Monetary policy

Introduction:-

Monetary policy is the process by which the monetary authority of a country controls
the supply of money, often targeting a rate of interest for the purpose of promoting
economic growth and stability. The official goals usually include relatively stable prices
and low unemployment. Monetary theory provides insight into how to craft optimal
monetary policy. It is referred to as either being expansionary or concretionary, where an
expansionary policy increases the total supply of money in the economy more rapidly
than usual, and contraction policy expands the money supply more slowly than usual or
even shrinks it. Expansionary policy is traditionally used to try to combat unemployment
in a recession by lowering interest rates in the hope that easy credit will entice businesses
into expanding. Concretionary policy is intended to slow inflation in hopes of avoiding
the resulting distortions and deterioration of asset values. Monetary policy is the process
by which the government, central bank, or monetary authority of a country controls (i) the
supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to
attain a set of objectives oriented towards the growth and stability of the economy.
Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that
is the price at which money can be borrowed, and the total supply of money. Monetary
policy uses a variety of tools to control one or both of these, to influence outcomes like
economic growth, inflation, exchange rates with other currencies and unemployment.
Where currency is under a monopoly of issuance, or where there is a regulated system of
issuing currency through banks which are tied to a central bank, the monetary authority
has the ability to alter the money supply and thus influence the interest rate (to achieve
policy goals).

The term monetary policy is also known as the 'credit policy' or called
'RBI's money management policy' in India. How much should be the supply of money in
the economy? How much should be the ratio of interest? How much should be the
viability of money? etc. Such questions are considered in the monetary policy. From the
name itself it is understood that it is related to the demand and the supply of money.

VARIOUS DEFINITIONS;-

Economic strategy chosen by a government in deciding expansion or contraction in the

country's money-supply. Applied usually through the central bank, a monetary policy
employs three major tools:

(1) Buying or selling national debt

(2) Changing credit restrictions

(3) Changing the interest rates by changing reserve requirements.

Monetary policy plays the dominant role in control of the aggregate-demand

and, by extension, of inflation in an economy. Also called monetary regime.

From both these definitions, it is clear that a monetary policy is related to the availability
and cost of money supply in the economy in order to attain certain broad objectives. The
Central Bank of a nation keeps control on the supply of money to attain the objectives of
its monetary policy.

Objectives of Monetary Policy

The objectives of a monetary policy in India are similar to the objectives of its five year
plans. In a nutshell planning in India aims at growth, stability and social justice. After the
Keynesian revolution in economics, many people accepted significance of monetary
policy in attaining following objectives.

1. Rapid Economic Growth

2. Price Stability

3. Exchange Rate Stability

 4. Balance of Payments (BOP) Equilibrium

5. Full Employment

6. Neutrality of Money

7. Equal Income Distribution

These are the general objectives which every central bank of a nation tries to attain by
employing certain tools (Instruments) of a monetary policy. In India, the RBI has always
aimed at the controlled expansion of bank credit and money supply, with special attention
to the seasonal needs of a credit.Let us now see objectives of monetary policy in detail:-

1. Rapid Economic Growth: It is the most important objective of a monetary policy. The
monetary policy can influence economic growth by controlling real interest rate and its
resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by
reducing interest rates, the investment level in the economy can be encouraged. This
increased investment can speed up economic growth. Faster economic growth is
possible if the monetary policy succeeds in maintaining income and price stability.
2. Price Stability: All the economics suffer from inflation and deflation. It can also be
called as Price Instability. Both inflation are harmful to the economy. Thus, the
monetary policy having an objective of price stability tries to keep the value of money
stable. It helps in reducing the income and wealth inequalities. When the economy
suffers from recession the monetary policy should be an 'easy money policy' but when
there is inflationary situation there should be a 'dear money policy'.
3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in
terms of any foreign currency. If this exchange rate is very volatile leading to frequent
ups and downs in the
exchange rate, the international community might lose confidence in our economy. The
monetary policy aims at maintaining the relative stability in the exchange rate. The RBI
by altering the foreign exchange reserves tries to influence the demand for foreign
exchange and tries to maintain the exchange rate stability.
4. Balance of Payments (BOP) Equilibrium: Many developing countries like India
suffer from the Disequilibrium in the BOP. The Reserve Bank of India through its
monetary policy tries to maintain equilibrium in the balance of payments. The BOP has
 two aspects i.e. the 'BOP Surplus' and the 'BOP Deficit'. The former reflects an excess
money supply in the domestic economy, while the later stands for stringency of money.
If the monetary policy succeeds in maintaining monetary equilibrium, then the BOP
equilibrium can be achieved.
5. Full Employment: The concept of full employment was much discussed after Keynes's
publication of the "General Theory" in 1936. It refers to absence of involuntary
unemployment. In simple words 'Full Employment' stands for a situation in which
everybody who wants jobs get jobs. However it does not mean that there is Zero
unemployment. In that senses the full employment is never full. Monetary policy can be
used for achieving full employment. If the monetary policy is expansionary then credit
supply can be encouraged. It could help in creating more jobs in different sector of the
economy.
6. Neutrality of Money: Economist such as Wicks Ted, Robertson has always
considered money as a passive factor. According to them, money should play only a
role of medium of exchange and not more than that. Therefore, the monetary policy
should regulate the supply of money. The change in money supply creates monetary
disequilibrium. Thus monetary policy has to regulate the supply of money and
neutralize the effect of money expansion. However this objective of a monetary policy
is always criticized on the ground that if money supply is kept constant then it would be
difficult to attain price stability.
7. Equal Income Distribution: Many economists used to justify the role of the fiscal
policy is maintaining economic equality. However in resent years economists have
given the opinion that the monetary policy can help and play a supplementary role in
attainting an economic equality. Monetary policy can make special provisions for the
neglect supply such as agriculture, small-scale industries, village industries, etc. and
provide them with cheaper credit for longer term. This can prove fruitful for these
sectors to come up. Thus in recent period, monetary policy can help in reducing
economic inequalities among different sections of society
Instrument of monetary policy

The instruments of monetary policy are tools or devise which are used by the monetary
authority in order to attain some predetermined objectives. There are two types of
instruments of the monetary policy as shown below.

(A) Quantitative Instruments or General Tools

The Quantitative Instruments are also known as the General Tools of monetary policy.
These tools are related to the Quantity or Volume of the money. The Quantitative Tools
of credit control are also called as General Tools for credit control. They are designed to
regulate or control the total volume of bank credit in the economy. These tools are
indirect in nature and are employed for influencing the quantity of credit in the country.
The general tool of credit control comprises of following instruments.

1. Bank Rate Policy (BRP)

The Bank Rate Policy (BRP) is a very important technique used in the monetary policy
for influencing the volume or the quantity of the credit in a country. The bank rate refers
to rate at which the central bank (i.e. RBI) rediscounts bills and prepares of commercial
banks or provides advance to commercial banks against approved securities. It is "the
standard rate at which the bank is prepared to buy or rediscount bills of exchange or other
commercial paper eligible for purchase under the RBI Act". The Bank Rate affects the
actual availability and the cost of the credit. Any change in the bank rate necessarily
brings out a resultant change in the cost of credit available to commercial banks. If the
RBI increases the bank rate than it reduce the volume of commercial banks borrowing
from the RBI. It deters banks from further credit expansion as it becomes a more costly
affair. Even with increased bank rate the actual interest rates for a short term lending go
up checking the credit expansion. On the other hand, if the RBI reduces the bank rate,
borrowing for commercial banks will be easy and cheaper. This will boost the credit
creation. Thus any change in the bank rate is normally associated with the resulting
changes in the lending rate and in the market rate of interest. However, the efficiency of
the bank rate as a tool of monetary policy depends on existing banking network, interest
elasticity of investment demand, size and strength of the money market, international flow
of funds, etc.
2. Open Market Operation (OMO)
The open market operation refers to the purchase and/or sale of short term and long term
securities by the RBI in the open market. This is very effective and popular instrument of
the monetary policy. The OMO is used to wipe out shortage of money in the money
market, to influence the term and structure of the interest rate and to stabilize the market
for government securities, etc. It is important to understand the working of the OMO. If
the RBI sells securities in an open market, commercial banks and private individuals buy
it. This reduces the existing money supply as money gets transferred from commercial
banks to the RBI. Contrary to this when the RBI buys the securities from commercial
banks in the open market, commercial banks sell it and get back the money they had
invested in them. Obviously the stock of money in the economy increases. This way when
the RBI enters in the OMO transactions, the actual stock of money gets changed.
Normally during the inflation period in order to reduce the purchasing power, the RBI
sells securities and during the recession or depression phase she buys securities and
makes more money available in the economy through the banking system. Thus under
OMO there is continuous buying and selling of securities taking place leading to changes
in the availability of credit in an economy.

However there are certain limitations that affect OMO viz; underdeveloped securities
market, excess reserves with commercial banks, indebtedness of commercial banks, etc.

3. Variation in the Reserve Ratios (VRR)

The Commercial Banks have to keep a certain proportion of their total assets in the form
of Cash Reserves. Some part of these cash reserves are their total assets in the form of
cash. Apart of these cash reserves are also to be kept with the RBI for the purpose of
maintaining liquidity and controlling credit in an economy. These reserve ratios are
named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR
refers to some percentage of commercial bank's net demand and time liabilities which
commercial banks have to maintain with the central bank and SLR refers to some percent
of reserves to be maintained in the form of gold or foreign securities. In India the CRR by
law remains in between 3-15 percent while the SLR remains in between 25-40 percent of
bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out a change in
commercial banks reserves positions. Thus by varying VRR commercial banks lending
capacity can be affected. Changes in the VRR helps in bringing changes in the cash
reserves of commercial banks and thus it can affect the banks credit creation multiplier.
RBI
increases VRR during the inflation to reduce the purchasing power and credit creation.
But during the recession or depression it lowers the VRR making more cash reserves
available for credit expansion.

(B) Qualitative Instruments or Selective Tools

The Qualitative Instruments are also known as the Selective Tools of monetary policy.
These tools are not directed towards the quality of credit or the use of the credit. They are
used for discriminating between different uses of credit. It can be discrimination favoring
export over import or essential over non-essential credit supply. This method can have
influence over the lender and borrower of the credit. The Selective Tools of credit control
comprises of following instruments.

1. Fixed Margin Requirements

The margin refers to the "proportion of the loan amount which is not financed by the
bank". Or in other words, it is that part of a loan which a borrower has to raise in order to
get finance for his purpose. A change in a margin implies a change in the loan size. This
method is used to encourage credit supply for the needy sector and discourage it for other
non-necessary sectors. This can be done by increasing margin for the non-necessary
sectors and by reducing it for other needy sectors. Example:- If the RBI feels that more
credit supply should be allocated to agriculture sector, then it will reduce the margin and
even 85-90 percent loan can be given.

2. Consumer Credit Regulation

Under this method, consumer credit supply is regulated through hire-purchase and
installment sale of consumer goods. Under this method the down payment, installment
amount, loan duration, etc is fixed in advance. This can help in checking the credit use
and then inflation in a country.
3. Publicity

This is yet another method of selective credit control. Through it Central Bank (RBI)
publishes various reports stating what is good and what is bad in the system. This
published information can help commercial banks to direct credit supply in the desired
sectors. Through its weekly and monthly bulletins, the information is made public and
banks can use it for attaining goals of monetary policy.
4. Credit Rationing

Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount
available for each commercial bank. This method controls even bill rediscounting. For
certain purpose, upper limit of credit can be fixed and banks are told to stick to this limit.
This can help in lowering banks credit expoursure to unwanted sectors.

5. Moral Suasion

It implies to pressure exerted by the RBI on the Indian banking system without any strict
action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit
during inflationary periods. Commercial banks are informed about the expectations of the
central bank through a monetary policy. Under moral suasion central banks can issue
directives, guidelines and suggestions for commercial banks regarding reducing credit
supply for speculative purposes.

6. Control through Directives

Under this method the central bank issue frequent directives to commercial banks. These
directives guide commercial banks in framing their lending policy. Through a directive
the central bank can influence credit structures, supply of credit to certain limit for a
specific purpose. The RBI issues directives to commercial banks for not lending loans to
speculative sector such as securities, etc beyond a certain limit.

7. Direct Action
Under this method the RBI can impose an action against a bank. If certain banks are not
adhering to the RBI's directives, the RBI may refuse to rediscount their bills and
securities. Secondly, RBI may refuse credit supply to those banks whose borrowings are
in excess to their capital. Central bank can penalize a bank by changing some rates. At
last it can even put a ban on a particular bank if it dose not follow its directives and work
against the objectives of the monetary policy.
Parameters of Monetary Policy in India

Objectives

It is generally believed that central banks ideally should have a single

overwhelming objective of price stability. In practice, however, central banks are
responsible for a number of objectives besides price stability, such as currency stability,
financial stability, growth in employment and income. The primary objectives of central
banks in many cases are legally and institutionally defined. However, all objectives may
not have been spelt out explicitly in the central bank legislation but may evolve through
traditions and tacit understanding between the government, the central bank and other
major institutions in an economy.

Of late, however, considerations of financial stability have assumed increasing

importance in monetary policy. The most serious economic downturns in the recent years
appear to be generally associated with financial instability. The important questions for
policy in the context of financial instability are the origin and the transmission of different
types of shocks in the financial system, the nature and the extent of feedback in policy
and the effectiveness of different policy instruments.

Transmission Mechanism

Monetary policy is known to have both short and long-term effects. While it
generally affects the real sector with long and variable lags, monetary policy actions on
financial markets, on the other hand, usually have important short-run implications.
Typical lags after which monetary policy decisions begin to affect the real sector could
vary across countries. It is, therefore, essential to understand the transmission mechanism
of monetary policy actions on financial markets, prices and output. Central banks form
their own views on the transmission mechanism based on empirical evidence, and their
monetary strategies and tactics are designed, based on these views. However, there could
be considerable uncertainties in the transmission channels depending on the stages of
evolution of financial markets and the nature of propagation of shocks to the system.
The four monetary transmission channels, which are of concern to policy makers
are: the quantum channel, especially relating to money supply and credit; the interest rate
channel; the exchange rate channel, and the asset prices channel. Monetary policy
impulses under the quantum channel affect the real output and price level directly through
changes in either reserve money, money stock or credit aggregates. The remaining
channels are essentially indirect as the policy impulses affect real activities through
changes in either interest rates or the exchange rate or asset prices. Since none of the
channels of
monetary transmission operate in isolation, considerable feedbacks and interactions, need
to be carefully analyses for a proper understanding of the transmission mechanism.

The exact delineation of monetary policy transmission channels becomes difficult

in the wake of uncertainties prevalent in the economic system, both in the sense of
responsiveness of economic agents to monetary policy signals on the one hand, and the
proper assessment by the monetary authority of the quantum and extent of desired policy
measures on the other. The matter is particularly complex in developing countries where
the transmission mechanism of monetary policy is in a constant process of evolution due
to significant ongoing structural transformation of the economy.

Strategies and Tactics

It is important to distinguish strategic and tactical considerations in the conduct of

monetary policy. While monetary strategy aims at achieving final objectives, tactical
considerations reflect the short run operational procedures. Both strategies and tactics for
monetary management are intricately linked to the overall monetary policy framework of
a central bank. Depending upon the domestic and international macroeconomic
developments, the long run strategic objective could change, leading to a change in the
nature and the extent of short run liquidity management.

The strategic aspects of monetary management crucially depend on the choice of a

nominal anchor by the central bank. In this regard, four broad classes of monetary
strategies could be distinguished. Two of these, viz., monetary targeting and exchange
rate targeting strategies, use a monetary aggregate and the exchange rate respectively as
an explicit intermediate target. The third, viz., multiple indicator approach, does not have
an explicit intermediate target but is based on a wide range of monetary and financial
indicators. The fourth, viz., inflation targeting, also does not have an intermediate target,
but is characterized by an explicit final policy goal in terms of the rate of inflation.
In the 1970s when monetary policy came into prominence, many countries
adopted either money supply or exchange rate as intermediate targets. During the late
1980s, these paradigms started to change following globalization, technological
advancements and large movement of capital across national boundaries.

In view of difficulties in conducting monetary policy with explicit intermediate

targets, of late, some countries are switching to direct inflation targeting, which works by
explicitly announcing to the public the goals for monetary policy and the underlying
framework for its implementation.
In this framework, the monetary authorities have the freedom to deploy the
instruments of monetary policy to the best of their capacities, but are limited in their
discretion of policy goals. The framework is advocated on the ground that it clearly spells
out the extent of central bank accountability and transparency.

In reality, monetary policy strategy of a central bank depends on a number of

factors that are unique to the country and the context. Given the policy objective, any
good strategy depends on the macroeconomic and the institutional structure of the
economy. An important factor in this context is the degree of openness of the economy.
The more open an economy is, the more the external sector plays a dominant role in
monetary management. The second factor that plays a major role is the stage of
development of markets and institutions: with technological development as an essential
ingredient. In a developed economy, the markets are integrated and policy actions are
quickly transmitted from one sector to another. In such a situation, perhaps it is possible
for the central bank to signal its intention with one single instrument.

Operating Procedures

Operating procedures refer to the choice of the operational target, the nature, extent
and the frequency of different money market operations, the use and width of a corridor
for market interest rates and the manner of signaling policy intentions. The choice of the
operating target is crucial as this variable is at the beginning of the monetary transmission
process. The operating target of a central bank could be bank reserves, base money or a
benchmark interest rate. While actions of a central bank could influence all these
variables, it should be evident that the final outcome is determined by the combined
actions of the market forces and the central bank.The major challenge in day-to-day
monetary management is decision on an appropriate level of the operating target. The
success in this direction could be achieved only if the nature and the extent of interaction
of the policy instruments with the operating target is stable and is known to the central
bank. As the operating target is also influenced by market movements, which on
occasions could be extremely volatile and unpredictable, success is not always
guaranteed. Further, success is also dependent on the stability of the relationship between
the operating target and the intermediate target. In a monetary targeting framework, this
often boils down to the stability and the predictability of the money multiplier. In an
interest rate targeting framework, on the other hand, success depends upon the strength of
the relationship between the short-term and the long- term interest rates. Finally, the
stability of the relationship between the intermediate and the final target is critical to the
successful conduct of the operations.
Monetary Policy Transparency

Transparency in monetary policy is emphasized in the recent years on the ground

that it leads to a reduction in the market’s uncertainty about the monetary authority’s
reaction function. It is further argued that greater transparency may improve financial
market’s understanding of the conduct of monetary policy and thus reduce uncertainty.
The limits to transparency are also recognized since publishing detailed results of a
central bank’s economic projections may eliminate an element of surprise, which is useful
on occasions with respect to the central bank’s operations in financial markets.
 CHAPTER-3

MONETARY POLICY IN INDIA

Monetary Policy in India

Policy Making Process

Traditionally, the process of monetary policy in India had been largely internal with
only the end product of actions being made public. A process of openness was initiated by
Governor Rangarajan and has been widened, deepened and intensified by Governor Jalan.
The process has become relatively more articulate, consultative and participative with
external orientation, while the internal work processes have also been re-engineered to
focus on technical analysis, coordination, horizontal management, rapid responses and
being market savvy.

The stance of monetary policy and the rationale are communicated to the public in a
variety of ways, the most important being the annual monetary policy statement of
Governor Jalan in April and the mid-term review in October. The statements have become
over time more analytical, at times introspective and a lot more elaborate. Further, the
statements include not only monetary policy stance or measures but also institutional and
structural aspects. The monetary measures are undertaken as and when the circumstances
warrant, but the rationale for such measures is given in the Press Release and also
statements made by Governor and Deputy Governors unless a deliberate decision is taken
not to do so on a contemporaneous basis. The sources for appreciating the policy stance
encompass several statutory and non-statutory publications, speeches and press releases.
Of late, the RBI website has become a very effective medium of communication and it is
rated by experts as one of the best among central bank websites in content, presentation
and timeliness. The Reserve Bank’s communications strategy and provision of
information have facilitated conduct of policy in an increasingly market- oriented
environment.

Several new institutional arrangements and work processes have been put in place
to meet the needs of policy making in a complex and fast changing world. At the apex of
policy process is Governor, assisted closely by Deputy Governors and guided by
deliberations of a Board of Directors. A Committee of the Board meets every week to
review the monetary, economic, financial conditions and advise or decide appropriately.
Much of the data used by the Committee is available to the public with about a week’s
lag. There are several other standing committees or groups of the Board and Board for
Financial Supervision plays a critical role in regard to institutional developments. Periodic
consultations with academics, market participants and financial intermediaries take place
through Standing Committees and Groups, in addition to mechanisms such as resource
management discussions with banks. Within the
Reserve Bank, the supervisory data, market information, economic and statistical analysis
are reoriented to suit the changing needs. A Financial Markets Committee focuses on a
day-to-day market operations and tactics while a Monetary Policy Strategy Group
analyses strategies on an ongoing basis.

Operating Procedures

In the pre-reform period prior to 1991, given the command and control nature of the
economy, the Reserve Bank had to resort to direct instruments like interest rate
regulations, selective credit control and the cash reserve ratio (CRR) as major monetary
instruments. These instruments were used intermittently to neutralise the monetary impact
of the Government’s budgetary operations.

The administered interest rate regime during the earlier period kept the yield rate of
the government securities artificially low. The demand for them was created through
intermittent hikes in the Statutory Liquidity Ratio (SLR). The task before the Reserve
Bank was, therefore, to develop the markets to prepare the ground for indirect operations.

As a first step, yields on government securities were made market related. At the
same time, the Reserve Bank helped create an array of other market related financial
products. At the next stage, the interest rate structure was simultaneously rationalized and
banks were given the freedom to determine their major rates. As a result of these
developments, the Reserve Bank could use OMO as an effective instrument for liquidity
management including to curb short-term volatilities in the foreign exchange market.

Another important and significant change introduced during the period is the
reactivation of the Bank Rate by initially linking it to all other rates including the Reserve
Bank’s refinance rates (April 1997). The subsequent introduction of fixed rate repo
(December 1997) helped in creating an informal corridor in the money market, with the
repo rate as floor and the Bank Rate as the ceiling. The use of these two instruments in
conjunction with OMO enabled the Reserve Bank to keep the call rate within this
informal corridor for most of the time. Subsequently, the introduction of Liquidity
Adjustment Facility (LAF) from June 2000 enabled the modulation of liquidity conditions
on a daily basis and also short term interest rates through the LAF window, while
signaling the stance of policy through changes in the Bank Rate.
Gains from Reform

It has been possible to reduce the statutory preemption on the banking system. The
Cash Reserve Ratio, which was the primary instrument of monetary policy, has been
brought down from 15.0 per cent in March 1991 to 5.5 per cent by December 2001. The
medium-term objective is to bring down the CRR to its statutory minimum level of 3.0
per cent within a short period of time. Similarly, Statutory Liquidity Ratio has been
brought down from 38.5 per cent to its statutory minimum of 25.0 per cent by October
1997.

It has also been possible to deregulate and rationalize the interest rate structure.
Except savings deposit, all other interest rate restrictions have been done away with and
banks have been given full operational flexibility in determining their deposit and lending
rates barring some restrictions on export credit and small borrowings.

The commercial lending rates for prime borrowers of banks have fallen from a high
of about 16.5 per cent in March 1991 to around 10.0 per cent by December 2001.

In terms of monetary policy signals, while the Bank Rate was dormant and seldom
used in 1991, it has been made operationally effective from 1997 and continues to remain
the principal signaling instrument. The Bank Rate has been brought down from 12.0 per
cent in April 1997 to 6.5 per cent by December 2001. It is envisaged that the LAF rate
would operate around the Bank Rate, with a flexible corridor, as more active operative
instrument for day-to-day liquidity management and steering short- term interest rates.

A contrasting feature in the positions between 1991 and 2001 is India’s foreign
exchange reserves. The monetary and credit policy for 1991-92 was formulated against
the background of a difficult foreign exchange situation. Over the period, external debt
has been contained and short-term debt severely restricted, while reserves have been built
in an atmosphere of liberalization of both current account and to some extent capital
account.

The foreign currency assets of the Reserve Bank have increased from US $ 5.8
billion in March 1991 to US $ 48.0 billion in December 2001. In view of comfortable
foreign exchange reserves, periodic oil price increases (for example in 1996-97, 1999-00
and 2000-01) did not translate into Balance of Payment (BoP) crises as in the earlier
occasions. Such enlargement of the foreign currency assets, on the other hand, completely
altered the balance sheet of the Reserve Bank.
Large capital inflows have been accommodated by the Reserve Bank while its
monetary impact has been sterilised through OMO. This has helped in reducing the
government’s reliance on credit from the Reserve Bank. Consequently, there has been
secular decline in monetized deficit, and in the process net foreign exchange assets of the
Reserve Bank have become the principal contributor to reserve money expansion in the
recent period.
Tasks before the Reserve Bank

These are impressive gains from reforms but there are emerging challenges to the
conduct of monetary policy in our country. Thus, while the twin objectives of monetary
policy of maintaining price stability and ensuring availability of adequate credit to the
productive sectors of the economy have remained unchanged, capital flows and
liberalization of financial markets have increased the potential risks of institutions, thus
bringing the issue of financial stability to the fore. Credit flow to agriculture and small-
and medium-industry appears to be constrained causing concerns. There are significant
structural and procedural bottlenecks in the existing institutional set up for credit delivery.
The pace of reforms in real sector, particularly in property rights and agriculture also
impinge on the flow of credit in a deregulated environment. The persistence of fiscal
deficit, with the combined deficit of the Central and State Governments continuing to be
high, draws attention to the delicate internal and external balance.

It is necessary to recognize the existence of the large informal sector, the limited
reach of financial markets relative to the growing sectors, especially services, and the
overhang of institutional structure that tend to constrain the effectiveness of monetary
policy in India. The road ahead would be demanding and the Reserve Bank would have to
strive to meet the challenge of steering the structurally transforming economy from a
transitional phase to a mature and vibrant system and increasingly deal with alternative
phases of the business cycle. Some of the immediate tasks before the Reserve Bank are
presented to provoke debate and promote research.

Modeling Exercises

In addressing a gathering of elite econometricians assembled here, a mention should

be made about developments in monetary modeling. It is well recognized that monetary
policy decisions must be based on some idea of how decisions will affect the real world
and this implies conduct of policy within the framework of a model. As Dr. William
White of Bank for International Settlements (BIS) mentioned in an address recently in
RBI, “the model may be as simple as one unspecified equation kept in the head of the
central bank Governor, but one must begin somewhere. Economics may not be a science,
but it
should at least be conducted according to scientific principles recognizing cause and
effect”. While reliance on explicit modeling was rather heavy in some central banks,
particularly in the 1960 and 1970s, there has been increasing awareness among the policy
makers of the limitations of such models for several reasons. It is difficult to arrive at a
proper model for any economy with the degree of certainty that policy makers want
especially in view of observed alterations in the private sector behavior in response to
official behavior.

Further, data to monitor the economy are sometimes inadequate, or delayed, and
often revised. It is said that in regard to modern economies, not only the future but even
the past is uncertain, due to significant revisions in data. The process of deregulation
coupled with technological progress has led to increasing role for market prices and
consequently more complexities for establishing relationships in an environment where
everything happens very fast, and in a globally interrelated financial world. In brief, there
is need to recognize the complexities in model building for monetary policies and
approach it with great humility and a dose of skepticism but ample justification for such
modeling work certainly persists.

It is felt that this is an appropriate time to explore more formally the relationship
among different segments of the markets and sectors of the economy, which will help in
understanding the transmission mechanism of the monetary policy in India. With this
objective in mind, the Reserve Bank had already announced its intention to build an
operational model, which will help the policy decision process. An Advisory Group with
eminent academicians like Professors Mihir Rakshit, Dilip Nachane, Manohar Rao, Vikas
Chitre and Indira Rajaraman as external experts and a team from within the Reserve Bank
were set up for developing such a model.The model was initially conceived to focus on
the short-term objective of different sources and components of the reserve money based
on the recommendations of an internal technical group on Liquidity Analysis and
Forecasting. Though multi-sector macro-econometric models are available, such models
are based on yearly data and hence these may not be very useful for guiding the short-
term monetary policy actions of the Reserve Bank.

Accordingly, it was felt that a short-term liquidity model may be developed in the
Reserve Bank focusing on the inter-linkages in the markets and then operational these
linkages to other sectors of the economy. The
34 Advisory Group met twice and after
deliberations felt that a daily/ weekly/fortnightly model would give an idea about short- to
medium-term movements but models using annual data will also be useful to assess the
implications of the monetary policy measures on the real economy. On the basis of the
advice of eminent experts in the Advisory Group, it has been decided to modify the
approach.
The current thinking in the Reserve Bank is broadly on the following lines: the
short-term liquidity model making use of high frequency data will be explored.
Accordingly, the interaction of the financial markets with weekly data focusing mainly on
policy measures and different rates in the financial markets. An observation in the
operational framework of the model is limited as the LAF has been operationalised only a
year ago. A crucial aspect in an exercise is the forecast of currency in circulation.

The intention of the Reserve Bank is to expedite the technical work in this regard
and seek the advice of individual members of Advisory Group on an ongoing basis both
at formal and informal levels. It is expected that the draft of the proposed model would be
put in public domain shortly. The Reserve Bank would seek the active participation of the
interested econometricians in the debate on the draft model and give benefit of advice to
the Reserve Bank for finalizing and adoption.

Reduction in CRR

Among the unrealized medium-term objectives of reforms in monetary policy, the

most important is reduction in the prescribed CRR for banks to its statutory minimum of
3.0 per cent. The movement to
3.0 per cent can be designed in three possible ways, viz., the traditional way of pre-
announcing a time- table for reduction in the CRR; reducing CRR as and when
opportunities arise as is being done in recent years; and as a one-time reduction from the
existing level to 3.0 per cent under a package of measures.

In the initial years, the first approach was effective but had to be abandoned when
the time-table had to be disrupted to meet the eruption of global financial uncertainties
and pressures on foresaw market. Hence, the second approach of lowering CRR when
opportunities arise has been adopted, and now it has been brought down to 5.5 per cent.
However, if it is felt that this approach takes a longer time and a compressed time-frame
35 markets, it is possible to contemplate a
is desirable to expedite development of financial
package of measures in this regard. The package could mean the reduction of CRR to the
statutory minimum level of 3.0 per cent accompanied by several changes such as in the
present way of maintenance of cash balances by banks with RBI. With the lagged reserve
maintenance system now put in place, banks can exactly know their reserve requirements.
With the information technology available with banks and with the operationalisation of
Clearing Corporation of India Ltd. (CCIL) shortly and with the development of repo
market, it would be appropriate if CRR is maintained on a daily basis. However, till banks
adjust to such changes in the maintenance of CRR, a minimum balance of 95 per cent of
the required reserves on a daily basis may have to be maintained when CRR is reduced to
3.0 per cent. The other elements of package have to be worked out carefully.
Access to Call Money Market

An important related component of ongoing reform relates to restricting the call

money market to banks and Primary Dealers (PDs). Several measures have been initiated
in this regard but in view of the growing importance attached to stability in the financial
system and the growing alternatives to access liquidity management through activation of
facilitated by the CCIL, there is a strong case to impose some limits on access to non-
collateralised borrowing through call money even under the dispensation of restricted
participation only to banks and PDs. The call money window should be used to iron out
temporary mismatches in liquidity and banks should not use this on a sustained basis as a
source of funding their normal requirements. A beginning has been made by prescribing
for access to call money a ceiling of 2.0 per cent of aggregate deposits in respect of urban
cooperative banks (UCBs). Such a stipulation can be extended to all commercial banks
and with some modifications such as, an alternative of 25.0 to 50.0 per cent of their net
owned funds. If a bank has any temporary need to go beyond the ceilings prescribed for
access to call money, the Reserve Bank could consider such requests to alleviate possible
shocks to individual banks.

Similarly, once the repo market develops, PDs should reduce and in fact consider
eliminating their access to the call money market. There is an opinion that such
restrictions of access to call money in Indian conditions would add to stability in financial
markets and help develop term money market. A final decision would no doubt be taken
after discussions in Technical Advisory Committee on financial markets of the Reserve
36
Bank, and further consultations with market participants.
Liquidity Adjustment Facility

The Reserve Bank influences liquidity on a day-to-day basis through LAF and is
using this facility as an effective flexible instrument for smoothening interest rates. The
operations of non-bank participants including FIs, mutual funds and insurance companies
that were participating in the call/notice money market are in the process of being
gradually reduced according to pre-set norms. Such an ultimate goal of making a pure
inter-bank call money market is linked to the operationalisation of the CCIL and
attracting non-banks also into an active repo market. The effectiveness of LAF thus will
be strengthened with a pure inter-bank call/notice money market in place coupled with
growth of repo market for non-bank participants. The LAF operations combined with
judicious use of OMOs are expected to evolve into a principal operating procedure of
monetary policy of the Reserve Bank. To this end, the Reserve Bank may have to reduce
substantially the liquidity through refinance to banks and PDs. For example, if the
Reserve Bank intends to tighten the money market conditions through LAF, the
automatic access of refinance facility from the Reserve Bank to banks and PDs may
reduce the effectiveness of such an action and thereby cause transmission losses of
monetary policy. It may be appropriate to note that in most of the developed financial
markets, the standing facilities operate at the margin.

At present the Reserve Bank provides standing facilities comprising the support
available to banks under Collateralised Lending Facility (CLF) and export credit facility
to banks, and liquidity support to PDs. One way of reducing the standing facility will be
to eliminate CLF from the standing facilities and reducing the present ratio of normal and
back-stop facilities. The existing methodology of calculating eligible export credit
refinance continues till March 2002 and the Reserve Bank has expressed its intention of
moving away from sector specific refinance. As CRR gets lowered and repo market
develops, the refinance facilities should also be lowered giving more effectiveness to the
conduct of monetary policy.

Highlights of the RBI’s

37
 Benchmark Repo Rate increased by 25 basis points (bps) from 8.25% to 8.50% with
immediate effect; Reverse Repo and Marginal Standing Facility stands revised to 7.50%
and 9.50%, respectively

Bank Rate, Cash Reserve Ratio and Statutory Liquidity Ratio unchanged at 6%, 6% and
24%

Baseline projection for headline WPI inflation for March 2012 maintained at 7%;
inflation expected to remain sticky in October-November 2011 and decline from
December 2011 onwards

Baseline projection for GDP growth for FY12 revised to 7.6%; in September 2011, the
RBI had indicated downside risks to its growth projection of 8% for 2011-12 made in May
2011 and July 2011, led by moderating domestic demand and impact of weakening global
growth momentum and rising uncertainty

Monetary stance remains focused on containing inflation and anchoring inflationary

expectations, whilst aiming to balance growth concerns

Guidance provided regarding a low likelihood of a further policy rate hike in December
2010
Interest on savings account balances deregulated - Banks allowed to offer differential
rates for savings deposits beyond Rs. 1 lakh; Deregulation could trigger increase in cost of
funds for Banks

Non-food credit and broad money growth projections retained at 18% and 15.5%,
respectively.

.Systemic liquidity remains within RBI

Systemic liquidity remained in deficit mode throughout Q2FY12, but largely remained
within RBI’s comfort zone of +/-1% of net demand and time liabilities, with the exception
of a few days in September 2011 on account of38
pressures related to advance tax payments.
 The Marginal Standing facility (MSF) introduced by RBI in May 2011 available to Banks
at 1% higher than Repo rate has been largely unutilized, as Banks were able to access
adequate liquidity through the LAF.

Banks maintained average excess SLR investments (including Reverse Repo) of

more than Rs.

2.7 lakh-crore during H1FY12, marginally lower than 2.9 lakh-crore in H1FY11. The
average SLR levels remained around 28.8% of NDTL as against the mandated 24%. GoI
spending during the first half has remained high as indicated by the negative balance with
RBI since April 2011 despite achieving 61% of FY12’s gross market borrowings in up to
October 14, 2012. However, the full year GoI borrowing target has been revised upwards
by about Rs. 53,000 crore which means the GoI’s gross market borrowing in H2FY12
would be around Rs. 2.03 lakh-crore. This could exert some pressure on systemic
liquidity particularly if credit demand remains benign.

Implications of bank ownership for the credit channel of monetary policy

transmission: Evidence from India

1. Introduction

The recent financial crisis brought to the fore 50

the debate about the bank lending channel
of monetary policy transmission. Traditional macroeconomic models such as the IS-LM
representation assume that monetary policy affects the real economic activity by changing
interest rates which, in turn, affects the investment demand of the firms. However, this
line of argument has increasingly come under scrutiny. To begin with, evidence suggests
that investment decisions of firms are affected much more by factors such as cash flows
than by the cost of borrowing (Bernanke and Gertler, 1995). Evidence also suggests that
banks are not passive intermediaries between the central bank and end users of money
such as the Firms.

For example, in an early discussion of this issue, Bernanke and Blinder (1992)
demonstrate that the composition of banks’ portfolios change systematically in response
to monetary policy initiatives. They conclude that the impact of monetary policy on the
investment of firms is not entirely demand driven, and that at least part of it can be
explained by the supply side or the bank lending channel. Kashyap and Stein (1993)
demonstrate that if a central bank pursues tighter monetary policy, there is a decline in the
amount of bank loans to
firms and simultaneously a rise in the issuance of commercial paper, and include that
contractionary monetary policy reduces loan supply. Importantly, research suggests that
there might be significant heterogeneity in the reaction of banks to monetary policy
initiatives. It may, for example, depend on the extent of competition in the banking sector.
Olivero, Li and Jeon (2011) argue that an increase in competition in the banking sector
weakens the transmission mechanism of monetary policy through the bank lending
channel.

Banks’ reaction to monetary policy initiatives also depends on the quality of their balance
sheets. Peek and Rosengren (1995) argue that an important determinant of a bank’s
reaction would be its capital-to- asset ratio. If banks find it difficult (or expensive) to raise
capital, for example, they could be reluctant to
lend even if there is ample demand for credit in the aftermath of easing of monetary
policy. This hypothesis finds support in the empirical litera- ture. Kishan and Opiela
(2000) find that small and undercapitalized banks are most affected by monetary policy.
Gambacorta (2005) too finds that lending of undercapitalized Italian banks is adversely
affected by contractionary monetary policy, even though lending is not correlated with
51
bank size. Further, there is a directional asymmetry in the impact of monetary policy on
the lending behaviour of undercapitalised banks (Kishan and Opiela, 2006). In the event
of contractionary monetary policy, there is a sharp tightening in loan disbursal by
undercapitalised banks, but in the event of an expansionary monetary policy there is no
corresponding expansion of credit disbursal.

The reaction of banks to monetary policy also depends on the composition of their
assets. The traditional or money view of monetary policy transmission assumes that all
asset classes are perfect substitutes of each other. If, therefore, contractionary monetary
policy leads to a reduction in deposits, a bank is capable of substituting for this loss of
deposits dollar for dollar, using other assets like CDs, such that loan supply is not
affected. Stein (1998) argues that, contrary to this view, assets included in a bank’s
balance sheet are not perfect substitutes. For example, since deposits are guaranteed by
the FDIC (or its overseas counterpart), while CDs are not, there may be adverse selection
in the market for CDs, such that banks do not use these instruments to compensate for
loss of deposits dollar for dollar. This results in a decline in loan supply. It follows that
banks that have less liquid assets such that t hey cannot quickly and costlessly compensate
for loss of deposits in the event of contractionary monetary policy or, alternatively, those
that cannot raise funds quickly to the same end, would react more to monetary policy
changes. Kashyap and Stein (2000) find that monetary policy has greater impact on loan
supply of banks with low securities-to-assets ratios. The literature does not, however,
empirically examine the impact of bank ownership on the lending channel of monetary
policy transmission.

This is hardly surprising, given that much of the literature is based on the United States
and Western European experiences, where private ownership of banks overwhelmingly
dominates. However, as pointed out by La Portal et al. (2002), State-ownership of banks
is ubiquitous in much of the world, especially in emerging economies. Indeed, the 2007–
09 financial crises has led to significant state- ownership of banking assets even in
developed countries such as the United Kingdom, and concerns about the lending
activities of the de facto nationalised banks have brought into focus the impact of bank
ownership on the lending channel in the developed country context as well. In this paper,
we address this lacuna in the literature, and examine whether the impact of monetary
policy on lending differs across banks with different ownerships.
52
Studying how bank ownership plays a role in the credit channel of monetary
policy transmission is important because public sector banks account for a significant
portion of the banking assets and loan portfolio emerging economies, and, at the same
time, many of these country are fiscally constrained such that monetary policy may be the
only instrument available to policy makers to induce growth. This indeed is currently the
situation in a wide range of developed countries as well. Our analysis provides an
empirical basis for this policy debate concerning the relative effectiveness of monetary
policy when a significant proportion of the banking sector is under state ownership. This
is one of the key contributions of the paper.

Further, by isolating the response of foreign owned banks, it adds to the small but
growing literature on the impact of foreign banks on credit growth, especially in emerging
economies context. Our second important contribution is that we separately examine the
reaction of different types of banks (i.e., private, state and foreign) in easy and tight
monetary policy regimes. As mentioned
Earlier, reaction of banks to monetary policy changes may be asymmetric:

a change in interest rates might have very different outcomes, depending on whether these
rates are low or high to begin with. If an asymmetry does exist, a greater understanding of
the differences in the impact of monetary policy in easy and tight money regimes would
be imperative for successful monetary policy interventions. The richness of our
contribution is enhanced by the fact that, for each of these monetary policy regimes, we
estimate the reaction of the different types of banks based on ownership.

Finally, we examine whether impact of monetary policy differs With respect to

different maturities, and hence riskiness, of lending activities. Specifically, we examine
the impact of monetary policy on disbursal of (more risky) medium term credit and (less
risky) short-term credit. We estimate the impact for tight and easy monetary regimes, and
also for the different types of banks. We use bank- level data from India to examine these
issues. We focus on India for several reasons. First, India is a fast growing emerging
market that embraced the market economy in the early nineties and has since liberalized
its economy substantially. Importantly, in the absence of a well developed market for
corporate bonds, banks are by far the largest source of credit for Indian companies, and
hence bank lending plays an important role in the transmission of monetary policy in
India. Second, the Indian banking sector is also
53 marked by the presence of a number of
state-owned and private-owned (including foreign) banks, who compete on a level
playing field. Third, the state-owned banks themselves have
autonomy regarding lending decisions, and many of them have sold shares to private (and
even foreign) shareholders, thereby opening themselves up to greater scrutiny. Indeed,
Indian state-owned banks resemble the de facto nationalized banks of the United
Kingdom much more closely than state-owned banks in former transition economies of
Central and Eastern Europe (see, e.g., Bonin and Wachtel, 2002).

Reaction Of Cooperative

There is a fairly large literature on the bank lending channel of monetary policy. But
much of this literature is in the context of the United States, Europe and other developed
economies where the banks are heterogeneous but are almost entirely in private sector.
The emerging market economies, by contrast, have their fair share of state-owned banks,
such that, in these contexts, the implications of ownership for the bank lending channel
remains an important, yet largely unexplored, policy consideration. In this paper we
address this issue, using bank-level data from India. Our results suggest that there are
considerable differences in the reactions of different types of banks to monetary policy
initiatives of the central bank. During periods of tight monetary policy, as captured by the
monetary conditions index, state-owned banks, old private banks and foreign banks
curtail credit in response to an increase in interest rate. The reaction of foreign banks is
particularly sharp.

The reaction of the new private banks is not statistically significant. By contrast,
during easy money periods, an increase in interest rates by the central bank leads to an
increase in the growth of credit disbursed by old private banks, with no significant
reactions from other types of banks. The regression results
also indicate that the adverse reaction to a policy initiated increase in interest rate in a
tight monetary regime is much greater for medium term borrowing than for short-term
borrowing. Our results have two significant implications
54 for the literature on bank lending
channel. First, it suggests that the bank lending channel of monetary policy might be
much more effective in a tight money period than in an easy money period. In other
words, if interest rates are low, then a central bank that desires monetary contraction may
have to raise the rate substantially to witness an impact on money supply through the
bank lending channel. This has implications for future analyses of the bank lending
channel; the condition under which
a central bank changes its policy rate should be explicitly taken into account. It has also
implications for the implementation of monetary policy strategies during a business cycle
period or economic crisis.

For example, if the economy is going through a downturn and the authorities try to
stimulate the economy towards the recovery zone, then, depending upon the type of
money regime the economy is in, the policymakers need to consider making adjustments
in policy rates to get the desired effects.

Indian Banks - The Effects of Confused Monetary Policy

Confused! That’s what I would call the present state of Indian monetary policy today.
While normally the Reserve Bank of India decides monetary policy and banks
factor it into their lending and deposit rates, the present situation in India is very
different. The Government wants banks to follow a policy which is at variance with
the policy of the Central Bank. The Government by asking banks not to pass on the
effects of the interest rate hike by the Reserve Bank of India to their
constituents unless they follow a particular procedure reminds one of the days of
the license permit raj which prevailed in India till the early 1990's when the
present state of liberalization started. While it is too early to say that Indian
reforms are being derailed, yet attempts like this by the Finance Ministry are bound
to have adverse effects on the Indian Economy and securities markets.

55
It was only in may this year that the Indian securities markets went into tailspin when
the Government tried to bring in taxes through the administrative route. This new
use of administrative authority in the commercial decisions of banks is bound to
have an adverse effect on share values , bank profitability and allocation of
resources in the economy. Bank share prices reportedly fell three percent in one day
on account of the latest attempt by the Government to micromanage the banks.

As a result of this latest directive of the Government, the public sector banks are
confused and are putting all loan decisions on hold. This is bound to have an effect
on the availability
of funds in the economy for trade, industry and consumption. The
fallout of this could be catastrophic Analysts should keep a watch on the efforts of the
Finance Ministry to micromanage the Indian economy as in my view this is today
the latest challenge for the Indian economy - continue to perform in the face of
increased government intervention.

The Reserve Bank of India's third quarter review of monetary policy was devoid of major
surprises. The only change in monetary policy instruments — a cut in the Cash Reserve
Ratio (CRR) by 0.50 percentage point to 5.5 per cent — was largely expected. The move
will release Rs.32, 000 crore of funds impounded from banks, almost immediately. The
key policy interest rate, the repo rate, remains unchanged at 8.5 per cent. Consequently,
the reverse repo stays at 7.5 per cent and the marginal standing facility at 9.5 per cent. A
cut in the repo rate would have more definitely indicated a downward shift in the
monetary stance but the RBI has argued that the CRR reduction is the best it could do
under the prevailing circumstances and ought to be interpreted as a signal for a softer
monetary policy regime.

According to the RBI, the CRR is a policy instrument with liquidity dimension. Its
reduction will bring down the cost of money for banks and have a bearing on their ability
to lend at lower rates. It may well be so but, for most market participants, a repo rate
reduction would be the more authentic signal. Soon after the policy announcement on
Tuesday, attention has immediately shifted to how soon the RBI will act in that direction.
56
The reasons

The RBI has cited three well known reasons in support of its latest stance. Economic
growth is decelerating due to the combined impact of uncertain global environment,
cumulative effect of past monetary tightening and domestic policy uncertainty.

(a) While some slowdown in the growth of demand was expected as a result of earlier
monetary policy moves to control inflation, at this juncture risks to growth have
increased.

(b) The fall in WPI inflation is due to a sharp decline in the prices of seasonal vegetables.
However, protein-based food items and non-manufactured food inflation remain high.
Further, there are many upside risks to inflation. Global petroleum prices remain high.
The lingering effect of recent rupee depreciation continues and there is a significant
slippage in the fiscal deficit.
(c) Liquidity conditions have remained tight beyond the comfort zone of the RBI despite
massive infusions through open market operations.

All these have tied RBI's hands and postponed its decision to cut the repo rate. Less clear
is what the half a percentage point cut in the CRR will do to ease liquidity as a critical
step towards making banks lend more. Some analysts, notably A. Seshan (former senior
RBI official), see an inherent contradiction in the policy statement: how does a situation
of liquidity shortage co-exist with low credit off take from the banking system?

‘A crowding out' effect

Consider the following: Money supply has been on expected lines but non-food credit
growth at 15.7 per cent has been below the indicative projection of 18 per cent. The latter
is due to the combined impact of a slowing economy and risk aversion among banks
concerned over non-performing assets (NPAs). There is also ‘a crowding out' effect of
increased government borrowing. Net credit to government has increased at a
57
significantly higher rate of 24.4 per cent as compared with 17.3 per cent last year. The last
point may be one of the reasons to explain the tightness in the money market. But the RBI
has done its bit to ease liquidity by buying back dated securities, for instance. Far more
difficult it is to reconcile low credit off take with liquidity shortage.

The only explanation is that banks have become even more shy of lending than is
apparent. As pointed out earlier, an increase in the NPAs does contribute to increased risk
aversion among banks. There is also a widespread fear psychosis: the bona fide
commercial decisions of bankers are being questioned many, many years later.

Power sector in deep trouble

A number of infrastructure sectors, especially power, are mired in deep financial troubles.

Telecom is in a mess. More recently, Kingfisher Airlines and Air India have shown how
deep-seated the financial problems are even in a sunrise sector such as civil aviation.
Aversion to lending

Many times in the past too, risk aversion on the part of banks has been cited to explain the
fall in lending. Given the dominance of government banks, it is of utmost importance to
put in place a system of accountability, which will not penalize risk-taking.

In short, the RBI's betting on a CRR cut as a means of assuaging the disappointment over
the absence of more overt repo rate reduction might have paid off in the short run. Stock
markets are up. But for the CRR cut draws attention to some structural blocks such as risk
aversion that will limit its potential.

Rural Co-operatives

58
Licensing of Co-operatives
1- The Committee on Financial Sector Assessment (Chairman: Dr. Rakesh Mohan and
Co-Chairman: hri Ashok Chawla) had recommended that rural co-operative banks, which
failed to obtain a licence by end- March 2012, should not be allowed to operate. The
Reserve Bank, along with the National Bank for Agriculture and Rural Development
(NABARD) implemented a roadmap for issuing licences to unlicensed state co-operative
banks (StCBs) and district central co-operative banks (DCCBs) in a non- disruptive
manner, to ensure the completion of licensing work by end-March 2012. After
considering the NABARD’s recommendations for issuance of licences based on
inspection/quick scrutiny, one out of 31 StCBs and 41 out of 371 DCCBs were found to
be unable to meet the licensing criteria by end-March 2012. In this regard, suitable action
will be initiated in due course.
Streamlining of Short-Term Co-operative Credit Structure

2- After recapitalisation of the three-tier short-term co-operative credit structure

(STCCS), 41 DCCBs having high level of financial impairment as of end-March 2012
were unable to meet the licensing criteria. In order to examine issues of structural
constraints and explore strengthening of the rural co- operative credit architecture with
appropriate institutions and instruments of credit to fulfil credit needs, it is proposed:
to constitute a Working Group to review the STCCS, which will undertake an in-
depth analysis of the STCCS and examine various alternatives with a view to reducing
the cost of credit, including feasibility of setting up of a two-tier STCCS as against the
existing three-tier structure.
Urban Co-operative Banks

Exposure of UCBs to Housing, Real Estate and Commercial Real Estate

1- At present, UCBs are permitted to assume aggregate exposure on real estate,

commercial real estate and housing loans up to59
a maximum of 10 per cent of their total
assets with an additional limit of 5 per cent of their total assets for housing loans up to
`1.5 million. In order to facilitate enhanced priority sector lending, it is decided:

To permit UCBs to utilise the additional limit of 5 per cent of their total assets for
granting housing loans up to `2.5 million, which is covered under the priority sector.

2- 77. Detailed guidelines in this regard will be issued separately.

Licences for Setting up New Urban Co-operative Banks

1- As announced in the Monetary Policy Statement of April 2010, an Expert Committee

(Chairman: Shri

Y. H. Malegam) was constituted in October 2010 for studying the advisability of granting
licences for setting up new UCBs. The Committee was also mandated to look into the
feasibility of an umbrella organization for the UCB sector. The Committee submitted its
report in August 2011. The report was placed in public domain in September 2011 for
comments and suggestions from stakeholders. In the light of the feedback received, it is
proposed.
Highlights of the RBI’s Second Quarter Review of Monetary Policy for 2011-12 –
October 2011

Benchmark Repo Rate increased by 25 basis points (bps) from 8.25% to 8.50% with
immediate effect; Reverse Repo and Marginal Standing Facility stands revised to 7.50%
and 9.50%, respectively

Bank Rate, Cash Reserve Ratio and Statutory Liquidity Ratio unchanged at 6%, 6% and
24%

Baseline projection for headline WPI inflation for March 2012 maintained at 7%;
inflation expected to remain sticky in October-November
60 2011 and decline from
December 2011 onwards

Baseline projection for GDP growth for FY12 revised to 7.6%; in September 2011, the
RBI had indicated downside risks to its growth projection of 8% for 2011-12 made in May
2011 and July 2011, led by moderating domestic demand and impact of weakening global
growth momentum and rising uncertainty

Monetary stance remains focused on containing inflation and anchoring inflationary

expectations, whilst aiming to balance growth concerns

Guidance provided regarding a low likelihood of a further policy rate hike in December
2010

Interest on savings account balances deregulated - Banks allowed to offer differential

rates for savings deposits beyond Rs. 1 lakh; Deregulation could trigger increase in cost of
funds for Banks

Non-food credit and broad money growth projections retained at 18% and 15.5%,
respectively.
Systemic liquidity remains within RBI comfort zone; large government borrowings
in H2FY12 could exert some pressure

Systemic liquidity remained in deficit mode throughout Q2FY12, but largely remained
within RBI’s comfort zone of +/-1% of net demand and time liabilities, with the exception
of a few days in September 2011 on account of pressures related to advance tax payments.
The Marginal Standing facility (MSF) introduced by RBI in May 2011 available to Banks
at 1% higher than Repo rate has been largely unutilized, as Banks were able to access
adequate liquidity through the LAF.

Banks maintained average excess SLR investments (including Reverse Repo) of

more than Rs.

lakh-crore during H1FY12, marginally lower than 2.9 lakh-crore in H1FY11. The average
SLR levels remained around 28.8% of NDTL as against the mandated 24%. GoI spending
during the first half has remained high as indicated by the negative balance with RBI
since April 2011 despite achieving 61% of FY12’s
61 gross market borrowings in up to
October 14, 2012. However, the full year GoI borrowing target has been revised upwards
by about Rs. 53,000 crore which means the GoI’s gross market borrowing in H2FY12
would be around Rs. 2.03 lakh-crore. This could exert some pressure on systemic
liquidity particularly if credit demand remains benign.

Inflation expected to moderate in December 2011; decline to 7% by March 2012

The Central Bank indicated that the monetary policy tightening effected so far has helped
in containing inflation and anchoring inflation expectations, whilst acknowledging that
both remain elevated. Headline wholesale price index (WPI) inflation has averaged 9.6%
in FY12 so far and remained in excess of 9% in each month in the current fiscal year,
substantially higher than the RBI’s comfort zone. Additionally, inflation has been driven
by all the three groups of items, namely, primary articles, fuel & power and manufactured
products, reflecting a generalization of inflationary pressures.

The RBI expects inflation to remain sticky in October-November 2011, despite the
substantial policy tightening that it has undertaken since March 2010. However, the
policy review indicates a downward momentum in the de-personalized sequential
62
quarterly WPI data. Additionally, WPI data for September 2011 indicates that the index
levels declined or remained unchanged for six of the 11 sub-groups of non food
manufactured products on a month-on-month basis, suggesting that inflationary pressures
have begun to moderate in certain sectors. The Central Bank expects WPI inflation to
decline significantly in December 2011 and continue to moderate in 2012-13.

With the potential adverse impact of the rupee depreciation, incomplete transmission of
commodity price movements, suppressed inflation related to domestic coal and electricity
prices and structural rigidity of food inflation likely to be offset by the lagged impact of
cumulative monetary policy actions and moderating demand, the RBI continues to expect
inflation to decline to 7% by March 2012, in line with ICRA’s expectations (6.8-7%). The
RBI also highlighted that the impact of tight monetary policy has been diluted by the
expansionary fiscal position, and emphasized that slippages in the fiscal deficit relative to
the budget estimates would have implications for domestic inflation.
Baseline projection of real GDP growth for 2011-12 revised to 7.6%

The Central Bank revised the baseline projection for GDP growth for FY12 to 7.6%. In
September 2011, the RBI had indicated downside risks to its growth projection of 8% for
2011-12 made in May 2011 and July 2011, led by moderating domestic demand and
impact of weakening global growth momentum and rising uncertainty. The pace of
growth of gross domestic product (GDP) at factor cost (constant prices) moderated to
7.7% in Q1FY12, from 8.8% in Q1FY11, led by a decline in the pace of industrial
growth. The Central Bank indicated that capacity utilization moderated in Q1FY12 as
compared to the previous quarter while business expectations declined in Q2FY12. The
Index of Industrial Production (IIP) recorded sluggish 3.9% growth in July-August 2011
relative to the same months in 2010, lower than the 6.8% growth recorded in Q1FY12.
Notably, sluggish global growth is expected to dampen Indian exports and therefore its
manufacturing sector, given linkages of the Indian economy with the global economy.
Additionally, the RBI indicated that the services sector too may see some moderation in
growth on account of inter-sectoral linkages. An
63increase in the sown area and a favorable
monsoon rainfall in 2011 are likely to boost agricultural output in FY12, although the
pace of growth is likely to be moderate given the high base effect.

The RBI indicated concerns to growth originating from the global macroeconomic
environment, which may undergo a sharp deterioration in the absence of a credible
solution to sovereign debt and financial problems in Europe, impacting Indian economic
growth through trade, finance and confidence channels. The Central Bank also
highlighted the potential crowding out of private sector investment following an increase
in Government of India’s borrowing programmed for H2FY12.

Overall, ICRA expects the Indian economy to expand by 7.5-7.7% in FY12, similar to the
baseline projection of 7.6% GDP growth for FY12 made by the RBI.
Guidance suggests low likelihood of rate change in December 2011

Given the anticipated trajectory of inflation and risks regarding growth impulses, the
Central Bank provided a guidance of a relatively low likelihood of a rate action in the
December 2011. Further, the RBI indicated that if the evolving inflationary trajectory is
similar to its forecasts, further rate hikes may not be warranted.

The RBI indicated that the stance of monetary policy is intended to:

• Maintain an interest rate environment to contain inflation and anchor inflation

expectations.

• Stimulate investment activity to support raising the trend growth.

• Manage liquidity to ensure that it remains in moderate deficit, consistent with effective
monetary transmission.
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Notably, the Central Bank indicated in the Second Quarter Review of Monetary Policy
that the monetary stance is intended to stimulate investment activity, as compared to the
earlier intention to manage the risk of growth falling significantly below trend. This
highlights the policy challenges facing the RBI, whose policy stance simultaneously
intends to contain inflationary pressures.
The Central Bank indicated the following expected outcomes of its monetary measures and
guidance:

Continue to anchor medium-term inflation expectations on the basis of a credible

commitment to low and stable inflation.

Reinforce the emerging trajectory of inflation, which is expected to begin to decline in

December 2011.

Contribute to stimulating investment activity.

Credit growth remains robust despite hardening interest rates; could moderate in
H2FY12

Systemic credit in the current fiscal has remained robust with incremental Bank credit of
nearly Rs. 2.1 lakh-crore up to October 7, 2011, only marginally lower than Rs. 2.3 lakh-
crore in the same period of FY11. The y-o-y credit growth remained strong at around
19.3% as on October 7, 2011, as compared to around 20% as on October 8, 2010, higher
than the RBI’s projection of 18%. However, moderating economic growth and an
unyielding interest rate environment, in conjunction with a high base effect are likely to
dampen the pace of growth of credit off-take in H2FY12. ICRA expects the full-year
credit growth in FY12 to moderate from the current levels to around 18- 19%, and remain
close to the RBI’s baseline projection.

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Data released by the RBI regarding deployment of credit to various sectors up to August
2011 indicates that the 2.5% growth of Bank credit so far in FY123, was primarily driven
by credit to industry and retail housing, while credit to services remained flat and
agricultural credit declined in the current year. Within industry, a large chunk of the
incremental credit extended in the current fiscal has been absorbed by the metals sector
(23%) and the infrastructure sector (36% of total incremental credit in FY12), particularly
power (31%) and roads (11%) while credit to telecom shrank (11%). The medium and
large industrial sectors which grew by 4.5% and 6.2%, respectively, continue to attract a
greater share of Bank funding as compared to services and retail loans. While housing
credit expanded by Rs. 18,060 crore between April and August 2011 (5.2% growth), data
suggests incremental credit off-take for retail housing has slowed significantly.
Deregulation of Savings Bank Deposit Interest Rate

In recent periods, the spread between the savings deposit and term deposit rates has
widened significantly. RBI had increased the savings bank deposit interest rate from 3.5%
to 4.0% in April 2011, pending deregulation. The savings bank deposit interest rate
deregulated with immediate effect, subject to the following two conditions:

Banks will have to offer a uniform interest rate on savings bank deposits up to Rs. 1
lakh, irrespective of the amount in the account within this limit.

For savings bank deposits over Rs.1 lakh, a Bank may provide differential rates of
Interest

The decision to deregulate of the bank savings deposits rate (operational guidelines
awaited) is likely to benefit the deposit holders as they can get higher returns on their
deposits but at the same time increase the interest rate sensitivity and the asset-liability
mismatches for Banks. At the systemic level, savings accounts are estimated to account
for 22%-23% of total Bank deposits as on Sep 30, 2011, the increase in saving rate could
dilute the NIM by ~10-12 basis points, (assuming
66 a broad based 50-75 bps increase in the
savings bank deposit interest rate; without factoring in any rise in lending rates) while the
post tax impact could be lower at 7-8 basis points, therefore return on equity could get
diluted by less than 1%.
The impact could be more for banks with higher savings deposits. We believe that this
step would add to the profitability pressures on the Banks in light of tighter monetary
stance followed by the Central Bank unless they are able to pass on the burden to the
borrowers.
Conclusion

There is a fairly large literature on the bank lending channel of monetary policy. But
much of this literature is in the context of the United States, Europe and other developed
economies where the banks are heterogeneous but are almost entirely in private sector.
The emerging market economies, by contrast, have their fair share of state-owned banks,
such that, in these contexts, the implications of ownership for the bank lending channel
remains an important, yet largely unexplored, policy consideration. In this paper we
address this issue, using bank-level data from India. Our results suggest that there are
considerable differences in the reactions of different types of banks to monetary policy
initiatives of the central bank. During periods of tight monetary policy, as captured by the
monetary conditions index, state-owned banks, old private banks and foreign banks
curtail credit in response to an increase in interest rate. The reaction of foreign banks is
particularly sharp.

The reaction of the new private banks is not statistically significant. By contrast,
during easy money periods, an increase in interest rates by the central bank leads to an
increase in the growth of credit disbursed by old private banks, with no significant
reactions from other types of banks. The regression results
also indicate that the adverse reaction to a policy initiated increase in interest rate in a
67
tight monetary regime is much greater for medium term borrowing than for short-term
borrowing. Our results have two significant implications for the literature on bank lending
channel. First, it suggests that the bank lending channel of monetary policy might be
much more effective in a tight money period than in an easy money period. In other
words, if interest rates are low, then a central bank that desires monetary contraction may
have to raise the rate substantially to witness an impact on money supply through the
bank lending channel. This has implications for future analyses of the bank lending
channel; the condition under which a central bank changes its policy rate should be
explicitly taken into account. It has also implications for the implementation of monetary
policy strategies during a business cycle period or economic crisis.

For example, if the economy is going through a downturn and the authorities try to
stimulate the economy towards the recovery zone, then, depending upon the type of
money regime the economy is in, the policymakers need to consider making adjustments
in policy rates to get the desired effects.
SUGGESTIONS

1. According to my experience bank should also concentrate on new policies of

monetary.

2. It should increase rates of interest for customers.

3. New monetary policies should be applied seriously.

4. Without any mistake policies should be adopted.

5. Bank should focus on their various services.

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6. Bank should also give knowledge to customers about time-to-time changes in
monetary policy.

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