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Market needs to be more efficient for liquidity management:Dr Mohan

Written by: Staff

Mumbai, Mar 31 (UNI) As Reserve Bank of India(RBI) withdraws from the primary market participation from tomorrow in accordance with the Fiscal Responsibility and Banking Management (FRBM) Act, 2003, there is an urgent need to bridge the institutional gap with minimal necessary changes in the regulations so that market operations retain their efficiency, both from the view point of central bank and the market participants, according to a top Central Banker.

Making his observations at the economic conference here recently, RBI deputy Governor Rakesh Mohan said further improvements in liquidity management would substantially depend on the abilities to improve forecasting of liquidity in the system.

The short span within which liquidity conditions have been changing by a large amount, became the biggest constraint in targeting short-term interest rates.

''More effort for understanding the fiscal position and the government cash balances, as also the timing of foreign capital flows are of paramount importance in this context'', he said.

The conduct of monetary policy and management in the context of large and volatile capital flows has proved to be difficult for many countries. As India became convertible on the current account, and liberalised its capital account in a carefully sequenced manner since the balance of payment crisis of 1991, Dr Mohan observed that the country too had been faced with similar problems.

The evolving policy mix involved careful calibration that took into account diverse objectives of central banking, changes in the monetary policy framework and operating procedures, and widening of the set of instruments for liquidity management.

In spite of the relative success in liquidity management in India, several challenges remain ahead, Dr Mohan said.

He said, notwithstanding the large size of the debt markets, absence of a vibrant term market, the illiquidity of a large set of securities and limitations of corporate debt market continue to come in way of further contemplated changes.

While RBI now enables market participants to meet their marginal liquidity demand twice a day on each working day, there is a moral hazard that passive operations by central bank in the market may be resulting in some market players not doing enough for their own liquidity management.

As the system moves to maintenance of statutory liquidity requirement (SLR) securities at statutory minimum levels, liquidity provision would become more difficult unless the instrument set is widened to facilitate market players to even out their liquidity mismatches.

Dr Mohan felt that after substantial opening of the economy, and deregulation of interest rates that price discovery of the rate of interest has become important.

Consequently, RBI has had to experiment on a continuous basis. It has had to operate simultaneously on the external account in the foreign exchange market to contain volatility in the exchange rate, and in the domestic market to contain volatility in interest rates.

Since both the exchange rate and interest rate are the key prices reflecting the cost of money, it is particularly important for the efficient functioning of the economy that they be market determined and be easily observed.

Excessive fluctuation and volatility masks the underlying value and gives rise to confusing signals. The task of liquidity management then is to provide a framework for the facilitation of forex and money market transactions that result in price discovery sans excessive volatility.

Before opening of the economy through the 1990s, both the current and capital accounts were controlled. However, despite trade restrictions the current account was in constant deficit, which had to be financed mostly by debt, both official aid flows and private debt. Portfolio flows were not permitted and foreign direct investment was negligible.

The only largely 'uncontrolled' flows were NRI deposits, which waxed and waned according to macro-economic conditions.

An important element in coping with liquidity management has been smoothening behaviour of the central bank and the communication strategy.

In the more recent period, the IMD redemptions were carried out successfully with temporary volatility in money markets accompanied by liquidity shortages during December 2005.

However, monetary policy operations were carried out to contain disequilibrium in line with the monetary policy stance with a medium-term objective. At the same time necessary liquidity has been provided in recent months to address the tighter liquidity due to frictional factors, he added.


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