAF) window in two stages had an effect on re- money market rates exhibit extreme volnewed borrowings in the marginal stand- atility, particularly those of collateraling facility (MSF) at a rate of 10.25% in the ised borrowing and lending obligations later part of July 2013 (Graph A), though (CBLO), with an SD of 1.24. borrowers had initially not availed them- Table 1: Volatility in Money Market Rates Call CBLO Market Repo CP ^ CD ^ selves of this facility to a great extent. FurPeriod April 2012 to 29 January 2013 ther, the RBI conducted open market sales SD 0.28 0.25 0.14 0.71 0.78 of government securities, absorbing liAvg * 8.02 7.92 8.04 14.22 9.69 quidity to the tune of Rs 2,500 crore on 18 CV 0.03 0.03 0.02 0.05 0.08 July 2013 against the notied amount of Period 30 Jan 2013 to 19 March 2013 SD 0.23 0.53 0.08 0.70 0.23 Rs 12,500 crore. It received an enthusiastic Avg * 7.68 7.52 7.81 14.18 9.15 response from participants, with total bids CV 0.03 0.07 0.01 0.05 0.03 exceeding Rs 24,000 crore. Period 20 March 2013 to 3 May 2013
Graph A: Repo and MSF Borrowings from RBI's LAF Window (Rs crore)
2,25,000

short-term liquidity to market participants who have been restricted or phased out from the call money market has not been achieved. As per Clearing Corporation of India data, mutual funds were the net lenders in the CBLO market and cornered around 70% of the average CBLO lending.
Table 2: Average Daily Money Market Activity (Rs crore)
Month * Call Money CBLO Market Repo

27-Apr-12 25-May-12 29-Jun-12 27-Jul-12 31-Aug-12 28-Sep-12 25-Oct-12 30-Nov-12 28-Dec-12 24-Jan-13 22-Feb-13 28-Mar-13 26-Apr-13 31-May-13 28-Jun-13 26-Jul-13 21-Aug-13

19,295 15,162 11,903 10,873 9,459 11,825 10,933 10,392 10,750 13,167 11,676 14,313 15,252 12,645 12,673 10,944 10,436

39,440 31,317 39,030 38,881 44,673 50,241 44,380 38,410 41,729 41,278 42,313 46,687 55,993 47,907 61,589 71,805 70,626

15,245 14,657 18,036 16,974 17,883 18,505 23,424 20,381 15,041 18,176 23,943 23,239 25,847 28,288 27,140 25,050 20,435

*Period ending last Friday of every month. Source: RBI, compiled by EPWRF.

2.1 Money Market Rates Money market rates remained relatively stable in 2012-13, but the recent liquiditytightening measures have caused sudden spikes in short-term money market rates. Following the RBIs monetary-easing stance, which began in April 2012, call money witnessed stable behaviour after initially hovering above the repo rate. The overnight rate remained within the repo and reverse repo corridor, and even touched the lower bound in some intermittent trading sessions, reecting a comfortable liquidity situation. But the overnight rate ruled above the repo rate towards the end of the scal year with tight liquidity conditions caused by year-end credit requirements. In the current scal year, call money rates eased considerably and fell below the reverse repo rate, but spiked to above 10% levels, reecting the
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SD 0.29 1.08 0.78 0.09 0.13 Avg * 7.53 7.41 7.67 13.32 10.05 CV 0.04 0.15 0.10 0.01 0.01 Period 4 May 2013 to 21 August 2013 # SD 1.05 1.24 1.14 0.27 0.66 Avg * 7.67 7.50 7.79 12.84 9.49 CV 0.14 0.17 0.15 0.02 0.07
*: Average is in %. ^: Calculation based on high rates. #: Data up to 31 July for CP and CD. Source: www.rbi.org.in, compiled by EPWRF.

2.2 Money Market Turnover In the scal year 2012-13, the average volume of call money transactions was Rs 12,500 crore, which showed a decline from the beginning of the year. The trend continued in the current scal year, and in July 2013 the average volume fell to around Rs 11,000 crore. Contrary to this, transaction volumes in the CBLO market increased substantially and accounted for around 65% of the total money market volume (Table 2). However, the primary objective of providing an alternative avenue for
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The recent measures have inicted collateral damage on the government securities market and distorted bond yields, which surged to a ve-year high with investors demanding higher returns in an auction of cash management bills (CMBs). The yield of one-year government security paper has been above 11% in the recent period, indicating an inverted yield curve. Another attempt by the RBI to tighten cash by auctioning CMBs witnessed an overwhelming response from investors aspiring for high interest rates. The 20 August CMBs auction with a notied amount of Rs 11,000 crore received 171 bids amounting to Rs 37,680 crore. For these 27-day CMBs, the RBI set a cut-off rate of 12.28% (Table 3). This
Table 3: Auction Results of Cash Management Bills (CMBs)
Date Maturity Notified Accepted Amount Amount Rs crore Yield (%)

25-Jul-13 25-Jul-13 01-Aug-13 05-Aug-13 12-Aug-13 13-Aug-13 19-Aug-13 20-Aug-13 Total

28-days 56-days 6-days 7-days 35-days 34-days 28-days 27-days

3,000 3,000 3,000 3,000 11,000 11,000 11,000 11,000 56,000

2,195 3,000 3,000 3,000 11,000 11,000 11,000 11,000 55,195

11.18 11.20 8.88 9.93 11.71 11.94 12.24 12.28

Source: RBI Press Releases.

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ECONOMIC NOTES
Graph C: FIIs Investment in Equity and Debt and Rupee-Dollar Exchange Rate
Amount in Rs crore Rs/$

totally defeats the medium-term objective of monetary policy. 3 Rupee Exchange Rate The RBIs efforts to stabilise rupee volatility have so far proved ineffective. Since April 2013, the rupee has tumbled by nearly 17% against the dollar and the reference rate stood at Rs 65.42 on 22 August despite measures by the central bank and the government to defend it. Global nancial market developments following indications that the US is likely to taper off quantitative easing (QE) have triggered outows of portfolio investment, particularly from the debt segment. This has led to signicant depreciation of the rupee since the end of May 2013. From June 2013 to 21 August, foreign institutional investors (FIIs) sold a net of Rs 71,000 crore in the equity and debt markets. The bulk of the FII outow has been from the debt market worth Rs 53,000 crore, leading to turmoil in the nancial market (Graph C). 3.1 Forex Market Intervention Following the depreciation of the rupee in mid-2011, the RBI frequently intervened in the forex market, both in its spot and forward segments, by selling dollars. Initially, these interventions helped stabilise the rupee and improve it against the dollar. The RBI aggressively intervened in the forward segment by selling dollars, and the outstanding net forward sales position was more than $12,300 million in 2012-13. In the spot market, the RBI sold an average of $311

2800 1800 800 -200 -1200 -2200 -3200 -4200

52

54

56

58

60
Rs/$

62

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Graph D: Forward Quotations for Rupee versus US Dollar

59 61 63 65 67

1-month quotation 6-month quotation 3-month quotation

1-year quotation

1/4

10/4

19/4

28/4

7/5

16/5

25/5

3/6

12/6

21/6

30/6

9/7

18/7

27/7

12/8/13
5/8 14/8

24/4/13

16/5/13

27/5/13

18/6/13

29/6/13

10/7/13

21/7/13

-5200

5/5/13

7/6/13

2/4/13

million a month. However, in the rst quarter of 2013-14, the RBI reduced its forward sales, and at the end of June 2013 the outstanding net forward sales position stood at $4,914 million. It has been widely held that market participants were taking undue advantage of forward dollar sales by hedging in non-deliverable forwards markets overseas, Table 4: Forex Market Intervention by RBI ($ Million) Month Spot Spot Sale Net Spot Forward Forward Outstanding resulting in heightened specPurchase Intervention Purchase Sale Forward @ ulative activities. In the spot Apr-2012 0 275 -275 250 -3,703 -3,453 May-2012 778 1,263 -485 650 -10,959 -10,309 market, the RBI sold a net Jun-2012 650 700 -50 400 -14,484 -14,084 $2,252 million during June Jul-2012 0 785 -785 550 -15,009 -14,459 2013 (Table 4). Aug-2012 100 552 -452 450 -14,557 -14,107 The movement of the rupee Sep-2012 300 310 -10 295 -14,347 -14,052 in the forward market has Oct-2012 1,055 1,150 -95 100 -14,182 -14,082 been signalling further depreNov-2012 855 1,776 -921 600 -14,137 -13,537 ciation against the dollar Dec-2012 1,685 1,735 -50 300 -13,787 -13,487 Jan-2013 2,039 2,057 -18 603 -13,412 -12,809 in the coming months. The Feb-2013 3,021 3,301 -280 1,302 -13,412 -12,110 near-month quotations have Mar-2013 3,165 2,345 820 1,806 -12,812 -11,006 moved in tandem with spot Apr-2013 3,298 2,780 518 2,009 -10,242 -8,233 quotations, while three-month May-2013 3,003 3,110 -107 1,974 -7,774 -5,800 and one-year forward quotaJun-2013 469 2,721 -2,252 2,245 -7,159 -4,914 tions show a severe deprecia'+: Purchases. -: Sales, @: End of the month Source: www.rbi.org.in tion bias (Graph D).
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4 Concluding Observations The RBIs short-term monetary operations seemed to adopt a position that was contrary to its medium-term accommodative stance. This was awkward and left market participants perplexed. In the late 1990s, in a similar situation, the RBI directly used monetary weapons such as the repo rate, CRR, bank rate, and other measures. One fallout has been the RBI targeting the exchange rate. Another fallout has been that it is difcult to determine when the current markettightening measures will be rolled back. The measures have also undermined hopes of an easing of monetary policy.
References
RBI (2013): Macroeconomic and Monetary Developments in 2012-13 , Reserve Bank of India, available at http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/MMDA300413FL_97E519DA10.pdf (2013): Macroeconomic and Monetary Developments, First Quarter Review 2013-14 , Reserve Bank of India, available at http://rbidocs.rbi. org.in/rdocs/Publications/PDFs/M290713 FC66587B599. pdf

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