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RBI's fresh agility helps tame India's money market volatility

Posted on 2014-10-10

The Reserve Bank of India (RBI) has finally made progress in taming the country's volatile money markets, displaying two traits it has been rarely associated with in the past: flexibility and a willingness to correct course mid-way.

The overnight cash rate, a key indicator of liquidity, has recovered from a summer of wild swings that threatened RBI Governor Raghuram Rajan's key goal of reforming India's money market.

The swift response shown by a central bank under new management impressed bankers. Appointed a little over a year ago, Rajan, a former chief economist at the International Monetary Fund, is credited with making the RBI more amenable to change.

"The new RBI management has been very proactive in responding to markets, be it money markets or forex markets," said Pramod Patil, an assistant vice-president of fixed income and foreign exchange trading at United Overseas Bank in Mumbai.

Money markets are crucial in India because banks rely on overnight funding to finance longer-term borrowing - a reliance that has often made the market volatile.

After Rajan pledged in August to look into the causes of the volatility that gripped the overnight cash rate the previous month, the bank quickly made the changes that bankers wanted, including injecting short-term cash more frequently.

That instantly calmed the market, sending a message that, under Rajan, the RBI was no longer staid and unresponsive but had instead become more attuned to market needs.

RBI officials declined to comment on the central bank's nimble action, but fired by success they appear set to make further reforms.

Among the RBI's plans is the introduction of longer-term repos - potentially as long as 180 days, according to one official - and to build a yield curve that allows banks to borrow in several maturities. The longest-term repo regularly offered is currently 14 days.

Other initiatives include the development of a private repo market, where lenders would be allowed to lend to each other, as in the United States and other more developed markets.

READINESS TO CORRECT

By reducing banks' reliance on overnight funding and shifting to a longer-term policy tool, the RBI hopes to force banks to plan their short-term cash needs better.

To accomplish that, a year ago the RBI had started injecting funds via term repos - or cash-for-loans transactions - to smoothen volatility.

Banks welcomed the steps, but panned the implementation, saying the RBI was not injecting funds often enough and not unveiling repos of shorter terms than 7 days.