Monetary Policy, Financial Regulation and Procyclicality of the Financial System - The Indian Experience Mohua Roy Monetary Policy Department Reserve Bank of India
Outline of the Presentation Monetary Policy Financial Regulation Procyclicality of the Financial System 2
Major Functions of RBI Monetary Policy Function Regulation and Supervision Function Payment System Policy and Oversight Function Management of forex reserves, including gold Issue of Currency Function Banker to banks and Lender of Last Resort Management of Government Debt Function Banker to Government 3
Preamble of the RBI Act, 1934 Preamble of the Act: 'to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally, to operate the currency and credit system of the country to its advantage'. No explicit mandate for price-stability or formal inflation targeting Evolved to include macro-economic and financial stability 4
Monetary Policy Framework. Objectives Maintaining Price Stability Ensuring availability of adequate credit to support growth Maintaining financial stability Emphasis modulated as per prevailing circumstances Policy Statement, April 2006 stated it has become important to recognise and exploit the strong complementarity between macroeconomic and financial stability. Assessing the financial sector - 1999-2000 & 2006-9 Setting up a Financial Stability Unit (2009) 5
Monetary Policy Framework... Monetary Targeting Approach (till 1997-98) Multiple Indicator Approach (from 1998-99) Policy perspectives drawn from juxtaposing and analysing High-frequency data Interest rates/rates in financial markets Medium-frequency data Currency, Inflation rate, Money Supply, Credit, other banking data, Asset prices Low-frequency data - Fiscal position, Trade & Capital Flows, Real Output Developments. 6
Monetary Policy Framework... Instruments - Direct - Cash Reserve Ratio (CRR) - Statutory Liquidity Ratio - Direct Credit Controls - Refinance - Indirect Open Market Operations (OMO) - Outright Sales/Purchase - Repo Operations as under Liquidity Adjustment Facility (LAF) - Market Stabilisation Scheme (MSS) - Interest Rates (Bank Rate) - Macroprudential tools 7
Views on Multiple Indicator Approach Large panel of indicators check-list approach Does not provide for a clearly defined nominal anchor for monetary policy. Complexity in conduct of monetary policy Level of financial market development Nature of monetary transmission Need to maintain the resource balance between the government and the private sector A single model or a limited set of indicators may not be a sufficient guide. Flexible approach with multiple instruments has served well
India Inflation and Growth Statistics Year Growth (%) Change in WPI (%) 1951-1955 3.61-2.47 1956-1960 4.27 6.27 1961-1965 2.84 5.76 1966-1970 4.66 6.73 1971-1975 3.08 11.99 1976-1980 3.24 8.53 1981-1985 5.10 6.53 1986-1990 6.18 7.83 1991-1995 5.38 10.55 1996-2000 5.92 5.08 2000-2005 2005-2010 6.30 8.40 4.74 4.43
Financial Stability Measures in a Statement Monetary Measures... Repo and Reverse Repo Rates Bank Rate Reserve Requirements Developments and Regulatory Measures Financial Stability Interest Rate Policy Financial Markets Money, G-sec, Forex Credit Delivery Mechanisms & Other Banking Services Prudential Measures for Banks & NBFCs Institutional Developments Payment and Settlement Systems Information Technology Legal Issues International Financial Standards and Codes 10
Financial Regulation Preserving financial stability, while promoting growth RBI regulates banks, primary dealers, nonbanking financial companies (NBFCs) and money, G-sec and forex markets Gradual integration with overseas markets capital controls Regulatory policies to contain bank exposure to sensitive sectors, prone to asset bubbles real estate capital markets Ensuring maintenance of adequate capital and liquidity of banks Containing undue volatility in the forex and debt markets 11
Regulatory framework prior to the crisis - I Capital Requirements Liquidity Buffers Management of Concentration Risk Capital Market Exposure (CME) Limit on Inter-bank Exposures Commercial Real Estate (CRE) Exposure Investment Portfolio Accounting Policies Unrealised Gains and Gains on Securitised Deals Measure of Leverage Investment in Non-Government Securities 12
Exposure Norms for Commercial Banks Expos ure to Limit 1 Single Borrower 15 per cent of capital funds (Additional 5 per cent on infrastructure exposure) 2 Group Borrower 40 per cent of capital funds (Additional 10 per cent on infrastructure expo sure) 3 NBFC 10 per cent of capital fund 4 NBFC AFC 15 per cent of capital fund 5 Indian Joint Venture/Wholly o wned 20 per cent of capital funds subsidiaries abroad/overseas step down subsidiaries of Indian corporates 6 Capital Market Exposure (a) Banks holding of shares in any The lesser of 30 per cent of paid-up s hare company capital of the company or 30 per cent of the pa id-up capital of banks (b) Banks aggregate exposure to 40 per cent of its net worth capital market (solo basis) (c) Banks aggregate exposure to 40 per cent of its consolidated net worth capital market (group basis) (d) Banks direct exposure to 20 per cent of net worth capital market (solo basis) (e) Banks direct exposure to 20 per cent of consolidated net worth capital market (group basis) 7 Gross Holding of capital among banks / financial institutions 10 per cent of capital fund 13
Regulatory framework prior to the crisis II Securitisation Derivatives Collateralised Money Market Corporate Governance Compensation of CEOs Restrictions on External Debt Intermediation Market Infrastructure Supervision of Financial Conglomerates (HLCCFM) Regulation of Non-Banking Fin. Cos. 14
Movements in Real and Financial Variables Per cent 40.00 35.00 30.00 25.00 20.00 15.00 10.00 5.00 0.00-5.00-10.00 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 GDP Grow th Current Account Deficit/GDP Year WPI Inflation Bank Credit Grow th 15
Policies to Contain Procyclicality of the Financial System Pre-emptive Countercyclical Prudential Measures From 2004 through 2007 to contain excessive credit growth to sensitive sectors Provisioning Differential risk weights Sectors where asset prices were increasing rapidly (such as real estate and capital markets) and Retail or personal loan sectors - underwriting standards diluted during credit boom 16
Impact of the Crisis Initial impact was muted (2007) Massive jump in capital inflows Sterilisation through MSS Monetary tightening till August 2008 Banks had no direct exposure to complex derivatives Limited indirect exposure Post-Lehman Failure, the crisis spread through Real Sector Channel Confidence Channel Financial Channel 17
India s Response to the Crisis Government Three fiscal stimulus packages Tax cuts Increase in expenditure Interest rate subvention to exporters Reserve Bank of India Aggressive easing of Monetary Policy Reserve Requirements and Policy Rates cut Refinance increased Counter-cyclical regulatory measures 18
Counter-cyclical Regulatory Measures Date Capital Market Housing Other Retail Commercial. Real Estate NBFCs-ND- SI Risk Weights Provision s Risk Weights Provisions Risk Weights Provisions Risk Weights Provisions Risk Weights Provisions Dec-04 100 0.25 75 0.25 125 0.25 100 0.25 100 0.25 Jul-05 125 0.25 75 0.25 125 0.25 125 0.25 100 0.25 Nov-05 125 0.40 75 0.40 125 0.40 125 0.40 100 0.40 May-06 125 1.00 75 1.00 125 1.00 150 1.00 100 0.40 Jan-07 125 2.00 75 1.00 125 2.00 150 2.00 125 2.00 May-07 125 2.00 50-75 May-08 125 2.00 50-100 Nov-08 125 0.40 50-100 Nov-09 125 0.40 50-100 1.00 125 2.00 150 2.00 125 2.00 1.00 125 2.00 150 2.00 125 2.00 0.40 125 0.40 100 0.40 100 0.40 0.40 125 0.40 100 1.00 100 0.40 19
Countercyclical Prudential Policies Outcome 2004-2007 Moderated sector-specific credit growth Served prudential purpose Did not affect other sectors through rate-changes. 2008-2009 Banks capital/liquidity unimpaired Restored liquidity to credit-starved sectors Overall RBI deviated from orthodoxy about handling asset price bubbles Used prudential measures to safeguard the banking system from any fallout of asset price bubbles and busts. Liquidity ratios helped too. 20
Current Macroeconomic Environment in India There are now clear signs of resurgence of growth in India; Capital inflows strong; Domestic equity markets have been on the rise; Industrial growth robust; and Overall business sentiment has improved considerably. 21
Impact on the Macro-economy Average 2003-04 to 2007-08 2008-09 2009-10 1 2 3 4 Real GDP growth 8.9 6.7 7.2 Wholesale Price Index (Average) 5.3 8.4 6.0 Consumer Price Index*(Average) 5.0 9.1 9.3 Weighted Average Call Money Rate 5.6 7.1 3.2 10 year G-sec Yield (Average) 6.9 7.6 7.1 Weighted Average Lending Rate (Scheduled Commercial Banks) 12.4 11.1 10.3 Modal BPLR (Public Sector Banks) 11.8 12.5 12.0 (per cent) * Industrial Workers 22
Capitalisation of Indian Banks All commercial banks migrated to Basel II effective March 31, 2009. CRAR of banks was 13.0 per cent at end-march 2008; 13.2 per cent at end-march 2009 Minimum CRAR - 9 per cent; Tier I CRAR to be at least 6 per cent by March 31, 2010. Some foreign banks have infused capital for their Indian operations Public sector banks largest credit books also require capital to lend more. 23
Behaviour of Daily Call, Repo, CBLO Rates 12.0 10.0 8.0 Per cent 6.0 4.0 2.0 0.0 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Market Repo (Non-RBI) Call Money CBLO Reverse Repo Rate Repo Rate 24
Recent Views on Single vs Multiple Indicator Approach Monitoring money and credit may help policymakers interpret asset market developments and draw implications from them for the economic and financial outlook. (Goodhart, 2007). Central bankers must be aware of importance of monetary analysis and its implications, both for economies individually and globally. (Trichet, 2010).
Exit Strategy Debate Arguments for Beginning Reversal of Monetary Easing Inflation CPI Inflation very high Impact on inflation expectation on account of food prices Excess liquidity may result in asset price build-up Arguments for Deferring Reversal of Monetary Easing Economic recovery is fragile Export growth is negative Inflation mainly due to supply-side constraints Reversal may raise interest rates Tightening will attract more capital inflows 26
Exit Strategy - Actual First phase of exit by the Reserve Bank (October 2009) Statutory Liquidity Ratio restored to 25 per cent Forex swap facility of banks was discontinued Special liquidity facilities were withdrawn Second phase of exit by the Reserve Bank (January 2009) Raised Cash Reserve Ratio by 75 basis points on account of Growing confidence in the economy Risk of supply-side inflation spilling over into a wider inflationary process. Policy rates unchanged as sustainability of recovery was uncertain Third phase of exit by the Reserve Bank (March 2009) Repo Rate and Reverse Repo each raised by 25 bps, to 5.0 per cent and 3.5 per cent, respectively. 27 Recovery sustainable, inflation becoming broad-based, adequate liquidity
Financial Regulation Issues Asset-Liability management infrastructure funding KYC guidelines vs financial inclusion Credit Information Credit rating ensuring robustness & reliability Risk management capabilities HR and IT issues 28
Conclusion Monetary policy in India more eclectic Financial Regulation broad-based Procyclicality of Financial System aim to minimise it Multiple instruments provided increased flexibility Swift and effective response to crisis Normalisation process has started without disturbing overall growth prospects 29
Thank You! 30