How the RBI Manages Liquidity, From the LAF Corridor to Sterilisation and Beyond

The Reserve Bank of India has largely been successful in its liquidity management in terms of the immediate objective of ensuring that the policy repo rate decided by the MPC is reflected fully and instantaneously in the weighted average call money rate. In fact, barring weekend spikes, primary dealers running out of funds and other exceptional circumstances, the call money rate evolves tightly bound within the LAF corridor defined by the two standing facilities, the SDF and the MSF. Most of the time, it ‘middles’ the corridor, hugging the policy repo rate, which lies at the centre of the space between the MSF and SDF by design. This reflects monetary marksmanship. 

The call money rate functions like a benchmark for all money market rates. In the overnight segment, the CBLO rate and the market repo rate tend to be closely aligned with the call money rate. These overnight rates then perform the role of benchmarks for the rates on instruments for a slightly longer tenor, such as the 91-day Treasury bill rate, and the rates on certificates of deposit and commercial paper. They, in turn, become benchmarks for slightly longer-tenor instruments and thereby the transmission of the policy rate across the money market, overnight to 1 year, is more or less quick and full. By influencing both demand for and supply of reserves, the central bank completes the first leg of monetary transmission – from policy rate to short-term money market rates. Against this backdrop, it is worthwhile to look at specific aspects of liquidity management.

Sterilisation
Foreign capital inflows and outflows have a big influence on markets, as they also do on overall economic activity. When there are inflows, for instance, they add to market volumes and augment supply in the foreign exchange market. This may lead to exchange rate appreciation in the absence of a commensurate increase in demand. If the appreciation is excessive, leading to mispricing of the rupee against foreign currencies and undue volatility with repercussions for the broader economy, the RBI may step into the market and buy up excess dollars.

The result is an infusion of rupees in the system, which can depress interest rates in domestic segments of the financial markets, causing substantial easing of financial conditions. This abundance of domestic liquidity may, in turn, encourage excessive risk-taking, endangering financial stability. It may also encourage an expansion in spending, stoking inflation and risking macroeconomic instability. So, in the next stage, or even simultaneously, the RBI can sell its holdings of domestic assets in exchange for the created rupees, thereby keeping the money supply unchanged and avoiding undue inflation or financial instability risks. 

The opposite happens when there are capital outflows and market turnover contracts. To avoid deflationary pressures, including depreciation of the rupee, the RBI buys government securities from banks and injects rupees into the system, thus keeping money markets stable.

Balance Sheet Impact of Open Market Operations
The impact of open market operations by the RBI is asymmetric between the balance sheets of banks and that of the RBI. Let’s first take the impact on a bank’s balance sheet when the RBI buys government securities through open market operations. The bank’s holdings of securities in its investment portfolio decline, but the RBI pays it rupees that are credited to its account with the RBI. So, the bank’s balance sheet remains unchanged. The asset side adjusts – investments go down but cash with the RBI goes up commensurately.

In the RBI’s balance sheet, however, there is a different impact. Its assets expand because its own investment portfolio goes up due to the securities it bought from the bank. Its liabilities also go up because cash balances of banks with it increase with the money it has paid for the securities. Thus, the whole balance sheet expands, resulting in the creation of new money.

Balance Sheet Impact of the CRR
The impact of a change in the CRR is also different between banks’ balance sheets and that of the RBI, but with a subtle nuance. When the CRR is increased by the RBI, the balances of banks with the RBI go up. Banks get the money for paying the CRR by selling their investments or securities or by reducing loans and advances. Once again, the adjustment occurs entirely on the assets side of the bank’s balance sheet and it remains unchanged.

In the RBI’s balance sheet, however, liabilities go up because banks’ balances go up, and investments go up because banks sell securities to it to obtain the money for the CRR. The RBI’s balance sheet expands, but no money is created because the expansion in liabilities is impounded within the RBI’s balance sheet. The reduction in the bank’s assets leads to lower credit and lower economic activity.

The LAF Corridor as an Instrument of Liquidity Management
There have been occasions when the RBI has used the LAF corridor as an instrument. During the taper tantrum of 2013, when the rupee was under intense downward pressure and inflation was raging, the RBI cut off providing liquidity and squeezed market liquidity so that money market rates rose to the ceiling of the LAF corridor – the MSF rate. Pressure on the rupee eased as the demand for dollars was stemmed. Importantly, the repo rate was kept unchanged.

Again in the pandemic, the most important objective was to keep markets functioning and liquidity flowing at a cheap rate. So, abundant liquidity was created, taking the call money rate to the floor of the LAF corridor and even below, close to zero. The repo rate was cut, but only to 4%, to keep it aligned with the target. This experience was unique, because other central banks took their policy rates to the zero lower bound and even into negative territory, with adverse consequences that are playing out even today.

Liquidity Management Framework and Liquidity Forecasting
As per the RBI Act, as amended in 2016, the RBI’s liquidity management framework and any changes thereto have to be put out in the public domain through the Monetary Policy Report released twice a year.

• Currently, the weighted average call money rate (WACR) is the operating target of monetary policy.
• The objective of liquidity management operations is to keep the WACR aligned with the policy repo rate.
• Both the standing facilities under the LAF, (i) the MSF, and (ii) the SDF, are available on all days of the week throughout the year.
• Other Instruments of Liquidity Management are VRR/VRRR auctions of various maturities; outright OMOs; buy/sell forex swaps.
• The seven-day VRR/VRRR operation at a variable rate is the primary liquidity management tool.
• The primary operation is supported by fine-tuning operations of various maturities.
• The Automated Sweep-In and Sweep-Out facility helps banks manage daily liquidity by automatically moving funds between their current accounts and the RBI’s LAF.

The RBI’s liquidity forecasting framework looks a few weeks ahead. It essentially consists of balancing autonomous factors such as changes in currency in circulation, changes in banks’ balances with the RBI, changes in government balances and settlement of foreign exchange interventions with the policy tools that I have described. The choice of instruments depends on the type of liquidity that is to be modulated.

This is Part 10 of the Masterclass with Michael Patra.

Masterclass with Michael Patra: Previous Sessions

Part 1
Origins, Ideas and Institutions
Michael Patra begins the masterclass by tracing how central banks evolved from fragile monetary experiments into institutions entrusted with preserving trust, stability and confidence.

Part 2
RBI and the Safeguarding of Confidence
The series then turns to the RBI’s evolution, its expanding institutional role, and the balance between autonomy, growth and price stability.

Part 3
The Rise and Fall of Monetary Policy Regimes
From Bretton Woods to monetary targeting, the masterclass examines how central banks repeatedly reinvented monetary policy frameworks when old anchors collapsed.

Part 4
When Monetary Anchors Collapse
As monetary targeting broke down globally, central banks were pushed again into uncertainty, instability and regime change.

Part 5
Central Banking and Monetary Policy Regimes: The Indian Experience
How India’s trysts with crises, policy responses and changing gears in the development strategy imposed monetary policy regime shifts upon the RBI.

Part 6
Inflation Targeting and the Contract of Trust
From time inconsistency to flexible mandates, Michael Patra explains how inflation targeting became the world’s most durable monetary policy regime.

Part 7
India: Survival of the FITtest
From the Urjit Patel committee to the first MPC, Michael Patra traces how India designed, legislated and launched flexible inflation targeting.

Part 8
Lessons From India’s Inflation Targeting Decade
After a decade tested by a pandemic and war, Michael Patra distils four lessons from India’s flexible inflation-targeting framework. 

Part 9
The Plumbing in the Monetary Policy Architecture
Patra explains the plumbing of monetary policy, tracing how RBI liquidity management transmits the MPC’s repo rate through banks and money markets.