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Monetary Policy and You - Outside View by Arvind Chari
Monetary Policy and You

The Reserve Bank of India (RBI), India's Central Bank, meets every two months (in what is now termed as the Bi-Monthly Monetary Policy Meeting - changed from once every 45 days ) to decide on the level of interest rates suitable to target a particular level of inflation in the economy; to regulate the supply of money and credit in the system to achieve the targeted growth; and to effect structural and technical changes in the banking system.

Any monetary and credit policy measure introduced by altering the cost of money (interest rates) and/or by regulating the money flow in the system thus impacts everyone in the country. There are a lot of expectations that gets built up in anticipation of a policy change and market prices start aligning to this eventuality. Market participants and the media, especially the pink press, are agog with discussions on the nature and tools of the policy measure and the extent to which it would be used.

In its most recent monetary policy, announced on 1st April 2014, the RBI kept all interest rates unchanged. It thus retained the Repo rate @ 8% after having raised it by 25 bps (0.25%) each in 3 of its last 4 meetings. The market participants had anticipated the 'pause' and thus were not surprised by the RBI action. This though was against the experience of the prior meetings; where the RBI under the new governor, Dr. Raghuram Rajan had surprised the markets with its rate actions.

But generally, institutional investors like us and Corporate treasuries tend to be more aware of the macro environment and implement suitable mechanisms to insulate themselves or take advantage of the probable monetary policy actions. But the common man on the street, who is equally affected by the Central Bank's actions, might not have the awareness or even an access to suitable products to safeguard himself.

Through this article, we outline the reasons for the central banks' actions, the key macro indicators/ trends to follow and attempt to address whether a common man can pre-empt the monetary policy action and structure his investments and/or borrowings accordingly.

To start off with, one would need to know the various monetary and credit policy tools available with the RBI. Broadly, the central bank uses the following tools to achieve its stated objectives -

    A. To signal the level of Interest Rates -

    • Repo Rate - It is the rate at which banks borrow from the RBI. An increase in the rate would signal a higher cost of funds for banks and thus for all borrowers. Over time, a continued increase in the Repo rate would lead to an increase in the interest rates on fixed deposit as well as on loan products. And vice versa. So, the higher the rate, the higher would be the general level of interest rates. The Repo rate is usually hiked as a response to rising inflation and to curb inflation expectations. The Repo rate would be cut

      • Reverse Repo Rate - It is the rate at which the banks lend to the central bank. This rate acts as a floor for interest rates as the RBI itself is ready to borrow at this rate.. The Reverse Repo rate is now set at 100 bps (1%) below the Repo rate. As the Repo rate is changed, the reverse repo rate automatically changes.

      • Marginal Standing Facility (MSF) - The MSF rate is set at 100 bps (1%) above the Repo rate. It is viewed as a penal rate and is used by banks when fund availability is tight and demand for funds increases thus forcing them to borrow at the higher rate from the RBI.

      The current Repo rate is 8% and hence the Reverse Repo rate is 7% and MSF is 9%.

      In the current context, the RBI thus uses only the Repo rate to signal changes in its monetary policy. But as we show in the table below; there are certain rare instances where they also have the ability to use the Reverse Repo and MSF to signal their stance.

    B. To control liquidity; credit flow and money supply in the economy -
    • Cash Reserve Ratio (CRR) - It is the amount of money (as a % of net deposits) the banks need to maintain as a reserve with the central bank. If the RBI intends to reduce the amount of money in the banking system (tighten liquidity) it would increase the CRR and vice versa. A higher CRR rate would mean that banks have lesser money to lend. The CRR is currently at 4%

    • Statutory Liquidity Ratio (SLR) - It is the amount of money (as a % of net deposits) the banks need to maintain by investing in government and state government securities. Banks are mandated currently to invest 23% of its (net deposits) in SLR securities

    • Open Market Operations (OMO) - As banks are the biggest owners of bonds issued by the government (government securities or G-Secs), the RBI would buy G-secs (OMO purchases) from banks to increase the liquidity in the system or sell its stock of G-secs (OMO sales) to suck out excess liquidity from the banking system.
The RBI can of course use many other tools to regulate the credit flow to corporate and individual borrowers like Risk Weights & Provisioning Norms but to avoid complication we would avoid discussing them.

Dr. Rajan, the current governor of the Reserve Bank of India, said this on his taking office on September 4th, 2014. The primary role of the central bank, as the Act suggests, is monetary stability, that is, to sustain confidence in the value of the country's money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.

Thus, a Central Bank's primary objective is to contain inflation and manage the expectations of inflation. On any deviation from the desired objectives of low and stable inflation and potential growth rate, the central bank would use the above mentioned tools actively.

The RBI has used most of the above mentioned measures over the past year to achieve its intended objective. The table below describes the key monetary policy measure taken in the last year and its rationale

Table - I - Recent Key Monetary Policy Measures
Date Measure and Extent Reason
Jan-13 CRR Rate CRR Rate Cut by 25 bps to 4.00% Gave liquidity of approx 17,500 cr in the system RBI eases liquidity to allow banks to cut lending rates
Mar-13 Repo Rate Rate cut by 25 bps to 7.50% Inflation fell below 6.0%, which gave RBI chance to cut rates further
May-13 Repo Rate Rate cut by 25 bps to 7.25% Inflation below 5.00%, RBI cut rates further by 25 bps to support growth
Jul-13 MSF Rate MSF Rate hiked by 200 bps from 8.25% to 10.25%
Other Liquidity tightening measures
Hiked rates and tightened liquidity to raise short term rates and curb INR depreciation & INR volatility
Sep-13 Repo Rate MSF Rate Repo Rate hiked by 25 bps to 7.50% MSF Rate cut by 75 bps to 9.50% RBI recalibrates the policy under Dr. Rajan by hiking
Repo rates to counter inflation at the same time cutting MSF rate as INR comes under control 
Oct-13 Repo Rate
MSF Rate
Repo Rate hiked by 25 bps to 7.75%
MSF Rate cut by 75 bps to 8.75%
RBI continues re-calibration.
Jan-14 Repo Rate Repo Rate hiked by 25 bps to 8.00% High Core CPI inflation makes RBI to hike rates further
Apr-14   All Rates were unchanged Inflation coming under RBIs comfort zone & growth still below potential
(Source RBI - 1 bps is 0.01%; or 100 bps is 1%)

Measure Extent Summary
SBI 1 year Deposit Rate Increased from 8.5% in January 2013 to 9% currently Deposit and Lending rates react slowly through a cycle.
SBI Base Lending Rate Cut initially from 9.75%to 9.7% and then raised to 10.0% currently
HDFC Home Loan Rate HDFC Retail Prime Lending rate (RPLR) has increased from 15.5% to 16.75% currently
(Source SBI; Bloomberg ; HDFC)

As seen above, there have been substantial changes in monetary policy, in both directions in the last one year. And evidently, it has also had its impact on market interest rates.

Government bond yields, (10 year maturity) which fell in April &May 2013 to as low as 7% as RBI was cutting rates; rose by more than 2% to trade above 9% by April 2014; as inflation increased and RBI hiked interest rates to manage inflation and currency.

Investors in bond funds in 2013 found out to their shock that investments in fixed income can also be risky as their NAVs tumbled with the sudden rise in bond yields (fall in bond prices)

Deposit and Lending rates though tend to be much stickier than market interest rates. Between January 2013 till April 2014; SBI This does suggest that, for the common man the impact of the monetary policy is not immediate and allows him time to adjust his financial profile.

We believe that the new monetary policy framework being evolved by the RBI under Dr. Rajan of targeting the CPI inflation would simplify the conduct of monetary policy and help investors and the common man plan the impact of monetary policy to a greater extent.

We would discuss in detail on that in our next piece.

Framing the monetary policy is a science but it is not Rocket Science! And through a series of articles on fixed income and macro economy, I intend to enable the retail investor in making more informed decisions.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.

The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view.


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