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Policy Rate

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The policy rate is the key lending rate of the central bank in a country. It is a monetary policy instrument under the control of the Central Bank -Reserve Bank of India (RBI) - to regulate the availability, cost and use of money and credit.

A change in the policy rate alters all other short term interest rates in the economy, thereby influencing the level of economic growth and inflation. (A low interest rate regime is considered conducive to growth while it generally fuels inflation)

In India, the fixed repo rate quoted for sovereign securities in the overnight segment of Liquidity Adjustment Facility (LAF) is considered as the policy rate. (It may be noted that India has many other repo rates in operation - eg. Market repo, repo on corporate debt securities etc.; for more details please see the concept of 'Repo and Reverse Repo').

In most countries, policy rate is generally the repo rate, though the nomenclature varies from country to country. For instance, in US, it is called the federal fund rate. Some countries use cash reserve ratio (China) or bank rate (UK) as the main policy rates to influence credit growth.

Repo rate, or repurchase rate in the overnight LAF window, is the fixed rate at which RBI lends to banks for a day. This is done by RBI buying government bonds from banks with an agreement to sell them back at a fixed rate. Repo rate changes transmit through the money market to alter the other interest rates in the financial system, which in turn influence aggregate demand - a key determinant of inflation and growth.

If the RBI wants to make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. In other words, an increase in the repo rate will lead to liquidity tightening and vice-versa, other things remaining constant.

Legal Backing for the Policy Rate in India

The Reserve Bank of India and Government of India signed the Monetary Policy Framework Agreement on 20 February 2015, to task RBI with the responsibility for price stability and inflation targeting. The term ‘policy rate’ got first defined in this Agreement even though the repo rate had emerged as the key policy rate for signalling the monetary policy stance since June 2000.

Subsequently, the government while unveiling the Union Budget for 2016-17, proposed to amend section 2 of the RBI Act, 1934 through the Finance Bill 2016 to give a legal backing for the aforementioned Monetary Policy Framework Agreement and inflation targeting approach in the conduct of monetary policy. Accordingly, it was decided to insert Section 2(iv)(ccccii) which defines "policy rate" as the rate for repo-transactions under sub-section (12AB) of section 17 of the RBI Act, 1934.

Sub-section (12AB) of section 17 of the RBI Act, 1934, defines "repo" as "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".

Finance Bill 2016 was made into an Act- The Finance Act, 2016 - in May 2016.

Fixing of the policy rate

RBI fixes the overnight LAF repo rate and the same is announced through the monetary policy statements. The policy framework of the RBI aims at setting the repo rate based on a forward looking assessment of inflation, growth and other macroeconomic risks, and modulation of liquidity conditions to anchor money market rates at or around the repo rate.

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

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[1].

The typical corridor used by RBI has been 200 basis points (100 basis point (bps) = 1%) or +/-100 bps from 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.

Consequent to the introduction of inflation targeting regime and Monetary Policy Framework Agreement, it has been decided that the "policy rate" will be decided by the Monetary Policy Committee (MPC), which in their view is consistent with maintaining price stability while keeping in mind the objective of growth. The MPC takes decisions based on majority vote (by those who are present and voting). In case of a tie, the RBI governor will have the second or casting vote. The decision of the Committee would be binding on the RBI.

The provision of creating an MPC for fixation of policy rate was made through the Finance Act, 2016.

History and Emergence of the Indian Policy Rate

The operating procedure of monetary policy in India has evolved over the years from regulation and direction of credit (that is which sector of the economy should receive credit and at what rate) to liquidity management in a market environment.

In the beginning, Bank Rate[2] was used as a general instrument of interest rate policy in India. With the nationalization of banks in 1969 (so as to aid channelization of credit to select priority sectors and to finance government deficits /operations) focus shifted to statutory liquidity ratio (SLR) and Cash reserve Ratio (CRR). The level of SLR was progressively increased from the statutory minimum of 25% in February 1970 to 38.5% by September 1990 thereby enabling Government to expand its expenditures beyond its means. The CRR was mainly used to neutralise the inflationary impact of deficit financing by the Government and was gradually raised from its statutory minimum of 3% in September 1962 to 15% by July 1989. During this period, the Bank Rate had a limited role in monetary policy operations, as it was ineffective due to the increasing prescription of differential rates for various sector-specific refinance facilities and the lack of a genuine bill market.

With the liberalization of the economy in 1991 and the onset of capital flows, liquidity absorption began to be carried out through reverse repos (then called as repos, in contrast to the international usage of the term) introduced in 1992. The government market borrowing through auctions since 1992-93 led to development of a secondary market in government securities and the market determination of interest rates. Furthermore, the exchange rate began to have a bearing on monetary management with exchange rate liberalisation - the rupee became fully convertible on the current account in 1994 – and the opening up of the economy.

By the second half of the 1990s, liquidity management operations by the RBI moved away from direct instruments to indirect instruments. The CRR was brought down from 15% of net demand and time liabilities (NDTL) of banks during July 1989-April 1993 to 9.5 % by November 1997. The SLR was reduced to the statutory minimum of 25% by October 1997.

RBI introduced an Interim Liquidity Adjustment Facility (ILAF) in April 1999 to minimise 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. 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.

During the phase of ILAF, the standing lending facilities for banks included a variety of rates for various participants fixed either at the bank rate or 2-4% above the bank rate (eg. For banks it was Collateralised Lending Facility (CLF), Additional Collateralised lending facility (ACLF) and Export Credit Refinance (ECR); and for primary dealers (PDs), it was Level I and Level II liquidity support[3] ). Thus, the entitlement and the rate at which these facilities were available were different. Therefore, there were multiple standing lending facilities available at multiple rates. These rates were administered in nature, and were rationalised subsequently.

The transition from ILAF to a full-fledged LAF began in June 2000 and was undertaken in three stages ending in 2004. With effect from March 29, 2004, the repo rate got unified to the Bank Rate at 6%, and with that the entire quantum of ECR and liquidity support to PDs was made available at the repo rate, thereby completely delinking the standing facilities to banks from the Bank Rate. Thus, the repo rate emerged as the lending rate of the RBI for all practical purposes. As a result, the importance of the Bank Rate as a monetary policy instrument waned.

Subsequently, the LAF scheme was revised, taking into account the recommendations of the Internal Group on LAF and suggestions from market participants and experts. Accordingly, the 1-day reverse repo was phased out, and in its place the 7-day fixed rate reverse repo on a daily basis and the 14-day variable rate reverse repo on a fortnightly basis were introduced in March 2004. Repo operation was, however, retained on an overnight basis. Also, the repo rate was scaled down to 6% and aligned with the Bank Rate under the revised LAF scheme. Accordingly, a single liquidity injection facility available at a single rate was introduced by merging the normal facility and backstop/standing facility (means providing last-resort support in terms of funds or security).

In order to restore flexibility in liquidity management, the RBI reintroduced the 1-day fixed rate reverse repo in August 2004 while continuing with 7-day and 14-day reverse repos and overnight fixed rate repos. Eventually, in order to have greater flexibility in liquidity management, the 7-day fixed rate and the 14-day variable rate reverse repos were phased out and the LAF was operated through overnight fixed rate repo and reverse repo effective from November 1, 2004. With effect from October 29, 2004, the nomenclature of repo and reverse repo was interchanged as per international usage.

With the introduction of revised LAF in 2004, 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. Now Repo rate is the rate at which banks borrow funds from the Reserve Bank against eligible collaterals and the reverse repo rate is the rate at which banks place their surplus funds with the RBI under the liquidity adjustment facility (LAF).

With the introduction of Liquidity Adjustment Facility - Repo/Reverse Repo Rate depending upon the status of underlying durable liquidity started functioning as the policy rate. In a surplus liquidity condition, the reverse repo rate becomes the operating policy rate. In a deficit liquidity situation, the repo rate becomes the policy rate. On introduction of LAF, discounting/rediscounting of bills of exchange by the Reserve Bank has been discontinued. As a result, the Bank Rate became dormant as an instrument of monetary management. Further, focus was on de-risking the financial sector by encouraging collateralised borrowings. The substantial growth of the collateralised market (repos and Collateralised Borrowing and Lending Obligations (CBLOs) developed by Clearing Corporation of India Ltd.) vis-à-vis the uncollateralised market (Call money market) reflects the result of the deliberate policy attempt to mitigate risk in the wholesale financial market by increased use of collateral (By 2013 share of uncollateralised call money market had gone down below 15%).

The Report of the Working Group on Operating Procedure of Monetary Policy (RBI, March 15, 2011; Chairman: Shri Deepak Mohanty) first recommended the need to have a single policy rate rather than having multiple ones. It also recommended the repo rate as the single policy rate. Further, it emphasized 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.

Based on the Group’s recommendations, in the Monetary Policy Statement of 3 May 2011, it was decided to make the following changes in the extant operating procedures of monetary policy:

The next major change in the policy rate determination happened 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, 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 particularly the call money market rates.

Urjit Patel Committee, while recommending inflation targeting regime for the central bank advised continuing with the operating framework recommended by the 2011 Working Group 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, 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.

As per the Expert Committee view, the 14-day term repo rate is superior to the overnight policy rate since it allows market participants to hold central bank liquidity for a relatively longer period, thereby enabling them to on lend/repo term money in the inter-bank market and develop market segments and yields for term transactions. More importantly, term repos can wean away market participants from the passive dependence on the RBI for cash/treasury management. Overnight repos under the LAF have effectively converted the discretionary liquidity facility into a standing facility that could be accessed as the first resort, and precludes the development of markets that price and hedge risk. Improved transmission of monetary policy thus becomes the prime objective for setting the 14-day term repo rate as the operating target instead of the weighted average call money rates.

1."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.

2. Under Section 49 of the Reserve Bank of India Act, 1934, the Bank Rate has been defined as “the standard rate at which the Reserve Bank is prepared to buy or re-discount bills of exchange or other commercial paper eligible for purchase under the Act. On introduction of LAF, discounting/rediscounting of bills of exchange by the Reserve Bank has been discontinued. As a result, the Bank Rate became dormant as an instrument of monetary management. It is now aligned to Marginal Standing Facility (MSF) rate and is used for calculating penalty on default in the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR).

3. With the introduction of ILAF in April 1999, the general refinance facility introduced on April 26, 1997, with the limit fixed at 1 % of banks' fortnightly average outstanding aggregate deposits in 1996-97 was withdrawn and replaced by a collateralised lending facility (CLF) for scheduled commercial banks. The entitlement under CLF was fixed at up to 0.25 per cent of the fortnightly average outstanding aggregate deposits in 1997-98 for two weeks at the Bank Rate. Additional collateralised lending facility (ACLF) for an equivalent amount of CLF was made available at the Bank Rate plus 2 per cent. CLF and ACLF availed for periods beyond two weeks were subjected to a further penal rate of 2 per cent (i.e., Bank Rate plus 4 per cent) for an additional two-week period. The Export Credit Refinance (ECR) facility for scheduled commercial banks was provided at the Bank Rate. Liquidity support to Primary Dealers (PDs) against collateral of government securities based on bidding commitment and other parameters - termed as Level I support - was given at the Bank Rate with a repayment period of 90 days. Additional liquidity support - termed as Level II support - at the Bank Rate plus 2 per cent against collateral of government securities was also made available for a period not exceeding two weeks.

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