In mid-March this year RBI announced a liquidity injection tool in the shape of forex swap. The unusual step was taken to ease the right overnight liquidity in the economy. It’s well known that OMO purchases have a bearing on a sovereign yield curve and inflating domestic asset size of central bank. Nevertheless, a new tool of liquidity management was there in RBI’s kitty.

System Liquidity

System liquidity is popularly measured by the net liquidity injected/ absorbed by the central bank. An optimum level of liquidity is required for the smooth functioning of the banking system and to keep the interbank rate in sync with policy rate, which is the first stage of policy rate transmission. A persistent system liquidity deficit implies that some or many participants of the market are unable to fund their immediate commitments, and there is a general loss of trust.

So how do different regulatory bodies react to such a situation? The most extensively used tools are: open market purchases, cutting reserve ratio, conducting reverse repo auctions and foreign exchange swap. Apart from this, the financial crises have seen many such unconventional tools.

Unique Liquidity Infusion Tools

US Fed utilised the more or less dormant discount window to pump in liquidity majorly in the shape of the Term Auction Facility (TAF). Whereas, Term Auction of Security Facility (TASF) allowed participants to borrow US treasury securities against collateral of other eligible securities. Similarly, the New Zealand central bank also allows approved counterparties to borrow from the central bank’s kitty of securities, which are otherwise not available in the secondary market. Reserve Bank of New Zealand also resorted to unconventional monetary policy having a substantial impact on liquidity easing: – a) Bank bills as collateral in the repo operations, b) Lower-rated securities and RMBS (residential mortgage-backed security) been accepted as collateral

In the aftermath of Greek Crisis, Emergency Liquidity Assistance had been used by ECB extensively to provide liquidity to “solvent but illiquid” financial institution at a higher interest rate than benchmark rate.

In the UK, as Brexit became an imminent UK central bank also started Corporate Bond Purchase Program.

Catering to the twin objectives of weeding out risky lending and ensuring the flow of money to the growing economy, Chinese Central Bank (PBOC) came up with novel tools. Apart from seasonal, temporary contingent reserve arrangement and other conventional liquidity management tool PBOC – a) provides longer maturity fund through Medium Term Lending Facility (MLF), b) short term liquidity assistance through Short Term Liquidity Operation, c) Central Banks Bill Swap and c) utilise enormous sized foreign Asset.

These are only some instances of uncommon tool used by central banks around the world to pep up system liquidity, but the list is not exhaustive.

Liquidity Projection

A projection of the future liquidity scenario of the Central Bank also adds to the market confidence, certainty and reduced volatility. The ECB and BoE are publishing the data on the forecasting of the balance sheet of the central bank.

Future Prospects

India itself has taken a major policy decision in 2016 by resolving to move towards neutral liquidity which had considerable bearing on the market and the yield curve. However, the economy underwent liquidity crunch during September-October 2018. The recent decision of the MPC to revisit the existing liquidity management framework (LMF) was long outstanding as the last such review was done in 2014.

Like China, India also needs to ensure funding for its growing economy while extirpating the risky financing. It will be very interesting to see how the new LMF will take shape — something unique? Provision for a forecast for greater clarity?

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