Recession: Role of monetary and fiscal policies - Part 1

When there is inflation, RBI sells securities to mop up the excess money in the market, and when
inflation is very low, RBI buys securities for increasing the supply of money

WHEN THE private sector fails, public sector intervenes and helps the market to come up. There
are two basic policies in this context: ‘Monetary and Credit Policy’ and ‘Fiscal Policy’. Let us
briefly elaborate on the market failure and then on the roles of these policies in that context.

A market efficiently organises various economic activities on the basis of demand and supply to
bring about coordinated economic decisions. Efficiency is understood in the sense of Pareto
optimality – the impossibility of reallocating resources to make one person better off without
making anyone else worse off. But sometimes market fails to achieve this objective. One basic
reason of this failure is when some costs and/or benefits are not fully reflected in the market
price. For example, if prices do not communicate society’s desire and constrains accurately, the
market would fail. Another example is when private decisions based on these prices do not
generate an efficient allocation of recourses. In essence, a market system fails because of any of
the following reasons:

 Lack of or weak property rights;

 Public goods and/or common property characteristics;
 Externalities;

Asymmetric information.

These reasons somehow distort both the supply-side and demand-side of the market system
which is crucial for its efficient and effective functioning.

Monetary and Credit Policy

Monetary and Credit Policy is essentially managed by central bank (known by different names in
different countries; in India it is the Reserve Bank of India). In a nutshell, this policy is linked
with the control of the supply of money and its availability to the people, and the cost of money
or rate of interest to bring about economic stability in the system.

Monetary policy can be either expansionary or contractionary. The first one increases the total
supply of money to face unemployment and recession by lowering the interest rates, and the
second one decreases it by raising interset rates to control inflation.

In essence, The Monetary Policy and Credit Policy regulates the supply of money and the cost
and availability of credit in the economy. It deals with both the lending and borrowing rates of
interest for commercial banks. The Monetary Policy aims to maintain price stability, full
employment and economic growth.

The Monetary and Credit Policy is the policy statement, traditionally announced twice a year in
India, through which the Reserve Bank of India (RBI) seeks to ensure price stability for the
economy essentially by controlling money supply, interest rates and the inflation. Money supply
is referred as M3- which indicates the level (stock) of legal currency in the economy. This policy
also contains norms for the banking and financial sector and the institutions which are governed
by it. These would be banks, financial institutions, non-banking financial institutions, money
markets foreign exchange (forex) market.

Monetary and Credit Policy uses the following terms:

Bank Rate (or the discount rate) is the minimum rate at which the Central Bank provides loans to
the commercial banks. Usually, an increase in bank rate increases the lending rates of
commercial banks. Changes in bank rate affect credit creation by banks through altering the cost
of credit.

Cash Reserve Ratio:  All commercial banks are required to keep a certain amount of its deposits
in cash with Reserve Bank of India. This percentage is called the Cash Reserve Ratio.

Money Supply (M3):  M3 is a broad concept of money supply which includes net time deposits
(fixed deposits), savings deposits with post office saving banks and all the components of M1
(which equals the sum of currency with the public, demand deposits with the public and other
deposits with the public). In other words, M3 refers to the total volume of money circulating in
the economy.

Statutory Liquidity Ratio:  Banks in India are required to maintain 25 per cent of their demand
and time liabilities in government securities and certain approved securities. These are
collectively known as SLR securities.

Repo Rate:  A repurchase agreement or ready forward deal is a secured short-term (usually 15
days) loan by one bank to another against government securities. The Repo rate is the rate at
which at which the RBI repurchases government securities from the commercial banks. For
pumping in short-term liquidity into the system. The Reverse Repo Rate is the rate at which
banks park their short-term excess liquidity with the RBI.

Open Market Operations:  This relates to the buying and selling of securities by the Reserve
Bank of India in open market operations for purposes of credit control. When there is inflation,
RBI sells securities to mop up the excess money in the market, and when inflation is very low,
RBI buys securities for increasing the supply of money.

RECESSION CLOWDS LOOMING, RBI ACTS FOR FINANCIAL

STABILITY:
MUMBAI: Announcing, further measures for Monetary and Liquidity Management, the Reserve Bank
of India (RBI) today cut repo rate by 50 basis points. With this new repo rate stands at 7.5 per cent.

In its Mid-Term Review of the Annual Policy Statement for 2008-09, the Reserve Bank of India indicated
that in the context of the uncertain and unsettled global situation and its indirect impact on our
domestic economy and our financial markets, it would closely and continuously monitor the situation
and respond swiftly and effectively to developments. In doing so, the Reserve Bank will employ both
conventional and unconventional measures.

RBI noted that global financial conditions continue to remain uncertain and unsettled, and early signs of
a global recession are becoming evident. These developments are being reflected in sharp declines in
stock markets across the world and heightened volatility in currency movements. International money
markets are yet to regain calm and confidence and return to normal functioning.

It was also indicated in the Mid-Term Review that the current challenge for the conduct of monetary
policy is to strike an optimal balance between preserving financial stability, maintaining price stability
and sustaining the growth momentum. Inflation, in terms of the wholesale price index (WPI), has been
softening steadily since August 9, 2008 and has declined to 10.68 per cent for the week ended October
18, 2008.

Globally, pressures from commodity prices, including crude, appear to be abating. The moderation in
key global commodity prices, if sustained, would further reduce inflationary pressures. On the growth
front, it is important to ensure that credit requirements for productive purposes are adequately met so
as to support the growth momentum of the economy, RBI said.

Domestic financial markets have been functioning normally. Prudent regulatory surveillance and
effective supervision have ensured that our financial sector has been and continues to be robust.
However, the global financial turmoil has had knock-on effects on our financial markets; this has
reinforced the importance of focusing on preserving financial stability,

The Reserve Bank has reviewed the current and evolving macroeconomic situation and liquidity
conditions in the global and domestic financial markets. Based on this review, it has decided to take the
following further measures:

(i) On October 20, 2008, the Reserve Bank announced a reduction in the repo rate under the Liquidity
Adjustment Facility (LAF) by 100 basis points from 9.0 to 8.0 per cent. In view of the ebbing of upside
inflation risks as also to address concerns relating to the moderation in the growth momentum, it has
been decided to reduce the repo rate under the LAF by 50 basis points to 7.5 per cent with effect from
November 3, 2008.

(ii) The cash reserve ratio (CRR) of scheduled banks is reduced by 100 basis points from 6.5 per cent to
5.5 per cent of net demand and time liabilities (NDTL). This will be effected in two stages: by 50 basis
points retrospectively with effect from the fortnight beginning October 25, and by a further 50 basis
points prospectively with effect from the fortnight beginning November 8, 2008. This measure is
expected to release around Rs.40,000 crore into the system.
(iii) On September 16, 2008, the Reserve Bank had announced, as a temporary and ad hoc measure, that
scheduled banks could avail additional liquidity support under the LAF to the extent of up to one per
cent of their NDTL and seek waiver of penal interest. It has now been decided to make this reduction
permanent. Accordingly, the Statutory Liquidity Ratio (SLR) will stand reduced to 24 per cent of NDTL
with effect from the fortnight beginning November 8, 2008.

(iv) In order to provide further comfort on liquidity and to impart flexibility in liquidity management to
banks, it has been decided to introduce a special refinance facility under Section 17(3B) of the Reserve
bank of India Act, 1934. Under this facility, all scheduled commercial banks (excluding RRBs) will be
provided refinance from the Reserve Bank equivalent to up to 1.0 per cent of each bank's NDTL as on
October 24, 2008 at the LAF repo rate up to a maximum period of 90 days. During this period, refinance
can be flexibly drawn and repaid.

(v) On October 15, 2008 the Reserve Bank announced, purely as a temporary measure, that banks may
avail of additional liquidity support exclusively for the purpose of meeting the liquidity requirements of
mutual funds (MFs) to the extent of up to 0.5 per cent of their NDTL. A similar facility of liquidity support
for non-banking financial companies (NBFCs) is also found to be necessary to enable them to manage
their funding requirements. Accordingly, it has now been decided, on a purely temporary and ad hoc
basis, subject to review, to extend this facility and allow banks to avail liquidity support under the LAF
through relaxation in the maintenance of SLR to the extent of up to 1.5 per cent of their NDTL. This
relaxation in SLR is to be used exclusively for the purpose of meeting the funding requirements of NBFCs
and MFs. Banks can apportion the total accommodation allowed above between MFs and NBFCs flexibly
as per their business needs.

(vi) As indicated in the Reserve Bank's press release of September 16, 2008, as on some previous
occasions, the Reserve Bank will continue to sell foreign exchange (US dollar) through agent banks to
augment supply in the domestic foreign exchange market or intervene directly to meet any demand-
supply gaps. The Reserve Bank would either sell the foreign exchange directly or advise the bank
concerned to buy it in the market. All the transactions by the Reserve Bank will be at the prevailing
market rates and as per market practice. Entities with bulk forex requirements can approach the
Reserve Bank through their banks for this purpose.

(vii) It has been decided, as a temporary measure, to permit Systemically Important Non-Deposit taking
Non-Banking Financial Companies (NBFCs-ND-SI) to raise short- term foreign currency borrowings under
the approval route, subject to their complying with the prudential norms on capital adequacy and
exposure norms. Details in this regard have been notified separately and are available on the Reserve
Bank's web site.