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Monetary Policy Simplified : Anil Menon

Monetary Policy is formulated and announced by Central Bank of a country. This


policy aims at influencing interest rate. This is a difficult task because the interest
rates should be such that it should be high enough to restrict inflation but at the
same time should not be so high enough as to impede economic growth. In India,
Reserve Bank of India (RBI) has the responsibility of managing three trinity tasks,
which by their very nature, are inherently opposing. These three tasks are capping
inflation expectations, influencing foreign exchange rates and also managing capital
flows. RBI has announced its midyear monetary policy on 2 nd Nov. It has sent some
clear signals, which makes for some interesting analysis. The present article seeks
to simplify & present it in a logical manner.

Q1) When is monetary policy announced in India and what policy rates are normally
announced?

Ans. Traditionally, monetary policy in India is announced every quarter. However


Mr.Subbarao, the present Governor of RBI, has taken a decision to announce it
every six weeks. The key policy rates are the Repo Rate and Reverse Repo Rate,
Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR).

Q2) What is CRR & SLR?

Ans. These are essentially tools used to control Money Supply. All commercial Banks
have to maintain the same as a % of Deposits and can only lend the remaining
balance after meeting these requirements. CRR is maintained by banks as cash
deposits with RBI while SLR is maintained as investments in Govt Securities and
Treasury Bills (Govt. debt). Currently CRR is at 6% and SLR is at 25%, the total
being 31% .

Q3) How does RBI influence interest rates and therefore inflation through CRR &
SLR?

Ans. RBI seeks to control demand side inflation by increasing interest rates. One of
the ways of achieving this increase is by increasing CRR and/or SLR. Consequently
banks will have lower funds for lending and would therefore increase interest rates
on their loans. Similarly, when RBI seeks to decrease interest rates, it could reduce
CRR and/or SLR. Commercial banks would then have more funds to lend and would
thereby reduce their lending rates. It may be noted here that banks investing in
Govt. debt as SLR requirements helps the Govt fund its borrowing program. Also
certain banks invest in Govt debt more than the required SLR may be due to lack of
lending opportunities or their conservative nature. In the current policy, there is no
change in CRR & SLR. Repo rate and Reverse Repo rate has been increased
Q3) What is Repo and Reverse Repo rate?

Ans. Repo essentially stands for Repurchase rate. In a repo transaction, RBI injects
liquidity by agreeing to buy Govt debt from commercial banks. It is called repo as
there is an implicit condition that after a pre specified period, commercial banks are
obligated to repurchase the same bonds from RBI. During repurchase commercial
banks need to repay the principal amount and also an additional interest. This
interest rate is the repo rate. Thus repo rate is the rate at which RBI injects liquidity
into the economy.

Similarly in a Reverse Repo transaction, RBI issues bonds in which commercial


banks invest. Thus liquidity is sucked out from the system for the period of the
Reverse Repo transaction. At the end of the reverse repo, Govt buys back these
bonds. RBI pays interest to the commercial banks for the period of investment. Thus
reverse repo rate is the rate at which RBI sucks out excess liquidity from the
economy.

In the current policy, RBI has raised the repo rate to 6.25% and reverse repo rate to
5.25%. This is a signal by RBI of its intent in moderating inflation expectations,
without affecting economic growth. RBI has also taken some steps in lending
towards real estate assets and in controlling the real estate bubble.

Q4) What is a real estate bubble?

Ans. In a bubble the market prices of goods moves far away from its intrinsic value.
In simplified terms, a bubble is formed when asset prices rise due to speculative
reasons. RBI is worried about the irrational rise in prices of real estate especially in
housing. It has proposed significant tightening regards the teaser loans, (called as
special loans by commercial banks) advanced towards purchase of real estate
assets.

Q5) What are teaser loans?

Ans. These are essentially loans with a low interest rate initially, which increases
subsequently. RBI is worried that there will be higher number of defaults in the later
years as the interest rates on these teaser loans increase. It has therefore raised
the standard provision on teaser loans from the current 0.4% to 2%. Provision being
a reduction from profits, banks would now earn less on the teaser loans.
Commercial banks are thus discouraged from continuing these teaser loans.
Another important announcement is the increase of risk weights for loans above 75
lakhs from 100% to 125%. Banks will have to therefore set aside more capital for
such loans. Thus interest rates on loans above Rs. 75 lakhs is expected to go up.
Apart from higher risk weight and provisions, RBI has also mandated a higher LTV.
Q6) What is LTV?

Ans. LTV is Loan to Value which is essentially the amount of loan towards a
particular asset. LTV is now capped at 80% for real estate assets, so banks can now
lend lower amounts than earlier. This provision has been brought in due to the 10/
90 scheme offered by many builders. In this scheme, buyers have to invest only
10% upfront while the balance 90% is funded by banks. The 10/90 scheme is
therefore expected to be discontinued. RBI is thus clearly aggressive about
containing real estate prices.

Q7) What are the other are other key measures have been announced by RBI?

Ans. RBI has also proposed relaxation in Urban Co-operative Bank (UCB) norms.
UCBs with a minimum net worth of Rs. 50 crores can get multi state status and
extend their areas of operations beyond the sate of registration. RBI has also
permitted sound UCBs to engage business correspondents and facilitators using
information and communication technology (ICT) solutions. This is a clear reversal
of the earlier tougher regulatory requirements mandated by RBI at least for the
better managed UCBs. This reversal can be attributed to RBI’s current drive towards
increasing financial inclusion in India.

Prof Anil Menon interacts with students of MBA in the area of Finance at S.P. Jain
Institute Of Management Studies.