Open Market operations

Open Market operations: A central bank will engage in an open market operation (OMO) to provide (or withhold) liquidity in its currency to (or from) a bank or group of banks. The central bank can engage in a repo or secured lending transaction with a commercial bank, whereby the central bank gives the money as a deposit for a specified period and concurrently takes an eligible asset as collateral. This is how the name was historically derived: the central bank gives the money as a deposit for a defined period. OMO is a central bank’s main tool for carrying out monetary policy.

The primary goal of open market operations is to manage the short-term interest rate and the supply of base money in an economy, which has the impact of growing or reducing the money supply. Open market operations also occasionally remove excess liquidity from commercial banks. This entails purchasing and selling government securities or other financial instruments in order to satisfy the demand for base money at the target interest rate. This implementation is governed by monetary targets like inflation, interest rates, or exchange rates.

Open market operations procedure

For a collection of commercial banks known as the “direct payment banks,” the central bank manages loro accounts. A balance on such a loro account (which the commercial bank views as a nostro account) represents central bank funds in the currency in question.

Open market operations can be carried out by simply increasing or decreasing (crediting or debiting) the amount of electronic money that a bank has in its reserve account at the central bank because central bank money currently exists primarily in the form of electronic records (electronic money) rather than in the form of paper or coins (physical money). Unless a direct payment bank demands to exchange a portion of its electronic money against banknotes or coins, this does not necessitate the establishment of new physical currency.

The majority of affluent nations forbid central banks from making loans without needing appropriate assets as security. As a result, the majority of central banks list the assets that can be traded on the open market. Technically, the loan is made by the central bank and simultaneously taken in exchange for an equivalent quantity of a qualifying asset provided by the commercial bank that is borrowing.

The fact that India is a developing nation and that its capital flows are considerably different from those in rich nations has a significant impact on its open market operation. As a result, the Reserve Bank of India (RBI), India’s central bank, must implement policies and employ tools appropriately.

The cash reserve ratio (CRR) and the SLR were the primary sources of funding and interest rate regulation for the RBI before to the 1991 financial reforms (Statutory Liquidity Ratio). However, following the reforms, open market operations became more popular and CRR’s use as a tool was downplayed. OMOs work better at modifying [market liquidity].

The RBI uses two different types of OMOs:

• Buying or selling government securities directly is referred to as an outright purchase (PEMO). (Permanent)
• Short-term and subject to repurchase, repurchase agreement (REPO)

The market remained less liquid and unbalanced even after CRR was eliminated as an instrument. Thus, in response to the Narasimhan Committee Report’s (1998) recommendations, The RBI established a Liquidity Adjustment Facility (LAF). It started in June 2000 and was created to keep an eye on market interest rates and daily liquidity management. The RBI establishes the repo rate and reverse repo rate for the LAF. When selling assets to the RBI (daily injection of liquidity), the repo rate applies; however, the reverse repo rate applies when banks repurchase those securities (daily absorption of liquidity). Additionally, the RBI’s fixed interest rates are used to determine other market interest rates.

Open Market Operations: Even if the OMO and LAF policies were successful in stopping the daily massive capital inflows into India, another tool was required to maintain the liquidity. Thus, the market stabilization scheme (MSS), a new program, was established in response to the suggestions of the Working Group of RBI on Instruments of Sterilization (December 2003). While the MSS was established to sterilize the liquidity absorption and make it more durable, the LAF and OMOs dealt with day-to-day liquidity management.

This plan calls for the RBI to issue more T-bills and securities to absorb the liquidity. Additionally, the funds are deposited into the Market Stabilization Scheme Account (MSSA). The RBI is prohibited from using this account to pay interest or discounts or to credit premiums to it. The government establishes a cap on the issuance of these instruments in coordination with the RBI.