Our country’s central bank, the Reserve Bank of India (RBI) controls the issue and supply of the Indian rupee. The RBI plays an important part in the Development Strategy of the Government of India.
The RBI carries out India’s monetary policy or control of liquidity and exercises supervision and control over banks and non-banking finance companies in India.
Liquidity means ‘the cash or money in a system’. Liquidity is measured in terms of the monetary base and the Reserve Bank of India (RBI) is the sole supplier of liquidity in the country. The Monetary policy is how a country controls its money supply. If the situation in a country isn’t good and unemployment is high, growth is low, then, in that case, more money flowing around the economy makes it easier for people to get loans to make big investments, which helps the economy get going again. This is called expansionary, or loose monetary policy.
But when things are going really well, there can sometimes be a problem of inflation, where prices for everything steadily increase. In these situations, the central bank may want to pull some money out of the system, so that with less money in the economy, each unit is more valuable. Therefore, by decreasing the money supply, a central bank can prop up the value of its money and stop inflation[i]
The main way most central banks including the RBI control money supply is buying and selling government debt in the form of short-term government bonds. Government security is a bond or other type of debt obligation that is issued by a government with a promise of repayment upon the security’s maturity date. Government securities are usually considered low-risk investments because they are backed by the taxing power of a government.
Economists call this process as ‘open market operations’ because the central bank is selling bonds on the open market. Central banks usually own a big portion of their country’s debt. When they want to shrink the money supply, they can sell some of that debt to banks or investors. People hand over money to buy the debt, and money is taken out of the economy, as money that used to be floating from person to person disappears into the central bank. When the central bank wants to add more money to the economy it can buy debt, taking government debt out of the economy and replacing it with new money.
Thus OMOs are the market operations conducted by the RBI by way of sale/ purchase of G-Secs (government securities ) to/ from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.[ii]
These operations are often conducted on a day-to-day basis in a manner that balances inflation while helping banks continue to lend. 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.
Working in Open Market Operations
RBI employs two kinds of OMOs:
- Outright Purchase (PEMO) – this is permanent and involves the outright selling or buying of government securities.
- Repurchase Agreement (REPO) – this is short-term and is subject to repurchase.
Whenever, RBI engages in OMOs to purchase government securities through either PEMO or REPO agreement, its financial assets on the balance sheet increase by the amount of purchase. For the same, the central bank writes a cheque to the bank or participating institution from which RBI has purchased the securities. The institutions then deposit the cheque in their account held with a commercial bank, which then sends the cheque for clearance to the RBI. With this, the liabilities side of the balance sheet of RBI increases as the number of reserves of the bank with the central bank increases. According to the relationship, M3=MB*m (where M3 is money supply, MB is monetary base and m is multiple figures), with an increase in the monetary base (MB) or monetary liability; money supply or M3 increases by multiple m. Conversely, in case of securities sale by the RBI, the money supply decreases in the market with a decrease in the monetary base or liability of the central bank.
Importance and features of OMOs
Certain features of this mechanism proved to be more successful than other techniques of monetary control.
- Firstly, such operations bring the central bank close in touch with the portfolio of all classes of lenders, it is able to influence the activities of non-bank financial intermediaries as well[iii], whereas techniques such as the discount rate policy or the variation in the reserve ratio touch only a fringe of the money market.
- Secondly, it involves a direct draft on the reserve base of the member-banks, In this respect, it resembles the technique of variable reserve ratio and differs from the Bank rate policy which produces its impact indirectly through variation in the cost of acquiring the reserves through borrowing from the central bank.
- Thirdly, in a continually changing environment, open market operations go to prove its worth in a better way than manipulation of the Bank rate, The central bank of a country, if it so’ desires, Can apply the technique of open market operations Continually and unobtrusively, on a day-to-day or week-to-week basis. Frequent changes in the Bank rate is difficult and dangerous and reserve requirements can be varied much less frequently, Moreover, the technique involves no compulsion. The central bank just varies the price of securities so as to induce holders to buy and sell securities but does not compel the banks (or non-banks) to buy and sell.
Therefore in countries where Bank rate policy may not be effective (usually in countries having undeveloped money markets), open market operations must occupy the place of most importance in central banks.
RBI’s Operation Twist
Operation Twist’ is RBI’s simultaneous selling of short-term securities and buying of long-term securities through open market operations (OMO). Under this mechanism, the short-term securities are transitioned into long-term securities.
The term ‘Operation Twist’ is an Indian version of unconventional measures taken by the US Federal Reserve in 2011 in its bid to boost economic growth after getting hit by the global financial crisis.
Whenever there is a long-term investment deficit in the country and the investors are hesitant to make long-term investments in the economy, the government jumps in to revive growth by lowering the interest rate for long-term investment ventures.
RBI carried out the first phase of ‘Operation Twist’ on December 23, 2019, when it sold short-term securities worth Rs 10,000 crore and bought long-term securities worth the same value. This operation involves buying and selling government securities simultaneously in order to bring down long-term interest rates and bolster short-term rates.
[iii] Joseph Aschheim – Techniques of Monetary Control (Baltimore,1965) p, 17.
Student, Symbiosis Law School Pune
Rachita is Student at Symbiosis Law School, Pune. She is originally from Chennai and has completed secondary and higher secondary education at Indian High School, Dubai. She is an aspiring lawyer with an avid interest in Intellectual Property Law. For any clarifications, suggestions and feedback kindly find her at email@example.com