Impact of monetary policy

ACKNOWLEDGEMENT

Through my gratitude towards my supporters yet I like to add a few hearts full for the people who were part of this project in numerous ways. People who gave understanding support right the project ideas were conceived.

First I want to thank to Miss. Swati mehta lecturer of Lovely Professional University, Phagwara for assigning this term paper & I also want to give hands full gratitude to her for her help & guidance. I would like to thank all the faculty of Lovely Business School for having faith in me & for their kind inspirations & helping me whenever asked.

Last but not least, I expand my heartiest gratefulness all people who have been directly or indirectly involved in this project & have given me their best wishes & all help that I needed for the completion of the term paper.

MONETARY POLICY

Monetary policy is the management of money supply and interest rates by central banks to influence prices and employment. Monetary policy works through expansion or contraction of investment and consumption expenditure.

Monetary policy is that part of economic policy in which central bank controls the cost and supply of money and credit by applying different techniques. It is also main function of central bank.

In India RBI is sole institute who is taking steps to regulate money and credit by controlling its supply. Monetary policy regulates both volume and value of currency and credit.

Monetary policy is the process by which the government, central bank (RBI in India), or monetary authority of a country controls.

  1. the supply of money
  2. Availability of money
  3. Cost of money or rate of interest, in order 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

OBJECTIVE OF MONETARY POLICY

  • To control the supply of money in the market.
  • To control the cost of money and credit.
  • Exchange stability
  • Full employment

WHY IT IS NEEDED?

What monetary policy -at its best -can deliver is low and stable inflation, and thereby reduces the volatility of the business cycle. When inflationary pressures build up, it is monetary policy only which raises the short-term interest rate (the policy rate), which raises real rates across the economy and squeezes consumption and investment. The pain is not concentrated at a few points, as is the case with government interventions in commodity markets.

Monetary policy in India underwent significant changes in the 1990s as the Indian Economy became increasing open and financial sector reforms were put in place. In the 1980s, monetary policy was geared towards controlling the quantum, cost and directions of credit flow in the economy. The quantity variables dominated as the transmission Channel of monetary policy. Reforms during the 1990s enhanced the sensitivity of price signals from the central bank, making interest rates the increasingly Dominant transmission channel of monetary policy in India.

INSTRUMENTS OF MONETARY POLICY IN INDIA

BANK RATE

Bank rate is that rate which is charged by Central bank for issue loan to the member banks. By changing it, central bank can control the credit.

If Central bank increase this bank rate, all commercial banks will increase their interest rate by this loan become costly and flow of fund in the form of credit will decrease.

The Bank Rate has been reduced by 500 basis points in the last five years. Banks have the freedom to fix interest rates on term deposits, with flexibility in offering as approved by their boards. The only regulated rate is on the saving accounts with cheque facility.

The reduction in the administered interest rates on small saving announced in the Union Budget 2003-04 and moderate inflation enabled a 50 basis point reduction in the saving deposit rate to 3.5 percent per annum from March 1, 2003

OPEN MARKET OPERATION

Open market operation refer to the purchase and sale of government securities by the Central Bank to alter the reserve base of the banks and hence to check their capacity to expand credit.

The OMO sales of May31- June 1, 2002 were conducted to neutralize the impact of CRR cut of 50 basis points on June 1, 2002. In order to ensure that a sufficient stock of marketable securities would be available in the portfolio of the Reserve Bank for conducting OMO from time to time, the government of India converted Rs. 40,000 crore of 4.6 percent

If RBI wants to contract the credit, then RBI will sell the security of member bank and member bank's flow of cash will stop. If RBI wants to expand credit in recession, then RBI will start to buy the security of member banks and member banks get cash and they can now use it for providing more loans to customers.

CASH RESERVE RATIO / STATUTORY MINIMUM RESERVE

Under section 42(i) of the Reserve Bank of India Act, scheduled banks are required to keep a certain percentage of their demand and time liabilities with the RBI. An increase in the CRR is an indicator of restrictive monetary policy.

If RBI wants to expand credit, then RBI will decrease this ratio, after this all banks have to keep less fund as reserve with RBI. So, they will issue more credit to public.

It is subject to the condition that incremental do not exceed 100 percent of the excess and that the total reserve do not exceed 15 percent of their demand and time liabilities. This has changed thereafter. The medium term objective is, however to reduce the CRR to the statutory minimum level of 3.0 percent.

Accordingly, on a review of the developments in the international and domestic financial markets, a 75 basis point reduction in the CRR during June to November, 2002 was followed by a further 25 basis point cut from June 14,2003 taking the level of the CRR down to 4.5 percent.

STATUTORY LIQUIDITY RATIO

The Banks in India are required statutorily to maintain a prescribed minimum proportion of their total demand and time liabilities (L) in the form of liquid assets.

These liquid assets consists of excess reserves (ER), unencumbered government and other approved securities (I) and other current account balances with other banks (CB)

Thus, SLR = ER + I +CB

CHANGES IN MARGINAL REQUIREMENT OF LOAN:-

Marginal requirement is the difference between value of security and actual loan accepted by bank. Suppose a person wants to take loan of Rs. 80 , we has to give security of Rs. 100 then marginal requirement is Rs. 100 - Rs. 80 = Rs. 20.

If RBI wants to contract the credit , this rate will increase suppose , if RBI fixes it as 40 % , then customer can get loan of Rs. 60 after giving security of Rs. 100 . So, trend of getting loan will decrease.

If RBI wants to expand the credit, this rate will decrease suppose; if RBI fixes it as 10% more people will take loan, if they get Rs. 90 in cash after giving security of Rs. 100.

So, by this way RBI controls credit.

MORAL PERSUASION / INSPIRATION

RBI as central bank of country can control credit with moral persuasion. Under this persuasion, RBI can call a meeting of all commercial bank and give advice in discussion that they should not give loan for speculative purposes.

RATIONING OF CREDIT

RBI has right to create ration of credit under monetary policy. It can be done by following way:-To fix the amount of loan for a particular bank.

  • To fix Quota for all banks.
  • To fix Quota for different traders.

REGULATION OF CONSUMER CREDIT

In case inflation, prices are increased. To control prices central bank contract credit to reduce the total amount of installment for payment.

In case of deflation, prices are decreased to control prices central bank expand credit to increase the amount of installment.

LENDING RATES

The downward rigidity in lending rates is reflected in spreads over the prime lending rates (PLR). Unconscionably wide spreads are unwarranted in a period of low inflation.

Moreover, the adversely impact the overall credit portfolio of Banks and obscure the appropriate pricing of loans. In this context, banks are required to announce the maximum spread over the PLR for all advances except consumer credit.

CHALLENGES BEFORE MONETARY POLICY :

  1. Financial markets are unperturbed: with the flattening of yield curves, the compression of risk spreads and the search for yields continues unabated.
  2. Second, global imbalances have actually increased with no fears of hard landing, but with some sense of readying for a bumpy soft landing. Movements in major exchange rates are not reflecting fundamentals in an environment of generalized elevation in asset prices and abundant liquidity.
  3. Third, strong global economic growth could be accompanied by emerging pressures on core inflation. the challenge facing us is to judge the compatibility of the current pace of growth with non-accelerating inflation In the event of a judgment that the current growth momentum is more cyclical than structural, the stance of monetary policy would need to reflect a sensitivity to the inevitability of a downturn. On the other hand, the judgment that structural factors predominate would warrant a different policy stance.
  4. An overriding concern faced by the Reserve Bank is the persistently high growth of bank credit, with attendant worries relating to the quality of bank credit The sharp increase in credit to sectors such as housing, commercial real estate and retail loans have also been worrisome on account of the vulnerability of banks to credit concentration risks.
  5. It is difficult to arrive at a clear judgment as to what rate of credit growth is too high in relation to potential growth.
  6. Some of the models integrate policy behavior with the banking system, the demand for a broad monetary aggregate, and a rich array of goods and financial market variables, providing a more complete understanding of the monetary transmission mechanism. Weak economic assumptions and large models combine to reveal difficulties with sorting out policy effects that other approaches fail to bring out.

CREDIT CONTROL INSTRUMENTS FROM 2004 - 2009 (SEPTEMBER)

MONETARY POLICY 2004-05

HIGHLIGHTS

GDP growth projection for 2004-05 at 6.0-6.5 %

GDP growth revised downward to 6-6.5 % as against 6.5 -7.0% earlier taking into account the impact of deficient monsoon on kharif output, improved prospects for growth in industrial output and buyyancy in exports vis -a vis the likely adverse impact of higher oil prices on GDP growth.

Inflation rate projected at around 6.5 % by march 2005

Inflation rate revised upward to 6.5 % by march 2005 from 5 % earlier on account of below normal monsoon this year and higher than anticipated magnitude and persistence of international oil and commodity prices.

Repo Rate increased by 25 basic points to 4.75 %

Fixed repo rate hiked in view of the current macroeconomics and overall monetary conditions. The spread between the repo rate and the reverse repo rate has been reduced by 25 basic points from 150 basic points to 125 basic points.

OTHERS

Bank Rate unchanged at 6.0 %, Ceiling on Interest Rates on NRE Deposits raised to LIBOR + 50 basic points

IMPACT OF MONETARY POLICY

INFLATION:

The lack of evidence of demand -drive inflationary pressures perhaps did not warrant a shift in the monetary stance. However in the current economic scenario it was quite logical for RBI to take a significant step to control inflation.

The base effect will pull down inflation rate in the coming months .The future course of inflation will primarily be shaped by behaviour of crude prices and its transmission into the domestic economy. We expect average inflation between 6-6.5 percent in 2004-05.

INTEREST RATES:

A 25 bps hike in the repo rate is expected to lead to a 22 bps rise in the call rate .16 bps increases in one year yield and a 14 bps surge in ten -years yields over the next fortnight.

Hence, the ten -year yield is expected at around 6.8 percent over the next fortnight as compared to an average of 6.66 percent currently. Under these circumstances, the repo rate hike is expected to lead to fiscal year -end interest rate on ten -year G-secs at 7 %.

The liquidity squeeze can be observed from the falling amount of the outstanding repo balance since the month of sep. the outstanding amount in the daily repo balance fell from rupees 4900 crores to a low of the rupees 5599 crores on 24 oct 2004, the 50 bps hike in the cash ratio in two stages together with rise in non food credits has, thus sucked out the liquidity from the system

MONETARY POLICY 2005-06

HIGHLIGHTS

GDP growth projection for 2005-06 at 7 per cent

Real GDP growth projected at 7 per cent on the back of 3 per cent growth in agriculture under assumption of normal monsoons. Industry and services sectors expected to maintain their current growth momentum while absorbing the impact of oil prices.

Inflation rate for 2005-06 projected at 5.0-5.5 per cent

Point-to-point inflation rate placed at 5.0-5.5 per cent on account of upward pressure in international oil and primary commodity prices, credit growth and non pass-through of international oil prices to domestic prices. Positive cushion expected from the increase in sectoral productivity, level of food stocks and for ex reserves.

Reverse repo rate increased by 25 basis points to 5.0 per cent

Fixed reverse repo rate hiked by 25 basis points (bps) in view of the current macroeconomic and overall monetary conditions. The spread between the reverse repo rate and the repo rate has been reduced by 25 basis points from 125 bps to 100 bps.

OTHERS

  • M3 growth projected at 14.5 per cent in 2005-06
  • Non-food bank credit projected to increase by 19.0 per cent in 2005-06
  • Bank rate unchanged at 6.0 per cent
  • Cash reserve ratio unchanged at 5.0 per cent

IMPACT OF MONETARY POLICY

INFLATION:

The lack of evidence of demand-driven inflationary pressures perhaps did not warrant a shift in the monetary stance. The Reserve Bank of India (RBI) has raised the reverse repo rate by 25 basis points to emphasise its commitment to keep inflationary pressures benign. But the current inflationary situation has largely been a supply-side phenomenon, driven by oil and metal prices. The future course of inflation will primarily be shaped by the behaviour of the international prices of crude oil and other commodities, its transmission into the domestic economy and also the pricing power of manufacturers. If input prices stay high, the companies will either have to accept smaller margins or raise prices.

INTEREST RATES:

The 1-year and the 10-year paper are expected to trade at an average of 5.87 percent and 7.17 per cent over the next month and the call money rate is expected at 4.94 per cent. Over the longer term, global tightening of interest rates, particularly in the US, is expected to continue, though the pace of rate hikes will depend on the strength of recovery and inflationary pressures. Domestically, the government's borrowing programme, in conjunction with rise in corporate credit demand, is also expected to exert an upward pressure on interest rates. With oil prices as the critical risk factor, we expect the fiscal year-end interest rate on ten-year G-sec between 7.25-7.50 per cent.

EXCHANGE RATES:

While the policy suggests a slowdown in capital inflow momentum, the tapering of economic growth in the US and the Euro zone makes a case for limited overseas investment opportunities. This, together with a bullish domestic growth outlook, will attract foreign inflows. Thus, in the immediate future, liquidity is expected to remain comfortable. However, over the longer term, steep rate hikes in the US will hit portfolio investments. We expect the rupee to remain around Rs 44 against the dollar.

INTEREST RATES

Interest rates and liquidity

MONETARY POLICY 2006-07

HIGHLIGHTS

  • Repo rate hiked by 25 bps to 7.50 per cent
  • Reverse repo rate kept unchanged at 6 per cent
  • Bank rate kept unchanged at 6 per cent, cash reserve ratio kept unchanged at 5.5

Percent

  • Inflation target unchanged at 5.0-5.5 per cent for FY07 - aims inflation ceiling at 5

Per cent as a medium-term goal

  • FY07 GDP growth target raised to 8.5-9.0 per cent vs. 8.0 per cent in October
  • Ups provisioning norm on standard assets for 4 asset categories to 2 per cent vs. 1

Percent

  • Enduring capital inflows poses challenge to liquidity management
  • Capital inflows can reduce policy tightening efficacy
  • Inflation view critical in terms of monitoring, action
  • "Determined" policy response warranted to contain inflation
  • Food article prices to impact inflation rest of FY07
  • Flows to the real estate sector add to demand pressure
  • Continuing signs of aggregate demand firming up

MACRO ANALYSIS

In its third quarter review, the RBI has increased the repo rate from 7.25 to 7.50, an increase of 25 bps. With one more round of repo rate hike, the spread between the reverse repo rate and the repo rate has now been widened to 150 bps, thus signalling more volatility in interest rates. Earlier, during December 2006 and January 2007, the RBI had hiked the cash reserve ratio by 50 bps in two stages to curb excessive liquidity in the system.

The rate of inflation based on the wholesale price index (WPI) has scaled up to a two-year high of about 6 per cent recently against the RBI's expectations of 5-5.5 per cent for the year. The average inflation increased from 5.1 per cent in Q2 FY07 to 5.4 per cent during Q2 FY07. Inflation in primary articles scaled up to 7.7 per cent during the quarter, up from 6.2 percent witnessed during the previous quarter. Further, the rate of inflation based on consumer prices also averaged at 6.8 per cent during October-November. While there is a continuing price pressure on primary articles due to supply constraint, inflation in manufacturing articles is also experiencing a rise. Inflation of manufactured products increased from 4.9 per cent in December to 5.2 per cent in January (till week ending January 13).

Exchange rate and net FII inflow

The rupee witnesses an appreciation during the third quarter. It appreciated from an average of 46.37 to the dollar during Q2 FY06 to 44.98 against the dollar during Q3 FY07.Robust economic growth, along with bullish domestic stock market, kept the investor sentiment on the currency high. Further, the interest rate differential with international economies helped attract capital inflows into the economy. Net FII inflows into the domestic market (debt and equity) increased from US$2.77 billion during Q2 FY07 to US$3.16 billion during Q3 FY07, with November witnessing the highest net FII inflow of US$2.21 billion during the current fiscal.

IMPACT ANALYSIS ON ECONOMY

INFLATION

A 25 bps hike in the repo rate by the RBI falls in line with our expectations. Given the robust industrial and economic growth witnessed in the fiscal so far, the rate hike aims to curb inflationary pressure emanating in the economy. The current inflation scenario is dominated by supply constraints in primary articles, whereby the monetary tightening is not expected to impact much. However, the rate hike will keep a check on demand pressures by way of keeping a check on credit growth and elevated asset prices in the economy. Also, even though the global oil prices have moderated down considerably, concerns remain, in view of continued effort of OPEC to push up global oil prices. In the medium term, while the rate hike is expected to curb the pressures emerging from the demand side, the duty cuts and fiscal policy measures taken by the Government recently should help easing the overall inflationary situation. We expect the average inflation for the year to remain in the 5-5.5 per cent range.

INTEREST RATE

As the markets had already factored in a rate hike by the Central bank, a relief rally followed after the announcement of reverse-repo rate being left unchanged. The yield on the benchmark 8.07 per cent government security fell from 7.9 per cent, a level it had acquired in anticipation of the policy, to its short-term equilibrium of 7.3 per cent. The hike in the repo rate - the benchmark lending rate in the economy, signals an upward bias towards other lending rates. Monetary tightening, together with increased provisioning requirement, would keep the liquidity situation tight. Going forward, we see yield on the 10-year G-sec to lie in the range of 7.8-8.0 per cent by the end of the fiscal year.

EXCHANGE RATE

The repo rate hike is not expected to have any direct impact on the exchange rate in the near term. However, upward revision of growth forecasts of the current year would signal stronger sentiment on the economy. A significant interest rate differential with respect to international markets, together with an upbeat sentiment, would attract more capital inflows into the economy, thus pumping liquidity into the market. This influx of capital inflows could offset the RBI's objective of monetary tightening. Further, any significant appreciation in the currency is expected to be monitored carefully by the RBI so as not to hamper its export competitiveness. In balance, we expect the rupee to trade around 45-46 against the dollar by the end of the fiscal year.

IMPACT ANALYSIS ON BANKING

DEPOSITS

RBI's assessment of developments growth in aggregate deposits of scheduled commercial banks (SCBs) accelerated to 21.1 percent year-on-year (y-o-y) as on January 5, 2007 from 16.2 per cent a year ago, on the back of higher accretion to time deposits.

During the same period, demand deposits grew by 19.2 per cent y-o-y as compared with 28.7per cent a year ago. However, accretion to time deposits was significantly higher. Growth in time deposits accelerated to 22.9 per cent y-o-y from 15.0 per cent a year ago. The RBI attributes the high growth in time deposits to higher interest rates on deposits as well as tax benefits, apart from acceleration in economic activity. Interest rates on time deposits of 1-3 years maturity offered by public sector banks increased from a range of 5.75-6.75 per cent in March 2006 to 6.75-8.25 per cent in January 2007. Rates offered by private sector banks on deposits of similar maturity increased from arrange of 5.50-7.75 per cent to 6.75-9.25 per cent over the same period.

ADVANCES

RBI's assessment of developments Bank credit of SCBs registered a growth of 30.2 per cent as on January 5, 2007 as compared with 29.7 per cent a year ago. During the same period, non-food credit registered a growth of 31.2 per cent similar to the rate a year ago.

Credit growth has been largely broad-based. About 34 per cent of incremental non-food credit was absorbed by industry, 12 per cent by agriculture, 15 per cent by loans to the housing sector and another 11 per cent by 'other retail loans'. Loans to commercial real estate, which increased by 84 per cent, y-o-y, absorbed 5 per cent of incremental non-food credit.

MONETARY POLICY 2007-08

HIGHLIGHTS

  • Repo rate unchanged at 7.75 per cent
  • Reverse repo rate unchanged at 6 per cent
  • Bank rate unchanged at 6 per cent
  • Cash reserve ratio increased by 50 basis points to 7.5 per cent with effect from November 10, 2007
  • RBI retains flexibility to conduct repo/reverse repo auctions at a fixed rate or at variable rates
  • No change in the inflation target for 2007-08 — aim to keep inflation close to 5 per cent, with a medium term objective of around 3 per cent
  • No change in GDP growth forecast for 2007-08 at 8.5 per cent
  • Management of capital flows and its implications for liquidity identified as the biggest challenge
  • Inflation to be contained close to 5.0 per cent during 2007-08 and in the range of 4.0-4.5 percent over the medium term.
  • M3 growth to be contained at 17.0-17.5 per cent during 2007-08.
  • Growth of non-food credit to be contained at 24.0-25.0 per cent during 2007-08.
  • Ceiling interest rate on FCNR (B) deposits reduced by 50 basis points (bps) to LIBOR minus 75 bps.
  • Ceiling interest rate on NR (E) RA deposits reduced by 50 bps to LIBOR/SWAP rates.
  • Overseas investment limit (total financial commitments) for Indian companies enhanced to 300 per cent of their net worth.
  • Listed Indian companies limit for portfolio investment abroad in listed overseas companies enhanced to 35 per cent of net worth.
  • Aggregate ceiling on overseas investment by mutual funds enhanced to $4 billion.
  • Prepayment of external commercial borrowings (ECBs), without prior Reserve Bank of India (RBI) approval, increased to $400 million.
  • Present limit for individuals for any permitted current or capital account transaction increased from $50,000 to $100,000 per financial year in the liberalised remittance scheme.
  • Risk weight on residential housing loans to individuals for loans up to Rs 2 million reduced to 50 per cent as a temporary measure.
  • Moderation of capital flows preferred so as to contain broad money supply growth within the target of 17.0 - 17.5 per cent
  • RBI aims to ensure a monetary and interest rate environment that supports export and investment demand in addition to ensuring price stability.

Liquidity and interest rates

Yield on the 1-year government security (G-sec) declined from the first quarter average of 7.81 per cent to the second quarter average of 7.15 per cent. Yield on the benchmark 10-year G-sec also dropped from an average of 8.12 per cent in the first quarter to 7.90 per cent in the second quarter. This fall in gilt yields is basically reflective of surplus liquidity in the financial system, resulting from massive capital flows and increased government spending.

Ensuring price stability and adequate provision of bank credit to productive sectors are the twin objectives of this Monetary Policy. In addition, ensuring the stability of the currency has gained importance in recent months due to heavy foreign inflows. As a result, the RBI also continued to intervene in the foreign exchange market to prevent undue appreciation of the domestic currency.

Recent pattern

In its first quarter review of the Monetary Policy 2007-08, announced on July 31, 2007, the RBI withdrew the cap of Rs 3,000 crores on daily reverse repo under the LAF with effect from August 6. The central bank's decision was particularly significant in the face of the excess liquidity in the banking system. The policy rates' corridor of reverse repo and repo rates, wherein the call money rate tends to move in the absence of any caps on absorption and injection, became operational again. However, the call rates have gone outside the official corridor of the repo and the reverse repo rate only once in the second quarter. In mid-August, commercial banks had to meet the increased CRR requirements, which pushed up demand for funds, and consequently, call rates touched 10 percent.

MONEY MARKET RATES IN 2007

SIGNIFICANT INCREASE IN MARKET LIQUIDITY

During the second quarter, following the financial market crisis in the US, inflows to emerging markets rose considerably. While net FII inflows during the first quarter were around US$ 4.2 billion, they almost doubled in the second quarter to around US$ 7.9 billion. Further, October (up to 29th) alone witnessed net inflows of around US$ 5.5 billion, around US$ 1 billion more than the entire first quarter's figure.

Excess liquidity has resulted in a significant growth in transaction volumes in the money market in the recent months. Average daily transactions, which were around Rs 460 billion in the first quarter, rose to over Rs 600 billion in October.

IMPACT ANALYSIS ON ECONOMY

INFLATION

A 50 bps hike in the CRR, which is likely to result in a cash outflow of around Rs 15,000 crores from the banking system, signals a tighter Monetary Policy and the central bank's continued emphasis on price stability in the wake of unprecedented FII inflows in recent months. Additionally, the RBI expects headline inflation to increase as and when international oil prices pass-through to the domestic economy.

INTEREST RATES

As noted earlier, a principal source of excess liquidity in the second quarter was a substantial increase in net foreign inflows. The RBI has indicated that it would like to see a moderation in foreign inflows. Given the uncertainty in the current economic environment, the RBI has given itself flexibility as far as interest rates are concerned. Going forward, we expect the yield on 10-yr G-sec to lie at 7.8-8.0 per cent by the end of the fiscal.

EXCHANGE RATE

An unchanged growth forecast for the current year signals stable sentiments regarding the economy. Any further appreciation in the currency is expected to be monitored carefully by the RBI so as to maintain export competitiveness. The CRR hike will provide the RBI more legroom to intervene in the forex market. In all, we expect the rupee to trade at around 40.5 against the dollar by end of the fiscal.

IMPACT ANALYSIS ON BANKING

DEPOSITS

RBI's assessment of developments Accretion to bank deposits remained buoyant, led by time deposits. On an annual basis, aggregate deposits grew at 24.9 per cent as against 20.4 per cent a year ago. As per the RBI's document 'Macroeconomic and Monetary Developments: Mid-Term Review 2007-08', released on October 29, 2007, growth in demand deposits decelerated from 21.7 per cent on October 13, 2006 to 16.7 percent at end-March 2007 and further to 16.4 per cent on October 12, 2007. Conversely, growth in time deposits accelerated from 18.8 per cent on October 13, 2006 to 23.2 per cent at end-March 2007 and further to 24.7 percent on October 12, 2007. Concomitantly, accretion to postal deposits slowed down considerably during the year.

During April-October 2007, public sector banks (PSBs) decreased their deposit rates, particularly at the upper end of the range for various maturities, by 25-60 bps. Deposit rates of PSBs increased by 25-75 bps at the lower end for deposits of maturities of 1 year and above. Interest rates offered by the PSBs on deposits of above 1 year maturity moved from 7.25-9.75 per cent in April 2007 to 8.0-9.5 per cent in October 2007.

A Private sector bank deposit rates for up to 1 year maturity decreased from 3.00-10.00 per cent to 2.50-9.25 per cent over the same period. Foreign banks' deposit rates for up to 1 year maturity also declined from 3.00-9.50 per cent to 2.00-9.00 per cent during the same perioddeposit rates for up to 1 year maturity decreased from 3.00-10.00 per cent to 2.50-9.25 per cent over the same period. Foreign banks' deposit rates for up to 1 year maturity also declined from 3.00-9.50 per cent to 2.00-9.00 per cent during the same period.

ADVANCES

RBI's assessment of developments Bank credit rose by 23.3 per cent up to October 12, 2007, as compared with the increase of 28.8 per cent a year ago.As per the RBI's document 'Macroeconomic and Monetary Developments: Mid-Term Review 2007-08', growth in bank credit to the commercial sector has exhibited some moderation during 2007-08 till date in contrast to the strong pace of the preceding 3 years.

The deceleration in credit growth, coupled with the acceleration in deposits growth, led to a fall in the incremental credit-deposit ratio (y-o-y) of SCBs to 67.0 per cent as on October 12, 2007 from 94.3 per cent a year ago. As at end-March 2007, the incremental credit-deposit ratio was around 86 per cent (y-o-y) as compared with 110 per at end-March 2006.

The benchmark prime lending rates (BPLRs) of private sector banks moved from 12.50-17.25 per cent in April2007 to 13.00-16.50 per cent in October 2007. The range of BPLRs for PSBs and foreign banks, however, remained at 12.50-13.50 per cent and 10.00-15.50 per cent, respectively, during this period.

MONETARY POLICY 2009-10 (3RD QUARTER)

HIGHLIGHTS

  • The Statutory Liquidity Ratio (SLR) for scheduled commercial banks raised by 1 per cent to 25 percent from November 7.
  • Real gross domestic product (GDP) growth forecast retained at 6 per cent with an upside bias; sees modest decline in agriculture.
  • Wholesale price index (WPI) inflation projection revised upwards to 6.5 per cent with an upside bias by end-March 2010.
  • Money supply growth projection for 2009-10 revised downwards to 17 per cent from 18 per cent announced in the annual policy document.
  • The non-food credit growth target revised downwards to 18 per cent from 20 per cent.
  • Collateralised Borrowing and Lending Obligation (CBLO) transactions of banks to come under CRR from November 21.
  • RBI proposes permitting the recognised stock exchanges to offer rupee futures contracts in euro, yen and sterling limit for export credit refinance facility returned to pre-crisis level of 15 per cent from 50 per cent.
  • Special repos for banks, Special Term Repo, and FX swap facility of banks discontinued immediately. For ex swap facility discontinued for banks.
  • The special refinance facility for scheduled commercial banks discontinued.
  • Final guidelines for Corporate Bond Repos to be issued by end-November.
  • Separate Trading for Registered Interest and Principal of Securities (STRIPS) to be launched, as scheduled, during the current financial year.
  • Floating rate bonds (FRBs) to be issued during the current financial year depending upon market conditions and market appetite.
  • Proposal to hike the provisioning requirement for advances to the commercial real estate sector from 0.4 percent to 1 per cent. Minimum lock-in period for all types of loans would be 1 year before these can be securitised

IMPACT ANALYSIS ON ECONOMY

LIQUIDITY SITUATION

With the persisting low demand for credit, liquidity in the banking system continues to be in abundance. This is obvious from the lack of transactions under repo window since the beginning of the current fiscal. Banks continue to park their idle funds with the RBI through the reverse repo window, indicating that they could easily meet short-term funding requirements with their own resources.

This is also evident from the low inter-bank call rates, which stayed close to the lower-bound of the LAF corridor since the beginning of 2009-10. As indicated by the RBI, the 1 per cent rise in the SLR will not impact the liquidity position of the banking system and credit to the private sector since scheduled commercial banks are currently maintaining SLR investments at 27.6 per cent of their NDTL, net of LAF collateral securities, and 30.4 per cent of NDTL, inclusive of LAF collateral securities.

INFLATION -

Inflation based on WPI, moved into the positive territory in September after staying in the negative zone for 13 weeks. The current bout of rise in inflation is mainly due to the sharp increase in food prices, resulting from the deficient monsoon and hence, lowers kharif production. Also the diminishing high base effect is contributing in pushing inflation up. As the food prices are expected to stay firm and the high base effect starts fading, we expect inflation to reach close to around 6.5 to 7.0 per cent by March 2010. On balance, average annual inflation in 2009-10 is expected to be in the range of 1.5-2.0 per cent.

INTEREST RATE -

The pressure on the benchmark 10-year paper should decline going forward, as the supply of government securities will come down significantly in the second half of the year. Moreover, the disinvestment strategy of the government is likely to attract more foreign investment and hence increase liquidity in the system This would reduce the pressure on 10-year G-sec yields. However, with the inflationary pressures rising in the wake of poor monsoons, the yields could see some hardening towards the fiscal year-end. On balance, we expect yield on the 10-year G-sec to be in the range of 6.7-6.9 per cent by March 2010 end.

IMPACT ANALYSIS ON BANKING

DEPOSITS

RBI's assessment of developments on an aggregate basis, as on October 9, 2009, growth in deposits marginally declined to 20 per cent year-on-year (y-o-y) as compared with 21.5 per cent on October 10, 2008. As in the past, the growth in deposits was led by time deposits, reflecting some switching of demand deposits and other savings instruments to time deposits.

Within aggregate deposits, time deposits grew by 20.9 per cent as compared to 21.6 per cent during the same period. However, growth in demand deposits has slowed down to 10.3 per cent versus 17.7 per cent last year.

ADVANCES

RBI's assessment of developments on an aggregate basis, growth in bank credit decelerated to 10.8 per cent as on October 9 , 2009 as compared to 29.5 per cent on October 10, 2008. During 2008-09, growth in non-food bank credit (y-o-y basis) slowed down from a peak of 29.4 per cent in October 2008 to 17.5 percent by March 2009. This downward trend has continued in the first half of 2009-10.

During the current financial year (up to October 9, 2009), non-food credit expanded by11.2 percent (y-o-y) as compared to 29.4 per cent last year.Several factors have contributed to the slowdown in non-food bank credit as follows: Overall credit demand from the manufacturing sector slowed down, reflecting a decline in commodity prices and drawdown of inventories.

This deceleration in credit growth was more pronounced in the case of private banks that slowed down sharply to 15.3 per cent on October 9, 2009, from32.7 per cent in the previous year and foreign banks contracted to register a negative growth of 15.9 per cent from 32.9 per cent growth in the previous year.

As on August 28, 2009, the y-o-y growth in bank credit to agriculture increased sharply to 25.6 per cent from 18.6 per cent as on August 29, 2008. While credit to the housing sector decelerated to 5.4 per cent as compared to 12.4 per cent, the credit growth to industry slowed down to 17.9 per cent from 32.9 per cent last year. The lower expansion in credit relative to the expansion in deposits led to a fall in the incremental credit-deposit ratio (y-o-y) of scheduled commercial banks (SCBs) to 40.9 per cent as on October 9, 2009 from 96.2 per cent as on October 10, 2008.

The impact of lower cost of funds for banks also reflected on the interest rates on bank loans with BPLRs being reduced in the range of 125-275 bps by public sector banks, 100-125 bps by private banks and 125 bps by five major foreign banks.

THE NEW FUNCTIONS OF MONETARY POLICIES THAT HAVE EMERGED

It reinforce more on the price stability and well-anchored inflation expectations while ensuring a monetary and interest rate in the environment that supports export and investment demand in the economy that will enable continuation of the growth momentum.

To re-emphasize credit quality and orderly conditions in financial markets for securing macroeconomic and, in particular, financial stability while simultaneously pursuing greater credit penetration and financial inclusion. To respond swiftly with all possible measures as appropriate to the evolving global and domestic situation impinging on inflation expectations and the growth momentum.

CHANGES IN MONETARY POLICIES THAT HAVE COME DUETO GLOBAL CRISIS (DEPRESSION):

The policy responses in India since September 2008 have been designed largely to mitigate the adverse impact of the global financial crisis on the Indian economy. The conduct of monetary policy had to contend with the high speed and magnitude of the external shock and its spill-over effects through the real, financial and confidence channels. The evolving stance of policy has been increasingly conditioned by the need to preserve financial stability while arresting the moderation in the growth momentum.

The Reserve Bank has multiple instruments at its command such as repo and reverse repo rates; cash reserve ratio (CRR), statutory liquidity ratio (SLR), open market operations, including the market stabilisation scheme (MSS) and the LAF, special market operations, and sector specific liquidity facilities. In addition, the Reserve Bank also uses prudential tools to modulate flow of credit to certain sectors consistent with financial stability.

The availability of multiple instruments and flexible use of these instruments in the implementation of monetary policy has enabled the Reserve Bank to modulate the liquidity and interest rate conditions amidst uncertain global macroeconomic conditions.

CONCLUSION

Broadly in our view the RBI's commitment to maintain comfortable liquidity should allow interest rates to remain low over the coming quarters, adding greater momentum to the imminent upturn and that will ensure GDP growth. I believe that low interest rates, combined with the reducing leverage in borrowers' balance sheets, due to equity-raising and rising earnings will definitely help to boosts credit demand.

Potential Monetary tightening measures, such as CRR hikes in the coming policies, are unlikely to dampen demand anytime soon; rather, such measures are likely only if Capital inflows are robust in the first place, which will actually improve the GDP growth, Savings and Investments, and the Banking sector growth outlook.

Within the sector, we prefer private banks, in light of their stronger core competitiveness and likelihood of market share gains, as the external environment becomes more conducive from 2HFY2010E onwards. Axis Bank remains our top pick in the sector.

Wholesale price inflation, the one of the most accepted method in India touched 8.24 percent in mid-May, far above the central bank's comfort zone of 5.5 percent for 2008/09. The central bank held off outright rate increases for a year, opting instead to keep cash availability tight, as prices pressures largely came from supply constraints and record commodity prices rather.

BIBLOGRAPHY

  • Magazine - Investime ,vol 9 ,issue 4 ,april 2008,editor Ravi Sharma Pg 13 , Article -Credit Market -an overview.
  • Magazine -Deloitte ,April 09 , Global Economic Slowdown and its impact on the Financial services industry in India.
  • RBI Monthly Bulletin ,May 2009,Pg 688 -721 By Dr. D . Subbarao ,Governor, Monetary Policy Statements 2009-2010
  • RBI Monthly Bulletin ,August 2009,Pg 1208 -1212 By Dr. D . Subbarao ,Governor, Monetary Policy Statements 2009-2010 First Quarter Review.
  • RBI Monthly Bulletin ,August 2009,Pg 1274 -1263 By Dr. D . Subbarao ,Governor, Macroeconomic and First Quarter Review 2009-2010.
  • RBI Monthly Bulletin ,February 2009,Pg 178 -192 By Dr. D . Subbarao ,Governor, Macroeconomic and Third Quarter Review 2008-2009.
  • http://www.stockmarketsreview.com/news/rbis_2q_fy2010_monetary_policy_maintains_status_quo_in_rates_20091029_1479/
  • http://www.funonthenet.in/forums/index.php?topic=109014.0
  • http://epress.anu.edu.au/narayanan/mobile_devices/ch05s02.html
  • http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=410
  • http://www.funonthenet.in/forums/index.php?topic=109014.0
  • http://www.oenb.at/en/geldp_volksw/zentral_osteuropa/banksecfmstab/banking_sector_and_financial_stability.jsp
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  • http://www.financialexpress.com/news/Monetary%20policy%20and%20banking%20sector%20reforms/172338/

ANNEXURES

ARTICLES

Monetary policy and banking sector reforms

The busy season credit policy of the Reserve Bank has the imprint of continuity and responds to changes in the internal and external environment. The marginal increase in repo and reverse repo rates is a signal of strong commitment to keeping a grip on inflationary pressures. Inflation of 4-5% is acceptable in a growing economy. If properly controlled and monitored, it can even provide growth impulses. Governor YV Reddy has been doing a commendable job in providing stability to monetary policy, reigning in inflation and ensuring our macroeconomic fundamentals remain strong. His steady hand has ensured our monetary policy stays ahead of the curve and the burden of high fiscal deficits and rising global oil prices is cushioned.

Apart from being the principal monetary authority, RBI is also the supervisor and regulator of banks, owner of the largest public sector bank (SBI) and also exercises ownership functions for other public sector banks. Apart from the operator/regulator conflict, this arrangement carries the risk that monetary and credit policy could be influenced by considerations of impact on bottom lines of banks. RBI also wears the hat of government's debt manager and carries out market borrowing operations for the Central and state governments. This role could also influence the framing of credit policy, conflicts with banking regulator functions and deny government the benefit of finer spreads on its sovereign borrowings.

RBI's role as manager of for ex reserves could also impact on credit policy—eg, restrictions on banks for external borrowings. RBI is also the owner of Deposit Guarantee Corporation (DGC), a role rarely performed by any central bank. DGC is expected to look at the functioning of banks from the perspective of depositors and exercise supervisory functions.

In the past, it was argued that for a developing country like India, there is a need to coordinate macroeconomic policy-making and that sufficient skills are not available outside RBI to perform some of the specialised functions. With the maturing of our economy and financial markets, it is time consideration is given to some of these issues. Many countries have already started moving in the direction of not burdening the monetary authority wit other functions.

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