Context

Recently, the Reserve Bank of India (RBI) decided to introduce long-term repo operations (LTRO) and revised its liquidity management framework to facilitate the transmission of monetary policy actions and flow of credit to the economy.

Background:                                  

• The central bank will conduct long-term repos operations (LTROs) of one- and three-year tenors for up to a total amount of 1 lakh crore at the policy repo rate.
• LTROs conducted under this scheme will be in addition to the existing Liquidity Adjustment Facility (LAF) and Marginal Standing Facility (MSF)
• Objective: This is a direct incentive by RBI to boost credit growth, even as the monetary policy committee (MPC) earlier kept benchmark rates unchanged because of uncertainty in the inflation outlook.
  • Credit lending in the economy is at low levels. India’s credit growth slowed to 7.1% in 2019.
• External Benchmark System: Earlier, the central bank mandated all banks to link their floating rate loans to an external benchmark instead of the marginal cost-based lending rate (MCLR).
  • After the introduction of external benchmark system, most banks linked their lending rates for housing, personal and micro and small enterprises (MSEs) to the policy repo rate of the RBI.
• LTROs will be conducted on CBS (E-KUBER) platform.
• RBI’s action is reminiscent of the European Central Bank’s (ECB’s) unequivocal promise of funds to the banking system in 2011.
• Measures used by RBI:
  • Cash reserve ratio (CRR) norms were also eased for new retail loans to improve credit flow.
  • Revised the liquidity management framework, and finalized weighted average call rate (WACR) as the single operating target.
  • RBI also abolished the daily variable rate reverse repo and replaced it with a daily fixed-rate reverse repo.
• An Accommodative Monetary policy during 2019-20: As on end January 2020, Monetary Policy Committee (MPC) cut the repo rate by 110 basis points in four consecutive meetings. In its 5th meeting, MPC kept the repo rate unchanged.
  • A repo rate cut means that RBI will lend money to commercial banks at a lower rate.
  • A lower repo rate will reduce cost of borrowing for commercial banks.
  • This incentivises commercial banks to lend money to businesses at a lower interest rate.
  • At a lower rate of interest, businesses will borrow more, and more liquidity is injected into the economy.

Analysis:

Why was External Benchmark System introduced?

• MCLR had replaced base rate regime: The MCLR-based regime had replaced the earlier base rate regime to provide transparency in the transmission of monetary policy decisions.
• Marginal cost-based lending rate:MCLR is an internal benchmark rate that depends on various factors such as fixed deposit rates, source of funds and savings rate. The price of loan comprises the MCLR and spread/profit margin of the bank.
• Problem with MCLR regime: When RBI cut the repo and reverse repo rates, banks did not pass the full benefits to borrowers. It is not that banks did not cut their MCLR. They did albeit by a much lower percentage.
  • MCLR system is opaque since it is an internal benchmark that depends on the way a bank does its business.
  • Due to internal benchmarking of loan price, policy rate cuts often don't reach the borrowers.
  • Unmatched policy transmission: In December 2019, one-year median MCLR has declined by 49 basis points since February while RBI cut the repo rate by 135 basis points cumulative in the same period.
• External Benchmark Regime: Under the new regime, interest rate for floating loan wills immediately responses to changes in repo rate or Treasury bill rate. Banks were free to choose from any of the external benchmark mentioned below:
  • RBI's policy repo rate
  • Government of India3-Months Treasury Bill yield published by the Financial Benchmarks India Pvt Ltd (FBIL)
  • Government of India 6-Months Treasury Bill yield published by the FBIL
  • Any other benchmark market interest rate published by the FBIL
• Loans to medium enterprises also linked to external benchmark: RBI has decided to link pricing of loans by scheduled commercial banks for the micro, small and medium enterprises to an external benchmark like the repo rate with effect April 1, 2020.
• Note: Banks were free to charge a spread, i.e., margin and risk premium over and above the external benchmark.

Why is RBI introducing LTRO now?

• Increase liquidity in event on non-accommodative stance of MPC: Keeping in view the inflationary pressures, MPC in its 5^th meeting kept the repo rate unchanged.This gave RBI a chance to use others measures that are essentially outside the ambit of MPC.
  • To overcome the impact of an absent rate cut, and add impetus to the slowing economy RBI resorted to measure of LTRO.
• Availability of durable liquidity: 1 lakh crore will be injected into the banking system that will enable banks to reduce their lending rates.
  • The ?1 trillion borrowed by banks under this special window will be locked in at the current repo rate of 5.15%.
  • Basically, this means banks can give the RBI government bonds and borrow money for 1 and 3 years at a fixed rate.
• Lower cost of funds for banks: Funds are being given at the policy rate (repo rate), which is relatively cheaper than the prevailing market rates.
  • This will bring down cost of funds for banks without effectively cutting deposit rates.
  • It is expected to bring down short-term rates and boost investment in corporate bonds, as corporate borrowing rates will fall.
• Ensure Monetary Transmission: It is an effort by the RBI to ensure better monetary policy transmissionand make effective the transmission of earlier repo rate cuts.
• Manage bond yields: This, along with other measures of RBI like ‘Operation Twist’ will help RBI manage bond yields.

What was the immediate impact of LTRO?

• Fall in short-term bond yields: Shorter duration government bond yields plunged on after RBI announced LTRO.

Benefits of LTRO

• Increased flow of credit to productive sectors:This should encourage banks to undertake maturity transformation smoothly and seamlessly so as to augment credit flows to productive sectors.
• Improve growth: This step demonstrates RBI’s intent towards supporting growth.
• Will act against inflationary pressures: Given the elevated headline inflationary pressures, this measure will be an incentive for banks to lock medium-term funding at currently low (repo) rates.

CRR reduced for certain segments

• CRR is currently at 4% of net demand and time liabilities (NDTL) or a sum of the bank’s deposits and borrowings.
  • Banks must set aside CRR with RBI, but do not earn any interest on it.
  • The lower the CRR requirement, the better it is for banks, as they can lend that much more and earn interest on it.
• To improve credit flow, RBI temporarily removed the cash reserve ratio (CRR)for every new retail loan made to finance automobiles, homes, and to small businesses.
  • Cheaper money helps spur credit demand.
• This will make it attractive for banks to lend to retail and small businesses.
• It essentially translates into a short-term cut in CRR.
• This scheme will be available for new loans given till 31 July 2020.

Revised liquidity management framework

• Surplus liquidity:Liquidity in the banking system is currently estimated at a surplus of a massive ?3.6 trillion.
• Revised liquidity management framework: RBI revised the existing liquidity management framework through which it ensures adequate liquidity in the system.
  • This was done so that sufficient credit is provided to all productive sectors in the economy, and excess liquidity in the system is channelized to supply adequate credit.
• WACR as the single operating target: According to the revised framework, RBI finalized weighted average call rate (WACR) as the single operating target.The call rate is the interest rate at which banks lend overnight money to each other.
  • RBI will ensure enough liquidity to anchor the call rate at around the repo rate.
  • This means that if the call rate inches above the repo rate, it would signal liquidity deficit and the central bank will bring its tools to infuse liquidity.
  • Similarly, if the call rate is below the repo rate, it would mean the banking system has surplus liquidity. In that case, the central bank can operate to suck out the liquidity through its operations.
• No need to maintain 1% of NDTL: With WACR being the single operating target, the liquidity provision of RBI to maintain 1% of net demand and time liabilities (NDTL), does not arise.
  • Hence, RBI withdrew the current provision of maintaining assured liquidity of 1% of net demand and time liability (NDTL).
• Introduced a variable 14-day term repo/reverse repo operation: Under the new framework, RBI has withdrawn the daily fixed rate repo and 14-day term repos and, instead, introduced a variable 14-day term repo/reverse repo operation, which will be conducted to coincide with the cash reserve ratio maintenance cycle.
  • Owing to surplus liquidity, banks participate in lending excess reserves to RBI in exchange of G-Sec.
  • Earlier banks used to dump unlimited amounts of excess cash with the RBI at daily fixed reverse repo rates.
  • Within the new framework, now banks have to decide every 14 days how much excess cash they will need for CRR and other purposes and lend the balance for 14 days to RBI.
  • Many banks will be afraid to give away all their excess cash to RBI for 14 days fearing demand coming up.
  • Hence, they will park relatively less money with RBI and more money will be available for supply of credit.
• The introduction of LTRO is likely to make reverse repo rate as the operative policy rate over a point of time.
  • It can be seen through WACR’s recent drifted towards the reverse repo rate (lower bound), effectively bringing down cost of bank funds just as a rate cut would have.

Conclusion

RBI introduction of LTRO is more of a credit policy than monetary policy. Monetary policy’s effectiveness in driving credit and overall growth is limited, keeping in mind that the inflation is currently high. It needed some direct measures to ensure credit reaches to the sectors where there is requirement.