Friday, 5 October 2018

What is OMO and will RBI use it to tackle yields and liquidity?

If you open the bond markets page or the economy reports, the one concept you will often get to hear is that of Open Market Operations or OMOs in short. The government through the RBI intervenes in the money markets and bond markets in many ways. The main purpose is to maintain balance and stability in the bond markets. Bond markets can become unstable if the yields become too volatile or when the liquidity in the market becomes too volatile. There are 3 broad ways in which the RBI intervenes and regulates the rates and liquidity in the debt markets:
  • Use of repo rate trajectory. We see this being done by the Monetary Policy Committee (MPC) once every two months. The repo rates are the benchmark for lending and borrowing in the market and the RBI can raise or cut these rates to send signals. In the last 2 policies in June and August, the RBI had hiked rates by 25 basis points or 0.25%.
  • The RBI also regulates the bond and money markets through reserve requirements. Banks are required to maintain CRR and SLR with the RBI in the form of liquid deposits and in the form of SLR securities. These requirements can also be shifted to regulate the liquidity and rates in the market.
  • The third method is called open market operations (OMOs), where the RBI will buy or sell government securities and the same will be used to infuse and absorb liquidity in the markets. When liquidity is too high, OMOs will imply selling bonds to absorb the liquidity. When the liquidity is too tight, the RBI will buy bonds in the market to infuse liquidity. Recently, the RBI had announced an OMO of Rs.10,000 crore to improve the liquidity in the bond markets.
What exactly are open market operations (OMO)?
Open market operations are conducted by the RBI by way of sale or purchase of Government securities (G-Secs) to adjust money supply conditions. Why does the RBI do that? The RBI sells G-Secs to suck out liquidity from the system and buys back G-Secs to infuse liquidity into the system. These OMOs are often conducted on a day-to-day basis with a view to balance inflation while helping banks continue to lend. The daily OMO figures of the RBI are disclosed on the RBI website. The RBI uses OMO along with other monetary policy tools such as repo rate, cash reserve ratio and statutory liquidity ratio to adjust the quantum and price of money in the system. We have already seen the three principal tools above.
What is the relevance of OMOs under different conditions?
In India, liquidity conditions tighten in the second half of the financial year (mid-October onwards) due to a slowdown in government spending and at the same time the onset of the festival season leads to a seasonal spike in currency demand. Moreover, activities of foreign institutional investors, advance tax payments, etc. also cause an ebb on flow of liquidity.
That is where the RBI intervenes because if liquidity gets too tight then call rates may shoot up sharply and skew the entire money market equations. The RBI manages the availability of money through the year to make sure that liquidity conditions don’t impact the level of interest rates that the RBI has targeted to maintain the delicate balance between inflation and GDP growth in the economy. Liquidity also has another very important implication. Liquidity management is essential so that banks and their borrowers don’t face a cash crunch. The RBI will buy G-Secs if it thinks systemic liquidity needs a boost and offloads such bonds if it wants to mop up excess money.
What do OMOs mean for investors?
The RBI’s roadmap on OMO is an important forward-looking statement of intent. Liquidity has a bearing on both interest rates and inflation rates and that is why OMOs are so critical. The fact that the RBI wants to maintain ample liquidity in the system, hints that it is now less worried about inflation and is keen that banks should transmit lower rates to borrowers. In fact, the OMO outlook also tells you about the RBI’s outlook for interest rates and inflation.
There is one more thing to watch out here. Large open market purchases by the RBI can give the government a helping hand in its borrowing programme and investors normally frown upon such measures. This is nothing but the virtual monetisation of government debt by the Reserve Bank and could have larger inflationary implications. However, when the government is reconciled to a higher fiscal deficit then the RBI has normally been accommodating towards larger government debt by way of OMO.
Sufficient liquidity via OMOs is always welcome. What the RBI needs to ensure is that such an endeavour is in sync with the largest objectives of the monetary policy.

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