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Monetary policy demystified…

Mar 9, 2005

Apart from the Union Budget, another ‘event’ that has a lasting impact on the economy is the RBI’s monetary policy. Declared semi-annually (i.e. March and September), the monetary policy takes stock of the economy’s liquidity and inflationary conditions and employs the necessary tools to revive it. In its conduct of monetary policy, the central bank responds to the evolving economic activity within an articulated monetary policy framework.Objectives of the monetary policy
Traditionally RBI has pursued the twin objectives of price stability and growth. The objectives of the monetary policy have thus evolved as those of maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy. While maintaining a judicious balance between price stability and economic growth, the relative emphasis between the two is governed by the prevailing circumstances at a particular time. Apart from these two important goals, there has been a conscious attempt, on the part of RBI in recent years, to maintain orderly conditions in the foreign exchange market and curb destabilizing and self-fulfilling speculative activities. This has assumed strategic importance for the sustainability of the external sector in the face of growing cross border capital flows into the economy.

Instruments of monetary policy
The instruments can be broadly classified into direct and indirect ones. Typically, direct instruments include cash reserve (CRR) and/or statutory liquidity ratios (SLR), directed credit and administered interest rates. The indirect instruments generally operate through repurchase (repos) and outright transactions in government securities (open market operations). The reforms in the financial sectors have enabled RBI to expand the array of instruments at its command. While the prime target of monetary policy continues to be banks’ reserves, the use of the same is sought to be de-emphasized and the liquidity management in the system is being increasingly undertaken through open market operations (OMO), both outright and repos.

The CRR and SLR rates that peaked in the early 90’s have now been considerably relaxed with the RBI adopting other measures for controlling money supply. This has translated into better liquidity for the banking sector.

The following is a brief explanation of each of the aforementioned instruments:

CRR/SLR: Cash reserve ratio (CRR) determines the level of cash banks need to hold against their net demand and time liabilities. Similarly, statutory liquidity ratio (SLR) requires banks to maintain a part of their liabilities in the form of liquid assets (e.g. government securities).

Bank rate: Bank rate is the rate at which RBI lends to the banking entities to meet their liquidity requirements.

Interest rates: Credit and interest rate directives take the form of prescribed targets for allocation of credit to preferred sectors or industries and prescription of deposit and lending rates.

OMO and LAF: Liquidity management in the system is carried out through open market operations (OMO) in the form of outright purchases or sales of government securities and daily repo and reverse repo operations under Liquidity Adjustment Facility (LAF).

Market Stabilisation Scheme (MSS): The liquidity impact of large inflows was managed till the year FY04 largely through the day-to-day LAF and OMO. In the process, the stock of government securities available with RBI declined progressively and the burden of sterilisation (sucking out excess liquidity) increasingly fell on LAF operations. In order to address these issues, the Reserve Bank in March 2004 signed a memorandum of understanding with the Government of India for issuance of treasury bills and dated government securities under the MSS. The intention of MSS was essentially to ensure liquidity absorption of a more enduring nature by way of sterilisation against the day-to-day normal liquidity management operations.

Recent measures
In a bid to tame the runaway inflation, RBI increased the CRR in September 2004 from 4.5% to 5%. The central bank’s sudden move was to suck around Rs 70 bn out of the banking system. Besides, RBI also cut the interest rate that it pays to banks on the cash balances from 6% to 3.5%. This was to discourage banks from parking additional funds with RBI and thereby lend more. With the revival in credit demand and inflation under control, it is unlikely that RBI will hike the CRR rates any further. This is in tune with the central bank’s reiteration from time to time that it would continue to pursue its medium-term objective of reducing CRR to its statutory minimum of 3%, while retaining the option of tinkering with it as and when required, to manage liquidity.

Way ahead
The recent budget measures to allow higher autonomy to RBI, to remove the CRR and SLR caps, will also equip the apex bank with more authority to channelise the excess funds in the economy to more productive directions. Besides, allowing the apex bank to undertake repo and reverse repo operations will further stabilize money market operations.

The monetary policy has not only to be forward looking but also grapple with an uncertain future. Additional complexities are likely to arise in case of an emerging market like India, which is transiting from a relatively closed to a progressively open economy. In an environment of increasing capital inflows, narrowing cross-border interest rate differentials (eg. Fed rates vis a vis Indian G-Sec rates) and surplus liquidity conditions, exchange rate movement tend to have linkages with interest rate movements. The challenge of the monetary authority (i.e. RBI) is to balance the various choices into a coherent whole and to formulate a policy that can best facilitate the country’s economic objectives.

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