RBI’s monetary measures to monitor recession
With the world coming out of an economic crisis and India’s inflation rate and rate of interest soaring high, one cannot help but think whether we are heading the same way again. If anything is to be learnt from history, it is that recession in an economy has an oscillatory effect. And anybody can see that the time intervals, between economic slumps, are decreasing.1 In times of crisis and economic volatility, the monetary and credit policy of nations are geared towards steady economic growth instead of economic booms. In essence, the monetary policy regulates the supply of money and the cost and availability of credit in the economy. Also, for precisely such purpose has the Reserve Bank of India (“RBI”) been established in India and given wide powers under the RBI Act, 1934 (“Act”).
This bulletin attempts to look at the various concepts upon which the RBI bases its monetary and credit policies, innovative as well traditional in nature, to maintain economic stability in India. Taking examples from the last critical two years, this article will underscore the notion that the Indian monetary and credit policy is doing well to India.
1.0 Role of the RBI as an Apex Bank
The RBI plays a prominent role in controlling and monitoring the lending rate of scheduled banks2 by fluctuating the cash liquidity available with the commercial banks. The cost of credit is directly proportional to the prices of goods and services in the country. Hence, the RBI through its monetary and credit tools seeks to maintain price stability and economic growth in the economy. Being the apex institution, the RBI monitors, regulates and controls the Indian banking and financial system. The preamble to the RBI states “whereas it is expedient to constitute a RBI to regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.”3
The monetary policy can be either expansionary (followed in deep recession) or contractionary (followed in times of economic boom). It deals with both the lending and borrowing rates of interest for commercial banks by way of several policy
instruments. The RBI through the commercial banks regulates the liquidity for industries as a measure to control prices of goods and services. The monetary policy aims to maintain price stability, full employment and economic growth in the economy. The RBI announces it monetary policy once a year, a mid-course review six months thereafter and quarterly reviews. Now, let us discuss and understand the various monetary and credit policy instruments that the RBI has.
- Monetary and Credit Policy Instruments
In order to limit the adverse impact of the economic crisis on the Indian economy, the RBI, takes a number of measures, both traditional and innovative in nature. The RBI uses multiple instruments such as the Liquidity Adjustment Facility (“LAF”), Open Market Operations (“OMO”), Cash Reserve Ratio (“CRR”) and securities under the Market Stabilization Scheme (“MSS”) to augment the liquidity in the system thereby combating pressure on the economy. These mechanisms are discussed as follows:
- Bank Rate
Bank rate is defined as “the standard rate at which the bank is prepared to buy or rediscount bills of exchange or other commercial paper eligible for purchase under the Act”.4 Whenever the RBI wants to reduce credit, the bank rate is increased and whenever the volume of bank credits is to be expanded, the bank rate is reduced. From the change in the bank rate, the RBI seeks to influence the cost of bank credit. In mid- September 2008, the RBI reduced its bank rate and infused liquidity in the economy in order to minimize the impact of the recession in India. The current bank rate is 6%.5
OMOs are a central bank’s sales and purchases of government bonds. They are usually carried out to keep the market in line with the target interest rate and these are adjusted to meet inflation targets. Another objective on open market operations is to ensure the liquidity of the banking system, so there is an element of short term control of the money supply. The short term liquidity of individual banks is ensured by central bank lending, such as discount window facilities. When open market operations are carried with the intention of injecting money into the economy to stimulate it out of a recession, or just in order to finance government spending by buying an oversupply of government debt, this is called ‘quantitative easing or printing money’.
The government issues treasury bills and/or dated government securities under the MSS in addition to its normal borrowing requirements under OMOs, for absorbing liquidity from the system. These will have all the attributes of existing treasury bills and dated government securities.6 Under the scheme, RBI issues bonds on behalf of the government and the money raised under bonds is impounded in a separate account with RBI. The money does not go into the government account. MSS was introduced by way of an agreement between the government and the RBI in early 2004.
In 2004, Foreign Institutional Investors started bringing in dollars to buy Indian stocks. This resulted in an oversupply of US dollars in the Indian market. RBI thereafter bought dollars, thus creating an equivalent amount of rupees. This dollar buying raised forex reserves and thus there was a liquidity overhang that was caused by the inflow of dollars. Thereafter the government was forced to mop up the rupees by creating the MSS bonds.
- Variable Reserve Requirements
The commercial banks are required to keep a certain percentage of deposits as reserves with the RBI.7 The RBI is legally authorized8 to raise or lower the minimum reserves that the bank must maintain against the total deposits. If the percentage of reserves to be maintained is increased, the commercial banks will be left with less cash and, therefore, they have to decrease their lending and if this limit is reduced, the commercial banks will have more cash with them and they would be able to expand credit. The RBI has a few mechanisms to control the commercial banks’ liquidity. These mechanisms are utilized through the control of Statutory Liquidity Ration (“SLR”) and Cash Reserve Ratio (“CRR”).9 The RBI having regard to the needs of securing monetary stability in the economy can prescribe the CRR for Scheduled Banks10 without any floor or ceiling rate.11 The banks in India are also required to maintain a certain percentage of their Net demand and Time Liabilities (“NDTL”) in cash, gold and certain unencumbered securities which shall be known as SLR securities.12 The current rates of SLR and CRR are 6% and 24% respectively.
- Liquidity Adjustment Facility (“LAF”)
LAF is a facility extended by the RBI to the scheduled commercial banks and primary dealers (underwriters to government securities) to avail of liquidity in case of requirement or park excess funds with the RBI in case of excess liquidity on an overnight basis against the collateral of government securities. Fundamentally, LAF enables liquidity management on a day-to-day basis. The operations of LAF are conducted by way of repurchase agreements with RBI being the counter-party to all the transactions.13 In terms of section 17 (12AB) of the Act, the RBI is allowed to undertake the dealing in repo and reverse repo.
- Selective Credit Control
The RBI has been given the power to control advances granted by the commercial banks.14 The RBI is empowered to determine the policy in relation to advances to be followed by banks generally or by any bank in particular. The RBI has also been authorized under various provisions of the Act to issue directions to banks with regard to advances, the margins to be maintained in respect of secured advances and it can also prescribe the rate of interest and other terms and conditions on which advances may be made.
In a span of seven months between October 2008 and April 2009, there was unprecedented policy activism. For example: (i) the repo rate15 was reduced by 425 basis points to 4.75%, (ii) the reverse repo rate16 was reduced by 275 basis points to 3.25%, (iii) the CRR was reduced by a cumulative 400 basis points to 5.0%, and (iv) the actual/potential provision of primary liquidity was of the order of Rs. 5.6 trillion (10.5% of GDP).17
While India was not immune from the repercussions of the recession but because of adopting the above mentioned mechanisms, it was shielded from its impact to quite an extent. The magnitude of the repercussions felt India can in no way be compared to the likes of nations such as the United States, United Kingdom, Japan and France. One may only infer that, despite being a capitalistic and globalised economy,
the RBI’s monetary and credit policies adopted during the Recession were effective in combating the various constraints on society.
Due to the global nature of an economic crisis on one hand and accelerated trade and financial integration of the Indian economy with the world since the 1990s, the Indian economy is no longer immune from the repercussions of a global economic crisis. The RBI’s monetary and credit policy during the recession and even after, shielded India from the fate of many other nations, United States of America to name one. However, with inflation rates and rate of interest at such a steep incline, the RBI needs to find more innovative and long term strategies to keep its head above the water. Another recession is inevitable, and as Edward de Bono said, “If you cannot accurately predict the future then you must flexibly be prepared to deal with various possible futures.”
This bulletin is prepared by Shiasta Arora and Himanshu Gupta (under the supervision of Neeraj Dubey, Sr. Associate), both final year law students at Amity Law School, Delhi who are pursuing their internships at PSA.
6 Launching of Market Stabilization Scheme by RBI in the Press Release dated February 24, 2004.
7 Section 42 of the Act.
8 Section 42(1A) of the Act.
9 CRR is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method (increase of CRR rate), to drain out the excessive money from the banks.
10 Ibid at 2 above.
11 Section 42(1) of the Act.
12 Section 24 of the Banking Regulation Act, 1949.
13 Scheme of Liquidity Adjustment Facility dated May 30, 2000, Ref. IDMC No 3968 /03.75.00/ 99- 2000.
14 Section 17 of the Banking Regulation Act, 1949.
15 Section 17(12AB)(a) of the Act. Repo rate is the rate at which Indian banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate.
16 Section 17(12AB)(b) of the Act. Reverse Repo rate is the rate at which RBI borrows money from banks. An increase in reverse repo rate can cause the banks to transfer more funds to RBI due to the attractive interest rates which can cause the money to be drawn out of the banking system.
17 Speech by Executive Director, RBI dated February 29, 2010.
http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=470, visited on April 04, 2011.