monetary policypgdm[1]

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MONETARY POLICY

Dr.V.Raman NairDirector

SCMS ± COCHIN



Introduction

y What is Monetary Policy?

y Types of Policies

y Objectivesy Monetary Measures



What is Monetary Polic y

y The term Monetary polic y refers to actionstaken by a government, central bank, or monetary authority of a country to affect monetary

magnitudes or other financial conditions.

y It is the process used to control (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectivesoriented towards the growth and stability of theeconomy.



What is Monetary Polic y

y Aims to attain a set of objectives oriented towardsthe growth and stability of the economy.

y Operates on monetary magnitudes or variables

such as money supply, interest rates andavailability of credit.

y Ultimatel y operates through its influence onexpenditure flows in the economy.

y MP affects liquidity and by affecting liquidity, andthus credit, it affects total demand in the economy.



Types of Policies

y Monetary policy is referred to as either being an expansionary policy, or a contractionary policy.

Expansionary polic y increases the total suppl y of mone y inthe economy.

Expansionary polic y is traditionall y used to combat unemplo yment in a recession by lowering interest rates

Contractionary polic y decreases the total mone y suppl y.

Contractionary polic y involves raisinginterest rates tocombat inflation.

y Monetary policy is contrasted with fiscal policy, which refersto government borrowing, spending and taxation.



Types of Policies

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation TargetingInterest rate on overnight

debtA given rate of change in the CPI

Price Level TargetingInterest rate on overnight

debt A specific CPI number

Monetary Aggregates The growth in money supply A given rate of change in the CPI

Fixed Exchange RateThe spot price of the

currency

The spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the gold

price

Mixed Policy Usually interest rates Usually unemployment + CPI change



Polic y of v arious nations

y A ustralia - Inflation targetingy Brazil - Inflation targetingy Canada - Inflation targetingy Chile - Inflation targetingy China - Monetary targeting and targets a currency baskety

Eurozone - Inflation targetingy Hong Kong - Currency board (fixed to US dollar)y India - Multiple indicator approachy New Zealand - Inflation targetingy Norway - Inflation targetingy Singapore - Exchange rate targetingy

South A

frica - Inflation targetingy Switzerland - Inflation targetingy Turkey - Inflation targetingy United Kingdom - Inflation targeting, alongside secondary targets on 'output

and employment'.y United States - Mixed policy (and since the 1980s it is well described by the

³Taylor rule,´ which maintains that the Fed funds rate responds to shocks in

inflation and output)



Objectives

MP is a part of general economic policy of the govt.ThusMP contributes to the achievement of the goals of economic policy.

y Inflation Control

y Credit Growthy Full Employment

y Price Stability

y Economic Growth

y

Stable exchange ratey Healthy BoP

y Greater equality in distribution of income & wealth

y Financial stability



Backgrounder: Monetary Policy Framework in India

y Prior to mid-1980s: Direct Instruments of Monetary Control (based on credit budgeting)

y Mid-1980s to 1998 : Monetary targeting Framework suggested by Sukhmoy Chakaravarty Report (based onmoney demand stability & money multiplier

predictability)

y 1998 Onwards ± Multiple Indicator A pproach



Major Institutional Changes After 1991

y Interest rates freed

y Exchange rate: from managed to free float

y Full current account convertibility & substantial liberalizationof capital account

y Direct & portfolio investment encouraged

y Premium on stock market issues freed

y A utomatic monetization of budget deficits stopped

y Yields on gilts made market determinedy Private and foreign banks encouraged



How Did the RBI Respond?

y Reserve Requirements (CRR) cut from 15.0% in 1989-1993to 4.5% in June 2003

y Directed investments in gilts (SLR) brought down from38.5% in 1990-92 to statutory minimum of 25.0% by Oct.

1997y In A pril 1997, refinance rate (bank rate) activated and then

brought it down from 11% (12.0% in Oct 1991) to 6.0% in A pril 2003

y In June 1988 new monetary aggregates suggested

y In Dec.1997 fixed reverse rate repo introduced that helpedestablish an informal corridor for short-term interest rates;in June 2000 L A F established

y RBI announced that from 1998-99 it would follow amultiple indicator approach



How Was Monetary Transmission Impacted?

y Money demand became less stable and money multiplier lesspredictable than before

y

Disequilibrium in money markets started affecting short-terminterest rates

y Relatively, rate channels gained importance over quantumchannels

y Evidence of increased integration amongst financial markets

y Term structure is still segmented. FX-market efficiency holdsonly at short-end.



Current Operating Framework & Operating Procedures

y Mix of targeting bank reserves and short-term interest rates

y Bank reserves are targeted through reserve requirements as wellas open market operations

y Open market operations are primarily used to keep short-terminterest rates in an informal corridor set by reverse repo & reporates

y The central bank conducts fixed rate repo operations under L A Fon daily basis



Measures

y Least Inflation Policy

y Interest Rates

y CRR and SLR

y Monetary Base

y Reserve Requirements



Monetary Magnitudes

y The Reserve Bank of India defines the monetary aggregates as:y Reser ve Mone y (M0): Currency in circulation + Bankers¶ deposits

with the RBI + µOther¶ deposits with the RBI = Net RBI credit to theGovernment + RBI credit to the commercial sector + RBI¶s claims on banks + RBI¶s net foreign assets + Government¶s currency liabilities tothe public ± RBI¶s net non-monetary liabilities.

y M1: Currency with the public + Deposit money of the public (Demanddeposits with the banking system + µOther¶ deposits with the RBI).

y M2: M1 + Savings deposits with Post office savings banks.y M3: M1+ Time deposits with the banking system = Net bank credit to

the Government + Bank credit to the commercial sector + Net foreignexchange assets of the banking sector + Government¶s currency liabilities to the public ± Net non-monetary liabilities of the bankingsector (Other than Time Deposits).

y M4: M3 + A ll deposits with post office savings banks (excludingNational Savings Certificates).



Growth of M3 and Differential Contribution of Components



Credit Polic y

y Central Bank may directly affect the money supply tocontrol its growth.

y Or it might act indirectly to affect cost and availability of credit in the economy.

y In modern times the bulk of money in developed economiesconsists of bank deposits rather than currencies and coins.y So central banks today guide monetary developments with

instruments that control over deposit creation and influencegeneral financial conditions.

y Credit policy is concerned with changes in the supply of credit.

y Central Bank administers both the Credit and Monetary policy



Price Stability: The Dominant Objective Contd..

y Price Stability contributes improvements in the standard of living of people.

y It promotes saving in the economy while discouragingunproductive investment.

y Stable prices enable exports to compete in internationalmarkets and contribute to the strengthening of BoP.

y Price stability leads to interest rate stability, and exchangerate stability (via export import stability).

y It contributes to the overall financial stability of the

economy.



Operation of Monetary Policy Instruments

1. Discount Rate

(Bank Rate)

2.Reserve Ratios

3. Open Market

Operations

Operating

Target

Monetary Base Bank Credit

Interest Rates

Intermediate

Target

Monetary

Aggregates(M3)

Long term

interest rates

Ultimate

Goals

Total Spending

Price Stability

Etc.



Instruments of Monetary Policy

y Variations in Reserve Ratios

y Discount Rate (Bank Rate)

(also called rediscount rate)

y Open Market Operations (OMOs)

y Other Instruments



Cash Reser ve R atio

y In terms of Section 42 (1) of the Reserve Bank of India A ct,1934 the Reserve Bank having regard to the needs of securing the monetary stability in the country, prescribesthe CRR for Scheduled Commercial Banks (SCBs) withoutany floor or ceiling rate.

y A t present, effective from the fortnight beginning February 13, 2010 the CRR is prescribed at 5.50 per cent of a bank'stotal of demand and time liabilities adjusted for theexemptions.

y A t present no incremental CRR is required to be maintained

by Banks.y Since reserves are high-powered money or base money, by

varying CRR, RBI can reduce or add to the bank¶s requiredreserves and thus affect bank¶s ability to lend.




y Demand Liabilities include all liabilities which are payableon demand that include current deposits, demand liabilitiesportion of savings bank deposits, margins held against lettersof credit/guarantees, balances in overdue fixed deposits, cash

certificates and cumulative/recurring deposits, outstandingTelegraphic Transfers (TTs), Mail Transfer (MTs), DemandDrafts (DDs), unclaimed deposits, credit balances in the CashCredit account and deposits held as security for advances which are payable on demand. Money at Call and Short Notice

from outside the Banking System should be shown againstliability to others.




y Time Liabilities are those which are payableotherwise than on demand that include fixeddeposits, cash certificates, cumulative and recurring

deposits, time liabilities portion of savings bank deposits, staff security deposits, margin held againstletters of credit, if not payable on demand, depositsheld as securities for advances which are not payable

on demand and Gold deposits.




y OtherDemand and Time Liabilities (ODTL) includeinterest accrued on deposits, bills payable, unpaid dividends,suspense account balances representing amounts due to other banks or public, net credit balances in branch adjustment

account, any amounts due to the "Banking System" which arenot in the nature of deposits or borrowing. Such liabilities may arise due to items, like (i) collection of bills on behalf of other banks, (ii) interest due to other banks and so on.

y Participation Certificates issued to other banks, the balancesoutstanding in the blocked account pertaining to segregatedoutstanding credit entries for more than 5 years in inter- branch adjustment account, the margin money on billspurchased / discounted and gold borrowed by banks fromabroad, also should be included in ODTL.




y Liabilities not to be included for DTL/NDTL computation

(a) Paid up capital, reserves, any credit balance in the Profit & Loss A ccount of the bank, amount of any loan taken from the RBI and the amount of refinance taken from Exim Bank, NHB, N A B A RD, SIDBI.

(b) Net income tax provision. (c) A mount received from DICGC towards claims and held by banks pending adjustments thereof. (d) A mount received from ECGC by invoking the guarantee. (e) A mount received from insurance company on ad-hoc settlement of claims pending judgment of the

Court. (f) A mount received from the Court Receiver. (g) The liabilities arising on account of utilization of limits under Bankers A cceptance Facility (B A F). (h) District Rural Development A gency (DRD A ) subsidy of Rs.10,000/- kept in Subsidy Reserve Fund

account in the name of Self Help Groups. (i) Subsidy released by N A B A RD under Investment Subsidy Scheme for

Construction/Renovation/Expansion of Rural Godowns. (j) Net unrealized gain/loss arising from derivatives transaction under trading portfolio. (k) Income flows received in advance such as annual fees and other charges which are not refundable.

(l) Bill rediscounted by a bank with eligible financial institutions as approved by RBI. (m) Provision not being a specific liability arising from contracting additional liability and created from

profit and loss account. (n) Scheduled Commercial Banks are not required to include inter-bank term deposits/term borrowing

liabilities of original maturities of 15 days and above and up to one year in "Liabilities to the BankingSystem" (item 1 of Form " A "). Similarly banks should exclude their inter-bank assets of term deposits andterm lending of original maturity of 15 days and above and up to one year in " A ssets with the BankingSystem" (item III of Form A ) for the purpose of maintenance of CRR. The interests accrued on thesedeposits are also exempted from reserve requirements.




y Exempted Categories

Ùi. Liabilities to the banking system in India as computedunder Clause (d) of the Explanation to Section 42(1) of

the RBI A

ct, 1934.

Ùii. Credit balances in A CU (US$) A ccounts.

Ùiii. Transactions in Collateralized Borrowing and

Lending Obligation (CBLO) with Clearing Corporationof India Ltd. (CCIL).

Ùiv. Demand and Time Liabilities in respect of theirOffshore Banking Units (OBUs).




y Procedure for Computation of CRR In order to improve the cash management by banks, as a measure of

simplification, a lag of one fortnight in the maintenance of stipulatedCRR by banks has been introduced with effect from the fortnight beginning November 06, 1999.

y

Maintenance of CRR on Dail y Basis With a view to providing flexibility to banks in choosing an optimumstrategy of holding reserves depending upon their intra fortnight cashflows, all Scheduled Commercial Banks are required to maintainminimum CRR balances up to 70 per cent of the average daily required reserves for a reporting fortnight on all days of the fortnight with effect from the fortnight beginning December 28, 2002.

y No Interest Payment on Eligi ble Cash Balancesmaintained by SCBs with RBI under CRR In view of the amendment carried out to RBI A ct 1934, omitting sub-

section (1B) of section 42, the Reserve Bank of India does not pay any interest on the CRR balances maintained by Scheduled CommercialBanks with effect from the fortnight beginning March 31, 2007.




y Penalties From the fortnight beginning June 24, 2006, penal interest will be

charged as under in cases of default in maintenance of CRR by Scheduled Commercial Banks:

Ù In cases of default in maintenance of CRR requirement on a daily basis which is presently 70 per cent of the total CRR requirement,penal interest will be recovered for that day at the rate of three percent per annum above the Bank Rate on the amount by which theamount actually maintained falls short of the prescribed minimum

on that day and if the shortfall continues on the next succeedingday/s, penal interest will be recovered at a rate of five per cent perannum above the Bank Rate.



Statutory Liquidity Ratio

y Consequent upon amendment to the Section 24 of theBanking Regulation A ct, 1949 through the Banking Regulation( A mendment) A ct, 2007 replacing the Regulation( A mendment) Ordinance, 2007, effective January 23, 2007,

the Reserve Bank can prescribe the Statutory Liquidity Ratio(SLR) for SCB in specified assets.

y The value of such assets of a SCB shall not be less than suchpercentage not exceeding 40 per cent of its total demand andtime liabilities in India as on the last Friday of the secondpreceding fortnight as the Reserve Bank may, by notificationin the Official Gazette, specify from time to time.




y Reserve Bank has decided that all SCBs shall continue to maintain a uniform SLR of 25 per cent on their total net demand and time liabilities (NDTL), valued inaccordance with the method of valuation specified by the Reserve Bank of India fromtime to time: a) in cash, or b) in gold valued at a price not exceeding the current market price, or

c) in unencumbered investment in the following instruments which will bereferred to as ³statutory liquidity ratio (SLR) securities": Dated securities issued up to September 8, 2009

Treasury Bills of the Government of India;

Dated securities of the Government of India issued from time to time under

the market borrowing programme and the Market Stabilisation Scheme;

State Development Loans (SDLs) of the State Governments issued from timeto time under their market borrowing programme; and

A ny other instrument as may be notified by the Reserve Bank of India.




y Penalties: If a banking company fails to maintainthe required amount of SLR, it shall be liable to pay to RBI in respect of that default, the penal interest

for that day at the rate of 3 per cent per annum abovethe Bank Rate on the shortfall and if the defaultcontinues on the next succeeding working day, thepenal interest may be increased to a rate of 5 per

cent per annum above the Bank Rate for theconcerned days of default on the shortfall.



Repo A nd Reverse Repo

y Repo rate is the rate at which banks borrow rupees fromRBI against approved securities for meeting their day today requirements or to fill short term gap.

y 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.

y The rate charged by RBI for its Repo operations is 5.75%and Reverse Repo rate is 4.50%.

y These types of operations are generally for overnightoperations.



Repurchase agreements

Definition: selling an asset with an explicit agreement to repurchase the asset after

a set period of time

Example: A bank has deficient reserves and needs to borrow overnight.1. Bank A sells a treasury security to Bank B at P0

2. Bank A agrees to buy the treasury back at a higher price Pf > P0

3. Bank B earns a rate of return implied by the difference in prices

4. Since the loan is backed by collateral, the rate is usually low

i R A =Pf ± P0

P0

360

daysx



Discount Rate (Bank Rate)

y Discount rate is the rate of interest charged by the central bank for providing funds or loans to the banking system.

y Funds are provided through rediscounting of commercial bills.

y Raising Bank Rate raises cost of borrowing by commercial

banks, causing reduction in credit volume to the banks, anddecline in money supply.

y Variation in Bank Rate has an effect on the domestic interestrate, especially the short term rates.

y

Market regards the increase in Bank rate as the official signalfor beginning of a tight money situation.

y current bank rate at which RBI lends to Banks is 6%.



Open Market Operations (OMOs)

y OMOs involve buying (outright or temporary) andselling of govt securities by the central bank, from orto the public and banks.

y RBI when purchases securities, pays the amount of money by crediting the reserve deposit account of theseller¶s bank, which in turn credits the seller¶s depositaccount in that bank.



Annual Review Monetary Polic y 2010-11

RBI has pursued an accommodative monetary policy beginningmid-September 2008 in order to mitigate the adverse impact of the global financial crisis on the Indian economy. A gainst this

backdrop, the stance of monetary policy of the Reserve Bank for

the 2010-11 will be as follows:y A nchor inflation expectations, while being prepared to respond

appropriately, swiftly and effectively to further build-up of inflationary pressures.

y A ctively manage liquidity to ensure that the growth in demand

for credit by both the private and public sectors is satisfied in anon-disruptive way.

y Maintain an interest rate regime consistent with price, outputand financial stability.



First Quarter Review of Monetary Polic y 2010-11

y Monetary polic y actions expected to:

i) Moderate inflation by reining in demand pressures andinflationary expectations.

ii) Maintain financial conditions conducive to sustaininggrowth.

iii) Generate liquidity conditions consistent with more effectivetransmission of policy actions.

iv) Restrict the volatility of short-term rates to a narrower

corridor.Highlightsy The repo rate under the Liquidity A djustment Facility (L A F) has

been raised to 5.75 per cent.

y The reverse repo rate under the L A F has been raised to 4.50 percent.



y Reduction in excess liquidity will help anchorinflationary expectations.

y

The recovery process will be supported withoutcompromising price stability.

y The calibrated exit will align policy instruments withthe current and evolving state of the economy.

Expected Outcomes



Recent Challenges to Monetary Policy Design «(i)

y Large capital inflows, which sometimes become unpredictable and volatile

y Lowering inflation expectations amidst oil price shock

y Handling A sset Price Considerations in Monetary Policy

y Large credit growth driven by consumption as well as investment

demand; possible unknown future financial stability risks in currentdebt driven credit boom supported by retail credit



Recent Challenges to Monetary Policy Design «(ii)

y Issues of A utonomy, A ccountability, Transparency & Decision-makingstructures

y Seeking Greater Central Bank Independence while ensuring monetary-fiscal coordination

y Continued large fiscal deficits, placing debt management burden onmonetary policy

y FRBM is correcting this« but would bring new challenges for conduct of monetary operations



Final Issue: The Issue of Trilemma

y What to emphasize less: free capital mobility, monetary policy independence or exchange rate misalignments?

y Importance of managing capital account in macro-economic

framework of large & volatile capital flows in an emerging markety Should we not intervene at all? Should we sterilize or not?

y Is the framework fine?

y Should the operating procedures be altered?



Stimulus Package

y On the fiscal front, the stimulus by the government in thesecond half of 2008-09 has clearly contributed significantly to the recovery. It may be recalled that the crisis-drivenstimulus by way of reduction in excise levies, interest rate

subventions and additional capital expenditure came on topof structural measures already built into the budget such asthe Sixth Pay Commission A ward and farm debt waiver.

y Since October 2008, Government has launched Stimulus

packages worth $4bn (around Rs.20,000Cr) to combat theeconomic slowdown following the collapse of LehmanBrothers



Stimulus Package Highlights

y Relaxation in foreign borrowing rules for firms in the realestate sectors and infrastructure, and increase of foreigninvestment limit to $15bn in corporate bonds fromJanuary,2009.

y Decrease in main policy rates by RBI along withrecapitalising state run banks to the tune of $200bn. Therecapitalising process will take place in two years (January 2009 to January 2011) to ensure that banking system doesnot suffer from Capital A dequacy constraints)

y A n additional expenditure of Rs.20,000Cr in first quarter of 2009 towards rural infrastructure and social security schemes.



y A n across the board cut of 4% on advalorem Cenvat rate(excluding petroleum products) was implemented fromJanuary¶09 to March ¶09.

y A uthorised IIFCL (Indian Infrastructure Finance Company

Ltd) to raise Rs.10,000 Cr to refinance bank lending toinfrastructure projects in December, 2008.

y NBFCs, dealing with infrastructure financing werepermitted to access ECD from multilateral or bilateralfinancial institutions, under the approval of RBI since

December,2008.y Since December,2008, FII investment limit in Rupee

denominated Corporate bonds in India was increased fromUS$6bn to US$15bn

Stimulus Package Highlights

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