Economists have welcomed the slew of liquidity management measures announced by RBI in its latest monetary policy, saying it will result in quicker transmission of policy rates to lending rates.

Why new liquidity management measures were required?

Bank lending rates have not fallen to the same extent as policy rates have.There was also a growing clamour for easier liquidity in the money market to help monetary policy transmission.


The existing framework on liquidity was put in place in May 2011. Since then, the policy stance was to keep liquidity in deficit mode with -1% of NDTL being associated with the usual level of comfort. While this framework served well during the ensuing phase of monetary tightening, it created hindrance for efficient transmission when the easing cycle commenced from January 2015 onwards.

Important structural changes announced:

The first change is to keep liquidity in neutral rather than deficit mode, as was the wont of the central bank till now. The change from deficit to neutral mode means that the RBI will have to aggressively buy dollars as well as government securities to release money into the money market. The size of its balance sheet seems set to increase.Second, the so-called interest rate corridor between the repo rate (or the rate at which banks borrow from the RBI) and the reverse repo rate (or, the rate at which banks park their excess money with the RBI) has shrunk from 1% to 0.5%. Banks will now borrow from RBI at 6.5% and keep excess money with the central bank at 6%. Central banks use such policy corridors to keep overnight call money rates within a desired band.



The most obvious result is a reduction in the volatility of short-term interest rates.Lower volatility in the interbank money market could have an important effect on bank behaviour. Banks tend to hoard liquidity when interest rates are jumping around. An anchored call money rate will ensure that banks are more comfortable trading with each other for overnight money rather than depending on the central bank for emergency funds.What this also means is that short-term interest rates will not be hostage to the liquidity forecasting errors of commercial banks, and even perhaps the unexpected movements in the cash balances that the government maintains.The new changes will further help the Indian central bank improve its liquidity marksmanship.


The success of the new liquidity policy will depend not just on its theoretical structure but also how it is translated into practice. The elimination of the liquidity deficit in the money market may make it difficult for the RBI to defend the repo rate as its policy rate. A sudden gush of capital inflows could send the domestic money market into surplus mode, and thus make the reverse repo the effective policy rate. Such an inadvertent switch can confuse the markets as well as reduce the effectiveness of monetary policy.