rcnt movs in indian monetry plcy

8/2/2019 Rcnt Movs in Indian Monetry Plcy

1/21

Project Report

Recent moves in Indian Monetary policy

And

Its implication for Banks and Corporate Sector

Submitted to: Submitted by:

Dr. Harsh Purohit Aviruchi Bharti

WISDOM DeepsuhasaBanasthali Vidyapith Divya Sharma

Kanupriya


2/21

EQUITY RESEARCH

ACKNOWLEDGEMENTS

I am profusely thankful to Dr. Harsh Purohit for helping me in the successful completion of the

project and guiding me the right way to proceed forward. I am also grateful for his advices in orderto get authentic and valuable information.

I am also very thankful to my Parents and my Siblings for their continuous concern about thisproject and my well being during this course of action.

And finally I would like to thank God for his helps and blessings throughout this project.

Aviruchi Bharti

2 | P a g e


3/21

EQUITY RESEARCH

EXECUTIVE SUMMARY

CONTENT

PART 1

CERTIFICATE FROM SUPERVISOR i

ACKNOWLEDGEMENT ii

EXECUTIVE SUMMARY iii

PART 2

3 | P a g e


4/21

EQUITY RESEARCH

4 | P a g e

CHAPTERS Page no.

1. INTRODUCTION TO MONETARY POLICY 8

1.1 Definition 10

1.2 Why and when it has been introduced in India?

11

1.3 What are the objectives of Monetary Policy ? 12

1.4 Movement of Monetary Policy in the history

2. HOW MONETARY POLICY DOES BRINGS ABOUT

CHANGES IN OUR ECONOMY?

14

2.1 CRR

16

2.2 SLR 17

2.3 Bank Rate 18

2.4 Repo rate

2.5 Reverse Repo Rate 19

2.6 Open market Operation

2.7 Selective Credit Control 19

3. EFFECT ON THE BANKING SECTOR 20

3.1 Retail Customer

20

3.2 Corporate Customer 22

3.2.1 FMCG Sector 22

3.2.2 IT Sector

23

3.2.3 Production and Manufacturing Unit 23

3.2.4 Automobile Unit

24

3.2.5 Service Sector Companies 25

3.2.6 Telecommunication Sector 26

3.3 Affect On Bank Loan 27

3.3.1 New loans 28


5/21

EQUITY RESEARCH

PART 3

LIST OF TABLESS.No NAME OF THE TABLE PAGE NO

1 11

2 28

3 32

PART 4

LIST OF FIGURES AND GRAPHSS.No NAME OF FIGURES AND GRAPHS PAGE NO

1 11

2 18

3 26

4 30

5 33

6 34

5 | P a g e


6/21

EQUITY RESEARCH

CHAPTER 1

1: INTRODUCTION TO MONETARY POLICY

Monetary policy is the management of money supply and the interest rates by the central bank tocontrol the price and the employment. We can also say that Monetary policy is a central bank'sactions to influence the availability of the money in the economy, as a means to promote nationaleconomic goals. (In case of India its the Reserve Bank of India is that central bank and in case ofAmerica its the Federal ReserveBank).1.1: Definition

In other words we can say that the Monetary policy is the process by which the monetaryauthorityof a country controls the supply of moneyin the economy, often by increasing ordecreasing the rate ofinterestfor the purpose of promotingeconomic growth and stability.

1.2: Why and when it has been introduced in India?

In INDIA monetary policies are introduced and implemented by The Reserve Bank of India(RBI) which was established in 1935 and was nationalized in 1949.

Over the last five decades, the conduct of monetary policy in India has undergone sharp

transformation and the present mode of monetary policy has evolved over time with numerousmodifications. Under this topic, we shall trace the evolution of institutional arrangements, changesin the policy framework, objectives, targets and instruments of monetary policy in India in the lightof shifts in theoretical underpinnings and empirical realities. The discussion on the historicaldevelopments of monetary policy in India can be carried out with different ways of periodisation.Our method of periodisation is primarily based on the policy environment. Based on the policyframework, broadly two distinct regimes can be delineated in the monetary policy history of India,since Independence. The first regime refers to the credit-planning era followed since the beginning

6 | P a g e
http://en.wikipedia.org/wiki/Monetary_authorityhttp://en.wikipedia.org/wiki/Monetary_authorityhttp://en.wikipedia.org/wiki/Supply_of_moneyhttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Economyhttp://en.wikipedia.org/wiki/Supply_of_moneyhttp://en.wikipedia.org/wiki/Interesthttp://en.wikipedia.org/wiki/Economyhttp://en.wikipedia.org/wiki/Monetary_authorityhttp://en.wikipedia.org/wiki/Monetary_authority


7/21

EQUITY RESEARCH

upto the mid-1980s. The second is the regime started with adoption of 'money-multiplier'framework, implemented as per recommendations of Chakravarty Committee (RBI 1985).However, both the regimes command appropriateness under the circumstances and institutionalstructure existed during the respective periods. In the first regime, there was a shift towards atightly regulated regime for bank credit and interest rates since the mid-1960s with emergence of a

differential and regulated interest rate regime since 1964, adoption of the philosophy of socialcontrol in ANALYTICS OF MONETARY POLICY IN INDIA 14 December 1967, the event'bank nationalization' in 1969, increasing deficit financing by the government, etc. Similarly, thepost-Chakraarty Committee regime also can be separated into two sub-periods distinguished by theevent of economic reforms of 1991-92. There was a radical shift from direct to indirect instrumentsand emergence of a broad, deep and diversified financial market, with prevalence of greaterautonomy, in the post-reform period. Thus, the whole period since Independence can be dividedinto four subperiods in our discussion on the historical development of monetary policy in India.They are (i) Initial Formative Period, which extends since Independence upto 1963, (ii) Period ofHigh Intervention (Regulation) and Banking Expansion with social control since 1964 to 1984, (iii)New Regime of Monetary Targeting with Partial Reforms, from 1985 to 1991, and (iv) Post-

Reform Period with Financial Deepening,since 1992.

2.2 - Initial Formative Period (1947-1963)Prior to the Independence, the broad objectives of monetary policy in Indiacould be classified as (a) issue of notes, acting in national interest by curtailingexcessive money supply and to overcome stringency where it mitigated productionactivities, (b) public debt management, and (c) maintaining exchange value of theRupee. In the initial days of Independence, there were some challenges for monetaryoperations due to the event of partition and consequent division of assets of RBI, andits responsibility of currency and banking management in the transitory phase in thetwo new Dominions. In Independent India, the advent of planning era withestablishment of Planning Commission in 1950 brought a directional change in allparameters in the economic management. As bulk of the actions and responsibilitiespertaining to the economic policy rested with the Planning Commission, other entitiesof policymaking including the monetary authority had a supplementary role.However, setting the tone of monetary policy, the First Five Year Planenvisaged, "judicious credit creation somewhat in anticipation of the increase inANALYTICS OF MONETARY POLICY IN INDIA15production and availability of genuine savings" (GOI, 1951). During the First FiveYear Plan, monetary management witnessed a distinguished order with effective coordinationbetween the then Finance Minister Chintaman Deshmukh, a formerGovernor of RBI and the then Governor of RBI Benegal Rama Rau. The RBI decidedto withdraw support to the gilt-edged market signifying the proof of an independentmonetary policy (da Costa, 1985). The initiatives of the Finance Minister to controlgovernment expenditure with emphasis to enhance revenue and capital receiptsfacilitated such a move. A mere 10.3 percent growth of money supply in the wholeFirst Plan reflects restrictive monetary policy during this period.In the next two five year plans, conduct of monetary policy faced

7 | P a g e


8/21

EQUITY RESEARCH

unprecedented challenges due to the new initiatives in the planning regime and thedegree of independence enjoyed by the RBI was heavily curtailed. At the beginning ofthe Second Five Year Plan, both foreign exchange reserves and India's external creditwere very high for easy availability of required investments. In this backdrop, underthe able leadership of Prof. P. C. Mahalanobis the plan exercise emphasised on heavy

industries. Although, there were notable success in the front of output expansionmainly lead by industrialisation during the Second Five Year Plan, there were somesetbacks for monetary policy operations. Firstly, finance minister T. T.Krishnamachari emphasised on transforming sterling balances into investment goodssince 1956-57. The foreign exchange assets depleted to the extent of Rs. 664 croresduring a decade since then. There was increasing pressure on the RBI to providecredit to the government. Thus, when the real income (NNP) increased by 21.5 percent in Second Five Year Plan, money supply (Ml) increased by 29.4 per cent (daCosta, 1985). During this period, the prices increased by 35.0 per cent contrary to themagnificent control on it in the First Five Year Plan.'Selective Credit Control' was followed during this period as a remedy to

overcome the dilemma of controlling inflationary pressure and need for financingdevelopmental expenditure (Iengar, 1958). Much needed expenditure on infrastructureprojects, which was not immediately productive exerted upward pressure on the pricesANALYTICS OF MONETARY POLICY IN INDIA16of consumer goods. On the other hand, the private sector was to be provided credit forcomplementary expansion of investment. Hence, monetary policy did not adoptgeneral tightening or relaxation of credit but some sectors were provided preferentialcredit and for some others the credit was made expensive.In the Third Five Year Plan, the 1962 hostilities with China further addedpressure on monetary policy operations. This was mainly due to the creditrequirement of the government for the increasing defence and developmentalexpenditure. Thus, money supply (Ml) during this period increased by as high as 57.9percent. With only 11.8 percent growth of NNP in the Third Plan, prices rose by closeto 32 percent.Thus, the conduct of monetary policy became a process of passiveaccommodation of budget deficits, by early 1960s. The decade of 1960s witnessed agradual shift of priority from price stability to greater concerns for economic growthand accompanying credit control. A new differential interest rates regime emergedwith a view to influence the demand for credit and imparting an element of disciplinein the use of credit. Under the 'quota-cum-slab' introduced in October 1960,minimum lending rates were stipulated. This was the beginning of a move towardsregulated regime of interest rates.2.3- Period of High Regulation and Bank Expansion (1964 - 1984)This period witnessed radical changes in the conduct of monetary policypredominantly caused by interventionist character of credit policy and externaldevelopments. The process of monetary planning was severely constrained by heavilyregulated regime consisting of priority sector lending, administered interest rates,refinance to the banks at concessional rates to enable them to lend at cheaper rates topriority sectors, high level of deficit financing, external oil price shocks, etc. Inflation

8 | P a g e


9/21

EQUITY RESEARCH

was thought to be primarily caused by supply factors and not emanating frommonetary causes. Hence, output expansion was thought to be anti-inflationary andemphasis was attributed on the credit expansion to step up output. In the process, theANALYTICS OF MONETARY POLICY IN INDIA17

government occupied the pivotal role in monetary management and the RBI waspushed down to the secondary position.Since the mid-1960s, regulation of the domestic interest rates becameubiquitous in India. In September 1964 a more stringent system for bank credit basedon net liquidity position was introduced and both deposit and credit rates wereregulated. The introduction of Credit Authorisation Scheme (CAS) in 1965 initiatedrationing of bank credit (RBI, 1999). With implementation of CAS, prior permissionof RBI was required for sanctioning of large credit or its augmentation. It served thetwin objectives of mobilising financial resources for the Plans and imparting bettercredit discipline. The degree of constraints on the monetary authority startedmounting up with the measures of 'social control' introduced by the Government of

India in December 1967, which envisaged a purposive distribution of credit with aview to enhance the flow of credit to priority sectors like agriculture, small sectorindustries and exports coupled with mobilisation of savings. Accordingly, NationalCredit Council was set up to provide a forum for discussing and assessing the creditpriorities. Credit to certain economic activities like exports was provided withconcessional rates since 1968. The transfer of financing of public procurement anddistribution and fertliser operations from government to banks in 1975-76 furtherconstrained the banking operations. The rationalisation of CAS guided byrecommendations of Tandon Committee (1975), Chore Committee (1979) andMarathe Committee (1983) subsequently refined the process of credit rationing.The event of nationalisation of major commercial banks in July 1969constitutes an important landmark in the monetary history of India, which hadsignificant bearings on the banking expansion and social control of bank credit. Thenationalisation of banks led to use of bank credit as an instrument to meet socioeconomicneeds for development. The RBI began to implement credit planning withthe basic objective of regulating the quantum and distribution of credit to ensurecredit flow to various sectors of the economy in consonance with national prioritiesand targets. There was massive branch expansion in the aftermath of bankANAL YTICS OF MONETARY POLICY IN INDIA18nationalisation with the spread of banking facilities reaching to every nook and cornerof the country. The number of bank branches rapidly increased from 8,262 in 1969 to13,622 in 1972, which subsequently increased to 45,332 by 1984.These developments had significant implications for financial deepening ofthe economy. During this period the growth of financial assets was faster as comparedto the growth of output. The volume of aggregate deposit of scheduled commercialbanks increased from Rs 4,338 crore in March 1969 to Rs 60,596 crore in March 1984and the volume of bank credit increased from Rs 3,396 crore to Rs 41,294 crore inbetween the same period (Table II. 1). Particularly, non-food credit increased from Rs3,915 crore in March 1970 to Rs 37,272 crore in March 1984. The average annual

9 | P a g e


10/21

EQUITY RESEARCH

growth rate of aggregate deposits markedly increased from 9.5 per cent for the period1951-52 to 1968-69 to 19.3 per cent for the period 1969-70 to 1983-84. In betweenthe same period, bank credit increased from annual average of 10.9 per cent to 18.2per cent. This period also witnessed growing volume of priority sector lending, whichhad not received sufficient attention by the commercial banks prior to nationalisation.

The share of priority sector advances in the total bank credit of scheduled commercialbanks rose from 14 per cent in 1969 to 36 per cent in 1982. The share of medium andlarge industries in the bank credit had come down from 60.6 per cent in 1968 to 37.6per cent in 1982.During this period, monetary policy of the RBI mainly focused on bank credit,particularly non-food credit, as the policy indicator. Basically, the attention waslimited to the scheduled commercial banks, as they had high proportion of bankdeposits and timely available data. Emphasis on demand management through controlof money supply was not in much evidence upto mid-1980s. Reserve money was notconsidered for operational purposes as the major source of reserve money creation -RBI's credit to the government - was beyond its control. Due to lack of control on the

reserve money and establishment of direct link between bank credit and output, creditaggregates were accorded greater importance as indicators of the stance of monetarypolicy and also as intermediate targets.ANALYTICS OF MONETARY POUCY IN INDIA19Among the policy instruments, SLR was mainly used to serve the purpose ofraising resources for the government plan expenditure from the banks. The level ofSLR had progressively increased from the statutory minimum of 25 per cent inFebruary 1970 to 36 per cent in September 1984 (Table II.2). Banks were providedfunds through standing facilities such as 'general refinance' and 'export refinance' tofacilitate developmental financing as per credit plans. The instrument of CRR wasmainly used to neutralise the inflationary impact of deficit financing. The CRR wasraised from its statutory minimum of 3 per cent since September 1962 to 5 per cent inJune 1973 (Table 11.2). Gradually it was hiked to 9 per cent by February 1984. Duringthis period, the Bank Rate had a limited role in monetary policy operations.The year 1976 constitutes one of the most eventful period in the monetarythinking in India, when a heated debate surfaced on the issue of validity of the thenprevailing monetary policy procedure. The first dissenting note came from S.B. Guptawith his seminal article advocating in favour of 'money-multiplier' approach. Gupta(1976a) argued that, the then practice of RBI's money supply analysis simply sums upits various components, and hence merely an accounting or ex post analysis. It wasaccused of being tautological in nature. He suggested, money supply analysis basedon some theory of money supply like money multiplier approach could provide betterunderstanding of the determinants of money supply. He also highlighted thedifference in monetary impact of financing government expenditure through creditfrom RBI versus investment of the banks in government securities.However, RBI economists rejected Gupta's analysis as mechanistic andunsatisfactory in theory and useless in practice (Mujumdar, 1976) and claimed that,RBI's analysis provides an economic explanation of money supply in India.Mujumdar (1976) questioned the basic ingredients of 'money-multiplier approach'

10 | P a g e


11/21

EQUITY RESEARCH

such as stability of the relationship between money supply and reserve money,controllability of reserve money and endogeneity of money-multiplier, and stated that,"... in certain years if the expansion in M does not confirm to the postulatedrelationship, one has to explain away the situation by saying that the multiplier itselfANALYTICS OF MONETARY POLICY IN INDIA

20has changed". He also claimed that, RBI analysis takes into account both primarymoney supply through the RBI and secondary expansion through commercial banksand provides a total explanation of variations in money supply. As against this,multiplier approach explains only the secondary expansion through the moneymultiplier.Shetty, Avadhani and Menon (1976) supplemented Mujumdar in defendingRBFs money supply analysis. They argued that, money supply is both an economicand a policy controlled variable. As an economic variable it may be determined by thebehaviour of the public to hold currency and bank deposits, but as a policy controlledvariable it depends on the monetary authority's perception about the appropriate levelof primary and secondary money. Thus, they refuted any simple and mechanical

relationship between reserve money and money supply. They completely rejected theappropriateness of projecting monetary aggregates based on money-multiplier in theshort-term due to erratical behaviour of related coefficients, but they do not rule outusefulness of long-term projections. On the issue of the relationship between reservemoney and money supply, Shetty et al (1976) asserted that, "it is incorrect of Gupta tostate that the RBI is ignorant of the significance of reserve money in monetaryanalysis. The RBI, however, does not consider it as the single element for explanationof the sources of changes in money supply."At this point a reconciliatory note came from Khatkhate (1976). Heemphasised the usefulness of 'money-multiplier framework' as suggested by Gupta(1976a), but was critical of him for accusing the RBI being not aware of it. Accordingto Khatkhate (1976), "Gupta is quite right in suggesting this line, but the difficulty isthat it has no connection with the RBI presentation of monetary data. And what iseven worse is that Gupta does no better than the RBI in proposing his alternative."Towards end of 1970s, there were resentments regarding the way monetarymanagement is operated in the policy circle. With large part of the monetary reserveoutside the control of monetary authority, the channel of credit allocation to fewpockets of the commercial sector could transmit very limited influence to the realeconomic variables. The neglect of issues related to monetary targeting viewed as anunnecessary byproduct of the preoccupation with credit targeting.The period 1979-82 witnessed a turbulent phase for Indian economy. During1979-80 adverse weather conditions caused record downfall in foodgrains production.It was accompanied by a setback in industrial production. The budget nonethelesscontinued to be expansionary. The budgetary deficit as percentage of GDP was 2.13per cent in 1979-80 and 1.82 per cent in 1980-81. The external sector added to furtherdeterioration of the situation with hike in prices of petroleum products and fertilisers.All these contributed together towards prevalence of a widespread general inflation.Reserve money growth was explosive and financial crowding out threatened long runprospects of stable growth. These macroeconomic developments made the conduct ofmonetary policy extremely difficult and progressively brought a sharp shift in

11 | P a g e


12/21

EQUITY RESEARCH

monetary policy.2,4- New Regime of Monetary Targeting (1985 - 1991)In the backdrop of intellectual debate as discussed above and prevailingeconomic conditions, it was imperative to comprehensively review the functioning ofthe monetary system and carry out necessary changes in the institutional set up and

policy framework of the monetary policy. This was materialised by setting up a highlevel committee in 1982, under the chairmanship of Prof. Sukhamoy Chakravarty.The major recommendations of the Chakravarty Committee include, inter alia,shifting to 'monetary targeting' as the basic framework of monetary policy, emphasison the objectives of price stability and economic growth, coordination betweenmonetary and fiscal policy to reduce the fiscal burden on the former and suggestion ofa scheme of interest rates in accordance with some valid economic criteria. Clarifyingthe stand on monetary targeting with feedback, Rangarajan (2002) asserts that, c*thescheme of fixing monetary targets based on expected increase in output and thetolerable level of inflation is far removed from the Friedmanite or any other version ofmonetarism." The Committee endorsed the use of bank reserves as the main operating

target of monetary policy and laid down guidelines relating to the optimal order of thegrowth of money supply in view of stability in demand for money.The recommendations of Chakravarty Committee guided far-reachingtransformation in the conduct of monetary policy in India. There was a shift to a newpolicy framework in the conduct of monetary policy by introducing monetarytargeting. In addition, recommendations of the Report of the Working Group onMoney Market, 1987 (Chairman: Vaghul) and subsequent move to activate the moneymarket by introducing new financial instruments such as 182-day Treasury Bills(TBs), Certificates of Deposit (CDs), Commercial Paper (CP) and ParticipationCertificates, and, establishment of Discount and Finance House of India (DFHI) inApril 1988 created new institutional arrangements to support the process of monetarytargeting.It was felt that, the complex structure of administered interest rate and crosssubsidisationresulted in higher lending rates for the non-concessional commercialsector. The concessional rates charged to the priority sector necessitated maintainingthe cost of funds i.e. deposit rates at a low level. Nevertheless, there was a move toactivate money market with new instruments to serve as a transmission channel ofmonetary policy, within this administered regime. Gradually, the complex lendingrate structure in the banking sector was simplified in 1990. By linking the interest ratecharged to the size of loan, the revised structure prescribed only six slabs(Rangarajan, 2002). However, credit rationing continued with its due importance inthe new framework to support the growth process. The share of priority sectors intotal non-food credit rose from 36.9 per cent in 1980-81 to the peak of 43.6 per cent in1986-87. But, inadequacy of this system slowly emerged due to problems in themonitoring of credit thereby causing delays in the sanctioning of bank credit. With thestrengthening of the credit appraisal systems in banks, the CAS lost its relevancethrough the 1980s, eventually leading to its abolition in 1988.During this period, the primitive structure of the financial markets impededtheir effective functioning. The money market lacked depth, with only the overnightinterbank call money market in place. The interest rates in the government securities

12 | P a g e


13/21

EQUITY RESEARCH

market and credit market were tightly regulated. The dispensation of credit to thegovernment took place via SLR stipulations, where commercial banks were made toset aside a substantial portion of their liabilities for investments in governmentsecurities at below market rates, known in the literature as 'financial repression'. TheSLR had touched the peak of 38.5 by September 1990 (Table 11.2). As increasing SLR

was not adequate, the RBI was forced to be a residual subscriber. The process offinancing the government deficit involved 'automatic monetisation', in terms ofproviding short-term credit to the government that slipped into the practice of rollingover the facility. The situation was aggravated as the government's fiscal balancerapidly deteriorated. The process of creating 91-day ad hoc TBs and subsequentlyfunding them into non-marketable special securities at a very low interest rateemerged as the principal source of monetary expansion. In addition, RBI had tosubscribe dated securities those not taken up by the market. As a result, the net RBIcredit to the Central Government which constituted about 77 per cent of the monetarybase during the 1970s, accentuated to over 92 per cent during the 1980s (Table II. 1).In such an environment, monetary policy had to address itself to the task of

neutralising the inflationary impact of the growing deficit by raising CRR from timeto time. CRR was mainly being used to neutralise the financial impact of thegovernment's budgetary operations rather than an independent monetary instrument.2.5- Post-Reform Period with Financial Deepening (1992 Onwards)Indian economy experienced severe economic crisis in mid-1991, mainlytriggered by a balance of payment difficulty. This crisis was converted to anopportunity by introducing far-reaching reforms in terms of twin programs ofstabilisation and structural adjustment. The financial sector received its due share ofattention in the reform process mainly guided by the influential recommendations ofNarasimham Committee - I (1991) and - II (1998). To curtail the excessive fiscaldominance on the monetary policy in the spirit of the recommendations of theChakravarty Committee (RBI, 1985) and Narasimham Committee (RBI, 1991), thememorandum of understanding (MoU) was signed between the Government of Indiaand the RBI in 1994. Consequently, the issuance of ad hoc TBs was eliminated witheffect from April 1, 1997. Instead, Ways and Means Advances (WMA) wasintroduced to cope with temporary mismatches. This was a momentous step andnecessary condition towards greater autonomy in the conduct of monetary policy. Asa result, the proportion of net RBI credit to government to reserve money hassubstantially come down to close to 50 per cent in recent years (Table II. 1).Interestingly, this period witnessed the new problem of coping with increasinginflow of foreign capital due to opening up of the economy for foreign investment.Foreign exchange reserves increased from mere US $ 5.83 billion in March 1991 toUS $ 25.18 billion in March 1995. Presently, foreign exchange reserves with RBIstand at close to US $ 82 billion. Hence, increase in foreign exchange assets had asizeable contribution to raise reserve money in this period. As a proportion of reservemoney, the share of net foreign assets is increased from 9.1 per cent in 1990-91 to38.1 per cent in 1995-96 and subsequently reached 78.1 per cent in 2001-02 (TableII. 1). To negate the effect of large and persistent capital inflows, RBI absorbed excessliquidity through outright OMO and repos under liquidity adjustment facility (RBI,2003a).

13 | P a g e


14/21

EQUITY RESEARCH

In the post reforms era, emphasis was placed to develop and deepen variouscomponents of the financial market such as money market, government securitiesmarket, forex market, which has significant implication for the monetary policy toshift from direct to indirect instruments of monetary control. To widen the moneymarket in terms of improving short term liquidity and its efficient management, new

instruments such as inter-bank Participation Certificates, CDs and CP were furtheractivated and new instruments in the form of TBs of varying maturities (14-, 91- and364-day) were introduced. The DFHI was instrumental to activate the secondarymarket in a range of money market instruments, and the interest rates in moneymarket instruments left to be market determined.The government securities market witnessed radical transformation towardsbroadening its base and making the yields market determined. Major initiatives in thisdirection include introducing the system of auctions to impart greater transparency inthe operations, setting up a system of Primary Dealers (PDs) and Satellite Dealers(SDs) to trade in Gilts, introducing a delivery versus payment (DvP) system forsettlement, adopting new techniques of flotation, introducing new instruments with

special features like zero coupon bonds, partly paid stock and capital-indexed bonds,etc. All these measures have helped in creating a new treasury culture in the country,and today, the demand for the government securities is not governed by solely SLR.requirements but by considerations of treasury management. Now, the SLR is at thestatutory minimum of 25 per cent since October 1997, far below than its peak of 38.5per cent in February 1992 (Table II.2). Also, the CRR has been gradually broughtdown to the current level of 4.5 per cent (effective from June 2003) from 10 per centin January 1997 and 15 per cent in October 1992. Certain initiatives to reform theforeign exchange market include, inter alia, moving to full convertibility of Rupee inthe current account since August 1994, greater freedom to Authorised Dealers (ADs)to manage their foreign exchanges, activation of the forward market and setting up aHigh Level Committee (Chairman: S.S. Tarapore) to provide a roadmap for capitalaccount convertibility. All these measures acted towards making the foreign exchangerate market-determined and linking it to the domestic interest rates.In the process of reforms, the interest rate structure was rationalised in thebanking sector and there is greater emphasis on prudential norms. Banks are givenfreedom to determine their domestic term deposit rates and prime lending rates(PLRs), except certain categories of export credit and small loans below 2 lakhRupees. All money market rates were set free. The 'Bank Rate' was reactivated in1997 by linking it to various refinance rates.Because of all these reforms, we find today, interest rates in various segmentsof the financial market are determined by the market and there is close association intheir movement, as discussed in detail in Chapter 5. The developments in all thesegments have led to gradual broadening and deepening of the financial market. Thishas created the enabling conditions for a smooth move towards use of indirectinstruments of monetary policy such as open market operations (OMO) includingrepos and reverse repos. The operation of LAF has been used as an effectivemechanism to withdraw or inject liquidity on day-to-day basis and providing acorridor for call money rate. In June 2002, RBI has come out with its Short TermLiquidity Forecasting Model to evaluate the short term interaction between the

14 | P a g e


15/21

EQUITY RESEARCH

monetary policy measures and the financial markets, which will be immensely helpfulfor imparting discipline once started operation. Because of reforms in the financialmarket, new interest rate based transmission channels have opened up. Importantly,this period has witnessed emergence of monetary policy as an independent instrumentof economic policy (Rangarajan, 2002).

To sum up, this chapter undertakes an analytical survey of evolution ofmonetary policy in India. We observed that, the existing policy regime andinstitutional arrangements constrained monetary management in the pre-reformperiod. Monetary policy during this period was limited to credit rationing. The keysegments of the financial market in India are developed only in the post-reform periodand the interest rates were deregulated. Recently, there has been greater emphasis inshort-term liquidity management in monetary policy operation with emergence of abroad-based and developed financial market. In the new environment, the operatingprocedure and monetary transmission mechanism are completely transformed. Theseobservations will guide our econometric analysis of monetary policy in India in thefollowing chapters.

1.3: What are the objectives of Monetary Policy?

The main aim of the monetary policy is to control inflation, to lower the rate of unemployment,and to stabilize the economic output. It also helps in maintain the demand across the economy andtries to influence the demand of individuals and how a person chooses to spend money on goodsand services. It can either be referred as being expansionary or contractionary. When themonetary policy is expansionary, it increases the total supply of money in the economy morerapidly than usual, and when the policy is contractionary then it shrinks the money supply moreslowly than usual. Expansionary policy is generally applied when the unemployment rate has to bereduced. Under such an action the interest rate is lowered in a hope that easy credit will encouragebusinesses in expanding. Whereas in case of contractionary policy the interest rate is increased todiscourage the consumers demand so that the price of the commodities comes down and thedeterioration of asset values is controlled.

15 | P a g e
http://en.wikipedia.org/wiki/Expansionary_monetary_policyhttp://en.wikipedia.org/wiki/Expansionary_monetary_policyhttp://en.wikipedia.org/wiki/Expansionary_monetary_policy


16/21

EQUITY RESEARCH

16 | P a g e

INFLATION

UNEMPLOYMENT

ECONOMIC OUTPUT

THESE ARE THE BASIC OBJECTIVE OF MONETARY

POLICY


17/21

EQUITY RESEARCH

CHAPTER 2

2: HOW DOES MONETARY POLICY BRINGS ABOUT CHANGES IN OUR

ECONOMY?

The Monetary Policy affects /brings about changes economy with the help of following tools.

Cash Reserve ratio

Statutory Liquidity Ratio

Bank Rate

Repo rate

Reverse Repo Rate

Open Market Operation Selective Credit Control

What is Repo rate?(Present repo rate is 8.5 %)

The rate at which the RBI lends shot-term money to the commercial banks. When the repo rateincreases, the borrowing from RBI becomes more expensive so the commercial banks will alsoincrease its lending rate to the individual and thus the borrowing from the commercial for the

17 | P a g e


18/21

EQUITY RESEARCH

common man becomes expensive. This is basically done to discourage the customer to take loan,thus decreasing the money supply in the economy.

RBI Repo rate or key short term lending rateWhen reference is made to the Indian interest rate this often refers to the repo rate, also called the

key short term lending rate. If banks are short of funds they can borrow rupees from the ReserveBank of India (RBI) at the repo rate, the interest rate with a 1 day maturity. If the central bank ofIndia wants to put more money into circulation, then the RBI will lower the repo rate. The reverserepo rate is the interest rate that banks receive if they deposit money with the central bank. Thisreverse repo rate is always lower than the repo rate. Increases or decreases in the repo and reverserepo rate have an effect on the interest rate on banking products such as loans, mortgages andsavings.

What is Reserve repo rate?(Present repo rate is 7.5 %)

Reserve repo rate is the rate at which commercial banks park their short-term excess liquidity withthe RBI. The RBI increase the rate when it feels there is too much money floating in the bankingsystem. An increase in the reverse repo rate means that the RBI will provide more interest on themoney that commercial bank will keep with the RBI .This in turn borrow money from the banks ata higher rate of interest. As a result, banks would prefer to keep their money with the RBI.

What is Bank Rate?Bank Rate is the standard rate which Central Bank of the country (RBI) is prepared to buy orrediscount bills of exchange or other eligible commercial paper from the bank. It is the basic costof rediscounting the and refinance facility from RBI.How is bank rate different from repo rate?The Bank rate is the rate at which commercial banks, which are temporarily short of cash, canborrow from RBI.The repo rate enables banks, to acquire funds from RBI by selling the securitiesand at the same time agreeing to repurchase them at a later date at a predetermined price.Sokeeping securities and borrowing is repo rate, simple borrowing is bank rate.

Repo rate

Commercial banks borrow money from central bank by submitting securities. Here, interest rate islaid on the taken amount. This rate of interest is called repo rate. This is on short term basis andfixed at defined date and rate.

E.g.: This is like taking money at the usurer and taking back the thing which we have kept at himpaying the money and interest back at pre-defined date.Bank rate

This is also taking money from central bank. This is for longer period of time. Sale of securities isnot included.

18 | P a g e


19/21

EQUITY RESEARCH

E.g.: This is like taking money from a person and paying monthly the interest for taken amount.Similarities between repo rate and bank rateBoth rates are fixed by RBI.Differences between repo rate and bank rate

- Repo rate is meant for short term basis. Bank rate is meant for long term basis.

- In repo rate, there is need of securities submission. In bank rate, there is no need of securitysubmission.

What is CRR (Cash Reserve ratio)?

CRR means Cash Reserve Ratio. Banks in India are required to hold a certain proportion of their

deposits in the form of cash. However, actually Banks dont hold these as cash with themselves,but deposit such case with Reserve Bank of India (RBI) / currency chests, which is consideredas equivalent to holding cash with them.RBI uses CRR either to drain excess liquidity or to release funds needed for the economy fromtime to time. Increase in CRR means that banks have less funds available and money is sucked outof circulation. Thus we can say that this serves duel purposes i.e. it not only ensures that a portionof bank deposits is totally risk-free, but also enables RBI to control liquidity in the system, andthereby, inflation by tying the hands of the banks in lending money.Thus, when a banks deposits increase by Rs100, and if the cash reserve ratio is 9%, the banks willhave to hold additional Rs 9 with RBI and Bank will be able to use only Rs 91 for investments andlending / credit purpose. Therefore, higher the ratio (i.e. CRR), the lower is the amount that bankswill be able to use for lending and investment. This power of RBI to reduce the lendable amountby increasing the CRR makes it an instrument in the hands of a central bank through which it cancontrol the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in thebanking system.

What Is SLR (Statutory Liquidity Ratio)?It refers to the supplementary liquid reserve requirement of the bank, in addition to the CRR. SLRis maintained by all the (scheduled and the non-scheduled banks) in the form of Cash in hand(exclusive of the minimum CRR), current account balance with SBI and other public sectorcommercial bank, unencumbered approved security and gold. SLR from 0 per cent 40 percent ofbanks DTL(Demand and Time Liabilities). presently its 24%SLR has mainly three objectives:

To restrict expansion of banks credit.

To increase banks investment in approved securities

And to ensure solvency of the bankThe effect of an incresae

19 | P a g e


20/21

EQUITY RESEARCH

It indicates minimum percentage of deposits that a bank has to maintain in form of gold, cash orother approved securities with the RBI. Thus, we can say that it is ratio of cash and some otherapproved to liabilities (deposits) it regulates the credit growth in India.In addition to loans and advances, banks invest a part of their resources in the securities/ financialinstruments. The bulk of a bank's assets are held either in the form of

loans and advances and Investments.

Investments form a significant portion of a bank's assets, next only to loans and advances, and arean important source of overall income. Commercial banks' investments are of three broad types:(a) Government securities, (b) other approved securities and (c) other securities. These three arealso categorized into SLR (Statutory Liquidity Ratio) investment and non-SLR investments. SLRinvestments comprise Government and other approved securities, while non-SLR investmentsconsist of 'other securities' which comprise commercial papers, shares, bonds and debenturesissued by the corporate sector.

Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereasReverse repo rate signifies the rate at which the central bank absorbs liquidity from the banksReverse Report rate was an independent rate till 03/05/2011. However, in the monetary policyannounced on 03/05/2011, RBI has decided that now onwards the Reverse Repo Rate will not beannounced separately, but will be linked to Repo rate and it will always be 100 bps below the Reporate (till RBI decides to delink the same)

Ways through which Monetary Policy achieves its goal in the Economy

Traditionally the monetary policy controlled the economy by directly changing the money supplyin the economy thus affecting the demand of the individual but now it is done simply by changingthe interest rates.

20 | P a g e


21/21

EQUITY RESEARCH

If the government feels that there is a need to control the increasing inflation (as it is now) then thegovernment will inflate the interest rate of the bank deposit so then the consumer will startdepositing money in the bank (in their various schemes like fixed deposit, recurring deposit,buying government securities etc) thus there will be less money left in the hands of the consumers

to invest on the goods and services. This will result in the lowering of the demand of thecommodities, which in turn will compel the producer to reduce the price. Thus pulling inflationback to its normal position.

If the government finds that the GDP of the country is not satisfying and the unemployment ratehas increase to a significantly high level, the growth in the agricultural sector is low

Changes /reform in the monetary policy

CHAPTER 4

4. HOW MONETARY POLICY DOSE EFFECT THE STOCK MARKET

The effect of change in the monetary policy can be seen in the entire sector and so they are wellseen in the stock market also. The changes which can be seen in the Stock Market can be measured

by the change in the share prices. Researchers have been carrying on studies to assess the intensityof the effect and have even been successful in doing that.

The main aims of such studies are to firstly to find out, by how much do changes in monetarypolicy affect equity prices? and secondly is, why do changes in monetary policy affect stockprices?

Answering the first Question it is said that the changes in the stock price with the change in themonetary policy differs from one country to another like the study done in US states

21 | P a g e

rcnt movs in indian monetry plcy

Documents