RBI CREDIT CONTROL POLICY (ASSIGNMENT 4) Inflation control at the cost of growth seems to be message being sent by the

RBI in the first quarter review of Monetary Policy for 2008-09. Reserve Bank of India has hiked key rates in order to curb credit growth and has simultaneously lowered its expectation of GDP growth rate. Banks have been sounded off on the merits of good quality credit. The Reserve Bank of India announced its first quarter review of the Monetary Policy for 2008-09, and there is no good news. Inflation figures are looking higher than ever and the central bank announced an extremely hawkish policy to control the spiraling prices, and ready to forsake growth in the process. Highlights : RBI hikes repo rate by 50 bps; CRR by 25 bps | Interest rates may rise as RBI tightens monetary policy | 'RBI measures to contain inflation' The central bank has kept the Bank Rate and reverse repo rate unchanged, but has hiked the repo rate by 50 basis points, from 8.5 per cent to 9 per cent. The Cash Reserve Ratio (CRR) has been increased by 25 basis points to 9 per cent with effect from August 30, 2008. CRR has touched 9 per cent for the first time since 2000. While expressing alarm at the double-digit inflation, RBI has given the impression that it will not come down anytime soon. It has projected a realistic inflation rate of 7 per cent by March 2009. However, the GDP growth rate has been revised downwards as well. The expectation now stands at 8 per cent for FY09 as against 8-8.5 per cent as announced in the Annual Policy in April, earlier this year. Auto shares slump after RBI policy | RBI trims GDP growth rate to 8% | Housing, consumer loans to become costlier Severe targets have been set for growth in money supply. While the target for M3 is 17 per cent, credit growth has been set a target of 20 per cent and deposit growth of 17.5 per cent. Strictures for banks Simultaneously, commercial banks have been given strict instructions about the quality and quantity of credit. Banks have been asked to review their long-

term business strategies, which should not only be viable, but focus on credit quality as well. RBI would like to review these strategies from time to time, it said. The central bank has given a word of caution, said T S Narayanasami, CMD, Bank of India. What is CRR? | What is repo rate? It appears that banks have been sounded off on the perils of credit expansion. The central bank has kept in mind the worsening trade deficit and growing concerns over fiscal deficit, before setting these targets. With a more than expected slowdown in industrial and service sector growth, RBI wants to make demand control its goal, therefore credit growth must be moderate. This is evident from the first quarter policy review. There is pressure on banks to increase lending rates, according to M D Mallya, Chairman and Managing Director, Bank of Baroda. Most banks have already been increasing their deposit rates over the past few months; now there is a likelihood of an increase in lending rates. Click here to read previous articles Both Bank of India and Union Bank of India have said that an increase in lending rates by atleast 0.5 per cent is on the cards. How does all this impact the growth story? The hike in repo rate and CRR seems to be an ongoing process. HDFC has predicted another 50-70 basis points hike in the repo rate during the coming months. A curb on credit expansion, could impact the investment demand of the corporate sector. Even though banking is a small part of the growth story, a 100-125 basis points increase in the lending rates could raise the cost of funds in the system considerably. So far, the consistent but moderate increases in lending rates have applied to the retail side of banking. Now they could affect the investment side. Once access to capital is restricted and recourse to external finance is limited, the expansion programme of several corporates could be put on hold or curtailed.

Could this sluggishness in growth persist? If investment becomes moderate, we may find the average rate of growth of GDP to be in the range of 7-8 per cent over the next 2-3 years, according to economists. While FY08 promises to be a difficult years, the impact of curtailed demand and sluggish investment will be felt with a lag in FY10. Heres what a few banks have to say. While Deutsche Bank has predicted a GDP growth rate of 7.3-7.8 per cent, HSBC is expecting the GDP to grow at 7.5-7.8 per cent during FY09. India was looking at catching up with China in the growth story. However, stumbling blocks like inflationary pressures, caused by external and internal shocks, has postponed its plans for now. Inflation control at the cost of growth has become a reality. Axing CRR and SLR Apart from the issue of capital adequacy, the other major aspect of reforms has been manifest in form of axing of the CRR and the SLR. When reform was started, SLR was 38.5 per cent of net demand and time liabilities (DTL). In addition to it, the incremental SLR was 30 per cent. The incremental SLR was abolished and the average of SLR dropped over the years to 25 per cent. Similarly, CRR during the beginning of reform was 15 per cent of the net DTL. In addition, there was 10 per cent incremental CRR. The incremental CRR of 10 per cent of DTL was removed in the very initial phase of reform and the average CRR was brought down in successive instalments from 15 to 5 per cent by June 2002. But thereafter, it was raised marginally to cope up with the changing scenario of the Indian economy to 7.5 per cent, but after viewing at the CRR related to nonresident Indians (NRIs) deposits where the CRR is zero, the effective CRR on all kinds of the deposits taken together is lower than 7 per cent. Table 1.2 shows how CRR and SLR were revised in stages. In fact, the SLR/CRR had to be reduced only gradually because the government securities did not enjoy high demand for them in general. Any sudden slash in SLR would have affected the government borrowing. Again, in the absence of adequate demand, the government securities did not prove an effective tool for credit control. The RBI had to depend on CRR for having effective control on credit. Table 1.2 Changes in CRR and SLR

CRR SLR aIn addition, there was incremental CRR of 10%. bIn addition, there was incremental SLR of 30%. Interest rates & investments Interest rates & the bond prices are inversely related to each other. When interest rates move up, it causes the bond prices to fall & vice versa. Say for example, you have a bond, which is yielding 10% now. Suddenly, the interest rates in the economy move up to 11%. Now your bond is giving fewer yields than the market return. Obviously it price is going to fall in such a case. Reverse is the case when interest rates fall, the bond price will move up because it is giving more returns than the market return. So movements in interest rates have serious implications for individual investments. Inflation and economy
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Inflation effects the economy on three sides. One, it is directly linked to interest rates. The interest rates prevailing in an economy at any point of time are nominal interest rates, i.e., real interest rates plus a premium for expected inflation. Due to inflation, there is a decrease in purchasing power of every rupee earned on account of interest in the future, therefore the interest rates must include a premium for expected inflation. In the long run, other things being equal, interest rates rise one for one with rise in inflation. Two, it effects the exchange rate. The exchange rates between the currencies of two countries depend upon the level of inflation prevailing in the two countries. According to Purchasing Power Parity principle, the change in the value of one currency vis a vis another, is approximately equal to the inflation

differential of the two countries. So the inflation levels provide an indication of the movement of currencies against each other. Three, there is also an inverse inflation between inflation & economic growth. Other things being equal, economic growth is equal to the difference between money supply growth & inflation. Money supply and the economy
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Money supply also effects the economy on three sides. One, money supply is used to control the inflation in an economy. On the demand side, whenever money supply in the economy increases, consumer-spending increases immediately in the economy because of increased money in the system. But supply cant vary in the short term, so there is a temporary mismatch of demand & supply in the economy which exerts an upward pressure on inflation. This argument assumes that demand drives supply, which is generally the case. On the supply side, due to an increase in demand, supply can only be increased by capacity additions. This causes the cost of production to rise & that is reflected in inflation. Two, money supply also has a direct relationship with the growth of an economy. Until an economy reaches full employment level, the economy growth is the difference between money supply growth rate & the inflation, other things being equal. When an economy reaches full employment level, the growth in money supply is set off by a growth in inflation, other things being equal. This happens because output cant rise after full employment & therefore inflation increases one for one with the money supply.

Three, money supply also has a relationship with interest rates. One variable can be used to control the other. Both cant be controlled simultaneously. If the RBI wants to peg the interest rate at a certain level, it has to supply whatever money is demanded at that level of interest rate. If it wants to fix the money supply at a certain level, the demand & supply of money will determine the interest rates. Usually it is easier for RBI to control the interest rates through its open market operations (OMO). So, the money supply is allowed to vary but RBI controls it by playing around with interest rates through its OMO.

Fiscal deficit and economy

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Fiscal deficit is difference between the receipts & expenditure of the government. An increase in fiscal deficit means that the government is not able to meet its expenditure out of its receipts. Primarily, it has to go to RBI to get the money required. RBI can either issue new notes, which will increase the money supply in the system (the vices of increase in money supply have been discussed above) or it can raise the required amount from the market by issuing new T bills & G secs. Issuing these intruments will suck out the liquidity from the system & it will put unnecessary pressure on the interest rates. So, on both counts, the increase in fiscal deficit causes the interest rates to rise in an economy. Also, it will crowd out the private investment from the economy.

Cash Reserve Ratio (CRR) & statutory liquidity ratio (SLR) and an economy
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CRR is the percentage of its total deposits a bank has to keep with RBI in cash or near cash assets & SLR is the percentage of its total deposits a bank has to keep in approved securities. The purpose of CRR & SLR is to

keep a bank liquid at any point of time. When banks have to keep low CRR or SLR, it increases the money available for credit in the system. This eases the pressure on interest rates & interest rates move down. Also when money is available & that too at lower interest rates, it is given on credit to the industrial sector which pushes the economic growth. Current account deficit and economy
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Current account balance is the difference between exports & imports of the country, added to it is net earnings from invisibles. When a country is running a current account deficit, it implies that the domestic savings are sufficient enough to fund domestic investment. The deficit has to come from capital account surplus, i.e., more foreign capital inflows. This trend makes an economy vulnerable to a crisis, if the foreign investment is of short term in nature because it can be taken away at any point of time & can have a run on a countrys currency. The South East Asian crisis is a classic example of this.

Fiscal policy and economy

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Fiscal policy is an instrument in the hands of government for reallocation of resources according to nations priority, redistribution, promotion of private savings & investments & the maintenance of stability. An expansionary fiscal policy means more investment spending on part of government. This increases the interest rates in the economy because government resort to borrowings to finance the expenditure. When interest rates rise, they cause private investment to fall. This phenomenon is called "Crowding out of private investment". A contractionary fiscal policy means less expenditure by government, which hampers the economic growth of a country. So the

government has to strike a balance between growth prospects & crowding out. Monetary policy and economy
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It refers to a regulatory policy whereby the monetary authority of a country maintains its control over the money supply for the realization of general economic objectives. It involves manipulation of money supply, the level & structure of interest rates & other conditions effecting the level of credit. The central bank signals the market about the availability of credit & interest rates through this policy. The RBI fixes the bank rate in this policy which forms the basis of the structure of interest rates & the CRR & SLR, which determines the availability of credit & the level of money supply in the economy. So it plays a very important role in the development of a economy.

Relationship between fiscal & monetary policy

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Both the policies are so interdependent on each other that fiscal policies pursued by the government determine the general directions of monetary policy, & depending upon the monetary control exercised in the monetary policy, the fiscal policies have to be devised. In Indian economy, the monetary policy is brought into play only to correct the adverse effects of fiscal policy. The RBI has no say in determining the level of deficit financing of central government. When deficit financing increases, the RBI has to resort to tight monetary policy to curb the rise in liquidity & inflationary conditions in the country. So the CRR & SLR is raised. Its only recently, when there was so much of debate going on to make RBI more autonomous, that the RBI has got some say in deficit financing. Thats why we are witnessing cuts in CRR.

So both the policies have to work in tandem to realize the economic objectives. Currency fluctuations
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Currency mainly fluctuates because of three reasons. First is inflation. Theoretically, the rate of change in exchange rate is equal to the difference in inflation rates prevailing in the 2 countries. So, whenever, inflation in one country moves, say increases relative to other country, its currency falls down. Two, when the current account balance of country is running in deficit. This means that the importers of the country will demand more of foreign currency to pay for their imports. The demand supply mismatch will cause the currency to fall. Third is speculation. When big players speculate in a particular currency, the currency moves accordingly.

Depreciation of a currency : good or bad

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Depreciation of a currency effects an economy in two ways, which are in a way counter to each other. On the one hand, it makes the exports of a country more competitive, thereby increasing them. On the other hand, it decreases the value of a currency relative to other currencies, thereby decreasing the importance of that currency. So, the policy makers have to strike a balance between the two.

Importance of money market in an economy

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Money market forms the basis of term structure of interest rates. Money market includes call money market, market for sovereign securities & other instruments of short term nature like commercial paper. The interest rates follow a general principle, as the term to maturity increases, the interest rates also increases because current consumption is always

preferred to future consumption. So one has to pay premium for longer maturity. The call money market forms the basis for short term interest rates. Any institution who wants to lend overnight can place its funds in this market. The rates for sovereign securities are slightly above call rates because their term to maturity is high. Like that, the interest rates are determined according to the interaction of demand of & supply for funds according to their maturity. Money market forms the basis for the yield curve. Difference between real & nominal GDP
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Nominal GDP measures the value of output in a particular period at the prices of that period or in current rupees. Nominal GDP changes from year to year because of two reasons. One, there is a change in the physical output of goods & services & two, the market prices of goods & services produced also change. Real GDP measures the changes in physical output in the economy between different time periods by valuing all goods produced in the two periods at some base year's prices, or in constant rupees. It means that the today's output of goods & services will be multiplied by base year's prices to get the real GDP of current period. In other words, real GDP is nothing but nominal GDP adjusted for inflation.

Inflation targeting & interest rate targeting

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A sustained increase in money supply in the economy will, in the long run, lead to an equal increase in the inflation & in the short run, it will lead to a decrease in interest rates, but in the long run, the real interest rates will come down to the same level because of an equal increase in inflation. So there is always a trade off that the monetary authority of a country has to

make between the two things. If it allows money supply to grow to keep interest rates down, it is called interest rate targeting & if it keeps money supply in check to keep inflation under control, it is called inflation targeting. The RBI, right now, is targeting inflation because if it is able to keep inflation in check, the interest rates will be automatically come in check as the nominal interest rate is equal to real interest plus inflation & real interest rates remain constant in the long run. Interest rates change because of changes in inflation.