Monetary Policy

Monetary Policy

This article deals with ‘Monetary Policy .’ This is part of our series on ‘Economics’ which is important pillar of GS-3 syllabus . For more articles , you can click here

Introduction

In any economy

Financial Intermediaries
  • Monetary Policy is  made by Central Bank of nation to control money supply in the economy.
  • Objectives of monetary policy can be (depending on economy)
    1. Inflation control
    2. Accelerating growth of economy
    3. Exchange rate stabilisation
    4. Balance saving & investments
    5. Generating employment

Monetary policy can be

Expansionary – Increases total money supply in an economy
Eg in 2008, all countries including India used this to beat recession
Traditionally used to combat unemployment in recession by lowering interest rate
Contractionary – Decreases total money supply in economy
Eg 2010 onwards India & many other countries used it
Traditionally to combat inflatory trends in economy

When Monetary policy is announced in India?

a. Till 1988-89

Was announced twice a year according  to agricultural cycles

Slack season policy April -September
Busy season policy October -March

b. After 1989

  • Since monetary policy has become dynamic in nature, RBI reserve its right to alter it from time to time , depending upon state of economy
  • Share of credit toward industry increased  (earlier was agriculture)
  • Major policy was announced in April & review take place every quarter . But within quarter at any time RBI can make any major change in policy depending upon need

c. Presently

Changes can be done at any time when RBI feels it is required but announced  necessarily after two months

Tools used by RBI for Monetary Policy

RBI implements it using two tools

a. Quantitative /Indirect/General Tools

  • Reserve Ratios (CRR,SLR)
  • OMO (Open Market Operation)
  • Rates (Repo, Reverse Repo ,Bank rate, Marginal Standing Facility etc.)

b. Qualitative /Selective/Direct Tools

  • Margin /Loan to Value Ratio
  • Consumer Credit Control
  • Rationing
  • Moral suasion
  • Direct Action

1 . Quantitative tools

Quantitative Tools of Monetary Policy

1.1 Reserve Ratios

a. Cash Reserve Ratio (CRR)

  • It is the Cash that is kept by the Bank with RBI
  • Bank cant lend it to anyone. Bank earns no interest or profit on this
  • RBI get these powers from RBI Act 
  • Presently (July 2020)  –  3% of Net Demand and Time Liabilities
  • Applicable on Scheduled Banks , Non-Scheduled Banks & Cooperative Banks

b. Statutory Liquidity Ratio (SLR)

  • A bank has to set aside this much money in cashgold & government  securities or RBI approved very secure Securities like those of PSUs  (liquid assets)
  • Some profit is earned
  • It is mandated under RBI Act.
  • Although not used as Monetary Policy Tool but if decreased, large amount of capital is infused in economy
  • Presently(July 2020) –  18% of Net Demand and Time Liabilities 
  • SLR is applicable on following Institutions all commercial banks ,  Cooperative Banks and NBFC deposit taking  . RBI can prescribe separate levels for each.

Trends of CRR and SLR

Note – Earlier , CRR & SLR used to be very high (53% combined) . As a result, banks had very less money to lend . This impacted Indian Economy because rate of loans were high and businesses were not expanding as a result. This was one of (the many) reasons of 1990 Balance of Payment Crisis. Narsimhan Committee & other experts asked government to reduce this. As a result it was gradually reduced

CRR Trends

SLR Trends

Use of CRR and SLR

  • CRR and SLR can be used to fight Inflation and Deflation
  Inflation Fight Deflation Fight
Method Tight | Dear Policy Easy | Cheap Policy
CRR,SLR Increase Decrease
  • They also act as security in case of bank run.

Side Topic : CRR Exemption 

  • Feb 2020 : RBI has announced that banks will not have to maintain CRR for all the loans they have given to three sectors namely automobile sector, residential sector and loans to MSME industries for next 5 years.
  • This will boost loans to these sectors.

Side Topic : What are G-Secs

  • Concepts like Repo, Reverse Repo and Open Market Operations involve the concept of G-Secs ( or Government Securities). Hence, we will first deal with the concept of G-Secs
  • When Government wants  extra money for their schemes, they ask RBI to print that much Government Securities (G-Secs) and give equivalent cash in return. G-Secs are the  promissory notes in which it is promised that Government will pay interest of x% to the holder for y years and pay principal at the end of tenure .
G-Secs
  • Now RBI can use these G-Secs for various operations . Eg :  to absorb the excessive liquidity from market etc

1.2 Policy Rates/ Liquidity Adjustment facility (LAF)

  • LAF  includes both Repo Rate & Reverse Repo Rate
  • RBI adjusts the liquidity of market using these tools
  • Repo & Reverse Repo operations can only be done at Mumbai & in securities as approved by RBI (T Bills , Central/state Govt securities)

a. Repo rate

  • Repo Rate is short form for Repurchase Rate
  • In this , Bank borrow immediate funds from the RBI for short term ( upto 14 days) with Government Securities as collateral and simultaneously agrees to repurchase the same Securities after a specified time at a specified price.
  • Amount that can be borrowed : minimum  5 crore to unlimited
  • All  Banks , Central & State Governments and Non Banking Financial Institutions are eligible 
  • When bank borrow, it will give its securities worth say ₹ 100 crore & agree to repurchase it back  at rate of ₹ 104 crore ( if Repo rate is 4)
Repo Rate
  • But during whole operation, bank has to maintain its SLR ie Collateral securities can,t be from SLR quota
  • Present Repo Rate is  4%  (May 2020)

Recent Trends  

RBI is reducing the rates continuously to spur economic activity by providing cheap money to the banks to lend it to public.

Long Term Repo Operations (LTRO)

  • RBI has introduced new instrument called Long Term Repo Rate (LTRO).
  • It is for long tenure of 1 to 3 years .
  • All the concepts are same as Repo Rate but interest is charged annually .
  • Total plan is to loan Rs 1 lakh crore to banks via LTRO which will increase the loanable funds with banks to boost the demand in economy.

b. Marginal Standing Facility (MSF)

  • Marginal Standing Facility introduced in  2010
  • Suppose bank is in dire need of cash but doesn’t have spare securities. Under such conditions, bank can borrow under MSF by pledging SLR securities
  • But they will have to pay 0.25% higher than Repo Rate (as punishment say)

MSF= Repo + 0.25%

  • Only Scheduled Commercial Banks can avail this facility within range of minimum 1 crore  & Maximum 1% of Net Time and Demand Liabilities. 
  • It helps to solve short term crunch
  • It is also necessary because Repo operations are limited to specific period during day

c. Reverse Repo Rate

  • In this RBI takes money from banks & give them securities (opposite of Repo Rate) 
  • RBI borrower & Banks /Union & State Governments / NBFI etc lenders
  • Collateral =  Yes
  • All clients which were eligible in Repo rate are eligible here too
  • Reverse Repo = Repo -0.25%  (Current Rate : 3.75 % (ie Repo (4%) -0.25%))

Policy Corridor

Policy Corridor

Tri-Party Repo Agreement

Until now, such facility was not available to Corporate Houses where they could issue Corporate Bonds to lenders and agree to repurchase these Bonds at later date at pre-determined rate . They also wanted to use this route to raise funds .

But there is issue of trust in this case . Hence, there is need of Intermediary who can assure lenders that Corporate House will surely buy back these bonds at decided rate   . In case, borrowers refuses to pay,  intermediary Custodian will pay that amount to Lender. Custodian will charge fee for providing this service .

Tri-Party Repo Agreement
  • In ordinary repo, there are two parties- borrower vs. lender (RBI).
  • In Tri-party Repo, there are 3 parties 1) borrowers 2) lenders 3) Tri-Party Agent ( presently 2 – BSE and NSE) who, acts as an intermediary between the two parties to facilitate collateral custody, payment and guaranteed settlement.
  • RBI issued guidelines for this in 2017
  • This is not a tool of Monetary Policy. It helps deepening Corporate Bond market.

d. Bank Rate

  • When banks borrow long term funds from RBI , they would pay this interest to RBI
  • Presently-4.25 % (May 2020)  ( although Bank Rate = MSF but both are declared separately)
  • Collateral = Nothing(can borrow without pledging securities)
Bank Rate
  • Although RBI don’t use this tool to control money supply , but if it does, same theory apply here as well
Inflation Fight Increase Bank Rate
Deflation Fight Decrease Bank Rate
  • It is not the main tool to control money supply these days  but act as penal rate charged on banks for shortfalls in meeting their reserve requirements. How it is done?
    • If Bank is not maintaining its SLR or CRR,  then bank is fined penalty on whatever amount is less from amount to be maintained . Rate Charged is  determined as :-
      1. First  time : Bank rate +3%
      2. Second Time : Bank Rate +5% and so on

1.3 Open Market Operations (OMO)

  • In Open Market Operations (OMO) ,  RBI starts buying/selling government securities to control money supply.
  • It is different than Repo and Reverse Repo Rate because here there is no promise by either party to repurchase it back. RBI will pay the interest rate to the holder of Security but there is no repurchase agreement.

How govt use this to control money supply

Case 1 : When there are inflatory trends in market , RBI issue these securities . Banks buy these securities & money supply decreases

 Open      Market Operations

Case 2 : When government wants to increase money supply , it starts buying these securities at high price

 Open      Market Operations

Why banks go for OMO although there are no compulsions on this ??

  • Lot of money keep on lying idle with banks .
  • Banks don’t earn any interest on that . Hence, it is better to invest those in govt securities & earn ~8% interest on it

Dollar-Rupee swap

  • To manage liquidity in the market, RBI has come up with new tool.
  • March -April 2019 : three-year currency swap scheme = RBI will purchase $5 billion from banks in exchange for rupees.

Currently , in Repo and Reverse Repo, RBI uses G-Secs . But there is issue of higher Bond Yields . To address this issue , Dollar –  Rupee Swap comes to scene

  1. Increasing Liquidity = Buy $ from Banks and give them money
  2. Decreasing Liquidity = Give $ to Banks and take ₹ from them
Dollar-Rupee swap

Benefit

  • Issue of higher Bond Yields on G-Secs addressed.
  • Government can increase Forex Reserve via this.
  • Banks can earn some interest out of the forex reserves lying idle in their kitty.
  • Dollar – ₹ exchange rate = ₹ will become strong and fall of ₹ against $ can be arrested

Operation Twist

  • 1961: “Operation Twist” was first used by the USA.
  •  Jan 2020 : RBI also used this route . It is officially called “Special Open Market Operation (OMO) wherein the Central bank simultaneously buys and sells G-sec of varying maturities to adjust their yields. This will help to  reduce interest rates on corporate bonds and they can raise money for their expansion at favourable rates .
Operation Twist

2. Qualitative / Selective / General tools

2.1 Marginal Requirements/LTV(Loan to Value)

  • If Spice Airlines  wants to borrow money from SBI and pledges ₹100 crore collateral but RBI prescribe margin (Loan to Value ration) of say 65%, then SBI can give only 65crore loan.
  • It is obligatory for SBI to obey directives of RBI in this context (unlike base rate)
  • Hence, it is Selective direct tool.

2.2 Consumer Credit Regulation

  • In this, RBI can make various regulations on credit
  •  Eg
    1. Can increase  down payment from say 10% to 30% (it will force some persons to delay their decision to buy vehicles financed through bank loans)
    2. Can decrease  least EMI for automobile sector say from ₹ 5,000 to 3,000

2.3 Selective Credit Control

  • In this , RBI can instruct Banks to not extend loans to particular sector (Negative / Restrictive Tools) or give minimum %age to particular sector (positive) .
  • These are Qualitative and Direct Tools.

2.3.1 Negative  Restrictions

a. Ceiling to big loans

  • From 1965 to 1989
  • Under this, all Commercial Banks had to obtain prior approval of RBI before giving loans greater than ₹ 1 Crore to single borrower.

b. Ceiling on Non Food Loans

  • Started in 1973
  • To boost Green Revolution
  • So that more loans go towards agriculture sector

These tools were used before LPG Reforms, but they weren’t effective because these can be easily flouted using loopholes.

2.3.1 Positive Restrictions

a. Priority Sector Lending (PSL) / Rationing 

  • Rationing is main feature of Communist Economy. Eg In Soviet Union,  they used to make provisions like they will give particular amount of loan to particular sector. PSL is form of Rationing.
  • PSL means Giving specific minimum amount of loans to some Priority Sectors. In India, 40% loans are given to Priority Sector.
  • Government can increase supply of money to that sector by increasing its limit.
  • Dealt in detail in Banking Sector .

2.4 Moral Suasion

  • “Persuasion” without applying punitive measures. RBI governor tries this tactic via conferences, informal meetings, letters, seminars, convocation, panel discussion, memorial lectures. 
  • Eg
    1. Please reduce giving automobile loans, instead invest your money in government securities.
    2. I have reduced repo rate , now you also decrease your base rate.
  • It is not obligatory on part of bank to follow orders but generally  they do follow.

2.5 Direct Action

  • RBI can take direct action against any bank for going against the rules. RBI gets this power under Banking Regulation Act, RBI Act, Foreign Exchange Management Act , Prevention of Money Laundering Act etc.
  • Eg : if bank is not maintaining CRR or SLR , RBI can scrap its license
Direct Action

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