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Open Market Operations

IndianMoney.com Research Team | Posted On Tuesday, February 12,2019, 05:02 PM

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Open Market Operations

 

 

What are open market operations?

Open market operations are the purchase and sale of government securities and treasury bills by RBI. Open market operations or OMO helps regulate money supply in the Indian economy. OMO is the buying and selling of Government Securities in the open market with the purpose of expanding or contracting money supply in the banking system. RBI conducts OMO through commercial banks and not the public.

RBI conducts open market operations by sale/purchase of g-secs to adjust money supply in the economy. RBI sells g-secs and banks purchase them sucking out liquidity from the system. If RBI wants to infuse liquidity into the system, it simply buys g-secs. OMO balances inflation and banks continue to lend.

RBI uses OMO in union with cash reserve ratio CRR, repo rate which is currently 6.25% and statutory liquidity ratio SLR, to adjust money supply in the system.

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Open Market Operations

Open market operations by RBI:

Liquidity conditions get tight in India towards October (Second half of the Financial Year). Government expenditure usually slows down and this is the festival season where there’s a spike in currency demand. FIIs and advance taxes also cause fluctuations in the flow of liquidity.

This is where RBI steps in. RBI smoothens the availability of money throughout the year. This is because it doesn’t want liquidity conditions to affect ideal level of interest rates it looks to maintain in the economy. RBI doesn’t want borrowers to face a cash crunch. It buys g-secs to boost liquidity and sells g-secs to mop up excess liquidity.

Liquidity affects interest rates and inflation. Let’s say its tight liquidity and RBI buys g-secs to pump liquidity into the system. This excess liquidity helps banks lower interest rates. You find home loan and car loan EMIs going down.

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Open market operations example:

Open market operations = RBI selling/buying government securities to control money supply.

Government securities are like a piece of paper. It’s a promise like “give me Rs 500. I’ll give you 7% for the next 10 years and then return the borrowed amounts of Rs 500. Government securities enjoy Sovereign backing.

Case: Inflation is rising in the economy. Prices of goods and services are increasing. RBI sells g-secs in the open market to suck out liquidity. This pushes down inflation in the economy.

How does this happen? Let’s say SBI purchases g-secs from RBI. When SBI pays for these bonds, the money SBI has to lend goes down. SBI has less money to lend.

Let’s understand OMO with a simple example: You go to the shop to pick up items, but find they are highly priced because of inflation. (This is the rise in the prices of goods and services with time).RBI could indulge in OMO to bring down prices. (Reduce inflation).

RBI sells g-secs to banks which purchase them. Banks have less money to lend. RBI has basically sucked out liquidity from the system.

Banks raise loan rates to maintain profits. People postpone availing homes, cars, starting businesses as interest rates are high. There’s less demand, less jobs and less income. To boost demand RBI could cut repo rates so that home loan interest rates go down. Government could cut taxes or increase government borrowings to increase economic demand. Cut in taxes increases disposable income in the hands of customers. This boosts aggregate demand in the economy.

How Open Market Operations affect Interest Rates?

Let’s say there’s high inflation in India. This is because there’s excess liquidity in the economy. RBI indulges in open market operations OMO where it sells g-secs to banks. The liquidity gets squeezed out as banks buy g-secs. This is because banks have less money to lend. RBI can use repo rates, CRR and SLR in sync with open market markets. Banks have to maintain share of banks total deposits with RBI in the form of liquid cash. This is CRR or cash reserve ratio of 4%. SLR or statutory liquidity ratio is the minimum portion of NDTL (Net Demand and Time Liability) that banks maintain with RBI in the form of gold, cash or liquid assets. SLR is currently 19.5%. If banks hike CRR and SLR, banks have less money to lend.

Repo rate is the rate at which RBI lends to commercial banks. It currently stands at 6.25%. When inflation is high RBI raises repo rates. As repo rates increase banks pay more interest on FDs and other deposits. Banks hike lending rates on car loan, home loans and so on. With home loan, car loan EMIs on the rise, demand goes down. Inflation falls and the cycle gets repeated.

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Recently, RBI cut repo rates from 6.5% to 6.25% as inflation was low in India. RBI has indulged in open market operations in December-January period to the tune of Rs 50,000 Crores to maintain the interest rates set. This would boost liquidity (very important after the IL&FS fiasco). Excess liquidity could boost inflation and increase jobs and growth in the economy. 

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