Download - Report on Monetary Policy
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Report of MEE
Topic: Monetary
Policy of RBISubmitted By:
Tushar Kathuria(54)
Jeso P. James(28)
Jatin Kakkar(26)
Nishu Singh(37)
Sweta Anand(56)
Pritha(40)
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Monetary policy
Monetary policy is the process by which the monetary authority of a country
controls the supply of money, often targeting a rate of interest. Monetary
policy is usually used to attain a set of objectives oriented towards the growth
and stability of the economy. These goals usually include stable prices and low
unemployment. Monetary theory provides insight into how to craft optimal
monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a
contractionary policy, where an expansionary policy increases the total supply
of money in the economy rapidly, and a contractionary policy decreases the
total money supply or increases it only slowly. Expansionary policy is
traditionally used to combat unemployment in a recession by lowering interest
rates, while contractionary policy involves raising interest rates to combat
inflation. Monetary policy is contrasted with fiscal policy, which refers to
government borrowing, spending and taxation.
The central bank influences interest rates by expanding or contracting themonetary base, which consists of currency in circulation and banks' reserves
on deposit at the central bank. The primary way that the central bank can
affect the monetary base is by open market operations or sales and purchases
of second hand government debt, or by changing the reserve requirements. If
the central bank wishes to lower interest rates, it purchases government debt,
thereby increasing the amount of cash in circulation or crediting banks'
reserve accounts. Alternatively, it can lower the interest rate on discounts or
overdrafts (loans to banks secured by suitable collateral, specified by the
central bank). If the interest rate on such transactions is sufficiently low,
commercial banks can borrow from the central bank to meet reserve
requirements and use the additional liquidity to expand their balance sheets,
increasing the credit available to the economy. Lowering reserve requirements
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has a similar effect, freeing up funds for banks to increase loans or buy other
profitable assets.
A central bank can only operate a truly independent monetary policy when the
exchange rate is floating. If the exchange rate is pegged or managed in any
way, the central bank will have to purchase or sell foreign exchange. These
transactions in foreign exchange will have an effect on the monetary base
analogous to open market purchases and sales of government debt; if the
central bank buys foreign exchange, the monetary base expands, and vice
versa. But even in the case of a pure floating exchange rate, central banks
and monetary authorities can at best "lean against the wind" in a world where
capital is mobile.
Accordingly, the management of the exchange rate will influence domestic
monetary conditions. To maintain its monetary policy target, the central bank
will have to sterilize or offset its foreign exchange operations. For example, if a
central bank buys foreign exchange (to counteract appreciation of the
exchange rate), base money will increase. Therefore, to sterilize that increase,
the central bank must also sell government debt to contract the monetary
base by an equal amount. It follows that turbulent activity in foreign exchange
markets can cause a central bank to lose control of domestic monetary policy
when it is also managing the exchange rate.
Monetary policy tools
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
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currency. When the central bank disburses/collects this hard currency
payment, it alters the amount of currency in the economy, thus altering the
monetary base.
Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy
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.
Discount window lending
Many central banks or finance ministries have the authority to lend funds to
financial institutions within their country. By calling in existing loans or
extending new loans, the monetary authority can directly change the size of
the money supply.
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. In the United
States, 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
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total volume in the bond market. One cannot set independent targets for both
the monetary base and 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 to mandate 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.
Currency board
A currency board is a monetary arrangement that pegs the monetary base of
one country to another, the 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 currency board. This limits the possibility for the local
monetary authority to inflate or pursue other objectives. The principalrationales behind a currency board are three-fold:
1. To import monetary credibility of the anchor nation;
2. To maintain a fixed exchange rate with the anchor nation;
3. To establish credibility with the exchange rate (the currency board
arrangement is the hardest form of fixed exchange rates outside of
dollarization).
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WHAT ARE THE INSTRUMENTS OF MONETARY
POLICY?
Fiduciary or paper money is issued by the Central Bank on the basis ofcomputation of estimated demand for cash. Monetary policy guides theCentral Banks supply of money in order to achieve the objectives of pricestability (or low inflation rate), full employment, and growth in aggregateincome. This is necessary because money is a medium of exchange andchanges in its demand relative to supply, necessitate spendingadjustments. To conduct monetary policy, some monetary variables whichthe Central Bank controls are adjusted-a monetary aggregate, an interest
rate or the exchange rate-in order to affect the goals which it does notcontrol. The instruments of monetary policy used by the Central Bankdepend on the level of development of the economy, especially its financialsector. The commonly used instruments are discussed below.
Reserve Requirement: The Central Bank may require Deposit MoneyBanks to hold a fraction (or a combination) of their deposit liabilities(reserves) as vault cash and or deposits with it. Fractional reserve limitsthe amount of loans banks can make to the domestic economy and thuslimit the supply of money. The assumption is that Deposit Money Banks
generally maintain a stable relationship between their reserve holdings andthe amount of credit they extend to the public.
Open Market Operations: The Central Bank buys or sells (on behalf ofthe Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market). One such security is TreasuryBills. When the Central Bank sells securities, it reduces the supply ofreserves and when it buys (back) securities-by redeeming them-it increasesthe supply of reserves to the Deposit Money Banks, thus affecting thesupply of money. Lending by the Central Bank: The Central Banksometimes provide credit to Deposit Money Banks, thus affecting the level
of reserves and hence the monetary base.Interest Rate: The Central Bank lends to financially sound Deposit MoneyBanks at a most favourable rate of interest, called the minimum rediscountrate (MRR). The MRR sets the floor for the interest rate regime in themoney market (the nominal anchor rate) and thereby affects the supply ofcredit, the supply of savings (which affects the supply of reserves andmonetary aggregate) and the supply of investment (which affects fullemployment and GDP). Direct Credit Control: The Central Bank can direct
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Deposit Money Banks on the maximum percentage or amount of loans(credit ceilings) to different economic sectors or activities, interest ratecaps, liquid asset ratio and issue credit guarantee to preferred loans. In thisway the available savings is allocated and investment directed in particulardirections.
Moral Suasion: The Central Bank issues licenses or operating permit toDeposit Money Banks and also regulates the operation of the bankingsystem. It can, from this advantage, persuade banks to follow certain pathssuch as credit restraint or expansion, increased savings mobilization andpromotion of exports through financial support, which otherwise they maynot do, on the basis of their risk/return assessment.
Prudential Guidelines: The Central Bank may in writing require theDeposit
Money Banks to exercise particular care in their operations in order thatspecified
outcomes are realized. Key elements of prudential guidelines remove some
discretion from bank management and replace it with rules in decisionmaking.
Exchange Rate: The balance of payments can be in deficit or in surplusand
each of these affect the monetary base, and hence the money supply inone
direction or the other. By selling or buying foreign exchange, the CentralBank
ensures that the exchange rate is at levels that do not affect domesticmoney
supply in undesired direction, through the balance of payments and thereal 3
exchange rate. The real exchange rate when misaligned affects the current
account balance because of its impact on external competitiveness. Moral
suasion and prudential guidelines are direct supervision or qualitative
instruments. The others are quantitative instruments because they have
numerical benchmarks.
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How RBI policy impacts interest
rates
The Reserve Bank of India (RBI), which is India's central bank and the bank, is
one of the most important players in the Indian economy and financial
markets. It is in charge of monetary policy which has a big impact on liquidity
and interest rates in the financial system. Let's look at some of the basics of
monetary policy and how it impacts the average investor.
The RBI has several goals of which controlling inflation is one of the most
important. When inflation is rising and threatening to spin out of control, as it
is today, the RBI 'tightens' monetary policy which means reducing the amount
of liquidity (floating money) in the economy. Though the RBI's policies may
take up to a year to show their full effect they are perhaps the most effective
way of reducing inflation.
How the RBI conducts monetary policy
The RBI has several tools for conducting monetary policy: two of the most
important are the cash reserve ratio (CRR) and the liquidity adjustment facility
(LAF).
The CRR is the proportion of their deposits which banks have to keep with the
RBI. Raising the CRR is one of the most effective ways for the RBI to suck
liquidity out of the financial system which reduces demand in the economy
and therefore helps curb inflation. Thus recently the RBI raised the CRR from
7.5 per cent to 8 per cent which sucked Rs 18,000 crores out of the banking
system.
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The LAF can be thought of as a way for the RBI to lend and borrow to banks for
very short periods, typically just a day. The repo rate is the RBI's lending rate
and reverse repo rate is the RBI's borrowing rate. These two rates help the RBI
influence short-term interest rates in the rest of the financial system.
Currently the RBI has left the repo/reverse repo rates untouched but if
inflationary pressures remain strong it may be forced to increase them.
Impact on interest rates
What impact does monetary policy have on the different interest rates in the
economy like the home loan rate? The RBI doesn't directly control these
interest rates but in general a tighter monetary policy leads to higher interest
rates.
This relationship isn't iron-clad though, and major banks like SBI and ICICI
have stated the recent CRR hike wouldn't necessarily lead to higher interest
rates. However if the RBI continues to tighten policy further by raising the CRR
again or raising the repo/reverse repo rates, it's possible that banks will
respond by raising interest rates on various loans including home loans.
Impact on stock markets
If you watch investment channels or read business papers, you will know that
the financial markets pay obsessive attention to the actions of the RBI. This is
with good reason since any changes in monetary policy has an immediate
impact on financial markets.
In general a tighter policy will hurt investor sentiment and stock prices. There
will be less liquidity floating around and higher interest rates will raise the cost
of capital for companies hurting their bottom lines and stock prices.
Companies which have high levels of debt are especially vulnerable.
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A tighter policy will harm some sectors like banking and real estate more than
others. For example banks don't earn interest on the reserves they keep with
the RBI; therefore an increase in the CRR immediately hurts their bottom line.
Similarly if tighter policy leads to higher interest rates, this will reduce demand
for housing as home loans become more expensive.
Impact on exchange rates
The RBI's monetary policy will also have an impact on exchange rates. In
particular if Indian interest rates rise because of tighter policy, the demand for
Indian interest-paying assets will also rise, leading to an increase in the value
of the rupee.
This helps with inflation since imports will now be cheaper in rupee terms. For
example if the price of oil is $100 per barrel and the rupee rises in value from
Rs 45 to Rs 42 per dollar, the rupee price of a barrel of oil will fall from Rs
4,500 to Rs 4,200.
On the flip side, the rising rupee will have a negative impact on export-
oriented companies; for example major IT stocks which have done quite well
recently may fall.
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RBI Annual Monetary Policy 2010-11 An Update
In its annual monetary policy review for 2010-11, RBI increased its policy
rates.
Repo rate and Reverse repo rate increased by 25 bps to 5.25% and
3.75% respectively, with immediate effect. Impact: Repo is the rate at
which banks borrow from RBI and Reverse Repo is the rate at which
banks deploy their surplus funds with RBI. Both these rates are used by
financial system for overnight lending and borrowing purposes. An
increase in these policy rates imply borrowing and lending costs for
banks would increase and this should lead to overall increase in interest
rates like credit, deposit etc. The higher interest rates will in turn lead to
lower demand and thereby lower inflation. The move was in line with
market expectations
Cash reserve ratio (CRR) increased by 25 bps to 6.00%, to apply from
fortnight beginning from 24 April 2010. Impact: When banks raise
demand and time deposits, they are required to keep a certain percentwith RBI. This percent is called CRR. An increase in CRR implies banks
would be required to keep higher percentage of fresh deposits with RBI.
This will lead to lower liquidity in the system. Higher liquidity leads to
asset price inflation and also leads to build up of inflationary
expectations. Before the policy, market participants were divided over
CRR. Some felt CRR should not be raised as liquidity would be needed to
manage the government borrowing program, 3-G auctions and credit
growth. Others felt CRR should be increased to check excess liquidity
into the system which was feeding into asset price inflation and general
inflationary expectations. Some in the second group even advocated a
50 bps hike in CRR.
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By increasing the rate by 25 bps, RBI has signaled that though it wants
to tighten liquidity it also wants to keep ample liquidity to meet the
outflows. Governors statement added that in 2010-11, despite lower
budgeted borrowings, fresh issuance will be around Rs 342300 cr
compared to Rs 251000 cr last year.
RBIs Domestic Outlook for 2010-11
Table 1: RBIs Indicative Projections (All Fig In %, YoY)
2009-10
targets (Jan
10 Policy)
2009-10
Actual
Numbers
2010-11
targets (Apr
10 Policy)
GDP 7.5 Expected at
7.2 by CSO
8 with an
upward bias
Inflation (based on
WPI, for March
end)
8.5 9.9 5.5
Money Supply
(March end)
16.5 17.3 17
Credit (March end) 16 17 20
Deposit (March
end)
17 17.1 18
Source: RBI
Growth: RBI revised its growth forecast upwards for 2010-11 at 8% with
an upward bias compared to 2009-10 figures of 7.5%. It said Indian
economy is firmly on the recovery path. RBIs business outlook survey
shows corporate are optimistic over the business environment. Growth
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in industrial sector and services has picked up in second half of 2009-10
and is expected to continue. The exports and import sector has also
registered a strong growth. It is important to note that RBI has placed
the growth under the assumption of a normal monsoon. India could have
achieved a near 8% growth in 2009-10 itself, if monsoons were better.
Table 2 looks at growth forecasts of Indian economy for 2010-11 by
various agencies.
Table 2:Projections of GDP Growth by various
agencies for 2010-11 (in %, YoY)
2009-10 2010-11
RBI 7.5 with an
upward bias
8 with an upward
bias
PMs Economic Advisory
Council
7.2 8.2
Ministry of Finance 7.2 8.5 (+/- 0.25)
IMF 6.7 8
Asian Development Bank 7.2 8.2
OECD 6.1 7.3
RBIs Survey of
Professional Forecasters
7.2 8.5
Inflation: RBIs inflation projection for March 11 is at 5.5% compared
to FY March-10 estimate of 8.5% with an upward bias (the final figure
was at 9.9%). RBI said inflation is no longer driven by supply side factors
alone. First WPI non-food manufactured products (weight: 52.2 per cent)
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inflation, increased sharply from (-) 0.4%in November 2009, to 4.7% in
March 2010. Fuel price inflation also surged from (-) 0.7 per cent in
November 2009 to 12.7% in March 2010. Further, contribution of non-
food items to overall WPI inflation, which was negative at (-) 0.4% in
November 2009 rose sharply to 53.3% by March 2010. So, overall
demand pressures on inflation are also beginning to show signs. These
movements were visible in March 2010 itself, pushing RBI to increase
rates before the official policy in April 2010.
Monetary Aggregates: RBI has increased the projections of all three
monetary aggregates for 2010-11. These projections have been made
consistent with higher expected growth in 2010-11. Higher growth will
lead to more demand for credit. Then management of government
borrowing program will remain a challenge as well. High growth coupled
with the borrowing program will need higher financial resources.
Therefore, projections for money supply, credit and deposit are raised to
17%, 20% and 18% respectively. However, higher growth in money
supply would also lead to build up of higher inflation and inflationary
expectations. Let us understand what M1 and M3 mean.
There are various measures to calculate money supply. Each measure
can be classified by placing it along a spectrum between narrow and
broad monetary aggregates. Narrow money includes most acceptable
and liquid forms of payment like currency and bank demand deposits.
Broad money includes narrow money and other kinds of bank deposits
like time deposits, post office savings account etc.
These different types of money are typically classified as Ms. the
number of Ms usually range from M0 (narrowest) to M3 (broadest) but
which Ms are actually used depends on the system. There are four Ms in
India:
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o M1: Currency with the public + Demand Deposits + Other
deposits with the RBI.
o M2: M1 + Savings deposits with Post office savings banks.
o M3: M1+ Time deposits with the banking system
o M4: M3 + All deposits with post office savings banks (excluding
National Savings Certificates).
Growth in M3 is higher than M1 from April- November 2009. From Dec-
2009 onwards, the growth rate in M1 is higher than M3. The difference
in M1 and M3 comes from the growth rate in time and demand deposits.
Growth in Time deposits is higher than demand deposits between April-
November 2009. From December 2009, onwards growth in demanddeposits picks up. This in turn reflects in differences in growth rate of M1
and M3. The growth rate in currency is volatile. It declines 15% in
August 2009 and then again increases to 17.9% in December 2009. It
then declines to 15.6% in March 2010. Hence, the difference between
M1 and M3 comes from surge in growth of demand deposits and decline
in growth of time deposits.
So, this just confirmed what Kohli said. She added this could
be interpreted in two ways. First, spending on consumption and
production is increasing as economy has recovered from recession.
Second, it could be people are spending now as they expect higher
inflation in future. Higher inflation in future could also lead to higher
returns on assets and property in future; therefore people prefer to
spend now.
It will be interesting to watch trends in M1 and M3 from now on as well.
RBI also outlined downside risks with its projections:
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First, there is still substantial uncertainty about the pace and shape of
global recovery
Second, if the global recovery does gain momentum, commodity and
energy prices, which have been on the rise during the last one year,
may harden further. This could put upwards pressure on inflation
Third, monsoon will continue to play a vital role both from domestic
demand and inflation perspective.
Fourth, policies in advanced economies are likely to remain highly
expansionary. High liquidity in global markets coupled with higher
growth in emerging economies foreign capital flows are expected to
remain higher. This will put pressure on exchange rate policy. RBI
usually does not comment on its exchange rate policy. As the economic
situation is exceptional, RBI also commented on Indias exchange rate
policy.
Our exchange rate policy is not guided by a fixed or pre-announced target or
band. Our policy has been to retain the flexibility to intervene in the market to
manage excessive volatility and disruptions to the macroeconomic situation.
Recent experience has underscored the issue of large and often volatile
capital flows influencing exchange rate movements against the grain of
economic fundamentals and current account balances. There is, therefore, a
need to be vigilant against the build-up of sharp and volatile exchange rate
movements and its potentially harmful impact on the real economy.
Policy Stance
The policy stance remains unchanged from January 2010 policy.
Table 3: Comparing RBIs Policy Stance
October 2009 Policy January 2010 Policy April 2010 Policy
Watch inflation Anchor inflation Anchor inflation
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trend and be
prepared to
respond swiftly
and effectively
Monitor liquidity to
meet credit
demands of
productive sectors
while securing
price and financial
stability
Maintain monetary
and interest rate
regime consistent
with price and
financial stability,
and supportive of
the growth
process
expectations,
while being
prepared to
respond
appropriately,
swiftly and
effectively to
further build-up of
inflationary
pressures.
Actively manage
liquidity to ensure
that the growth in
demand for credit
by both the
private and public
sectors is satisfied
in a non-disruptive
way.
Maintain an
interest rate
regime consistent
with price, output
and financial
stability.
expectations, while
being prepared to
respond
appropriately,
swiftly and
effectively to
further build-up of
inflationary
pressures.
Actively manage
liquidity to ensure
that the growth in
demand for credit
by both the private
and public
sectors is satisfied
in a non-disruptive
way.
Maintain an
interest rate
regime consistent
with price, output
and financial
stability.
Source: RBI
Summary: Given the economic outlook, policy ahead is going to remain
challenging. There are many trade-offs RBI has to manage. It needs to manage
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high inflation without impacting the growth process. The recent inflation
numbers show rising demand side pressures on inflation. The market
participants are already looking at an increase of around 100-150 bps by
March 2011 end. The higher interest rates would make it difficult to manage
the government borrowing program and also invite more capital flows. High
interest rates could also lead to higher lending costs for the corporate sector.
The challenges are not limited to domestic factors alone. The concerns remain
on future outlook of advanced economies which complicates the policy
process further.
Other Development and Regulatory Policies
In its Annual (in April) and Mid-term review (in October) of monetary policy,
RBI also covers developments and proposed policy changes in financial
system.
Some of the developments announced in this policy are:
New Products/Changes in guidelines
Currently, Interest rate futures contract is for 10 year security. RBI has
proposed to introduce Interest rate futures for 2 year and 5 year
maturities as well.
RBI has permitted recognized stock exchanges to introduce plain vanilla
currency options on spot US Dollar/Rupee exchange rate for residents
Final guidelines for regulation of non- convertible debentures of maturity
less than one year by end-June 2010
RBI had proposed to introduce plain vanilla Credit Default Swaps in
October 2009 policy. RBI would place a draft report on the same by end-
July 2010
Earlier, banks could hold infrastructure bonds in either held for trading
or available for sale category. This was subject to mark to market
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requirements. However, most banks hold these bonds for a long period
and are not traded. From now on, banks can classify such investments
having a minimum maturity of seven years under held to maturity
category. This should lead banks to buy higher amount of infrastructure
bonds and push infrastructure activity.
The activity in Commercial Papers and Certificates of deposit market is
high but there is little transparency. FIMMDA has been asked to develop
a reporting platform for Commercial Papers and Certificates of deposit.
Setting up New Banks
Finance Minister, in his budget speech on February 26, 2010 announced
that RBI was considering giving some additional banking licenses to
private sector players. NBFCs could also be considered, if they meet the
Reserve Banks eligibility criteria. In line with the above announcement,
RBI has decided to prepare a discussion paper on the issues by end-July
2010 for wider comments and feedback.
In 2004 seeing the financial health of urban cooperative banks, it was
decided not to set up any new UCBs. Since then the performance of
these banks has improved. It has been decided to set up a committee to
study whether licences for opening new UCBS can be done.
In February 2005, the Reserve Bank had released the roadmap for
presence of foreign banks in India. The roadmap laid out a two-phase,
gradualist approach to increase presence of foreign banks in India. The
first phase was between the period March 2005 March 2009, and the
second phase after a review of the experience gained in the first phase.
In the first phase, foreign banks wishing to establish presence in India
for the first time could either choose to operate through branch
presence or set up a 100% wholly-owned subsidiary (WOS), following the
one-mode presence criterion. Foreign banks already operating in India
were also allowed to convert their existing branches to WOS while
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following the one-mode presence criterion. However, because of the
global crisis the second phase which was due in April 2009 could not be
started. The global financial crisis has also thrown some lessons for
policymakers. Drawing these lessons RBI would put up a discussion
paper on the mode of presence of foreign banks through branch or WOS
by September 2010.
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First quarterly review of monetary policy 2010-11
RBI Governor, Dr D V Subbarao announced the first quarterly review of
monetary policy today. The measures taken were quite on the expected
Benchmark Repo rates hiked by 25 bps to 5.75% with immediate effect.
Benchmark Reverse Repo rates hiked by 50 bps to 4.50% with
immediate effect.
The interest rate corridor between the Repo and Reverse Repo window
reduced to 125 bps from 150 bps.
CRR, SLR and Bank rate kept unchanged at 6%, 25% and 6%,
respectively.
Baseline inflation projection for March 2010 increased to 6% from 5.5%.
Baseline estimate for GDP growth for 2010-11 revised to 8.5% from 8%.
Bank deposit growth target of 18% maintained for FY2010-11; Bank
deposit growth stood at 15.0% year-on-year as on July 2, 2010.
Bank credit growth target of 20% maintained for FY2010-11; Bank credit
growth stood at 22.3% year-on-year as on July 2, 2010.
RBI to undertake mid-quarter policy reviews starting September 2010.
Impact of monetary policy
As expected, RBI has raised the policy rates. This is the fourth rate hike
since March this year raising the Repo by a total of 100 bps and Reverse
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Repo by 125 bps. Moving differently from earlier moves, the quantum of
change in the policy rates; repo and reverse repo is different. The
Liquidity Adjustment Facility (LAF) corridor has been shrunk to 125 bps,
a change first time since November2008.
What this means?
Short term interest rates, particularly, interbank repo market rates hover in
between the LAF corridor in order to prevent arbitrage opportunities for the
banks. Because of tight liquidity conditions, short term rates have been quite
volatile. This measure is aimed at containing this volatility in the rates.
Since end-May, banks have been borrowing from RBI through its LAF
Repo window. Out of four rate hikes since March, two were affected
when there was ample liquidity in the system. But the last two have
come at a time when the liquidity conditions have tightened. Thus
interest cost of banks will go up. Assuming that banks will borrow about
Rs 50,000 cr for the year as whole from Repo, the combined effect of
the last two hikes will shave off about Rs 250 cr from banking sectors
profits.
What would also hurt bankss profitability is that deposit rates have also
risen. Thus lending rates, in general will go up in order to protect net
interest margin (NIM).
Inflationary expectations have driven RBI to raise the rates. Policy
stance of RBI has shifted to to containing inflation and anchoring
inflationary expectations. RBI has noted that inflationary expectations
have firmed up. Accordingly, RBI has also raised the projection for end-
March 2011 to 6%. RBI has commented that it will continue to take
actions to counter inflationary expectation.
Though RBI has not hinted at further rate hikes, but its strong concern
for inflation implies that good growth prospect along with continued high
inflation will in make it imperative for RBI to increase rates.
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RBI Annual Monetary Policy 2011-12 aquick review
Each time you think the hype and dilemmas would be lesser for RBI, each time it increases.
April-2011 policy started with another effort to increase transparency at RBI. Till April-2011, RBI
announced its monetary policy closed doors with bankers. This was followed by interaction with
media in the evening and researchers next day.
From Apr-2011, RBI decided to live telecast the policy announcement on TV. The telecast was also
streamed live on banks website. This was a great measure as now public knows the policies along
with the others attending the meeting.
Now coming to the policy. First, RBI has made changes in the operating framework of
monetary policy. Earlier it was both reverse and repo rate which changed (along with CRR, SLR
depending on the situation). Now, going by Deepak Mohanty report, RBI has decided to adopt a
one rate framework with a corridor like seen in other central banks. New framework is
Reverse repo lower than repo by 100 bps. Changes automatically with Repo rate and no more
independent rate. To form bottom of the corridor
Repo rate in the middle becomes the policy rate
A new rate called Marginal Standing Facility (MSF) above Repo rate by 100 bps. In this Banks
can borrow overnight up to one per cent of their respective NDTL. This is like the discount rate of Fed
which is higher than Fed Funds Rate. To form top of the corridor. Mohanty committee had suggested
making bank rate as the top of the corridor. But a new rate has been added. RBI should have given
some reason for the same.
Another important thing is banks will not need to take permission for waiver of default from SLR
compliance. This is something this blog suggested in Dec-10 (taking insights from behavioral
economics)
Weighted call rate becomes the operating target. This means the call rate movement
becomes critical. RBI will try to keep it closer to Repo and in the corridor.
Based on this, policy rates have changed to:
http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=24333http://mostlyeconomics.wordpress.com/2010/12/06/nudging-to-ease-deficit-liquidity-situation/http://mostlyeconomics.wordpress.com/2010/12/06/nudging-to-ease-deficit-liquidity-situation/http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=24333 -
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Repo rates increased by 50 bps to 7.25%
Rev repo automatically becomes 6.25%
MSF to be operational from 7 May 2011 at 8.25%
Bank rate and CRR unchanged at 6%
RBI has put up a paper to debate deregulation of savings bank rate. As spread between savings
deposit and term deposit rates has widened this rate has been increased to 4%. This will hit banks
further as now they will have to pay higher interests. Research shows savings deposits at around
12.5 lakh crore on March-2011. This would imply additional cost of Rs 6,250 Cr. The latest
profitability numbers are still not out. In Mar-2010, net profits of banks was Rs 57,109 Cr. Based
on 2010 figure the impact on banks profits could be around 10-11%. It should be lower as of now
as profits must be higher. The Net interest margins will be affected as well.
The basis of the hike is based on purely inflation concerns. The statement notes how inflation has
been so persistent and always higher than RBI projections. Inflation control forms the theme of the
RBI stance. RBI even says if growth is lower on a short-term because of inflation control measures
let it be:
Over the long run, high inflation is inimical to sustained growth as it harms investment by creating
uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing
them down, therefore, even at the cost of some growth in the short-run, should take precedence.
I never really understood the statements made by even noted names - one has to tolerate high
inflation for high growth. It was plain silly. The fact is low inflation is one of the most important
factors for high sustained growth. In 2003-08 high growth period, average headline inflation was
5.30% and core was 5.00%. This made high growth possible. If inflation then had ran to around
10%, 9% growth would have been not possible.
The statement takes Gokarns highly useful speech forward. He showed there is a threshold
inflation level for economies and if inflation higher than it, growth gets affected. This threshold
inflation around 5-5.5% and current levels almost double this threshold. So, if your growth pushes
inflation to 9-10% levels as is the case, growth will be affected via high interest rates and lowerinvestment.
Some said you cannot have 9% growth and 2% inflation. Well we are talking about more
reasonable 5-5.5% inflation. Who is even mentioning 2% when RBIs long-term average inflation is
3%. Subbarao rightly says in his press statement:
http://mostlyeconomics.wordpress.com/2011/04/07/is-indias-recent-high-infllation-a-new-normal/http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=24335http://mostlyeconomics.wordpress.com/2011/04/07/is-indias-recent-high-infllation-a-new-normal/http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=24335 -
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Before I close, I want to reiterate what I said earlier, by making a brief comment on the growth-
inflation trade off, an issue that has been widely debated in the run up to this policy. High and
persistent inflation undermines growth by creating uncertainty for investors, and driving up
inflation expectations. An environment of price stability is a pre-condition for sustaining growth in
the medium-term. Reining in inflation should therefore take precedence even if there are someshort-term costs by way of lower growth.
I hope that ends the so-called trade-off talks.
RBI has also hinted in inflation projections that inflation to remain at 9% till Sep-11 and then trend
lower to 6% by mar-11. There is tremendous uncertainty on that outlook given uncertain oil
prices, external demand etc.
RBIs projections for FY 2011-12:
GDP at 8%
inflation at 6% with upward bias by Mar-12
Non-food Credit at 19%, Money growth at 16% and deposit at 17%
The stance of monetary policy of the Reserve Bank will be as follows:
Maintain an interest rate environment that moderates inflation and anchors inflation
expectations.
Foster an environment of price stability that is conducive to sustaining growth in the medium-
term coupled with financial stability
Manage liquidity to ensure that it remains broadly in balance, with neither a large surplus
diluting monetary transmission nor a large deficit choking off fund flows.
RBI also says meeting fiscal targets look difficult given high food and fuel prices. So monitoring of
ficsal targets to be done with vigilance. Also deregulation of oil retail market to be done for better
assessment.
Overall a much-needed policy. With policy rates even lower than core inflation, 50 bps was the
need of the hour. Negative real interest rates in a high growing economy is just a disaster waiting
to happen on inflation front. Banks were reluctant to hike deposit and credit rates saying 25
bps rate hike will not lead to any changes. So RBI has gone tougher. This should lead to tighter
monetary policy and better transmission.
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Other than this there are some measures to improve the financial market infrastructure as it is
given in annual and mid-term reviews. Some important ones:
Measures taken to improve banking sector resilience. Provisions enhanced for NPAs of banks.
This to hit banks further.
Banks investing in debt oriented MFs leading to circular flow of funds. This investment capped to
10% of banks net worth. Aggregate banks net worth around 5 lakh crore. So net investment in debt
mutual funds at 50,000 Cr. RBI explains:
The liquid schemes continue to rely heavily on institutional investors such as commercial banks
whose redemption requirements are likely to be large and simultaneous. DoMFs, on the other
hand, are large lenders in the over-night markets such as collateralised borrowing and lending
obligation (CBLO) and market repo, where banks are large borrowers. DoMFs invest heavily in
certificates of deposit (CDs) of banks. Such circular flow of funds between banks and DoMFs couldlead to systemic risk in times of stress/liquidity crunch.
G-sec trading: to extend the period of short sale of G-sec from the existing five days to a
maximum period of three months.
Financial Inclusion: to allocate at least 25 per cent of the total number of branches to be opened
during a year to unbanked rural (Tier 5 and Tier 6) centres.
Urban Coop banks:
to permit scheduled UCBs satisfying certain criteria to provide internet banking facility to their
customers.
to permit well-managed and financially sound UCBs to become members of the negotiated
dealing system
M-banking:
to treat mobile-based semi-closed prepaid instruments issued by non-banks on par with other
semi-closed payment instruments and raise the limit from Rs 5,000 to Rs 50,000, subject to certain
conditions.