INDIAN BANKING SYSTEM (PART-1) MONETARY POLICY OF RBI

Transcription

1 INDIAN BANKING SYSTEM (PART-1) MONETARY POLICY OF RBI 1. INTRODUCTION Hello students, welcome to the series on Indian banking system. The topic of this lecture is monetary policy of RBI. The objectives of this lecture are to make you understand the quantitative measures taken by RBI to control the monetary policy. The need for appropriate adjustment in monetary and fiscal policy of India arose with the introduction of the five year plans. This adjustment was required to match the pace and pattern of planned development of the Indian economy. Since the year 1952, the emphasis of the monetary policy is on promoting the main objective of the economic policy of the Indian government. These objectives are speedy economic development of the country to raise the national income as well as the standard of living of the individuals living in India and the other objective is to control & reduce the inflationary pressure on the Indian economy. According to Ruddar Datt and K.P.M. Sundharam, this policy of reserve bank of India since the first plan period was termed broadly as one of the controlled expansion that is a policy of adequate financing of economic growth and at the same time ensuring reasonable price stability, because of the rapid economic development in the Indian economy and to meet the increased demand for investment, funds expansion of currency and credit became essential. RBI realised this need for expansion of credit and money supply. This was encouraged with the rapid development and diversification of the Indian economy. At the same time, RBI also realised that an excessive expansion of money and credit would be inflationary and will disturb the financial stability of the Indian economy. Ultimately RBI effectively helped the Indian economy to expand through expansion of money and credit. RBI attempted to check the rise in prices by the use of selective controls.

2 2. RBI S ANTI INFLATIONARY MONETARY POLICY Let snow talk about RBI s antiinflationary monetary policy; we already know that RBI encouraged expansion of credit and money supplybut it was well aware of the problem of inflation to rise because of this. The Indian economy has been working with considerable inflationarypotential that is rapid increase in money supply with the public and banking system since the year1972, it also includes expansion of bank credit to finance, trade and industry. In the beginning of the year1970, a serious inflationary situation emerged because of frequent fluctuations in agricultural production, faulty government policies, global inflationary situation directly due to hikein oil prices, the gulf war etc. Looking at this situation, RBI abandoned the controlled expansionand adopted the policy of credit restraint or tight monitory policy. RBI still follows such tight monetary policy with varying degree of success. RBI had to enter the foreign exchange market in a big way to prevent heavy depreciation of rupee from theyear 1994 to 1996.This was repeated in January 1998 and later to prevent the rupee following the experience of South Asian currencies. Bimal Jalan, the then Governor of RBI, suggested various measures to preventthe rapid fall of rupee against dollar, these may be considered as the short term objectives of monetary policy of RBI. 3. LONG TERM OBJECTIVES OF MONETARY POLICY The long term objectives of monetary policy of RBI is to ensure bank s firm commitment to pursue a low and stable orderof inflation, the assumption in this case is that the real growth will be in jeopardy if inflation goes beyond the margin oftolerance. There are two main tools of monetary policy and these tools are general credit control, selective and direct credit control, according to Ruddar Datt and K.P.M. Sundharam, since 1955 and 1956, particularly after 1973and 1974, the inflationary rise in prices has beensteadily mounting, increased government expenditure finance through deficit spendinghas the direct effect of pushing up the prices, wages and income. Short falls in production and hoarding and speculationin essential commodities have contributed to inflationary pressure.

3 RBI controls inflation through quantitative and qualitativemeasures, the quantitative measures are used to control the volume of credit and indirectly to control the inflationary and deflationary pressurescaused by expansion and contraction of credit whereas the qualitative measures encourage the quality of use of credit in specific area or field of activity. 4. THE QUANTITATIVE MEASURES OF RBI S MONETARY POLICY The quantitative measures of RBI s monetary policy are also known as general methods and qualitative measures of RBI to control its monetary policy are also known as selective methods. Quantitative measures include bank rate, change in cash reserve ratio or CRR, statutory liquidity ratioor SLR, open market operation or OMO and repo and reserve repo rate. Qualitative system includes selective or direct credit control through credit authorization scheme or CAS and credit monitoring arrangement or CME. Though we have already discussed these instruments in the last lecture, let us talk about these instruments in detail in this lecture. To begin let us discuss the quantitative measures or thegeneral measures, first point here is bank rate, according to Ruddar Datt and K.P.M Sundharam, in accordance with the general tradition of the 1930 s, RBI started with the cheap money policy and had fix a low bank rate that was 3 % and did not change it till November 1953, when it raised the bank rate to 3.5 %. The bank rate gradually rose to 10 % in July 1981, these were the only changes during this period, the bank rate remained unchanged at 10 % for another 10 years that isfrom 1981 to 1991, it was revised upwards to 11 % in July 1991 and further to 12 % in October The bank rate as on 11 May 2011 was 6 %. One of the important monetary instruments in the modern economy is the bank rate or the central banks pre discount rate, it is because it s role is to signal and clarify the central bank s monetary and interest rates stands to all participants in the financial sector andparticularly in banks.

4 An effective monetary policy can change the prime lending rate of banks by changing the bank rate and will ultimately act as anindependent instrument for monetary control. As highlighted by Ruddar Datt and K.P.M Sundharam, the role of bank rate as an instrument of monetary policy has been very limited in India because of some basic reasons and these reasons are,the first reason is the structure of interest rates is administered by RBI, they are not automatically linkedto the bank rate, the other reason is commercial banks enjoy specific refinance facilities and not necessarily rediscount their eligible securities with RBI at bank rate and the last reason is the bill market is under developed and the different sub market s of the money market are not influenced by the bank rate. Thus bank rate is not considered as pace setter in India, it is important to note here that the deposit rates and the lending rates of the bank s are not related to the bank rate. The government of India and RBI are reviewing the rules and procedures for general access to RBI rediscount facilities so as to make bank rate an important as well as active instrument of monetary policy in India. Bank rate helps in reduction of interest rate and stimulates borrowing from banks.the bank rate in the year 1997 was 11 % and in the first half of 2011, it was 6 %.

5 5. CRR AND OTHER QUANTITATIVE MEASURES The next instrument for quantitative measure to control monetary policy is cash reserve ratio or CRR, under the RBI act 1934, every commercial bank has to keep certain minimum cash reserve with RBI, initially it was 5 % against demand deposits and 2 % against the time deposits, these are also known as statuary cash reserves, since the year 1962, RBI was empowered to vary the cash reserve requirement between 3 % and 15 % of the total demand and time deposits. During the year 1973, RBI excise this power twice as a form of credit squeeze, the statuary reserves were raised from 3 % to 5 % in June 1973 and to 7 % in September 1973,

6 since then RBI has raised or reduce CRR a number of times to influence the volume of cashwith the commercial banking system and thus influence their volume of credit. 6. CASH RESERVE RATIO OR CRR The next instrument for quantitative measure to control monetary policy is cash reserve ratio or CRR, under the RBI act 1934, every commercial bank has to keep certain minimum cash reserve with RBI, initially it was 5 % against demand deposits and 2 % against the time deposits. These are also known as the statutory cash reserves, since the year 1962, RBI was empowered to vary the cash reserve requirement between 3 % and 15 % of the total demand and time deposits.during the year 1973, RBI exercise this power twice as a form of credit squeeze,the statuary reserves were raised from 3 % to 5 % in June 1973 and to 7 % in September 1973,since then RBI has raised or reduced CRR number of times, it did so to influence the volume of cash with the commercial banking system and thus influence their volume of credit. In the year 1995 and 1996, when Indian economy was passing through a severe liquidity problem which adversely affected the investment and production, RBIreduce CRR to 8 % in the year 1997 and 5 % in the year 2002,reduction of CRR and expansion of bank credit to industry and trade will stimulate the growth of Indian economy, the objective of RBI is to reduce CRR to the statuary minimum of 3%, the next instrument for quantitative measureto control monetary policy is thestatuary liquidity ratioor SLR. Apart from cash reserve requirements which commercial banks have to keep with RBI under RBI act 1934 and under section 24 of the banking regulation act 1949, all commercial banks have to maintain liquid assets in the form of cash, gold and un-encumbered approvedsecurities equal to not less than 25 % of their total demand and time deposit liabilities, this is known as statuary liquidity requirement and this is in addition to statuary cash reserverequirements. All the banks must maintain adequate liquid assets, for example under the banking regulation act 1949; commercial banks are required to maintain minimum ratio of liquid assets. RBI is authorized tochange the minimum liquidity ratio, it raise the liquidity ratio from 25 % to 38.5 %, it was because of the two reasonsand these reasons arehigher liquidity ratio forces commercial banks to maintain a large proportion of their resources in liquid form and thus reduces their capacity to grant loans and advances to business and industry.

7 Thus it is anti-inflationaryin impact and the other reason is a higher liquidity ratio diverts banks funds from loans and advances to investment in government and other approved securities, in other words a higher SLR was used to divert bank funds to finance government expenditure. The stepping up of SLR and CRR reduces the capacity of the commercial banks to expand credit to businesses and industry and thus are anti-inflationary, as per the recommendations by the Narasimham committee in the year1991, RBI reduce the SLR by 25 % in October 1997 and is to be removed completely.. 7. OPEN MARKET OPERATIONS OR OMO The next instrument for quantitative measure to control monetary policy is open market operations or OMO. In the words of Ruddar Datt&K.P.M Sundharam, in economies with well developed money market, central banks use open market operations that is buying and selling eligible securities by the central bank in the money market. This is done to influence the volume of cash reserves with commercial banks and thus influence the volume of loans and advancesthey can make to the industrial and commercial sectors. But this instrument is rarely used by RBI, the large scale open market operations were undertaken in the year 1991 by RBI and the banking sector because of the enormous inflow of the foreign funds in India. RBI reduces the ability of banks to lend to the industrial and commercial sector by selling the government securities in the market and withdrawing a part of cash reserves of the commercial banks. Banks capacity to give fresh loans depends upon the amount of cash reserve in excess of their statutory CRR. If the cash surplus is eliminated and statutory CRR is reduced, then the banks have to contact their credit supply to generate cash reserve and meet the statutory CRR. Because of this, the supply of bank credit which involves the creation of demand deposits, fall & money supply contracts. The opposite situation happens when RBI purchases government securities from the market and pay for them. The commercial banks will then have surplus cash to create more credit and more bank deposits and ultimately the supply of money will expand.

8 8. REPO RATE OR REVERSE REPO RATE The next instrument for quantitative measures to control monetary policy is repo rate or reverse repo rate. Repo or Reverse Repo rate is the rate under the liquidity adjustment facility or LAF. This is to determine the corridor for short term money market interest rates; in turn this is expected to trigger movement in other segments of the financial market and the real economy. As we discussed in the last lecture liquidity adjustment facility or LAF consist of daily infusion or absorption of liquidity on a repurchase basis through repo that is liquidity injection and reverse repo that is liquidity absorption auction operations using the government securities as collateral. Thus repo or reverse repo rate may be termed as the rate at which RBI lends short term money to the banks while borrowing from RBI the repo rate increases and it becomes more expensive. Repo rate increases when RBI makes it more expensive for the banks to borrow money, repo rate becomes cheaper when RBI makes it cheaper for banks to borrow money whereas reverse repo rate is termed as the rate at which banks deposit their short terms excess liquidity with the RBI. It is used as a tool for RBI when large amount of money is floating in the banking system and increase in the reverse repo rate means that the RBI will borrow money from the banks at a higher rate of interest. So banks prefer to keep their money with the RBI. Thus repo rate indicates the rate at which liquidity is injected in the banking system by RBI whereas reverse repo rate indicates the rate at which the central bank absorbs liquidity from the banks. So we have discussed the various tools used by RBI to facilitate quantitative measure to control the monetary policy.

9 9. CONCLUSION Now look at this table, as released by RBI on 2 nd May 2011, this table talks about the movement in key policy rates in India. It takes into consideration the reverse repo rate, repo rate and cash reserve ratio. As you can see here in this table, on Oct. 11 th, 2008, the reverse repo rate was 6%, repo rate was 9% and cash reserve ratio was 6.5% whereas on April 21 st 2009, the reverse repo rate was 3.25%, repo rate was 4.75% and cash reserve ratio was 5% and ultimately on March 17 th 2011, the reverse repo rate was 5.75%, repo rate was 6.75% and cash reserve ratio was 6%. Referring back to the control of monetary policy by RBI, we have understood that RBI controls it through quantitative and qualitative measures. Quantitative measures are also known as general methods whereas qualitative measures are known as selective methods. The quantitative measure include bank rate, change in cash reserve ratio or CRR, Statutory liquidity ratio or SLR open market operation or OMO and Repo And Reverse Repo rate. Whereas the qualitative system includes selective or direct credit control through credit authorisation scheme or CAS and credit monitoring arrangement or CMA. In the next lecture, we will discuss the qualitative measures use by RBI to control the monetary policy. We will also talk about the effectiveness of these measures. Thank you.