Interference of central bank in markets, Financial Management

Interference of Central bank in Markets:

Some dilemmas exist in the issue of central bank intervention in the market to correct the volatilities in the prices. In some countries the central banks never interfere in the bond markets to even out the volatility in the bond market. Looking the other way, reduction of volatility in the market obstructs the progress of secondary markets as it rules out the development of hedging instruments, which in turn are used to offset volatility.

On the other hand, some instances justify the interference approach by central banks. For example, the incident on September 11, 2001 has sought the close intervention of the Federal Reserve in the market. India too, experienced many such circumstances and some as: border conflicts, US sanctions, and other exigencies where the RBI had shown its intent to intervene in the market. Hence the difference between the normal market conditions and external shocks should be taken into consideration while deciding about the interference of the central bank. If the exogenous shocks exist, interference or willingness to intervene may be required whereas in the normal market conditions the choice of intervention must be available, but the evolving forces in the market should guide its actual development.

Regarding the RBI's intervention policy, three important areas need mention. First, the liquidity management concern in the money market. The RBI does it through the Liquidity Adjustment Facility, operating an interest rate corridor in the rates of interest of the repo and reverse repo markets. Second, the RBI's responsibility of government debt makes the RBI intervene through private placement in the exceptional situations. That is, if RBI thinks that the market cannot provide entire borrowing without any disruption, it offers private placement. Third, if the auction bids of the treasury bills are unacceptable the RBI transfers to itself some amount of finance, which is called devolvement. Primary dealers underwrite the issues of government securities and receive commission. Thus, if the government requires funds due to high fiscal deficit and the market is not so liquid, the RBI intervenes to provide stability in the system. It is at its will to divest the securities it has taken through private placement.

The RBI also conducts operations to offset the external shocks in the forex markets, and also makes efforts to prevent the transmission of the effect to the bond market. Thus, whenever the RBI has taken monetary actions on the exchange market, expectations of liquidity action have risen in the bond markets.


Posted Date: 9/10/2012 7:47:33 AM | Location : United States

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