Open Market operations

14/05/2020 0 By indiafreenotes

An open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds in the open market (this is where the name was historically derived from) or, in what is now mostly the preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral. A central bank uses OMO as the primary means of implementing monetary policy. The usual aim of open market operations is aside from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks to manipulate the short-term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.

Process of open market operations

The central bank maintains loro accounts for a group of commercial banks, the so-called direct payment banks. A balance on such a loro account (it is a nostro account in the view of the commercial bank) represents central bank money in the regarded currency. Since central bank money currently exists mainly in the form of electronic records (electronic money) rather than in the form of paper or coins (physical money), open market operations can be conducted by simply increasing or decreasing (crediting or debiting) the amount of electronic money that a bank has in its reserve account at the central bank. This does not require the creation of new physical currency, unless a direct payment bank demands to exchange a part of its electronic money against banknotes or coins.

In most developed countries, central banks are not allowed to give loans without requiring suitable assets as collateral. Therefore, most central banks describe which assets are eligible for open market transactions. Technically, the central bank makes the loan and synchronously takes an equivalent amount of an eligible asset supplied by the borrowing commercial bank.

India’s Open Market Operation is much influenced by the fact that it is a developing country and that the capital flows are very different from those in developed countries. Thus India’s central bank, the Reserve Bank of India (RBI), has to make policies and use instruments accordingly. Prior to the 1991 financial reforms, RBI’s major source of funding and control over credit and interest rates was the cash reserve ratio (CRR) and the SLR (Statutory Liquidity Ratio). But after the reforms, the use of CRR as an effective tool was deemphasized and the use of open market operations increased. OMOs are more effective in adjusting [market liquidity].

The two type of OMOs used by RBI:

  • Outright purchase (PEMO): Is outright buying or selling of government securities. (Permanent)
  • Repurchase agreement (REPO): Is short term, and are subject to repurchase

However, even after sidelining CRR as an instrument, there was still less liquidity and skewedness in the market. And thus, on the recommendations of the Narsimham Committee Report (1998), The RBI brought together a Liquidity Adjustment Facility (LAF). It commenced in June, 2000, and it was set up to oversee liquidity on a daily basis and to monitor market interest rates. For the LAF, two rates are set by the RBI: repo rate and reverse repo rate. The repo rate is applicable while selling securities to RBI (daily injection of liquidity), while the reverse repo rate is applicable when banks buy back those securities (daily absorption of liquidity). Also, these interest rates fixed by the RBI also help in determining other market interest rates.

India experiences large capital inflows every day, and even though the OMO and the LAF policies were able to withhold the inflows, another instrument was needed to keep the liquidity intact. Thus, on the recommendations of the Working Group of RBI on instruments of sterilization (December, 2003), a new scheme known as the market stabilization scheme (MSS) was set up. The LAF and the OMO’s were dealing with day-to-day liquidity management, whereas the MSS was set up to sterilize the liquidity absorption and make it more enduring.

According to this scheme, the RBI issues additional T-bills and securities to absorb the liquidity. And the money goes into the Market Stabilization scheme Account (MSSA). The RBI cannot use this account for paying any interest or discounts and cannot credit any premiums to this account. The government, in collaboration with the RBI, fixes a ceiling amount on the issue of these instruments.