Open market operation is an important tool of liquidity management. OMOs are actively used to neutralize excess liquidity in the system and to contain wide fluctuations in the domestic money and foreign exchange markets. It is an actively used technique of monetary control in developed countries such as the UK, and USA. OMOs directly affect the availability and cost of credit. Its two objectives are (1) to influence the reserves of commercial banks, in order to control their power of credit creation and (2) to affect the market rates of interest.
OMOs involve the sale or purchase of government securities by the central bank, there by reducing the resources available with the banks for lending. The bank’s capacity to create credit, that is, give fresh loans depends upon its surplus cash, that is the amount of cash resources in excess of the statutory cash reserve ratio (CRR) stipulated by the Reserve bank. The open market sale of securities reduces the surplus cash resources of banks as these resources are used to purchase government securities. Banks have to contract their credit supply to generate some cash resources to meet the CRR. The supply of bank credit which involves the creation of demand deposit falls and money supply contracts. The reverse happens when the Reserve Bank undertakes open market purchase of government securities. The open market purchase for securities leads to a reduction in the stock of securities of the seller bank and an expansion in the free surplus cash which augments the credit creation capacity of banks. The result is an expansion in the supply of bank credit and an increase in money supply.
Open market operations do not after the total stock of government securities but change the proportion of government securities held by the Reserve Bank and commercial and cooperative banks. Open market sales result in a fall in net RBI credit to government (NRCG) and an increase in the other banks’ (cooperative and commercial) credit to government (OBCG) without affecting the budget (fiscal) deficit in anyway.
The Reserve Bank resorts to private placement when market conditions for government securities is not favorable and conducts open market sales later when liquidity conditions turn favorable. Thus, the Reserve Bank influences the resources position of banks, yields on government securities and cost of bank credit through the open market sale and purchase of government securities.
The Reserve Bank can buy or sell or hold government securities without any restrictions. The bank purchased and sold government securities up to 1991-92 out of the surplus funds of IDBI, Exim Bank, NABARD and other institutions under a special buy back arrangement. Till 1991-92 the market of open market operations was quite narrow as interest rates were administrated and the government securities market was not broad based ether. However, with the limitation of several measures to promote both primary and secondary markets in government securities the OMO markets have become active and OMOs have merged as an important tool of debt management. Accordingly various steps have been taken to alter the composition, maturity structure, and yield of government securities. The Reserve Bank also introduced the sale of securities from its own account on the basis of repo. Besides this, the bank offers for sale only a select number of securities which it wishes to undertake in response to market conditions, instead of maintaining a list including all dated securities in its portfolio. The Reserve Bank has also put on its purchase list a couple of securities for cash with a view to providing liquidity to at least a few securities.