S. M. Lokare*
With intense market stress impeding the normal transmission mechanism,
and pushed to a situation of ‘interest rate conundrum’, central banks in several
countries responded aggressively by using their balance sheets in many
unconventional ways to extinguish the bonfire of global crisis. As an upshot,
central banks’ balance sheets witnessed unprecedented expansion, besides
significant change in the composition, posing several challenges and risks for
future monetary management. In this milieu, it is imperative that central banks
develop a credible and coherent exit strategy to roll back crisis time interventions,
while providing signals to markets on achieving medium-term policy goals amidst
forestalling the risk of a premature withdrawal. In the Indian context, with the
RBI unleashing ample rupee and forex liquidity, normalcy and orderly conditions
were restored in the markets, without compromising either on the asset quality
of its balance sheet or on the eligible counterparties. Unlike other countries,
RBI’s balance sheet did not witness any unusual expansion, since two important
measures of liquidity injection, viz., reduction in CRR and unwinding of MSS,
actually led to contraction in the balance sheet, while the policy induced change
in the money multiplier through the CRR allowed desired quantitative expansion
in the broad money.
(I) Prologue
1. The movements in central bank balance sheets received an unprecedented
focus in the analysis of policy response of central banks to the global crisis. As
the nominal policy rates tended to hit the “zero lower bound” in advanced
economies and transmission mechanism weakened significantly due to severe
market stress, reliance on quantitative easing, through both conventional and
unconventional measures increased considerably. This was manifested in large
expansion in the balance sheets of central banks, with significant compositional
shifts on both asset and liability sides.
2. As the crisis began to unfold, the authorities- national Governments and
central banks, particularly in the advanced countries recognised at an early stage
that they needed to respond swiftly and act aggressively. The central banks
embarked upon an unprecedented wave of both conventional and unconventional
policy responses to make available ample liquidity at lower cost and thereby help
in shoring up the confidence in the financial system and arresting the economic
slowdown that followed. Policy responses, which began initially in terms of
conventional monetary easing, turned out to be more innovative overtime.
3. Notwithstanding the swift and sizeable easing of policy rates, the limitations
of interest rate as a policy instrument soon came to surface in many countries,
with transmission mechanism getting significantly hampered. With policy rates
in many countries tending to touch historically low levels, the zero lower bound
emerged as a binding constraint, making it impossible to depend only on
conventional policy measures. To contain the crisis of confidence and ease the
financial conditions, central banks ventured aggressively by using their balance
sheets in unconventional ways. As a corollary, the dramatic expansion in balance
sheets of central banks became a key manifestation of the response of central
banks to the financial crisis.
4. Although the forceful and coordinated policy actions were successful in
extinguishing the initial damages and averting a global financial collapse, the unconventional measures entail several challenges and risks in terms of
management of assets and liabilities in the balance sheets of central banks,
highlighting the importance of designing an appropriate exit policy. In this
context, this paper endeavors to examine the impact of policy actions taken
during the crisis on the balance sheets of central banks, besides outlining the
future challenges and lessons in the management of assets and liabilities in the
balance sheets of central banks during the course of exit.
5. Against this backdrop, Section II presents the key policy actions and
developments in the central bank balance sheets in respect of major advanced
countries, which were in the forefront of the battle against the global crisis and
examines their impact and future implications for their balance sheets. Section
III sets out the key policy actions of the central banks in emerging market
economies (EMEs) and explores the impact, if any, on their balance sheets. The
likely challenges in the management of assets and liabilities of central banks
and the exit policy options from the unprecedented accommodative policy are
discussed in Section IV. Section V outlines in brief, the Indian context, narrating
particularly as to how it was different from the trends in central banks of
advanced countries. The last Section sets out the concluding remarks.
SECTION-II
Advanced Economy Central Banks :
Policy Interventions and their Impact on Balance Sheets
(1) Balance Sheet as a Tool of Monetary Policy : Few Stylised Facts from
the Literature
6. In theoretical literature, unconventional monetary policy is said to be
implemented by combining the two elements of the central bank balance sheet,
viz., size and composition. The size corresponds to expanding balance sheet,
while keeping its composition unchanged (narrowly defined as quantitative
easing). The composition pertains to changing the composition of balance sheet, while keeping its size unchanged by replacing conventional assets with
unconventional assets (narrowly defined as credit easing) (Shiratsuka, 2009).
7. Bernanke (2009a) first called the Federal Reserve’s (Fed) approach to
supporting credit market as credit easing. In the literature, the unconventional
monetary policy is referred to in the context of providing an empirical evidence
on monetary policy strategies, when short-term interest rates are very low or
even zero (Bernanke and Reinhart, 2004). Bernanke and Reinhart examined the
effects of changing the composition and size of the central bank balance sheet,
in addition to altering market expectations about the future course of short-term
interest rates. They focused primarily on the portfolio rebalancing effect
stemming from the changes in the composition and size of the central bank
balance sheet. By shifting the composition of asset holdings from shorter to
longer-dated government securities, a central bank may influence term premiums
and an overall yield curve, if investors treat them as imperfect substitutes.
Similarly, by increasing the monetary base, a central bank may also influence
prices and yields of non-money assets, if the monetary base is an imperfect
substitute for other financial assets (Shiratsuka, 2009).
8. In a financial and economic crisis, both sides of the central bank balance
sheet play an important role in countering the adverse effects stemming from the
financial system. The asset side works as a substitute for private financial
intermediation, for instance, through the outright purchase of credit products.
The liability side, especially expanded excess reserves, functions as a buffer for
funding liquidity risk in the money markets. In addition, the two sides interact
closely, since malfunctions in financial intermediation are closely tied to funding
liquidity risk at financial institutions, resulting in the increased demand for excess
reserves.
9. In practice, given the constraints on policy implementation, central banks
combined the two elements of their balance sheet, i.e., size and composition, to
enhance the overall effects of unconventional policy measures during the recent crisis. In that respect, quantitative easing, often used in a vague manner, better
fits as a package of unconventional policy measures making use of both the asset
and liability sides of the central bank balance sheet, designed to absorb the shocks
to the economy.
(2) Central Bank Policy Interventions
10. As the crisis in global financial markets deepened in mid-September 2008,
triggered by the collapse of Lehman Brothers, the pressure on financial markets
mounted, the credit spreads widened to record levels and equity prices crashed
to historic lows, leading to widespread volatility across markets. The turmoil
transcended from credit and money markets to the global financial system more
broadly. Amidst the deteriorating global financial environment, monetary
authorities in the industrial world were the first to act with aggressive monetary
easing, so much so that policy rates reached to record lows. On October 8, 2008,
six major central banks undertook the first ever round of coordinated action in
policy rate cuts. A similar swift action was followed from other central banks
subsequently (Table 1). As could be seen, the interest rate option was used to the
maximum possible extent during September 2008 to March 2009.
Table 1 : Policy Rate Cuts in Advanced Countries |
Country/
Region |
Key Policy Rate |
Policy Rate
(As on July 9, 2009) |
Change in Policy Rates
(Basis points) |
Sept 2008 -
March 2009 |
Since end-
March 2009 |
1 |
2 |
3 |
4 |
5 |
Australia |
Cash Rate |
3.00 (Apr. 8, 2009) |
(-) 400 |
0 |
Canada |
Overnight Rate |
0.25 (Apr. 21, 2009) |
(-) 250 |
(-) 25 |
Euro area |
Interest Rate on
Main Refinancing Operations |
1.00 (May 13, 2009) |
(-) 275 |
(-) 50 |
Japan |
Uncollateralised
Overnight Call Rate |
0.10 (Dec.19, 2008) |
(-) 40 |
0 |
UK |
Official Bank Rate |
0.50 (Mar. 5, 2009) |
(-) 450 |
0 |
US |
Federal Funds Rate |
0.00 to 0.25 (Dec.16, 2008) |
(-) 200 |
0 |
Source : International Monetary Fund, websites of respective central banks and The Economist. |
Why Balance Sheet Emerged as a Tool of Monetary Policy in the Recent Crisis?
11. Although central banks responded aggressively by the swift and sizeable
easing in policy rates, given the exceptional nature of the crisis, the conventional
wisdom about interest rate as an all weather effective policy instrument in a market
economy received a setback. With persisting strains in the financial markets and
the rise in credit and liquidity risk premia, the transmission mechanism was greatly
hampered. Illustratively, despite sharp declines in policy rates, yields on corporate
bonds hardened. Though banks generally passed on the reductions in their funding
costs to their customers, they tightened credit standards substantially, offsetting
the impact of rate cuts on overall financial conditions. With policy rates in many
countries reaching historically low levels, the zero lower bound became a real
constraint, rendering it hard to follow conventional policy options.
12. With conventional monetary policy having reached its limit, any further
policy stimulus required a different set of tools (Bernanke, 2009). Amidst the
complex and challenging environment, central banks were forced to look beyond
the interest rate channel and explore all possible ways- both conventional and
unconventional- to restore the functioning of credit markets and ease the financial
conditions. This is how balance sheet emerged as the main instrument and in
turn, became the key manifestation of central banks’ response to the global crisis.
In fact, the degree of balance sheet expansion served as a barometer of financial
market distress (Sheard, 2009).
Forceful Liquidity Easing
13. Several liquidity easing measures were initiated, basically focusing on
reducing term interbank market spreads, seen as an indicator of tensions in
the key market segment. This was circumvented in two ways. First, by
directly providing more term funding, so as to offset some of the shortfall
in market supply. Second, by indirectly addressing impediments to the
smooth distribution of reserves in the system and ensuring access to funding
from the central bank (Table 2).
Table 2: Select Central Banks Policy Actions |
Category |
Objective |
No. |
Measure adopted |
FED |
ECB |
BoE |
BoJ |
BoC |
RBA |
SNB |
1 |
2 |
3 |
4 |
5 |
6 |
7 |
8 |
9 |
10 |
11 |
I |
Achieve
the official stance of
Monetary
Policy |
A. |
Exceptional fine-tuning operations |
√ |
√1 |
√ |
√ |
√ |
√ |
√ |
B. |
Change in reserve requirements |
|
√2 |
|
|
|
|
|
C. |
Narrower corridor on overnight rate |
√3 |
√ |
√ |
|
|
|
|
D. |
Payment of interest on reserves |
√ |
|
|
√4 |
|
|
|
E. |
Increased treasury deposit |
√ |
|
|
|
√ |
|
|
F. |
Short-term deposit or central bank bill |
|
√ |
√ |
√ |
|
√ |
√ |
II |
Influence
wholesale inter-bank
market
conditions |
A. |
Modification of discount window facility. |
√5 |
|
√ |
|
|
|
|
B. |
Exceptional long-term operations |
√ |
√6 |
√ |
√ |
√ |
√ |
√ |
C. |
Broadening the range of eligible collaterals |
√ |
√ |
√ |
√ |
√ |
√ |
√ |
D. |
Broadening of eligible counterparties |
√ |
|
√ |
√ |
√ |
√ |
|
E. |
Inter-central bank FX swap lines |
√ |
√ |
√ |
√ |
√ |
√ |
√ |
F. |
Introducing or easing conditions for securities lending |
√ |
|
√ |
√ |
√ |
|
|
III |
Influence
credit market
and
broader
financial conditions |
A. |
CP funding/purchase/ collateral eligibility |
√7 |
|
√8 |
√9 |
√10 |
√11 |
|
B. |
ABS funding/ purchase/collateral eligibility |
√12 |
√13 |
√8 |
|
|
√11 |
|
C. |
Corporate bond funding/purchase /collateral
eligibility |
|
|
√8 |
√14 |
√10 |
|
|
D. |
Purchase of public sector securities |
√15 |
|
√8 |
√16 |
|
|
|
E. |
Purchase of other non-public sector
securities |
|
|
|
√17 |
|
|
√18 |
Note: √ : Indicates Yes Blank Space: No
FED : Federal Reserve; ECB : European Central Bank; BoE : Bank of England; BoJ : Bank of Japan; BoC : Bank
of Canada; RBA : Reserve Bank of Australia; SNB: Swiss National Bank.
1: Including front loading of reserves in maintenance period; 2: Expand range over which reserves are
remunerated; 3: Lower the discount rate relative to the target Federal Funds Rate; 4: Pay interest on excess
reserve balance; 5: Reduce rate and expand term on discount facility: allow participation of primary dealers
(Primary Dealer Credit Facility); 6: Including fixed rate full allotment operations; 7: Finance purchase of shortterm
CD, CP and asset- backed CP (ABCP); 8: Asset purchase facility; 9: Increase frequency and size of CP repo
operations & introduce outright CP purchases; 10: Term Purchase & Resale Agreement Facility for private sector
instruments; 11: Acceptance of residential mortgage backed securities & ABCP as collateral in repo operations;
12: Finance purchase of asset backed securities, collateralised by student, credit, auto & other guaranteed loans;
13: Purchase of covered bonds; 14: Expand range of corporate debt as eligible collateral &introduce loan facility
against corporate debt collateral; 15: Purchase treasury debt as well as direct obligations of and MBS backed
by housing related government sponsored enterprises; 16: Purchase of Japanese Government bonds
to facilitate smooth money market operations; 17: Purchase equity held by financial institutions;
18: Purchase foreign currency securities.
Source: Adopted from BIS Annual Report, 2008-09. |
14. Many advanced country central banks extended conventional liquidity
easing measures, such as easing the terms and availability of existing central
bank facilities, like standing lending windows. Second, the access to central
bank lending was enhanced thereafter by extending the tenor of financing and
widening the range of counterparty financial institutions. Third, several central
banks introduced or eased conditions for lending out highly liquid securities
– typically sovereign bonds – against less liquid market securities in order to
improve funding conditions in the money market. Fourth, stipulations on the
provision of reserves were eased substantially by expanding the list of eligible
collateral and counterparty coverage, and lengthening the maturity of
refinancing operations1. Fifth, several central banks also undertook foreign
exchange swaps or loans with other central banks to alleviate severe shortages
of foreign exchange.
15. Though these liquidity easing measures were mostly in line with the
standard central bank lender-of-last-resort function, their range and magnitude
were well above the traditional levels2. Shortage of US Dollar led to Federal
Reserve using inter-central bank swap lines. With the intensification and spread
of US dollar shortages in mid-September, swap lines with the Federal Reserve
grew in number, time zone and geographical coverage and size. The use of the
swap lines came to be seen as a significant driver of balance sheet expansions
for major central banks during this period (BIS, 2008).
Move to Aggressive Credit and Quantitative Easing
16. As the crisis deepened, interest rate channel became ineffective due to
policy rates at zero or near-zero level in the advanced countries. The central
banks in these countries were, thus, forced to go for quantitative easing. This
response was focused directly on alleviating tightening credit conditions in the
non-bank sector and easing of broader financial conditions. There were two
approaches to this quantitative easing. First, funds were provided to non-banks
to improve liquidity and reduce risk spreads in specific markets, such as
commercial papers (CPs), asset-backed securities and corporate bonds. Direct
purchase of public sector securities was also made to influence benchmark
yields more generally. Second, central banks purchased government or
government-guaranteed securities from banks or other institutions in order to
improve their access to credit and ease liquidity conditions. The quantitative
easing involving government securities tended to be more important in bankcentered
systems (Japan and the UK). Credit easing with private securities
generally played a larger role in market-centered systems (the US) (BIS, 2009).
17. The Federal Reserve focused heavily on non-bank credit markets as well
as operations involving private sector securities, such as the Commercial Paper
Funding Facility and the Term Asset-Backed Securities Loan Facility. The
European Central Bank (ECB) focused on banking system liquidity by
conducting fixed rate full-allotment refinancing operations with maturities of up
to 12 months and by purchasing covered bonds. In the case of Bank of Japan
(BoJ), substantial efforts were directed at improving funding conditions for
firms through various measures pertaining to CPs and corporate bonds. In a few
cases, central banks directly provided financing to corporate borrowers.
Irrespective of the approach adopted, the quantitative easing led to manifold
expansion in the balance sheets of central banks.
18. The usage levels of various unconventional central bank market operations
could be seen from the Table 3.
Table 3 : Major Crisis Interventions of Central Banks |
No. |
Central Bank Interventions |
Maximum Amount |
Amount used as at end-June 2009 |
I |
US Federal Reserve (in billion US dollars) |
|
|
|
1. Short-term liquidity provision |
|
|
|
TAF |
** |
282 |
|
CPFF |
*** |
114 |
|
2. Long-term liquidity provision |
|
|
|
TALF |
1,000 |
25 |
|
3. Outright purchases of assets |
|
|
|
Agency mortgage backed securities |
1,250 |
462 |
|
Agency debt |
200 |
97 |
|
Treasury securities |
300 |
184 |
II |
Bank of England (in billion pounds) |
|
|
|
1. Outright purchases of assets |
|
|
|
Asset Purchase Facility# |
175 |
105 |
III. |
European Central Bank (in billion euros) |
|
|
|
1. Short-term liquidity provision |
|
|
|
Long-term refinance operations @ |
Unlimited |
728 |
|
2. Outright purchases of assets |
|
|
|
Covered bonds |
60 |
0 |
IV |
Bank of Japan (in billions of Yen) |
|
|
|
1. Short-term liquidity provision |
|
|
|
SFSOFCF^ |
Unlimited |
7,467 |
|
2. Outright purchases of assets |
|
|
|
Commercial paper |
3,000 |
197 |
|
Corporate bonds |
1,000 |
174 |
Note: TAF =Term Auction Facility; CPFF = Commercial Paper Funding Facility;
TALF = Term Asset- Backed Securities Loan Facility;
SFSOFCF = Special Funds-Supplying Operations to Facilitate Corporate Financing.
**: The amount is determined at each auction. ***: There is a limit per issuer.
#: Purchasing commercial paper, corporate bonds, and gilts.
@ : Providing liquidity at a fixed rate, full allotment basis up to one year.
^ : Providing liquidity against collateral of private credit instruments at a fixed rate,
allotment basis up to 3 months.
Source : Global Financial Stability Report, October, 2009. |
(3) Impact of Policy Actions on Central Bank Balance Sheets
19. The use of different monetary policy instruments has differing impacts on
balance sheets. In the context of central banks using wide array of monetary
policy tools during the recent financial crisis, the effect that different instruments
can have on the typical balance sheet is presented in Table 4.
Table 4: A Synoptic View of Balance Sheet Movements under
Different Monetary Policy Instruments |
Monetary Policy
Instrument |
Operation |
Central Bank Balance Sheet Movements |
Monetary
Base |
Bank
Reserves |
NDA |
NFA |
(i) Standing
Facilities |
Higher loans through
refinancing facility |
↑ |
↑ |
↑ |
Constant |
Higher deposits through
deposit facility |
↓ |
↓ |
↓ |
Constant |
(ii) Open Market
Operations |
Outright purchase of
securities or repos |
↑ |
↑ |
↑ |
Constant |
Outright sales of securities
or reverse repos |
↓ |
↓ |
↓ |
Constant |
(iii) Open Market-
Type Operations |
Positive net issuance of
central bank or govt. papers |
↓ |
↓ |
↓ |
Constant |
Negative net issuance of
central bank or govt. papers |
↑ |
↑ |
↑ |
Constant |
(iv) Credit and
Deposit Auctions |
Auctioning of credit |
↑ |
↑ |
↑ |
Constant |
Auctioning of deposits |
↓ |
↓ |
↓ |
Constant |
(v) Foreign
Exchange Operations |
Purchase of foreign Currency |
↑ |
↑ |
Constant |
↑ |
Foreign exchange swap |
↑ |
↑ |
Constant |
↑ |
(vi) Shift of Public
Sector Deposits |
To the banking system |
↑ |
↑ |
↑ |
Constant |
From the banking system to
the central bank |
↓ |
↓ |
↓ |
Constant |
(vii) Reserve
Requirements |
Increase in reserve ratios : |
|
|
|
|
Short-term |
↑ |
↑ |
↑ |
Constant |
Medium-term |
? |
? |
? |
Constant |
Reduction in reserve ratios |
|
|
|
|
Short-term |
↓ |
↓ |
↓ |
Constant |
Medium-term |
? |
? |
? |
Constant |
Adopted from Schaechter (2001). |
Analytics of Key Developments in the Central Bank Balance Sheets
20. The changes in the balance sheets emerged as the key manifestation of
central banks’ response to the global financial market turmoil, as central banks
used their existing tools in innovative ways, besides introducing new ones, in
order to relive the liquidity shortages and ensure the smooth functioning of the
markets. In the aftermath of bankruptcy of Lehman and Brothers in September
2008, as central banks stepped up their intermediation role in money markets
and extended crucial support to other credit markets, the size and complexity of
their balance sheets increased significantly (ECB, 2009). However, it needs to
be noted that making cross-national comparisons of central bank balance sheets
is fraught with difficulty as each central bank differs in terms of operational
procedures, accounting and disclosure conventions. With this limitation, this
paper attempts to analyse the key developments in respect of balance sheets of
major central banks, viz., Fed, ECB and BoJ during the recent crisis.
(A) Overall Size of the Balance Sheet
• Until September 2008, the size of the central banks’ balance sheets had not
changed significantly. Liquidity injections were offset through the sale of
central bank assets or downward adjustments to the size of the refinancing
operations, in order to ensure that no excess liquidity remained in the
banking system (Chart 1).
• As the financial turmoil intensified during the fourth quarter of 2008, the
Fed introduced a credit easing programme and the ECB initiated a number
of enhanced credit support measures, both of which triggered a significant
expansion in their respective balance sheets. Subsequent improvements in
money market conditions during the first half of 2009 led to a reduction in
the total assets of the ECB and the Fed.
• High demand for the one-year refinancing operation, conducted in June
2009, however, triggered a second round of increase in the size of the
ECB’s balance sheet.
• Due to the high level of outstanding banknotes, the BoJ’s balance sheet
was relatively already large before the start of the financial market turmoil,
with the result that its increase in size was smaller (ECB, 2009).
• Before the onset of financial market turmoil, the balance sheets of three
central banks differed in size relative to GDP and banknotes in circulation.
The Fed had the smallest balance sheet relative to the size of both GDP and
banknotes in circulation, while the ECB and the BoJ had the largest in terms
of banknotes in circulation and relative to GDP, respectively (Table 5).
Table 5 : Total Assets Relative to GDP and Bank Notes in Circulation |
|
ECB |
Fed |
BoJ |
Relative to GDP (%) |
Jun-2007 |
10 |
6 |
16 |
Peak |
19 |
15 |
23 |
Peak Reference Date |
02-01-2009 |
17-12-2008 |
31-03-2009 |
Aug-2009 |
16 |
14 |
22 |
Relative to Bank Notes in Circulation (%) |
Jun-2007 |
144 |
109 |
111 |
Peak |
231 |
266 |
144 |
Peak Reference Date |
02-01-2009 |
17-12-2008 |
31-03-2009 |
Aug-2009 |
194 |
232 |
139 |
Adopted from ECB Monthly Bulletin, October, 2009. |
• These differences could be explained, at least in part, by various factors,
such as different financial market structures, monetary policy implementation
frameworks and economic conditions.
• With expansion in central bank assets since October 2008, the Fed’s
balance sheet became the largest relative to banknotes, even if it remained
the smallest in terms of GDP.
Key Drivers of Balance Sheets Expansion
21. The following are the factors that contributed to the expansion of central
bank assets.
(B) Impact of Liquidity Injection Operations (Assets Side)
Federal Reserve
22. The size of the Fed’s balance sheet had not seen any significant expansion
between June 2007 and September 2008, because the excess liquidity provided
through the new lending facilities was absorbed through the sale and redemption
of Treasury securities, which raised the amount of one category of assets and
reduced the amount of another. Since the beginning of the financial market
turmoil in August 2007, however, the balance sheet of Fed grew in size and
changed in composition. Fed’s policy reactions put more emphasis on the asset
side of the central bank balance sheet, an approach referred to as credit easing.
As a result, the total assets of the Fed increased significantly from $869 billion
on August 8, 2007, to well over $2 trillion to date. In fact, the Fed’s policy assets
expanded by approximately 4,000 per cent since 2006 (Stella, 2009). The
specific drivers of these balance sheet changes are set out below.
(i) The Fed launched a one-month term repo programme in early 2008, which
resulted in significant expansion in the outstanding amount of repos from
an average of US$ 30 billion during the first half of 2007 to US$ 130
billion in May 2008. However, with the introduction of lending programmes
following the bankruptcy of Lehman Brothers, there was a large increase in the excess reserve balances, with the result that the Fed discontinued its
regular repos in January 2009 (Chart 2).
(ii) In order to provide term funding, the Fed launched the Term Auction
Facility (TAF) in December 2007. As a corollary, the outstanding amount
under TAF peaked at almost US$ 500 billion in March 2009, before
reverting back to around US$ 76 billion as on January 6, 2010.
(iii) In addition to the regular repos and the TAF, changes in the outright portfolio
also affected the size and composition of the Fed’s balance sheet during the
financial crisis. Initially, in order to compensate for the liquidity injected
through the TAF and the other new lending programmes, the Fed sold
Treasury securities of around US$ 300 billion between June 2007 and
September 2008.
(iv) In view of its credit easing policy, however, the Fed began to purchase
federal agency debt securities in September 2008 and federal agency
mortgage-backed securities in January 2009. This portfolio amounted to
US$ 740 billion in August 2009. Moreover, in April 2009, the Fed resumed
its purchases of Treasury securities and, thus, had increased its portfolio by
US$ 270 billion by the end of August 2009.
 |
(v) Another item that contributed to the strong expansion in the Fed’s balance
sheet was ‘other lending’. This includes the discount window, i.e., standing
lending facility available to depository institutions. With the Fed reducing
the spread between the discount window rate and its target for the federal
funds rate (100 to 50 basis points in August 2007 and to 25 basis points in
March 2008) and extending the maturity of discount window lending
(overnight to 30 days and 90 days, respectively), the use of the discount
window increased from an average of US$ 200 million in June 2007 to
almost US$ 100 billion in October 2008.
(vi) Besides, the primary dealers (counterparties of the Fed for OMOs) were
given access to a similar overnight standing lending facility- the Primary
Dealer Credit Facility in March 2008.
(vii) Furthermore, several credit easing measures introduced (under ‘other
lending’) after September 2008 also contributed to the expansion of Fed’s
balance sheet. These are (a) Asset-Backed Commercial Paper Money
Market Mutual Fund Liquidity Facility to finance credit institutions’
purchases of asset-backed commercial paper from money market mutual
funds, (b) Commercial Paper Funding Facility (October 2008) to enhance
the liquidity in the CP market and Money Market Investor Funding Facility
to provide liquidity to money market investors and (c) Term Asset-backed
Securities Loan Facility (March 2009) to support the issuance of assetbacked
securities collateralised by consumer and small business loans.
(viii) These new lending programmes, the increased use of the discount window,
the funding provided in the context of the merger between Bear Stearns
and JPMorgan Chase and the restructuring of AIG increased ‘other lending’
from US$ 190 million at the end June 2007 to a peak of US$ 600 billion
at the end of 2008. The improvement in financial market conditions,
however, led to a decrease in demand for the new lending facilities to US$
220 billion by the end of August 2009 (Stella, 2009 and ECB, 2009).
European Central Bank
23. ECB launched a series of enhanced credit support measures in October
2008, which were supplemented by several additional tools in May 2009. First,
the ECB began conducting all refinancing operations at a fixed rate while
allotting all bids received from counterparties. Second, this operational change
was coupled with enhanced credit support by expanding the already long list of
collaterals eligible for OMOs. Third, the number and frequency of long-term
refinancing operations (LTROs) with maturities ranging from one to six months
were raised. These measures resulted in a significant increase in the size of the
ECB’s balance sheet, as may be seen below.
(i) The outstanding amount of LTROs increased from €150 billion in June
2007 to over €600 billion at the end of 2008, almost doubling the total
amount of outstanding refinancing, which peaked at €850 billion during
the first week of January 2009.
(ii) The outstanding amount of main refinancing operations (MROs) also
increased from an average of €190 billion during the first phase of the
financial turmoil to €340 billion at the beginning of December 2008, which
however, recorded a decline thereafter (Chart 3A and B).
(iii) With the easing of money market conditions during the first half of 2009,
demand for LTROs declined gradually. However, with the carrying out of
first one-year LTRO in June 2009, counterparties’ interest in the operation
increased, resulting yet again in a significant increase in the size of the
ECB’s balance sheet. The total amount of outstanding refinancing reached
€900 billion at the end of June 2009.
(iv) As a part of credit support programme, ECB introduced outright purchase
of covered bonds in July 2009. A portfolio worth €9 billion was purchased
during the first two months alone (ECB, 2009).
Bank of Japan
24. BoJ introduced various measures to facilitate corporate financing, including
fixed rate full allotment liquidity provisions against eligible corporate debts. It
also resumed the purchase of stocks held by financial institutions and introduced
a scheme to provide subordinated loans to them (Shiratsuka, 2009). As a result,
BoJ also witnessed expansion in the balance sheet and change in its composition,
albeit, on a lower scale (ECB, 2009).
(i) First, since June 2007, it increased the level of its repo operations by
around JPY 19 trillion (Chart 4).
(ii) Second, the BoJ’s holdings of Japanese government bonds declined in
2007 and 2008, mainly because purchases of Japanese government bonds
were lower than those of redemptions.
(iii) Third, to support credit markets, the BoJ began purchasing CPs in February
2009 and corporate bonds in March 2009, the total amounts of which reached
to JPY 100 billion and JPY 250 billion, respectively, in August 2009.
(iv) Finally, in order to facilitate corporate financing, the BoJ introduced special
fund-supplying operations with a fixed rate, for an unlimited amount and
backed by corporate debt in January 2009. Due to these operations, the
item ‘other lending’ reached JPY 7.5 trillion in March 2009.
(C) Impact of Inter-Central Bank Swap Lines
25. The ECB and several other central banks undertook a joint action with the
Federal Reserve allowing access to US dollar liquidity against domestic
collateral to their domestic counterparties through swap arrangements. As a
result, there was a qualitative change in the composition of the central banks’
balance sheets. The total amount of central bank liquidity swaps of the Fed
peaked to US$ 583 billion, almost a quarter of its total assets, in mid-December
2008. In the same month, almost half of the US$ 600 billion in central bank
liquidity swaps (equivalent to €200 billion) were on the liability side of the
ECB’s balance sheets, while the corresponding figure for the BoJ was one-fifth
(equivalent to JPY 11 trillion) (ECB, 2009). The international demand for US
dollar refinancing declined gradually to reach US$ 10 billion on the Fed’s
balance sheet by the first week of January 2010.
(D) Impact of Liquidity Absorbing Operations (Liabilities Side)
26. In view of massive liquidity injections, the three central banks had to
absorb excess liquidity by way of different instruments. The Fed reached an
agreement with the Treasury, according to which, it would issue securities and
deposit the proceeds in a supplementary account with the Fed. As a result, the
Fed absorbed more than US$ 500 billion by October and November 2008, after
which the outstanding amount gradually fell to US$ 5 billion by the first week
of January 2010. The supplementary finance programme (which provided for
sterlisation of the liquidity injection by the Fed) is remarkable in the sense that
it is rare for central banks to obtain liquidity management assistance to this
extent and with such an alacrity (Stella, 2009).
27. In respect of ECB, the liability item that witnessed the largest increase was
the deposit facility, which rose from around €1 billion at the end of June 2007
to over €300 billion by the beginning of 2009. Subsequently, the average amount
placed in the deposit facility declined gradually to less than €20 billion by June
2009, but rose again to around €300 billion during July 2009, before reaching
€160 billion by the first week of January 2010. The ECB also absorbed liquidity
through fine-tuning operations in the course of the maintenance period on
several occasions.
28. The minimum reserve requirements with the central banks also played
an important role in absorbing the excess liquidity in the system. The current
account balances with the Fed and BoJ covering minimum reserve
requirements and excess reserves increased significantly since October 2008,
owing to the introduction of the remuneration of excess reserves, which
enabled banks to hold excess reserves at no cost. The current account balances
with the Fed increased from less than US$ 20 billion in June 2007 to US$
860 billion in August 2009 and from less than JPY 10 trillion to JPY 12
trillion in the case of BoJ.
29. Thus, the massive increases in liquidity provision on the asset side of the
balance sheet and liquidity absorption on the liability side show the important
role that the central banks played as intermediaries, particularly during the
period following the collapse of Lehman Brothers in September 2008.
(E) Developments in Autonomous Factors
30. During the financial crisis, the liability side of the balance sheets of the three
central banks also grew as a result of the increase in autonomous liquidity factors,
in particular euro banknotes, euro area government deposits and US Treasury
deposits. The financial crisis affected the demand for banknotes (Chart 5). In
addition to the long-term upward trend and the seasonal increases in the quantity
of banknotes in circulation, there was a significant rise in the demand for euro
banknotes and US dollar banknotes at the end of September 2008. In the first
half of October 2008, the demand for euro banknotes was approximately €35
billion, approximately two-thirds of which was for €500 banknotes. Since highdenomination
banknotes are usually used as a store of value (i.e., as a substitute
for bank deposits) and not for transaction purposes, the high demand may be
related to a lack of confidence in the banking system at that time. The extraordinary
demand for euro banknotes tapered off at the end of October 2008, after governments had announced extraordinary measures to support the banking
sector (ECB, 2009). The growth in the Federal Reserve’s banknotes outstanding,
which had been decelerating since 2003, rose in May 2008.
 |
31. Thus, in response to the financial turmoil, the Fed, ECB and BoJ introduced
significant measures to support the continued access of financial institutions to
liquidity and to reduce the tensions in credit markets. These measures led to
considerable increase in the size and complexity of their balance sheets.
(F) Implications of Changes in Central Bank Balance Sheets
32. There are several implications that emerge from the recent changes in the
central bank balance sheets.
• First, with change in the composition, the risk profile of central bank
balance sheets also seems to have undergone a change. The central banks
purchase of assets, such as MBSs and CPs has increased their credit and
valuation risks. The broadening of the set of eligible securities that
central banks accept as collateral for extending credit through new
facilities and to a number of eligible counterparties has also raised the
counterparty risk.
• Second, there could be some interest rate risks. For instance, for the Fed,
the excess reserves have an overnight maturity. Against these short-term
liabilities, longer-term and illiquid assets have been created. In principle,
if short-term interest rates were to move up very sharply, the cost of
funding on the liabilities side could eventually exceed the return on the
Fed’s assets. Moreover, excess reserves may decline with economic
recovery but corresponding reduction in certain assets could be difficult,
unless the market for these assets improve. The bigger the balance sheet,
the greater would be the amount of interest-rate risks (Dudley, 2009).
• Third, the income position of central banks has also undergone a change.
While low returns on central bank assets have reduced revenue, liquidity injections have increased the amount of reserves over which interest is
received3, thereby increasing the central bank profits (Stella 2009 and
GFSR, 2009).
• Fourth, a massive expansion of the central bank balance sheet is the
corollary of public intervention in private financial transactions, potentially
distorting incentives and resource allocation in the private sector. In
particular, such side-effects become more obvious as the duration of
quantitative easing prolongs (Shiratsuka, 2009). The moral hazard would
affect the future risk taking tendencies in the market.
• Fifth, the large excess reserves might result in rapid credit expansion,
fuelling inflationary pressures. After all, inflation is driven mainly by two
variables – inflation expectations and the degree of pressure on resources.
But the lack of marketability of certain types of assets in the central bank
balance sheet may not be useful in normal open market operations. This
could hinder liquidity management operations and, thus, would dilute the
ability of monetary policy as inflationary pressures re-emerge.
• Sixth, the Treasury purchase program in the US created the perception that
the Fed was providing the fiscal authorities with the means to fund a more
stimulative fiscal policy than they would otherwise have been able to
finance. It has been viewed that this could undermine credibility of the
central bank and trigger a damaging rise in inflation expectations.
• Seventh, the changes in balance sheets have also raised the apprehensions
about the financial situation that could jeopardize operational and financial
independence of central bank (Stella, 2009).
• Lastly, going forward, an exit strategy may require phased reduction in
excess reserves of banks as abrupt unwinding of reserves could disrupt financial markets. Concomitantly, if inflation expectations firm up, central
banks may need to increase the remuneration rate they pay on excess
reserves as a means to ensure the targeted policy rate. This in turn would
entail additional cost for central banks, which to some extent though would
be offset by the extra income resulting from expanded balance sheets, they
face substantial income risk (GFSR, October 2009).
SECTION-III
Emerging Economy Central Banks :
Policy Actions and their Impact on Balance Sheets
33. In the aftermath of September 2008, as the contagion spilled over to the
emerging markets, their central banks also resorted to several unconventional
measures in response to the sudden tightening of global liquidity conditions.
EMEs undertook various liquidity easing and foreign exchange measures,
although the magnitude of their use of credit easing and quantitative easing was
much more limited (Table 6).
(1) Policy Response by EMEs
34. In EMEs, as exchange rates came under pressure with the intensification of
stress in the global dollar markets and net capital inflows began to reverse,
central banks in these countries initiated foreign exchange liquidity easing
measures. It is only in the beginning of November 2008, the policy interest rates
were reduced in many EMEs, indicating that conventional domestic monetary
policy easing lagged the unconventional measures (Ishi, et al, 2009). Central
banks in many EMEs resorted to liquidity injections and frequent cuts in policy
rates, albeit, from much higher levels (Chart 6).
Liquidity Easing
35. Central banks in several EMEs resorted to cuts in reserve requirement
ratios, introduction of reserve averaging and hike in exemption thresholds with a view to ease the domestic liquidity shortages. Most of them also eased the
terms of existing standing and market-based liquidity providing facilities, viz.,
extension of maturities, easing the collateral requirements, increasing the frequency of auctions, etc. Several central banks provided domestic liquidity to
targeted institutions for on-lending to the market entities (Table 7).
Table 6 : Select Unconventional Measures by the EME Central Banks |
Type |
Country |
Measure |
1 |
2 |
3 |
4 |
I |
Domestic Liquidity Easing |
1. |
Direct money marketinstruments |
China |
Reduction in reserve requirements. |
Hungary |
Nigeria |
2. |
Systemic domestic
liquidity arrangements |
Philippines |
Expansion in the eligible collateral for standing repo
facility to include foreign currency denominated
sovereign debt securities. |
Israel |
Central bank’s announcement to transact OMOs with
govt. debt of different types and maturities. |
Chile |
Broadening the list of eligible collateral for monetary
operations to include CPs. |
II. |
Foreign Exchange Easing |
1. |
Foreign Exchange
Liquidity Injection |
Brazil |
Central bank’s announcement to sell 1-month dollar
liquidity lines. |
Philippines |
Central bank’s approval to open dollar repo facility. |
Turkey |
Introduction of daily dollar selling auctions. |
India |
Allowing banks to borrow funds from their overseas
branches up to a prescribed limit. |
Indonesia |
Reduction in the foreign exchange reserve
requirement for commercial banks. |
Serbia |
Reduction in the required reserves against foreign
assets. |
2. |
Cross Central Bank
Currency Swap
Arrangements |
Brazil |
Temporary reciprocal swap lines with the Federal
Reserve by the Banco central do Brazil, the Banco
de Mexico, the Bank of Korea and the Monetary
Authority of Singapore. |
Mexico |
Korea |
Singapore |
III |
Credit and Quantitative Easing |
|
|
Korea |
Announcement of central bank financing (up to a limit) to a bond fund to purchase CPs. |
|
|
Israel |
Central bank announcement to purchase govt. bonds. |
Adopted from Ishi, et al, (2009). |
 |
Table 7 : Number of Measures Implemented in Select EMEs (September 2008-May 2009) |
Country |
Liquidity Easing Measures |
Foreign Exchange Easing Measures |
Foreign Exchange
Liquidity Injections |
Cross-Central Bank
Currency Swaps |
1 |
2 |
3 |
4 |
Brazil |
12 |
9 |
2 |
Mexico |
1 |
1 |
2 |
China |
4 |
1 |
|
Hong Kong SAR |
3 |
1 |
1 |
India |
5 |
7 |
1 |
Indonesia |
11 |
4 |
|
Korea |
5 |
4 |
5 |
Malaysia |
3 |
- |
- |
Philippines |
3 |
4 |
- |
Singapore |
- |
- |
2 |
Adopted from Ishi, et al, (2009). |
Foreign Exchange Easing
36. Central banks in EMEs eased the terms of existing foreign exchange
facilities, i.e., extending maturities, broadening the collateral, etc., and also put
in place new foreign exchange facilities such as dollar repo and swap facilities4.
The list of counterparties was widened to include non-banking financial
institutions and key non-financial institutions (e.g. exporters or energy importers).
The foreign exchange liquidity limits were also relaxed, covering removal of
ceilings on bank purchases of offshore foreign exchange and easing of capital
inflow limits. In addition, some central banks lowered the required reserve ratio
for bank foreign currency liabilities and shifted the currency structure of required
reserves away from foreign exchange. In order to ease the foreign exchange
liquidity conditions, central banks in countries like Brazil, Korea, Mexico and
Singapore had dollar swap arrangements with the Federal Reserve (BIS, 2008).
Credit and Quantitative Easing
37. In respect of EMEs, the use of credit and quantitative easing measures
were limited. Illustratively, the Bank of Korea purchased corporate debt and
CPs, while the Bank of Israel undertook quantitative easing between March and
August 2009.
38. The policy response by EMEs probably reflected the tighter constraints on
liquidity easing measures faced by them, including external vulnerability,
shallower financial markets, conflicts between macroeconomic and systemic
stability objectives. Many of the EMEs also avoided a financial crisis and had
to deal with only the risk of slowdown in growth. As a result, they did not have to take measures similar to that of advanced economies. Most EMEs maintained
positive interest rates to avoid the risk of exchange rate depreciation and capital
outflows. The quantitative easing measures were also of limited magnitude,
thereby limiting the extent of increase in the size of central bank balance sheets.
(2) Impact of Policy Actions on Central Bank Balance Sheets
39. Beginning in September 2008, although many EMEs began to take
measures to ease foreign exchange and domestic currency liquidity conditions,
unconventional measures did not play much role for them as in the advanced
countries. The liquidity easing measures reinforced in some cases by foreign
exchange liquidity provided by reserve currency central banks seemed to have
had some success in alleviating short-term liquidity pressures. However, the
size of emerging market central bank balance sheets did not increase by the
same magnitude as those of their advanced country counterparts (GFSR,
October 2009). Although there was not much of an expansion in the emerging
market central banks’ balance sheets, the trends show a co-movement among
these countries. It is noteworthy that the trends in RBI’s balance sheet were in
tandem with those of other emerging market central banks (Chart 7).
 |
40. The size of central bank balance sheets in EMEs increased much less due
to the depletion of international reserves in many cases, due to capital outflows
(Ishi, et al, 2009) (Chart 8).
(3) Key Difference between Central Banks of Advanced Economies and
EMEs
41. While central banks of both the developed countries and emerging markets
resorted to unconventional monetary measures, there were differences in terms
of timing, nature and magnitude of the actions.
• In the advanced economies, the switchover was from conventional
monetary tools to unconventional measures due to policy rates reaching
zero or nearing zero. In contrast, in many EMEs, the unconventional
foreign exchange easing measures such as currency swap preceded
domestic liquidity easing measures due to sudden tightening of global
liquidity conditions. Thereafter, the conventional measures of loosening
policy rates followed.
• To ease liquidity, central banks in EMEs relied mostly on direct instruments
such as reserve requirements. Central banks in advanced countries, on the other hand, resorted to measures such as widening the list of counterparties
and extending the maturity of liquidity providing operations.
• Central banks in advanced countries also eased liquidity through securities
liquidity provision, i.e., swap of illiquid private sector securities for liquid
government securities. Central banks in EMEs hardly resorted to such
measures. Furthermore, the central banks in advanced countries extensively
used credit and quantitative easing measures, while they were barely used
in the EMEs.
• In view of the extensive use of the credit and quantitative easing, the
enlargement in the balance sheets of central banks in the advanced countries
was far larger than those in the EMEs (Ishi, et al, 2009).
SECTION- IV
Exit Policy and Challenges in Management of Assets and Liabilities
42. The debate about the exit from the unconventional monetary policy began
in early 2008. The question initially was “how”, but gradually, with signs of
improvement in the real and financial spheres, the question “when” came to the
fore. The exit or the reversal would be a multi-faceted process and would unfold
differently, depending on prospects for growth, inflation and the financial
system in each country (Baudchon, 2009).
Why Exit ?
43. A strong central bank balance sheet is essential for the quality of currency
and the stability of financial system (Bagus, 2009). The financial crisis witnessed
substantial changes in the balance sheets of the world’s major central banks.
From a monetarist’s point of view, according to which inflation is a monetary
phenomenon, the question of the exit strategy takes the centre stage.
44. The policies during the crisis, which hugely expanded the monetary base,
are considered potentially inflationary, with the inflation risk arising from
three sources: over-stimulation by adoption of hyper-accommodative monetary
policy, excess liquidity in the banking system and potential deanchoring of
inflation expectations (linked to excess liquidity). To prevent runaway inflation,
the central banks need to withdraw in a timely manner the monetary policy
stimulus injected into the system. Second, it is possible that large increases in
excess reserves could conceivably diminish the willingness of banks to lend.
(Dudley, 2009). Moreover the abundant liquidity, if not withdrawn quickly,
colud pose risks inducing the same excesses and imbalances that transpired as
a run-up to the recent crisis. The exit from unconventional policy measures
becomes all the more important in view of several challenges and risk they
pose for authorities.
Risks and Challenges from Unconventional Policy Measures
45. The unconventional measures of liquidity, credit and quantitative easing
introduced by central banks during the crisis pose several challenges and risks
(IMF, 2009).
• Unconventional measures may inadvertently allocate credit to inefficient
markets at the expense of efficient markets, constraining financial sector
restructuring in the short run, and impairing future economic growth.
• The gradual replacement of high-quality and liquid assets with illiquid
claims on central bank balance sheets reduces operational flexibility and
thereby constrains future monetary management.
• The quasi-fiscal nature of some unconventional measures blurs the
distinction between monetary and fiscal policies and together with the
pressure to continue to provide financing, could potentially compromise
central bank independence.
• Though these unconventional monetary policy instruments may be
effective in boosting the economy, when price stability is at stake, they
have their limits with broader implications.
• The expansion in reserve money amidst announcements of unconventional
measures by central banks leads to inflation expectations.
• As the effects of such policies are not well-known, the conduct of monetary
policy is bound to be surrounded by much more uncertainty than is
normally the case.
• Most importantly, liquidity injections need not be greatly effective when
financial intermediaries continue to remain unhealthy.
• There is a risk of introducing distortions in financial prices without a
careful design of the measures.
• Unconventional measures may have a more direct redistributive impact on
specific sectors of the economy or categories in society than normal
monetary policy actions.
• Thus, a high degree of common understanding and cooperation between
fiscal and monetary authorities is required with a clear definition of
respective responsibilities and fields of action (IMF, 2009).
46. For the EMEs, prolonged and sizable liquidity easing could be
counterproductive as they are prone to large and potentially destabilising capital
inflows. As the tradeoffs between price, fiscal and financial stability objectives
are sharper in the EMEs, the case for credit easing by central banks was weaker.
Quantitative easing was also less appropriate for EMEs than advanced countries.
Firstly, while the financial crisis was less severe and inflation was higher, policy
rates were far from being zero. Secondly, vulnerability of EMEs to volatile
capital flows would require keeping the policy rate higher to compensate
currency holder for exchange risk. Otherwise, quantitative easing could lead to
capital outflows in these countries (Ishi, et al, 2009).
Constraints in Exit
47. As monetary stimulus was injected by using unconventional means,
central banks may lack the tools needed to undo their previous actions.
Quantitative tightening would decrease inter-bank and overall liquidity and
could lead to a stronger, deflationary credit tightening. The financial crisis
could become aggravated with destablising effects. In fact the financial crisis
was caused by solvency problems that led to liquidity constraint. Central banks
tried to fight this by increasing the provision of liquidity and buying or loaning
against the bad assets that caused the solvency problems. If central banks
reverse their actions, the solvency problems could reemerge with earlier
liquidity problems.
48. While early withdrawal of monetary accommodation may derail the
recovery process, delayed actions may build up inflationary expectations.
Therefore, balancing growth and inflation remains a major challenge for central
banks. In short, the key issues facing monetary policymakers in advanced
countries are when to start tightening and how to unwind large central bank
balance sheets.
Designing an Appropriate Exit Strategy
49. It becoms imperative for policymakers to consider and articulate the exit
strategy as to how and in what sequence policies may be unwound. It is essential
to develop a credible and coherent exit strategy to roll back crisis interventions
when market conditions permit and the economic outlook is on a firm recovery
path. Successful disengagement would require coherent sequencing and clear
communications from the central banks. Specific unwinding plans need to be
calibrated while providing signals to markets on achieving medium-term policy
goals, while avoiding the risk of a premature withdrawal of support when
conditions are still fragile (GFSR, October 2009).
50. Central banks could devise plans to unwind unconventional measures to
ensure a smooth return to market-based financial intermediation and to address concerns that excessive liquidity could eventually drive a resurgence of inflation.
With some markets getting stablised, some liquidity support measures have
already started to unwind naturally. Nevertheless, central banks would need to
ensure that they have the necessary tools to reverse the accommodative policy
stance, while recognising that they may have to keep some illiquid assets on
their balance sheets for some time.
51. In the recent discussions in the literature, several plausible options have
been proposed for exit policy (Box I).
Asset Side Management
52. The central banks, particularly in advanced countries, have to consider
when and how to withdraw from the segments of the markets in which they had intervened (asset side). The objective is to return to the use of the interest rate
as the monetary policy instrument, aiming at price stability, while sustaining the
growth recovery. This could be achieved even in the face of high excess reserves,
although the magnitude of reserve accumulation has been large and poses a
challenge (GFSR, October 2009).
Box I : Exit Strategy: Plausible Options
Several options have been suggested in the recent literature, some of which are presented below.
• Letting programs to purchase securities expire, or stopping them beforehand.
• Selling purchased assets directly into the market, or under reverse repos (without selling them
outright). Selling directly would probably be a last-resort solution, as central banks traditionally
prefer to avoid creating a “market-event”.
• Selling “legacy” assets, particularly public securities acquired before the crisis, at lower prices
without the risk of incurring losses on those assets.
• Imposing more severe conditions for access to the various funding facilities.
• Terminating the funding facilities.
• Raising the interest rate on reserve balances- an incentive for banks to leave reserves with the
Fed, in order to contain the supply of credit and thus, the risk of inflation. The ability to vary the
interest paid on reserves also decouples management of the Fed’s balance sheet from interest
rate decisions, which could be useful given the state of excess reserves, in that it does not prevent
increases in the Fed funds rate.
• Reactivating the US Treasury’s Supplementary Financing Program (SPF), a special Fed
measure5. The main drawback of this option is that it could convey the impression of the Fed
relinquishing independence relative to the Treasury (Baudchon, 2009).
53. In terms of the modus-operandi, when the central bank holds short-term assets,
it can easily mop up excess reserves by simply letting these assets mature. If the
liquidity facilities are demand-driven, unwinding takes place automatically when
funding markets improve and banks reduce their demand for precautionary excess
liquidity. This unwinding process could be encouraged further if borrowing from
the central bank is provided at a rate that would restore normal market incentives.
54. In respect of central banks whose increase in reserves is larger than the
increase in short-term instruments, retiring short-term instruments might not be
sufficient to mop up excess reserves entirely. When the central bank extends
liquidity by purchasing long-term instruments, such as government and
corporate bonds or a variety of impaired structured credit products, it would
need to sell or exchange them in order to unwind excess liquidity.
55. Asset sales can proceed if a market for the assets exists, which is not
necessarily the case for some central bank holdings. Sales of relatively illiquid
instruments or large quantities should proceed with caution as selling could
destabilise fragile markets. Furthermore, when central banks hold large portfolios
of government debt, the government should avoid the temptation to influence
their disposal and recognise the independence of the central bank (GFSR, October
2009).
Liability Side Management
56. On the liabilities side, the central bank could use additional instruments of
market operations, such as liquidity-absorbing repo operations and central bank
bills to absorb excess reserves (GFSR, October 2009 and BIS, 2009) (Table 8).
For instance, it is argued that the Fed would be able to reduce its balance sheet in a smooth manner with interest payments on reserves, combined with steps to
reduce excess reserves, such as large-scale repurchasing agreements, term
deposits to financial institutions, and the outright sale of its holdings of longterm
securities (Bernanke 2009).
Table 8: Supplementary Operations for Managing
the Central Bank Balance Sheet |
Options |
Fed |
ECB |
BOE |
BOJ |
Issuance of Central Bank Bills
(Debt Certificates) |
Not available
(Supplementary
Finance Program
used instead |
Not used |
√ |
√ |
Reverse Repos |
√ |
Not used (Deposit
actions would be
used instead) |
Not
regularly
used |
√ |
Remuneration on Excess
Reserves |
√
(Recent) |
Deposit facility for
surplus reserves |
√
(Recent) |
√ (Recent) |
Source: GFSR, October, 2009. |
57. In addition, by remunerating excess reserves, the central bank could
determine the policy rate by setting a floor on the overnight rate. These
operations could prove to be highly costly for a central bank, as they would also
channel interest income from the central bank to banks. One of the concerns is
whether the technical modalities of the withdrawal of excess liquidity would
impair the ability of central banks to control interest rates, their main monetary
policy tool, and whether the impact of high level of liquidity on credit growth
could become inflationary.
58. The experience since the fall of 2008 as well as Japan’s experience earlier
in the past decade suggests that the existence of excess reserves in itself does
not necessarily have an inflationary effect when the financial system is seriously
impaired. However, the timing of unwinding excess liquidity and, hence, the
extent to which the central bank can rely fully on remuneration to deal with
excess reserves, depends critically on the condition of the financial system.
59. Timing is complicated by the fact that some policies may be effective even
if their usage is limited, as they may be bolstering confidence or acting as a
backstop to a class of institutions or investors. In general, a facility can be
phased out by raising its costs or gradually decreasing its availability. Expensive
policies or those where costs are not commensurate with the benefits should be
considered first for withdrawal, as also the policies that significantly distort
financial markets.
60. Importantly, given the global nature of the crisis and the types of
unconventional policies used, attention must be paid to the cross-border impact
of unwinding, and coordination may be helpful, notably with regard to the
withdrawal of guarantees for bank debt across countries where potential
arbitrage opportunities can arise. Given that this is uncharted territory for
policymakers, some experimentation may be appropriate to test market
conditions. If warranted, reinstatement of some facilities should not be viewed
as a setback (GFSR, October 2009).
61. The right mix of interventions and timing of their withdrawal are critical to
restore the financial system to health. An appropriate future exit strategy should
focus on achieving the right balance between exiting too early- at the cost of
causing credit spreads to jump abruptly and risking a loss of confidence- and
prolonging stimulus, thereby providing excess liquidity, re-initiating asset price
inflation, and funding leveraged and carry-trade activities. The choice is between
tightening too early or too fast (undermining the fragile base of the recovery),
and tightening too late (which could raise inflation risks).
62. Communicating about the exit strategy is an integral part of the exit
strategy. Central bank credibility is linked to anchoring expectations (regarding
inflation or rates). An exit strategy that is clearly identified and understood
strengthens monetary policy effectiveness because it reassures that inflation and
the entire yield curve will remain under control, once growth resumes. For
central banks, that are engaged in both kinds of policies, withdrawing credit easing (the measures intended to loosen credit conditions) should pose less of a
problem than withdrawing quantitative easing (purchasing long-term
government securities or similar instruments to ease interest rate and credit
spreads), because the former will be to a large extent endogenous, without
requiring any special intervention by the central bank.
63. The improvement in the economic and financial landscape would
automatically reduce banks’ need for central bank money. This type of passive
automatic adjustment strategy is already at work. Illustratively, ECB’s
unconventional policy measures were devised with exit consideration in mind,
and hence, some of the measures would phase out naturally (Trichet, 2009).
SECTION-V
Indian Context : Policy Response by the Reserve Bank
and Impact on its Balance sheet
(1) India’s Monetary Policy Response to the Financial Crisis
64. There are several unique aspects, which enabled India to withstand the
impact of the global crisis in a non-disruptive manner. Although financial
markets in India came under pressure temporarily, owing to the spillover of
illiquidity and volatility from the markets of advanced economies, all marketsstarting
from money to credit market - functioned normally throughout, and the
excessive volatility in the markets was contained within two months by the
Reserve Bank, ensuring ample rupee and forex liquidity in the system.
65. With the intensification of financial crisis after the collapse of Lehman
and Brothers in September 2008 and in view of the reduction in capital
inflows and consequent pressures in the foreign exchange market, the Reserve
Bank sold foreign exchange in the market, consistent with its policy objective
of maintaining orderly conditions in the foreign exchange market. While
foreign exchange sales attenuated the mismatch in the foreign exchange
market, these operations drained liquidity from the rupee market and
accentuated pressures on the rupee liquidity. As a response, the Reserve Bank embarked upon pro-actively managing liquidity since mid-September 2008 to
assuage the liquidity pressures through a variety of measures. These measures,
inter-alia, included, (i) reduction in the repo rate by 425 basis points to 4.75
per cent, (ii) reduction in the reverse repo rate by 275 basis points to 3.25 per
cent, (iii) cut in the cash reserve ratio (CRR) by a cumulative 400 basis points
to 5.0 per cent.
66. Fresh issuances under the Market Stabilisation Scheme (MSS) was
withheld and buyback of existing MSS securities was also undertaken to inject
liquidity into the system. Buybacks were aligned with government market
borrowing programme. Following the amendment to the Memorandum of
Agreement on the MSS, Rs.12,000 crore was transferred to the Government
cash account from the MSS cash account. Reflecting the various operations,
MSS balances declined from Rs.1,75,362 crore at end-May 2008 to around
Rs.88,000 crore by end-March 2009. The Reserve Bank also came to respond
to the global financial crisis with the initiation of other measures such as cut
in the statutory liquidity ratio (SLR), opening of new refinancing windows,
refinance to SIDBI and EXIM Banks, and clawing back of prudential norms
with regard to provisioning and risk weights. The measures to improve forex
liquidity included, increase in interest rate ceilings on non-resident deposits,
easing of restrictions on external commercial borrowings and on short-term
trade credits (Annex).
67. The experience with MSS requires a special mention in the context of
assessment of RBI’s balance sheet, because it has shown that it operates
symmetrically, acting as a store of liquidity during surges in capital inflows and
ensuring domestic liquidity management at the time of capital outflows.
Moreover, in view of the government market borrowing programme, the
Reserve Bank undertakes purchases of government securities under its open
market operations as warranted by the evolving monetary and financial market
conditions. The various monetary and liquidity measures initiated since mid-
September 2008 released actual/potential liquidity amounting to Rs.5,61,700
crore (Table 9).
Table 9 : Actual/ Potential Release of Primary Liquidity
(Since Mid-September 2008) |
Measure/Facility |
Amount (Rs.crore) |
Monetary Policy Operations (1 to 3) |
|
1. Cash Reserve Ratio (CRR) Reduction |
1,60,000 |
2. Open Market Operations (purchases) |
80,080 |
3. MSS Unwinding/Buyback/De-sequestering |
1,55,544 |
Extension of Liquidity Facilities (4 to 8) |
|
4. Term Repo Facility |
60,000 |
5. Increase in Export Credit Refinance |
26,576 |
6. Special Refinance Facility for SCBs (Non-RRBs) |
38,500 |
7. Refinance Facility for SIDBI/NHB/EXIM Bank |
16,000 |
8. Liquidity Facility for NBFCs through SPV |
25,000 |
Total (1 to 8) |
5,61,700 |
Memo : |
|
Statutory Liquidity Ratio (SLR) Reduction |
40,000 |
Source : First Quarter Review of Statement on Monetary Policy for the Year 2009-10. |
Why and How Indian Situation was Different from the Central Banks of
Advanced Economies?
68. There were several key differences between the policy response by the
Reserve Bank and the central banks in many advanced countries, which could
be seen below :
i) In the first place, India did not experience a financial crisis; its financial
system remained largely insulated, as it was not exposed to the toxic assets
and failing institutions in the advanced economies.
ii) India, however, was impacted by the global recession, and the policy
stimulus in India aimed primarily at containing the pace and duration of
economic slowdown.
iii) Unlike several export-dependent and external capital dependent countries,
India’s growth process was driven by domestic savings and domestic
demand, which clearly contributed to limit the impact of global recession
on India.
iv) Unlike the advanced economies, thus, India did not have to use large-scale
policy stimulus to bailout failing institutions and freezing markets. No
stimulus for recapitalising banks, buying back illiquid assets or guaranteeing
the liabilities of banks was necessary.
v) Despite significant pressures on India’s balance of payments in the second
half of 2008-09 when both exports started to decline and capital inflows
reversed, the comfortable foreign exchange reserves facilitated Reserve
Bank’s operations in the foreign exchange market to preserve orderly
conditions.
vi) There was no dilution of collateral standards, which were largely
government securities, unlike the mortgage securities and CPs in the
advanced economies.
vii) In the process of liquidity injection, the counter-parties involved were
banks; even liquidity measures for mutual funds, NBFCs and housing
finance companies were largely channeled through the banks.
viii) Availability and deployment of multiple instruments facilitated better
sequencing of monetary and liquidity measures.
ix) The gradual and sequential approach to liberalisation of the capital account
also prevented leveraging of the Indian financial system for taking positions
in troubled assets in the advanced economies.
x) Adequate regulatory precautions ensured that complex structures like
synthetic securitisations did not contaminate the Indian markets and
prudential measures were also designed to discourage excessive exposure
of the banking system to sensitive sectors and asset price bubbles
(Thorat, 2009).
xi) The experience in the use of procyclical provisioning norms and countercyclical
regulations ahead of the global crisis helped to manage financial
conditions in a non-disruptive manner.
xii) Despite large liquidity injection, the Reserve Bank’s balance sheet did not
show unusual increase, unlike the global trend, because of release of earlier
sterilised liquidity (Mohanty, 2009).
69. With the prompt and timely conduct of liquidity management operations
along with those of exchange rate management and internal debt management
in a synchronized manner, the Reserve Bank ensured that there was no dearth of
liquidity in the system. The combined policy response of the Reserve Bank was
aimed at sustaining the domestic growth, consistent with price and financial
stability (Mohanty, 2009).
(2) Delineation of Key Developments in the Reserve Bank’s Balance Sheet
70. As the crisis deepened and global macro economic conditions deteriorated,
EMEs were confronted with reversal in the capital flows. As a result of capital
outflows, the balance of payments position of India came under pressure during
the third quarter of 2008-09. As a corollary, the Reserve Bank was required to
draw down the reserves to make up for the shortfall in order to ensure orderly
conditions in the foreign exchange market. The drawdown of reserves led to
corresponding contraction in the base (reserve) money. Concomitantly, the
Reserve Bank had to ensure the required expansion in net domestic assets
(NDA) by resorting to conventional policy measures. First through the open
market operations (OMO) involving outright purchases of government securities
in the secondary market and secondly, through the provision of liquidity through
repos under its daily liquidity adjustment facility (LAF) (Chart 9).
71. A large part of the NDA that explains the trends in reserve money was in
the form of net RBI credit to the Government, which comprises the combined
effects of OMO operations, LAF operations (repo and reverse repo), MSS
balances and the Governments balance with the Reserve Bank. While the lower
CRR and unwinding of MSS were the primary instruments for expanding
liquidity, much of the surplus liquidity came back to the Reserve Bank through
reverse repo under the LAF and high surplus balances of the Government with
the Reserve Bank by the end of 2009.
 |
72. The MSS was another instrument that came handy for the Reserve Bank to
expand liquidity in the system by unwinding of the securities held under MSS6.
The amount sterilised through MSS remained immobilised in the Central
Government’s account with the Reserve Bank. As at end-September 2008, MSS
amount stood over Rs. 1.7 trillion. The unwinding of MSS balances gave adequate
space for the Reserve Bank to embark on necessary liquidity expansion without
resorting to expansion in its balance sheet in any significant measure. Nevertheless,
the timing of the unwinding was also modulated in such a way that the large
borrowing programme of the government was managed smoothly, without
exerting undue pressure on the market. Besides, the reduction in CRR of banks
from 9 per cent to 5 per cent released Rs.1.6 trillion of primary liquidity to the
banking system.
73. The CRR measure changed the monetary conditions in two ways. On the
components side, the reduction in reserve requirement by 4 percentage points
and the associated decline in bankers’ deposits with the RBI led to a reduction
in the growth of reserve money. The balance sheet of the RBI also contracted
but the CRR measure helped money multiplier to deliver the quantitative easing
impact. The average money multiplier rose from 4.3 in March 2008 to 4.8 in March 2009, reaching further to 5.1 per cent at end-December 2009, reflecting
the impact of lowering of CRR. An increase in money multiplier resulted in
higher increase in broad money (Chart 10).
74. On the sources side, the decline in net foreign assets of the Reserve Bank,
driven by capital outflows was more than offset by expansion in net domestic
assets, however, the impact was not adequate to give rise to a large increase in
the balance sheet size or reserve money. A decomposition of net RBI credit to
the Centre (which is the major component of Reserve Bank net domestic
assets) shows that the Government deposits with the Reserve Bank fell
considerably on account of unwinding of MSS, which contributed to
contraction in the Reserve Bank’s balance sheet on the liabilities side along
with the reduction in bankers’ deposits with the Reserve Bank. On the asset
side, marketable securities held by the Reserve Bank (which include both
OMOs and LAF) did not increase significantly (Chart 11). In fact, during the
period following November 2008, the liquidity released through relatively
sharp unwinding of the MSS was ploughed back by the banks into reverse
repos (despite a 2.75 percentage points reduction in reverse repo rate),
indicating lower credit off-take and surplus liquidity in the banking system.
 |
 |
75. In India, thus, the provision of adequate liquidity, despite being large, was
achieved without compromising either on the asset quality in the Reserve Bank’s
balance sheet or on the eligible counterparties. The liquidity requirements of nonbank
financial entities were catered to indirectly by extending liquidity support to
the designated counterparties, like commercial banks and primary dealers. The
liquidity expansion achieved through unwinding of MSS and reduction in reserve
requirement ensured that the Reserve Bank’s balance sheet did not expand
significantly, unlike in several other central banks (Chart 12).
SECTION VI
Concluding Remarks
76. The exceptional nature of financial crisis tested the ability of central banks
to act as lender of the last resort (LOLR). Since the global financial crisis started
because of illiquidity of the assets, rather than run on banks by the depositors,
the liquidity management response of the central banks had to go beyond the
conventional LOLR function, which was reflected in the sheer size and
composition of the central bank balance sheets. A key issue that emerged was
the need for an adequate array of policy tools to contain the stress in the financial
markets. The policy responses during the crisis were remarkable in terms of their
scale, intensity and exceptional coordination across the countries. Advanced
countries, which initially began with conventional policy rate cuts, later turned
to unconventional policy measures while using their balance sheets in unusual
ways, as transmission mechanism was impaired and modulation in interest interest
rate became ineffective. As an outcome of the unprecedented actions involving
quantitative easing, central bank balance sheets expanded considerably, with
significant change in their composition as well.
77. The assets of the Fed and the BoE more than doubled, that too in a matter
of weeks, while that of the ECB grew by more than 30 per cent. In the Fed’s
case, this reflected direct lending to banks and dealers through existing and new
lending facilities; indirect lending to money market funds; purchases of
commercial papers (CPs) through special purpose vehicles (SPVs) and drawings
by foreign central banks on dollar swap lines. In Europe, the key drivers of ECB
balance sheet covered enhanced credit support measures along with standing
facilities, which involved increasing the number, frequency of operations and
the list of eligible collaterals. Balance sheet changes in respect of BoJ were
mainly driven by introduction of measures to facilitate corporate financing,
along with the purchase of CPs and corporate bonds.
78. The central banks in emerging markets also responded to the contagion that
spilled over to their economies through the confidence, trade and capital movement channels. Their responses mainly covered foreign exchange and
liquidity easing measures, though the extent of their use of credit and quantitative
easing measures was limited. As a result, the increase in the central bank balance
sheets of these countries was nowhere near the change that occurred in respect
of advanced country central banks. It is notable that the trends in respect of RBI’s
balance sheet were in tune with the changes in central banks’ balance sheets of
EMEs, but with specific unique features because of its dependence on CRR and
MSS unwinding, both of which entailed contraction in the RBI balance sheet.
79. With the significant changes in the size of central bank balance sheets,
several challenges have come to the fore, viz., change in the risk profile of
balance sheets with rise in credit, valuation and counter-party risks besides
interest rate risks; change in the income position of central banks; excess
reserves limiting the willingness of banks to lend; questions over marketability
of certain types of assets and illiquid claims impeding the operational flexibility
and constraining future monetary management. The unconventional measures
have also several other implications in terms of their adverse impact on resource
allocation, price discovery mechanism and potential inflation expectations.
80. In view of the above challenges, it is imperative on the part of central banks
to develop a credible and coherent exit strategy to roll back crisis time
interventions when market conditions permit and the economies return to a firmer
recovery path. While early withdrawal of monetary accommodation may derail
the recovery process, delayed actions may build up inflationary expectations.
Therefore, balancing recovery and inflation remains a major challenge for central
banks, even though the inflation risk in advanced economies remain largely
contained, supporting thereby the need to delay exit till recovery becomes
stronger and more durable. Successful disengagement would require coherent
sequencing and clear communications from the central banks. Specific unwinding
plans will need to be calibrated while providing signals to markets on achieving
medium-term policy goals, while avoiding the risk of a premature withdrawal
of support as conditions look still fragile. Attention must be paid to the cross border impact of unwinding and coordination may be helpful. The exit or the
reversal would be a multi-faceted process and would unfold differently, depending
on prospects for growth, inflation and the financial system in each country
81. India, avoided a financial crisis at home, but was affected by the knock on
effects of global recession. The temporary pressure on financial markets in
terms of increased volatility was contained by the Reserve Bank with its prompt
and careful conduct of the liquidity management operations. The MSS
instrument provided Reserve Bank the much needed flexibility to carry out its
market operations. The reduction in CRR, while raising the money multiplier,
enabled adequate liquidity injection to the system. As a consequence, the
balance sheet of RBI did not see any notable change during the phase of crisis.
With the beginning of exit announced in the October 2009 Policy Statement, the
remaining measures to be reversed fall in the domain of conventional monetary
policy, which will happen in response to the growth and inflation outlook over
time. Thus, for the Reserve Bank, there are no balance sheet related concerns,
unlike in the advanced economies.
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delivered at the Federal Reserve Board Conference on Key Developments in Monetary
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—— (2009): “The Crisis and the Policy Response”, Lecture delivered at the London School
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December.
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of “How” versus “When”, Remarks made at the Association for a Better New York Breakfast
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October.
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Annex : Policy Response of the Reserve Bank During Recent Crisis |
Item |
Key Measures |
1 |
2 |
Monetary Measures |
• Cut in the repo rate under the LAF by a cumulative 425 basis points from 9.0 to 4.75 per cent between October 2008 to April 2009. |
• Cut in the reverse repo rate by a cumulative 275 basis points from 6.0 to 3.25 per cent during the above period. |
Rupee Liquidity/ Credit Delivery |
• Cut in the CRR by a cumulative 400 basis points of NDTL from 9.0 per cent to 5.0 per cent between October 2008 to April 2009. |
• Introduction of a special refinance facility under Section 17(3B) of the Reserve Bank of India Act, 1934 under which all SCBs (excluding RRBs) were provided refinance from the Reserve Bank equivalent to up to 1.0 per cent of each bank’s NDTL as on October 24, 2008 at the LAF repo rate up to a maximum period of 90 days. Banks were encouraged to use this facility for the purpose of extending finance to micro and small enterprises. The facility was to available to upto September 30, 2009. |
• Institution of a term repo facility for an amount of Rs.60,000 crore under the LAF to enable banks to ease liquidity stress faced by mutual funds, NBFCs and housing finance companies (HFCs) with associated SLR exemption of 1.5 per cent of NDTL. This facility was to available up to September 30, 2009. |
• Reduction in statutory liquidity ratio (SLR) by one percentage points from 25 to 24 per cent of NDTL with effect from the fortnight beginning November 8, 2008 (reversed in October 2009). |
• Introduction of a mechanism to buy back dated securities issued under the MSS so as to provide another avenue for injecting liquidity of a more durable nature into the system. |
• Extension of the period of entitlement of the first slab of pre-shipment and post-shipment rupee export credit, by 90 days each, with effect from November 15, 2008 and December 1, 2008, respectively. |
• Increase in the eligible limit of the ECR facility for scheduled banks (excluding RRBs) from 15 per cent to 50 per cent of the outstanding export credit eligible for refinance at the prevailing repo rate under the LAF. |
• To allocate amounts, in advance, from SCBs for contribution to the SIDBI and the NHB to the extent of Rs.2,000 crore and Rs.1,000 crore, respectively, against banks’ estimated shortfall in priority sector lending in March 2009. |
• Reduction in the provisioning requirements for all types of standard assets (for residential housing loan beyond Rs.20 lakh, standard advances in the commercial real estate sector, personal loans including outstanding credit card receivables, loans and advances qualifying as capital market exposure and non-deposit taking systemically important NBFCs) to a uniform level of 0.40 per cent except in case of direct advances to agricultural and SME sector, which could continue to attract provisioning of 0.25 per cent, as hitherto. |
• Downward revision of risk weights on banks’ exposures to certain
sectors, which had been increased counter-cyclically earlier. All
unrated claims on corporates and claims secured by commercial real
estate would attract a uniform risk weight of 100 per cent as against
the risk weight of 150 per cent prescribed earlier. Claims on rated as
well as unrated non-deposit taking systemically important non-banking
financial companies (NBFC-ND-SI) were uniformly risk weighted
at 100 per cent. As regards the claims on asset financing companies
(AFCs), there was no change in the risk weights, which continue to
be governed by the credit rating of the AFCs, except the claims that
attracted a risk weight of 150 per cent under the new capital adequacy
framework, was reduced to a level of 100 per cent. |
• In order to provide liquidity support to housing, export and MSE sectors,
the Reserve Bank provided a refinance facility of Rs.4,000 crore to the
NHB, Rs. 5,000 crore to the EXIM Bank and Rs. 7,000 core to the
SIDBI up to March 2010. |
• For more effective liquidity management, the Reserve Bank widened
the scope of OMOs by including purchases of Government securities
through an auction-based mechanism in addition to operations through
NDS-OM. |
Foreign Exchange
Liquidity |
• Continuation of selling foreign exchange (US dollars) through agent
banks to augment supply in the domestic foreign exchange market or
intervene directly to meet any demand-supply gaps. |
• To institute special market operations to meet the foreign exchange
requirements of public sector oil marketing companies against oil bonds
when they become available. |
• The ceiling rate on export credit in foreign currency was increased to
LIBOR plus 350 basis points subject to banks not levying any other
charges. |
• Authorised Dealer (AD) category - I banks were allowed to borrow
funds from their head office, overseas branches and correspondents
and overdrafts in nostro accounts up to a limit of 50 per cent of their
unimpaired Tier 1 capital as at the close of the previous quarter or US$ 10
million, whichever was higher, as against the earlier limit of 25 per cent. |
• As a temporary measure, HFCs registered with the NHB were allowed to
raise short-term foreign currency borrowings under the approval route,
subject to compliance with prudential norms laid down by the NHB. |
• A forex swap facility with tenure up to three months to Indian public
and private sector banks having overseas operations in order to provide
them flexibility in managing their short term funding requirements at
their overseas offices. The facility was to available up to March 31,
2010. |
• Cumulative increase in the interest rate ceilings on FCNR (B) and NR(E)
RA term deposits by 175 basis points each since September 16, 2008. |
• Proposals from Indian companies to prematurely buyback their FCCBs
was to be considered under the approval or automatic route, depending
on the extent of discount of the FCCBs and the source of funds, subject
to compliance with certain stipulated conditions. (The buyback should
be financed by the company’s foreign currency resources held in India
or abroad and/or out of fresh external commercial borrowing (ECB)
raised in conformity with the current norms for ECBs). Extension of
FCCBs was also to be permitted at the current all-in-cost for the relative
maturity. |
ECB Norms |
• The all-in-cost ceiling for ECBs of average maturity period of three
to five years and of maturity period over five years was enhanced to
300 basis points above LIBOR and 500 basis points above LIBOR,
respectively. The all-in-cost ceiling for trade credit less than three years
was enhanced to 6-month LIBOR plus 200 basis points. |
• ECBs up to US$ 500 million per borrower per financial year were
permitted for rupee/foreign currency expenditure for permissible enduses
under the automatic route. |
• The definition of infrastructure sector for availing ECB was expanded to
include mining, exploration and refinery sectors. Payment for obtaining
license/permit for 3G spectrum by telecom companies was classified as
eligible end-use for the purpose of ECB. |
• The requirement of minimum average maturity period of 7 years for
ECB of more than US$ 100 million for rupee capital expenditure by the
borrowers in infrastructure sector was dispensed with. |
• Borrowers were granted the flexibility to keep their ECB proceeds
offshore or keep it with the overseas branches/subsidiaries of Indian
banks abroad or to remit these funds to India for credit to their rupee
accounts with AD category-I banks in India, pending utilisation for
permissible end-uses. |
• NBFCs exclusively involved in financing of the infrastructure sector
were permitted to avail of ECBs under the approval route from
multilateral/regional financial institutions and Government- owned
development financial institutions for on-lending to the borrowers in
the infrastructure sector, subject to compliance with certain conditions. |
* S. M. Lokare is working with the Division of Money and Banking, Department of Economic Analysis
and Policy, Reserve Bank of India. In this endeavour, he is grateful to Sri Sitikantha Pattanaik, Director
and Sri K.U.B.Rao, Officer-in-Charge, for the encouragement. The views aired in this paper are strictly
personal. Errors and omissions, if any, are the sole responsibility of the author.
1 For instance, in the US, collateral normally available only at the discount window was made available
for open market operations. In the UK, additional securities, including some well-rated asset-backed securities
and covered bonds were accepted in the three-month repo operation.
2 In some cases, they stepped in to provide direct lending to distressed institutions and took other
exceptional measures to improve funding conditions in credit markets. For instance, the Fed lengthened
the maturity of its refinancing operations. In addition, an increasing share of the latter was lent to primary
dealers against a wide range of less liquid securities to help improve their balance sheets via the Fed’s Term
Securities Lending Facility. Similarly, the BoE allowed banks to swap less liquid securities against more
liquid ones under its Special Liquidity Scheme. The BoE, ECB and SNB substituted longer-term open
market operations (OMOs) for shorter-term operations. More auctions were also conducted at a fixed rate
with full allotment.
3 With the payment of interest on excess balances, market participants will have little incentive for
arranging federal funds transactions at rates below the rate paid on excess reserves. By helping set a floor on
market rates in this way, payment of interest on excess balances will enhance the Fed’s ability to keep the
federal funds rate around the target for the federal funds rate.
4 Most major emerging market central banks conducted outright sales of foreign exchange reserves to
help meet the local market’s demand for foreign currency funding and to relieve pressure on the exchange
rate. In addition, some central banks sought to offer foreign exchange reserves to counterparties under
repurchase agreements (Brazil and the Philippines). Some central banks announced modifications (widening
of counterparty eligibility, extension of term) to their existing FX swap facilities to make the distribution of
foreign currency more efficient and flexible (Korea and Indonesia). Some others set up new swap facilities
(Brazil, Chile and Poland) or announced their readiness to conduct swaps with counterparties as needed
(Hong Kong SAR).
5 Under the program, the Treasury issues special bills, with the proceeds added to the liabilities side of the Fed’s
balance sheet. When buyers pay, the Treasury’s account at the Fed is credited and excess reserves are reduced by
the same amount.
6 MSS securities are essentially short-term government securities, introduced in April 2004, as an
instrument of sterilisation to partly neutralise the expansionary effects of surges in capital inflows. |