Report of MEE Topic: Monetary Policy of RBI

Submitted By:
Tushar Kathuria(54) Jeso P. James(28) Jatin Kakkar(26) Nishu Singh(37)

Sweta Anand(56) Pritha(40)

Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest. Monetary policy is usually used to attain a set of objectives oriented towards the growth and stability of the economy. These goals usually include stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy rapidly, and a contractionary policy decreases the total money supply or increases it only slowly. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation. The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements

has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets. A central bank can only operate a truly independent monetary policy when the exchange rate is floating. If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile. Accordingly, the management of the exchange rate will influence domestic monetary conditions. To maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate.

Monetary policy tools

Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard

currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base.
Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.
Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.
Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the

total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool open market operations; one must choose which one to control. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.
Currency board

A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are three-fold: 1. To import monetary credibility of the anchor nation; 2. To maintain a fixed exchange rate with the anchor nation; 3. To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization).

WHAT ARE THE INSTRUMENTS OF MONETARY POLICY?

Fiduciary or paper money is issued by the Central Bank on the basis of computation of estimated demand for cash. Monetary policy guides the Central Banks supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income. This is necessary because money is a medium of exchange and changes in its demand relative to supply, necessitate spending adjustments. To conduct monetary policy, some monetary variables which the Central Bank controls are adjusted-a monetary aggregate, an interest rate or the exchange rate-in order to affect the goals which it does not control. The instruments of monetary policy used by the Central Bank depend on the level of development of the economy, especially its financial sector. The commonly used instruments are discussed below. Reserve Requirement: The Central Bank may require Deposit Money Banks to hold a fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it. Fractional reserve limits the amount of loans banks can make to the domestic economy and thus limit the supply of money. The assumption is that Deposit Money Banks generally maintain a stable relationship between their reserve holdings and the amount of credit they extend to the public. Open Market Operations: The Central Bank buys or sells (on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and nonbanking public (that is in the open market). One such security is Treasury Bills. When the Central Bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money. Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit Money Banks, thus affecting the level of reserves and hence the monetary base. Interest Rate: The Central Bank lends to financially sound Deposit Money Banks at a most favourable rate of interest, called the minimum rediscount rate (MRR). The MRR sets the floor for the interest rate regime in the money market (the nominal anchor rate) and thereby affects the supply of credit, the supply of savings (which affects the supply of reserves and monetary aggregate) and the supply of investment (which affects full employment and GDP). Direct Credit Control: The Central Bank can direct

Deposit Money Banks on the maximum percentage or amount of loans (credit ceilings) to different economic sectors or activities, interest rate caps, liquid asset ratio and issue credit guarantee to preferred loans. In this way the available savings is allocated and investment directed in particular directions. Moral Suasion: The Central Bank issues licenses or operating permit to Deposit Money Banks and also regulates the operation of the banking system. It can, from this advantage, persuade banks to follow certain paths such as credit restraint or expansion, increased savings mobilization and promotion of exports through financial support, which otherwise they may not do, on the basis of their risk/return assessment. Prudential Guidelines: Deposit The Central Bank may in writing require the

Money Banks to exercise particular care in their operations in order that specified outcomes are realized. Key elements of prudential guidelines remove some discretion from bank management and replace it with rules in decision making. Exchange Rate: The balance of payments can be in deficit or in surplus and each of these affect the monetary base, and hence the money supply in one direction or the other. By selling or buying foreign exchange, the Central Bank ensures that the exchange rate is at levels that do not affect domestic money supply in undesired direction, through the balance of payments and the real 3 exchange rate. The real exchange rate when misaligned affects the current account balance because of its impact on external competitiveness. Moral suasion and prudential guidelines are direct supervision or qualitative instruments. The others are quantitative instruments because they have numerical benchmarks.

How RBI policy impacts interest rates

The Reserve Bank of India (RBI), which is India's central bank and the bank, is one of the most important players in the Indian economy and financial markets. It is in charge of monetary policy which has a big impact on liquidity and interest rates in the financial system. Let's look at some of the basics of monetary policy and how it impacts the average investor. The RBI has several goals of which controlling inflation is one of the most important. When inflation is rising and threatening to spin out of control, as it is today, the RBI 'tightens' monetary policy which means reducing the amount of liquidity (floating money) in the economy. Though the RBI's policies may take up to a year to show their full effect they are perhaps the most effective way of reducing inflation. How the RBI conducts monetary policy The RBI has several tools for conducting monetary policy: two of the most important are the cash reserve ratio (CRR) and the liquidity adjustment facility (LAF). The CRR is the proportion of their deposits which banks have to keep with the RBI. Raising the CRR is one of the most effective ways for the RBI to suck liquidity out of the financial system which reduces demand in the economy and therefore helps curb inflation. Thus recently the RBI raised the CRR from 7.5 per cent to 8 per cent which sucked Rs 18,000 crores out of the banking system.

The LAF can be thought of as a way for the RBI to lend and borrow to banks for very short periods, typically just a day. The repo rate is the RBI's lending rate and reverse repo rate is the RBI's borrowing rate. These two rates help the RBI influence short-term interest rates in the rest of the financial system. Currently the RBI has left the repo/reverse repo rates untouched but if inflationary pressures remain strong it may be forced to increase them. Impact on interest rates What impact does monetary policy have on the different interest rates in the economy like the home loan rate? The RBI doesn't directly control these interest rates but in general a tighter monetary policy leads to higher interest rates. This relationship isn't iron-clad though, and major banks like SBI and ICICI have stated the recent CRR hike wouldn't necessarily lead to higher interest rates. However if the RBI continues to tighten policy further by raising the CRR again or raising the repo/reverse repo rates, it's possible that banks will respond by raising interest rates on various loans including home loans. Impact on stock markets If you watch investment channels or read business papers, you will know that the financial markets pay obsessive attention to the actions of the RBI. This is with good reason since any changes in monetary policy has an immediate impact on financial markets. In general a tighter policy will hurt investor sentiment and stock prices. There will be less liquidity floating around and higher interest rates will raise the cost of capital for companies hurting their bottom lines and stock prices. Companies which have high levels of debt are especially vulnerable.

A tighter policy will harm some sectors like banking and real estate more than others. For example banks don't earn interest on the reserves they keep with the RBI; therefore an increase in the CRR immediately hurts their bottom line. Similarly if tighter policy leads to higher interest rates, this will reduce demand for housing as home loans become more expensive. Impact on exchange rates The RBI's monetary policy will also have an impact on exchange rates. In particular if Indian interest rates rise because of tighter policy, the demand for Indian interest-paying assets will also rise, leading to an increase in the value of the rupee. This helps with inflation since imports will now be cheaper in rupee terms. For example if the price of oil is $100 per barrel and the rupee rises in value from Rs 45 to Rs 42 per dollar, the rupee price of a barrel of oil will fall from Rs 4,500 to Rs 4,200. On the flip side, the rising rupee will have a negative impact on exportoriented companies; for example major IT stocks which have done quite well recently may fall.

RBI Annual Monetary Policy 2010-11 An Update In its annual monetary policy review for 2010-11, RBI increased its policy rates.

Repo rate and Reverse repo rate increased by 25 bps to 5.25% and 3.75% respectively, with immediate effect. Impact: Repo is the rate at which banks borrow from RBI and Reverse Repo is the rate at which banks deploy their surplus funds with RBI. Both these rates are used by financial system for overnight lending and borrowing purposes. An increase in these policy rates imply borrowing and lending costs for banks would increase and this should lead to overall increase in interest rates like credit, deposit etc. The higher interest rates will in turn lead to lower demand and thereby lower inflation. The move was in line with market expectations

Cash reserve ratio (CRR) increased by 25 bps to 6.00%, to apply from fortnight beginning from 24 April 2010. Impact: When banks raise demand and time deposits, they are required to keep a certain percent with RBI. This percent is called CRR. An increase in CRR implies banks would be required to keep higher percentage of fresh deposits with RBI. This will lead to lower liquidity in the system. Higher liquidity leads to asset price inflation and also leads to build up of inflationary expectations. Before the policy, market participants were divided over CRR. Some felt CRR should not be raised as liquidity would be needed to manage the government borrowing program, 3-G auctions and credit growth. Others felt CRR should be increased to check excess liquidity into the system which was feeding into asset price inflation and general inflationary expectations. Some in the second group even advocated a 50 bps hike in CRR.

By increasing the rate by 25 bps, RBI has signaled that though it wants to tighten liquidity it also wants to keep ample liquidity to meet the outflows. Governors statement added that in 2010-11, despite lower budgeted borrowings, fresh issuance will be around Rs 342300 cr compared to Rs 251000 cr last year. RBIs Domestic Outlook for 2010-11 Table 1: RBIs Indicative Projections (All Fig In %, YoY) 2009-10 targets 10 Policy) GDP 7.5 2009-10 (JanActual Numbers Expected 7.2 by CSO Inflation (based on8.5 WPI, end) Money (March end) Credit (March end) 16 Deposit end) Source: RBI (March17 17 17.1 20 18 Supply16.5 17.3 17 for March 9.9 2010-11 targets 10 Policy) at8 with an (Apr

upward bias 5.5

Growth: RBI revised its growth forecast upwards for 2010-11 at 8% with an upward bias compared to 2009-10 figures of 7.5%. It said Indian economy is firmly on the recovery path. RBIs business outlook survey shows corporate are optimistic over the business environment. Growth

in industrial sector and services has picked up in second half of 2009-10 and is expected to continue. The exports and import sector has also registered a strong growth. It is important to note that RBI has placed the growth under the assumption of a normal monsoon. India could have achieved a near 8% growth in 2009-10 itself, if monsoons were better. Table 2 looks at growth forecasts of Indian economy for 2010-11 by various agencies.

Table 2:Projections of GDP Growth by various agencies for 2010-11 (in %, YoY) 2009-10 RBI 7.5 with 2010-11 an8 with an upward bias 8.2

upward bias PMs Economic Advisory7.2 Council Ministry of Finance IMF 7.2 6.7

8.5 (+/- 0.25) 8 8.2 7.3 8.5

Asian Development Bank 7.2 OECD RBIs Survey 6.1 of7.2

Professional Forecasters

Inflation: RBIs inflation projection for March 11 is at 5.5% compared to FY March-10 estimate of 8.5% with an upward bias (the final figure was at 9.9%). RBI said inflation is no longer driven by supply side factors alone. First WPI non-food manufactured products (weight: 52.2 per cent)

inflation, increased sharply from (-) 0.4%in November 2009, to 4.7% in March 2010. Fuel price inflation also surged from (-) 0.7 per cent in November 2009 to 12.7% in March 2010. Further, contribution of nonfood items to overall WPI inflation, which was negative at (-) 0.4% in November 2009 rose sharply to 53.3% by March 2010. So, overall demand pressures on inflation are also beginning to show signs. These movements were visible in March 2010 itself, pushing RBI to increase rates before the official policy in April 2010.

Monetary Aggregates: RBI has increased the projections of all three monetary aggregates for 2010-11. These projections have been made consistent with higher expected growth in 2010-11. Higher growth will lead to more demand for credit. Then management of government borrowing program will remain a challenge as well. High growth coupled with the borrowing program will need higher financial resources. Therefore, projections for money supply, credit and deposit are raised to 17%, 20% and 18% respectively. However, higher growth in money supply would also lead to build up of higher inflation and inflationary expectations. Let us understand what M1 and M3 mean. There are various measures to calculate money supply. Each measure can be classified by placing it along a spectrum between narrow and broad monetary aggregates. Narrow money includes most acceptable and liquid forms of payment like currency and bank demand deposits. Broad money includes narrow money and other kinds of bank deposits like time deposits, post office savings account etc. These different types of money are typically classified as Ms. the number of Ms usually range from M0 (narrowest) to M3 (broadest) but which Ms are actually used depends on the system. There are four Ms in India:

M1: Currency with the public + Demand Deposits + Other deposits with the RBI. M2: M1 + Savings deposits with Post office savings banks. M3: M1+ Time deposits with the banking system M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).

o o o

Growth in M3 is higher than M1 from April- November 2009. From Dec2009 onwards, the growth rate in M1 is higher than M3. The difference in M1 and M3 comes from the growth rate in time and demand deposits. Growth in Time deposits is higher than demand deposits between AprilNovember 2009. From December 2009, onwards growth in demand deposits picks up. This in turn reflects in differences in growth rate of M1 and M3. The growth rate in currency is volatile. It declines 15% in August 2009 and then again increases to 17.9% in December 2009. It then declines to 15.6% in March 2010. Hence, the difference between M1 and M3 comes from surge in growth of demand deposits and decline in growth of time deposits. So, this just confirmed what Kohli said. She added this could be interpreted in two ways. First, spending on consumption and production is increasing as economy has recovered from recession. Second, it could be people are spending now as they expect higher inflation in future. Higher inflation in future could also lead to higher returns on assets and property in future; therefore people prefer to spend now. It will be interesting to watch trends in M1 and M3 from now on as well. RBI also outlined downside risks with its projections:

First, there is still substantial uncertainty about the pace and shape of global recovery Second, if the global recovery does gain momentum, commodity and energy prices, which have been on the rise during the last one year, may harden further. This could put upwards pressure on inflation

Third, monsoon will continue to play a vital role both from domestic demand and inflation perspective. Fourth, policies in advanced economies are likely to remain highly expansionary. High liquidity in global markets coupled with higher growth in emerging economies foreign capital flows are expected to remain higher. This will put pressure on exchange rate policy. RBI usually does not comment on its exchange rate policy. As the economic situation is exceptional, RBI also commented on Indias exchange rate policy.

Our exchange rate policy is not guided by a fixed or pre-announced target or band. Our policy has been to retain the flexibility to intervene in the market to manage excessive volatility and disruptions to the macroeconomic situation. Recent experience has underscored the issue of large and often volatile capital flows influencing exchange rate movements against the grain of economic fundamentals and current account balances. There is, therefore, a need to be vigilant against the build-up of sharp and volatile exchange rate movements and its potentially harmful impact on the real economy. Policy Stance The policy stance remains unchanged from January 2010 policy. Table 3: Comparing RBIs Policy Stance October 2009 Policy

January 2010 Policy

April 2010 Policy

Watch

inflation

Anchor

inflation

Anchor

inflation

trend respond

and

be to

expectations, while prepared respond appropriately, swiftly effectively inflationary pressures.

expectations, while being prepared to respond appropriately, swiftly and to effectively inflationary pressures. Actively manage liquidity to ensure that the growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way.

prepared and effectively

being to

swiftly

Monitor liquidity to meet demands while stability credit of securing

and to

further build-up of

productive sectors price and financial

further build-up of

Actively

manage

Maintain monetary and interest rate regime consistent with price and financial stability, and supportive of the process

liquidity to ensure that the growth in demand for credit by both the private and public sectors is satisfied in a non-disruptive way. Maintain interest an rate

growth

Maintain interest regime and stability.

an rate consistent financial

regime consistent with price, output and stability. financial

with price, output

Source: RBI Summary: Given the economic outlook, policy ahead is going to remain challenging. There are many trade-offs RBI has to manage. It needs to manage

high inflation without impacting the growth process. The recent inflation numbers show rising demand side pressures on inflation. The market participants are already looking at an increase of around 100-150 bps by March 2011 end. The higher interest rates would make it difficult to manage the government borrowing program and also invite more capital flows. High interest rates could also lead to higher lending costs for the corporate sector. The challenges are not limited to domestic factors alone. The concerns remain on future outlook of advanced economies which complicates the policy process further. Other Development and Regulatory Policies In its Annual (in April) and Mid-term review (in October) of monetary policy, RBI also covers developments and proposed policy changes in financial system. Some of the developments announced in this policy are: New Products/Changes in guidelines

Currently, Interest rate futures contract is for 10 year security. RBI has proposed to introduce Interest rate futures for 2 year and 5 year maturities as well.

RBI has permitted recognized stock exchanges to introduce plain vanilla currency options on spot US Dollar/Rupee exchange rate for residents Final guidelines for regulation of non- convertible debentures of maturity less than one year by end-June 2010 RBI had proposed to introduce plain vanilla Credit Default Swaps in October 2009 policy. RBI would place a draft report on the same by endJuly 2010

Earlier, banks could hold infrastructure bonds in either held for trading or available for sale category. This was subject to mark to market

requirements. However, most banks hold these bonds for a long period and are not traded. From now on, banks can classify such investments having a minimum maturity of seven years under held to maturity category. This should lead banks to buy higher amount of infrastructure bonds and push infrastructure activity.

The activity in Commercial Papers and Certificates of deposit market is high but there is little transparency. FIMMDA has been asked to develop a reporting platform for Commercial Papers and Certificates of deposit.

Setting up New Banks

Finance Minister, in his budget speech on February 26, 2010 announced that RBI was considering giving some additional banking licenses to private sector players. NBFCs could also be considered, if they meet the Reserve Banks eligibility criteria. In line with the above announcement, RBI has decided to prepare a discussion paper on the issues by end-July 2010 for wider comments and feedback.

In 2004 seeing the financial health of urban cooperative banks, it was decided not to set up any new UCBs. Since then the performance of these banks has improved. It has been decided to set up a committee to study whether licences for opening new UCBS can be done.

In February 2005, the Reserve Bank had released the roadmap for presence of foreign banks in India. The roadmap laid out a two-phase, gradualist approach to increase presence of foreign banks in India. The first phase was between the period March 2005 March 2009, and the second phase after a review of the experience gained in the first phase. In the first phase, foreign banks wishing to establish presence in India for the first time could either choose to operate through branch presence or set up a 100% wholly-owned subsidiary (WOS), following the one-mode presence criterion. Foreign banks already operating in India were also allowed to convert their existing branches to WOS while

following the one-mode presence criterion. However, because of the global crisis the second phase which was due in April 2009 could not be started. The global financial crisis has also thrown some lessons for policymakers. Drawing these lessons RBI would put up a discussion paper on the mode of presence of foreign banks through branch or WOS by September 2010.

First

quarterly

review

of

monetary policy 2010-11

RBI Governor, Dr D V Subbarao announced the first quarterly review of monetary policy today. The measures taken were quite on the expected Benchmark Repo rates hiked by 25 bps to 5.75% with immediate effect. Benchmark Reverse Repo rates hiked by 50 bps to 4.50% with immediate effect. The interest rate corridor between the Repo and Reverse Repo window reduced to 125 bps from 150 bps. CRR, SLR and Bank rate kept unchanged at 6%, 25% and 6%, respectively. Baseline inflation projection for March 2010 increased to 6% from 5.5%. Baseline estimate for GDP growth for 2010-11 revised to 8.5% from 8%. Bank deposit growth target of 18% maintained for FY2010-11; Bank deposit growth stood at 15.0% year-on-year as on July 2, 2010. Bank credit growth target of 20% maintained for FY2010-11; Bank credit growth stood at 22.3% year-on-year as on July 2, 2010. RBI to undertake mid-quarter policy reviews starting September 2010.

Impact of monetary policy

As expected, RBI has raised the policy rates. This is the fourth rate hike since March this year raising the Repo by a total of 100 bps and Reverse

Repo by 125 bps. Moving differently from earlier moves, the quantum of change in the policy rates; repo and reverse repo is different. The Liquidity Adjustment Facility (LAF) corridor has been shrunk to 125 bps, a change first time since November2008. What this means? Short term interest rates, particularly, interbank repo market rates hover in between the LAF corridor in order to prevent arbitrage opportunities for the banks. Because of tight liquidity conditions, short term rates have been quite volatile. This measure is aimed at containing this volatility in the rates.

Since end-May, banks have been borrowing from RBI through its LAF Repo window. Out of four rate hikes since March, two were affected when there was ample liquidity in the system. But the last two have come at a time when the liquidity conditions have tightened. Thus interest cost of banks will go up. Assuming that banks will borrow about Rs 50,000 cr for the year as whole from Repo, the combined effect of the last two hikes will shave off about Rs 250 cr from banking sectors profits.

What would also hurt bankss profitability is that deposit rates have also risen. Thus lending rates, in general will go up in order to protect net interest margin (NIM).

Inflationary expectations have driven RBI to raise the rates. Policy stance of RBI has shifted to to containing inflation and anchoring inflationary expectations. RBI has noted that inflationary expectations have firmed up. Accordingly, RBI has also raised the projection for endMarch 2011 to 6%. RBI has commented that it will continue to take actions to counter inflationary expectation.

Though RBI has not hinted at further rate hikes, but its strong concern for inflation implies that good growth prospect along with continued high inflation will in make it imperative for RBI to increase rates.

RBI Annual Monetary Policy 2011-12 a quick review

Each time you think the hype and dilemmas would be lesser for RBI, each time it increases. April-2011 policy started with another effort to increase transparency at RBI. Till April-2011, RBI announced its monetary policy closed doors with bankers. This was followed by interaction with media in the evening and researchers next day. From Apr-2011, RBI decided to live telecast the policy announcement on TV. The telecast was also streamed live on banks website. This was a great measure as now public knows the policies along with the others attending the meeting. Now coming to the policy. First, RBI has made changes in the operating framework of monetary policy. Earlier it was both reverse and repo rate which changed (along with CRR, SLR depending on the situation). Now, going by Deepak Mohanty report, RBI has decided to adopt a one rate framework with a corridor like seen in other central banks. New framework is

Reverse repo lower than repo by 100 bps. Changes automatically with Repo rate and no more

independent rate. To form bottom of the corridor

Repo rate in the middle becomes the policy rate A new rate called Marginal Standing Facility (MSF) above Repo rate by 100 bps. In this Banks

can borrow overnight up to one per cent of their respective NDTL. This is like the discount rate of Fed which is higher than Fed Funds Rate. To form top of the corridor. Mohanty committee had suggested making bank rate as the top of the corridor. But a new rate has been added. RBI should have given some reason for the same.

Another important thing is banks will not need to take permission for waiver of default from SLR compliance. This is something this blog suggested in Dec-10 (taking insights from behavioral economics)

Weighted call rate becomes the operating target. This means the call rate movement

becomes critical. RBI will try to keep it closer to Repo and in the corridor.

Based on this, policy rates have changed to:

Repo rates increased by 50 bps to 7.25% Rev repo automatically becomes 6.25% MSF to be operational from 7 May 2011 at 8.25% Bank rate and CRR unchanged at 6%

RBI has put up a paper to debate deregulation of savings bank rate. As spread between savings deposit and term deposit rates has widened this rate has been increased to 4%. This will hit banks further as now they will have to pay higher interests. Research shows savings deposits at around 12.5 lakh crore on March-2011. This would imply additional cost of Rs 6,250 Cr. The latest profitability numbers are still not out. In Mar-2010, net profits of banks was Rs 57,109 Cr. Based on 2010 figure the impact on banks profits could be around 10-11%. It should be lower as of now as profits must be higher. The Net interest margins will be affected as well. The basis of the hike is based on purely inflation concerns. The statement notes how inflation has been so persistent and always higher than RBI projections. Inflation control forms the theme of the RBI stance. RBI even says if growth is lower on a short-term because of inflation control measures let it be: Over the long run, high inflation is inimical to sustained growth as it harms investment by creating uncertainty. Current elevated rates of inflation pose significant risks to future growth. Bringing them down, therefore, even at the cost of some growth in the short-run, should take precedence. I never really understood the statements made by even noted names - one has to tolerate high inflation for high growth. It was plain silly. The fact is low inflation is one of the most important factors for high sustained growth. In 2003-08 high growth period, average headline inflation was 5.30% and core was 5.00%. This made high growth possible. If inflation then had ran to around 10%, 9% growth would have been not possible. The statement takes Gokarns highly useful speech forward. He showed there is a threshold inflation level for economies and if inflation higher than it, growth gets affected. This threshold inflation around 5-5.5% and current levels almost double this threshold. So, if your growth pushes inflation to 9-10% levels as is the case, growth will be affected via high interest rates and lower investment. Some said you cannot have 9% growth and 2% inflation. Well we are talking about more reasonable 5-5.5% inflation. Who is even mentioning 2% when RBIs long-term average inflation is 3%. Subbarao rightly says in his press statement:

Before I close, I want to reiterate what I said earlier, by making a brief comment on the growthinflation trade off, an issue that has been widely debated in the run up to this policy. High and persistent inflation undermines growth by creating uncertainty for investors, and driving up inflation expectations. An environment of price stability is a pre-condition for sustaining growth in the medium-term. Reining in inflation should therefore take precedence even if there are some short-term costs by way of lower growth. I hope that ends the so-called trade-off talks. RBI has also hinted in inflation projections that inflation to remain at 9% till Sep-11 and then trend lower to 6% by mar-11. There is tremendous uncertainty on that outlook given uncertain oil prices, external demand etc. RBIs projections for FY 2011-12:

GDP at 8% inflation at 6% with upward bias by Mar-12 Non-food Credit at 19%, Money growth at 16% and deposit at 17%

The stance of monetary policy of the Reserve Bank will be as follows:

Maintain an interest rate environment that moderates inflation and anchors inflation

expectations.

Foster an environment of price stability that is conducive to sustaining growth in the medium-

term coupled with financial stability

Manage liquidity to ensure that it remains broadly in balance, with neither a large surplus

diluting monetary transmission nor a large deficit choking off fund flows.

RBI also says meeting fiscal targets look difficult given high food and fuel prices. So monitoring of ficsal targets to be done with vigilance. Also deregulation of oil retail market to be done for better assessment. Overall a much-needed policy. With policy rates even lower than core inflation, 50 bps was the need of the hour. Negative real interest rates in a high growing economy is just a disaster waiting to happen on inflation front. Banks were reluctant to hike deposit and credit rates saying 25 bps rate hike will not lead to any changes. So RBI has gone tougher. This should lead to tighter monetary policy and better transmission.

Other than this there are some measures to improve the financial market infrastructure as it is given in annual and mid-term reviews. Some important ones:

Measures taken to improve banking sector resilience. Provisions enhanced for NPAs of banks.

This to hit banks further.

Banks investing in debt oriented MFs leading to circular flow of funds. This investment capped to

10% of banks net worth. Aggregate banks net worth around 5 lakh crore. So net investment in debt mutual funds at 50,000 Cr. RBI explains:

The liquid schemes continue to rely heavily on institutional investors such as commercial banks whose redemption requirements are likely to be large and simultaneous. DoMFs, on the other hand, are large lenders in the over-night markets such as collateralised borrowing and lending obligation (CBLO) and market repo, where banks are large borrowers. DoMFs invest heavily in certificates of deposit (CDs) of banks. Such circular flow of funds between banks and DoMFs could lead to systemic risk in times of stress/liquidity crunch.

G-sec trading: to extend the period of short sale of G-sec from the existing five days to a

maximum period of three months.

Financial Inclusion: to allocate at least 25 per cent of the total number of branches to be opened

during a year to unbanked rural (Tier 5 and Tier 6) centres.

Urban Coop banks: to permit scheduled UCBs satisfying certain criteria to provide internet banking facility to their

customers.

to permit well-managed and financially sound UCBs to become members of the negotiated

dealing system M-banking:

to treat mobile-based semi-closed prepaid instruments issued by non-banks on par with other

semi-closed payment instruments and raise the limit from Rs 5,000 to Rs 50,000, subject to certain conditions.