Monetary Policy

The Reserve Bank of India will announce its Monetary and Credit Policy for the first half of the financial year 2003-04 on April 29. In simple terms, this policy determines the supply of money in the economy and the rate of interest charged by banks. The policy also contains an economic overview and presents future forecasts.

Objectives of Monetary Policy

The Monetary and Credit Policy is the policy statement, through which the Reserve Bank of India seeks to ensure adequate liquidity to meet credit growth and support investment demand while maintaining price stability. Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into.

The main parameters are - money supply, interest rates and inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy, and it mainly consists of currency with public and Demand and Time Deposits with banks.

Besides, the RBI also announces norms for the banking and financial sector and the institutions, which are governed by it.

Monetary Policy Announcement schedule

Earlier, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary and Credit Policy. This was commensurate with the agricultural cycles and April to September was called the slack season policy and October to March was the Busy season policy. But now, as the share of credit to agriculture has come down and credit to industry being granted year round, monetary policy is announced only once with a mid term review. Moreover, Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy.

Impact of Monetary Policy on Corporates/ Individuals

It impacts Corporates and individuals on the Interest rate front.

Depending upon interest rate stance of RBI, banks lower/increase their lending rates and borrowing rates. Since the rates of interest affect the borrowing costs of corporates and as a result, their bottomlines (profits), the monetary policy is very important to them. Similarly, rates of interest affect the interest earnings of individuals on their bank deposits.

Since the financial sector reforms commenced, the RBI has moved towards a market-determined interest rate scenario. This means that banks are free to decide on interest rates on term deposits and loans.

CRR & SLR

CRR (Cash Reserve Ratio) refers to portion of aggregate deposits banks need to keep/ maintain with the RBI. It ensures that a portion of bank deposits is totally risk-free and secondly it enables RBI to control liquidity in the system, and thereby, inflation.

Besides the CRR, banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements.

The government securities (also known as gilt-edged securities or gilts) are bonds issued by the Central government to meet its excess of expenditure over receipts. Although the bonds are long-term in nature, they are liquid as they can be traded in the secondary market.

Since 1991, as the economy has recovered and sector reforms increased, the CRR has fallen from 15 per cent in March 1991 to 4.75 per cent in November 2002. The SLR has fallen from 38.5 per cent to 25 per cent over the past decade.

Impact of CRR cut on interest rates

A cut in CRR requires Banks to keep lesser portion of deposits with banks and thus more liquidity to them to lend/ invest in gilts. Thus yield on Government securities comes down thus aiding softer interest rates.

Effect of Monetary Policy on Exporters

RBI announces Export refinance rate, or the rate at which the RBI will lend to banks, which have advanced pre-shipment credit to exporters.

A lowering of the Export Refinance rate would mean lower borrowing costs for the exporter.

Relation between Money supply, wages, Employment and Output

RBI tries to maintain money supply at such levels that economy operates at its full potential while minimizing the inflationary impact. If economy is operating at its full potential at its maximum possible level of employment, an increase in money supply will cause a rise in inflation. If economy does not operate at full potential, inflation can still be caused by other factors like supply situations (OPEC cartel increasing prices of Oil). If inflation is high, traditionally it leads to increase in employment as real wages decrease. Lower inflation, similarly should lead to lower employment as real wages increase. Moreover, GDP growth rate might suffer as people due to lower fears of future price increases might postpone consumption. But on the opposite higher inflation adversely affect exports as our goods become price incompetitive in the international markets.

Regulating Money Supply by RBI

RBI uses Private placement of Government Debt, Open market operations and CRR cut to regulate money supply in the market.

Under Open market Operations, RBI buys or sells Government Bonds in the secondary market. It sells bonds to absorb liquidity from the market if interest rates are falling sharply.

A CRR cut requires the banks to keep lesser money with the RBI and releases more funds for the banks to lend/ invest in Government securities. This results in increase in money supply.

Private placement of bonds by the Government with RBI allows the Government to borrow at lower interest rate, which otherwise Government would have issued at higher interest rate from the market. Private placement increases money supply, as Government gets money straight from RBI to spend.

Expectations from the Forthcoming Monetary Policy:

Bank Rate: At present Bank rate is at 6.25%. In its Oct 29, 2002 monetary policy review, RBI clearly indicated of the current week link between average lending rates of banks and the bank rate due to:

• High proportion of long term deposits at old and fixed interest rates
• Relatively high transaction costs
• Continued preference of depositors for fixed rather than variable interest rates

In-spite of lesser reduction in Lending rates of banks, Non food credit has shown a healthy pick-up in the current year and as on March 7, the non-food credit offtake in this year, net of ICICI and ICICI Bank merger effect is Rs. 84562 crores, compared to same period last year figure of 50786 crores. Thus sensitivity of credit off-take to interest rates is not as significant as other economic factors.

However, to put emphasis on softer interest rate bias, RBI should reduce bank rate by around 50 basis points to 5.75% and this would match with the currently prevailing call money rates. The market would similarly expect so.

Repo Rate: The repo rate was reduced thrice last year and is presently at 5%. This should further be reduced by 25 basis points to 4.75%. The markets might expect 50 basis points cut, but the RBI is unlikely to reduce it by this magnitude.

CRR: Cash Reserve Ratio, which at present stands at 4.75%, is expected to be reduced by 50 basis points to 4.25%, for the following reasons:

• RBI plans to reduce CRR to the statutory minimum level of 3% in a phased manner.
• This will provide liquidity support to the tune of around Rs. 6500 crores in the year of fresh borrowing program of the Government. If Food credit, which in the current year showed an absolute decline, rises, then Banks might get into some liquidity pressure due to healthy non-food credit offtake coupled with lesser increase in aggregate deposits, which might be a result of rapid reductions in deposit rates over the last two years.

Some Monetary Policy terms:

Bank Rate

Bank Rate is the rate at which Scheduled commercial banks borrow from the RBI. It is a signaling rate for banks to determine their lending and deposit rates. Bank rate directly affects the Bank's borrowing costs from RBI and any decrease in Bank rate spur banks to reduce their lending and deposit rates. A reduction also indicates to banks that RBI is following a softer interest rate policy.

Cash Reserve Ratio

All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the cash reserve ratio. The current CRR requirement is 4.75%.

Inflation

Inflation is a measure of price level prevailing in the economy. Higher inflation means higher prices over previous year level and vice-versa.

Money Supply (M3)

Money supply (M3) refers to amount of currency in the economy and is a sum of currency in circulation with public, demand and time deposits with banks and other deposits with RBI.

Statutory Liquidity Ratio

It is the ratio of banks investments in Government securities and other approved securities to aggregate deposits. The currently prescribed level of SLR is 25%.

Repo

A repurchase agreement or ready forward deal is a secured short-term loan by one bank to another against government securities.

Legally, the borrower sells the securities to the lending bank for cash, with the stipulation 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.

To monitor liquidity in the market on a daily basis, RBI conducts LAF (Liquidity Adjustment Facility) repo auction, which are of 1 day, 3 days and 14 days duration. The current repo rate is 5%.

Open Market Operations

An important instrument of credit control, the Reserve Bank of India purchases and sells securities in open market operations.

In times of inflation, RBI sells securities to mop up the excess money in the market. Similarly, to increase the supply of money, RBI purchases securities.

*Contributed by -
Vivek Kejriwal
Escorts Securities Ltd.