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Introduction to Indian Economy
The economy ofIndia is the twelfth largest in the world by market exchange rates and the
fourth largest in the world by GDP, measured on a purchasing power parity (PPP) basis. The
country was under socialist-based policies for an entire generation from the 1950s until the
1980s. The economy was characterized by extensive regulation,protectionism, and public
ownership, leading topervasive corruption andslow growth.Since 1991,continuing economic
liberalization has moved the economy towards amarket-based system.
Previously a closed economy, India's trade has grown fast. According to the WTO India
currently accounts for 1.5% of World trade as of 2007. According to the World Trade Statistics
of the WTO in 2006, India's total merchandise trade (counting exports and imports) was valued
at $294 billion in 2006 and India's services trade inclusive of export and import was $143 billion.
Thus, India's global economic engagement in 2006 covering both merchandise and services trade
was of the order of $437 billion, up by a record 72% from a level of $253 billion in 2004. India's
trade has reached a still relatively moderate share 24% of GDP in 2006, up from 6% in 1985.
The Indian economy has undergone substantial changes since the introduction of
economic reforms in 1991. These reforms were a comprehensive effort consisting of three main
http://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)http://en.wikipedia.org/wiki/Socialisthttp://en.wikipedia.org/wiki/License_Rajhttp://en.wikipedia.org/wiki/Protectionismhttp://en.wikipedia.org/wiki/Corruption_in_Indiahttp://en.wikipedia.org/wiki/Hindu_rate_of_growthhttp://en.wikipedia.org/wiki/Economic_liberalization_in_Indiahttp://en.wikipedia.org/wiki/Economic_liberalization_in_Indiahttp://en.wikipedia.org/wiki/Market_economyhttp://en.wikipedia.org/wiki/Market_economyhttp://en.wikipedia.org/wiki/Economic_liberalization_in_Indiahttp://en.wikipedia.org/wiki/Economic_liberalization_in_Indiahttp://en.wikipedia.org/wiki/Hindu_rate_of_growthhttp://en.wikipedia.org/wiki/Corruption_in_Indiahttp://en.wikipedia.org/wiki/Protectionismhttp://en.wikipedia.org/wiki/License_Rajhttp://en.wikipedia.org/wiki/Socialisthttp://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)http://en.wikipedia.org/wiki/India -
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Banking Sector from 1991 onwards
This phase has introduced many more products and facilities in the banking sector in its
reforms measure. In 1991, under the chairmanship of M. Narasimha, a committee was set up by
his name which worked for the liberalization of banking practices. The country is flooded withforeign banks and their ATM stations. Efforts are being put to give a satisfactory service to
customers. Phone banking and net banking is introduced. The entire system became more
convenient and swift. Time is given more importance than money.
The financial system of India has shown a great deal of resilience. It is sheltered from any
crisis triggered by any external macroeconomics shock as other East Asian Countries suffered.
This is all due to a flexible exchange rate regime, the foreign reserves are high, the capital
account is not yet fully convertible, and banks and their customers have limitedforeign exchange
exposure.
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The industrial sector has been going through a process of restructuring and consolidation
after liberalization. The industries have responded to the reforms through mergers and
acquisitions, adoption of cost cutting measures, foreign collaboration, technology up gradation
and outward orientation in sectors such as cement, steel, aluminium, pharmaceuticals, and
automobiles. Industrial growth increased sharply in the first five years after the reforms, but then
slowed to an annual rate of 4.5 percent in the next five years. From low growth rate of 2.7 per
cent in 2001-02, the industry sector grew at a rate of 7.1 per cent in 2002-03 and further to 9.8
per cent in 2004-05.There has been steady and continuous rise in supply of money in the
economy since initiation of reforms. Reserve Money has increased from Rs.99, 505 crores in
1991-92 to Rs.573066 crores in 2005-06.
Performance of the Indian economy on the inflation front, with price stability as one of
the prime objectives of the reform process has been satisfactory, particularly after the mid 1990s.
The annual average inflation rate based on Wholesale Price Index (WPI) was 10.6 per cent
between 1991-96, which fell down to 5.1 per cent in the period 1996-2001 and then to 4.7 per
cent in 2001-06.
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Reserve Bank of India
INTRODUCTION
The RBI, as the central bank of the country, is the centre of the Indian financial and
monetary system. As an institution, it has been guiding, monitoring, regulating, controlling, and
promoting the destiny of the Indian financial system. However, it is an oldest among the central
banks in the developing countries. It started functioning from April 1, 1935 on the terms of the
Reserve Bank of India Act, 1934. It was a private shareholders institution till January 1949, after
which it became a State-owned institution under the Reserve Bank of India Act, 1948. The share
capital was divided into shares of Rs. 100 each fully paid which was entirely owned by private
shareholders in the beginning. The Government held shares of nominal value of Rs. 2, 20,000.
The Bank is managed by a Central Board of Directors, four Local Boards of Directors,
and a committee of the central board of directors. The functions of the Local Boards are to
advise the Central Board on matters referred to them. The final control of the Bank vests in the
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Central Board which comprises the Governor, four Deputy Governors, and fifteen Directors
nominated by the Central government.
The internal organizational set-up of the Bank has been modified and expanded from
time to time in order to cope with the increasing volume and range of the Banks activities. The
principle of the internal organization is functional specialization with adequate coordination.
During the war and post-war years, the major preoccupation of the Bank was facilitation
of war finance, repatriation of sterling debt and planning and administration of exchange control.
The issues relating to regulation and supervision of banks came to occupy centre-stage in the
backdrop of a number of bank failures. The Banking Companies Act was enacted in 1949 to
empower the Reserve Bank with supervisory control over banks in order to ensure their
establishment and operation along sound lines. The Reserve Bank of India was nationalized on
January 1, 1949.
With the launch of Five-Year Plans in 1951, the Reserve Banks functions became more
diversified in terms of Plan financing, establishment of specialized institutions to promote
savings and investment in the Indian economy and to meet credit requirements of the priority
sectors. This was a novel feature for any central bank at that point of time. The Agricultural
Refinance Corporation was set up in 1963 for extending medium and long-term finance to
agriculture. Other institutional developments included setting up of the Industrial Finance
Corporation of India (1948), the Industrial Development Bank of India (1964) and Unit Trust of
India (1964). The role of monetary and credit policy in maintaining price stability was explicitly
emphasized for the first time in the First Five Year Plan. Plan financing by the Reserve Bank
evolved as deficit financing which took the form of system of issuance ofad hoc Treasury Bills.
This arrangement of financing the Government was intended to be temporary but acquired a
permanent character over time.
Devaluation of the rupee in June 1966 and nationalization of fourteen private sector
banks in July 1969 multiplied the responsibilities of the Reserve Bank. The move helped to
bridge the gaps in credit availability in many rural and urban areas and ensured sufficient funds
availability to the preferred sectors. In terms of the outcome, this phase succeeded in mobilizing
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private savings through the banks and paved the way for nationalization of six more private
sector banks in 1980.
For conserving foreign exchange reserves, the Government re-examined the provisions of
the Foreign Exchange Regulation Act, (FERA) 1947 and introduced changes in 1973 which
incorporated necessary changes for effective implementation of Government policy and
removing difficulties in the working of the existing legislation. In the light of concerns about
capital outflows, reinforced by repeated stress on balance of payments due to drought, war and
oil shocks, the emphasis was placed on utilizing domestic savings for domestic investment, while
continuing to preserve foreign exchange reserves.
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Functions of RBI
The RBI functions within the framework of a mixed economic system. With regard to
framing various policies, it is necessary to maintain close and continuous collaboration between
the government and the RBI. In the event of a difference of opinion or conflict, the governmentview or position can always be expected to prevail.
Main functions of the RBI
(i) To maintain monetary stability so that the business and economic life can deliver welfaregains of a property functioning mixed economy.
(ii) To maintain financial stability and ensure sound financial institutions so that monetarystability can be safely pursued and economic units can conduct their business with
confidence.
(iii)To maintain stable payments system so that financial transactions can be safely andefficiently executed.
(iv) To promote the development of financial infrastructure of markets and systems, and toenable it to operate efficiently i.e., to play a leading role in developing a sound financial
system so that it can discharge its regulatory function efficiently.
(v) To ensure that credit allocation by the financial system broadly reflects the nationaleconomic priorities and social concerns.
(vi) To regulate the overall volume of money and credit in the economy with a view to ensurea reasonable degree of price stability.
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Roles of RBI
1. Note Issuing AuthorityThe RBI has the sole right or authority or monopoly of issuing currency notes other than
one rupee notes and coins, and coins of smaller denominations. The issue of currency notes
is one of its basic functions.
2. Government BankerThe RBI is the banker to the Central and State governments. It provides to the
governments all banking services such as acceptance of deposits, withdrawal of funds by
cheques, making payments as well as receipts and collection of payments on behalf of the
government, transfer of funds, and management of public debt.
3. Bankers BankThe RBI, like all central banks, can be called a bankers bank because it has a very special
relationship with commercial and co-operative banks, and the major part of its business is with
these banks. The bank controls the volume of reserves of commercial banks and thereby
determines the deposits creating ability of the banks. The banks hold a part or all of their
reserves with the RBI. Similarly, in times of need, the banks borrow funds from the RBI. It is
therefore, called the bank of last resort.
4. Supervising AuthorityThe RBI has vast powers to supervise and control commercial and co-operative banks
with a view to developing an adequate and sound banking system in the country. Initially, they
used to give only orders but now it undertakes inspection of commercial banks and recommends
measures. It has the following powers:
(a) To issue licenses for the establishment of new banks and setting up of bank branches.(b) To prescribe minimum requirements regarding paid-up capital and reserves, transfer to
reserve fund, and maintenance of cash reserves and others.
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(c) To inspect the working of banks in India as well as abroad in respect of their organizationalsetup, branch expansion, mobilization of deposits, investments, and credit portfolio
management, credit appraisal, region-wise performance, profit planning, manpower
planning, and so on.
5. Exchange ControlOne of the essential functions of the RBI is to maintain the stability of the external value
of the rupee. It pursues this objective through its domestic policies and the regulation of the
foreign exchange market. As far as the external sector is concerned, the task of the RBI has the
following dimensions:
(a) To administer the foreign exchange control.(b) To choose the exchange rate system and fix or manage the exchange rate between therupee and other currencies.
(c) To manage exchange reserves.(d) To interact with the monetary authorities of other countries and with internationalfinancial institutions such as IMF.
6. Promoter of the financial systemApart from performing the functions already mentioned, the RBI has been rendering
developmental services which have strengthened the countrys banking and financial structure.
This has helped in mobilizing savings and directing credit flows to desired channels, thereby
helping to achieve the objective of economic development with social justice.
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Monetary Policy
Monetary policy is the management of money supply and interest rates by central banks
to influence prices and employment. Monetary policy works through expansion or contraction of
investment and consumption expenditure. Monetary policy is the process by which the
government,central bank,or monetary authority of a country controls (i) the supply of money,
(ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of
objectives oriented towards the growth and stability of the economy.Monetary policy is referred to as either being anexpansionary policy,or a contractionary
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 stop unemployment in a recession by lowering interest rates, while contractionary policy
involves raisinginterest rates in order to stopinflation.Monetary policy is contrasted with fiscal
policy, which refers to government borrowing, spending and taxation.
Monetary policy rests on the relationship between the rates of interest in an economy,
that is the price at which money can be borrowed, and the total supply of money. Monetary
policy uses a variety of tools to control one or both of these, to influence outcomes like economic
growth, inflation, exchange rates with other currencies and unemployment.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.
The beginning of monetary policy as such comes from the late 19th century, where it was
used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size
of the money supply or raises the interest rate. An expansionary policy increases the size of the
money supply, or decreases the interest rate. Furthermore, monetary policies are described asfollows: accommodative, if the interest rate set by the central monetary authority is intended to
create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or
tight if intended to reduce inflation.
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On the external front, rupee value has been linked to the market forces. Current account
convertibility was achieved in August 1994. FERA was repealed and replaced by a new
legislation - Foreign Exchange Management Act (FEMA), in 1999. Further, the Exchange
Control Department of the Reserve Bank was renamed as Foreign Exchange Department.
Besides, a large number of innovative products and newer players have come to play active role
and new hedging instruments have been introduced, viz., foreign currency-rupee options, etc.
Authorized dealers could use cross-currency options, interest rate and currency swaps,
caps/collars and forward rate agreements (FRAs) in the international forex market.
In the context of monetary policy framework, there has been a greater focus on liquidity
management engendered by the growing integration of financial markets, domestically and
internationally. With the near total deregulation of interest rates, the Bank Rate has beenreactivated since April 1997 as a reference rate and as a signaling device to reflect the stance of
monetary policy. Following the recommendations of the Working Group on Money Supply:
Analytics and Methodology of Compilation (Chairman: Y. V. Reddy), the Reserve Bank has
commenced compilation and publication of four monetary aggregates [M0 (monetary base), M1
(narrow money), M2 and M3 (broad money)]; and introduced three new liquidity aggregates (L1,
L2 and L3) by incorporating deposits with post- office savings banks, term deposits, term
borrowings and certificates of deposits of term lending and refinancing institutions and public
deposits of non-banking financial institutions; broadening of the definition of credit by including
items not reflected in the conventional bank credit; redefining the net foreign assets of the
banking system to comprise banks holdings of foreign currency assets net of (a) their holdings
of FCNR(B) deposits and (b) foreign currency borrowings.
With the liberalization of the external sector, the monetary targeting framework came
under stress due to increasing liquidity mainly on account of increased capital inflows,
necessitating a review of the monetary policy framework and the Reserve Bank switched over to
a more broad-based "multiple indicators approach" since 1998 in monetary policy formulation.
The informal monetary policy strategy meetings review the monetary and liquidity conditions
and the process has been made consultative. The Financial Markets Committee (FMC) monitors
the developments in financial markets on a daily basis. The Committee makes quick assessment
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of the liquidity conditions and recommends strategies for intervention in the money and
securities markets.
Monetary and credit aggregates have witnessed deceleration since their peak levels in
October 2008. The liquidity overhang emanating from the earlier surge in capital inflows has
substantially moderated in 2008-09. The Reserve Bank is committed to providing ample liquidity
for all productive activities on a continuous basis.
In its mid- term review of monetary policy on October 24, 2008, the Reserve Bank had
indicated that it would closely and continuously monitor the liquidity and monetary situation and
respond swiftly and effectively to the impact of the global developments on Indian financial
markets. The Reserve Bank had also indicated that the challenge for the conduct of monetary
policy is to strike an optimal balance among preserving financial stability, maintaining price
stability and sustaining the growth momentum.
In response to emerging global developments, the Reserve Bank has taken a number of
measures since mid-September 2008. The aim of these measures was to augment domestic and
forex liquidity and to enable banks to continue to lend for productive purpose while maintaining
credit quality so as to sustain the growth momentum.
On a further review of the evolving developments, the Reserve Bank has taken thefollowing measures:
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Enhancing Rupee Liquidity
The special term repo facility, introduced for the purpose of meeting the liquidity requirementsof mutual funds and non-banking finance companies would continue till end-march 2009. Banks
can avail of this facility either on incremental or on rollover basis within their entitlement of up
to 1.5 per cent of net demand and time liabilities.
As the upside risks to inflation have declined, monetary policy has been responding to
slackening economic growth in the context of significant global stress. Accordingly, for policy
purposes, money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this,
aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent. Thegrowth in adjusted non-food credit, including investment in bonds/debentures/shares of public
sector undertakings and private corporate sector and CPs, is placed at 20.0 per cent. Given the
wide dispersion in credit growth noticed across bank groups during 2008-09, banks with strong
deposit base should endeavour to expand credit beyond 20.0 per cent.
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Techniques of Monetary Control
Many techniques of monetary control- some old and well known have been used in India.
Among these are: (a) Open Market Operations (OMO), (b) Bank Rate, (c) Cash Reserve Ratio
(CRR), (d) Statutory Liquidity Ratio (SLR), (e) Interest Rates.
Some of the important features and evolution of these techniques are given below:
Open Market Operations
Open market operations are the means of implementing monetary policy by which a
central bank controls its national money supplyby buying and selling governmentsecurities,or
otherfinancial instruments.Monetary targets, such asinterest rates orexchange rates,are used to
guide this implementation. Since most money is now in the form of electronic records, rather
than paper records such as banknotes, open market operations are conducted simply by
electronically increasing or decreasing ('crediting' or 'debiting') the amount of money that a bank
has, e.g., in its reserve account at the central bank, in exchange for a bank selling or buying a
financial instrument. Newly created money is used by the central bank to buy in the open market
a financial asset, such as government bonds,foreign currency,orgold.If the central bank sells
these assets in the open market, the amount of money that the purchasing bank holds decreases,
effectively destroying money.
Under OMO, RBI buys or sells government bonds in secondary market. By absorbing
bonds, it drives up bond yields and injects money into market. When it sells, it does so to stuck
money out of the system.
OMO is an actively used technique of monetary control in the US, the UK and many
other countries. Through the open market sales and purchases of government securities, the RBI
can affect the reserves position of banks, yields on government securities, and volume and cost
of bank credit. However, it is the technique least used by the Bank, though it has wide powers touse it. There is no restriction the quantity or maturity of government securities which it can buy
or sell or hold. Technically, the Bank can conduct OMOs in treasury bills, state government
securities, and central government securities; but in practice they are conducted only in central
government securities of all maturities.
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The open market operations, repo and reverse repo operations have emerged as important
liquidity management tools. Further, Liquidity Adjustment Facility (LAF), which was introduced
in June 2000, has emerged as the principal operating instrument of monetary policy, enabling the
Reserve Bank to modulate short-term liquidity under varied financial market conditions. In order
to fine-tune the management of liquidity and in response to suggestions from market participants,
the Reserve Bank has introduced a Second Liquidity Adjustment Facility (SLAF) from
November 28, 2005. Further, to address the dilemma of keeping a balance between the twin
objectives of containing exchange rate volatility and maintenance of domestic price stability in
the face of surging capital inflows, the Market Stabilization Scheme (MSS) was introduced in
April 2004 to provide the Reserve Bank with an additional instrument of liquidity management.
Under the MSS, the cost of sterilization is borne by the Government. Under this program, the
RBI injected more than Rs. 60, 000 crores in one weeks time to counter balance the FPI activity,
when the financial melt down in American Economy happened.
As part of management of the demand for currency, it has been the endeavour of the
Reserve Bank to contain the volume of notes in circulation by coinciding the lower denomination
notes and conscious shift towards higher denomination notes in circulation. Major developments
in this regard include following a clean note policy, mechanization of note counting operations
by the commercial banks, outsourcing of coin distribution to the private operators to ease
pressure on distribution channels, regular reviews of security features of bank notes and
mechanization of destruction of soiled notes, etc. These operations are aimed at ensuring the
optimal level of customer service through adequate supply of good quality and secure notes and
coins in the country.
OMO: Goals and Objectives
The OMOs have both monetary policy and fiscal policy goals. Their multiple objectives
include: (a) To control the amount of and changes in bank credit and monetary supply throughcontrolling the reserve base of banks, (b) To make bank rate policy more effective, (c) To
maintain stability in government securities market, (d) To support government borrowing
programme, and (e) To smoothen the seasonal flow of funds in the bank credit market.
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In India, OMOs have mostly been used for the purpose of debt management and this has
undermined their effectiveness as a tool of monetary policy. The fact that government securities
market in India is not well-organized, broad-based and deep, and also that interest rates on
government securities, like other interest rates, were administered have reduced the efficacy of
OMOs so far. However, the authorities are now determined to make OMOs a major tool of
monetary policy. Similarly, the coupon rates of government securities have been raised and
made market-related and competitive, and a large number of measures have been taken to
develop and activise the government securities market in India.
This does not mean that OMOs did not contribute anything at all to monetary
management in the past. They have indirectly helped in the regulation of supply of bank credit
to the private sector in two ways. First, the bank has often conducted OMOs for switching
operations, i.e., the sale of long term scrips in exchange for short term ones. This has helped to
lengthen the maturity structure of government securities, which in turn, has been favorable for
the working of monetary policy. Second, the volume of the Banks net sales of government
securities has increased over the years.
Repo rate
Repo is a repurchase agreement i.e. Selling a security under an agreement to repurchase
at a pre-determined date and rate. Repo is money market instrument which enables short-term
borrowing and lending through sale/purchase operation. It introduced in December 1992.
Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the
rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to
get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more
expensive.
The repo rate is the rate at which RBI lends private and public sector banks while reverse
repo is the opposite. After cut, repo rate now stands at 4.75 pc while the reserve repo stands at3.25 pc.
Repo rate is the discounted interest rate at which a central bank repurchases government
securities. The central bank makes this transaction with commercial banks to reduce some of the
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short-term liquidity in the system. The repo rate is dependent on the level of money supply that
the central bank chooses to set as part of its monetary policy.
The central bank has the power to lower the repo rates while expanding the money supply
in the country. This enables the banks to exchange their government security holdings for cash.
In contrast, when the central bank decides to reduce the money supply, it implements a rise in the
repo rates.
When the central bank of the nation makes a decision regarding the money supply level
the repo or repurchase rate is determined by the market in response to the rules of supply and
demand.
The securities that are being evaluated and sold are transacted at the current market price
plus any interest that has accrued. When the sale is concluded, the securities are subsequently
resold at a predetermined price. This price is comprised of the original market price and interest,
and the pre-agreed interest rate, which is the repo rate.
Reverse repo rate
Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from
banks. It introduced by RBI during 1994 95. Banks are always happy to lend money to RBIsince their money is in safe hands with a good interest. An increase in Reverse repo rate can
cause the banks to transfer more funds to RBI due to these attractive interest rates. It can cause
the money to be drawn out of the banking system. The reverse repo rate or reverse repurchase
rate is applicable when a country's reserve borrows money from banks. If reverse repo rates
raise, it means that banks will provide more funds to the reserve. This is a safe proposition as
lending money to most reserves is an extremely safe financial transaction. In cases of reserves
borrowing money from banks, excess money left with the particular bank is channeled into the
reserve. This causes money to be taken out of the economic system. Reverse repo rates come into
play when there is a fund shortage being faced by the reserve. The repo rate in India is currently
7.75%. The reverse repo rate is 6.00%.
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Bank Rate
Bank rate, also referred to as the discount rate, is therate of interest which acentral bank
charges on the loans and advances that it extends to commercial banks and other financial
intermediaries. Changes in the bank rate are often used by central banks to control the money
supply. The term bank rate is commonly used by consumers to refer to the current rate of
interest given on a savings certificate of Deposit. The term bank rate is most commonly used by
consumers who are interested in either obtaining a purchase money mortgage, or a refinance
loan, when referring to the current mortgage rate.
The RBI provides financial accommodation in the form of rediscounting of bills of
exchange and promissory notes, and loans and advances to scheduled commercial and co-
operative banks and other approved financial institutions for financing bonafide internal and
external commercial, trade and production transactions. The Bank Rate is the basic cost of
refinance and discounting facilities. Section 49 of the RBI Act, 1934 defines it as the standard
rate at which the Bank is prepared to buy or rediscount bills of exchange or other eligible
commercial paper. In the early years, financial accommodation from the Bank was largely
provided at the Bank rate. Subsequently, owing to differential rates prescribed for various
sector-specific refinance facilities as also due to the absence of a genuine bill market, the Bank
rate application was confined to (a) the ways and means advances to the state governments, (b)
advances to primary co-operative banks for SSI, and (c) state financial corporations besides
penal rates on shortfalls in reserve requirements.
Cash Reserve Ratio
The present banking system is called a fractional reserve banking system, because the
banks need to keep only a fraction of their deposit liabilities in the form of liquid cash. The
authorities earlier used to change this fraction mainly for the purpose of ensuring the safety and
liquidity of deposits. Over the years, however, it has become an important and effective tool for
directly regulating the lending capacity of banks. The RBI has been using two ratios- the Cash
Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR)as instruments of credit control.
CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of
bank deposits, however over the years it has become an important and effective tool for directly
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regulating the lending capacity of banks and controlling the money supply in the economy.
When the RBI feels that the money supply is increasing and causing an upward pressure on
inflation, the RBI has the option of increasing the CRR thereby reducing the deposits available
with banks to make loans and hence reducing the money supply and inflation.
Cash Reserve Ratio is a bank regulation that sets the minimum reserves each bank must
hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands,
and would normally be in the form of fiat currency stored in a central bank.
The reserve ratio is sometimes used as a tool in monetary policy, influencing the
countrys economy, borrowing, and interest rates. Western central banks rarely alter the reserve
requirements because it would cause immediate liquidity problems for banks with low excess
reserves; they prefer to use open market operations to implement their monetary policy. The
Peoples Bank of China does use changes in reserve requirements as an inflation-fighting tool,
and raised the reserve requirement nine times in 2007. As of 2006 the required reserve ratio in
the United States was 10% on transaction deposits (component of money supply M1), and zero
on time deposits and all other deposits. An institution that holds reserves in excess of the
required amount is said to hold excess reserves.
Cash reserve Ratio (CRR) in India is the amount of funds that the banks have to keep
with RBI. If RBI decides to increase the percent of this, the available amount with the banks
comes down. RBI is using this method, to drain out the excessive money from the banks.
In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial Banks are
required to maintain with RBI an average cash balance, the amount of which shall not be less
than three percent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a
fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not
exceeding twenty percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act,
1934. In June 14, 2003, the rate of CRR is 4.50 per cent of the NDTL.
In terms of Section 42(1A) of RBI Act, 1934, the Scheduled Commercial Banks are
required to maintain, in addition to the balances prescribed under Section 42(1) of the Act, an
additional average daily balance, the amount of which shall not be less than the rate specified by
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the RBI in the notification published in the Gazette of India, such additional balance being
calculated with reference to the excess of the total of the NDTL of the bank as shown in the
return referred to in section 42(2) of the RBI Act, 1934 over the total of its NDTL at the close of
the business on the date specified in the notification. At present no incremental CRR is required
to be maintained by the Scheduled Commercial Banks.
The CRR refers to the cash which banks have to maintain with the RBI as a certain
percentage of their demand and time liabilities. Till 1962, a separate CRR was fixed in respect
of demand liabilities (5 percent) and time liabilities (2 percent). The Bank had powers to vary
these ratios up to a maximum of 20 percent and 8 percent respectively. Subject to these ceilings,
the RBI could ask banks to maintain with itself additional reserves as a specified percentage of
additional demand and time liabilities after certain specified date. This marginal CRR cannotexceed 100 percent.
In 1962, the separate CRRs were merged and one CRR came to be fixed as a certain
percentage of both demand and time liabilities with the maximum of 15 percent. The rules
regarding the marginal CRR were not changed. The actual minimum CRR fixed in 1962 was 3
per cent. The CRR is applicable to all scheduled banks including scheduled cooperative banks
and the Regional Rural Banks (RRBs), and non-scheduled banks. However, co-operative banks,
RRBs, and non scheduled banks have to maintain the CRR of merely 3 per cent, and so far it hasnot been changed by the RBI. The CRR is applicable to various NRI deposit accounts also but
the level of CRR in their case differs from the CRR for domestic deposits, and also among
themselves.
The RBI has powers to impose penal interest rates on banks in respect of their shortfall in
the prescribed CRR. The penal interest rate is normally 3 percent above the Bank rate for the
first week of default and 5 percent for the subsequent weeks till the default are made good. In
addition, the Bank can disallow fresh access to its refinance facility to defaulting banks and
charge additional interest over and above the basic refinance rate on any accommodation availed
of, and which is equal to the shortfall in CRR. In addition, from January 1985, default in CRR
results in graduated penalty by way of loss of interest on the defaulting banks cash balances.
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The RBI pays, since 1973, at its discretion, interest on that portion of cash reserves which
is the difference between the prescribed CRR and the minimum CRR of 3 percent, provided the
bank has not defaulted in respect of maintaining the prescribed CRR. Interest is not paid on
excess reserves.
With a view to providing flexibility to banks in choosing an optimum strategy of holding
reserves depending upon their intra period cash flows, all Scheduled Commercial Banks, are
required to maintain minimum CRR balances upto 70 per cent of the total CRR requirement on
all days of the fortnight. If any Scheduled Commercial Bank fails to observe the minimum level
of CRR on any days during the relevant 8 fortnight, the bank will not be paid interest to the
extent of one fourteenth of the eligible amount of interest, even if there is no shortfall in the CRR
on average basis.
Statutory Liquidity Ratio
In addition to the CRR, the RBI has made active use of another ratio, namely the SLR.
While the CRR enables the Bank to impose primary reserve requirements the SLR enables it to
impose secondary and supplementary reserve requirements, on the banking system. There are
three objectives behind the use of SLR: (a) to restrict expansion of bank credit (b) to increase
banks investment in government securities, and (c) to ensure solvency of banks. Through
variations in the SLR, the Bank is in a position to insulate a part of the government debt from the
open market impact because banks are then prevented from disinvesting government securities in
favour of commercial credit.
Statutory Liquidity Ratio (SLR) is a term used in the regulation ofbanking inIndia.It is
the amount which a bank has to maintain in the form:
1. Cash2. Gold valued at a price not exceeding the current market price3. Unencumbered approved securities (Government securities or Gilts come under this)
valued at a price as specified by theRBI from time to time.
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The quantum is specified as some percentage of the total demand and time liabilities (i.e.
the liabilities of the bank which are payable on demand anytime, and those liabilities which are
accruing in one months time due to maturity) of a bank. This percentage is fixed by theReserve
Bank of India.The maximum and minimum limits for the SLR are 40% and 25% respectively.
Following the amendment of the Banking regulation Act (1949) in January 2007, the floor rate of
25% for SLR was removed. Presently, the SLR is 24% with effect from 8 November, 2008.
The SLR is the ratio of cash in hand (exclusive of cash balances maintained by banks to
meet the required CRR, but not the excess reserves); balances in current account with the SBI, its
subsidiaries, other nationalized banks and the RBI; gold and unencumbered, approved securities,
i.e. central and state government securities, securities of local bodies and government guaranteed
securities to total DTL of banks. Between years 1949 to 1962, while calculating SLR, no
distinction was made between cash on hand and balances held with the RBI to meet CRR
requirements. The SLR, like CRR, is applicable to co-operative banks, non-scheduled banks,
and the RRBs, but it is maintained at a constant level of 25 percent. While the SLR defaults do
not invite penal interest payment and the loss of interest on cash reserves, they do result in
restrictions on the access to refinance from the RBI and in the higher cost of refinance. The RBI
is empowered to increase the SLR for scheduled commercial banks up to 40 percent.
The SLR remained at the level of 20 percent between years 1949 to 1962 in terms of the
definition then prevailing. Thereafter, it has been raised frequently and substantially. In 1990,
SLR has been increased from 20 percent to 38.5 percent. The significant increase in the SLR
does not mean that the monetary policy became quite restrictive during 1963 to 1990. An
increase in the SLR does not restrain total expenditure in the economy; it may restrict only the
private sector expenditure while helping to increase the government expenditure. In a sense,
therefore, the SLR is not a technique of monetary control; it only distributes bank resources in
favour of the government sector. It is therefore, not correct to indicate, as it often done, the
extent of immobilization of bank resources in terms of the combined level of the CRR and SLR.
As in the case of CRR, the post 1991 period is characterized by a declining phase for
SLR also; its level was reduced and it came to be much criticized during this phase. After 1992,
banks were required to maintain SLR based on multiple prescriptions. For example, in October
1992, the SLR was fixed at 38.25 percent, 38 percent and 37.25 percent of net DTL as on 3 April
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1992 with effect from fortnights beginning 9 January 1993, 6 February 1993, and 6 March 1993
respectively. The October 1997 credit policy rationalized this system of multiple rates of SLR
by collapsing them into a single prescription of 25 percent of banks. SLR has remained
unchanged at 25 percent since 1997 till today.
The SLR is commonly used to contain inflation and fuel growth, by increasing or
decreasing it respectively. This counter acts by decreasing or increasing the money supply in the
system respectively. Indian banks holdings of government securities (Government securities)
are now close to the statutory minimum that banks are required to hold to comply with existing
regulation. When measured in rupees, such holdings decreased for the first time in a little less
than 40 years (since the nationalization of banks in 1969) in 2005-06.
Statutory Liquidity Ratio refers to the amount that the commercial banks require to
maintain in the form of cash, or gold or government approved securities before providing credit
to the customers. Statutory Liquidity Ratio is determined and maintained by the Reserve Bank of
India in order to control the expansion of bank credit. Statutory Liquidity Ratio refers to the
amount that all banks require maintaining in cash or in the form of Gold or approved securities.
Here by approved securities we mean, bond and shares of different companies.
This Statutory Liquidity Ratio is determined as percentage of total demand and
percentage of time liabilities. Time Liabilities refer to the liabilities, which the commercial banks
are liable to pay to the customers on there anytime demand. The liabilities that the banks are
liable to pay within one month's time, due to completion of maturity period, are also considered
as time liabilities.
In India, Reserve Bank of India always determines the percentage of Statutory Liquidity
Ratio. There are some statutory requirements for temporarily placing the money in Government
Bonds. Following this requirement, Reserve Bank of India fixes the level of Statutory Liquidity
Ratio. At present, the minimum limit of Statutory Liquidity Ratio that can be set by the Reserve
Bank is 25%.
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Interest rates
The RBI has been following a policy stance of imparting flexibility to the interest rate
structure. Concerned over the downward rigidity of lending rates, even while deposit rates were
coming down, RBI advised banks to announce their benchmark prime lending rates (BPLRs)
based on their actual cost of funds, operating expenses and a minimum margin to cover
regulatory requirement. In response to this policy directive, all banks put in place a system of
BPLRs in 2003-04. The BPLRs of five major banks are lower by 25 to 50 basis points in
December, 2004 compared to the rates prevailing a year ago. During the current year, there has
been a marginal firming up of deposit rates by 25 basis points. Interest rates on housing loans
have firmed up marginally in the current year for banks. Call money rates firmed up from the
second half of the year, reflecting lower liquidity on account of large increase in bank credit. The
Bank Rate remained unchanged at 6.0 per cent in the current year.
The repo rate (reverse repo rate since October 29, 2004) under LAF was raised by 25
basis points to 4.75 per cent from October 27, 2004. The spread between reverse repo and repo
was narrowed by 25 basis points to 125 basis points.
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Towards this end, steps have been initiated to deregulate interest rates, to ease operational
constraints in the credit delivery system, to introduce new money market instruments, and so on.
The monetary policy is now geared towards (a) reducing the rigidities, (b) introducing flexibility,
(c) encouraging diversification, (d) promoting more competitive environment, and (e) imparting
greater discipline and prudence in the operations of the financial system.
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Equities in India
Lets review the performance of equities in India from past ten years. Equities in India
did provide attractive returns from 1979-91 however; they fared poorly in the decade of 1991-
2001.
If we see the compounded annual returns generated by Sensex, the most widely followed
equity index in India, at the end of 2001 were as follows for various investment periods:
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Investment Period Compound Return
1 year -20.5 %
2 years -23.3 %
3 years -2.0 %
5 years 1.2 %
7 years -2.6 %
10 years 5.5 %
Thus, we can see that equities have underperformed even bank deposits for each of the periods
considered above.
What is the Picture of Key Economic Numbers?
During the decade of 1991-2001, the nominal GDP of the country increased by about 3.7
times, forex reserves soared from a near zero level to a record of US $ 48 billion, exports
multiplies by 2.4 times, the prime lending rate fell from around 19% to 11.5%, and the earnings
of Sensex stocks grew at a compound rate of 13.3%.
It seems surprising that the growth of the economy and corporate earnings has not been
reflected in equity returns. What could have caused this discrepancy? The factors that have
contributed to this appear to be as follows:
1. The market was very bullish at the beginning of the decade of 1991-2001, but extremelybearish at the end of the decade.
2. During the decade of 1991-2001, the maximum growth occurred in the services sector (which
now accounts for nearly 50% of the GDP), whereas the services sector accounts for less than the
quarter of Sensex.
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3. The excessive volatility of the Indian stock market has perhaps driven away long-term
investors who can contribute to grater rationality in price movement.
4. The periodic scams that occurred during this period have shaken investorsconfidence.
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The Crisis and India
Like all emerging economies, India too has been impacted by the crisis, and much more
than was expected earlier. GDP growth has moderated reflecting lower industrial production,negative exports, deceleration in services activities, dented corporate margins and diminished
business confidence. There are some comforting factors well-functioning financial markets,
robust rural demand, lower headline inflation and comfortable foreign exchange reserves
which buffered us from the worst impact of the crisis. The fiscal stimulus packages of the
Government and monetary easing and regulatory action of the Reserve Bank have helped to
arrest the moderation in growth and keep our financial markets functioning normally.
In order to provide liquidity support to the housing sector, and particularly to housing
finance companies (HFCs) which have been adversely affected by the recent financial market
developments, it has been decided to provide a refinance facility of an amount of Rs 4,000 crore
to the National Housing Bank (NHB) under the provisions of Section 17(4DD) of the Reserve
Bank of India Act, 1934. This refinance will be available against the NHB's loans and advances
to HFCs. The facility will be available at the prevailing repo rate under the LAF for a period of
90 days. During this 90-day period, the amount can be flexibly drawn and repaid. At the end of
the 90-day period, the withdrawal can also be rolled over. This refinance facility will be
available up to March 31, 2010. The utilization of funds will be governed by the policy approved
by the Board of the NHB.
With a view to mitigating the pressures on account of the recent developments on loan
disbursements to Indian exporting companies and for honoring disbursements under export lines
of credit extended at the behest of the Government of India to overseas financial institutions,
sovereign governments and other entities for financing imports from India, it has been decided to
provide a refinance facility to the EXIM Bank under the provisions of Section 17(4J) of the
Reserve Bank of India Act, 1934. The refinance facility will be of an amount of Rs 5,000 crores.
It will be available at the prevailing repo rate under the LAF for a period of 90 days. During this
90-day period, the amount can be flexibly drawn and repaid. At the end of the 90-day period,
the withdrawal can also be rolled over. This refinance facility will be available up to March 31,
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2010. The utilization of funds will be governed by the policy approved by the Board of the
EXIM Bank.
The Reserve Bank will continue to closely monitor the developments in the global and
domestic financial markets and will take swift and effective action as appropriate. The Reserve
Bank will endeavour to minimize the stress on various sectors of the economy on account of the
international financial crisis and the global slowdown. The policy objective is to ensure adequate
availability of liquidity in the system and to maintain conditions conducive for flow of credit for
all productive purposes, particularly to the housing, export and small and medium industry
sectors.
The Reserve Bank of India (RBI) announced it will develop a regulatory and oversight
framework for mobile banking, and made clear its concern over the safety of transactions
through mobile phones. The large scale spread of mobile telephony has opened up new vistas
for banking in the form of mobile banking and the potential in this new sphere is enormous;
adequate steps to ensure safety and security in a mobile based computing / communicating
environment have to, however, be made.
Reserve Bank has decided to take up the following actions which measure the current assessment
of macroeconomic and monetary conditions.
Monetary Policy action
It Reduce the repo rate under the LAF by 25 basis points from 5.0% to 4.75% with
immediate effect. Reduce the reverse repo rate under the LAF by 25 basis points from 3.5% to
3.25% with immediate effect. Keep the CRR unchanged at 5.0% of net demand and time
liabilities (NDTL).
Reserve Banks Policy thrust
The thrust of the Reserve Bank's policy stance since mid-September 2008 has been aimed
at providing ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining
continued credit flow to productive sectors. Taken together, the policy measures of the Reserve
Bank have ensured that the Indian financial markets continue to function in an orderly manner.
These measures have added actual/potential liquidity in the financial system by over Rs.
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4,20,000 crores. This should assure financial markets that the Reserve Bank will continue to
maintain comfortable liquidity.
Interest Rate Response from Banks
Within the policy rate adjustment already effected by the Reserve Bank, there is scope for
banks to further reduce lending rates so as to ensure credit flow for all productive economic
activity. They hope and expect that banks will play their part in the economic adjustment process
by passing on the benefits of lower interest rates to their customers.
Government Borrowing
Government borrowing increased substantially in 2008-09. Net borrowing by the Central
Government in 2008-09 was increased nearly by three times than that in 2007-08. As per
estimates in the interim budget, net borrowing in the current year, 2009-10, will also be at this
elevated level. Even as the increase in borrowing was large and abrupt in the fourth quarter of
2008-09, they managed that in a non-disruptive manner through a combination of measures such
as unwinding of the MSS securities, open market operations and monetary easing. Admittedly,
yields had increased. But for the offsetting liquidity easing done by the Reserve Bank, yields
would have increased even more. Government will manage the borrowing in 2009-10 in a
similarly non-disruptive manner. An effort in this regard is the planned OMO purchases and
MSS unwinding in the first half of 2009/10 that will add primary liquidity of about Rs.1, 20,000
crore, the monetary impact of which is equivalent to CRR reduction by 3 percentage points.
Growth Outlook
In the January 2009 policy review, they projected growth for 2008-09 of 7.0 per cent with
a downward bias. The downside risks have since materialized, and GDP growth for 2008-09 is
now projected to turn out to be in the range of 6.5-6.7 per cent. Going forward, the fiscal and
monetary stimulus measures initiated during 2008-09 coupled with lower commodity prices willcushion the downturn by stabilizing domestic economic activity. On balance, with the
assumption of a normal monsoon, for policy purpose real GDP growth for 2009-10 is placed at
around 6.0 per cent.
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Inflation Outlook
On the price stability front, India's performance has been fairly good. Since
independence, the inflation rate, in terms of the wholesale price index (WPI), on an average
basis, was above 15 per cent in only five out of fifty years. In thirty-six out of fifty years,
inflation was in single digit and on most occasions high inflation was due to shocks food or oil.
The tolerance level to inflation has been low, relative to many developing countries, especially
on account of the democratic pressures in the country. The inflation rate accelerated steadily
from an annual average of 1.7 per cent during the 1950s to 6.4 percent during the 1960s and
further to 9.0 per cent in the 1970s before easing marginally to 8.0 per cent in the 1980s.
However, the inflation rate declined from an average of 11.0 per cent during 1990-95 to
5.3 per cent during the second half of the 1990s (1995-2000) and further to 4.9 per cent during
2003-07. More recently during 2006-07, WPI based inflation rate increased from 4.1 per cent at
the end of March 2006 to an intra-year peak of 6.7 per cent at end-January 2007 and remained
firm in the range of 6.1-6.6 per cent in the succeeding weeks before moderating to 5.9 per cent
by the end of the financial year (i.e., as on March 31, 2007). Since then, the inflation has further
moderated and as on June 16, 2007, the WPI inflation rate was 4.0 per cent. In recent period,
there has been considerable improvement in the fiscal position. The average gross fiscal deficit
of the central government as per cent to GDP during the 5 decade of 1980s was 6.8 per cent as
against 3.8 per cent in the 1970s. The Government of India is pursuing the path of rule-basedfiscal consolidation from the year 2004-05 under the Fiscal Responsibility and Budget
Management Act, 2003 where under time-specific targets have been mandated.
The underlying purpose of the targets is to reduce the ratio of gross fiscal deficit (GFD)
to gross domestic product (GDP) to three per cent by 2008-09. Furthermore, the revenue deficit
(RD) to GDP ratio has been targeted to touch 0.0 per cent by 2008-09 so that borrowed resources
can be used to meet only capital expenditures. The progress of targeted fiscal consolidation has
been satisfactory so far and GFD/GDP and RD/GDP ratios are budgeted to reduce to 3.3 per cent
and 1.5 per cent, respectively, in 2007-08. The objective is to meet the targets under the Fiscal
Responsibility Act by 2008-09.
The average current account deficit since 1950-51 has been around one per cent of the
GDP. During this period, except for 11 years when there was marginal surplus in the current
account, they had modest deficit during the rest of the years. In the aftermath of the balance of
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payment crisis in the early 1990s, several stabilization and structural reform measures were
undertaken. Keeping in view the global trend in commodity prices and domestic demand-
supply balance, it project WPI inflation at around 4.0 per cent by end-March 2010. Headline
WPI inflation decelerated sharply after August 2008 reflecting the fall in global commodity
prices. CPI inflation continues to be at near double-digit level but is expected to moderate in the
coming months. WPI inflation, however, is expected to be in the negative territory in the early
part of 2009-10 which is only of statistical significance and is not a reflection of demand
contraction as is the case in advanced economies.
Money Supply
Money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this,
the aggregate deposits of commercial banks are projected to grow by 18.0 per cent. The growth
in adjusted non-food credit, including investment in bonds/debentures/ shares of public sector
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undertakings and private corporate sector and CPs, is placed at 20.0 per cent. As always, these
numbers are indicative projections and not targets.
Challenges on the way forward
There are several immediate challenges facing the economy. These include: (a)
supporting the drivers of aggregate demand to enable the economy to return to its high growth
path; (b) boosting the flow of credit to all productive sectors of the economy; (c) managing the
large government borrowing programme in 2009-2010 in a non-disruptive manner; (d) restoring
the fiscal consolidation process; (e) ensuring an orderly withdrawal of the large liquidity injected
in the system since September 2008 by the Reserve Bank to support the economy's productive
requirements; and (f) the continued challenge of preserving the stability of our financial system
drawing from the lesson of the global crisis.
Here in India, there are several immediate challenges facing the economy which would
need to be addressed going forward. First, after five years of high growth, the Indian economy
was headed for a moderation in the first half of 2008-09. However, the growth slowdown
accentuated in the third quarter of 2008-09 on account of spillover effects of international
developments. While the moderation in growth seems to have continued through the fourth
quarter of 2008-09, it has been cushioned by quick and aggressive policy responses both by the
Reserve Bank and the Government. Notwithstanding the contraction of global demand, growthprospects in India continue to remain favorable compared to most other countries.
While public investment can play a critical role in the short-term during a downturn,
private investment has to increase as the recovery process sets in. A major macroeconomic
challenge at this juncture is to support the drivers of aggregate demand to enable the economy to
return to its high growth path.
The second challenge going forward is meeting the credit needs of the non-food sector.
Although, for the year 2008-09 as a whole, credit by the banking sector expanded, the pace of
credit flow decelerated rapidly from its peak in October 2008. This deceleration has occurred
alongside a significant decline in the flow of resources from non-bank domestic and external
sources. The deceleration in total resource flow partly reflects slowdown in demand, drawdown
of inventories by the corporate and decline in commodity prices. The expansion in credit,
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however, has been uneven across sectors. There is, therefore, an urgent need to boost the flow of
credit to all productive sectors of the economy, particularly to MSMEs, to aid the process of
economic recovery. The Reserve Bank continues to maintain and will maintain ample liquidity in
the system. It should be the endeavour of commercial banks to ensure that every creditworthy
borrower is financed at a reasonable cost while, at the same time, ensuring that credit quality is
maintained.
It may be noted that bank credit had accelerated during 2004-07. This, combined with
significant slowdown of the economy in 2008-09, may result in some increase in NPAs. While it
is not unusual for NPAs to increase during periods of high credit growth and downturn in the
economy, the challenge is to maintain asset quality through early actions. This calls for a focused
approach, due diligence and balanced judgment by banks.
Third, the Reserve Bank was able to manage the large borrowing programme of the
Central and State Governments in 2008-09 in an orderly manner. The market borrowings of the
Central and State Governments are expected to be higher in 2009-10. Thus, a major challenge is
to manage the large government borrowing programme in 2009-10 in a non-disruptive manner.
Large borrowings also militate against the low interest rate environment that the Reserve Bank is
trying to maintain to spur investment demand in keeping with the stance of monetary policy. The
Reserve Bank, therefore, would continue to use a combination of monetary and debt
management tools to manage government borrowing programme to ensure successful completion
of government borrowings in a smooth manner. The Reserve Bank has already announced an
OMO calendar to support government market borrowing programme through secondary market
purchase of government securities. During the first half of 2009-10, planned OMO purchases and
MSS unwinding will add primary liquidity of about Rs.1,20,000 crores which, by way of
monetary impact, is equivalent to CRR reduction of 3.0 percentage points. This should leave
adequate resources with banks to expand credit.
Fourth, another challenge facing the Indian economy is to restore the fiscal consolidation
process. The fiscal stimulus packages by the Government and some other measures have led to
sharp increase in the revenue and fiscal deficits which, in the face of slowing private investment,
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have cushioned the pace of economic activity. However, it would be a challenge to unwind fiscal
stimulus in an orderly manner and return to a path of credible fiscal consolidation. In this
context, close monitoring of the performance of the economy and the proper sequencing of the
unwinding process would have to be ensured.
Fifth, a continued challenge is to preserve our financial stability. The Reserve Bank
would continue to maintain conditions which are conducive for financial stability in the face of
global crisis. A sound banking sector, well-functioning financial markets and robust payment and
settlement infrastructure are the pre-requisites for financial stability. The banking sector in India
is sound, adequately capitalized and well-regulated. By all counts, Indian financial and economic
conditions are much better than in many other countries of the world. The single factor stress
tests carried out as part of the report of the Committee on Financial Sector Assessment (CFSA)
have revealed that the banking system in India can withstand significant shocks arising from
large potential changes in credit quality, interest rate and liquidity conditions. These stress tests
for credit, market and liquidity risk show that Indian banks are generally resilient.
Sixth, the Reserve Bank has injected large liquidity in the system since mid-September
2008. It has reduced the CRR significantly and instituted some sector-specific facilities to
improve the flow of credit to certain sectors. The tenure of some of these facilities has been
extended to provide comfort to the market. While the Reserve Bank will continue to support all
the productive requirements of the economy, it will have to ensure that as economic growth
gathers momentum, the large liquidity injected in the system is withdrawn in an orderly manner.
It is worth noting that even as the monetary easing by the Reserve Bank has potentially made
available a large amount of liquidity to the system, at the aggregate level this has not been out of
line with our monetary aggregates unlike in many advanced countries. As such, the challenge of
unwinding will be less daunting for India than for other countries.
Finally, we will have to address the key challenge of ensuring an interest rate
environment that supports revival of investment demand. Since October 2008, as the inflation
rate has decelerated and the policy rates have been reduced, market interest rates have also come
down. However, the reduction in interest rates across the term structure and across markets has
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not been uniform. Given the cost plus pricing structure, banks have been slow in reducing their
lending rates citing high cost of deposits. In this context, it may be noted that the current deposit
and lending rates are higher than in 2004-07, although the policy rates are now lower. Reduction
in deposit rates affects the cost only at the margin since existing term deposits continue at the
originally contracted cost. So lending rates take longer to adjust. Judging from the experience of
2004-07, there is room for downward adjustment of deposit rates. With WPI inflation falling to
near zero, possibly likely to get into a negative territory, albeit for a short period, and CPI
inflation expected to moderate, inflationary risks have clearly abated. The Reserve Banks
current assessment is that WPI inflation could be around 4.0 per cent by end-March 2010. Banks
have indicated that small savings rate acts as a floor to banks deposit interest rate. It may,
however, be noted that small savings and bank deposits are not perfect substitutes. Banks should
not, therefore, be overly apprehensive about reducing deposit interest rates for fear of
competition from small savings, especially as the overall systemic liquidity remains highly
comfortable. There is scope for the overall interest rate structure to move down within the policy
rate easing already effected by the Reserve Bank. Further action on policy rates is now being
taken to reinforce this process.
The Reserve Bank has been constantly monitoring global developments along with the
domestic economic situation. On the positive side, inflationary pressures have eased
significantly. Inflation as measured by year-on-year variations in the wholesale price index
(WPI) has declined to 3.36 per cent as on February 14, 2009, down by about three-fourths from
the high of 12.91 per cent as on August 2, 2008. However, consumer price inflation, as reflected
in various consumer price indices, is in the range of 9.85-11.62 per cent as of December 2008-
January 2009, has yet to show moderation. Consumer price inflation has remained at elevated
level due to increase in primary articles prices.
With WPI inflation having moderated significantly, consumer price inflation may also be
expected to decline, though with a lag.
At the same time, there is evidence of further slowing down of economic activity.
Exports registered negative growth for the four recent consecutive months, October 2008-
January 2009. Overall exports growth during 2008-09 (April-January) at 13.2 per cent was
significantly lower than 24.2 per cent during the same period of the last year. The index of
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industrial production (IIP) registered a negative growth of 2.0 per cent during December 2008,
with the manufacturing sector returning a negative growth of 2.5 per cent.
IIP growth during April-December 2008 at 3.2 per cent was about one-third of 9.0 per
cent during the corresponding period of the previous year due to slowdown in all the major
sectors. Real GDP growth in the third quarter of 2008-09 (September-December 2008) has been
placed at 5.3 per cent by the Central Statistical Organization (CSO). The services sector, which
has been the main engine of growth during the last several years, has also been slowing down.
Business confidence has been dented significantly and investment demand has decelerated.
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I nflation in I ndia
Inflation is the supply of excess money and credit relative to the goods and services
produced, resulting in increased prices. As the layman understands it, inflation results in the
increase in the price of some set of goods and services in a given economy over a period of time.
It is measured as the percentage rate of change of a price index.
Inflation in India is also a grave issue of concern, given the vast disparity between the
rich and the poor on the one hand or the Rural and the Urban on the other. Skyrocketing inflation
robs the poor, and hurts others, though much less grievously. The fruits of the much-talked about
economic growth have not reached large sections, especially in the rural areas.
Under extant conditions, the benefit of high prices paid by consumers does not flow back
to primary producers, but is siphoned away by middlemen and speculators who enjoy a free run
in an economy of shortages. If attention to agriculture has been limited to rendering lip service,
inefficiencies in the physical market remain unattended. With production trailing demand in
recent years, shortages of essential commodities have widened. Imports have become expensive
because of high global market prices.
It may be instructive to remember that inflation is not an overnight phenomenon. It is
benign to the extent that it allows us time to cover our self. In India, the onus to control and take
control of the situation of inflation is upon the Reserve Bank of India (RBI).
The Reserve Bank of India (Amendment) Act, 2006 gives discretion to the Reserve Bank
to decide the percentage of scheduled banks' demand and time liabilities to be maintained as
Cash Reserve Ratio (CRR) without any ceiling or floor. Consequent to the amendment, no
interest will be paid on CRR balances so as to enhance the efficacy of the CRR, as payment of
interest attenuates its effectiveness as an instrument of monetary policy.
The Reserve Bank of India (RBI) follows a multiple indicator approach to arrive at its
goals of growth, price stability and financial stability, rather than targeting inflation alone. This,
of course, leads to criticism from mainstream economists. In its effort to balance many
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objectives, which often conflict with each other, RBI looks confused, ineffective and in many
cases a cause of the problems it seeks to address.
The RBI has certain weapons which it wields every time and in all situations to counter
any form of inflationary situation in the economy. These weapons are generally the mechanisms
and the policies through which the Central Bank seeks to control the amount of credit flowing in
the market. The general stance adopted by the RBI to fight inflation is discussed in brief the
mechanism used by the RBI needs to take up a holistic approach to the same. Then it would deal
with very briefly suggestions that may shed some light on what could be the possible steps RBI
could take to control rising prices.
It is interesting to note that the Reserve Bank of India Governor. Dr Y. V. Reddy started
his stint with the aim of cutting down the Cash Reserve Ratio to 3 per cent (from the then 4.5 per
cent) but rising commodities inflation has forced him to raise it now to 6.5 per cent. But even this
6.5 per cent is way below what would truly contain inflation and it is almost certain that he will
be chasing the inflation curve for the next few years or so.
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Steps Generall y Taken By the RBI to Tackle I nf lation
According to the Annual Statement on Monetary Policy for the Year 2007- 08, a careful
assessment of the manner in which inflation is evolving in India reveals that primary food
articles have contributed significantly to inflation during 2006-07. At the same time, prices of
manufactured products account for well above 50 per cent of headline inflation. The recent
hardening of international crude prices has heightened the uncertainty surrounding the inflation
outlook.
The steps generally taken by the RBI to tackle inflation include a rise in repo rates (the
rates at which banks borrow from the RBI), a rise in Cash Reserve Ratio and a reduction in rate
of interest on cash deposited by banks with RBI. The signals are intended to spur banks to raise
lending rates and to reduce the amount of credit disbursed. The RBI's measures are expected to
suck out a substantial sum from the banks. In effect, while the economy is booming and the
credit needs grow, the central bank is tightening the availability of credit.
The RBI also buys dollars from banks and exporters, partly to prevent the dollars from
flooding the market and depressing the dollar indirectly raising the rupee. In other words, the
central bank's interactions have a desirable objectiveto keep the rupee devaluedwhich will
make India's exports more competitive, but they increase liquidity.
To combat this, the RBI does what it calls "sterilization"it sucks out the rupees it pays
out for dollars through sale of sterilization bonds. It then sells these bonds to banks. Economists
point out that there has not been much success in such sterilization attempts in India. The central
bank's attempt to offload Government bonds on banks has not been too successful in as much as
the banks sell the bonds and get rupees instead.
Economists also contrast this with the successful experience of China, where the state-
owned banks strictly abide by the central bank's dictates and absorb the sterilization bonds. That
discipline is lacking in India. The net effect is that the RBI has to resort to indirect methods of
sterilization, such as raising interest rates and raising CRR to contract liquidity. This makes India
more attractive for foreign capital flows that seek better returns and a vicious cycle follows. RBI
has to buy more foreign currency and sterilize.
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Consequences of RBI Policy
The economy was growing at a stupendous 9 per cent, second only to China worldwide, however
the brakes have been firmly pressed by the RBI due to their anti inflationary policy. If the CRR
and REPO rate are hiked frequently, the economy may take a U - turn, as most commercial
banks religiously increase their lending rates, without actually studying the impact.
The last time that the RBI had imposed its policy, the markets had signaled their
resounding reaction by a sharp fall in the Sensex by nearly 500 points. The impact on economic
growth is also likely to be sharp, judging by effects of similar therapy applied with disastrous
effect in the mid-1990s.
This would reduce the level of investment activity in the economy, particularly in the
infrastructure sector. Big corporate may ask for, and get, access to external commercial
borrowing, but not so favored are the bulk of small and medium entrepreneurs (SME). Housing
activity will suffer an impact because most loanees are on floating rates and will face increased
equated installments.
These measures generally taken by the RBI do not effectively tackle inflation but on the
other hand effectively stunts the growth pattern of the economy. The RBI seems to believe that
by merely reducing the credit flow and money flow in the economy, inflation can be curtailed.Inflation is a consequence of increasing demand Vis aVis the supply in the economy. The
demand must be effectively curtailed or pushe