*Last edited: 4-April-2025*
> Tags: #mss #sterlisation
>[!success] Table of Contents: Market Stabilisation Scheme (MSS)
>- [[#Capital Flows & Sterlisation]]
>- [[#Impact on Government's Account]]
>- [[#Cost of Sterlisation]]
>- [[#Resources]]
## Capital Flows & Sterlisation:
1. Around the end of 2003, when Dr. Y.V Reddy had joined as Governor. He looked at the macroeconomic parameters and RBI anticipated large capital inflows. During the late 2003 to early January 2004, two Groups were constituted in the RBI, one was on the issue of sterilisation and the other was for review of liquidity adjustment facility (LAF). The draft reports of these two Technical Groups and their deliberations were placed in the public domain on the RBI website and were intensely debated.
2. Between 2002-2004, when India received large capital inflows, RBI intervened and bought this foreign exchange form the open market because of the impact of capital flows on exchange rate and the real economy. Strengthening of local currency makes exports receive lesser rupees for the dollars they get for the exported goods. Exporters then tend to raise prices in such situations which makes their goods/services “non-competitive” in nature.
1. The world had entered into an era of abundant dollar liquidity with the Fed Fund Target rate falling from 6.5% in January 2001 to 1.75% in January 2002, then to 1.25% in January 2003 and finally, to 1% by July 2003.
2. It is a different thing that seeds of a crisis (GFC of 2008) that would overtake the global financial system five years later were allegedly being sown and nurtured by the overhang of cheap global liquidity
3. RBI can't simply restrict capital inflows through capital control measures as the inflows help shore up its reserves. Imposing restrictions could create negative expectations among foreign investors.
4. RBI has adopted a managed float currency regime wherein it intervenes to contain excessive movements/volatility in the exchange rate, like one happening due to exogenous capital inflows
5. This was also increasing the supply of money (currency in circulation/permanent reserves/liabilities of RBI) in the market. The increased liquidity was having an inflationary effect.
6. But it was not be consistent with the monetary and liquidity conditions required for RBI's two objectives of growth and price stability.
7. **==Related Notes==**
1. Arguments for/against capital flows in [Capital Flows - Account & Management](Capital%20Flows%20-%20Account%20&%20Management.md)
2. Managing Capital Flows in [Capital Flows - Account & Management](Capital%20Flows%20-%20Account%20&%20Management.md#Managing%20Capital%20Inflows)
3. Methods of Sterilisation in [Forex Market Interventions and Sterilisation](Forex%20Market%20Interventions%20and%20Sterilisation.md)
8. Thus, there was need to absorb “excess liquidity”. **This is called sterlisation and it is an important tool for conduct of monetary policy for a central bank which can expect exogenous capital flows.**
9. **Depletion of holdings of G-Secs:**
1. The initial burden of sterilisation was borne by the outright open market sale of dated securities and treasury bills. However, due to the depletion in the stock of [[G-Secs-Primary Market]], the burden of liquidity adjustment shifted to LAF as RBI was not permitted under the Act to issue central bank securities. ==It is to be noted that the [[Liquidity Adjustment Facility (LAF)]] was essentially designed to handle marginal liquidity surpluses/deficits, that is to manage temporary mismatches in liquidity on a day-to-day basis, and not large absorption or injection. But it did happen in 2003-04.
2. This resultant decline in net domestic assets (NDA) due to rise in Net Forex Assets (NFA) could lead to *collateral constraints* to the Reserve Bank’s market-based liquidity absorption operations, that is outright sales of securities and reverse repo auctions.
3. Also, under conditions of persistently large surplus liquidity, this constraint could become binding.
4. Stock of government securities was also needed for investments of surplus balances of the Central Government, besides investments by the State Governments in respect of earmarked funds (CSF/GRF).
5. Consolidated Sinking Fund (CSF), and Guarantee Redemption Fund (GRF) are reserve funds maintained by state governments with RBI as a cushion for states in case of financial difficulties, particularly when facing debt obligations or invoking guarantees, which invest in G-secs to ensure safety and returns.
10. Nov 2003 - Report of the [Internal Group on Liquidity Adjustment Facility](RBI_Group-Committee_20031202_Report%20of%20the%20Internal%20Group%20on%20Liquidity%20Adjustment%20Facility.pdf) was published.
1. [Box VIII.2 - Internal Group on Liquidity Adjustment Facility](RBI_Annual%20Report_2004.pdf#page=133&selection=60,0,61,47) in RBI's Annual Report-2004
2. [Box 3.2 Internal Group on Liquidity Adjustment Facility (2003)](RBI_History%20of%20The%20Reserve%20Bank%20of%20India%20(1997-2008)_Volume%20V.pdf#page=89&selection=3,0,5,58) in History of The Reserve Bank of India (1997-2008)-Volume V
11. December 02, 2003- ==A working group (Chairperson: Smt. Usha Thorat) submitted its **[report](https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?ID=342)** on Instruments of [[Forex Market Interventions and Sterilisation|Sterilization]] on December 02, 2003.==
12. Both the reports paved the way for the introduction of the Market Stabilisation Scheme (in March 2004).
> It was clear that RBI did not have sufficient holdings of govt. securities to absorb such large capital flows, and the FRBM act was expected to further reduce them. An attempt to conduct OMOs for such an absorption would have also impacted interest earnings of RBI on its debt portfolio. A large number of countries, such as Chile, China, Colombia, Indonesia, Korea, Malaysia, Peru, Philippines, Russia, Sri Lanka, Taiwan and Thailand have issued central bank securities. **As a prudential requirement, the RBI is prohibited from issuing its own securities.**
> However, the central banks of many of these countries faced deterioration in their balance sheets due to this practice of taking quasi fiscal cost on their balance sheet. Although these central banks operate autonomously, the consequences were erosion of capital and subsequent recourse to the government for infusion of capital.
13. Thus there was a need for scheme aimed that could improve monetary policy that was expected to lose its efficacy in the face of limited holdings of govt. securities to sterilise liquidity arising from large capital inflows that required intervention in the foreign exchange markets.
14. Following the recommendations contained in the Report, there was a lengthy discussion on the required changes in the monetary policy framework and the related issues.
15. Subsequently, the government of India acknowledged ==the need to strengthen the Reserve Bank in its ability to conduct exchange rate and monetary management operations in a manner that would maintain stability in the foreign exchange market and enable it to conduct monetary policy in accordance with its stated objectives.==
16. [February 23, 2004](RBI_Press%20Release_20040223_Launching%20of%20Market%20Stabilisation%20Scheme.pdf) - RBI announced the launching of the Market Stabilisation Scheme, on the basis of the recommendations of the Working Group on the Instruments of Sterilisation.
17. <span style="background-color:#F0FFFF;">In April 2004, when YV Reddy was the governor of RBI, after an [MoU](https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=9886) between RBI and the Government of India was signed on March 25, 2004, the MSS scheme was launched.</span>
1. May 18, 2004 - MSS Scheme as mentioned in [Annual Policy Statement for 2004-05](RBI_MPS_20040518_Annual%20Policy%20Statement%20For%20The%20Year%202004-05.pdf)
2. It allowed RBI to issue a separate ==short-term Government of India dated securities, treasury bills or cash management bills==. The dated securities/treasury bills are same as those issued for normal market borrowings. They are issued through normal auction process using e-kuber system. They can be traded in secondary markets.
3. The issuance of these securities helped RBI to mop up excess liquidity, the one of enduring nature, beyond what was absorbed under outright OMOs and under the day-to-day reverse repo operations of LAF.
4. The MoU decided to fix an annual limit for MSS operations. The limit would be decided by mutual consent between RBI and the Finance Ministry, Government of India for each, before the start of the financial year, based on the expected liquidity conditions and assessment of the [[Liquidity Adjustment Facility (LAF)#^fb61a9|durable]] liquidity.
**Why was there a need for govt. to decide the limit for MSS?**
1. ==Given larger public policy implications *(i.e., it affects inflation, exports, capital flows, and growth)* of the exchange rate in the Indian context (Reddy, 2008), it was deliberated whether it was desirable for the central bank alone to take a view on the extent of sterilisation. After considerable debate between and within Government and RBI, it was agreed in march 2004, that the limit for Market Stabilisation Scheme (MSS) would be prescribed by the Government from time to time in the light of proposals from RBI.
2. This implied that by prescribing the limits for the MSS, the Government was recognizing the fiscal cost that it was ready to bear in the context of external sector management.
5. Whenever such securities are issued by the Reserve Bank for the purpose of market stabilisation and sterilisation, a press release at the time of issue would indicate such purpose.
18. [==March 2, 2007](RBI_Press%20Release_20070302_Liquidity%20Management%20–%20Modified%20Arrangements.pdf) - MSS scheme was modified==
19. **However, in 2016, it was also used to sterlise the excess liquidity from demonetisation. Hence, MSS operations are used as sterilization tool used for “offsetting rupee liquidity”.
20. ==So along with LAF operations (for marginal/temporary liquidity), MSS and regular Open Market Operations (OMOs through auctions or on NDS-OM) including buybacks/redemptions, forex operations and CRR/SLR adjustments *(rarely)* would together help RBI to absorb durable liquidity.
21. In other words, RBI has been conducting liquidity management largely through the LAF, which is intended as a window for adjusting day-to-day liquidity mismatches, and the Market Stabilisation Scheme (MSS), which is used for addressing large swings in liquidity conditions which could have a more durable character
22. But the intention of introducing MSS is essentially to differentiate the liquidity absorption of a more enduring nature by way of sterilisation from the day-to-day normal liquidity management operations.
23. Timeline [^1]
1. 2004-05: With large capital inflows in October 2004, the ceiling under the MSS was increased from the initial Rs.60,000 crores to Rs.80,000 crores on October 14, 2004. As at end March 2005, the liquidity absorbed through the MSS was Rs.64,211 crores.
2. 2005-06: After November 2005, a strong demand for credit was seen and hence liquidity was in injection mode. Thus, balance under MSS reduced to Rs. 29,652 crores at end March 2006. MSS helped RBI to manage liquidity deficit.
3. 2006-07: Capital inflows continued in 2006-07 and the balances under MSS increased from Rs.29,063 crores at end-March 2006 to Rs. 62,974 crores at end-March 2007.
4. 2007-08: The ceiling for MSS was increased 4 four times from the initial Rs. 80,000 crores in April 2007 to Rs. 2,50,000 crores on on November 7, 2007. Outstanding balances under the MSS increased from Rs. 62,974 crores at end-March 2007 to Rs. 1,68,392 crores at end-March 2008.
5. Dec 1, 2016 - Reserve Bank of India [raised](https://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=38766) the ceiling for outstanding balance under MSS 20 times the initial [limit](https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=37297) of Rs 30,000 crore to Rs 6 lakh crore. This was to absorb excess funds from the banking system after the government’s step to demonetise few currency notes led to huge deposits with bank.
**MSS Balances (Rs. billion)**
| Type of Amount | **2004-05** | **2005-06** | **2006-07** | **2007-08** |
| ------------------ | ----------- | ----------- | ----------- | ----------- |
| Interest Payments | 20.6 | 34.2 | 26.1 | 83.5 |
| Outstanding Amount | 642.1 | 290.6 | 629.7 | 1,683.9 |
Note: MSS Outstanding balance as on July 11, 2008 was Rs. 1,714.8 billion.
<sub>Source [^2] : Union Finance Accounts, Union Budget Documents and Reserve Bank of India</sub>
9. 14. **Two other benefits of MSS scheme:**
1. **Liquidity support with redemption/buyback**
1. In the aftermath of financial crisis in 2008-09, redemption/buyback under MSS lead to injection large amount of liquidity of durable nature into the economy. Liquidity dried up and it justified boosting liquidity.
2. **Budgetary support way of transfer of balances:**
2. Both RBI and the govt. took measures to move the liquidity from deficit to surplus mode.
3. The existing MoU of 2004 on the MSS was amended in February 2009.
4. With this, ==a part of MSS balances were transferred to the government to help with stimulus expenditure. During 08-09 and 09-10, govt. had large borrowings.== Now this amount, if it was borrowed from public would have pushed up yields further and also increase the borrowing costs for govt. and private borrowers.
5. A total of Rs. 45,000 crores were transferred in separate instalments by March 31, 2009.
3. [[Liquidity Adjustment Facility (LAF)|LAF]] was restored to its intended function of daily liquidity management.
10. MSS securities are treated as eligible securities for the SLR, market repos and LAF.
11. As such, the MSS considerably enhanced the degree of freedom for monetary policy. It became a tool to conduct exchange rate and monetary management operations - a tool which could be used flexibly to both absorb and impart liquidity later when needed.
12. Thus, In India, in addition to various market-based instruments of sterilization have been used such as, LAF, OMO, MSS, balances of Government of India with the Reserve Bank, [[Forex Swaps]] and private placements for pre-payment of external loans, increasing the cash reserve ratio for banks.
## Impact on Government's Account
1. This cash received from issuances of MSS bonds were sequestered in a **separate account** maintained and operated by RBI. So these MSS balances are **NOT** part of the general government cash account at RBI.
2. It could not be used by Government and hence did not form part of its borrowing. Similarly, redemption of these bonds would not lead to any additional demand of funds from Government
1. Only in 2009, some funds were transferred to govt., due to the increased govt. spending/stimulus in response to the global financial crisis of 2008. It was done by an amendment to the original MoU in Feb-2009. This is called de-sequestering of the MSS balances.
2. All the costs of the scheme are incurred by the GoI. The major cost involved in MSS scheme would be in the form of discounts and interest payments on the outstanding bonds. So the impact for government on revenue and fiscal balances was only to the extent of interests and premiums/discounts.
3. Payment of interests/discount is not made from this account but by GoI. Also receipts of interest accrued on cash balances/premium is also not credited to this account.
4. Thus, the amounts credited into the MSS cash Account are appropriated only for the purpose of redemption and / or buy back of the Treasury Bills and / or dated securities issued under the MSS.
5. These receipts and payments, and thus the overall fiscal cost attributable to sterilisation of capital flows through the mechanism of MSS, are clearly shown in the government’s budget, which adds to fiscal transparency.
6. This helps RBI to measure cost of sterilization in a transparent manner.
7. South Korea had also used a similar instrument but its operational procedure was different.
## Reserve Money
1. When RBI buys dollars, the banks’ balances with RBI increases, and so does the reserve money.
2. To sterilise, RBI issues MSS bonds, and money moves from banks to Govt MSS account. The reserve money falls, offsetting the earlier increase in reserve money.
3. So "Excess reserves with RBI - these are banks’ balances in their current accounts with RBI" fall (liabilities side of the reserve money equation), and govt balances with RBI increases, that is the Net RBI credit to the government falls.
4. Thus, the MSS issuance and redemption have the same impact on reserve money (and system-level durable liquidity) as outright OMOs.
>Further Reading
>==1. [Box 1.2 Market Stabilisation Scheme](RBI_Annual%20Report_2004.pdf#page=11&selection=86,0,86,27) in the Annual Report 2004
>2. [Market Stabilisation Scheme](RBI_History%20of%20The%20Reserve%20Bank%20of%20India%20(1997-2008)_Volume%20V.pdf#page=91&selection=74,0,74,27) in History of The Reserve Bank of India (1997-2008)_Volume V
## Cost of Sterlisation
1. The cost is positive because of the lower interest rates abroad and higher domestic rates.
2. Here the cost can be considered as the difference between the amount of interest paid on securities issued under MSS scheme and the interest earned from the equivalent amount of foreign exchange.
3. As RBI transfers its surplus profits to govt., a high cost of sterilisation can have impact on government's fiscal position.
4. There is also a carrying cost of reserves:
1. However, to assume that whenever central bank accumulates reserves it has an adverse impact on the balance sheet, may, however, not turn out to be universally right.
2. For instance, till 2007, China’s domestic interest rates were lower than the return on foreign currency assets. In that case, the carrying cost of reserves was negative for the Chinese central bank, resulting in a quasi fiscal benefit.
5. Thus the carrying cost and cost of sterlisation, which are positive (for India), also called the fiscal or quasi-fiscal cost for adding reserves and holding to them.
6. In other words, holding reserves have a fiscal policy element, and hence public policy implications.
## Benefits of holdings forex Reserves
1. ==Holding reserves have benefits too, and hence the cost of reserves is more of an opportunity cost.==
2. Valuation of forex reserves is done on a marked-to-market basis on the balance sheet of RBI. An appreciation of the reserve currency translates into losses. But in some senses one can argue that such loss is notional. Again, every central bank has different ways of accounting. *Most of the central banks and, definitely, the RBI, adopt a conservative accounting practice so that un-realised gains are not shown*.
3. The issue here is how one calculates the cost of holding reserves or even “excess” reserves.
1. Since this is essentially an opportunity cost [(Reddy, 2008)](https://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=393), the only way that it can be calculated reasonably is in terms of interest rates on local currency assets vis-à-vis those for foreign currency assets.
4. Why still many central banks add reserves or are holding on to them? This is because there are macroeconomic benefits, which unfortunately are not quantifiable. They are:
1. One, it enhances the confidence in the economy, particularly of the emerging market economies and results in a better sovereign rating. This, in turn, translates into finer spreads at which both public and private sector can raise money.
2. Two, it enhances the capacity to absorb shocks. The shocks can be of two types: the real sector shocks in terms of oil shocks, food grain shock or both of them and the financial shocks in terms of the financial flows. On both, the real sector and the financial sector, there is scope for smoothening volatility when there are adequate reserves.
3. However, whether some excess volatility can be moderated in order to avoid the de-stabilising effects on growth and employment, is arguably another fundamental issue.
4. Therefore, we have to recognise not only the costs – which may be negative or positive – which are quantifiable but also the benefits which are not quantifiable.
# Related Notes
1. Arguments for/against capital flows in [Capital Flows - Account & Management](Capital%20Flows%20-%20Account%20&%20Management.md)
2. Managing Capital Flows in [Capital Flows - Account & Management](Capital%20Flows%20-%20Account%20&%20Management.md#Managing%20Capital%20Inflows)
3. Methods of Sterilisation in [Forex Market Interventions and Sterilisation](Forex%20Market%20Interventions%20and%20Sterilisation.md)
4. [[Financial Stability-Issues and Challenges - By Duvvuri Subbarao, 2009]]
5. [[Fiscal-Monetary Co-ordination in India - An Assessment 2013 OPEN]]
6. [[G-Secs-Primary Market]]
7. [[Liquidity Adjustment Facility (LAF)]]
8. [[Money Market Operations (MMO)]]
9. [[Open Market Operations (OMOs)]]
# References
1. RBI. (2003, Dec). [Report]((https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?ID=342)of the Working Group on Instruments of Sterilisation (Chairperson: Usha Thorat). [pdf](RBI_Group-Committee_20031212_Report%20of%20the%20Working%20Group%20on%20Instruments%20of%20Sterilisation.pdf) | [Summary of the Report](RBI_Group-Committee_20031202_Summary%20of%20the%20Report%20of%20the%20Working%20Group%20on%20Instruments%20of%20Sterilisation.pdf)
2. [Launching](https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=9788) of Market Stabilisation Scheme-Feb 23, 2004
3. [Memorandum of Understanding for Launching of the Market Stabilisation Scheme-Mar 25, 2004](https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=9886)
4. Reddy, Y. V. (2008, May 26). _[Fiscal policy and economic reforms](https://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=393)_ [Speech transcript]. Reserve Bank of India. [Link](https://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=374)
[^1]: Market Stabilisation Scheme and Management of Liquidity in the Period of Volatile Capital Inflows: The Indian Experience. A research [article](https://saudijournals.com/media/articles/SJEF_77_344-350.pdf) by Abhijit Pathak
[^2]: [Capital Flows to India](https://m.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=406) - Paper presented by Rakesh Mohan, Deputy Governor, Reserve Bank of India on February 1, 2008 at the annual meeting of Deputy Governors held at the Bank for International Settlements, Basel.