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Economics for everyone Easy Economics credit policy - interest rates in interest of nation

It also increased its benchmark prime lending rate by one per cent to 14 per cent with immediate effect. The hike will make the BPLR-related loans of the bank dearer to its customers. With this, vehicle loans having a three-year tenor will now carry an interest rate of 12 per cent as against 10.5 per cent earlier, the bank`s website said Prof.M.Guruprasad / 15:33, Aug 28, 2008

The issue: Interest rate in the interest of the nation thats the message that Reserve Bank of India (RBI) governor, Y.V. Reddy, sent out in his last quarterly policy review on Tuesday 29 July 2008. The message came in the form of

a steep 50 basis points (bps) hike in the repo rate, and a 25 bps one in the cash reserve ratio (CRR) both now stand at 9% respectively to check inflation, now at 12.01%. It also increased its benchmark prime lending rate by one per cent to 14% with immediate effect. The hike will make the BPLR-related loans of the bank dearer to its customers. With this, vehicle loans having a threeyear tenor will now carry an interest rate of 12% as against 10.5% earlier, the bank's website said. Key Policy highlights The repo rate has been hiked by 50 basis points to 9% from 8.5% earlier. The CRR, the ratio of cash balances to be maintained by banks with the central bank, has been increased by 25 basis points to 9% (effective from August 30, 2008). The bank rate (the rate at which the RBI lends to commercial banks) and the reverse repo rate under the liquidity adjustment facility have been kept unchanged. The gross domestic product (GDP) growth forecast for FY2009 has been revised downwards from 8-8.5% to around 8.0%, barring domestic or global shocks. Inflation to be contained around 7% by March 2009, with a medium-term objective of a 3% inflation rate. Earlier on June 11, 2008 the Reserve Bank today hiked its short term lending rate by 0.25 per cent with immediate effect, a move that is likely to force banks to increase interest rates and help check inflation. The Reserve Bank of India - has decided to increase the repo rate the central bank said in a statement in Mumbai.The reverse repo rate, at which RBI borrows money from banks in exchange of the government papers, however, has been kept intact at 6 per cent. The Reserve Bank said the decision has been taken with a view to containing inflation expectations among other things. The RBI statement said: Purpose: According to the official statement by the RBI 'The annual policy statement for the year 2008-09 (April 29, 2008) had stated, inter alia, that the overall stance of monetary policy in 2008-09 will broadly be to ensure a monetary and interest rate environment that accords high priority to price stability, well-anchored inflation expectations and orderly conditions in financial markets while being conducive to continuation of the growth momentum.'

Understanding the concept and the relevance of the Policy Definition The regulation of the money supply and interest rates by a central bank, such as the Reserve Bank of India and Federal Reserve Board in the U.S., in order to control inflation and stabilize currency. Monetary policy is one the ways the government can impact the economy. By impacting the effective cost of money, the Federal Reserve can affect the amount of money that is spent by consumers and businesses. It regulates the supply of money and the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks. The Monetary Policy aims to maintain price stability, full employment and economic growth. The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. It can increase or decrease the supply of currency as well as interest rate, carry out open market operations, control credit and vary the reserve requirements. Role of Reserve Bank of India: Establishment The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated.Though originally privately owned, since nationalisation in 1949, the Reserve Bank is fully owned by the Government of India. Preamble The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as:"...to regulate the issue of Bank Notes and 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." Main Functions Monetary Authority: Formulates, implements and monitors the monetary policy. Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.

Regulator and supervisor of the financial system: Prescribes broad parameters of banking operations within which the country's banking and financial system functions. Objective: maintain public confidence in the system, protect depositors' interest and provide cost-effective banking services to the public. Manager of Foreign Exchange Manages the Foreign Exchange Management Act, 1999. Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India. Issuer of currency: Issues and exchanges or destroys currency and coins not fit for circulation. Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality. Developmental role Performs a wide range of promotional functions to support national objectives. Related Functions Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker. Banker to banks: maintains banking accounts of all scheduled banks. Basic Economic Concepts Inflation, Interest rates and the RBI Interest rates measure the price of borrowing money. If a business wants to borrow Rs 1 million from a bank, the bank will charge a specific interest rate that will usually be expressed in terms of a percentage over a given period of time. For example, if the bank loaned the money to the company at a 5% annual rate, the company would need to repay Rs. 1,050,000 at the end of the year. From the company's perspective, the

value of that Rs 1,000,000 right now is greater than the Rs 1,050,000 in a year (presumably because they have plans for the money), which is why they want to borrow it. For the bank, it is earning a 5% return on a one-year investment. Generally, there are two types ofinterest rates : floating and fixed. A floating rate, also called an adjustable rate, moves in step with a rate that is set outside of the lending institution, such as the prime rate (the rate at which banks lend to their best customers). Relevance of Monetary and Credit Policy Historically, the Monetary Policy is announced twice a year - a slack season policy (April-September) and a busy season policy (OctoberMarch) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year. However, with the share of credit to agriculture coming down and credit towards the industry being granted whole year around, the RBI since 1998-99 has moved in for just one policy in April-end. However a review of the policy does take place later in the year. The monetary and credit policy is half yearly affair of the Reserve Bank of Traditionally, RBI, in this monetary and credit policy, announces structural and monetary measures to improve the functioning of the banking system and also functioning of the economy as whole. There are some key set of indicators to ensure stability in the economy. These include money supply,interest rates , inflation, amongst others. The RBI uses various tools to regulate or influence these indicators. The policy also provides a platform for the RBI to announce norms for financial entities including banks, financial institutions (FIs), non-banking financial companies (NFBCs), nidhis, primary dealers (PDs) in the money market, authorized dealers in the foreign exchange markets, which are regulated by the apex bank. The monetary authority uses various instruments to control the supply of money. These instruments are known as instruments of credit control. These instruments can be divided into two categories; quantitative and qualitative credit control, viz, bank rate policy, open market operation and changes in statutory reserve requirements. These methods are used to control the quantum methods of credit control are also known as selective credit control methods. These include credit rationing, direct action, changes in margin requirements moral suasion etc. The credit policy gives indication about the economy and the banking system in the country and it also provides an opportunity for the RBI to spell out on overview one the economy. The RBI now prefers to announce

monetary measures as and when the situation demands. Channels of Management: There are four main channels, which the RBI looks at: Quantum channel: money supply and credit (affects real output and price level through changes in reserves money, money supply and credit aggregates). Interest rate channel. Exchange rate channel (linked to the currency). Asset price. Impact on the individual: In recent years, the policy had gained in importance due to announcements in the interest rates. 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. Earlier, depending on the rates announced by the RBI, the interest costs of banks would immediately either increase or decrease. . 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 this rate. In other words, the bank rate is the rate at which banks borrow from the RBI. RBIs conduct of Monetary Policy: The RBI uses the interest rate, OMO, changes in banks' CRR and primary placements of government debt to control the money supply. OMO, primary placements and changes in the CRR are the most popular

instruments used. Open Market Operations (OMO) Under the OMO, the RBI buys or sells government bonds in the secondary market. By absorbing bonds, it drives up bond yields and injects money into the market. When it sells bonds, it does so to suck money out of the system. Primary deals in government bonds are a method to intervene directly in markets, followed by the RBI. By directly buying new bonds from the government at lower than market rates, the RBI tries to limit the rise in interest rates that higher government borrowings would lead to. CRR 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 changes in CRR affect the amount of free cash that banks can use to lend - reducing the amount of money for lending cuts into overall liquidity, driving interest rates up, lowering inflation and sucking money out of markets. 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. LAF (The Liquidity Adjustment Facility) 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. Some Monetary Policy Terms 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. 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. 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. 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. Impact on Stock Markets The financial markets Pay obsessive attention to the actions of the RBI. 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. The Federal Reserve System of U.S: Basically, the Federal Reserve System is America's central bank (similar to the Reserve Bank Of India). It was established in 1913 to maintain a sound and stable banking system throughout the United States and to promote a strong economy. The Federal Reserve System is composed of

12 regional banks in major cities around the country and the Central Bank, which is run by the Board of Governors and is based in Washington, D.C. The Board of Governors is made up of 7 members that are appointed to 14-year terms by the President and approved by the Senate. Almost all banks are a part of the Federal Reserve System, which requires that those banks maintain a certain percentage of their assets deposited with the regional Federal Reserve Bank. These "reserve requirements" are set by the Board of Governors and by changing the requirements; the Federal Reserve System can greatly impact the amount of money supply in the economy. Because of the great impact of changing the reserve requirement, the Federal Reserve rarely does this. The Federal Reserve System wears a great number of hats. First, it serves as a bank for banks: many transactions between banks are processed through the Federal Reserve System. Financial institutions are also able to borrow money through the Federal Reserve, but only after attempting to find credit elsewhere; the Federal Reserve System provides credit only when it cannot be found in the markets or in cases of emergency. Second, the Federal Reserve System acts as the government's bank. The tax system processes incoming and outgoing payments through a Federal Reserve checking account. The Federal Reserve also buys and sells government securities. The Fed even issues the U.S. currency, although the actual production of the currency is handled elsewhere. Third, the Federal Reserve System acts as a regulatory agency. The Fed polices the banking industry to make sure that things run smoothly and that the rights of consumers are protected.

Prof.M.Guruprasad Aicar Business School

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