Symbiosis Institute of Business ManagementMBA [Ex. Edu.] Batch 2012-2014

Semester I – Section

Anurag Verma(35413)

Assignment:

Analyze the various tools /instruments of monetary policy. Also discuss current monetary policy of Indian economy. Do you think they are able to check inflationary situation. Elaborate?

Description:

Instruments of Indian Monetary Policy

“A policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy is a monetary policy.”Monetary policy, also known as Credit Policy, helps RBI in deciding about the supply of money in an economy, ratio of interest to be charged for some amount of money. It provides measure to control inflation and most important of all it helps in deciding how to achieve the economic growth and development objectives of an economy.So to attain these objectives various monetary policy instruments are used.Monetary Policy InstrumentsPrincipal Instruments of monetary policy or credit control are broadly classified as:

Quantitative Instruments: These tools are related to the Quantity or Volume of the money. These are the instruments of monetary policy which affect overall supply of money/ credit in the economy. For example, Bank Rate, Cash Reserve Ratio.

Qualitative Instruments: These instruments direct or restrict the flow of credit to specified areas of economic activity. These include instruments like Margin Requirement, Direct Auction etc. It may be possible that some qualitative instruments may have shades of quantitative instrument.

We limit our scope to various quantitative instruments for this assignment.

Bank Rate: “The interest rate at which RBI lends money to the commercial banks.”Managing the bank rate is a preferred method by which central banks can regulate the level of economic activity. In most of the cases, the increase (or decrease) in bank rate is often followed by increase (or decrease) in market rate of interest.With the increase in the bank rate by RBI, commercial banks reduce their volume of borrowings from RBI as high bank rate increases their cost of borrowing. Thus, they have less availability of credit with them to lend to public or if they have, it is available at high rate. Therefore, with increase in bank rate

there is an increase in market rate of interest also and this ultimately results in reduced borrowing by public.

On the other hand, if the RBI reduces the bank rate, borrowings for commercial banks will become cheaper. And banks will also reduce their rates thus resulting in credit expansion.

Open Market Operations (OMO): “The open market operation refers to the purchase and/or sale of short term and long term securities by the RBI in the open market.” Let’s see how it helps in credit control.

RBI, especially during inflation, sells government securities in an open market which is purchased by commercial banks and private individuals. When commercial banks purchases securities, money get transferred to RBI from commercial bank. Thus, there is fall in money supply in an economy. Now due to decrease of money supply, purchasing power reduces which helps in controlling inflation. While, when RBI buys the securities from commercial banks in the open market, commercial banks sell securities and get back the money. It results in increase in the volume of money in the economy. It is done mostly during depression or recession.

Variable Reserve Rates (VRR): These basically include Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).

CRR: “Cash reserve ratio is the cash parked by the banks in their specified current account maintained with RBI.”

Commercial banks have to keep a certain percentage of their total deposits in the form of cash reserves with RBI. For example if CRR is 10% and total deposits with a bank are Rs. 100 crore, they will have to keep Rs. 10 crore with RBI as minimum cash reserves.

SLR: “Statutory liquidity ratio is in the form of cash (book value), gold (current market value) and balances in unencumbered approved securities.”

Every bank is required to maintain a fixed percentage of its assets in the form of cash and other liquid assets with RBI.

“Other liquid assets include cash, balances with RBI, balances in current accounts with banks, money at call and short notice, inter-bank placements due within 30 days and securities under “held for trading” and “available for sale” categories excluding securities that do not have ready market.”

By varying VRR commercial banks lending capacity can be affected. Suppose, commercial banks have total deposits of 100 crore with them. Now if VRR increases from 20% to 30%, than the reserves to be held by banks would increase from 20 crore to 30 crore.

Thus, the availability of money with commercial bank which can be used for credit creation will reduce by 10 crore. On the contrary any decrease in VRR will make more money available with banks for credit creation.

Liquidity Adjustment Facility: “A tool used in monetary policy that allows banks to borrow money through repurchase agreements.”

“Repo or ready forward contact is an instrument for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed.”

Thus, in Repo transaction banks borrow funds from RBI by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price. If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.“The reverse of the repo transaction is called ‘reverse repo’ which is lending of funds against buying of securities with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent.”

The RBI uses this tool when it feels there is too much money floating in the banking system. With the increase in reverse repo rate, RBI gives bank a lucrative rate for depositing money. Thus, banks prefer to deposit money with RBI rather than lending it. It results in reduction of money circulation in an economy and thus purchasing power.

LAF enables liquidity management on a day to day basis. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets.

Marginal Standing Facility Rate: “Banks will be able to borrow up to 1% of their respective Net Demand and Time Liabilities”. The rate of interest on the amount accessed from this facility is 100 basis points (i.e. 1%) above the repo rate.

This scheme will reduce volatility in the overnight rates and improve monetary transmission. This measure has been introduced by RBI to regulate short-term asset liability mismatches more effectively.

Current Monetary Policy of Indian EconomyThe monetary policy in India underwent gradual changes concerning both its strategy and its implementation. Quite some progress has been done in the direction indicated by best practices and the economic theory. Notwithstanding these changes, the RBI has been until recently unwilling to commit its monetary policy to a single objective and a clear definition of intermediate targets.

RBI monetary policy strategy is still guided by the multiple objectives of price stability, growth and financial stability, with relative weights depending upon evolving domestic and global macroeconomic and financial conditions. Price stability is an important but not the exclusive goal of monetary policy in India.

RBI has released its Monetary Policy Statement for 2012-13 and it has raised the concerns of current global scenario.

The US economy continues to show signs of modest recovery. Large scale liquidity infusions by the European Central Bank (ECB) have significantly reduced stress in the global financial markets. However, recent developments, for example in Spain, indicate that the euro area sovereign debt problem will continue to weigh on the global economy. Growth risks have emerged in emerging and developing economies (EDEs). And, amidst all these, crude oil prices have risen by about 10 per cent since January and show signs of persisting at current levels.

RBI has announced the Monetary Policy measures through its Mid Quarter Monetary Policy Review: September 12

Monetary and Liquidity Measures: On the basis of an assessment of the current macroeconomic situation, it has been decided :

To reduce the cash reserve ratio (CRR) of scheduled banks by 25 basis points from 4.75 percent to 4.5 percent of their net demand and time liabilities (NDTL) effective the fortnight beginning September 22, 2012. Consequently around INR 170 billion of primary liquidity, will be injected into the banking system.

Keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 8.0 percent. Consequently, the reserve repo rate under the LAF will remain unchanged at 7.0 percent, and the marginal standing facility (MSF) rate and the Bank Rate at 9.0 percent.

Here is the table which summarizes the current Monetary and Liquidity measures.

Sr No. Monetary Instrument Current Value as on Sep 20121 Cash Reserve Ratio (CRR) 4.5 percent2 Repo Rate 8.0 percent3 Reverse Repo Rate 7.0 percent4 Marginal Standing Facility (MSF) 9.0 percent5 Bank Rate 9.0 percent.

Do you think they are able to check inflationary situation. Elaborate ?

Domestic Economy

Growth

1. Economic activity picked up modestly in Q1 of 2012-13 in relation to the preceding quarter; but the sluggish momentum of value added in Q1 was evident across all sectors of the economy, and particularly in industry. Lead indicators point to slack activity in Q2 as well. Industrial production rose by just 0.1 per cent in July. In August, the manufacturing PMI (Purchasing Managers Indices) fell to its lowest level during 2012 so far, as a result of output disruptions due to power shortages and declining export orders. The services PMI, however, picked up in August on growth in new orders and employment. With the progressive reduction in the rainfall deficit, kharif sowing, though still below normal, has improved. Reassuringly, the late rains have augmented storage in reservoirs which should improve prospects for the rabi crop, mitigating to some extent the concerns about agricultural prospects.

Inflation

2. Headline WPI inflation (y-o-y) has remained sticky at around 7.5 per cent throughout the current financial year so far. At the disaggregated level, within primary food articles, the easing of vegetable prices in July-August was to a large extent offset by the surge in prices of cereals and pulses. Demand-supply imbalances in respect of protein-rich items persist. Fuel price inflation picked up in August, largely reflecting the upward revision in electricity prices. As welcome as the recent hike in diesel prices/rationalisation of LPG subsidy has been, the pass-through to administered prices remains incomplete. International crude prices are vulnerable to being driven up further by global liquidity. Core inflation pressures remained firm with non-food manufactured products inflation inching up from 5.1 per cent in April to 5.6 per cent in August and the momentum indicator remaining elevated. Even as demand pressures moderate, supply constraints and rupee depreciation are imparting pressures on prices, rendering them sticky.

3. In terms of the new CPI, inflation (y-o-y) remained broadly unchanged in July from June at close to 10 per cent, held up by rising prices of food items. Notwithstanding some easing in July, core CPI inflation (CPI excluding food and fuel sub-group) remains elevated.

4. While the recent upward revision in diesel prices and rationalisation of subsidy for LPG is a significant achievement, in the short-term, there will be pressures on headline inflation. Over the medium-term, however, it will strengthen macroeconomic fundamentals. It is important to note that these revisions were anticipated at the time of the April policy when a front-loaded repo rate reduction was undertaken. Over the longer run, holding down subsidies to under 2 per cent of GDP as indicated in the Union Budget for 2012-13 is crucial to manage demand-side pressures on inflation. Containing inflationary pressures and lowering inflation expectations warrant maintaining the momentum of recent policy actions to step up investment, alleviate supply constraints, and improve productivity.

Liquidity Conditions

5. Money supply (M3), bank credit and deposits have moderated in relation to their indicative trajectories, reflecting the slowing down of economic activity. Against this backdrop, liquidity conditions have remained comfortable since the FQR. However, going forward, the wedge between deposit growth and credit growth could widen on the back of the seasonal pick-up in credit demand in the second half

of the year. This, combined with outflows on account of advance tax payments and the onset of festival-related currency demand, could accentuate pressures on liquidity over the next few weeks. In these conditions, appropriate liquidity management assumes importance in order to ensure that drawals under the Liquidity Adjustment Facility (LAF) broadly remain within the indicative target of +/- 1 percent of NDTL, thereby facilitating monetary policy transmission and enabling adequate flow of credit to the productive sectors of the economy.

External sector

6. While the trade deficit narrowed in the first five months of 2012-13, the relatively large fall of exports in July-August is indicative of risks to the current account from the worsening global outlook. As regards external financing, the moderation in FDI inflows was partly compensated by a surge in non-resident deposits and a renewal of FIIs flows in recent months. Consequently, the rupee has been trading in a narrow range since the FQR. Looking ahead, a moderation in the trade deficit combined with increased inflows in response to domestic policy developments could ease pressures on the balance of payments. However, risks from global factors, in terms of both capital movements and oil prices will persist. Given these external risks, holding down the CAD to sustainable levels will depend on durable fiscal consolidation and, in particular, switching public expenditure from subsidies to capital outlay that crowds in private investment, thus preparing the ground for a revival of growth.

Guidance

7. Since the FQR, while growth risks have increased, inflation risks remain. Mitigating the growth risks and taking the economy to a higher sustainable growth trajectory requires concerted policy action across a range of domains, a process to which last week’s actions made a significant contribution. Monetary policy also has an important role in supporting the growth revival. However, in the current situation, persistent inflationary pressures alongside risks emerging from twin deficits – current account deficit and fiscal deficit - constrain a stronger response of monetary policy to growth risks. Accordingly, as this process evolves, the stance of monetary policy will be conditioned by careful and continuous monitoring of the evolving growth-inflation dynamic, management of liquidity conditions to ensure adequate flows of credit to productive sectors and appropriate responses to shocks emanating from external developments.