What is the Reserve Bank of India’s operating framework?

The monetary policy framework and the associated operating procedure of monetary policy in India have also evolved over time. On 3rd May 2011, the Reserve Bank in its Annual 6 BIS central bankers’ speeches Monetary Policy Statement announced a revised monetary policy operating procedure based on the recommendations of a Committee constituted for the purpose.5 Before I delve into the current operating procedure, let me give you a snapshot of the evolution of our monetary policy operations since the inception of the Reserve Bank of India in 1935. First, in the formative years during 1935–1950, the focus of monetary policy was to regulate the supply of and demand for credit in the economy through the Bank Rate, reserve requirements and OMO. Second, during the development phase during 1951–1970, the need to support plan financing through accommodation of government deficit financing by the RBI began to significantly influence the conduct of monetary policy. This led to introduction of several quantitative control measures to contain the consequent inflationary pressures while ensuring credit to preferred sectors. These measures included selective credit control, credit authorisation scheme (CAS) and “social control” measures to enhance the flow of credit to priority sectors. The Bank Rate was raised more frequently during this period. Third, during 1971–90, the focus of monetary policy was on credit planning. However, the dominance of fiscal policy over monetary policy accentuated and continued through the 1980s. To raise resources for the government from banks, the statutory liquidity ratio (SLR) was progressively increased from the statutory minimum of 25 per cent of banks’ net demand and time liabilities (NDTL) in 1970 to 38.5 per cent by 1990. And to neutralise the inflationary impact of deficit financing, the cash reserve ratio (CRR) was gradually raised from its statutory minimum of 3 per cent to 15 per cent of NDTL during the period. Fourth, the 1980s saw the adoption of monetary targeting framework based on the recommendations of Chakravarty Committee (1985). Under this framework, reserve money was used as operating target and broad money (M3) as an intermediate target. A number of money market instruments such as inter-bank participation certificates (IBPCs), certificates of deposit (CDs) and Commercial Paper (CP) were introduced based on the recommendations of Vaghul Committee (1987). Fifth, structural reforms and financial liberalisation in the 1990s led to a shift in the financing paradigm for the government and commercial sectors with increasingly market-determined interest rates and exchange rate. By the second half of the 1990s, in its liquidity management operations, the RBI was able to move away from direct instruments to indirect market-based instruments. The CRR and SLR were brought down to 9.5 per cent and 25 per cent of NDTL of banks by 1997. Sixth, the monetary policy operating procedure also underwent a change following the recommendation of Narasimham Committee II (1998). The RBI introduced the Interim Liquidity Adjustment Facility (ILAF) in April 1999, under which liquidity injection was done at the Bank Rate and liquidity absorption was through fixed reverse repo rate. The ILAF gradually transited into a full-fledged liquidity adjustment facility (LAF) with periodic modifications based on experience and development of financial markets and the payment system. The LAF was operated through overnight fixed rate repo and reverse repo from November 2004. The LAF helped to develop interest rate as an instrument of monetary transmission. In the process, two major weaknesses came to the fore. First was the lack of a single policy rate. The operating policy rate alternated between repo and reverse repo rates depending upon the prevailing liquidity condition. In a surplus liquidity condition, the operating policy rate was the reverse repo rate, while in a deficit liquidity situation it was the repo rate. Second was the lack of a firm corridor. The effective overnight interest rates dipped below the reverse repo  rate in surplus conditions and rose above the repo rate in deficit conditions. Moreover, overnight call rates became unbounded under occasional liquidity stress. Thus, more often the overnight interest rate remained outside the corridor

New operating procedure Against this background, the new operating procedure retained the essential features of the LAF framework with the following key modifications. First, the weighted average overnight call money rate was explicitly recognised as the operating target of monetary policy. Second, the repo rate was made the only one independently varying policy rate. Third, a new Marginal Standing Facility (MSF) was instituted under which scheduled commercial banks (SCBs) could borrow overnight at their discretion up to one per cent of their respective NDTL at 100 basis points above the repo rate.