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.
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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, chairman and managing director of state-run 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 percent 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.
If that cash was managed more directly through the banking system, it would cause less strain to money markets, they said.
A Leaf out of China's Book?
The absence of a benchmark other than the overnight rate has been a policy hurdle, requiring banks to offer rates on deposits based on fickle projections of liquidity and short-term rates.
The panel's proposal calls for the 14-day repo rate to replace the overnight repo rate as the policy benchmark.
The proposed changes would take India a step closer to China, where the central bank has since mid-2012 used a combination of forward repos and reverse repos to inject funds in periods ranging from seven to 28 days, and also to withdraw them when it wants to tighten cash conditions.
Yet the shift in policy proved insufficient to offset money market volatility in China, which experienced two massive funding crunches in June and December last year.
Commercial banks in India have to report their balance-sheet positions and maintain mandatory cash reserves every two weeks. A 14-day rate would therefore help banks plan and fund their books to match that reporting cycle.
"Instead of overnight rate, which is an ultra short-term benchmark and can be volatile depending on sudden needs of banks, a 14-day rate will mean a bank can lock in the funds at a particular rate for longer time and will be more stable," Narendra said.
That stability in funding could enable banks to reflect policy changes faster in their deposit rates. Bankers say the current one-day signalling rate tends to delay the transmission of policy shifts by as much as six to 12 months.
The overnight call money rate, which should ideally be close to the RBI's repo rate of 7.75 percent, has been on average about 80 basis points higher than the policy rate since October.
Bankers still expect to have some teething troubles if the proposals are adopted.
"If we move to a 14-day term repo borrowing, it will make the term repo rate more stable than the overnight rate," said Ashish Parthasarathy, treasurer at HDFC Bank. "But a bank's planning and forecasting of liquidity will get that much more important."
