Tools for Managing Liquidity in the Government Securities Market - Security Analysis and Investment Management

Finally, the development of related markets such as repo, futures and options also improves market liquidity of the government securities market by enabling participants to undertake hedging, arbitrage operations and speculative transactions. R e p o transactions enable market participants to finance long positions and cover short positions. A well structured futures market reduces hedging costs and, thus, makes it easier to undertake cash transactions. An options market provides flexibility for hedging and arbitrage.

Open Market Operations (OMO)

An open market operation (also known as OMO) is an activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy. The usual aim of open market operations is to control the short term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.

Since most money now exists in the form of electronic records rather than in the form of paper, open market operations are conducted simply by electronically increasing or decreasing (crediting or debiting) the amount of base money that a bank has in its reserve account at the central bank. Thus, the process does not literally require new currency. However, this will increase the central bank's requirement to print currency when the member bank demands banknotes, in exchange for a decrease in its electronic balance.

When there is an increased demand for base money, the central bank must act if it wishes to maintain the short-term interest rate. It does this by increasing the supply of base money. The central bank goes to the open market to buy a financial asset, such as government bonds foreign currency, gold, or seemingly nonvolatile (until the 2008 financial fallout) MBS’s. (Mortgage Backed Securities). To pay for these assets, bank reserves in the form of new base money (for example newly printed cash) are transferred to the seller's bank and the seller's account is credited. Thus, the total amount of base money in the economy is increased. Conversely, if the central bank sells these assets in the open market, the amount of base money held by the buyer's bank is decreased, effectively destroying base money.

India’s Open Market Operation is much influenced by the fact that it is a developing country and that the capital flows are much different than those in the other developed countries. Thus Reserve Bank Of India, being the Central Bank of the country, has to make policies and use instruments accordingly. Prior to the 1991 financial reforms, RBI’s major source of funding and control over credit and interest rates was the CRR (cash reserve ratio) and the SLR (statutory liquidity ration). But after the reforms, the use of CRR as an effective tool was de-emphasized and the use of open market operations increased. OMO’s are more effective in adjusting market liquidity.

The two traditional type of OMO’s used by RBI:

  1. Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent).
  2. Repurchase agreement (REPO): Is short term, and are subject to repurchase.

However, even after sidelining CRR as an instrument, there was still less liquidity and skewedness in the market. And thus, on the recommendations of the Narshiman Committee Report (1998), The RBI brought together a Liquidity Adjustment Facility (LAF). It commenced in June, 2000, and it was set up to oversee liquidity on a daily basis and to monitor market interest rates. For the LAF, two rates are set by the RBI: repo rate and reverse repo rate. The repo rate is applicable while selling securities to RBI (daily injection of liquidity), while the reverse repo rate is applicable when banks buy back those securities (daily absorption of liquidity). Also, these interest rates fixed by the RBI also help in determining other market interest rates.

India experiences large capital inflows every day, and even though the OMO and the LAF policies were able to withhold the inflows, another instrument was needed to keep the liquidity intact. Thus, on the recommendations of the Working Group of RBI on instruments of Sterilization (December, 2003), a new scheme known as the Market stabilization scheme (MSS) was set up. The LAF and the OMO’s were dealing with day to day liquidity management, whereas the MSS was set up to sterilize the liquidity absorption and make it more enduring.

According to this scheme, the RBI issues additional T-bills and securities to absorb the liquidity. And the money goes into the Market Stabilization scheme Account (MSSA). The RBI cannot use this account for paying any interest or discounts and cannot credit any premiums to this account. The Government, in collaboration with the RBI, fixes a ceiling amount on the issue of these instruments.

But for an open market operation instrument to be effective there has to be an active securities market for RBI to make any kind of effect on the liquidity and rates of interest.

The Reserve Bank’s Open Market Operations in Central government Securities

The Reserve Bank’s Open Market Operations in Central government Securities

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