credit & monetary policy 12.07.10

8/9/2019 Credit & Monetary Policy 12.07.10

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Banking AssignmentOn

CREDIT AND

MONETARY POLICIES

Submitted By :Group 1 :

Abhishek Kumar PRN 10020242001

AkankshaSaxena PRN 10020242002

Ashok Venkat PRN 10020242004

DivyNinadKoul PRN 10020242005

MBA AB, 2010-2012


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1. INTRODUCTION

Monetary policy is the management of money supply and interestrates by central

banks to influence prices and employment. Monetarypolicy works through expansion

or contraction of investment andconsumption expenditure.Monetary policy is the

process by which the government, centralbank (RBI in India), or monetary authority ofa country controls :

(i) The supply of money

(ii) Availability of money

(iii) Cost of money or rate of interest

In order to attain a set of o bjectives oriented towards the growth and stability of

theeconomy. Monetary theory provides insight into how to craftoptimal monetary

policy.

Monetary policy is referred to as either being an expansionary policy, or acontractionary policy, where an expansionary policy increases the total supply of

money in the economy, and a contractionary policy decreases the total money supply.

Expansionary policy is traditionally used to combat unemployment in a recession by

lowering interest rates, while contractionary policy involves raising interest rates in

order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers

to government borrowing, spending and taxation.Credit policy is not only a policy

concerned with changes in the supply of credit but it can be and is much more than

this.Credit is not merely a matter of aggregate supply, but becomes more important

factor since there is also issue of its allocation among competing users. There are

various sources of credit and other aspects of credit that need to be looked into are itscost and other terms and conditions, duration, renewal, risk of default etc. Thus the

potential domain of credit policy is very wide. Where currency is under a monopoly of

issuance, or where there is a regulated system of issuing currency through banks

which are tied to a central bank, the monetary authority has the ability to alter the

money supply and thus influence the interest rate in order to achieve policy

goals.Monetary policy, also described as money and credit policy, concerns itself with

the supply of money as so of credit to the economy.

Table 1. Examples of Central Banks

M

o

n

e

t

a

India Reserve Bank of India

U.S.A Federal Reserve bank.

U.K Bank of England

Pakistan Bank of Pakistan


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monthly adjustments of interest rates.During the 1870-1920 period the industrialized

nations set up centralbanking systems, with one of the last being the Federal Reserve

in1913.By this point the role of the central bank as the "lender of last

Resort" was understood. It was also increasingly understood that interest rates had an

effect on the entire economy, in no small part because of the marginal revolution in

economics, which focused on how many more, or how many fewer, people wouldmake a decisionbased on a change in the economic trade-offs. It also became clear

that there was a business cycle, and economic theory began understanding the

relationship of interest rates to that cycle. Research by Cass Business School has

also suggested that perhaps it is the central bank policies of expansionary

andcontractionary policies that are causing the economic cycle; evidence

Can be found by looking at the lack of cycles in economies before central banking

policies existed

3. OBJECTIVES OF MONETARY POLICY

The objectives are to maintain price stability and ensure adequateflow of credit to theproductive sectors of the economy. Stability ofthe national currency (after looking at

prevailing economicconditions), growth in employment and income are also looked

into.The monetary policy affects the real sector through long and variable periods

while the financial markets are also impacted through shorttermimplications. Major

objectives can be summarized as under:

i) To promote and encourage economic growth in the economy & ensure theeconomic stability at full employment or potential level of output. It aims toachieve the twin objectives of meeting in full the needs of production and trade,and at the same time moderating the growth of money supply to contain the

inflationary pressures in the economy.

ii) Sectorial deployment of Funds. Depending upon the priori ties laid down in theplans, the RBI has determined the allocation of funds, as also the interest ratesamong the different sectors.

There are four main 'channels' which the RBI looks at:

Quantum channel: money supply and credit (affects real outputand price level

through changes in reserves money, moneysupply and credit aggregates).

Interest rate channel.

Exchange rate channel (linked to the currency).

Asset price.

Price stability has evolved as the dominant objective of monetary policy for sustaining

economic growth and ensuring orderly conditions in the financial markets with

increasing openness of the Indian economy... The fundamentalidea is that it is only in

a low and stable inflation environment that economic growth can be continued.

Monetary policy also aims to be directly supportive of growth by ensuring that the


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credit requirements of various segments are met adequately through an appropriate

credit delivery and credit pricing mechanism and a conducive credit culture.

Monetary decisions today take into account a wider range of factors,

such as:

short term interest rates;

long term interest rates;

velocity of money through the economy;

exchange rate

credit quality

bonds and equities (corporate ownership and debt)

government versus private sector spending/savings

international capital flow of money on large scales

financial derivatives such as options, swaps and future contracted.

4. TYPES OF MONETARY POLICYIn practice, all types of monetary policy involve modifying the amount of base currency

(M0) in circulation. This process of changing the liquidity of base currency through the

open sales and purchases of (government-issued) debt and credit instruments is

called openmarket operations. Constant market transactions by the monetary

authority modify the supply of currency and this impacts other market variables such

as short term interest rates and the exchange rate. Thedistinction between the various

types of monetary policy lies primarily with these of instruments and target variables

that are used by the monetaryauthority to achieve their goals.

Table 2. Monetary policies with variables & objectives

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation TargetingInterest rate on overnightdebt

A given rate of change in the CPI

Price LevelTargeting

Interest rate on overnightdebt

A specific CPI number

MonetaryAggregates

The growth in moneysupply

A given rate of change in the CPI

Fixed Exchange

Rate

The spot price of the

currency The spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the goldprice

Mixed Policy Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange

rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold


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standard results in a relatively fixed regime towards the currency of other countries on

the gold standardand a floating regime towards those that are not.

i. Inflation targeting :

Under the Inflation targeting policy approach the target is to keep inflation, under a

particular definition such as Consumer Price Index, within a desired range. Theinflation target is achieved through periodic adjustments to the Central Bank interest

rate target. The interest rate used is generally the interbank rate at which banks lend

to each other overnight for cash flow purposes. Depending on the country this

particular interest rate might be called the cash rate or something similar. The interest

rate target is maintained for a specific duration using open market operations.

Typically the duration that the interest rate target is kept constant will vary between

months and years. This interest rate target is usually reviewed on a monthly or

quarterly basis by a policy committee.

ii. Price level targeting:

Price level targeting is similar to inflation targeting except that CPI growth in one year

is offset in subsequent years such that over time the price level on aggregate does not

move. Something similar to price level targeting was tried by Sweden in the 1930s,

and seems to have contributed to the relatively good performance of the Swedish

economy during the Great Depression. As of 2004, no country operates monetary

policy based on a price leveltarget.

iii. Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the

money supply. This approach was refined to include different classes of money and

credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued .

This approach is also sometimes called monetarism. While most monetary policy

focuses on a price signal of one form or another, this approach is focused on

monetary quantities.

iv. Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency.

There are varying degrees of fixed exchange rates, which can be ranked in relation to

how rigid the fixed exchange rate is with the anchor nation. Under a system of fiat

fixed rates, the local government or monetary authority declares a fixed exchange rate

but does not actively buy or sell currency to maintain the rate. Instead, the rate isenforced by non-convertibility measures (e.g. capital controls, import/export licenses,

etc.). In this case there is a black market exchange rate where the currency trades at

its market/unofficial rate. Under a system of fixed-convertibility, currency is bought and

sold by the central bank or monetary authority on a daily basis to achieve the target

exchange rate. This target rate may be a fixed level or a fixed band within which the

exchange rate may fluctuate until the monetary authority intervenes to buy or sell as

necessary to maintain the exchange rate within the band. Under a system of fixed


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exchange rates maintained by a currency board every unit of local currency must be

backed by a unit of foreign currency (correcting for the exchange rate). This ensures

that the local monetary base does not inflate without being backed by hard currency

and eliminates any worries about a run on the local currency by those wishing to

convert the local currency to the hard (anchor) currency. These policies often abdicate

monetary policy to the foreign monetary authority or government as monetary policy inthe pegging nation must align with monetary policy in the anchor nation to maintain

the exchange rate. The degree to which local monetary policy becomes dependent on

the anchor nation depends on factors such as capital mobility, openness, credit

channels and other economic factors

v. Gold standard

The gold standard is a system in which the price of the national currency as measured

in units of gold bars and is kept constant by the daily buying and selling of base

currency to other countries and nationals. The selling of gold

is very important for economic growth and stability. The gold standard might be

regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price

might be regarded as a special type of "Commodity Price Index". Today this type of

monetary policy is not used anywhere in the world, although a form of gold standard

was used widely across the world prior to 1971. Its major advantages were simplicity

and transparency.

5. MONETARY POLICY TOOLSThe monetary authority uses various instruments of monetary control in order to

influence the goal variables in desired directions and degrees. The target variablesare variables which the monetary authority tries to control or influence so as to

influence the goal variables in the desired manner. To serve the target function well, a

chosen target variable should possess the following four qualifications:

a) It should be closely related to goal variables and this relation should be wellunderstood and reliably estimable,

b) It should be rapidly affected by policy instruments,c) Non-policy influences on it should be relatively small,i.e, small relative to policy

influences, andd) It should be readily observable (a measurable) with little or no time lag.

Traditionally three variables have served as candidates for monetary-policy targets.

They are: money supply, bank credit, and interest rates in securities market.

Various Monetary policy tools are:


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i. Monetary base

Monetary policy can be implemented by changing the size of the monetary base.

This directly changes the total amount of money circulating in the economy. A

central bank can use open market operations to change the monetary base. The

central bank would buy/sell bonds in exchange for hard curre ncy. When the centralbank disburses/collects this hard currency payment, it alters the amount of

currency in the economy, thus altering the monetary base.

ii. Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary poli cy can

be implemented by changing the proportion of total assets that banks must hold in

reserve with the central bank. Banks only maintain a small portion of their assets

as cash available for immediate withdrawal; the rest is invested in illiquid assets

like mortgages and loans. By changing the proportion of total assets to be held as

liquid cash, the Federal Reserve changes the availability of loanable funds. This

acts as a change in the money supply. Central banks typically do not change the

reserve requirements often because it creates very volatile changes in the money

supply due to the lending multiplier.

iii. Discount window lending

Many central banks or finance ministries have the authority to lend funds to

financial institutions within their count ry. By calling in existing loans or extending

new loans, the monetary authority can directly change the size of the money

supply.

iv. Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing

the nominal interest rates. Monetary authorities in different nations have differing

levels of control of economy-wide interest rates. The Federal Reserve can set the

discount rate, as well as achieve the desired Federal funds rate by open market

operations. This rate has significant effect on other market interest rates, but there

is no perfect relationship. In the United States open market operations are a

relatively small part of the total volume in the bond market. One cannot set

independent targets for both the monetary base an d the interest rate because they

are both modified by a single tool open market operations; one must choose

which one to control. In other nations, the monetary authority may be able tomandate specific interest rates on loans, savings accounts or other financial

assets. By raising the interest rate(s) under its control, a monetary authority can

contract the money supply, because higher interest rates encourage savings and

discourage borrowing. Both of these effects reduce the size of the money supply.


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v. Currency board

A currency board is a monetary arrangement which pegs the monetary base of a

country to that of an anchor nation. As such, it essentially operates as a hard fixed

exchange rate, whereby local currency in circulation is backed by foreign currency

from the anchor nation at a fixed rate. Thus, to grow the local monetary base an

equivalent amount of foreign currency must be held in reserves with the currencyboard. This limits the possibility for the local monetary authority to inflate or pur sue

other objectives.

6. MONETARY POLICY OF RBI OVER YEARSNational income and saving play vital role on formulation of monetary policy. As the

income increases the spending will also increase, thus monetary will be less

intensively required and same is the case with increase in saving. The existence of

long-run equilibrium relationship among money and income represented by a money

demand function also has significant implications for monetary policy. The kind ofeconomy India has, it is effected by the dollar rate .India has services led growth is

getting reinforced by a sustained resurgence in industrial activity after a long hiatus of

slow down and restructuring during the period 1976 -1987.In recent years starting from

the mid-nineties promoting economic growth is being given greater emphasis in

monetary policy of RBI.

Three sub-periods:

Monetary policy of controlled examination (1951-1972).

Monetary policy in the pre-reforms period (1972-1991).

Monetary policy in the post-reforms period (1991-2000).

MONETARY POLICY OF CONTROLLED EXAMINATION (1951-1972)

Reserve banks responsibility in the circumstances is mainly to moderate the

expansion of credit and money supply in such a way as to ensure the legitimate

requirements of industry and trade and curb the use of credit for unproductive and

speculative purposes.

To ensure controlled expansion, RBI used the instruments:

x Changes in bank rate

x Changes in cash reserve ratio

x Selective credit control

MONETARY POLICY IN THE PRE-REFORMS PERIOD (1972-1991)

Price situation worsened during the years of 1972 -1974. To contain inflationary

pressures RBI further tightened its monetary policy.

It is similar to tight monetary policy.

EASY AND LIBERAL MONETARY POLICY (1996 onwards)

Liberal monetary policy adopted for encouraging private sector since 1996.


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Two instrument for monetary management BY RBI since 1996:

Reactivation of bank rate.

Repo rate system.

In 1996-97, the rate of inflation sharply declined. In the later half 1996 -97,

industrial recession gripped the Indian economy. To encourage the economicgrowth and to tackle the recessionary trend, the RBI eased its monetary policy.

Introduction of Repo rate. Repo rate increased from 3% in 1998 to 6.5% in 2005.

This instrument was consistently used in the monitory policy as a result of rapid

industrial growth during 2005-06.

Reverse Repo rate Through RRR, the RBI mops up liquidity from the banking

system. The Repo rate was cut from 3.50% to 3.25%.

Flow of credit to Agriculture The flow of credit to agriculture has increased from

34,013 (9.2% of overall credit) in 20 08 to 52,742 (13% in overall credit) in 2009

(Rs. in crore).

Reduction in Cash Reserve Ratio The CRR which was at 15% until 1995gradually reduced to 5% in 2005. The CRR remained unchanged in the current

monetary policy.

Lowering Bank rate The Bank rate was gradually reduced from 12% in 1997 to

6% in 2003.

7. Instruments of monetary policy in IndiaThe monetary policy is nothing but controlling the supply of Money. The RBI takes a look

at the present levels and also takes a call on what should be the desired level to promote

growth, bring stability of price (low inflation) and foreign exchange.

The Reserve Bank of India (RBI) as a designated monetary authority has no control overthe deficit financing of the central government and only limited control over its foreignexchange assets, we discuss below in detail the instruments of control used by the RBI:

:

A. Quantitative measures:

1. Open Market operations: It means the purchase and sale of securities by central

bank of the country.

The sale of security by the central bank leads to contraction of credit and purchase

thereof to credit expansion. It is useful for the developed countries. In India, the RBI

enters into sale and purchase of government securities and treasury bills. So the

RBIcan pump money into circulation by buying back the securities and vice versa. In

absence of an independent security market (all Banks are state owned); this is not

really effective in India.


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The major Limitations are that

When the central bank purchases the securities the cash reserve of member bank will

be increased and vice versa.

The bank will expand and contract credit according to prevailing economic and

political circumstances and not merely with reference to their cash reserves.

When the commercial bank cash balance increase the demand for loan and advance

should increase. This may not happen due to ec onomic and political uncertainty.

The circulation of bank credit should have a constant velocity.

2. Bank rate policy:Popularly known as repo rate and reverse repo rate, it is the

rate at which the RBI and the Banks buy or exchange money.

This results into the flow of bank credit and thusaffects the money supply.

Bank rate- It is the minimum rate at which the central bank of a country provides loan

to the commercial bank of the country. Bank rate is also called discount rate because

bank provides finance to the commercial bank by rediscounting the bills of exchange.When general bank raises the bank rate, the commercial bank raises their lending

rates;it results in fewer borrowings and reduces money supply in the economy.

Reverse repo rate It is the rate that RBI offers the banks for parking their funds with

it. Reverse repo operations suck out liquidity from the system.

Major limitation is that :

Well organized money market should exist in the economy.

Repo rate -y It is introduced through which RBI can add to liquidity in the banking system.

Through repo system RBI buys securities from the bank and there by provide

funds to them.

y Repo refers to agreement for a transaction between RBI and banks through

which RBI supplies funds immediately against government securities and

simultaneously agree to repurchase the same or similar securities after a

specified time which may be one day to 14 days.

y A repurchase agreement or ready forward deal is a secured short -term (usually

15 days) loan by one bank to another against government securities.

y Legally, the borrower sells the securities to the lending bank for cash, with thestipulation that at the end of the borrowing term, it will buy back the securities at

a slightly higher price, the difference in price representing the interest.

3. Cash Reserve ratio (CRR): This is the percentage of total deposits that the

banks have to keep with RBI. And this instrument can change the money supply

overnight.


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y Changing cash reserve ratio is an excellent instrument of control. The bank has to

keep certain amount of bank money with themselves as reserves against deposits.

y The increase in the cash rate leads to the contraction of credit only when the

banks excess reserves.

y The decrease in the cash rate leads to the expansion of credit and banks tends to

make more available to borrowers.

The Reserve Bank has been pursuing its medium-term objective of reducing CRR tothe statutory minimum level of 3.0 per cent. RBI gradually reduced the CRR from 11.0per cent in August 1998 to 7.5 per cent by May 2001... Rationalisation of CRR wasalso initiated by withdrawing various exemptions given to banks on certain specificcategories of liabilities for the CRR requirement. Subsequently, all categories ofbanks, including co-operative banks, were also made subject to the CRR prescriptionas applicable to the scheduled commercial banks. These measures were designed tofacilitate development of short-term yield curve, develop money market, enhanceavailability of lendable resources with banks and improve the efficacy of indirectinstruments in the conduct of monetary policy. Further, RBI announced its intention tomove away from sector-specific refinance.

4. Statutory Liquidity Requirement (SLR)&liquidity adjustment facility ( LAF )-this

is the proportion of deposits which Banks have to keep liquid in addition to

CRR.

y This also has a bearing on money supply.

y LAF is the instrument of monetary policy from June 2000 to adjust on daily basis

liquidity in the banking system.

y Through LAF, RBI regulates short -term interest rates while its bank rate policy

serves as a signaling device for its interest rate policy in the intermediate period.

RRBs are required to maintain SLR at 25 per cent of their NDTL in cash or gold or inunencumbered government and other approved securities. Unlike in the case ofscheduled commercial banks, balances maintained in call or fixed deposits by RRBswith their sponsor banks are treated as cash and hence, reckoned towards theirmaintenance of SLR. As a prudential measure, it is desirable on the part of all RRBsto maintain their entire SLR portfolio in government and other approved securities,which many of them are already doing. All RRBs may maintain their entire SLRholdings in government and other approved securities.

B. Qualitative measures:

1. Credit rationing: Imposing limits and charging higher/lower rates of interests in

selective sectors are what you see is being done byRBI.

2. Moral suasion: We hear of RBI's directive of priority lending in Agriculture sector.

Seems more of a directive rather than persuasion.It implies the central bank exerting


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pressure on banks by using oral and written appeals to expand or restrict credit in line

with its credit policy. It is a combination of persuasion and pressure which RBI is always

in a position to use on banks in general and errant banks in particular. This is exercised

through discussions, letters, speeches, and hints thrown to banks. This can be used by

the RBI to urge banks to keep a large proportion of their assets in the form of government

securities, lend their helping hand to develop a broad and active market in treasury billsand government securities, and not borrow excessively from the bank wh en it is engaged

in fighting the forces of inflation.

Major Interest Rate Policy

(a) Interest Rate Flexibility

The Bank Rate, the repo rate and the overnight call money rates have also been very

low in recent months ranging between 6.0 and 7.0 per cent. However, the sharp

reduction in nominal and real interest rates is not yet fully reflected in the interest rates

generally charged by banks on advances. There is also some evidence that the spread

between the interest rates charged by banks to different borrowers has also tended to

widen. The relatively lesser reduction in the rates of interest that most borrowers ha ve to

pay is despite the action taken by the Government in the last three years to lower

administered interest rates on Relief Bonds and small savings, etc. as well as the sharp

reduction by RBI in the CRR of banks (along with an increase in the interest r ate paid by

RBI on eligible cash balances maintained by banks with RBI). The reasons for the

relative downward inflexibility in the commercial interest rate structure seem to be

primarily due to the following factors:

y The average cost of deposits for major banks continues to be relatively high (6.25to 7.25 per cent). Further, a substantial portion of deposits is in the form of long -term deposits at fixed interest rates. Thus, flexibility available to banks to reduceinterest rates in the short-run, without adversely affecting their return on assets, islimited. The relatively high overhang of non -performing assets (NPAs) furtherpushes up the average cost of funds for banks, particularly public sector banks.

y The non-interest operating expenses of banks work out to 2.5 to 3.0 per cent oftotal assets, putting pressure on the required spread over the cost of funds.

y In view of legal constraints and procedural bottlenecks in recovery of dues bybanks, the risk-premium tends to be higher resulting in wider spread betweendeposit rates and lending rates.

y The large borrowing programme of the Government, over and above SLRrequirements, provides significant prospects for deployment of funds by banks insovereign paper.


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y Banks should provide information on deposit rates for various maturities andeffective annualized return to the depositors. This information should be madeavailable to RBI also, so that RBI can put a consolidated picture for all bankson its website.

y Banks should provide information on maximum and minimum i nterest rates

charged to their borrowers. RBI will put this information also in public domain.

y Banks are urged to switch over to all cost concept for borrowers by explicitlydeclaring the processing charges, service charges, etc. charged to borrowers.Such bank charges may also be publicly announced.

(c) Interest Rate on Export Credit

Exporters have the option to avail of pre-shipment and post-shipment credit in foreign

currency from banks in India. In order to make the interest rate even more competitivein the present low interest rate environment, it is desirable to further lower the ceilingrate on foreign currency loans for Indian exporters by banks. Considering thiscompetitive interest rate on foreign currency loans and to mitigate any po ssibleexchange risk, exporters are encouraged to make maximum use of foreign currencyloans in one or more currencies of their choice depending on the currency of theirexport receipts (e.g., US dollar, Euro, Pound Sterling, etc.). Indian banks, located inareas with concentration of exporters, are being advised to give this important facilitydue publicity and make it easily accessible to all exporters, including small exporters.In view of the need to ensure transparency and also encourage banks to cont inue toprovide finance at competitive rates, there is a need for putting in place a reportingsystem by which commercial banks provide information on interest rates charged on

pre-shipment and post-shipment credit. This will facilitate exporters in choosing themost competitive rate. With effect from June 15, 2002, banks report to RBI, theminimum and maximum lending rates to exporters.

(d)Abolition of Minimum Lending Rate for Co-operative Banks

State and Central Co-operative Banks were given freedom to determine their lendingrates subject to the prescription of minimum lending rate (MLR) of 12.0 per cent perannum by the Reserve Bank since October 18, 1994. Similarly, the Urban Co -operative Banks (UCBs) were subject to the prescription of MLR at 13.0 per cent perannum effective June 21, 1995, which was reduced to 12.0 per cent effective March 2,2002. Since August 26, 1996, RRBs were given freedom to determine their lendingrate. At present, commercial banks other than RRBs have the freedom in decidingtheir PLRs with the approval of their Boards. In the annual policy Statement of April2001, PLR was made a reference/benchmark rate, so that commercial banks are freeto lend at sub-PLR rates to creditworthy borrowers. In order to provide greaterflexibility to co-operative banks in a competitive environment, it is proposed:

y To withdraw the stipulation of MLR for all co-operative banks with immediateeffect. Co-operative banks will now be free to determine their lending rates


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taking into account their cost of funds, transaction cost, etc.withthe approvaloftheir managing committee. This will help the co-operative banks in attractinggood/prime borrowers.

y It should be ensured that the interest rate s charged by co-operative banks aretransparent and known to all their customers. Banks are, therefore, requested

to publish the minimum and maximum interest rates charged by them, anddisplay this information in every branch.

(e) Liberalization of Investment Norms of Funds Mobilized under FCNR(B) Deposits & Interest Rate on FCNR (B) Deposits

At present, banks are allowed to accept FCNR (B) deposits for a period of 1-3 years.However, on the assets side, there are certain restrictions on deploying the se funds.Presently, banks can lend funds to Indian residents for their foreign exchangerequirements or for financing of Joint Ventures or Wholly Owned Subsidiaries set upby resident corporates. Besides, banks can also invest such funds in certain money

market instruments which satisfy prescribed rating. In view of restrictions on thedeployment of funds, the assets side could be shorter in tenor than the liabilities sideresulting in asset-liability mismatches. Further, there exists interest rate risk in view ofchanges in LIBOR rates, if matching investment opportunities are not available tobanks. In this regard, RBI had received a number of representations from banks forreviewing the investment norms.

In order to avoid asset-liability mismatches, and also consistent with the riskmanagement guidelines put in place by RBI, banks are now permitted:

y To invest their FCNR (B) deposits in longer term fixed income instruments,subject to the condition that these instruments should have an appropriate

rating prescribed for the money market instruments. Moreover, banks have toobtain prior approval from their Boards with regard to type/tenor of instrumentsalong with relevant rating and likely cap on such investments within the asset -liability management (ALM) guidelines in force.

Currently, banks are free to accept FCNR (B) deposits for a maturity period of 1-3years and to offer fixed and floating rates, subject to the ceiling of LIBOR/SWAPrates. In view of the prevailing international environment of low interest rates, and toreduce the cost of FCNR (B) deposits, it is decided:

y To revise the above ceiling rate downward to LIBOR/SWAP rates for thecorresponding maturities minus 25 basis points.


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(f) Relaxation on Borrowing from and Investment inOverseas Market byBanks

At present, banks in India are allowed to borrow from and invest in the overseas

market up to 15 per cent of their unimpaired Tier I capital or US $ 10 million,

whichever is higher. In order to enable banks to have greater operati onal flexibility and

also to align the domestic interest rate with overseas market, it is decided to allow

banks to borrow up to 25 per cent of their unimpaired Tier I capital from overseas

market. The increased borrowing limit would enable banks to get cheaper funds and

help them to have adequate rupee resources and thus reduce the cost of funds for the

banks. While it will enhance the process of integration of Indian financial market with

the global market, different segments of the domestic market will a lso get further

integrated.

The new Functions of monetary policies that have emerged

To reinforce the emphasis on price stability and well-anchored inflationexpectations while ensuring a monetary and interest rate environment that

supports export and investment demand in the economy so as to enable

continuation of the growth momentum.

To re-emphasize credit quality and orderly conditions in financial markets for

securing macroeconomic and, in particular, financial stability while

simultaneously pursuing greater credit penetration and financial inclusion

To respond swiftly with all possible measures as appropriate to the evolving

global and domestic situation impinging on inflation expectations and the

growth momentum.

8. RESPONSIVENESS & EFFECTIVENESS OF MONETARY

POLICY IN INDIAChanges in monetary policies that have come due to global crisis give a good

example to understand responsiveness of the monetary policy of India . The policy

responses in India since September 2008 have been designed largely to mitigate the

adverse impact of the global financial crisis on the Indian economy. The conduct of

monetary policy had to contend with the high speed and magnitude of the external

shock and its spill-over effects through the real, financial and confidence channels.

The evolving stance of policy has been increasingly conditioned by the need to

preserve financial stability while arresting the moderation in the growth momentum.The Reserve Bank has multiple instruments at its command such as repo and reverse

repo rates; cash reserve ratio (CRR), statutory liquidity ratio (SLR), open market

operations, including the marketstabilisation scheme (MSS) and the LAF, special

market operations,and sector specific liquidity facilities. In addition, the Reserve Bank

also uses prudential tools to modulate flow of credit to certain sectors consistent with

financial stability. The availability of multiple instruments and flexible use of these

instruments in the implementation of monetary policy has enabled the Reserve Bank


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to modulate the liquidity and interest rate conditions amidst uncertain global

macroeconomic conditions.

The thrust of the various policy initiatives by the Reserve Bank has been on providing

ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining a market

environment conducive for the continued flow of credit to productive sectors. The key

policy Initiatives taken by the Reserve Bank since September 2008 are set out below:

a. Policy Rates

The policy repo rate under the liquidity adjustment facility (LAF ) was reduced by

400 basis points from 9.0 per cent to 4.75 percent.

The policy reverse repo rate under the LAF was reduced by 250basis points

from 6.0 per cent to 3.25 per cent.

b. Rupee Liquidity

The cash reserve ratio (CRR) was reduced by 400 basis points from 9.0 per cent

of net demand and time liabilities (NDTL) of banks to 5.0 per cent.

The statutory liquidity ratio (SLR) was reduced from 25.0 per cent of NDTL to

24.0 per cent.

The export credit refinance limit for commercial banks was enhanced to 50.0 per

cent from 15.0 per cent of outstanding export credit.

A special 14-day term repo facility was instituted for commercial banks up to 1.5

per cent of NDTL.

A special refinance facility was instituted for scheduled commercial banks

(excluding RRBs) up to 1.0 per cent of each banks NDTL as on October 24,

2008.

Special refinance facilities were instituted for financial institutions (SIDBI, NHB

and Exim Bank).

c. Forex Liquidity

The Reserve Bank sold foreign exchange (US dollars) and made available a

forex swap facility to banks.

The interest rate ceilings on nonresident Indian (NRI) deposits were raised.

The all-in-cost ceiling for the external commercial borrowings (ECBs) was

raised. The all-in-cost ceiling for ECBs through the approval route has been

dispensed with up to June 30, 2009.

The systemically important non-deposit taking non-banking financial companies

(NBFCs-ND-SI) were permitted to raise short-term foreign currency borrowings.

d. Regulatory Forbearance

The risk-weights and provisioning requirements were relaxed and restructuring

of stressed assets was initiated.


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Critical analysis of monetary policy in India

The specter of inflation has led the Reserve Bank of India (RBI) to repeatedly raise

interest rates and increase banks reserve requirements in classic monetary policy

responses. The RBI also faces the challenge of simultaneously managing the

exchange rate in the face of porous controls on international capital flows. While theexchange rate has depreciated recently as capital inflows have cooled, the hot button

issue just a few months ago was whether the exchange rate should be kept from

appreciating. Some economists argued for preventing exchange rate appreciation,

and managing the inflationary impact of capital inflows by selling government bonds,

thus soaking up excess liquidity. Others favoredan export-competitive exchange rate

policy, but also argued that monetary policy was irrelevant as current inflationary

symptoms were arising from temporary supply-side shocks. The radical position (at

least by Indian policy standards) has been that the RBI should focus on fighting

inflation, but give itself more room to do so by allowing the exchange rate to adjust to

market conditions. One version of this stance is that raising the interest rate is lesseffective as an inflationfightingpolicy than allow ing the rupee to appreciate, as financial

repression and underdeveloped financial markets keep interest rate changes from

rippling through the economy strongly enough. There are several empirical analyses

of the monetary transmission mechanism in India. These suggest that the interest

rate channel of monetary policy has strengthened since 1998, which should not come

as a surprise since there has been considerable financial liberalization, accompanied

by a revision of the RBIs policy approach. This result comes out in an interesting

fashion in a 2005 IMF study. The responses of firms to monetary tightening vary by

size and, while greater in the period 1998-2003 versus the prior half-decade, seem to

involve a reversal of initial cutbacks in corporate debt. Still, interest rates do affect firm

borrowing behavioral better feel for the aggregate impacts of monetary policy comes

from an economy wide analysis. This suggests the interest rate is an effective

inflation-fighting tool in India even though, as the many economists say, the financial

market in India is not yet matured. The results even indicate that output recovers with

a lag in the face of such interest rate increases. All this sounds quite good from the

perspective of what policymakers are currently doing, though there is nomodeling of

inflation expectations in India that we are aware of, and that issue seems to also be

driving monetary policy. Indian monetary policy is still very accommodative and

interest rates need to raise more to prevent global supply-side shocks from seeping

into the broader economy.The central bank held off outright rate increases for a year,

opting instead to keep cash availability tight, as prices pressures largely came from

supply constraints and record commodity prices rather than demand. The twin

objectives of monetary policy in India have evolved as maintaining price stability and

ensuring adequate flow of credit to facilitate the growth process.

OOOOOOUYY


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9. REVIEW OF MONETARY POLICY 2009-10These are impressive gains from reforms but there are emerging challenges to the

conduct of monetary policy in our country. Thus, while the twin objectives of monetary

policy of maintaining price stability and ensuring availability of adequate credit to the

productive sectors of the economy have remained unchanged, capital flows and

liberalization of financial markets have increased the potential risks of institutions, thusbringing the issue of financial stability to the fore. Credit flow to agriculture and small - and

medium-industry appears to be constrained causing concerns. There are significant

structural and procedural bottlenecks in the existing institutional set up for credit delivery.

The pace of reforms in real sector, particularly in property rights and agriculture also

impinge on the flow of credit in a deregulated environment. The persistence of fiscal

deficit, with the combined deficit of the Central and State Governments continuing to be

high, draws attention to the delicate internal and external balance.

It is necessary to recognize the existence of the large informal sector, the limited reach of

financial markets relative to the growing sectors, especially services, and the overhang of

institutional structure that tend to constrain the effectiveness of monetary policy i n India.

Among the unrealized medium-term objectives of reforms in monetary policy, the most

important is reduction in the prescribed CRR for banks to its statutory minimum of 3.0 per

cent. The movement to 3.0 per cent can be designed in three possible way s, viz., the

traditional way of pre-announcing a time-table for reduction in the CRR; reducing CRR as

and when opportunities arise as is being done in recent years; and as a one -time

reduction from the existing level to 3.0 per cent under a package of meas ures.

An important related component of ongoing reform relates to restricting the call money

market to banks and Primary Dealers (PDs).The call money window should be used to

iron out temporary mismatches in liquidity and banks should not use this on a sus tained

basis as a source of funding their normal requirements. A beginning has been made by

prescribing for access to call money a ceiling of 2.0 per cent of aggregate deposits in

respect of urban cooperative banks (UCBs). Such a stipulation can be extended to all

commercial banks and with some modifications such as, an alternative of 25.0 to 50.0 per

cent of their net owned funds.

The Reserve Bank influences liquidity on a day-to-day basis through LAF and is using

this facility as an effective flexible instrument for smoothening interest rates. The

operations of non-bank participants including FIs, mutual funds and insurance companies

that were participating in the call/notice money market are in the process of beinggradually reduced according to pre-set norms. The LAF operations combined with

judicious use of OMOs are expected to evolve into a principal operating procedure of

monetary policy of the Reserve Bank. To this end, the Reserve Bank may have to reduce

substantially the liquidity through refinance to banks and PDs.


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10. CONCLUSION:

Conduct of monetary policy is complex. It has not only to be forward looking but also to

grapple with uncertain future. Additional complexities arise in the case of an emerging

market like India, which is transiting from a relatively closed to a progressiv ely open

economy. The twin objectives of monetary policy in India have evolved as maintaining

price stability and ensuring adequate flow of credit to facilitate the growth process.

In an environment of increasing capital flows, narrowing cross -border interest ratedifferentials and surplus liquidity conditions, exchange rate movement tends to havelinkages with interest rate movements. The challenge of a monetary authority is tobalance the various choices into a coherent whole and to formulate a polic y as an art ofthe possible.


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11. BIBLIOGRAPHY

I. Clarinda, Richard; Jordi Gali & Mark Gertler (1998). Monetary policy rules inpractice Some international evidence, European Economic Review, Elsevier, vol.42(6), pp 1033-1067.

II. Friedman, B.M. (2001). Monetary Policy Abstract. International Encyclopedia of theSocial & Behavioral Sciences- 2001. pp. 99769984.

III. http://en.wikipedia.org/wiki/Monetary_policy

IV. http://finance.indiamart.com/investment_in_india/monetary_policy.html

V. http://www.rbi.org.in

VI. Pattnaik R.K. and S.N.V Siva Kumar (2010). The Reserve Bank of IndiasMonetary Policy Statement 2010-11: A Brief Account and an Assessment,Maharashtra Economic Development Council, Monthly Economic Digest May 2010pp 64-69

VII. Singh, Kanhaiya and Kaliappa Kalirajan (2006). Monetary Policy in India:Objectives, Reaction Function and Policy Effectiveness. Review of AppliedEconomics,Vol. 2(2)

credit & monetary policy 12.07.10

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