Why RBI disagrees with market perception on policy normalisation
Aim of VRRR to bring overnight rates up to the policy rate
Since the announcement of the monetary policy review in the first week of August, most market participants have interpreted liquidity absorption through the variable reverse repo auction (VRRR) as an indication that the Reserve Bank of India (RBI) has started unwinding its ultra-loose monetary policy.
In other words, the central bank seems to have started rolling back the easy money policy, which started with the nationwide lockdown imposed in the last week of March 2020.
The yields on 10-year government paper rose as much as 4 basis points immediately after the VRRR announcement on August 6.
RBI Governor Shaktikanta Das, while announcing the review of the monetary policy, said the central bank would conduct fortnightly VRRR auctions of ~2.5 trillion on August 13; ~3 trillion on August 27; ~3.5 trillion on September 9; and ~4 trillion on September 24.
The market mood changed abruptly following the announcement even as Das stated: “These enhanced VRRR auctions should not be misread as a reversal of the accommodative policy stance.”
In the recently released monthly bulletin on Tuesday, the article “State of the Economy” dwelt on why the market misread the VRRR announcement. “In response [to the VRRR announcement], a section of the media has sought to resurrect the ghosts of January 11, 2021 when markets misread the first announcement of a VRRR auction of ~2 trillion as liquidity tightening. Those fears proved unfounded,” the article said, which is authored by a host of central bank researchers, including the deputy governor in charge of monetary policy, Michael Patra.
The report had a disclosure: “Views expressed in this article are those of the authors and do not necessarily represent the views of the Reserve Bank of India.” In order to clear the air, the article comes up with a strong confutation of the perception that the 14-day VRRR was an indication of policy normalisation. To start with, the authors said, the suggestion to increase the amount of the VRRR came from market participants in the pre-policy consultative meetings, presumably to avoid “lazy” banking.
The second point the article highlighted was that the choice of variable rate auctions or fixed rate reverse repo was entirely with market participants. “They [market participants] can ab initio opt for the overnight fixed rate reverse repo or even if they have placed funds with the Reserve Bank of India for 14 days, they can withdraw at the end of the auction tenor and either park them at the fixed rate overnight window or deploy them in the market,” it said.
And finally, the report said the notion of VRRRS being a liquidity withdrawal tool by “stealth” was absurd when the RBI was simultaneously committing itself to conducting GSAP (Govern-ment Securities Acquisition Programme) and other liquidity-injecting operations.
The February 2020 circular
One important distinction the central bank made when it announced liquidity facilities under the revised Liquidity Management Framework in February 2020 was between temporary liquidity and durable liquidity.
The 14-day variable repo/reverse repo auctions were categorised as instruments to manage short-term or transient liquidity. When the tenor of the VRRR is more than 14 days, the objective is to manage durable liquidity.
By announcing a 14-day variable repo rate auction, the message was clear from the central bank. It does not want to disturb durable liquidity; it is the temporary liquidity surplus which it wants to absorb. One of the reasons behind this temporary surplus is lack of government spending.
Narrowing rate corridor
One objective behind this measure was to align the overnight rates to the repo rate. The central bank had a view -— since the current monetary policy framework is in place — that the weighted average call rate should hover around the repo rate.
“Regarding liquidity management, the RBI has maintained that the resumption of its VRRR auctions should not be misread as a reversal of the accommodative policy stance, as the amount absorbed under the fixed rate reverse repo is expected to remain more than ~4.0 trillion at end-september 2021. This decision will push up short-term rates towards the repo rate,” said Soumya Kanti Ghosh, group chief economic adviser, State Bank of India, in a note.
Jayanth Varma, one of the external members of the sixmember monetary policy committee, did not agree with the decision to maintain the accommodative stance, though he voted in favour of holding the interest rates.
Anagha Deodhar, chief economist, ICICI Securities, said: “While the MPC’S rate action was along expected lines, the VRRR decision and one committee member voting against accommodative stance were early signs of normalisation.”
In the recently released monthly bulletin on Tuesday, the article “State of the Economy” dwelt on why the market misread the VRRR announcement