17-01-2013, 02:43 PM
RBI’s MONETARY POLICY- A Detailed Overview
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What is RBI's Monetary Policy?
The Reserve Bank of India will announce its Monetary and Credit Policy for the first half of the financial year 2002-03 on April 29. Even as RBI Governor Bimal Jalan puts the finishing touches to the document, have you ever considered what is the significance of the biannual exercise?
In a world of policies in the financial sector, nothing could get as alien as the Monetary Policy. Terms like M3, CRR, SLR, PLR and OMO would make you think that the typical IT-bug has caught the financial sector. But take a closer look as the Monetary and Credit Policy is crucial to all of us and more so to the banking sector.
For the uninitiated, this policy determines the supply of money in the economy and the rate of interest charged by banks. The policy also contains an economic overview and presents future forecasts.
What is the Monetary Policy?
The Monetary and Credit Policy is the policy statement, traditionally announced twice a year, through which the Reserve Bank of India seeks to ensure price stability for the economy.
These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy.
Besides, the RBI also announces norms for the banking and financial sector and the institutions which are governed by it. These would be banks, financial institutions, non-banking financial institutions, Nidhis and primary dealers (money markets) and dealers in the foreign exchange (forex) market.
When is the Monetary Policy announced?
Historically, the Monetary Policy is announced twice a year - a slack season policy (April-September) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year.
Initially, the Reserve Bank of India announced all its monetary measures twice a year in the Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as RBI reserves its right to alter it from time to time, depending on the state of the economy.
How is the Monetary Policy different from the Fiscal Policy?
Two important tools of macroeconomic policy are Monetary Policy and Fiscal Policy.
The Monetary Policy regulates the supply of money and the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks.
The Monetary Policy aims to maintain price stability, full employment and economic growth.
The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. It can increase or decrease the supply of currency as well as interest rate, carry out open market operations, control credit and vary the reserve requirements.
The Monetary Policy is different from Fiscal Policy as the former brings about a change in the economy by changing money supply and interest rate, whereas fiscal policy is a broader tool with the government.
The Fiscal Policy can be used to overcome recession and control inflation. It may be defined as a deliberate change in government revenue and expenditure to influence the level of national output and prices.
For instance, at the time of recession the government can increase expenditures or cut taxes in order to generate demand.
On the other hand, the government can reduce its expenditures or raise taxes during inflationary times. Fiscal policy aims at changing aggregate demand by suitable changes in government spending and taxes.
The annual Union Budget showcases the government's Fiscal Policy.
What are the objectives of the Monetary Policy?
The objectives are to maintain price stability and ensure adequate flow of credit to the productive sectors of the economy.
Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into. The monetary policy affects the real sector through long and variable periods while the financial markets are also impacted through short-term implications.
What do the terms CRR and SLR mean?
CRR, or cash reserve ratio, refers to a portion of deposits (as cash) which banks have to keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and secondly it enables that RBI control liquidity in the system, and thereby, inflation.
Besides the CRR, banks are required to invest a portion of their deposits in government securities as a part of their statutory liquidity ratio (SLR) requirements.
The government securities (also known as gilt-edged securities or gilts) are bonds issued by the Central government to meet its revenue requirements. Although the bonds are long-term in nature, they are liquid as they can be traded in the secondary market.
Since 1991, as the economy has recovered and sector reforms increased, the CRR has fallen from 15 per cent in March 1991 to 5.5 per cent in December 2001. The SLR has fallen from 38.5 per cent to 25 per cent over the past decade.
What impact does a cut in CRR have on interest rates?
From time to time, RBI prescribes a CRR or the minimum amount of cash that banks have to maintain with it. The CRR is fixed as a percentage of total deposits. As more money chases the same number of borrowers, interest rates come down.
Does a change in SLR and gilts products impact interest rates?
SLR reduction is not so relevant in the present context for two reasons:
First, as part of the reforms process, the government has begun borrowing at market-related rates. Therefore, banks get better interest rates compared to earlier for their statutory investments in government securities.
Second, banks are still the main source of funds for the government.
This means that despite a lower SLR requirement, banks' investment in government securities will go up as government borrowing rises. As a result, bank investment in gilts continues to be high despite the RBI bringing down the minimum SLR to 25 per cent a couple of years ago.