The Financial Framework of India: Monetary Policy of RBI Deconstructed

Part of 1 of 3 - Exploring Open Market Operations

 

In part 1, we are going to be talking in terms of what are called the open market operations by the central banks, with a view to keep a check on the interest rates on the rates of inflation. And today, at the beginning of the trading day, we had this official press note contaminating out of the reserving of India.

The bank shall be entering into open market operations to the extent of 20,000 quad rupees in trashes of 10,000 quad rupees each very shortly, with a view to inject more money into the hands of the banks. Now, what really is this operation like as we all know, various banks as a part of. Statutory liquidity ratio are holding securities of government of India.

Also, the various state governments, but this is going to be dealing with the securities of government of India, of different maturities where the money of the banks is parked with the government of India at an auctioned rate, 10 years paper, 20 years, 30 years paper. And the banks are regularly getting interest from the government of India.

And at the end of the maturity of the. The money comes back to the bank. Now, what the Reserve Bank of India felt, and that is evident from the background of this announcement, is that the interest rates are Harding. In other words, people now require medium term funds, five-year loan, seven-year loan, 10-year loan to put as in.

Into the business to expand their business as we slowly crawl out of the lockdown on account of Covid. But since the interest rates are going up, it really means that the banks do not have in their covers long term funds, to then advance to various clients. So here is where the Reserve Bank jumps in. It says, Hey, bank of Friends, this is 20,000 Crows coming.

The Reserve Bank of India trade, and we are going to purchase those securities. And when we purchase those securities, obviously you pay money. And to whom do you pay the money to the banks and therefore banks are going to get rid of those securities and get money from the Reserve Bank of window and that.

Is medium term to long term paper. In other words, if you see the press note, the securities which are maturing in year 2024, 2027, 2030, 2032. Therefore, the to know or the remaining to know anything from four to 12 years, that is the type of money which Reserve Bank of India is going to buy. Of course, it is a kind of unlimited auction process where the bankers.

And depending on the market rate prevailing, the Reserve Bank accepts those bids. And what then happens is those securities come to the Reserve Bank of India and those 20,000 rupees will go to the banks who were holding the security. So therefore, the theory behind this is that those particular banks must necessarily then have those 20,000.

Within a period of less than a fortnight, and it would be expected of the bank management then to lend, if not aggressively, at least enthusiastically to projects that need the money. So that's where those 20,000 crawl Rupe is going to go. And it is expected not only funds would become available to the banks to lend to the entrepreneurs at the same time, it would help in depressing the rate of interest, otherwise the cost of money, if it's.

Then to that extent, the projects of the entrepreneurs become non-viable. Something very important, which we miss out. And this question is not asked, is it government borrowing? The answer is no. It is not. Any fresh additional government borrowing that is entirely a different subject. No money is going into the government.

Government itself not borrowing any money directly from the open market, the banks, or from the Reserve Bank of vendor. All that the Reserve Bank is doing is buying those securities of the banks. And now as far as the central government is concern, instead of paying those installments and interest for the banks, it is going to be paying that to the, it is a bank.

So, the government of India's balance sheets in terms of its own liabilities is unchanged. It'll continue to service the debt as it was doing quoi commercial banks, but now it'll do Quoi Reserve Bank. There was also a small note that while it is going to be chasing these securities, when you purchase, you are pumping money, it is also going to be.

Short term securities to the banks, something which is going to be expiring in October and November, essentially equivalent to the fixed deposit receipts of the banks from 46 days to 90 days. Now, what does that really mean? That meant that the people deposits like you and me are putting their money into the banks for a short period of time.

They really want to take an informed decision. And they are not going in for a three-year FDRs, so they're putting in the money into the bank for 46 days, for 90 days, and the bank really does not know where to park those fonts. There is something of a window, which is called as a reverse repo rate by the Reserve Bank, but that is basically where the banks spark money overnight.

So, what the Reserve Bank perhaps had. That while the long-term interest rates of the bank loans were going up, the shorter money, the interest rates were low. So, there was diversions between the two, and it is not a good idea to have too much of divergence. So, by selling those securities, it is creating a window for the various commercial banks to park their short-term funds with the Reserve Bank of India.

So that is going to create. A stability in the short run as well. So, a very balanced, prudent, and timely interaction by the Reserve Bank of India illustrating the open market mechanism. In summary that we, again, to end the Central Bank or the Reserve Bank and open market operation is going to purchase those securities.

Those securities are already floating about in the. It is an instrument between the central government and the various commercial banks, so when it buys, it pumps in money. Where does the money go? The money goes into the coffers of the banks, and they have more money in terms of medium to long term funds to pump into new investments as loans, which is the business of the banks, whereas the balance sheet of the central comment is unaffected.

Their debt servicing will continue as. Friends, there are other instruments of monetary policy. We'll be very shortly talking about them. For instance, very popular in America, quantitative easing and something which is very popular in India. What you call as monetizing the deficit, which is also sometimes called printing notes.

We'll be talking about this later, but if you want to keep yourself informed and apprised of these interesting short. Please do not forget to subscribe, click and share. They may friend like you for whom the open market operations appear to be Greek and Latin. But actually, it's a very simple concept and it is always good to know what the story behind the headlines is.

Until next time — Stay connected, stay tuned, stay safe. And next time we’ll talk about part 2 of this 3-part series on the financial framework of India.