What are Open Market Operations – Benefits, Examples and How it is Conducted
The central bank of a country has various monetary tools at its disposal that allows it to control money and credit. Open market operations is one such tool that allows central banks to expand or contact liquidity in the market. This is often done in alignment with the government policies.
The monetary policy of open market operations was first introduced by the US Federal Reserve in 1961 to help the country’s economy recover from recession after the Korean War. The Reserve Bank of India (RBI) also uses OMOs to adjust rupee liquidity conditions.
The following sections will discuss open market operations in more detail.
What are Open Market Operations (OMO)?
Open market operations refer to a monetary policy where a central bank simultaneously buys and sells government securities and treasury bills to control liquidity. In other words, securities are traded to control the amount of money in the banking system, which influences a country’s economic conditions.
Central banks make these trades with other banks and decide how much to trade. It targets the key policy rate, known as the repurchase or repo rate in India, to determine how much it wants to trade. This theoretically also affects other interest rates in India’s economy.
So, open market operations change money supplies, which affects the supply of loans and change interest rates, affecting people’s demand for loans.
When the RBI thinks that there is excess liquidity in the country’s economy, it sells government securities. Due to its very large volume of sales, liquidity is soon sucked out. When liquidity conditions are tight, the RBI buys government securities, releasing liquidity into the market.
What are the Different Types of Open Market Operations (OMO)?
Essentially there are two types of open market operations:
1. Permanent Open Market Operations
In this type of OMO, a central bank directly purchases and sells government securities. Historically, such procedures have long-term benefits which could solve problems like inflation, unemployment, price fluctuation of currency in circulation, etc. Permanent OMO involves continuous sale of short-term securities without a specific limit.
2. Temporary Open Market Operations
This is typically done to meet short-term financial needs or temporarily meet reserve requirements. The RBI uses Repo or reverse repos for such conditions. With the promise to sell its assets later, a trading desk purchases a security from the central bank under a repo agreement.
The difference between purchase price and selling price serves as the interest rate on a security. It can also be considered as a short-term collateralised loan by the central bank.
In a reverse repo, the trading desk sells the security to a bank’s central office with the promise to purchase it later. Overnight such transient open market operations are conducted using repos and reverse repos.
Also Read: What is Investment Banking and Who are Investment Bankers?
How are Open Market Operations Conducted?
Based on the prevailing economic conditions of a country, its central bank can take two different steps that are a part of the open market operations:
Step 1: Buying Government Bonds from Banks
A country’s central bank buys government bonds when the country is going through a recession and has an increased unemployment rate. It aims to increase the money supply in a country’s economy and lower the interest rate.
The central bank purchases government bonds or securities that the government issues, increasing the supply of the bank reserves. These new funds offer banks the power to grant more loans.
When market interest rates decrease, consumption and investment spending of people automatically increases. As a result, loans become easier to access, allowing more businesses to start and expand. This also lowers the opportunity cost of banks loaning reserves to other banks.
Thus, the purchase of government bonds from banks raises an economy’s real GDP; as a result, this approach is also known as expansionary monetary policy.
Step 2: Selling Government Bonds to Banks
When a country’s economy is experiencing high levels of inflation, the central bank sells government bonds to banks. This way, the central bank reduces the excess money in the market.
As a result, there is a decrease in the money supply, and interest rates increase. Due to this, people stop taking expensive loans and investing money in shares causing a drastic downfall in investments and overall consumption.
Since aggregate demand falls, the country’s real GDP could fall as well. This also decreases the supply of bank reserves. This method is also called contractionary open market operations.
Examples of Open Market Operations
In India, the Reserve Bank of India conducts open market operations to regulate the supply and flow of income in the Indian economy. An open market operations example in India would be when the RBI had undertaken this activity for the first time in India’s history in 2019.
The Reserve Bank of India sells and buys government bonds from G-Secs to and from the open market. The primary goal is to maintain viable rupee liquidity conditions in the market. When the RBI observes that the market has more than enough liquidity, it sells securities, reducing rupee liquidity. On the other hand, when the central bank feels that liquidity is scarce, it purchases G-secs on the open market.
What are the Advantages of Open Market Operations?
The main advantages of open market operations are as follows:
- This tool allows the central bank considerable flexibility in the timing and scope of monetary policy activities.
- Open market operations also allow the government to avoid the economic effects and market inefficiencies of more direct control measures.
- The central bank can maintain inflation at a certain range, which allows for steady growth while preventing an uncontrolled increase in the prices of goods and services.
- When buyers of bonds deposit their money to a central bank, it increases its reserve while lowering the capacity of banks to offer credit.
- It also allows the central bank to control the money supply in the economy directly. Using OMO, adequate liquidity can be maintained in the banking system, and excess liquidity prevented.
- This monetary policy tool also helps to check the value of the domestic currency against foreign currencies.
What are the Disadvantages of Open Market Operations?
Some of the disadvantages of open market operations are:
- There is a lack of a well-developed securities market for this instrument to work successfully and on a larger scale.
- A significant limitation of this tool is restricted dealings, as most countries’ central banks are not well prepared to handle losses. That is why they deal with short-term securities, as there will be relatively minor losses.
- There is a considerable difference between bank rates and open market operations. This leads to the possibility of replenishing the reserves faster than planned.
- Central banks usually face many difficulties in executing this activity. Buying government securities tends to be far more complex than selling them.
- Another major disadvantage of open market operations is that when it affects a significant number of securities, it could have a negative impact on banks’ assets. This also disrupts the government’s borrowing programme.
Important Points to Know about Open Market Operations
Some points to keep in mind about open market operations are:
- The RBI uses this tool to influence and regulate the repo rate that interbank loans use.
- The RBI purchases more securities and adds more money to the country’s economy to recover it from a recession.
- The central bank sells these securities when it wants to balance or decrease the flow of money in the market.
- The majority of government bonds are bought from the RBI by commercial banks, other financial companies and large business organisations.
- Open market operations have a significant effect on the deposits, reserves and credit-providing ability of banks.
- All RBI-regulated entities must hold government securities in a dematerialised format.
Also Read: What is NACH in Banking and How to Set-up a NACH Mandate?
Final Word
Open market operations affect the bank’s reserves, deposits, and capacity to extend credit. It is an essential tool for a central bank to balance growth and inflation in the economy. The RBI conducts open market activities in collaboration with commercial banks. However, the public is not involved in carrying out such operations.
Commercial banks, financial institutions, high networth individuals, and major enterprises are the primary purchasers of government bonds. These organisations have bank accounts, and each time they buy the bonds, the money is sent back to the RBI.
FAQs
Ans: The LAF is a facility that the RBI provides to the scheduled commercial banks and primary dealers (apart from regional rural banks or RRBs), allowing them to park excess funds. Commercial banks can do this if there is an excess of liquidity on an overnight basis in exchange for G-Securities, including state development loans (SDLs), as collateral. The LAF essentially makes it possible to control liquidity daily.
Ans: In a notification published in 2018, the RBI had stated that it would make Repurchase Transactions applicable to all eligible individuals. They can join or transact business in market repurchase transactions (repos).
Furthermore, the RBI permits re-repo of government securities to scheduled commercial banks, mutual fund companies and primary dealers. They have to maintain a Subsidiary General Ledger account with the RBI.
Ans: A bond is a type of debt instrument in which an investor lends money to a borrower, generally a corporation or government. The entity has to return the money after a predetermined period at a fixed or variable interest rate.
Companies, communities, states, and sovereign governments can sell bonds to raise money and finance various initiatives and endeavours. Owners of bonds are the issuer’s creditors or debt holders.
Ans: Treasury bills are certain money market instruments which the Indian government issues. They are available in three tenors: 91 days, 182 days, and 364 days. Treasury bills have no coupon and pay no interest. The RBI instead issues it at a discount, and one can redeem them at face value at maturity.
Ans: A market stabilisation scheme involves selling of securities and bonds, as opposed to open market operations, which include purchasing and selling government securities. The RBI carries out a market stabilisation scheme for a short period, usually less than six months, unlike open market operations.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
