This article would be published in two posts. I’ll try my best not to intimidate you.
Overview:
- RBI, myriad roles, and the instruments used
- Jargon Demistified and their impact
- Prior to liberalization
- Policies, Banks, and You!
Next post:
- Stock Markets and the policies
- Foreign exchange and the Rupee evaluation
- Overview of the Monetary Credit Policy 2006 – 2007
An intro:
RBI is governed by a central board (headed by a Governor) appointed by the Central Government. The current governor of RBI is Dr.Y.Venugopal Reddy (who succeeded Dr. Bimal Jalan on September 6, 2003). RBI has 22 regional offices across India.
Myriad roles:
1) Formulates, implements and monitors the monetary policy, maintaining price stability and ensuring adequate flow of credit to productive sectors, optimum Liquidity in the economy.
2) Prescribes broad parameters of banking operations within which the country's banking and financial system functions.
3) Manages the Foreign Exchange Management Act, 1999, facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.
Related Functions - Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker, owner and operator of the depository (SGL) and exchange (NDS) for government bonds.
Jargon demystfied:
Bank Rate - Bank rate is the minimum rate at which the central bank provides loans to the commercial banks. It is also called the discount rate. Usually, an increase in bank rate results in commercial banks increasing their lending rates. Changes in bank rate affect credit creation by banks through altering the cost of credit.
Cash Reserve Ratio - All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the cash reserve ratio. The current CRR requirement is 8 per cent.
Inflation - Inflation refers to a persistent rise in prices. Simply put, it is a situation of too much money and too few goods. Thus, due to scarcity of goods and the presence of many buyers, the prices are pushed up. The converse of inflation, that is, deflation, is the persistent falling of prices. RBI can reduce the supply of money or increase interest rates to reduce inflation.
Money Supply (M3) - This refers to the total volume of money circulating in the economy, and conventionally comprises currency with the public and demand deposits (current account + savings account) with the public.
The RBI has adopted four concepts of measuring money supply. The first one is M1, which equals the sum of currency with the public, demand deposits with the public and other deposits with the public. Simply put M1 includes all coins and notes in circulation, and personal current accounts.
The second, M2, is a measure of money, supply, including M1, plus personal deposit accounts - plus government deposits and deposits in currencies other than rupee.
The third concept M3 or the broad money concept, as it is also known, is quite popular. M3 includes net time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1.
Statutory Liquidity Ratio - Banks in India are required to maintain 25 per cent of their demand and time liabilities in government securities and certain approved securities.
These are collectively known as SLR securities. The buying and selling of these securities laid the foundations of the 1992 Harshad Mehta scam.
Repo - A repurchase agreement or ready forward deal is a secured short-term (usually 15 days) loan by one bank to another against government securities.
Legally, the borrower sells the securities to the lending bank for cash, with the stipulation that at the end of the borrowing term, it will buy back the securities at a slightly higher price, the difference in price representing the interest.
Open Market Operations - An important instrument of credit control, the Reserve Bank of India purchases and sells securities in open market operations.
In times of inflation, RBI sells securities to mop up the excess money in the market. Similarly, to increase the supply of money, RBI purchases securities.
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.
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.
There are four main 'channels' which the RBI looks at:
1) Quantum channel: money supply and credit (affects real output and price level through changes in reserves money, money supply and credit aggregates).
2) Interest rate channel.
3) Exchange rate channel (linked to the currency).
4) Asset price.
In recent years, the policy had gained in importance due to announcements in the interest rates.
Earlier, depending on the rates announced by the RBI, the interest costs of banks would immediately either increase or decrease.
A reduction in interest rates would force banks to lower their lending rates and borrowing rates. So if you want to place a deposit with a bank or take a loan, it would offer it at a lower rate of interest.
On the other hand, if there were to be an increase in interest rates, banks would immediately increase their lending and borrowing rates. Since the rates of interest affect the borrowing costs of corporates and as a result, their bottomlines (profits), the monetary policy is very important to them also.
Since the financial sector reforms commenced, the RBI has moved towards a market-determined interest rate scenario. This means that banks are free to decide on interest rates on term deposits and loans. Being the central bank, however, the RBI would have a say and determine direction on interest rates as it is an important tool to control inflation.
The bank rate is a tool used by RBI for this purpose as it refinances banks at the this rate. In other words, the bank rate is the rate at which banks borrow from the RBI.
….. to be continued in the next post, get ready for RBI fundae, phase 2.
Sources: http://sify.com/finance/fullstory.php?id=14186963, http://en.wikipedia.org/wiki/Reserve_Bank_of_India , rediff and others
- Swap
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