The Reserve Bank of India’s liquidity management begins the process of transmission from the operating target, the call money rate. In fact, the RBI keeps the call rate tightly bound within the MSF and the SDF corridor, and it typically hugs the repo rate which lies in the middle of the corridor. All other short-term rates in the money market evolve closely around the call money rate, which serves as a benchmark for all interest rates up to one year.

Money Market Dynamics

In the overnight money markets, the uncollateralised segment is restricted by the RBI to banks (and PDs) only to control counterparty risk, since banks are most closely regulated by the RBI and are subject to the CRR. The call-notice-term money market accounts for just over 2% of money market turnover. The CBLO/TREPS market accounts for the bulk of transactions with a share of 66% of turnover, followed by the repo market at 31%.

Before travelling further along the transmission channels into outer segments of the financial markets, it is interesting to observe how the first leg of transmission is affected by expectations through the overnight indexed swap (OIS) market. 

It is a financial derivative market where parties exchange fixed-rate interest payments (typically 5-year government securities yield) for a floating rate based on a compounded overnight index rate, such as the Mumbai Interbank Offered Rate (MIBOR).

The MIBOR is the benchmark interest rate for the overnight unsecured interbank lending market in India. It is calculated daily by the Financial Benchmarks India Private Ltd (FBIL), based on the weighted average of actual, volume-based transactions on the NDS-Call platform. It is commonly used as a reference rate for interest rate swaps and floating-rate, short-term debt instruments.

MIBOR moves with the call rate, and hence it aligns with the repo rate. So, the OIS market is used heavily for hedging interest rate risk. OIS is considered low-risk, as it is often collateralised. Analysts use it to guess the policy rate in the future.

Transmission Losses in the Money Markets

In reality, transmission losses start occurring as soon as the policy rate is conveyed to the money market by the RBI.

The first impediment is the phenomenon of urban cooperative banks offloading funds in the form of deposits collected by them in the second half of the day to specific commercial banks at a sub-repo rate of interest because they have not invested in the technological architecture for participating in the LAF (although they are allowed to).

As these transactions constitute call money market activity, the weighted average call money rate obtained during actual trading is pulled down by averaging. 

Another impediment is India’s missing money markets, which is the segment between three days and three months. Despite best efforts, including offering repos/reverse repos of various maturities under the LAF, the RBI has been unable to induce market participants to conduct transactions and facilitate price discovery in this segment.

Consequently, the policy rate impulse has to jump from the overnight market synapse to the three-month segment and, in the process, transmission is jerky, and there is a loss of power.

Furthermore, trading is highly concentrated in a few segments. For instance, large institutional players, primarily mutual funds and banks, rely heavily on TREPS to park surplus daily funds or meet short-term liquidity shortfalls efficiently. Collateralised rates tend to be a shade finer than the call money rate.

Moving outwards, the CP market has its problems that impede transmission, such as defaults and round-tripping between banks and NBFCs. Banks provide essential funding to NBFCs through working capital lines, term loans, and co-lending partnerships. In turn, banks invest in CPs issued by NBFCs.

Longer Pathways and Transmission Losses: Gilt Yield Curve

Moving on to longer-term rates, the government securities yield curve is used as a benchmark to determine interest rates for financial instruments of maturities above one year right up to 30-40 years.

In this market, the 91-day Treasury bill (T-bill) rate depends on the call rate and, in turn, it influences the 182-day T-bill rate and the 364-day T bill rate. The latter influences the 2-3 year yield, which influences the 5-year yield and so on.

The yield curve is the line joining the yields on all government securities from 91 days to 40 years. The shape and shifts in the yield curve are a good indicator of how expectations are forming. An upward-sloping and upward-shifting yield curve indicates expectations of higher growth, higher inflation and higher interest rates. Conversely, a downward-sloping or inverted yield curve (short-term rates higher than long-term rates) conveys a pessimistic outlook and expectations of easy monetary policy.

A peculiar feature of India’s government securities yield curve is that it is not smooth. Instead, it is disjointed because trading is concentrated at specific points – 91-day T-bills; 5-year security; 7-year security; 10-year security; 14-year security – called on-the-run securities.

This is a big impediment to monetary policy transmission in the form of losses of speed and strength.  Another impediment to smooth transmission is the term spread, measured as the difference between the 91-day T-bill rate and the 10-year security yield. When this spread widens, it means that the monetary policy moves are not being passed to the longer end of the yield curve. It is for this reason that central banks intervene directly at the longer end of the yield curve through unconventional monetary policy.

Furthermore, the government securities market is also vulnerable to spillovers from both global and domestic developments which, in turn, can hinder full transmission of monetary policy. 

Corporate Bond Market

The government securities yield curve is the benchmark for pricing corporate bonds. Accordingly, the latter’s rates generally evolve in alignment with the former. This market is segmented and narrow in India. The bulk of corporate bonds are privately placed at off-traded rates. 

More than 90% of trading happens in triple A-rated securities. Because of these market microstructure issues, monetary policy transmission to the corporate bond market gets adversely affected. The spread between 3-year and 5-year corporate bonds and government securities of similar maturity is an indication of creditworthiness. A higher spread indicates risk aversion and hence lesser transmission.

Credit Market

India’s credit markets that are regulated by the RBI have seen several regime shifts, with implications for monetary policy transmission. Each regime represents efforts by the RBI in consultation with banks to bring efficiency into this channel and ensure that monetary policy transmission takes place quickly, smoothly and fully.

• From Regulated to Deregulated Interest Rate Regime (1990s – 2011).
• Prime Lending Rate System (1994): An internal rate set by banks for top customers, serving as a base for other loans.
• Benchmark Prime Lending Rate (2003): A reference rate reflecting a bank's actual cost of funds, operating expenses, and a minimum margin.
• Base Rate System (2010): refers to a minimum interest rate set by banks, below which they can't lend; reflects cost of funds (deposits, borrowings), operating costs, and minimum profit margin.
• Marginal Cost of Funds-based Lending Rates (2016): the lowest interest rate a bank can charge for a loan plus a "spread" or "margin" for factors like negative carry on CRR, credit risk, operating expenses and tenor premium.
• External Benchmark Linked Lending Rate (2019): a bank's lending rate for floating-rate loans (like home loans) is directly tied to an external rate, ensuring faster and transparent transmission to borrowers.

Today, the stock of bank loans has elements of each of these pricing mechanisms, and as a result, transmission is far from being smooth and complete.

As we move towards expanding the ambit of the external benchmark linked pricing mechanism, which was recommended by the Committee that brought in inflation targeting, transmission is expected to improve significantly in swiftness and fullness.

Transmission is generally better during a tightening phase relative to an easing phase. In the current easing phase, for instance, although the entire policy easing of 100 basis points has been passed on to new deposits, much less has been passed on when the total stock of deposits is taken into account. The phenomenon of fixed rates on deposits hinders transmission.

Deposit rates are the basis for pricing lending rates as banks want to maximise the net interest margin or NIM. Here again there are transmission barriers because of different pricing mechanisms for the stock of loans. Loans with external benchmarks have been fully priced for the change in the repo rate; but if one takes the entire stock of loans into account, only about half of transmission has happened.

A big impediment to transmission is the administered interest rates on small savings. Although the government has agreed to a formula-based interest rate setting taking the average of government securities yields, this is hardly adhered to. Other impediments are the asset quality of SCBs, with impaired assets forcing higher-than-transmitted interest rates; and heterogeneous pricing methodologies of NBFCs.

Conclusion

To sum up, when the policy rate changes, it impacts money market rates instantly and simultaneously generates expectations among people about the likely course of interest rates in the near future. In turn, this shapes their views about wages because they want to be prepared for future inflation.

Thus, these expectations also contribute to inflation. Meanwhile, money market interest rates influence other short-term interest rates like those on Treasury bills, CPs, CDs, longer-term rates like those on bank loans, mortgages and yields on bonds. They also affect asset prices like equities and the exchange rate.

The result is that aggregate demand in markets for various products, and also factors like labour, responds to the changes in all these prices. Combined with people’s expectations, the whole economy is influenced by the monetary policy decision.

This is Part 12 of the Masterclass with Michael Patra.

Masterclass with Michael Patra: Previous Sessions

Part 1
Origins, Ideas and Institutions
Michael Patra begins the masterclass by tracing how central banks evolved from fragile monetary experiments into institutions entrusted with preserving trust, stability and confidence.

Part 2
RBI and the Safeguarding of Confidence
The series then turns to the RBI’s evolution, its expanding institutional role, and the balance between autonomy, growth and price stability.

Part 3
The Rise and Fall of Monetary Policy Regimes
From Bretton Woods to monetary targeting, the masterclass examines how central banks repeatedly reinvented monetary policy frameworks when old anchors collapsed.

Part 4
When Monetary Anchors Collapse
As monetary targeting broke down globally, central banks were pushed again into uncertainty, instability and regime change.

Part 5
Central Banking and Monetary Policy Regimes: The Indian Experience
How India’s trysts with crises, policy responses and changing gears in the development strategy imposed monetary policy regime shifts upon the RBI.

Part 6
Inflation Targeting and the Contract of Trust
From time inconsistency to flexible mandates, Michael Patra explains how inflation targeting became the world’s most durable monetary policy regime.

Part 7
India: Survival of the FITtest
From the Urjit Patel committee to the first MPC, Michael Patra traces how India designed, legislated and launched flexible inflation targeting.

Part 8
Lessons From India’s Inflation Targeting Decade
After a decade tested by a pandemic and war, Michael Patra distils four lessons from India’s flexible inflation-targeting framework. 

Part 9
The Plumbing in the Monetary Policy Architecture
Patra explains the plumbing of monetary policy, tracing how RBI liquidity management transmits the MPC’s repo rate through banks and money markets.

Part 10
How the RBI Manages Liquidity, From the LAF Corridor to Sterilisation and Beyond
Michael Patra explains how the RBI manages liquidity, from sterilisation and CRR operations to forecasting and the LAF corridor’s role in transmission.

Part 11
The Pipes: Monetary Policy Transmission
Setting the repo rate is only the start. Michael Patra explains how monetary policy reaches the economy and what gets lost along the way.