Monetary Policy

Suppose, at a particular time, equilibrium is reached for the price of any product, say wheat.

Now, the government decides to print a lot of Currency and distribute it to the public as an election gimmick to win elections. Will this practice end poverty in India? The answer is negative because although the money supply has increased, the number of goods in the economy hasn’t increased in the same proportion. It will lead to inflation as too much money is chasing a few goods. The wheat that was sold at Rs 100 will now sell at Rs 1000 (hypothetical amounts).

If we want to cope with this situation, there are two ways 

1. Either increase the supply of wheat (can be done by the government by asking FCI to overflow the market with wheat) or 
2. Reduce the supply of money (can be done by RBI via Monetary Policy) 

Combating Inflation

Combating Deflation

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, Standing Deposit Facility, Marginal Standing Facility etc.)

b. Qualitative /Selective/Direct Tools

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

We will discuss all this in detail.

• CRR is the percentage of public deposits (Net Demand and Time Liabilities (NDTL)) that banks have to keep with the RBI in cash at any point in time. Usually, RBI doesn’t give any interest in this.
• CRR provisions apply to Scheduled Banks, Non-Scheduled Banks & Cooperative Banks.
• RBI get these powers to impose CRR from RBI Act. 
• Present Rate (Feb 2023): 4.5% of Net Demand and Time Liabilities

• SLR is the percentage of NDTL that banks must maintain with themselves in the form of specified liquid assets (like cash, gold & government securities, or RBI-approved securities) at any point in time. 
• It is mandated under RBI Act.
• SLR applies to all Scheduled Banks, Non-Scheduled Banks, Cooperative Banks and NBFC deposit-taking. RBI can prescribe different levels for each.
• Although not used as Monetary Policy Tool, but if decreased, a large amount of capital is infused into the economy.  
• Present Rate (Feb 2023): 18% of Net Demand and Time Liabilities 

Note: Previously, CRR & SLR were very high (53% combined). As a result, banks had significantly less money to lend. It impacted the Indian Economy because the rate of loans was high, and businesses were not expanding. It was one of (the many) reasons for the 1990 Balance of Payment Crisis. Narasimhan Committee & other experts recommended reducing this. As a result, it was gradually reduced.

CRR Trends

The  RBI’s move to hike the  CRR by 50 bps resulted in a withdrawal of primary liquidity to the tune of ₹87,000 crore from the banking system.

SLR Trends

Use of CRR and SLR

CRR and SLR can be used to fight Inflation and Deflation

They also act as security in case of bank runs.

• 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 the Government wants extra money to fund its projects, it asks RBI to arrange it (as RBI is the Government’s Debt Manager). The Government gives the required cash to the Government and prints equivalent Government Securities (G-Secs). 
• Government Security (G-Sec) is a tradeable instrument issued by RBI on behalf of the Central Government or the State Governments. It acknowledges the Government’s debt obligation. It promises that Government will pay interest of x% to the holder for y years and pay principal at the end of tenure. 

• Now RBI can use these G-Secs for various operations. E.g. to absorb the excess liquidity from the market etc. 
• In India, the Central Government can issue Treasury Bills (or T-Bills) and Dated Securities, while State Governments can only issue Dated Securities to raise funds. 

Types of G-Secs

1. T- Bills

• T-bills are the short-term debt instruments issued by the Union Government. Presently, they are issued in three tenors, i.e., 91-day, 182-day and 364-days. 
• They are zero-coupon securities, i.e. Government pays no interest. Instead, they are sold at a discount on face value and redeemed at face value.

2. Dated G-Secs

• Dated G-Secs have a fixed interest rate on the face value and a tenor ranging from 5 to 40 years.

• Under LAF, Central Bank tends to reduce short-term liquidity fluctuations (money supply) in the economy through Repo and Reverse Repo transactions.  
• The official policy rate in India is REPO RATE (i.e. RBI announces Repo Rate only).
• Repo & Reverse Repo operations can only be done in Mumbai & through securities as approved by RBI.

• Marginal Standing Facility was introduced in 2010. 
• Suppose the Bank is in dire need of cash but doesn’t have spare securities. Under such conditions, the Bank can borrow overnight under MSF without any collateral. But they will have to pay 0.25% higher than Repo Rate (say as punishment)

MSF= Repo + 0.25%

(Presently (as of Feb 2023) = 6.75%)

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

In this, RBI takes money from banks & gives them securities (opposite of the Repo Rate)  (explained in the Infographic below)

• RBI pledges securities in the form of G-Secs. 
• All clients eligible in the Repo rate are eligible here as well. 
• The current Reverse Repo is 3.35%.

• Policy corridor is the difference between Marginal Standing Facility (Repo + 0.25%) and Standing Deposit Facility (Repo-0.25%)
• The formula has changed recently,
  • Before April 2022: Policy Corridor = total width between MSF <—> REPO <—> Reverse
  • After April 2022: Policy Corridor = Total width between MSF <—> REPO <—> SDF  
• Hence, SDF has replaced the Reverse Repo Rate as the floor of the Policy corridor.

• Bank Rate is the interest rate at which the central bank lends for the long term to commercial banks.  
• No collateral is required under these operations. 
• Presently: 6.75% (Feb 2023) (although Bank Rate = MSF, but both are declared separately)

Although RBI doesn’t use this tool to control the money supply, if it does, the same theory applies here as well.

• It is not the primary tool to control the money supply these days but acts as a penal rate charged to banks for shortfalls in meeting their reserve requirements. How is it done? 
• If a bank is not maintaining its SLR or CRR, it is fined a penalty on whatever amount is less than the amount to be maintained. Rate Charged is determined as:-
  • First time: Bank rate +3% 
  • Second Time: Bank Rate +5% and so on

• In Open Market Operations (OMO), the Central Bank (RBI) buys and sells Government Securities to influence the money supply in the economy.
• It is different from Repo and Reverse Repo Rates because there is no promise by either party to repurchase it back. RBI will pay the interest rate to the holder of the security, but there is no repurchasing agreement.

How does the government use this to control the money supply?

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

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

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

• A lot of money keeps on lying idle with banks. Banks don’t earn any interest on that. Hence, investing those in govt securities & earn ~8% interest on them is a better option. 

• To manage liquidity in the market, RBI has developed a new tool. It was started in 2019. 
• Under this, RBI purchases dollars from banks in exchange for rupees.
  • Increasing liquidity = Buy $ from Banks and give them ₹
  • Decreasing liquidity = Give $ to Banks and take ₹ from them

For example: In March 2022, RBI conducted a swap of $5 billion by infusing dollars and sucking rupees equivalent to $5 billion from the Indian economy.

Monetary policy transmission refers to how changes in the RBI’s policy rates  (such as  Repo) lead to commensurate changes in the rates of  Interest of the  Banks.

Issue

Earlier, when RBI decreased Repo Rate, Banks didn’t reduce their interest rates proportionately.

Why don’t banks transmit Repo Rate cuts to borrowers?

1. Banks don’t depend on RBI

• In India (& all developing countries), RBI is not the primary source of money for banks. Ordinary people are the main supplier(mainly because people don’t have many options to invest money in alternate investment facilities, e.g. mutual funds etc.) 

2. Small saving schemes  rate not reduced

• High small savings rates also limit transmission as banks worry that if they cut their deposit rates, customers will flee to small savings instruments such as PPF, NSC etc.

3. High Statutory Liquidity Ratio

• Significant money must be kept idle as SLR, which banks can’t lend. It reduces their ability to pass the benefit to consumers.

4. Banks increasing their Spread

• Due to losses incurred by banks due to high NPAs, banks increased their Spread to maintain their profits in absolute terms. 

5. Higher NPAs

• Indian banks face the issue of huge NPAs, which reduces banks’ profitability.

To deal with the inadequate transfer of Repo Rate cuts by banks to borrowers, RBI Came up with MCLR and External Benchmark  Rate System. 

How Banks decide their Interest Rate: Timeline

External Benchmark System

• Applicable from April 2019 (on recommendations of Dr Janak Raj Committee).
• All New Loans are to be linked with the External Benchmark system. 

In this system

• Banks have been asked to choose any of the following 4 benchmarks like 
  • Repo rate  or 
  • 91-day T-bill yield  or 
  • 182-day T-bill yield  or 
  • Any other benchmarks by Financial Benchmarks India Pvt. Ltd.
• It has to be updated at least every 3 months. 
• The Lending Rate of the Bank will be External Benchmark + Spread (e.g. if Bank choose Repo Rate as External Benchmark, then Interest Rate will be Repo Rate + Spread)

Benefits?

• Better transmission of Monetary Policy.
• Better transparency and accountability.