Reserve Bank of India’s (RBI) proposal to change its main policy tool to a 14-day rate from an overnight one is a move bankers expect to help them better align their lending rates with central bank decisions.
It will also reduce swings in the country’s volatile money markets, they said.
The proposals are included in a report released on Tuesday by a RBI panel. The main recommendation is that India moves to inflation as the main monetary policy objective ahead of economic growth and financial stability, with specific focus on consumer price inflation.
The panel suggested monetary policy should be decided by a committee, as opposed to the central bank governor as it is now, and a two-phased change eventually resulting in the 14-day rate for repurchase agreements, or repos, becoming the main operating rate. Repos are bonds-for-loans money market transactions.
Bankers and analysts welcomed the proposals, some of which can be adopted if RBI Governor Raghuram Rajan approves them. Others, such as the need for a monetary policy committee and an inflation-targeting framework, need legislative approval.
“Currently, there is not much of reference to money market rates when banks price their deposit products,” said M Narendra, CMD of Indian Overseas Bank.
“Since our deposits start from 7 days and 14 days, the RBI’s 14-day reference rate will be a strong reference point to build the pricing curve,” Narendra said.
The RBI currently sets monetary policy through rates for its overnight repo and reverse repo operations. Yet, the interbank market for repos, or repurchase agreements, suffers from relatively low volume trade.
In an economy where banks rely on overnight borrowings and swaps to fund longer-term lending, the constant uncertainty about the availability and cost of funds is a constraint. Volatility in overnight funding markets prevents banks from swiftly changing their lending and deposit rates with each shift in monetary policy.
Rajan has already begun encouraging banks to switch to longer-term borrowings. He introduced 14-day repos in October, soon after taking office in September as part of an ambitious slate of reforms that includes accelerating the development of India’s financial markets.
Since July, banks have also been barred from borrowing more than 0.5 per cent of their deposits from the central bank’s overnight window. “Rajan wants monetary policy transmission to happen faster,” said IDBI Bank executive director RK Bansal.
“Once 14-day term repo becomes the policy rate, that will be a better indicator for banks, and banks will price their deposits and loans accordingly,” Bansal said.
However, it is vital that the central bank stops managing the government’s cash balances before it transitions to a new system, bankers said. The balances can by huge and can cause market swings when they are shifted around the economy.