RBI’s Monetary Policy
Monetary policy refers all those operations, which are used to control the money supply in the economy. The overall objective of the monetary policy is twofold:
- To maintain economic and financial stability
- To ensure adequate financial resources for the purpose of development.
These objectives can be further simplified to:
- Maintaining price stability
- Adequate flow of credit to productive sectors
- Promotion of productive investments & trade
- Promotion of exports and economic growth
Reserve Bank of India announces Monetary Policy every year in the Month of April. This is followed by three quarterly Reviews in July, October and January.
Various tools / instruments of monetary policy
Various instruments of monetary policy can be divided into quantitative and qualitative instruments. Quantitative instruments are those which directly affect the quantity of money supply in the economy. Qualitative instruments are those which impact the money supply indirectly.
The quantitative instruments are:
- Open Market Operations
- Liquidity Adjustment Facility (Repo and Reverse Repo)
- Marginal Standing Facility
- SLR, CRR
- Bank Rate
- Credit Ceiling etc
On the other hand, qualitative instruments are: credit rationing, moral suasion and direct action (by RBI on banks).
Quantitative Instruments of Monetary Policy
Open Market Operations
Open Market Operations (OMO) refer to the purchase and sale of the Government Securities (G-Secs) by RBI from / to market. The objective of OMO is to adjust the rupee liquidity conditions in the economy on a durable basis. The working of OMOs is defines as below:
- When RBI sells government security in the markets, the banks purchase them. When the banks purchase Government securities, they have a reduced ability to lend to the industrial houses or other commercial sectors. This reduced surplus cash, contracts the rupee liquidity and consequently credit creation / credit supply.
- When RBI purchases the securities, the commercial banks find them with more surplus cash and this would create more credit in the system.
Thus, in the case of excess liquidity, RBI resorts to sale of G-secs to suck out rupee from system. Similarly, when there is a liquidity crunch in the economy, RBI buys securities from the market, thereby releasing liquidity. It’s worth note here that the market for government securities is not well developed in India but still OMO plays very important role.
Liquidity Adjustment Facility
Liquidity Adjustment Facility (LAF) is the primary instrument of Reserve Bank of India for modulating liquidity and transmitting interest rate signals to the market. LAF was first introduced in June 2000. It refers to the difference between the two key rates viz. repo rate and reverse repo rate. Informally, Liquidity Adjustment Facility is also known as Liquidity Corridor. Under Repo, the banks borrow money from RBI to meet short term needs by putting government securities (G-secs) as collateral. Under Reverse Repo, RBI borrows money from banks by lending securities. These are done by auctions so called “repo auctions” or “reverse repo auctions”. Other important points are as follows:
- The repo and reverse repo rates are decided by RBI on its own discretion.
- ONLY Government of India dated Securities/Treasury Bills are used for collateral under LAF as of now.
- While repo injects liquidity into the system, the Reverse repo absorbs the liquidity from the system.
- RBI only announces Repo Rate. The Reverse Repo Rate is linked to Repo Rate and is 100 basis points (1%) below repo rate. RBI makes decision regarding Repo Rate on the basis of prevalent market conditions and relevant factors.
- RBI conducts the Repo auctions and Reverse Repo auctions on daily basis from Monday to Friday except holidays.
- All the Scheduled Commercial Banks are eligible to participate in auctions except the Regional Rural Banks.
- Primary Dealers (PDs) having Current Account and SGL Account (Subsidiary General Ledger Account ) with Reserve Bank are also eligible to participate in the Repo and Reverse Repo auctions.
- Under the Liquidity Adjustment Facility, bids need to be for a minimum amount of Rs.5 crore and in multiples of Rs. 5 Crore thereafter.
Marginal Standing Facility
Marginal Standing Facility is a new Liquidity Adjustment Facility (LAF) window created by Reserve Bank of India in its credit policy of May 2011.
- MSF is the rate at which the banks are able to borrow overnight funds from RBI against the approved government securities.
Banks are already able to borrow from RBI via Repo Rate, then why MSF is needed?
MSF window was created for commercial banks to borrow from RBI in certain emergency conditions when inter-bank liquidity dries up completely and there is a volatility in the overnight interest rates. To curb this volatility, RBI allowed them to pledge G-secs and get more funds from RBI at a rate higher than the repo rate. Thus, overall idea behind the MSF is to contain volatility in the overnight inter-bank rates.
How the rate of interest in Repo, Reverse Repo and Marginal Standing Facility are related to each other?
The rate of interest on MSF is above 100 bps above the Repo Rate. The banks can borrow up to 1 percent of their net demand and time liabilities (NDTL) from this facility. This means that Difference between Repo Rate and MSF is 100 Basis Points. So, Repo rate will be in the middle, the Reverse Repo Rate will be 100 basis points below it, and the MSF rate 100 bps above it. Thus, if Repo Rate is X%, reverse repo rate is X-1% and MSF is X+1%.
Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are called Statutory Pre-emptions. The RBI has been empowered by Banking Regulation Act and RBI act to mandate commercial banks to maintain a certain portion of their Net Demand and Time Liabilities (NDTL) in the form of cash with the Reserve Bank [this is called Cash Reserve Ratio (CRR)] and in the form of investment in unencumbered approved securities [this is called Statutory Liquidity Ratio (SLR)].
Statutory Liquidity Ratio (SLR)
The banks and other financial institutions in India have to keep a fraction of their total net time and demand liabilities in the form of liquid assets such as G-secs (Government Securities), precious metals, other approved securities etc. This fraction is called Statutory Liquidity Ratio (SLR).
It is one of the two statutory pre-emptions because it gets its legal sanction from the section 24 (2A) of Banking Regulation Act 1949, which initially mandated for a 23% SLR. To comply with the SLR, the banks can keep any of the following:
- Cash in hand
- Gold owned by the bank
- Balance with RBI
- Net balance in current account
- Investment in Government securities
SLR has to be maintained at the close of business on every day. In the 1980s and 1990s, the SLR was very high (around 38.5%) and the first Narsimham Committee recommended to bring it down from 38.5% to 25%. At present, the SLR is 21.5% (February 2015).
Why SLR is needed?
There are three purposes to keep SLR. These are:
- It is an instrument of credit control
- It works as a cushion against the possibility of bank failures
- It is a conduit for financing government deficits.
We note here that SLR is not very frequently changed; so as an instrument of Credit Control; its role is limited. However, most important function SLR is doing in current times is to “finance the government deficit”. As far as its function as a cushion against bank failures is concerned, it is practically meaningless because weak commercial banks are not allowed to fail by the Government/RBI which is guided by the too-big-to-fail doctrine while resolving bank failures.
What is Double Financial Repression?
The Economic Survey 2014-15 pointed out the two side problem being faced by the banks in India. One the asset side, they are forced to keep a huge fraction of their assets in the form of SLR. It does not allow them to invest those assets in better avenues. On the liability side, they have to make huge fraction of their credits to Priority Sector. These two have led to the banks to reel under the so called “Double Financial Repression”. The survey recommended to gradually abolish SLR and also bring down mandatory Priority Sector Lending.
What will happen if SLR is brought down?
As mentioned above, the most important function SLR is doing in current times is to “finance the government deficit”. So, if SLR is abolished; the biggest casualty will be on the government borrowing programmes.
Cash Reserve Ratio
The Cash Reserve Ratio is the amount of funds that the banks are bound to keep with Reserve bank of India as a portion of their Net Demand and Time Liabilities (NDTL). This is also a statutory pre-emption because it draws its legality from Banking Regulation Act 1949.
The objective of CRR is to ensure the liquidity and solvency of the Banks. The CRR is maintained fortnightly average basis.
What happens when CRR is reduced?
When CRR is reduced, this means banks have to keep less funds with RBI and they have more funds to deploy in other businesses. When the banks have more money, they would try to lend it, thus increasing money supply in the system, and this might lead to reduction in the interest rates. Further, when money supply increases, too much money chases too few goods and this leads to rise in inflation. So, reducing CRR:
- Increases money supply
- Decreases interest rates on home loans, car loans etc. and in inter-bank market
- Reduces demand for money
- Increases inflation
What happens when CRR is increased?
When RBI increases the CRR, less funds are available with banks as they have to keep larger protions of their cash in hand with RBI. This means that banks will now have less money to play with. Moreover, Reserve Bank does not pay any interest on the CRR balances. Since commercial banks don’t earn any interest, the banks are left with an option than to increase the interest rates. If RBI hikes this rate substantially, banks will have to increase the loan interest rates. The home loans, car loans and EMI of floating Rate loans increase. Thus hike in CRR leads to increase of interest rates on Loans provided by the Banks. Reduction in CRR sucks money out of the system causing to decrease in money supply. When money supply decreases, the inflation comes down. In summary, when increasing CRR:
- Decreases money supply
- Increases interest rates on home loans, car loans etc. and in inter-bank market
- Increases demand for money
- Decreases inflation
Bank Rate refers to the official interest rate at which RBI will provide loans to the banking system which includes commercial / cooperative banks, development banks etc. Such loans are given out either by direct lending or by rediscounting (buying back) the bills of commercial banks and treasury bills. Thus, bank rate is also known as discount rate. Bank rate is used as a signal by the RBI to the commercial banks on RBI’s thinking of what the interest rates should be.
What happens when Bank Rate is increased or decreased?
When RBI increases the bank rate, the cost of borrowing for banks rises and this credit volume gets reduced leading to decline in supply of money. Thus, increase in Bank rate reflects tightening of RBI monetary policy. When RBI decreases the bank rate, the cost of borrowing for banks falls and thus credit volume gets increased leading to surge in supply of money. Thus, decrease in Bank rate reflects loosening of RBI monetary policy.
Difference between Bank Rate and Repo Rate
Bank Rate and Repo Rate seem to be similar terms because in both of them RBI lends to the banks. However:
- Repo Rate is a short-term measure and it refers to short-term loans and used for controlling the amount of money in the market.
- On the other hand, Bank Rate is a long-term measure and is governed by the long-term monetary policies of the RBI.
- In broader term, bank rate is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. RBI uses this tool to control the money supply.
Under the credit ceiling, RBI informs the banks to what extent / limit they would be getting credit. When RBI imposes a credit limit, the banks will get tight in advancing loans to public. Further, RBI may also direct the banks to provide certain fractions of their loans to certain sectors such as farm sector or priority sector.
Qualitative instruments of monetary policy
Margin requirements, consumer credit regulation, RBI guidelines, Moral suasion and direct action are the qualitative tools of monetary policy of the RBI.
- Margin requirements refers to difference between the securities offered and amount borrowed by the banks.
- Consumer credit regulation refers to issuing rules regarding down payments and maximum maturities of installment credit for purchase of goods.
- RBI Guidelines refers to the oral, written statements, appeals, guidelines, warnings etc. to the banks by RBI.
- Rationing of the credit refers to control over the credit granted / allocated by commercial banks.
- Moral Suasion refers to a request by the RBI to the commercial banks to take certain measures as per the trend of the economy. For example, RBI may ask banks to not to give out certain loans. It includes psychological means and informal means of selective credit control.
- Direct Action is taken by the RBI against banks that don’t fulfill conditions and requirements. RBI may refuse to rediscount their papers or may give excess credits or charge a penal rate of interest over and above the Bank rate, for credit demanded beyond a limit.
Monetary Policy Stance
Monetary policy stance is based upon the assessment of the macroeconomic and financial conditions and monetary measures taken on the basis of those conditions. The overall objective while taking such instance is to speed up the economic development of the nation and raise the national income and standard of living of the people. The examples of stance taken by RBI via its monetary policy are as follows:
- Immediately after independence, India entered into economic planning era. To contribute in the development of the economy, RBI took such an instance that it not only provides adequate financing and economic growth but also controls inflation. This was called monetary policy stance of “Controlled expansion”.
- Similarly, when inflation is high, RBI uses the various policy instruments to reduce the money supply in the economy. To do this, it would raise the Bank Rate, Repo Rate, CRR and SLR. All these would suck he liquidity out of system and bring down too much money chasing too few goods. This would finally bring down inflation. Such instance is called Tight Monetary Policy.
- RBI works as the monetary authority of India and thereby operates the monetary policy.