What is RBI's Monetary Policy?

Salil Panchal/Morpheus Inc.

The Reserve Bank of India will announce its Monetary and Credit Policy for
the first half of the financial year 2002-03 on Aril 2!" #ven as RBI $overnor
Bi%al &alan uts the finishin' touches to the docu%ent( have you ever considered what is
the si'nificance of the )iannual e*ercise+
In a world of olicies in the financial sector( nothin' could 'et as alien as the Monetary
Policy" Ter%s like M3( CRR( ,-R( P-R and .M. would %ake you think that the tyical
IT-)u' has cau'ht the financial sector" But take a closer look as the Monetary and Credit
Policy is crucial to all of us and %ore so to the )ankin' sector"
/or the uninitiated( this olicy deter%ines the suly of %oney in the econo%y and the
rate of interest char'ed )y )anks" The olicy also contains an econo%ic overview and
resents future forecasts"
What is the Monetary Policy?
The Monetary and Credit Policy is the olicy state%ent( traditionally announced twice a
year( throu'h which the Reserve Bank of India seeks to ensure rice sta)ility for the
econo%y"
These factors include - %oney suly( interest rates and the inflation" In )ankin' and
econo%ic ter%s %oney suly is referred to as M3 - which indicates the level 0stock1 of
le'al currency in the econo%y"
Besides( the RBI also announces nor%s for the )ankin' and financial sector and the
institutions which are 'overned )y it" These would )e )anks( financial institutions( non-
)ankin' financial institutions( 2idhis and ri%ary dealers 0%oney %arkets1 and dealers in
the forei'n e*chan'e 0fore*1 %arket"
When is the Monetary Policy announced?
3istorically( the Monetary Policy is announced twice a year - a slack season olicy
0Aril-,ete%)er1 and a )usy season olicy 0.cto)er-March1 in accordance with
a'ricultural cycles" These cycles also coincide with the halves of the financial year"
Initially( the Reserve Bank of India announced all its %onetary %easures twice a year in
the Monetary and Credit Policy" The Monetary Policy has )eco%e dyna%ic in nature as
RBI reserves its ri'ht to alter it fro% ti%e to ti%e( deendin' on the state of the econo%y"
3owever( with the share of credit to a'riculture co%in' down and credit towards the
industry )ein' 'ranted whole year around( the RBI since 4!!5-!! has %oved in for 6ust
one olicy in Aril-end" 3owever a review of the olicy does take lace later in the year"
CREDIT
POLICY
How is the Monetary Policy different from the Fiscal Policy?
Two i%ortant tools of %acroecono%ic olicy are Monetary Policy and /iscal Policy"
The Monetary Policy re'ulates the suly of %oney and the cost and availa)ility of credit
in the econo%y" It deals with )oth the lendin' and )orrowin' rates of interest for
co%%ercial )anks"
The Monetary Policy ai%s to %aintain rice sta)ility( full e%loy%ent and econo%ic
'rowth"
The Reserve Bank of India is resonsi)le for for%ulatin' and i%le%entin' Monetary
Policy" It can increase or decrease the suly of currency as well as interest rate( carry out
oen %arket oerations( control credit and vary the reserve re7uire%ents"
The Monetary Policy is different fro% /iscal Policy as the for%er )rin's a)out a chan'e
in the econo%y )y chan'in' %oney suly and interest rate( whereas fiscal olicy is a
)roader tool with the 'overn%ent"
The /iscal Policy can )e used to overco%e recession and control inflation" It %ay )e
defined as a deli)erate chan'e in 'overn%ent revenue and e*enditure to influence the
level of national outut and rices"
/or instance( at the ti%e of recession the 'overn%ent can increase e*enditures or cut
ta*es in order to 'enerate de%and"
.n the other hand( the 'overn%ent can reduce its e*enditures or raise ta*es durin'
inflationary ti%es" /iscal olicy ai%s at chan'in' a''re'ate de%and )y suita)le chan'es
in 'overn%ent sendin' and ta*es"
The annual 8nion Bud'et showcases the 'overn%ent9s /iscal Policy"
What are the objectives of the Monetary Policy?
The o)6ectives are to %aintain rice sta)ility and ensure ade7uate flow of credit to the
roductive sectors of the econo%y"
,ta)ility for the national currency 0after lookin' at revailin' econo%ic conditions1(
'rowth in e%loy%ent and inco%e are also looked into" The %onetary olicy affects the
real sector throu'h lon' and varia)le eriods while the financial %arkets are also
i%acted throu'h short-ter% i%lications"
There are four %ain 9channels9 which the RBI looks at:
;uantu% channel: %oney suly and credit 0affects real outut and rice level
throu'h chan'es in reserves %oney( %oney suly and credit a''re'ates1"
Interest rate channel"
#*chan'e rate channel 0linked to the currency1"
Asset rice"
ll this is more lin!ed to the ban!in" sector# How does the Monetary Policy im$act
the individual?
In recent years( the olicy had 'ained in i%ortance due to announce%ents in the interest
rates"
#arlier( deendin' on the rates announced )y the RBI( the interest costs of )anks would
i%%ediately either increase or decrease"
A reduction in interest rates would force )anks to lower their lendin' rates and )orrowin'
rates" ,o if you want to lace a deosit with a )ank or take a loan( it would offer it at a
lower rate of interest"
.n the other hand( if there were to )e an increase in interest rates( )anks would
i%%ediately increase their lendin' and )orrowin' rates" ,ince the rates of interest affect
the )orrowin' costs of cororates and as a result( their )otto%lines 0rofits1( the %onetary
olicy is very i%ortant to the% also"
But over the ast 2-3 years( RBI $overnor Bi%al &alan has referred not to
wait for the Monetary Policy to announce a revision in interest rates and
these revisions have )een when the situation arises"
,ince the financial sector refor%s co%%enced( the RBI has %oved
towards a %arket-deter%ined interest rate scenario" This %eans that )anks
are free to decide on interest rates on ter% deosits and loans"
Bein' the central )ank( however( the RBI would have a say and deter%ine direction on
interest rates as it is an i%ortant tool to control inflation"
The )ank rate is a tool used )y RBI for this urose as it refinances )anks at the this rate"
In other words( the )ank rate is the rate at which )anks )orrow fro% the RBI"
How was the scenario $rior to recent liberalisation?
Prior to recent li)eralisation( the RBI resorted to direct instru%ents like interest rates
re'ulation( selective credit control and CRR 0cash reserve ratio1 as %onetary instru%ents"
.ne of the risks e%er'in' in the ast <-= years 0throu'h the caital flows and
li)eralisation of the financial sector1 is that otential risk has increased for institutions"
Thus( financial sta)ility has )eco%e crucial and there are concerns relatin' to credit flows
to the a'ricultural sector and s%all-scale industries"
What do the terms %RR and &'R mean?
CRR( or cash reserve ratio( refers to a ortion of deosits 0as cash1 which )anks have to
kee>%aintain with the RBI" This serves two uroses" It ensures that a ortion of )ank
deosits is totally risk-free and secondly it ena)les that RBI control li7uidity in the
syste%( and there)y( inflation"
Besides the CRR( )anks are re7uired to invest a ortion of their deosits in 'overn%ent
securities as a art of their statutory li7uidity ratio 0,-R1 re7uire%ents"
The 'overn%ent securities 0also known as 'ilt-ed'ed securities or 'ilts1 are )onds issued
)y the Central 'overn%ent to %eet its revenue re7uire%ents" Althou'h the )onds are
lon'-ter% in nature( they are li7uid as they can )e traded in the secondary %arket"
,ince 4!!4( as the econo%y has recovered and sector refor%s increased( the CRR has
fallen fro% 4< er cent in March 4!!4 to <"< er cent in ?ece%)er 2004" The ,-R has
fallen fro% 35"< er cent to 2< er cent over the ast decade"
What im$act does a cut in %RR have on interest rates?
/ro% ti%e to ti%e( RBI rescri)es a CRR or the %ini%u% a%ount of cash that )anks
have to %aintain with it" The CRR is fi*ed as a ercenta'e of total deosits" As %ore
%oney chases the sa%e nu%)er of )orrowers( interest rates co%e down"
(oes a chan"e in &'R and "ilts $roducts im$act interest rates?
,-R reduction is not so relevant in the resent conte*t for two reasons:
/irst( as art of the refor%s rocess( the 'overn%ent has )e'un )orrowin' at %arket-
related rates" Therefore( )anks 'et )etter interest rates co%ared to earlier for their
statutory invest%ents in 'overn%ent securities"
,econd( )anks are still the %ain source of funds for the 'overn%ent"
This %eans that desite a lower ,-R re7uire%ent( )anks9 invest%ent in 'overn%ent
securities will 'o u as 'overn%ent )orrowin' rises" As a result( )ank invest%ent in 'ilts
continues to )e hi'h desite the RBI )rin'in' down the %ini%u% ,-R to 2< er cent a
coule of years a'o"
Therefore( for the urose of deter%inin' the interest rates( it is not the ,-R re7uire%ent
that is i%ortant )ut the si@e of the 'overn%ent9s )orrowin' ro'ra%%e" As 'overn%ent
)orrowin' increases( interest rates( too( rise"
Besides( 'ilts also rovide another tool for the RBI to %ana'e interest rates" The RBI
conducts oen %arket oerations 0.M.1 )y offerin' to )uy or sell 'ilts"
If it feels interest rates are too hi'h( it %ay )rin' the% down )y offerin' to )uy securities
at a lower yield than what is availa)le in the %arket"
How does the Monetary Policy affect the domestic industry and e)$orters in
$articular?
#*orters look forward to the %onetary olicy since the central )ank always %akes an
announce%ent on e*ort refinance( or the rate at which the RBI will lend to )anks which
have advanced re-shi%ent credit to e*orters"
A lowerin' of these rates would %ean lower )orrowin' costs for the e*orter"
*he stoc! mar!ets and money move similarly+ in some ways# Why?
Most eole attri)ute the link )etween the a%ount of %oney in the econo%y and
%ove%ents in stock %arkets to the a%ount of li7uidity in the syste%" This is not entirely
true"
The factor connectin' %oney and stocks is interest rates" Peole save to 'et returns on
their savin's" In true %arket conditions( this %ade )ank deosits or )onds 0whose returns
are linked to interest rates1 and stocks 0whose returns are linked to caital 'ains1(
co%etitors for eole9s savin's"
A hike in interest rates would tend to suck %oney out of shares into )onds or deositsA a
fall would have the oosite effect" This ar'u%ent has survived econo%etric tests and
ractical e*erience"
Is the money su$$ly related to jobs+ wa"es and out$ut?
At any oint of ti%e( the rice level in the econo%y is deter%ined )y the a%ount of
%oney floatin' around" An increase in the %oney suly - currency with the u)lic(
de%and deosits and ti%e deosits - increases rices all round )ecause there is %ore
currency %ovin' towards the sa%e 'oods and services"
Tyically( the RBI follows a least-inflation olicy( which %eans that its %oney %arket
oerations as well as chan'es in the )ank rate are 'enerally desi'ned to %ini%ise the
inflationary i%act of %oney suly chan'es" ,ince %ost eole can 'enerally see
throu'h this strate'y( it li%its the i%act of the RBI9s %onetary %oves to affect 6o)s or
roduction"
The %arkets( however( %ove to the RBI9s tune )ecause of the link )etween interest rates
and caital %arket yields" The RBI9s olicies have %a*i%u% i%act on volatile forei'n
e*chan'e and stock %arkets"
&o)s( wa'es and outut are affected over the lon' run( if the trends of hi'h inflation or
low li7uidity ersist for very lon' eriod"
If wa'es %ove slower than other rices( hi'her inflation will drive real wa'es lower
and encoura'e e%loyers to hire %ore eole" This in turn ra%s u roduction and
e%loy%ent"
This was the theoretical 6ustification of a lon'-ter% trend that showed that hi'her
inflation and e%loy%ent went to'etherA when inflation fell( une%loy%ent increased"
What are the measures to re"ulate money su$$ly?
The RBI uses the interest rate( .M.( chan'es in )anks9 CRR and ri%ary lace%ents of
'overn%ent de)t to control the %oney suly" .M.( ri%ary lace%ents and chan'es in
the CRR are the %ost oular instru%ents used"
8nder the .M.( the RBI )uys or sells 'overn%ent )onds in the secondary %arket" By
a)sor)in' )onds( it drives u )ond yields and in6ects %oney into the %arket" Bhen it
sells )onds( it does so to suck %oney out of the syste%"
The chan'es in CRR affect the a%ount of free cash that )anks can use to lend - reducin'
the a%ount of %oney for lendin' cuts into overall li7uidity( drivin' interest rates u(
lowerin' inflation and suckin' %oney out of %arkets"
Pri%ary deals in 'overn%ent )onds are a %ethod to intervene directly in %arkets(
followed )y the RBI" By directly )uyin' new )onds fro% the 'overn%ent at lower than
%arket rates( the RBI tries to li%it the rise in interest rates that hi'her 'overn%ent
)orrowin's would lead to"
%onsiderin" that interest rates are now twea!ed loo!in" at mar!et conditions+ is the
Monetary Policy losin" its im$ortance?
Bi%al &alan has said he would %ake the Credit Policy a 9non-event9 and would use the
olicy only to review develo%ents in the )ankin' industry and %oney %arkets" Interest
rate announce%ents since 4!!5-!! were )ased on econo%ic and %arket develo%ents"
The olicy now concentrates %ostly on structural issues in the )ankin' industry"
&ome Monetary Policy terms,
Ban! Rate
Bank rate is the %ini%u% rate at which the central )ank rovides loans to the co%%ercial
)anks" It is also called the discount rate"
8sually( an increase in )ank rate results in co%%ercial )anks increasin' their lendin'
rates" Chan'es in )ank rate affect credit creation )y )anks throu'h alterin' the cost of
credit"
%ash Reserve Ratio
All co%%ercial )anks are re7uired to kee a certain a%ount of its deosits in cash with
RBI" This ercenta'e is called the cash reserve ratio" The current CRR re7uire%ent is 5
er cent"
Inflation
Inflation refers to a ersistent rise in rices" ,i%ly ut( it is a situation of too %uch
%oney and too few 'oods" Thus( due to scarcity of 'oods and the resence of %any
)uyers( the rices are ushed u"
The converse of inflation( that is( deflation( is the ersistent fallin' of rices" RBI can
reduce the suly of %oney or increase interest rates to reduce inflation"
Money &u$$ly -M./
This refers to the total volu%e of %oney circulatin' in the econo%y( and conventionally
co%rises currency with the u)lic and de%and deosits 0current account C savin's
account1 with the u)lic"
The RBI has adoted four concets of %easurin' %oney suly" The first one is M4(
which e7uals the su% of currency with the u)lic( de%and deosits with the u)lic and
other deosits with the u)lic" ,i%ly ut M4 includes all coins and notes in circulation(
and ersonal current accounts"
The second( M2( is a %easure of %oney( suly( includin' M4( lus ersonal deosit
accounts - lus 'overn%ent deosits and deosits in currencies other than ruee"
The third concet M3 or the )road %oney concet( as it is also known( is 7uite oular"
M3 includes net ti%e deosits 0fi*ed deosits1( savin's deosits with ost office savin'
)anks and all the co%onents of M4"
&tatutory 'i0uidity Ratio
Banks in India are re7uired to %aintain 2< er cent of their de%and and ti%e lia)ilities in
'overn%ent securities and certain aroved securities"
These are collectively known as ,-R securities" The )uyin' and sellin' of these
securities laid the foundations of the 4!!2 3arshad Mehta sca%"
Re$o
A reurchase a'ree%ent or ready forward deal is a secured short-ter% 0usually 4< days1
loan )y one )ank to another a'ainst 'overn%ent securities"
-e'ally( the )orrower sells the securities to the lendin' )ank for cash( with the stiulation
that at the end of the )orrowin' ter%( it will )uy )ack the securities at a sli'htly hi'her
rice( the difference in rice reresentin' the interest"
1$en Mar!et 1$erations
An i%ortant instru%ent of credit control( the Reserve Bank of India urchases and sells
securities in oen %arket oerations"
In ti%es of inflation( RBI sells securities to %o u the e*cess %oney in the %arket"
,i%ilarly( to increase the suly of %oney( RBI urchases securities"