Monetary and Credit Policy

Definition

Deals with amount of money supply in economy to achieve broad economic goals.

• Taken care of by RBI
• Types
  • Expansionary - relaxing rates and ratios
  • Contractionary - increasing rates
• Historically announced 2 times a year in accordance with agri cycles.
• Since 2014, once every 2 months as recommended by Urjit Patel Committee (refer Urjit Patel Committee)

Goals

• Price stability
• Accelerating economic growth
• Exchange rate stabilization
• Balancing savings and investments
• Generating employment
• Financial stability

Terms

Net Time & Demand Liability (NDTL)

• total deposit of bank, excluding interbank deposit

Bond Yield Movement

• Bond returns generally try to match bank interests. Also people choose FD over bonds
• $\text{Bond Yield}=\frac{\text{Coupon Rate}}{\text{Current Bond Price}}$
• Coupon rate fixed; bond price fluctuates

Monetary Transmission

• RBI’s monetary policy decisions are passed on thru financial markets and later to businesses and households
• RR should get reflected in bank’s interest rate policy

Twin Balance Sheet Problem

• Corp faced losses in balance sheet ⇒ didn’t repay loan
• $\therefore$ banks also showed losses ⇒ increase interest rate
• ⇒ slow growth

Double Financial Repression

• Assets: restrictions on loans due to reserve requirements and priority sector lending
• Liability: govt schemes giving higher rates of interest than bank + high inflation

Internal Benchmark Lending Rate

• set of lending rates calculated after considering factors like
  1. Bank’s current financial situation
  2. Deposit rates
  3. NPA

Benchmark Prime Lending Rate (BPLR)

• benchmark rate for lending till 2010
• loans priced based on actual cost of funds
• opaque system
• banks subsidizing corp loans by charging high on retail customer, small enterprises

Base Rate and MCLR

• Base Rate used b/w Jun 2010 - April 2016; replaced BPLR
• Minimum rate at which loans can be given out (exception - agri)
• failed to lead to Monetary Transmission
  • BR not changed every month
  • RR not directly used to calc BR
  • 2011 - 2016: issues like high NPA, double financial repression
  • Federal Bank USA policies - USD stronger than INR
• Marginal Cost of Funds Based Lending Rate (MCLR) introduced
• rate calculated with
  • Marginal cost of funds
  • carrying cost of CRR
  • Tenor premium
• Benefits
  • ensuring monetary transmission
  • transparency in bank rate calc
  • lending rates fair for both lender and borrower
  • assist banks in becoming more profitable in long run

Types of Tools

Quantitative

• deal with money supply in overall economy
• eg:
  • LAF - Liquid Adjustment Facility
  • RR & RRR
  • Reserve requirements CRR, SLR
  • MSF
  • SDF
  • Bank Rate

Repo Rate

• interest at which RBI lends to banks and FI
• one day term
• used as policy rate

Long Term Repo Rate (LTRO)

• introduced 2020
• to infuse liquidity in market for long term lending at cheap rate
• 1 - 3 year funds from RBI at RR via GSec
• Targeted LTRO as RBI wants banks opting for LTRO to deploy in investment grade corp debt

Reverse Repo rate

• interest at which RBI borrows from banks and FI
• earlier RRR = RR - 0.25%

Qualitative

• selective credit control for specific sectors
• Banking Regulation Act, 1949 gives powers to apply tools
• eg: changing credit policies wrt agri or any specific sector

Margin Requirements

• introduced 1956
• ”margin” - part of amt which cannot be borrowed from bank
• RBI can vary margin requirements
  • during inflation → raise margin
  • during deflation → decrease margin

Consumer Credit Mechanism

• Consumer credit and supply regulated thru down paymens
• can be used to give loan relief, encourage credit and demand

Loan to Value (LTV)

• proportion of property value a lender can finance thru loans

Rationing of Credit

• credit rationed by limiting amt available for each commercial bank
• method controls rediscounting of bills by RBI
• upper limit of credit fixed by RBI

List of Tools

Liquidity Adjustment Facility (LAF)

• introduced 2000
• RBI to Bank to tackle temporary mismatch in liquidity (credit demand > deposit)
• Repo Rate and Reverse Repo rate are used
• only in securities approved by RBI (Treasury Bills, C/S Government Securities)
• Regional Rural Banks NOT eligible for LAF

Marginal Standing Facility

• introduced 2011
• enable commercial banks to borrow from RBI at penal rate
  • when amt under LAF is exhausted or
  • GSec in excess of SLR were exhausted or
  • did not hold more than the SLR limit
• aims to make more liquidity available if banks pay higher rate of interest
• MSF > RR

Bank Rate

• rate at which RBI lends long term to commercial banks
• tool to manage money supply and facilitate investment and growth
• dormant since LAF introduced
• 2000 - 2011, bank rate used as penal rate. Post 2011, MSF also penal rate, so both aligned.

Reserve Requirements

Cash Reserve Ratio (CRR)

• minimum % of bank’s NTDL it must deposit with RBI in cash
• can’t lend CRR, no interest

Statutory Liquidity Ratio (SLR)

• CRR like, but maintained with bank
• can’t lend
• cash, GSec, T-Bills, Sec
• banks may get some interest on GSec

Standing Deposit Facility

• introduced 2018, need arose after demonetization
• reduce liquidity without using GSec
• rate at which banks park money with RBI without RBI pledging GSec
• used for liquidity adjustments instead of fixed RRR

Open Market Operations

• purchase / sale of GSec for injection / absorption of liquidity in market
• QTI easing → OMO for injecting liquidity
• RBI buys GSec → GDP $\uparrow$
• RBI sells GSec → Inflation control

Operation Twist

• 2019, selling short term Gov bonds and buying long term Gov bonds for same amount to drive prices up
• Stimulate economy by lowering long term interest rates
• yield curve gets twisted

Quantitative Easing

Intervention in Forex Market

Moral Suasion

• pressure exerted by RBI on Indian banking system

Debt Instruments of Govt

Treasury Bills

Treasury Bills

Dated Security

• long term security or coupon bond with general maturity period > 1 year

External Benchmarks

• 2019, to ensure complete transparency, RBI mandated banks to adopt a uniform benchmark within a loan category
• diff from MCLR, which was an internal benchmark (fixed by bank)
• RBI offers 4 external benchmarks
  1. RR
  2. 91 day T-Bill yield
  3. 182 day T-Bill yield
  4. any other benchmark market interest rate as developed by Financial Benchmark India Pvt. Ltd.

Benefits

• bank free to decide their spread
• interest rates must be changed as per external benchmarks atleast once per 3 months
• better monetary transmission
• easier loan comparison (transparency) → more aware choices

Inflation Targeting Regime by RBI

• too much focus on keeping inflation low could make RBI keep interest rates too high → reduced GDP

Issues with Inflation Targeting

• RBI wishes to control inflation, but it depends on many out of control factors
  • Agri depend on monsoon
  • crude oil depend on external factors
• RBI can only control demand pull inflation, not cost pull inflation
• inflation needs to be controlled in collab with govt (fiscal policy, tax subsidy)
• major chunk of economy outside formal channels

Direct Action

• RBI can impose restrictions on a bank if they are not adhering to RBI directives
• RBI can levy penal rates and at times cancel licences

Monetary Policy Committee

Monetary Policy Committee

• Replaces earlier framework under which RBI gov had complete control over monetary policy decisions
• a Technical Advisory Committee advises RBI on monetary policy decisions
• RBI under no obligation to accept recommendations

MPC members

• 3 appointed by RBI
  • RBI Gov
  • Deputy Gov
  • One official nominated by RBI
• 3 external selection committee
  • Cabinet Secretary
  • Secretary of Dept. of Economic Affairs
  • RBI Gov
  • 3 experts in economics and banking
• RBI Gov has veto in case of ties

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Demonetization

Demonetization

• 8 November 2016
• 500 and 1000 banknotes demonetized - by executive decision
• earlier in 1946 and 1978 - by ordinance

Benefits

• attack black money
• prevent funding terrorism, gambling, human trafficking, speculation in real estate, gold, other social evils
• formalize and digitalize the economy
• widen tax net

Cons

• inconvenience
• logistical nightmare for large economy
• cost of printing new currency
• cash very miniscule part of black money

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