Role of Central Bank in Developing Economy – A Case Study of India

UNIVERSITY OF MUMBAI PROJECT ON CHANGING ROLE OF CENTRAL BANK IN DEVELOPING ECONOMY – A CASE STUDY OF INDIA

SUBMITTED BY LAVINA .H. UDASSI

PROJECT GUIDE PROF. MRS. SUNITI NAGPURKAR 

BACHELOR OF MANAGEMENT STUDIES

SEMESTER V (2009-2010)

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE, SINDHI COLONY, CHEMBUR – 400071 1

UNIVERSITY OF MUMBAI

PROJECT ON CHANGING ROLE OF CENTRAL BANK IN DEVELOPING ECONOMY – A CASE STUDY OF INDIA Submitted In Partial Fulfillmen F ulfillmentt of the requirements For the Award of the Degree of  Bachelor of Management By LAVINA .H. UDASSI

PROJECT GUIDE PROF. MRS. SUNITI NAGPURKAR 

BACHELOR OF MANAGEMENT STUDIES SEMESTER V (2009-2010)

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE, SINDHI COLONY, CHEMBUR – 400071 2

Declaration I, LAVINA .H. UDASSI student of BMS – Semester V (2009-2010) hereby declare that I have completed this project on CHANGING ROLE OF CENTRAL BANK IN DEVELOPING ECONOMY – A CASE STUDY OF INDIA.

The information submitted is true & original to the best of my knowledge.

Student’s Signature LAVINA .H. UDASSI Name of Student

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CERTIFICATE

This Th is is to ce cert rtif ify y th that at Ms. Ms. LAVI LAVINA NA .H .H.. UDAS UDASSI SI of TYBM TYBMS S has has successf successfully ully complete completed d the project project on CHANGING CHANGING ROLE OF CENTRAL BANK IN DEVELOPING ECONOMY – A CASE STUDY OF INDIA under the guidance of PROF. MRS. SUNITI NAGPURKAR.

Principal

Project Guide Prof. Mrs. Suniti Nagpurkar

Dr. (Mrs) J. K. Phadnis

Course Co-ordinator Mrs. A. Martina

External Examiner

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ACKNOWLEDGEMENT

It gives me great pleasure to submit this project to the University of Mumbai as a part of  curriculum of my BMS course. I take this opportunity with great pleasure to present before you this project on “CHANGING ROLE OF CENTRAL BANK IN DEVELOPING ECONOMY result of co-operatio co-operation, n, hard work and good wishes  – A CASE STUDY OF INDIA” which is a result of many people.

I would like to thank  Mrs. J. K. Phadnis, Principal of V.E.S College of Arts, Science & Commerce and Prof. Mrs. Martina, BMS Co-ordinator for enabling me to take up this

  project. project. Also, I would would like like to thank my project project guide guide Prof. Mrs. Suniti Nagpurkar for her  friendly guidance, constant involvement and handful han dful information in my project.

I would also like to appreciate contribution of my family and friends who have extended their  complete support in completion of this project.

Last but not the least; I am thankful to Mr. Kunal Jadhwani, Financial Analyst for his constant support and library staff for providing books related to this project.

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Executive Summary India is a democratic country where economy plays a very important role. The economy was characterized characterized by extensive extensive regulation, regulation, protectionism, protectionism, and public public ownership, ownership, leading to   perva pervasiv sivee corrup corrupti tion on and slow slow growth growth.. Since Since 1991, 1991, continu continuing ing economi economicc libera liberaliz lizati ation on has moved the economy towards a market-based system. The Indian Indian economy economy has und underg ergone one substa substanti ntial al changes changes since since the introd introduct uction ion of  economic economic reforms in 1991. They included included various measures measures like deregulating deregulating the markets markets and encouraging private participation; trade liberalization; dismantling the restrictions on domestic and foreign investments; reforming the financial sector and the tax system, etc. Today, Banking Banking is also an important important factor factor in Indian Financial Financial System. System. The banking system system in India has undergone significan significantt changes during last 16 years. years. There have been new   ban banks ks,, new new inst instru rume ment nts, s, new new wind window ows, s, new new opp oppor ortu tuni niti ties es and, and, along along with with all all this this,, new new challenges. While deregulation has opened up new vistas for banks to augment incomes, it has also entailed greater competition and consequently greater risks. Centra Centrall banking banking is the responsi responsibil bility ity of the Reserve Reserve Bank Bank of India, India, which in 1935 formally took over these responsibilities from then Imperial Bank of India, relegating it to commer commercia ciall banking banking functi functions ons.. After After India' India'ss indepen independen dence ce in 1947, 1947, the Reserv Reservee Bank Bank was nationalized and given broader powers.

The Reserve Bank of India has achieved transparency in its operations, especially in terms terms of evolvin evolving g commun communica icatio tion n policy policy aimed aimed at address addressing ing a wide wide range range of audienc audiences. es.  Notwithstanding the changing challenges of different regimes, the Reserve Bank has managed to evolve constructively on a continuous basis to cope with demands for stable macroeconomic manage management ment and financ financial ial stabil stability ity,, while while meeti meeting ng the object objective ivess of econom economic ic growth growth and development. As the economy becomes increasingly open and global, the role of the Reserve Bank will undergo further change and it will need to equip it for coping with these emerging challenges on a continuous basis.

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INDEX Sr no.

Chapter no.

1

I

Introduction

1–6

1.1

Indian Economy

1–2

1.2

Banking

3–4

1.3

Different periods of Banking Sector 

5–6

II

Indian Financial System

2.1

Financial sector & its importance

2.2

Measures

10 – 11

2.3

Changing role of RBI in financial sector 

12 – 15

III

Introduction Introduction to Central Bank in India

16 – 20

3.1

Reserve Bank of India

16 – 18

2

3

Title

Pg. no.

7 – 15 8–9

n

3.2

Functions

3.3

Role

19 – 20

4

IV

Monetary Policy & its objectives

21 – 26

5

V

Techniques of monetary control used by RBI

26 – 38

5.1

Open Market Operations

27 – 29

5.2

Repo rate and Reverse Repo rate

29 – 30

5.3

Bank rate

18

7

31 5.4

Cash Reserve Ratio 32 – 34

6

5.5

Statutory Liquidity Ratio

5.6

Interest Rate

VI

Equities in India

6.1

Introduction of Sensex for 10 years

6.2

Picture of GDP

35 – 37 38

39 – 45 39 – 40 40 – 41

6.3

RBI: Review on Bank Financing of equities 41 – 45

7

VII

Crisis & India

7.1

Introduction of Crisis

46 – 55 46 – 47

8

7.2

Various actions taken by RBI

7.3

Challenges forward to be faced by RBI

VIII

Inflation in India

8.1

Introduction

8.2

47 – 50 51 – 55

56 – 65

Steps taken by RBI to control it

56 – 57 58 – 61

8.3

Observations & Suggestions 62 – 65

9

IX

Conclusion 66

10

X

Bibliography

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CHANGING ROLE OF CENTRAL BANK IN DEVELOPING ECONOMY ECONOMY – A CASE STUDY OF INDIA

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CHAPTER I Introduction to Indian Economy

The economy of India of India is the twelfth largest in the world by market exchange rates and the fourth largest in the world by GDP, measured on a   purchasing power parity (PPP) basis. The country was under  socialist-based socialist-based policies for an entire generation from the 1950s until the 1980s. 198 0s. The econom economy y was charac character terize ized d by extensive extensive regulation regulation,, protectionism, protectionism, and and publ public ic ownership, leading to pervasive to  pervasive corruption and slow growth. growth. Since 1991, continuing economic liberalization has moved the economy towards a market-based system. system. Previously a closed economy, India's trade has grown fast. According to the WTO WTO India currently accounts for 1.5% of World trade as of 2007. According to the World Trade Statistics of the WTO in 2006, India's total merchandise trade (counting exports and imports) was valued at $294 billion in 2006 and India's services trade inclusive of export and import was $143 billion. Thus, India's global economic engagement in 2006 covering both merchandise and services trade was of the order of $437 billion, up by a record 72% from a level of $253 billion in 2004. India's trade has reached a still relatively moderate share 24% of GDP in 2006, up from 6% in 1985.

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The Indian Indian economy economy has und underg ergone one substa substanti ntial al changes changes since since the introd introduct uction ion of  economic reforms in 1991. These reforms were a comprehensive effort consisting of three main compon component entss namely namely,, libera liberaliz lizati ation, on, privat privatiza izatio tion n and global globalizat ization ion.. They They includ included ed variou variouss meas measur ures es like like dere deregu gula lati ting ng the the mark market etss and and enco encour urag agin ing g priv privat atee part partic icip ipat atio ion; n; trad tradee liberalization; dismantling the restrictions on domestic and foreign investments; reforming the financ financial ial sector sector and the tax syste system, m, etc. etc. All such policy policy initi initiati atives ves radica radically lly changed changed the economic set-up of the country and integrated it with the rest of the world. Thus, India was  placed in a globally competitive position so as to fully utilize its potentials and opportunities for  rapid growth of the economy.

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Introduction to Banking Banking in India originated in the last decades of the 18th century. The oldest bank in existence in India is the State Bank of India, a government-owned that is the largest commercial  bank in the country. Central banking is the responsibility of the Reserve Bank of India, which in 1935 formally took over these responsibilities from then Imperial Bank of India, relegating it to commer commercia ciall banking banking functi functions ons.. After After India' India'ss indepen independen dence ce in 1947, 1947, the Reserv Reservee Bank Bank was nationalized and given broader powers. In 1969, the government nationalized the 14 largest commercial banks; the government nationalized the six next largest in 1980. Currently, India has 88 scheduled commercial banks (SCBs) - 27 public sector banks (that is with the Government of India holding a stake), 31 private banks (these do not have government stake; they may be publicly listed and traded on stock exchanges) and 38 foreign  banks. They have a combined network of over 53,000 branches and 17,000 ATMs. The banking system in India has undergone significant changes during last 16 years. There have been new banks, new instruments, new windows, new opportunities and, along with all this, new challenges. While deregulation has opened up new vistas for banks to augment incomes, it has also entailed greater compet greater  competition ition and consequently consequently greater risks. India adopted adopted  prudential measures aimed at imparting strength to the banking system and ensuring its safety and soundness, through greater transparency, accountability and public credibility. Our Our bank bankin ing g sect sector or refo reform rm has has been been uniq unique ue in the the worl world d in that that it comb combin ines es a Comprehensi Comprehensive ve reorientat reorientation ion of competition competition,, regulation regulation and ownership ownership in a non disruptiv disruptivee and cost-effective manner. Indeed our banking reform is a good illustration of the dynamism of the   publi publicc sector sector in managi managing ng the overhang overhang problems problems and the pragma pragmatis tism m of public public policy policy in enabling the domestic and foreign private sectors to compete and expand. There has been no  banking crisis in India.

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The Government took steps to reduce its ownership in nationalized banks and inducted  private ownership but without altering their public sector character. The underlying rationale of  this approach is to assure that the salutary features of public sector banking was not lost in the transformation process. On account of healthy market value of the banks’ shares, the capital infusion into the banks by the Government has turned out to be profitable for the Government.

Banking Sector between 1947 -1969

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During the first phase the growth was very slow and banks also experienced periodic failures between 1913 and 1948. There were approximately 1,100 banks, mostly small. To streamline the functioning and activities of commercial of commercial banks, banks, the Government of India came up with The Banking Companies Act, 1949 which was later changed to Banking Regulation Act 1949 as per amending Act of 1965. Reserve Bank of India was vested with extensive powers for  the supervision of banking in India as the Central Banking Authority. During those day’s public has lesser confidence in the banks. As an aftermath deposit mobilization was slow. Abreast of it the savings bank facility provided by the Postal department was comparatively safer. Moreover, funds were largely given to traders.

Banking Sector between 1969 -1991 Government took major steps in this Indian Banking Sector Reform after independence. In 1955, it nationalized Imperial Bank of India with extensive banking facilities on a large scale especially in rural and semi-urban areas. It formed State Bank of India to act as the principal agent of RBI and to handle banking transactions of the Union and State Governments all over the country Seven banks forming subsidiary of State Bank of India was nationalized in 1960 on 19th July, 1969, major process of nationalization was carried out. It was the effort of the then Prime Mini Minist ster er of Indi India, a, Mrs. Mrs. Indi Indira ra Gandh Gandhi. i. 14 majo majorr comme commerc rcia iall banks banks in the the count country ry were were nationalized.

Second phase of nationaliza nationalization tion Indian Banking Sector Reform Reform was carried out in 1980 with with seve seven n more more banks banks.. Th This is step step broug brought ht 80% 80% of the the banki banking ng segm segmen entt in Indi Indiaa und under  er  Government Government ownership. ownership. After After the nationalization nationalization of banks, the branches branches of the public sector   bank India rose to approximately 800% in deposits and advances took a huge jump by 11,000%. Banking in the sunshine of Government ownership gave the public implicit faith and immense confidence about the sustainability of these institutions.

Banking Sector from 1991 onwards 14

This phase has introduced many more products and facilities in the banking sector in its reforms measure. In 1991, under the chairmanship of M. Narasimha, a committee was set up by his name which worked for the liberalization of banking practices. The country is flooded flooded with foreign banks and their ATM stations. Efforts are being put to give a satisfactory service to custom customers ers.. Phone Phone bankin banking g and net banking banking is introd introduce uced. d. The entire entire system system became became more more convenient and swift. Time is given more importance than money.

The financial system of India has shown a great deal of resilience. It is sheltered from any crisis triggered by any external macroeconomics shock as other East Asian Countries suffered. This is all due to a flexible exchange rate regime, the foreign reserves are high, the capital account is not yet fully convertible, and banks and their customers have limited foreign exchange exposure.

The industrial sector has been going through a process of restructuring and consolidation afte afterr libe libera rali lizat zatio ion. n. Th Thee indus industr trie iess have have resp respon onded ded to the the refo reform rmss thro throug ugh h merg merger erss and and acquisitions, adoption of cost cutting measures, foreign collaboration, technology up gradation and outwar outward d orient orientati ation on in sector sectorss such such as cement cement,, steel, steel, alumin aluminium ium,, pharmac pharmaceut eutica icals, ls, and automobiles. Industrial growth increased sharply in the first five years after the reforms, but then slowed to an annual rate of 4.5 percent in the next five years. From low growth rate of 2.7 per  cent in 2001-02, the industry sector grew at a rate of 7.1 per cent in 2002-03 and further to 9.8   per cent in 2004-05.There has been steady and continuous rise in supply of money in the economy since initiation of reforms. Reserve Money has increased from Rs.99, 505 crores in 1991-92 to Rs.573066 crores in 2005-06. Performance of the Indian economy on the inflation front, with price stability as one of  the prime objectives of the reform process has been satisfactory, particularly after the mid 1990s. The annual average inflation rate based on Wholesale Price Index (WPI) was 10.6 per cent  between 1991-96, which fell down to 5.1 per cent in the period 1996-2001 and then to 4.7 per  cent in 2001-06.

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CHAPTER II Indian Financial System

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Financial Sector The Indian financial system of the pre-reform period, before 1991, essentially catered to the needs needs of planned planned develop developmen mentt in a mixed-e mixed-econ conomy omy framew framework ork,, where where the Governm Government ent sector had a predominant role in economic activity. Interest rates on Government securities were artificially pegged at low levels, which were unrelated to the market conditions. The system of  administered interest rates was characterized by detailed prescriptions on the lending and the deposit side, leading to multiplicity and complexity of interest rates. Consequently Consequently,, by the end of the eighties, directed directed and concessional concessional availabilit availability y of bank  credit to certain sectors adversely affected the viability and profitability of banks. Thus, the transactions of the Government, the Reserve Bank and the commercial banks were governed by fiscal priorities rather than sound principles of financial management and commercial viability. It was then then recogni recognized zed that that this this approach approach,, which, which, concept conceptual ually ly,, sought sought to enhanc enhancee effici efficiency ency through a co-ordinate approach, actually led to loss of transparency, accountability and incentive to seek efficiency.

Need and importance of financial sector The New Economic Policy (NEP) of structural adjustments and stabilization programme was given a big thrust in India in in June 1991. The financial system reforms reforms have received special attention as a part of this policy because of the perceived interdependent relationship between the real and financial sectors of the modern economy. e conomy. The need for financial reforms had arisen because the financial institution and markets were in a bad shape. The banking sector suffered from lack lack of competition, low capital base, low low  productivity, and high intermediation costs. The role of technology was minimal, minimal, and the quality of service did not receive adequate attention. Proper risk management system system was not followed, and prudent prudential ial norms norms were weak. weak.

All these these resulte resulted d in poo poorr assets assets quality. quality. Develop Developmen mentt

financial institutions operated in an over – protected environment with most of the funding coming coming from assured assured source sources. s.

There There was little little competit competition ion in insura insurance nce and mutual mutual funds

industries industries.. Financial Financial markets markets were characterized characterized by control over pricing pricing of financial financial assets, assets,  barriers to entry, and high transactions transactions costs. The banks were running either at a loss or on very

17

low profits, and, consequently were unable to provide adequately for loan defaults, and build their capital. There had been organizational organizational inadequacies, inadequacies, the weakening of management management and control control functions, the growth of restrictive practices, the erosion of work culture, and flaws in credit manage management ment..

The strain strain on the perform performanc ancee of the banks had emanat emanated ed partly partly from from the

imposition of high Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and directed credit programmes for the priority sectors - all at below market or concessional or subsidized interest rates. This, apart from affecting affecting bank profitability adversely, adversely, had resulted in the low or  repressed or depressed interest rates on deposits and in higher interest rates on loans to the larger   borrowers from business and industry. Furthe Further, r, the functi functioni oning ng of the financ financial ial syste system, m, and the credit credit delive delivery ry as well well as recovery process had become politicized, which damaged the quality of lending and the culture of repaying loans. The widespread write-offs of the loans had seriously seriously jeopardized the viability of banks. As the closure of sick sick industrial units was discouraged by the government, banks had to continue to finance non-viable sick units, units, which further compromised compromised their own viability. The legal system system was not of much help help in recovering recovering loans. There was a lack of transparenc transparency y in  preparing statements of accounts by banks. In other words, the reforms had become imperative on account of the facts that despite its impressiv impressivee quantitativ quantitativee growth growth and achievements achievements,, the financial financial health, health, integrity integrity,, autonomy, autonomy, flexibilit flexibility, y, and vibrancy vibrancy in the financial financial sector sector had deteriorat deteriorated ed over the past many years. years. The allocation of resources had become severely distorted, the portfolio quality had deteriorated, and  productivity, efficiency and profitability profitability had been eroded in the system. system. Customer service was  poor, work technology remained outdated, outdated, and transaction costs were high. The capital base of  the the syst system em rema remain ined ed low, low, the the acco account untin ing g and disc disclo losu sure re pract practic ices es were were faul faulty ty,, and and the the administrative expenses had greatly soared. The system suffered also from a lack of delegation delegation of authority, inadequate internal controls and poor poo r housekeeping.

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Measures For a long time, an alarming increase of sickness in the Indian financial system had required urgent remedial measures or reforms which were introduced in 1991. Main and sub-objectives of financial reforms introduced in 1991:

(i) (i)

To devel develop op a mark market et-or -orie ient nted ed,, comp compet etit itiv ive, e, worl worldd-in inte tegr grat ated ed,, diver diversi sifi fied ed,, auto autono nomo mous us,, transparent financial system.

(ii) (ii)

To incr increa ease se the the allo alloca cati tive ve effi effici cien ency cy of avai availa lable ble savi saving ngss and and to prom promot otee acce accele lera rate ted d growth of the real sector.

(iii (iii)) To incr increa ease se or brin bring g about about the the effe effect ctiv ivene eness ss,, accou account ntab abil ilit ity, y, prof profit itab abil ilit ity, y, viab viabil ilit ity, y, vibran vibrancy, cy, balanc balanced ed growth growth,, operat operation ional al econom economy y and flexib flexibili ility, ty, profes professio sional nalism ism and depoliticisation in the financial sector. (iv) To increase increase the rate rate of of return return on real real investm investment. ent. (v)

To promote promote competit competition ion by creatin creating g level-playi level-playing ng fields fields and facilit facilitating ating free free entry entry and exit exit for institutions and market players.

(vi) (vi) To ensure ensure that that the rationa rationaliz lizati ation on of interest interest rates rates struct structure ure occurs, occurs, that interest interest rates rates are flexible, market-determined or market-related, and that the system offers to its users a reasona reasonable ble level level of positiv positivee real real intere interest st rates. rates.

In other words, words, the goal has been to

dismantle the administered system of interest rates. (vii) (vii) To reduce the levels levels of resource pre-empti pre-emptions ons and to improve the effective effectiveness ness of directed directed credit programmes. (viii) (viii) To build a financial financial infrastructu infrastructure re relating relating to supervisio supervision, n, audit, audit, technology, technology, and legal matters. (ix) To modernize modernize the instrume instruments nts of monetary monetary control control so as to to make them more more suitable suitable for the conduct of monetary policy in a market economy i.e. to increase the reliance on indirect or  market-incentives based instruments rather than direct or physical instruments of monetary control. 19

The key words describing reforms have been liberalization, deregulation, marketisation,  privatization, and globalization, all all of which convey reforms objectives in a clear manner. manner. The   basic premise underlying the reforms has been that the state ownership and regulation have harmed the financial system, particularly the banks and the investors, and that such regulation is no longer relevant and adequate. To use the well-known academic terminology, the objective of  financial reforms has been to correct and eliminate financial repression; and to transform a financially repressed system into a free system. Financial sector reforms are said to be grounded in the belief that the competitive efficiency in the real sectors of the economy cannot be realized to its full extent unless the allocative allocative efficiency efficiency of the private sector was improved. improved. The main thrust of financial financial sector  reforms was on the creation of efficient and stable financial institutions and markets, the removal if structural bottlenecks, introduction of new players and instruments, introduction of free pricing of financial financial assets, relaxation of quantitativ quantitativee restricti restrictions, ons, improvement improvement in trading, trading, clearing clearing and settlement settlement practices, promotion promotion of instituti institutional onal infrastru infrastructure cture,, refinement refinement of market microstructure, creation of liquidity, depth, and the efficient price discovery process, and ensuring technological up gradation.

Impact of Financial Reforms The reform process appears to have yielded some positive results at least in the banking sector as reflected in the relatively cleaner balance sheets of banks, reduction in non-performing assets in relative terms, improvement in operating profits, and fairly good progress in attaining capital capital adequacy ratio ratio and other prudential prudential norms. norms. The operating operating profits of 27 public sector   banks improved from Rs 3135 crores in 1992-93 to Rs 3, 696 crores in 1993-94, Rs 5, 629 crores in 1994-95, and Rs 7, 569 crores in 1995-96, and Rs 29, 715 crores in 2002-03. The non-performing assets of NBFCs have increased substantially in the immediate past. After a brief period of great strides, the mutual fund industry has come to be afflicted by a host of serious problems problems.. The funds mobilized mobilized by them have declined drasticall drastically y over the reform  period. The net asset values of their various schemes have declined. The volume of fresh capital raised raised on the primary primary stock market has declined significantl significantly. y. The secondary market market reforms 20

have not really progressed because of the recalcitrance of market operators and SEBI’s lack of  will.

The stock markets are are plagued by uncommonly uncommonly high number of drawbacks, weaknesses,

malpractices and so on.

Changing Role of RBI in financial sector Having talked about financial sector and the ongoing reform process in the sector, let us now turn our attention to what exact role RBI is playing for the financial sector in general and the financial reform process in particular. As all of us know, RBI is the central bank of the country. Central banks are very old institutions. The Bank of England was set up way back in 1694, the Bank of France is more than 200 years old and the Federal Reserve Bank was set up in 1913. As aptly stated by our Governor, Dr. Bimal Jalan, although RBI, set up in 1935, may appear a ‘toddler or at most a young adult’, it is one of the oldest central banks among the developing developing world. world. Traditional Traditionally, ly, central central banks have performed performed roles of currency currency authority, authority,  banker to the Government and banks, lender of last resort, supervisor of banks and exchange control (now it would be more appropriate to call it exchange management) authority. Generally, central banks in developed economies have price or financial stability as their prime objective.

The RBI has the twin objectives of maintaining price stability and promoting growth. The objectives are as follows:

1. Provision of adequate liquidity to meet credit growth and support investment demand in the economy while continuing a vigil on movements in the price level. 2. In line with the above to continue the present stance on interest rates including preference for  soft interest rates. 3. To impart greater flexibility to the interest rate structure in the medium-term

In developing economies, however, the growth objective assumes greater importance. Recent experience has shown that during recessionary or deflationary conditions achievement of  12 higher growths becomes the dominant objective of central banks, both in developing and developed economies. Let us now look at the evolution of RBI and its changing role and strategy over time. RBI was set up to regulate the issue of currency and keep reserves with a view to 21

securing monetary stability in India and generally to operate the currency and credit system of  the country to its advantage (RBI Act, 1934). Within these overall objectives, RBI performs a wide range of promotional functions, which are designed to support the country’s efforts to accelerate accelerate the pace of economic development development with with social justice. justice. In keeping with with the overall logic of reforms reforms that market based allocation allocation rather rather than directed allocation allocation of resources resources led to greater efficiency, the functions of the RBI have undergone a strategic shift under the current reforms. The strategy shifted from controlling institutions and markets to facilitation of efficient functionin functioning g of markets markets and strengthen strengthening ing of the supporting supporting institutional institutional infrastructure infrastructure.. The  preemptions in the form of CRR and SLR have been progressively p rogressively reduced. The scope of priority sector has been expanded.

The interest rate has been deregulated both on deposits and advances. From conservation of foreign exchange through control of transactions, the focus has shifted to facilitation of  foreign exchange transactions. Intervention in the foreign exchange market has shifted from fixing of exchange rate to merely curbing speculative volatility. Stability issues came to the fore especially after the crises in South East Asian countries in late 1990s. The RBI progressively strengt strengthene hened d prudent prudential ial regula regulatio tion n relati relating ng to capital capital adequac adequacy, y, income income recogn recogniti ition, on, asset asset clas classi sifi fica cati tion, on,

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strengthening was undertaken to ensure the progressive development and integration of the securities, money and forex markets. The RBI has made significant improvements in the quality of performance of regulatory and supervisory functions. Our standards 13 are comparable to the  best in the world. Attention is being paid to several contemporary issues such as, relative roles of  onsite onsite and off-site off-site supervisio supervision, n, functional functional versus instituti institutional onal regulation, regulation, relative stress stress on internal management, market discipline and regulatory prescriptions, consolidated approach to superv supervisi ision, on, etc. etc. Severa Severall legisl legislati ative ve initia initiati tives ves have also also been been taken taken up with with Govern Governmen ment, t, covering procedural law, debt recovery systems, Credit Information Bureau, Deposit Insurance, etc.

Progress in these is critical for effectiveness of RBI in the regulatory sphere. A recent important legislative development, which will improve the momentum of recovery of dues, is the enactm enactment ent of Securit Securitiza izatio tion n and Reconst Reconstruc ructi tion on of Financ Financial ial 22

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of 

Security Interest (SRFAESI) Act. Under this Act RBI has been entrusted with the role of  stipul stipulati ating ng suitab suitable le norms norms for regist registrat ration ion of securi securitiz tizati ation on or reconst reconstruc ructi tion on compan companies ies,,  prescribi  prescribing ng prudential prudential norms, norms, recommendin recommending g proper and transparent transparent accounting accounting and disclosure disclosure standa standards rds and framin framing g appropr appropriat iatee guidel guideline iness for the conduct conduct of asset asset recons reconstru tructi ction on and securitization.

Financial liberalization has heightened competition among banks, and between banks and other financ financial ial institut institutions. ions. But competit competition ion has engendere engendered d certain certain serious serious problems. problems. For  exampl example, e, the distin distincti ction on between between commer commercia ciall banking banking,, invest investmen mentt bankin banking, g, develop developmen mentt  banking,  banking, other specialized specialized institutions, institutions, and manufacturing manufacturing corporate corporate is getting getting blurred. Banks are entering into para-banking and other financial services; development financial institutions, mutual funds and insurance companies are entering into banking and each other’s fields; and manufacturi manufacturing ng corporate are entering entering into banking and financial financial activities. activities. Financial Financial reforms have have given given rise rise to new issues issues of financi financial al indust industry ry struct structure ure,, system systemati aticc or social social costs costs of  oligopoly. The market-based market-based exchange rate system has helped to open up the Indian Indian economy, economy, and to integrate it with the rest rest of the world. But the exchange rate has become far more volatile; it has become subject to severe external pressures; its management has become difficult; and there has been a partial loss of autonomy of domestic monetary policy. The primary impulses for establishing central banks in many parts of the world in the twentieth century emanated from exigency of financing wars. The necessity to finance wars also led to nationalization of many of the early central banks, which were functioning as private entities. Central banking efforts in India after independence were geared towards mobilizing resources for planned economic development and ensuring price stability. Central bank mandates in developing countries such as India have gone well beyond typical central banking functions to encompass a wide range of o f developmental pursuits in order to promote economic growth. Cent Centra rall banki banking ng was was init initia iall lly y prac practi tice ced d with with a larg largee numbe numberr of info inform rmal al norm norms, s, conventions and self-imposed codes of conduct. Instituting a medium of exchange and currency management management along with monetary monetary policy policy had been globally globally in focus till the Great Depression. Depression.

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With the passage of time, however, central banks took over a whole range of functions,  becoming multi-tasking institutions that conduct monetary policy, regulate and supervise the  banking system and perform a crucial role in the payment system. Crisis situations that emerged from time to time led to redefining of central bank b ank mandates. The role of the lender of last resort evolved over-time and enlarged into that of the regulator and supervisor, as also the custodian of financial stability. This gained credence in the face of danger of contagion as economies got integrated. The necessity to manage government debt debt emanat emanated ed from from the histor historic ic reason reasonss of financi financing ng wars. wars. The hazard hazardss of financ financing ing the  persi  persiste stent nt governm government ent defici deficits ts were, were, howeve however, r, well well recogni recognized zed and such such financi financing ng is being being increasingly avoided. In the wake of South-East Asian crisis of 1997, many central banks in developing countries initiated financial reforms. In this direction, central banks also played a vital role in development of the financial markets to strengthen the monetary policy transmission channels. Institutional development has been one of the major objectives of central banks in developing economies in order to spread the umbrella of organized credit in such economies. The functions of the Reserve Bank of India have been changing over time as it has responded to the emergi emerging ng requir requireme ements nts of the macro macro econom economy y and contin continuous uously ly divers diversify ifying ing financ financial ial system. Cent Centra rall bank bankss arou around nd the the worl world d have have been been vest vested ed with with a vari variet ety y of addi additi tion onal al responsibi responsibiliti lities es such as preparing preparing macroeconomi macroeconomicc data-bases, data-bases, data dissemina dissemination, tion, putting putting in   place advanced clearing clearing systems, systems, coordinatin coordinating g with the internation international al agencies, agencies, undertaking undertaking  policy-oriented research activities and bridging gaps in information.

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CHAPTER III Reserve Bank of India The RBI, as the central bank of the country, is the centre of the Indian financial and monetary system. As an institution, institution, it has been guiding, monitoring, regulating, regulating, controlling, and  promoting the destiny of the Indian financial system. system. However, it is an oldest among the central  banks in the developing countries. It started functioning functioning from April 1, 1935 on the terms of the Reserve Bank of India Act, 1934. It was a private shareholders shareholders institution till till January 1949, after  which it became a State-owned institution under the Reserve Bank of India Act, 1948. The share capital was divided into shares of Rs. 100 10 0 each fully paid which was entirely e ntirely owned by private shareholders in the beginning. The Government held shares of nominal value of Rs. 2, 20,000.

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The Bank is managed by a Central Board of Directors, four Local Boards of Directors, and a committee committee of the central board of directors. directors. The functions functions of the Local Boards are to advise the Central Board on matters referred to them. The final control of the Bank vests in the Central Board which comprises the Governor, four Deputy Governors, and fifteen Directors nominated by the Central government.

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The internal organizational set-up of the Bank has been modified and expanded from time to time in order to cope with the increasing volume and range of the Bank’s activities. The  principle of the internal organization is functional specialization with ade quate coordination. During the war and post-war years, the major preoccupation of the Bank was facilitation of war finance, repatriation of sterling debt and planning and administration of exchange control. The issues relating to regulation and supervision of banks came to occupy centre-stage in the  backdrop of a number of bank failures. The Banking Companies Act was enacted in 1949 to empowe empowerr the Reserv Reservee Bank Bank with with superv superviso isory ry control control over banks in order order to ensure ensure their  their  establishment and operation along sound lines. The Reserve Bank of India was nationalized on January 1, 1949. With the launch of Five-Year Plans in 1951, the Reserve Bank’s functions became more divers diversifi ified ed in terms terms of Plan Plan financ financing ing,, establ establish ishmen mentt of specia specializ lized ed instit instituti utions ons to promot promotee savings and investment in the Indian economy and to meet credit requirements of the priority sectors. This was a novel feature for any central bank at that point of time. The Agricultural Refinance Corporation was set up in 1963 for extending medium and long-term finance to agricu agricultu lture. re. Other Other instit instituti utional onal develop developmen ments ts includ included ed setti setting ng up of the Indust Industria riall Financ Financee Corporation of India (1948), the Industrial Development Bank of India (1964) and Unit Trust of  India (1964). The role of monetary and credit policy in maintaining price stability was explicitly emphasized for the first time in the First Five Year Plan. Plan financing by the Reserve Bank  evolved as deficit financing which took the form of system of issuance of ad of ad hoc Treasury Bills. This arrangement of financing the Government was intended to be temporary but acquired a  permanent character over time. Devaluation of the rupee in June 1966 and nationalization of fourteen private sector    banks in July 1969 multiplied the responsibilities of the Reserve Bank. The move helped to  bridge the gaps in credit availability in many rural and urban areas and ensured sufficient funds availability to the preferred sectors. In terms of the outcome, this phase succeeded in mobilizing   private savings through the banks and paved the way for nationalization of six more private sector banks in 1980.

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For conserving foreign exchange reserves, the Government re-examined the provisions of  the Foreign Exchange Regulation Act, (FERA) 1947 and introduced changes in 1973 which incorp incorpora orated ted necess necessary ary changes changes for effect effective ive implem implement entati ation on of Govern Governmen mentt policy policy and removing difficulties in the working of the existing legislation. In the light of concerns about capital outflows, reinforced by repeated stress on balance of payments due to drought, war and oil shocks, the emphasis was placed on utilizing domestic savings for domestic investment, while continuing to preserve foreign exchange reserves.

Functions of RBI The RBI functions functions within within the framework of a mixed economic economic system. With regard regard to framing various policies, it is necessary to maintain close and continuous collaboration between the government and the RBI. In the event of a difference difference of opinion or conflict, the government view or position can always be expected expe cted to prevail.

Main functions of the RBI (i) To maintain maintain monetar monetary y stability stability so that the business business and and economic economic life life can deliver deliver welfare welfare gains of a property functioning mixed economy. (ii) To maintain maintain financial stabili stability ty and ensure sound financia financiall institution institutionss so that monetary stabil stability ity can be safely safely pursue pursued d and econom economic ic units units can conduct conduct their busine business ss with with confidence. (iii) (iii) To mainta maintain in stable stable paymen payments ts syste system m so that that financ financial ial trans transact action ionss can be safely safely and efficiently executed. promote the development development of financial infrastructur infrastructuree of markets markets and systems, systems, and to (iv) To promote enable it to operate efficiently i.e., to play a leading role in developing a sound financial system so that it can discharge its regulatory function efficiently. (v) To ensure that credit allocation by the financial system broadly reflects the national

economic priorities and social concerns.

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(vi) To regulate regulate the overall volume volume of money and credit credit in the economy with with a view to ensure a reasonable degree of price stability.

Roles of RBI 1.

Note Issuing Authority

The RBI has the sole right or authority or monopoly of issuing currency notes other than one rupee notes and coins, and coins of smaller smaller denominations. The issue of currency notes is one of its basic functions. 2.

Government Banker Thee RBI Th RBI is the banke bankerr to the Cent Centra rall and and Stat Statee gov gover ernm nment ents. s.

It provid provides es to the the

governments all banking services such as acceptance of deposits, withdrawal of funds by cheques, making payments as well as receipts and collection of payments on behalf of the government, transfer of funds, and management of public debt. 3.

Banker’s Bank 

The RBI, like all central banks, can be called a bankers bank because it has a very special relationship with commercial and co-operative banks, and the major part of its business is with these these banks.

The bank controls controls the volume volume of reserve reservess of commerci commercial al banks and thereby thereby

determ determine iness the deposits deposits creatin creating g abili ability ty of the banks. banks. The banks hold a part part or all of their  their  reserves with the the RBI. Similarly, in times of need, the the banks borrow funds funds from the RBI. It is therefore, called the bank of last resort. 4.

Supervising Authority The RBI has vast powers to supervise and control commercial and co-operative banks

with a view to to developing an adequate and sound banking system system in the country. Initially, they used to give only orders but now it undertakes inspection of commercial banks and recommends measures. It has the following powers: (a)

To issue licenses for the establishment of new banks and setting up of bank branches. 29

(b)

To prescrib prescribee minimum minimum requirem requirement entss regard regarding ing paid-up paid-up capital capital and reserve reserves, s, transfe transferr to reserve fund, and maintenance of cash reserves and others.

(c)

To inspect the working of banks in India as well as abroad in respect of their organizational setup, setup, branch branch expans expansion ion,, mobil mobiliza izatio tion n of deposit deposits, s, invest investmen ments, ts, and credit credit portfo portfoli lio o manage management ment,, credit credit apprais appraisal, al, region region-wi -wise se perfor performan mance, ce, profit profit planni planning, ng, manpow manpower  er   planning, and so on. 5. Exchange Control

One of the essential functions of the RBI is to maintain the stability of the external value of the rupee. It pursues pursues this objective objective through its domestic domestic policies policies and the regulation regulation of the foreign exchange market. As far as the the external sector is concerned, the task of the RBI has the following dimensions: (a) To administer administer the foreign foreign exchange exchange control. control. (b) To choose the exchange rate system and fix or manage the exchange rate between the

rupee and other currencies. (c) To manage manage exchange exchange reserves reserves.. (d) To interact with the monetary authoritie authoritiess of other countries countries and with internation international al financial institutions such as IMF. 6. Promoter of the financial system

Apart from performing the functions already mentioned, the RBI has been rendering developmenta developmentall services services which have strengthene strengthened d the country’s country’s banking and financial financial structure. structure. This has helped in mobilizing savings and directing credit flows to desired channels, thereby helping to achieve the objective of economic development with social justice.

CHAPTER IV Monetary Policy 30

Monetary policy is the management of money supply and interest rates by central banks to influence prices and employment. employment. Monetary policy works through expansion or contraction of  invest investmen mentt and consumpt consumption ion expendit expenditure ure..

Moneta Mon etary ry policy policy is the proces processs by which the

government, central bank, or monetary authority of a country controls (i) the supply of money, money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of  objectives oriented towards the growth and stability of the eco nomy. Monetary policy is referred to as either being an expansionary policy, policy, or a contractionary  policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to stop unemployment in a recession by lowering interest rates, rates, while contractionary policy involves raising interest rates in order to stop inflation. Monetary policy is contrasted with fiscal  policy, which refers to government borrowing, spending and taxation. Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary  policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, inflation, exchange rates with other currencies and unemployment. unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through  banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate. The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or  tight if intended to reduce inflation. On the external front, rupee value has been linked to the market forces. Current account conver convertib tibili ility ty was achieved achieved in August August 1994. FERA FERA was repealed repealed and replac replaced ed by a new legisl legislati ation on - Foreig Foreign n Exchan Exchange ge Manage Managemen mentt Act (FEMA) (FEMA),, in 199 1999. 9. Furthe Further, r, the Exchang Exchangee 31

Contro Controll Depart Departmen mentt of the Reserv Reservee Bank Bank was rename renamed d as Foreig Foreign n Exchang Exchangee Depart Departmen ment. t. Besides, a large number of innovative products and newer players have come to play active role and new hedging instruments have been introduced, viz., foreign currency-rupee options, etc. Auth Author oriz ized ed deal dealer erss could could use use cros crosss-cu curr rrenc ency y opti option ons, s, inte intere rest st rate rate and and curre currenc ncy y swap swaps, s, caps/collars and forward rate agreements (FRAs) in the international forex market. In the context of monetary policy framework, there has been a greater focus on liquidity management management engendered by the growing integration integration of financial markets, markets, domesticall domestically y and intern internati ationa onally lly.. With With the near near total total deregul deregulati ation on of intere interest st rates, rates, the Bank Rate Rate has been been reactivated since April 1997 as a reference rate and as a signaling device to reflect the stance of  monetary policy. Following the recommendations of the Working Group on Money Supply: Analytics and Methodology of Compilation (Chairman: Y. V. Reddy), the Reserve Bank has commenced compilation and publication of four monetary aggregates [M0 (monetary base), M1 (narrow money), M2 and M3 (broad money)]; and introduced three new liquidity aggregates (L1, L2 and L3) by incorporating deposits with post- office savings banks, term deposits, term  borrowings and certificates of deposits of term lending and refinancing institutions and public deposits of non-banking financial institutions; broadening of the definition of credit by including items not reflected in the conventional bank credit; redefining the net foreign assets of the  banking system to comprise banks’ holdings of foreign currency assets net of (a) their holdings of FCNR(B) deposits and (b) foreign currency borrowings. With the liberalization of the external sector, the monetary targeting framework came under und er stress stress due to increa increasin sing g liquid liquidity ity mainly mainly on account account of increa increased sed capita capitall inflow inflows, s, necessitating a review of the monetary policy framework and the Reserve Bank switched over to a more broad-based broad-based "multiple "multiple indicators indicators approach" approach" since 1998 in monetary monetary policy formulati formulation. on. The informal monetary policy strategy meetings review the monetary and liquidity conditions and the process has been made consultative. The Financial Markets Committee (FMC) monitors the developments in financial markets on a daily basis. The Committee makes quick assessment of the liqui liquidit dity y conditi conditions ons and recomm recommend endss strate strategie giess for interv intervent ention ion in the money money and securities markets.

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Monetary and credit aggregates have witnessed deceleration since their peak levels in October 2008. The liquidity overhang emanating from the earlier surge in capital inflows has substantially moderated in 2008-09. The Reserve Bank is committed to providing ample liquidity for all productive activities on a continuous basis. ba sis. In its mid- term review of monetary policy on October 24, 2008, the Reserve Bank had indicated that it would closely and continuously monitor the liquidity and monetary situation and respond swiftly and effectively to the impact of the global developments on Indian financial markets. markets. The Reserve Bank had also indicated indicated that the challenge challenge for the conduct of monetary  policy is to strike an optimal balance among preserving financial stability, maintaining price stability and sustaining the growth momentum. In response to emerging global developments, the Reserve Bank has taken a number of  measures since mid-September mid-September 2008. The aim of these these measures was to augment domestic and forex liquidity and to enable banks to continue to lend for productive purpose while maintaining credit quality so as to sustain the growth momentum. On a further review of the evolving developments, the Reserve Bank has taken the following measures:

Enhancing Rupee Liquidity The specia speciall term term repo repo facili facility, ty, introd introduced uced for the purpos purposee of meeti meeting ng the liqui liquidit dity y requirements of mutual funds and non-banking finance companies would continue till end-march 2009. Banks can avail of this facilit facility y either on incremental incremental or on rollover rollover basis within within their  entitlement of up to 1.5 per cent of net demand and time liabilities. As the upside risks to inflation have declined, monetary policy has been responding to slackening slackening economic growth growth in the context context of significan significantt global stress. stress. Accordingly Accordingly,, for policy  purposes, money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent Co nsistent with this, aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent. The growth in adjusted non-food credit, including investment in bonds/debentures/shares of public sector undertakings and private corporate sector and CPs, is placed at 20.0 per cent. Given the

33

wide dispersion in credit growth noticed across bank groups during 2008-09, banks with strong deposit base should endeavour to expand credit beyond 20.0 per cent.

Objectives of monetary policy The objectives of monetary policy have undergone a change in emphasis over the years. In the planned economy, they perforce were very much similar to the objectives of economic   planni planning. ng.

Accord According ingly ly,, the objecti objectives ves of moneta monetary ry policy policy in India were (a) to accelerat acceleratee

econom economic ic develop developmen mentt in an enviro environme nment nt of reason reasonabl ablee price price stabil stabilit ity, y, and (b) to develo develop p appropriate institutional set-up set-up to aid this process. The key note of monetary policy may be said to be controlled expansion of bank credit and money supply, with special attention to seasonal requirements for credit. The Bank has been directing its attention attention to ensure that credit expansion takes place in the light of price variations without affecting the output, particularly the industrial output adversely adversely.. In other words, the objective objective has been one of disinflati disinflation on without deflation. deflation. Thee auth Th author orit itie iess have have come come to hold hold that that mone moneta tary ry polic policy y is able able to make make more more effe effect ctiv ivee contribution to price stability than other objectives. Further, it has come to be believed that by achieving reasonable price stability, it is possible to (a) Avoid waste of resources because inflation results in such a waste by increasing uncertainty about the future. (b) Create Create an enviro environme nment nt in which effici efficient ent decision decisionss are taken and greate greaterr employ employmen ment, t,  poverty alleviation, and balanced growth. In Ind India, ia, whi while le the bas basic ic obj object ective ivess of mon moneta etary ry pol policy icy,, nam namely ely,, pri price ce sta stabil bilit ity y and adequate credit flow to the productive sectors of the economy, have remained the same, the operat ope rating ing env enviro ironme nment nt has cha changed nged sig signif nifica icantl ntly. y. As poi pointe nted d out in the RBI RBI’s ’s Rep Report ort on Currency and Finance 2003-04, there is an increasing focus on the maintenance of financial stability in the context of better linkages between various segments of the financial markets including money, Government securities and forex markets. Managing the capital flows has emerged as an important concern of monetary policy. The phasing out of adhoc treasury bills and their the ir aut automa omatic tic monetizat monetization ion in 1997 imparted imparted a lot of fle flexib xibili ility ty to the RBI in mon moneta etary ry management. Simultaneously, however, reserve flows through the balance of payments M3 in

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2004-05 is projected to expand by 14.0 per cent. Non-food credit adjusted for investment in commercial paper, shares/ debentures/bonds of public sector undertakings (PSUs) and private corporate sector was projected to increase by 16.0 to 16.5 per cent in the annual policy statement of May 2004. This magnitude of credit expansion was expected to adequately meet the credit needs of all the product productive ive sectors of the economy. Contrary to the assum assumption ptionss underl underlying ying the annual policy statement for 2004-05, the south west monsoon turned out to be deficient by 13 per  cent in the current year. There was a surge in inflation following the rise in international oil and metal prices. The carry forward of liquidity compounded matters. With a view to addressing these issues, the RBI increased the CRR by 50 basis points, in two stages, to 5.0 per cent, thus bringing down the liquidity in the banking system by about Rs. 9,000 crores. The interest rate on eligible CRR balances was de-linked from the Bank Rate and was reduced to 3.5 per cent per annum. The Government of India raised the ceiling of MSS from Rs. 60,000 crores to Rs. 80,000 crores on August 26, 2004 to enable the RBI to effectively deal with the problem of overhang of liquidity. As the inflation was supply induced, the Government also reduced the duty rates on petroleum products twice in the year 2004-05. Taking the above developments into account, the RBI in its mid-term review of the annual policy statement for  2004-05 2004-0 5 (Oct (October ober 26, 2004), revised revised its GDP growth projection projection in 2004-0 2004-05 5 from a range of 6.5 to 7.0 per cent to 6.0 to 6.5 per cent. Inflation projection on a point to point basis was raised upwards to 6.5 per cent from around 5.0 per cent projected earlier. RBI has not affected any change cha nge in its earlier earlier pro projec jectio tion n of M3 and aggr aggregat egatee dep deposi ositt tar target get of com commer mercia ciall ban banks. ks. Considering credit growth in the first half, the projection of adjusted non-food bank credit has  been revised to 19.0 per cent from 16.0 to 16.5 per cent projected projected earlier. The mid-t mid-term erm review increased the fixed reverse repo rate by b y 25 basis points under the LAF to 4.75 per cent. And increase in the prices of crude petroleum in the international markets has posed new challe cha llenge ngess for mon moneta etary ry pol policy icy.. As ind indica icated ted ear earli lier, er, in the cur curren rentt yea year, r, the two maj major  or  constraints facing monetary management were carry forward of excess liquidity of over Rs. 81,000 crores from the previous year and rise in inflation following the rising international prices of petroleum crude. The annual policy statement for 2004- 05 had placed the growth of GDP in 2004-05 in the range of 6.5 to 7.0 per cent, on the assumption of sustained growth in industrial sector, normal monsoon and good performance of exports. On the assumption of no significant 35

supply shocks and appropriate management of liquidity, inflation rate in 2004-05, on a point-to  point basis, was placed at around 5.0 per cent. The mid-term review also proposed a switch over  to the international usage of the terms repo and reverse repo effective October 29, 2004. In the mid-term review, RBI proposed reduction in the spread between the reverse repo rate and repo rate by 25 basis points from 150 basis points to 125 basis points. Accordingly, the fixed repo rate under LAF will continue to remain at 6.0 per cent. The RBI has continued with its policy of  active demand management of liquidity through OMOs, including the LAF, MSS and CRR, and using the policy instruments at its disposal flexibly, as and when the situation warrants consistent with the objective of price stability. At the same time, RBI has also been ensuring adequate liquidity in the system so that all legitimate requirements of credit to maintain the growth momentum are met. The other important policy initiatives announced in the mid-term review relate to raising the ceiling on NRE interest rates, reduction of tenure of domestic term deposits, dispensing with the restrictive provisions of service area approach for delivery of agricultural credit, and measures for improving credit delivery to agriculture and small-scale industry (SSI) sectors.

CHAPTER V

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Techniques of Monetary Control Many techniques of monetary control- some old and well known have been used in India. Among these are: (a) Open Market Operations (OMO), (b) Bank Rate, (c) Cash Reserve Ratio (CRR), (d) Statutory Liquidity Ratio (SLR), (e) Interest Rates. Some of the important features and evolution of these techniques are given below:

Open Market Operations Open market operations are the means of implementing monetary policy by which a central bank controls bank controls its national money supply by buying and selling government securities, or  other financial other financial instruments. instruments. Monetary targets, such as interest rates or exchange or exchange rates, rates, are used to guide this implement implementation. ation. Since most money money is now in the form of electronic electronic records, records, rather  than than paper paper reco record rdss such such as bank banknot notes es,, open open mark market et opera operati tion onss are are condu conduct cted ed simp simply ly by electronically increasing or decreasing ('crediting' or 'debiting') the amount of money that a bank  has, e.g., in its reserve account at the central bank, in exchange for a bank selling or buying a financial instrument. Newly created money is used by the central bank to buy in the open market a financial asset, such as government bonds, bonds, foreign currency, currency, or gold or  gold.. If the central bank sells these assets in the open market, the amount of money that the purchasing bank holds decreases, effectively destroying money. Under OMO, RBI buys or sells government government bonds in secondary secondary market. By absorbing absorbing  bonds, it drives up bond yields and injects injects money into market. When it sells, it does so to stuck  money out of the system. OMO is an actively used technique of monetary control in the US, the UK and many other countries. Through the open market sales and purchases of government securities, securities, the RBI can affect the reserves position of banks, yields on government securities, and volume and cost of bank credit. However, it is the technique least used by the Bank, though it has wide powers to to use it. There is no restriction restriction the quantity or maturity maturity of government securities securities which it can buy or sell or hold. Techni Technically cally,, the Bank can conduct OMOs in treasury treasury bills, bills, state government government securities, and central government securities; but in practice they are conducted only in central government securities of all maturities.

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The open market operations, repo and reverse repo operations have emerged as important liquidity management tools. Further, Liquidity Adjustment Facility (LAF), which was introduced in June 2000, has emerged as the principal operating instrument of monetary policy, enabling the Reserve Bank to modulate short-term liquidity under varied financial market conditions. In order  to fine-tune the management of liquidity and in response to suggestions from market participants, the the Rese Reserv rvee Bank Bank has has intr introdu oduce ced d a Secon Second d Liqui Liquidi dity ty Adju Adjust stme ment nt Faci Facili lity ty (SLA (SLAF) F) from from  November 28, 2005. Further, to address the dilemma of keeping a balance between the twin objectives of containing exchange rate volatility and maintenance of domestic price stability in the face of surging capital inflows, the Market Stabilization Scheme (MSS) was introduced in April 2004 to provide the Reserve Bank with an additional instrument of liquidity management. Under the MSS, the cost of sterilizat sterilization ion is borne by the Government. Government. Under this program, program, the RBI injected more than Rs. 60, 000 crores in one week’s time to counter balance the FPI activity, when the financial melt down in American Economy happened. As part of management of the demand for currency, it has been the endeavour of the Reserve Bank to contain the volume of notes in circulation by coinciding the lower denomination notes and conscious shift towards higher denomination notes in circulation. Major developments in this regard include following a ‘clean note policy’, mechanization of note counting operations   by the commercial banks, outsourcing of coin distribution to the private operators to ease   press pressure ure on distri distribut bution ion channel channels, s, regula regularr review reviewss of securi security ty featur features es of bank notes notes and mechanization of destruction of soiled notes, etc. These operations are aimed at ensuring the optimal level of customer service through adequate supply of good quality and secure notes and coins in the country.

OMO: Goals and Objectives The OMOs have both monetary policy and fiscal policy goals. goals. Their multiple objectives objectives include: (a) To control the amount of and changes in bank credit and monetary supply through controlling the reserve base of banks, (b) To make bank rate policy more effective, (c) To mainta mai ntain in sta stabil bility ity in gove governm rnment ent sec securi uritie tiess mar market ket,, (d) To sup suppor portt gove governm rnment ent bor borrow rowing ing  programme, and (e) To smoothen the seasonal flow of funds in the bank credit market.

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In India, OMOs have mostly been used for the purpose of debt management and this has undermined their effectiveness as a tool tool of monetary policy. The fact that government securities securities market in India is not well-organized, broad-based and deep, and also that interest rates on government govern ment securities, securities, like other inter interest est rates, were administered administered have reduced the efficacy of  OMOs so far. Howeve However, r, the authorities authorities are now determined determined to make OMOs a major tool of  monetary monet ary policy. policy. Simil Similarly, arly, the coupon rates rates of government securiti securities es have been raised and made market-related and competitive, and a large number of measures have been taken to develop and activise the government gov ernment securities market in India. This Th is do does es no nott me mean an th that at OM OMOs Os di did d no nott co cont ntri ribu bute te an anyt ythi hing ng at al alll to mo mone neta tary ry management in the past. They have indirectly helped in the regulation regulation of supply of bank credit to the private private sector in two ways. First First,, the bank has often conducted conducted OMOs for switching switching operations, i.e., the sale of long long term scrips in exchange for short term ones. This has helped to lengthen the maturity structure of government securities, which in turn, has been favorable for  the working working of monetary policy. policy. Second, the volume volume of the Bank’s net sales of government government securities has increased over the years.

Repo rate Repo is a repurchase agreement i.e. Selling a security under an agreement to repurchase at a pre-determ pre-determined ined date and rate. Repo is money market instrument instrument which enables enables short-term short-term   borro borrowin wing g and lendin lending g through through sale/pur sale/purchas chasee operati operation. on.

It introd introduce uced d in Decembe Decemberr 1992. 1992.

Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more expensive. The repo rate is the rate at which RBI lends private and public sector banks while reverse repo is the opposite. After cut, repo rate now stands at 4.75 pc while the reserve repo stands at 3.25 pc. Repo rate is the discounted interest rate at which a central bank repurchases government securities. The central bank makes this transaction with commercial banks to reduce some of the

39

short-term liquidity in the system. The repo rate is dependent on the level of money supply that the central bank chooses to set as part of its monetary policy. The central bank has the power to lower the repo rates while expanding the money supply in the country. This enables the banks to exchange their government security holdings for cash. In contrast, when the central bank decides to reduce the money supply, it implements a rise in the repo rates. When the central bank of the nation nation makes a decision decision regarding regarding the money supply level the repo or repurchase rate is determined by the market in response to the rules of supply and demand. The securities that are being evaluated and sold are transacted at the current market price  plus any interest that has accrued. When the sale is concluded, the securities are subsequently resold at a predetermined price. This price is comprised of the original market price and interest, and the pre-agreed interest rate, which is the repo rate.

Reverse repo rate Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from  banks.  banks. It introduced introduced by RBI during 1994 – 95. Banks are always always happy to lend lend money to RBI since their money is in safe hands with a good interest. An increase in Reverse repo rate can cause the banks to transfer more funds to RBI due to these attractive attractive interest interest rates. It can cause the money to be drawn out of the banking system. system. The reverse reverse repo rate or reverse repurchase repurchase rate is applicable when a country's reserve borrows money from banks. If reverse repo rates raise, it means that banks will provide more funds to the reserve. This is a safe proposition as lending money to most reserves is an extremely safe financial transaction. In cases of reserves  borrowing money from banks, excess money left with the particular bank is channeled into the reserve. This causes money to be taken out of the economic system. Reverse repo rates come into  play when there is a fund shortage being faced by the reserve. “The repo rate in India is currently 7.75%. The reverse repo rate is 6.00%.”

Bank Rate 40

Bank rate, also referred to as the discount rate, is the rate of interest which a central bank  charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Changes in the bank rate are often used by central banks to control the money supply. supply. The term term bank rate is commonly commonly used used by consume consumers rs to refer to the current current rate rate of  interest given on a savings certificate of Deposit. The term bank rate is most commonly used by consumers who are interested in either obtaining a purchase money mortgage, or a refinance loan, when referring to the current mortgage rate. The RBI provides financial accommodation in the form of rediscounting of bills of  exchange and promissory notes, and loans and advances to scheduled commercial and cooperative banks and other approved financial institutions for financing bonafide internal and external exter nal commercial, commercial, trade and production production transacti transactions. ons. The Bank Rate is the basic cost of  refinance and discounting facilities. Section 49 of the RBI Act, 1934 defines it it as the standard rate at which the Bank is prepared to buy or rediscount bills of exchange or other eligible commercial comme rcial paper. In the early years, years, financial financial accommodation accommodation from the Bank was largely   provided provided at the Bank rate.

Subsequently Subsequ ently,, owing to differential differential rates rates prescribed prescribed for various

sector-specific refinance facilities as also due to the absence of a genuine bill market, the Bank  rate application application was confined to (a) the ways and means advances to the state governments, governments, (b) advances to primary co-operative banks for SSI, and (c) state financial corporations besides  penal rates on shortfalls in reserve requirements.

Cash Reserve Ratio 41

The present banking system is called a “fractional reserve banking system”, because the  banks need to keep only a fraction fraction of their deposit deposit liabilit liabilities ies in the form of liquid liquid cash. The authorities earlier used to change this fraction mainly for the purpose of ensuring the safety and liquidity of deposits. deposits. Over the years, however, it has become an important important and effective tool for  for  directly regulating the the lending capacity of banks. The RBI has been using two ratios- the the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR) – as instruments of credit control. CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of   bank deposits, however over the years it has become an important and effective tool for directly regulating the lending capacity of banks and controlling the money supply in the economy. When the RBI feels that the money supply is increasing and causing an upward pressure on inflation inflation,, the RBI has the option option of increasing increasing the CRR thereby thereby reducing the deposits deposits available available with banks to make loans and hence reducing the money supply and inflation. Cash Reserve Ratio is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a central bank. The reserv reservee ratio ratio is someti sometimes mes used as a tool tool in moneta monetary ry policy policy,, influe influenci ncing ng the country’s economy, borrowing, and interest rates. Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they prefer to use open market operations to implement their monetary policy. The People’s People’s Bank of China does use changes changes in reserve requirements requirements as an inflation inflation-fight -fighting ing tool, and raised the reserve requirement nine times in 2007. As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply “M1″), and zero on time deposits and all other deposits. An institution that holds reserves in excess of the required amount is said to hold excess reserves. Cash reserve Ratio (CRR) in India is the amount of funds that the banks have to keep with RBI. If RBI decides to increase the percent of this, the available amount with the banks comes down. RBI is using this method, to drain out the excessive money from the banks. In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial Banks are required to maintain with RBI an average cash balance, the amount of which shall not be less 42

than three percent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not exceeding twenty percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act, 1934. In June 14, 2003, the rate of CRR is 4.50 per cent of the NDTL. In terms of Section 42(1A) of RBI Act, 1934, the Scheduled Commercial Banks are required to maintain, in addition to the balances prescribed under Section 42(1) of the Act, an additional average daily balance, the amount of which shall not be less than the rate specified by the RBI in the notification published in the Gazette of India, such additional balance being calculated with reference to the excess of the total of the NDTL of the bank as shown in the return referred to in section 42(2) of the RBI Act, 1934 over the total of its NDTL at the close of  the business on the date specified in the notification. At present no incremental CRR is required to be maintained by the Scheduled Commercial Banks. The CRR refers to the cash which banks have to maintain with the RBI as a certain  percentage of their demand and time liabilities. liabilities. Till 1962, a separate CRR was fixed in in respect of demand liabiliti liabilities es (5 percent) and time liabilities liabilities (2 percent). percent). The Bank had powers to vary these ratios up to a maximum of 20 percent and 8 percent respectively. respectively. Subject to these ceilings, the RBI could ask banks to maintain with itself additional reserves as a specified percentage of  additional additional demand and time liabilities liabilities after certain certain specified specified date. This marginal marginal CRR cannot exceed 100 percent. In 1962, the separate CRRs were merged and one CRR came to be fixed as a certain  percentage of both demand and time liabilities with the maximum of 15 percent. The rules regarding the marginal CRR were were not changed. The actual minimum CRR fixed fixed in 1962 was 3  per cent. The CRR is applicable applicable to all scheduled scheduled banks including including scheduled scheduled cooperative cooperative banks and the Regional Rural Banks (RRBs), (RRBs), and non-scheduled banks. However, co-operative banks, RRBs, and non scheduled banks have to maintain the CRR of merely 3 per cent, and so far it has not been changed by the RBI. The CRR is applicable applicable to various NRI deposit deposit accounts accounts also but the level of CRR in their case differs from the CRR for domestic deposits, and also among themselves.

43

The RBI has powers to impose penal interest rates on banks in respect of their shortfall in the prescribed prescribed CRR. The penal interest interest rate is normally normally 3 percent above the Bank rate for the first first week of default and 5 percent for the subsequent subsequent weeks till the default default are made good. In addition, the Bank can disallow fresh access to its refinance facility to defaulting banks and charge additional interest over and above the basic refinance rate on any accommodation availed of, and which is equal to the shortfall shortfall in CRR. In addition, from January 1985, default default in CRR  results in graduated penalty by way of loss of interest on the defaulting bank’s cash balances. The RBI pays, since 1973, at its discretion, interest on that portion of cash reserves which is the difference between the prescribed CRR and the minimum CRR of 3 percent, provided the   bank has not defaulted defaulted in respect of maintaini maintaining ng the prescribed prescribed CRR. Interest Interest is not paid on excess reserves. With a view to providing flexibility to banks in choosing an optimum strategy of holding reserves depending upon their intra period cash flows, all Scheduled Commercial Banks, are required required to maintain maintain minimum CRR balances upto 70 per cent of the total CRR requirement requirement on all days of the fortnight. If any Scheduled Commercial Bank fails fails to observe the the minimum level of CRR on any days during the relevant 8 fortnight, the bank will not be paid interest to the extent of one fourteenth of the eligible amount of interest, even if there is no shortfall in the CRR  on average basis.

Statutory Liquidity Ratio

44

In addition to the CRR, the RBI has made active use of another ratio, namely the SLR. While the CRR enables the Bank to impose primary reserve requirements the SLR enables it to impose impose secondary and supplementary supplementary reserve reserve requirements, requirements, on the banking banking system. There are three objectives behind the use of SLR: (a) to restrict expansion of bank credit (b) to increase   banks banks investme investment nt in governm government ent securiti securities, es, and (c) to ensure ensure solvency solvency of banks. banks.

Throug Through h

variations in the SLR, the Bank is in a position to insulate a part of the government debt from the open market impact because banks are then prevented from disinvesting government securities in favour of commercial credit. Statutory Liquidity Ratio (SLR) is a term used in the regulation of  banking  banking in India India.. It is the amount which a bank has to maintain in the form: 1.

Cash

2.

Gold valued at a price not exceeding the current market price

3.

Unencumbered approved securities (Government (Government securities or Gilts come under this) valued at a price as specified by the RBI from time to time.

The quantum is specified as some percentage of the total demand and time liabilities (i.e. the liabilities of the bank which are payable on demand anytime, and those liabilities which are accruing in one month’s time due to maturity) of a bank. This percentage is fixed by the Reserve Bank of India. India. The maximum and minimum limits for the SLR are 40% and 25% respectively. Following the amendment of the Banking regulation Act (1949) in January 2007, the floor rate of  25% for SLR was removed. Presently, the SLR is 24% with effect from 8 November, 2008. The SLR is the ratio of cash in hand (exclusive of cash balances maintained by banks to meet the required CRR, but not the excess reserves); balances in current account with the SBI, its subsidiaries, other nationalized banks and the RBI; gold and unencumbered, approved securities, i.e. central and state government securities, securities of local bodies and government guaranteed securi securiti ties es to total total DTL of banks. banks. Betwee Between n years years 1949 to 1962, 1962, while while calculati calculating ng SLR, no distinction was made between cash on hand and balances held with the RBI to meet CRR  requirement requirements. s. The SLR, like CRR, is applicable applicable to co-operative co-operative banks, non-scheduled non-scheduled banks, and the RRBs, but it is is maintained at a constant level of 25 percent. While the SLR defaults do 45

not invite penal interest payment and the loss of interest on cash reserves, they do result in restrictions on the access to to refinance from the RBI and in the higher cost of refinance. The RBI is empowered to increase the SLR for scheduled commercial banks up to 40 percent. The SLR remained at the level of 20 percent between years 1949 to 1962 in terms of the definition then then prevailing. prevailing. Thereafter, it has been raised frequently frequently and substantially. In 1990, SLR has been increased increased from 20 percent to 38.5 percent. percent. The significan significantt increase in the SLR  does does not mean that the monetary monetary policy policy became became quite quite restrict restrictive ive during during 1963 to 1990. An increase in the SLR does not restrain total expenditure in the economy; it may restrict only the   private private sector expenditur expendituree while helping to increase increase the government government expenditure. expenditure. In a sense, therefore, the SLR is not a technique of monetary control; it only distributes bank resources in favour of the government government sector. sector. It is therefore, therefore, not correct to indicate, indicate, as it often done, the extent of immobilization of bank resources in terms of the combined level of the CRR and SLR. As in the case of CRR, the post 1991 period is characterized by a declining phase for  SLR also; its level was reduced and it came to be much criticized criticized during this phase. After 1992,  banks were required to maintain SLR based on multiple prescriptions. prescriptions. For example, in October  1992, the SLR was fixed at 38.25 percent, 38 percent and 37.25 percent of net DTL as on 3 April 1992 with effect from fortnights beginning 9 January 1993, 6 February 1993, and 6 March 1993 respectively. The October 1997 credit policy policy rationalized this system of multiple rates of SLR    by collapsi collapsing ng them them into into a single single prescr prescript iption ion of 25 percen percentt of banks. banks. SLR has remained remained unchanged at 25 percent since 1997 till today. The SLR is commonly used to contain inflation and fuel growth, by increasing or  decreasing it respectively. This counter acts by decreasing or increasing the money supply in the system respectively. Indian banks’ holdings of government securities (Government (Government securities) securities) are now close to the statutory minimum that banks are required to hold to comply with existing regulation. When measured in rupees, such holdings decreased for the first time in a little less than 40 years (since the nationalization of banks in 1969) in 2005-06. Statutory Liquidity Ratio refers to the amount that the commercial banks require to maintain in the form of cash, or gold or government approved securities before providing credit to the customers. Statutory Liquidity Ratio is determined and maintained by the Reserve Bank of  46

India in order to control the expansion expansion of bank credit. Statutory Statutory Liquidity Liquidity Ratio Ratio refers to the amount that all banks require maintaining in cash or in the form of Gold or approved securities. Her Here by appr approv oved ed secu securriti ities we mean mean,, bond bond and and shar shares es of dif differ ferent ent com compani panies es.. This Th is Stat Statut utor ory y Liqui Liquidi dity ty Rati Ratio o is dete determ rmin ined ed as perce percent ntag agee of tota totall dema demand nd and and  percentage of time liabilities. Time Liabilities refer to the liabilities, which the commercial banks are liable to pay to the customers on there anytime demand. The liabilities that the banks are liable to pay within one month's time, due to completion of maturity period, are also considered as time liabilities. In India, Reserve Bank of India always determines the percentage of Statutory Liquidity Ratio. There are some statutory requirements for temporarily placing the money in Government Bonds. Following this requirement, Reserve Bank of India fixes the level of Statutory Liquidity Ratio. At present, the minimum limit of Statutory Liquidity Ratio that can be set by the Reserve Bank is 25%.

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Interest rates The RBI has been following a policy stance of imparting flexibility to the interest rate structure. Concerned over the downward rigidity of lending rates, even while deposit rates were coming down, RBI advised banks to announce their benchmark prime lending rates (BPLRs)   bas based ed on th thei eirr act actua uall co cost st of fu funds nds,, op oper erat atin ing g exp expen ense sess and a mi mini nimum mum ma marg rgin in to co cove ver  r  regulatory requirement. In response to this policy directive, all banks put in place a system of  BPLRs in 2003-04. The BPLRs of five major banks are lower by 25 to 50 basis points in December, 2004 compared to the rates prevailing a year ago. During the current year, there has  been a marginal firming up of deposit rates by 25 basis points. Interest rates on housing loans have firmed up marginally in the current year for banks. Call money rates firmed up from the second half of the year, reflecting lower liquidity on account of large increase in bank credit. The Bank Rate remained unchanged at 6.0 per cent in the current year. The repo rate (reverse repo rate since October 29, 2004) under LAF was raised by 25  basiss points to 4.75 per cent from October 27, 2004. The spread between  basi between reverse repo and repo was narrowed by 25 basis points to 125 basis points. Towards this end, steps have been initiated to deregulate interest rates, to ease operational constraints in the credit delivery system, to introduce new money market instruments, and so on. The monetary policy is now geared towards (a) reducing the rigidities, (b) introducing flexibility, (c) encouraging diversification, (d) promoting more competitive environment, and (e) imparting greater discipline and prudence in the operations of the financial system.

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CHAPTER VI Equities in India Let’s review the performance of equities in India from past ten years. Equities in India did provide attractive returns from 1979-91 however; they fared poorly in the decade of 19912001.

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If we see the compounded annual returns generated by Sensex, the most widely followed equity index in India, at the end of 2001 were as follows for various investment periods: Investment Period

Compound Return

1 year

-20.5 %

2 years

-23.3 %

3 years

-2.0 %

5 years

1.2 %

7 years

-2.6 %

10 years

5.5 %

Thus, we can see that equities have under performed even bank deposits for each of the periods considered above.

What is the Picture of Key Economic Numbers? During the decade of 1991-2001, the nominal GDP of the country increased by about 3.7 times, forex reserves soared from a near zero level to a record of US $ 48 billion, exports multiplies by 2.4 times, the prime lending rate fell from around 19% to 11.5%, and the earnings of Sensex stocks grew at a compound rate of 13.3%. It seems surprising that the growth of the economy and corporate earnings has not been reflected in equity returns. What could have caused this discrepancy? The factors that have contributed to this appear to be as follows: 1. The market was very bullish at the beginning of the decade of 1991-2001, but extremely  bearish at the end of the decade.

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2. During the decade of 1991-2001, the maximum growth occurred in the services sector (which now accounts for nearly 50% of the GDP), whereas the services sector accounts for less than the quarter of Sensex. 3. The excessiv excessivee volati volatilit lity y of the Indian Indian stock stock market market has perhaps perhaps driven driven away long-t long-term erm investors who can contribute to grater rationality in price movement. 4. The periodic scams that occurred during this period have shaken investor’s confidence.

RBI and SEBI Review on ‘Bank Financing of Equities’ Background: Accordingly, the RBI-SEBI Technical Committee has reviewed the guidelines on bank financing of equities and investments in shares issued by the Reserve Bank of India keeping in view the  position of banks’ investments in shares as also advances against shares and other connected exposures.

Methodology: The Committee reviewed the policy formulated by the Board of Directors of banks; the ceilings prescribed by the Boards for exposure to capital market, the operational mechanism put in place as also the data reported by the banks in respect of investment in shares, advances against shares and guarantees issued on behalf of the brokers. The Committee observed that banks have by and large adhered to RBI guidelines. However However,, a few banks had overex overexten tended ded exposur exposuree by way of advance advancess against against shares, shares, in violation of the spirit of the RBI guidelines. The Committee also took into took into account the abnormal decline observed in the prices of equity shares after the presentation of the Union Budget for the year 2001-2002 in the Parliament on February 28, 2001, leading to the payment problems by some brokers in the Calcutta Stock Exchange, the Stock Exchange, Mumbai and NSE. The Committee observed from the provisional data collected by Reserve Bank of India that bank  51

guarantees amounting to Rs.69.29 crore had been invoked by the Calcutta Stock Exchange in order to meet the payment obligations of some of its members.

Guidelines:

(i) Ceiling on bank’s investments in shares and debentures: a) Within the overall exposure to sensitive sectors, a bank’s investment in shares, convertible debentures and units of equity oriented mutual funds should not exceed 5% of the bank’s total outstanding domestic credit ( excluding inter- bank lending and advances outside India) as on March 31 of the previous year.  b) The above ceiling for investments in shares, etc., is the maximum permissible ceiling and a  bank’s Board of Directors is free to adopt a lower ceiling, keeping in view its overall risk profile. Where the present present outstanding outstanding investments investments in shares shares are relatively relatively small and below the overall overall ceiling, the Board should lay down an annual ceiling for fresh investments in equities. c) Banks may make investment in shares directly taking in to account the in-house expertise available within the bank as per the investment policy approved by the Board of Directors. d) Banks may also make investment in units of UTI and SEBI approved other diversified mutual funds with good track records as per the investment policy approved by the Board of Directors. Banks should make investments investments in specific specific schemes of mutual mutual funds / UTI and not place funds with mutual funds / UTI for investments in the capital market on their behalf. e) Underwriting Underwriting commitments commitments taken up by the banks in respect of primary primary issues through book   building route would also be within the above overall ceiling. f) Investments Investments in shares shares and debentures debentures / bonds should as hitherto, hitherto, be reckoned for the purpose purpose of arriving at the prudential norm on single borrower and borrower – group exposure e xposure ceilings. g) Credit Credit substit substitute utess like like Commer Commercia ciall Paper, Paper, non non-co -conver nvertib tible le debent debenture ures, s, etc., etc., may not be reckoned as part of credit portfolio for arriving at the ceiling on bank’s investments in shares and debentures. 52

(ii) Financing of Initial Public Offerings (IPOs): (a) Banks are permitted to grant advances for subscribing to IPOs to individuals. The maximum amount of finance that can be extended to an individual against IPOs should be Rs.10 lakh, as applicable to advances against physical shares. The other terms and conditions for financing of  IPOs (including the minimum margin of 50% and 25% against physical and dematerialized shares, respectively) should be the same as those applicable to advances against shares to individuals. The corporate should not be extended credit by banks for investment in other  companies’ companies’ IPOs. Similarly, Similarly, banks should not provide provide finance finance to NBFCs for further lending to individuals for IPOs. (b) Finance extended by a bank for IPOs should be reckoned as an exposure to capital market.

(iii) Issue of guarantees on behalf of brokers: A minimum margin of 25% inclusive of cash margin should be obtained by banks for issue of  guarantees on behalf of share brokers. Banks may, at their discretion, obtain margin higher than 25% as per the policy approved by their Board of Directors.

(iv) Advances against shares and debentures debenture s to individuals individua ls and share brokers: (a) The terms and conditions for financing of individuals against shares and debentures, viz., maximum amount of finance of Rs.10 lakh and Rs.20 lakh against physical and dematerialized shares with a minimum margin of 50% and 25%, respectively within the overall policy approved  by the Board, remain unchanged. (b) Banks are free to provide need based credit facilities to share brokers and market makers against shares and debentures held by them as stock-in-trade after making a careful assessment of the requirements for finance. Banks may decide on the basis of the commercial judgment, the quantum as well as margin on the finance provided to the stock brokers and market makers. (c) Loans Loans sancti sanctioned oned to corpor corporate ate against against the securi security ty of shares shares for meetin meeting g promot promoters ers’’ contribution to the equity of new companies in anticipation of raising resources and bridge loans 53

sanc sancti tion oned ed to comp compan anie iess for for a peri period od not not exce exceed edin ing g one year year agai agains nstt expec expecte ted d equi equity ty flows/issues, expected proceeds of non-convertible debentures, external commercial borrowings, GDRs and / or funds in the nature of foreign direct investments, would continue to be within the overall ceiling of 5%.

(v) Risk Management and internal control: Banks Banks desiro desirous us of making making invest investmen ments ts in equity equity shares, shares, etc. etc. within within the above above ceilin ceiling g and financing of equities, should observe the following guidelines: g uidelines: a) Build up adequate expertise in equity research by establishing a dedicated equity research department, as warranted by their scale of operation,  b) Formulate a transparent policy and procedure for investment in shares, etc. c) The decision in regard to individual investments in shares, etc. should be taken by the Inves Investm tment ent Comm Commit itte teee set set up by the the bank bank.. Th Thee Inve Invest stme ment nt Commi Committ ttee ee shou should ld be held held accountable for the investments made by the bank. d) Banks should review on an ongoing basis, their investment in shares with a view to assessing the risks due to volatility in asset prices. e) As a prudential measure, a bank’s exposure to investment in equities whose prices are subject to volatility (e.g. shares, convertible debentures and units of equity-oriented mutual funds ) should not normally exceed 20% of o f its net worth. f) In addition to the ceiling of 5% 5 % on investments, the Board of Directors of banks should also fix an overall ceiling on advances against shares, i.e. financing of IPOs, advances to individuals and share brokers and market makers, issue of guarantees on behalf of brokers, advances to corporate to meet promoters’ contribution, etc. g) The following may be excluded for reckoning the bank’s aggregate exposure by way of  financing of equities:

54

i.

Advan Advance cess agai agains nstt col colla late teral ral secu securi rity ty of shar shares es..

ii.

Adva Advanc nces es to indi ndividu vidual alss for for pers person onal al pur purpose posess like educ educat atiion, on, hous housiing, ng, consumption, etc. against the security of shares.

(vi) Valuation and disclosure: Banks should mark to market their investment portfolio in equities like other investments as per the the valu valuat atio ion n norms norms pres prescr crib ibed ed by RBI. RBI. Furth Further er,, banks banks shoul should d disc disclo lose se the the tota totall investments made in shares, convertible debentures and units of equity oriented mutual funds as also aggregate advances against shares, etc., in the ‘Notes on Accounts’ to their balance sheets,   begin beginnin ning g from the year year ending ending March March,, 2001.

In 2008, 2008, in case of FPI, FPI, RBI was sucki sucking ng

liquidity from the market through selling of government securities and in the same year, in case of Lehman Brothers collapse, RBI was wa s injecting liquidity into the market so, in this contradictory case, the role of RBI has changed to maintain the liquidity stability.

(vii) Review of Guidelines: The Standing Technical Committee of RBI and SEBI will review the guidelines after six months in consultation with banks keeping in view their institutional set up, operational mechanism and the experience gained.

55

CHAPTER VII The Crisis and India

Like all emerging economies, economies, India too has been impacted by the crisis, and much more than was expected earlier. GDP growth has moderated reflecting lower industrial production, negative exports, deceleration in services activities, dented corporate margins and diminished  business confidence. There are some comforting factors — well-functioning financial markets, robust rural demand, lower headline inflation and comfortable foreign exchange reserves —  which buffered us from the worst impact of the crisis. The fiscal stimulus packages of the Government and monetary easing and regulatory action of the Reserve Bank have helped to arrest the moderation in growth and keep our financial markets functioning normally.

In order to provide liquidity support to the housing sector, and particularly to housing finance companies (HFCs) which have been adversely affected by the recent financial market developments, it has been decided to provide a refinance facility of an amount of Rs 4,000 crore to the National Housing Bank (NHB) under the provisions of Section 17(4DD) of the Reserve Bank of India Act, 1934. This refinance will be available against the NHB's loans and advances to HFCs. The facility will be available at the prevailing repo rate under the LAF for a period of  90 days. During this 90-day period, the amount can be flexibly drawn and repaid. At the end of  the 90-day 90-day period, period, the withdraw withdrawal al can also also be rolled rolled over. This This refina refinance nce facil facility ity will be available up to March 31, 2010. The utilization of funds will be governed by the policy approved  by the Board of the NHB.

With a view to mitigating the pressures on account of the recent developments on loan disbursements to Indian exporting companies and for honoring disbursements under export lines of credit extended at the behest of the Government of India to overseas financial institutions, sovereign governments and other entities for financing imports from India, it has been decided to 56

 provide a refinance facility to the EXIM Bank under the provisions of Section 17(4J) of the Reserve Bank of India Act, 1934. The refinance facility will be of an amount of Rs 5,000 crores. It will be available at the prevailing repo rate under the LAF for a period of 90 days. During this 90-day period, period, the the amount can be flexibly flexibly drawn drawn and repaid. repaid.

At the end of the 90-day 90-day period, period,

the withdrawal can also be rolled over. This refinance facility will be available up to March 31, 2010. The utilization of funds will be governed by the policy approved by the Board of the EXIM Bank.

The Reserve Bank will continue to closely monitor the developments in the global and domestic financial markets and will take swift and effective action as appropriate. The Reserve Bank will endeavour to minimize the stress on various sectors of the economy on account of the international financial crisis and the global slowdown. The policy objective is to ensure adequate availability of liquidity in the system and to maintain conditions conducive for flow of credit for  all productive purposes, particularly to the housing, export and small and medium industry sectors. The Reserve Bank of India (RBI) announced it will develop a regulatory and oversight framework for mobile banking, and made clear its concern over the safety of transactions through mobile phones. “The large scale spread of mobile telephony has opened up new vistas for banking in the form of mobile banking and the potential in this new sphere is enormous; adequate steps to ensure safety and security in a mobile based computing / communicating environment have to, however, be made.” Reserve Bank has decided to take up the following actions which measure the current assessment of macroeconomic and monetary conditions.

Monetary Policy action It Reduce the repo rate under the LAF by 25 basis points from 5.0% to 4.75% with immediate effect. Reduce the reverse repo rate under the LAF by 25 basis points from 3.5% to to 3.25% 3.25% with immedi immediate ate effect. effect. Keep Keep the CRR unchang unchanged ed at 5.0% of net demand demand and time time liabilities (NDTL).

57

Reserve Bank’s Policy thrust The thrust of the Reserve Bank's policy stance since mid-September 2008 has been aimed at provid providing ing ample ample rupee rupee liquid liquidit ity, y, ensuri ensuring ng comfor comfortab table le dollar dollar liquid liquidit ity y and mainta maintaini ining ng continued credit flow to productive sectors. Taken together, the policy measures of the Reserve Bank have ensured that the Indian financial markets continue to function in an orderly manner. These These measur measures es have have added added actual actual/po /poten tentia tiall liquid liquidity ity in the financ financial ial syste system m by over Rs. 4,20,000 crores. This should assure financial markets that the Reserve Bank will continue to maintain comfortable liquidity.

Interest Rate Response from Banks Within the policy rate adjustment already effected by the Reserve Bank, there is scope for   banks to further reduce lending rates so as to ensure credit flow for all productive economic activity. They hope and expect that banks will play their part in the economic adjustment process  by passing on the benefits of lower interest rates to their customers.

Government Borrowing Government borrowing increased substantially in 2008-09. Net borrowing by the Central Government in 2008-09 was increased nearly by three times than that in 2007-08. As per  estimates in the interim budget, net borrowing in the current year, 2009-10, will also be at this elevated level. Even as the increase in borrowing was large and abrupt in the fourth quarter of  2008-09, they managed that in a non-disruptive manner through a combination of measures such as unwinding unwinding of the MSS securities securities,, open market operations operations and monetary monetary easing. Admittedly Admittedly,, yields yields had increased. But for the offsetting offsetting liquidity liquidity easing done by the Reserve Reserve Bank, yields would have increased even more. Government will manage the borrowing in 2009-10 in a similarly non-disruptive manner. An effort in this regard is the planned OMO purchases and MSS unwinding in the first half of 2009/10 that will add primary liquidity of about Rs.1, 20,000 crore, the monetary impact of which is equivalent to CRR reduction by 3 percentage points.

Growth Outlook  In the January 2009 policy review, they projected growth for 2008-09 of 7.0 per cent with a downward bias. The downside risks have since materialized, and GDP growth for 2008-09 is now projected to turn out to be in the range of 6.5-6.7 per cent. Going forward, the fiscal and 58

monetary stimulus measures initiated during 2008-09 coupled with lower commodity prices will cush cushio ion n the the down downtu turn rn by stab stabil iliz izin ing g domes domesti ticc econo economi micc acti activi vity ty.. On bala balance nce,, with with the the assumption assumption of a normal normal monsoon, for policy policy purpose real GDP growth for 2009-10 is placed at around 6.0 per cent.

Inflation Outlook  On the the pric pricee stab stabil ilit ity y fron front, t, Indi India' a'ss perf perfor orma manc ncee has has been been fair fairly ly good good.. Sinc Sincee independence, the inflation rate, in terms of the wholesale price index (WPI), on an average  basis, was above 15 per cent in only five out of fifty years. In thirty-six out of fifty years, inflation was in single digit and on most occasions high inflation was due to shocks – food or oil. The tolerance level to inflation has been low, relative relative to many developing countries, countries, especially especially on account of the democratic pressures in the country. The inflation rate accelerated steadily from an annual average of 1.7 per cent during the 1950s to 6.4 percent during the 1960s and further to 9.0 per cent in the 1970s before easing marginally to 8.0 per cent in the 1980s. However, the inflation rate declined from an average of 11.0 per cent during 1990-95 to 5.3 per cent during the second half of the 1990s (1995-2000) and further to 4.9 per cent during 2003-07. More recently during 2006-07, WPI based inflation rate increased from 4.1 per cent at the end of March 2006 to an intra-year peak of 6.7 per cent at end-January 2007 and remained firm in the range of 6.1-6.6 per cent in the succeeding weeks before moderating to 5.9 per cent  by the end of the financial year (i.e., as on March 31, 2007). Since then, the inflation inflation has further  moderated and as on June 16, 2007, the WPI inflation rate was 4.0 per cent. In recent period, there has been considerable improvement in the fiscal position. The average gross fiscal deficit of the central government as per cent to GDP during the 5 decade of 1980s was 6.8 per cent as against 3.8 per cent in the 1970s. The Government of India is pursuing the path of rule-based fisc fiscal al cons consol olid idat atio ion n from from the the year year 2004 2004-0 -05 5 under under the the Fisc Fiscal al Resp Respon onsi sibi bili lity ty and and Budge Budgett Management Act, 2003 where under time-specific targets have been mandated. The underlying purpose of the targets is to reduce the ratio of gross fiscal deficit (GFD) to gross domestic product (GDP) to three per cent by 2008-09. Furthermore, the revenue deficit (RD) to GDP ratio has been targeted to touch 0.0 per cent by 2008-09 so that borrowed resources can be used to meet only capital expenditures. The progress of targeted fiscal consolidation has  been satisfactory so far and GFD/GDP and RD/GDP ratios are budgeted to reduce to 3.3 per cent

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and 1.5 per cent, respectively, in 2007-08. The objective is to meet the targets under the Fiscal Responsibility Act by 2008-09. The average current account deficit since 1950-51 has been around one per cent of the GDP. During this period, except for 11 years when there was marginal surplus in the current account, they had modest deficit during the rest of the years. In the aftermath of the balance of    payment crisis in the early 1990s, several stabilization and structural reform measures were undertaken. undertaken.

Keeping Keeping in view view the global global trend trend in commodi commodity ty prices prices and domestic domestic demanddemand-

supply balance, it project WPI inflation at around 4.0 per cent by end-March 2010. Headline WPI inflation decelerated sharply after August 2008 reflecting the fall in global commodity  prices. CPI inflation continues to be at near double-digit level but is expected to moderate in the coming months. WPI inflation, however, is expected to be in the negative territory in the early   part of 2009-10 which is only of statistical significance and is not a reflection of demand contraction as is the case in advanced economies.

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Money Supply Money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this, the aggregate deposits of commercial banks are projected to grow by 18.0 per cent. The growth in adjusted non-food credit, including investment in bonds/debentures/ shares of public sector  undertakings and private corporate sector and CPs, is placed at 20.0 per cent. As always, these numbers are indicative projections and not targets.

Challenges on the way forward Ther Th eree are are seve severa rall imme immedi diat atee chal challe leng nges es faci facing ng the the econo economy my.. Th Thes esee incl include ude:: (a) (a) supporting the drivers of aggregate demand to enable the economy to return to its high growth  path; (b) boosting boosting the flow of credit credit to all productive productive sectors of the economy; (c) managing the large government borrowing programme in 2009-2010 in a non-disruptive manner; (d) restoring the fiscal consolidation process; (e) ensuring an orderly withdrawal of the large liquidity injected in the system since September 2008 by the Reserve Bank to support the economy's productive requirements; and (f) the continued challenge of preserving the stability of our financial system drawing from the lesson of the global crisis. Here in India, there are several immediate challenges facing the economy which would need to be addressed going forward. First, after five years of high growth, the Indian economy was headed for a moderation in the first half of 2008-09. However, the growth slowdown accentuated in the third quarter of 2008-09 on account of spillover effects of international developments. While the moderation in growth seems to have continued through the fourth quarter of 2008-09, it has been cushioned by quick and aggressive policy responses both by the Reserve Reserve Bank and the Government. Government. Notwithsta Notwithstanding nding the contractio contraction n of global demand, demand, growth growth  prospects in India continue to remain favorable compared to most other countries. While public investment can play a critical role in the short-term during a downturn,   private investment has to increase as the recovery process sets in. A major macroeconomic challenge at this juncture is to support the drivers of aggregate demand to enable the economy to return to its high growth path. The second challenge going forward is meeting the credit needs of the non-food sector. Although, for the year 2008-09 as a whole, credit by the banking sector expanded, the pace of  61

credit flow decelerated rapidly from its peak in October 2008. This deceleration has occurred alongside a significant decline in the flow of resources from non-bank domestic and external sources. The deceleration in total resource flow partly reflects slowdown in demand, drawdown of invent inventori ories es by the corpor corporate ate and declin declinee in commod commodity ity prices prices.. The expans expansion ion in credit credit,, however, has been uneven across sectors. There is, therefore, an urgent need to boost the flow of  credit to all productive sectors of the economy, particularly to MSMEs, to aid the process of  economic recovery. The Reserve Bank continues to maintain and will maintain ample liquidity in the system. It should be the endeavour of commercial banks to ensure that every creditworthy  borrower is financed at a reasonable cost while, at the same time, ensuring that credit quality is maintained.

It may be noted that bank credit had accelerated during 2004-07. This, combined with significant slowdown of the economy in 2008-09, may result in some increase in NPAs. While it is not unusual for NPAs to increase during periods of high credit growth and downturn in the economy, the challenge is to maintain asset quality through early actions. This calls for a focused approa approach, ch, due dilige diligence nce and balanc balanced ed judgmen judgmentt by banks. banks.

Third, the Reserve Bank was able to manage the large borrowing programme of the Central and State Governments in 2008-09 in an orderly manner. The market borrowings of the Central and State Governments are expected to be higher in 2009-10. Thus, a major challenge is to manage the large government borrowing borrowing programme programme in 2009-10 2009-10 in a non-disrupt non-disruptive ive manner. Large borrowings also militate against the low interest rate environment that the Reserve Bank is trying to maintain to spur investment demand in keeping with the stance of monetary policy. The Rese Reserv rvee Bank Bank,, ther theref efor ore, e, woul would d conti continue nue to use use a comb combin inat atio ion n of monet monetar ary y and and debt debt management tools to manage government borrowing programme to ensure successful completion of government borrowings in a smooth manner. The Reserve Bank has already announced an OMO calendar to support government market borrowing programme through secondary market  purchase of government securities. During the first half of 2009-10, planned OMO purchases and MSS unwindi unwinding ng will will add primar primary y liqui liquidit dity y of about about Rs.1,2 Rs.1,20,00 0,000 0 crores crores which, which, by way of  monetary impact, is equivalent to CRR reduction of 3.0 percentage points. This should leave adequate resources with banks to expand credit. 62

Fourth, another challenge facing the Indian economy is to restore the fiscal consolidation  process. The fiscal stimulus packages by the Government and some other measures have led to sharp increase in the revenue and fiscal deficits which, in the face of slowing private investment, have cushioned the pace of economic activity. However, it would be a challenge to unwind fiscal stimulus in an orderly manner and return to a path of credible fiscal consolidation. In this context, close monitoring of the performance of the economy and the proper sequencing of the unwinding process would have to be ensured. Fifth, a continued challenge is to preserve our financial stability. The Reserve Bank  would continue to maintain conditions which are conducive for financial stability in the face of  global crisis. A sound banking sector, well-functioning financial markets and robust payment and settlement infrastructure are the pre-requisites for financial stability. The banking sector in India is sound, adequately capitalized and well-regulated. By all counts, Indian financial and economic conditions are much better than in many other countries of the world. The single factor stress tests carried out as part of the report of the Committee on Financial Sector Assessment (CFSA) have revealed that the banking system in India can withstand significant shocks arising from large potential changes in credit quality, interest rate and liquidity conditions. These stress tests for credit, market and liquidity risk show that Indian banks are generally resilient.

Sixth, the Reserve Bank has injected large liquidity in the system since mid-September  2008. 200 8. It has reduce reduced d the CRR signif significa icantl ntly y and instit institute uted d some some sector sector-sp -speci ecific fic facil faciliti ities es to improve the flow of credit to certain sectors. The tenure of some of these facilities has been extended to provide comfort to the market. While the Reserve Bank will continue to support all the productive requirements of the economy, it will have to ensure that as economic growth gathers momentum, the large liquidity injected in the system is withdrawn in an orderly manner. It is worth noting that even as the monetary easing by the Reserve Bank has potentially made available a large amount of liquidity to the system, at the aggregate level this has not been out of  line with our monetary aggregates unlike in many advanced countries. As such, the challenge of  unwinding will be less daunting for India than for other countries.

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Fina Finall lly, y, we will will have have to addre address ss the the key key chal challe lenge nge of ensur ensurin ing g an inte intere rest st rate rate environment that supports revival of investment demand. Since October 2008, as the inflation rate has decelerated and the policy rates have been reduced, market interest rates have also come down. However, the reduction in interest rates across the term structure and across markets has not been uniform. Given the cost plus pricing structure, banks have been slow in reducing their  lending rates citing high cost of deposits. In this context, it may be noted that the current deposit and lending rates are higher than in 2004-07, although the policy rates are now lower. Reduction in deposit rates affects the cost only at the margin since existing term deposits continue at the originally contracted cost. So lending rates take longer to adjust. Judging from the experience of  2004-07, there is room for downward adjustment of deposit rates. With WPI inflation falling to near zero, possibly likely to get into a negative territory, albeit for a short period, and CPI inflat inflation ion expecte expected d to modera moderate, te, inflat inflation ionary ary risks risks have clearl clearly y abated. abated. The Reserv Reservee Bank’s Bank’s current assessment is that WPI inflation could be around 4.0 per cent by end-March 2010. Banks have indicated that small savings rate acts as a floor to banks’ deposit interest rate. It may, however, be noted that small savings and bank deposits are not perfect substitutes. Banks should not, not, ther theref efor ore, e, be over overly ly appre apprehen hensi sive ve about about reduc reducin ing g depo deposi sitt inte intere rest st rate ratess for for fear fear of  competition from small savings, especially as the overall systemic liquidity remains highly comfortable. There is scope for the overall interest rate structure to move down within the policy rate easing already effected by the Reserve Bank. Further action on policy rates is now being taken to reinforce this process. The Reserve Bank has been constantly monitoring global developments along with the dome domest stic ic econo economi micc situ situat atio ion. n. On the the posit positiv ivee side side,, infl inflat atio ionar nary y pres pressu sure ress have have ease eased d significantly. Inflation as measured by year-on-year variations in the wholesale price index (WPI) has declined to 3.36 per cent as on February 14, 2009, down by about three-fourths from the high of 12.91 per cent as on August 2, 2008. However, consumer price inflation, as reflected in various consumer price indices, is in the range of 9.85-11.62 per cent as of December 2008January 2009, has yet to show moderation. Consumer price inflation has remained at elevated level due to increase in primary articles prices. With With WPI inflat inflation ion having having modera moderated ted signif significa icantl ntly, y, consum consumer er price price inflat inflation ion may also also be expected to decline, though with a lag. 64

At the same time, there is evidence of further slowing down of economic activity. Export Exportss regist registere ered d negati negative ve growth growth for the four four recent recent consecut consecutive ive months months,, October October 200 20088January 2009. Overall exports growth during 2008-09 (April-January) at 13.2 per cent was significantly lower than 24.2 per cent during the same period of the last year. The index of  industrial industrial production production (IIP) registered registered a negative negative growth growth of 2.0 per cent during during December December 2008, with the manufacturing sector returning a negative growth of 2.5 per cent. IIP growth during April-December 2008 at 3.2 per cent was about one-third of 9.0 per  cent during the corresponding period of the previous year due to slowdown in all the major  sectors. Real GDP growth in the third quarter of 2008-09 (September-December 2008) has been  placed at 5.3 per cent by the Central Statistical Organization (CSO). The services sector, which has been the main engine of growth during the last several years, has also been slowing down. Business confidence has been dented den ted significantly and investment demand has decelerated.

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CHAPTER VIII Inflation in India Inflation is the supply of excess money and credit relative to the goods and services  produced, resulting in increased prices. As the layman understands it, inflation results in the increase in the price of some set of goods and services in a given economy over a period of time. It is measured as the percentage rate of change of a price index. Inflation in India is also a grave issue of concern, given the vast disparity between the rich and the poor on the one hand or the Rural and the Urban on the other. Skyrocketing inflation robs the poor, and hurts others, though much less grievously. The fruits of the much-talked about economic growth have not reached large sections, especially in the rural areas. Under extant conditions, the benefit of high prices paid by consumers does not flow back  to primary producers, but is siphoned away by middlemen and speculators who enjoy a free run in an economy of shortages. If attention to agriculture has been limited to rendering lip service, inefficiencies in the physical market remain unattended. With production trailing demand in recent years, shortages of essential commodities have widened. Imports have become expensive  because of high global market prices. It may be instructive to remember that inflation is not an overnight phenomenon. It is  benign to the extent that it allows us time to cover our self. In India, the onus to control and take control of the situation of inflation is upon the Reserve Bank of India (RBI). The Reserve Bank of India (Amendment) Act, 2006 gives discretion to the Reserve Bank  to decide the percentage of scheduled banks' demand and time liabilities to be maintained as Cash Reserve Ratio (CRR) without any ceiling or floor. Consequent to the amendment, no interest will be paid on CRR balances so as to enhance the efficacy of the CRR, as payment of  interest attenuates its effectiveness as an instrument of monetary policy.

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The Reserve Bank of India (RBI) follows a multiple indicator approach to arrive at its goals of growth, price stability and financial stability, rather than targeting inflation alone. This, of course, course, leads leads to criti criticis cism m from from mainst mainstrea ream m econom economist ists. s. In its effort effort to balanc balancee many many objectives, which often conflict with each other, RBI looks confused, ineffective and in many cases a cause of the problems it seeks to address. The RBI has certain weapons which it wields every time and in all situations situations to counter  counter  any form of inflationary situation in the economy. These weapons are generally the mechanisms and the policies through which the Central Bank seeks to control the amount of credit flowing in the market. The general stance adopted by the RBI to fight inflation is discussed in brief the mechanism used by the RBI needs to take up a holistic approach to the same. Then it would deal with very briefly suggestions that may shed some light on what could be the possible steps RBI could take to control rising prices. It is interesting to note that the Reserve Bank of India Governor. Dr Y. V. Reddy started his stint with the aim of cutting down the Cash Reserve Ratio to 3 per cent (from the then 4.5 per  cent) but rising commodities inflation has forced him to raise it now to 6.5 per cent. But even this 6.5 per cent is way below what would truly contain inflation and it is almost certain that he will  be chasing the inflation curve for the next few years or so.

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Steps Generally Taken By the RBI To Tackle Inflation

Accord According ing to the Annual Statemen Statementt on Mon Moneta etary ry Policy Policy for the Year 20072007- 08, a carefu carefull assessment of the manner in which inflation is evolving in India reveals that primary food articles have contributed significantly to inflation during 2006-07. At the same time, prices of  manufactured products account for well above 50 per cent of headline inflation. The recent hardening of international crude prices has heightened the uncertainty surrounding the inflation outlook. The steps generally taken by the RBI to tackle inflation include a rise in repo rates (the rates at which banks borrow from the RBI), a rise in Cash Reserve Ratio and a reduction in rate of interest on cash deposited by banks with RBI. The signals are intended to spur banks to raise lending lending rates and to reduce the amount of credit disbursed. disbursed. The RBI's measures measures are expected to suck out a substantial sum from the banks. In effect, while the economy is booming and the credit needs grow, the central bank is tightening the availability of credit. The RBI also buys dollars from banks and exporters, partly to prevent the dollars from flooding the market and depressing the dollar — indirectly raising the rupee. In other words, the central bank's interactions have a desirable objective — to keep the rupee devalued — which will make India's exports more competitive, but they increase liquidity. To combat this, the RBI does what it calls "sterilization" — it sucks out the rupees it pays out for dollars through sale of sterilization bonds. It then sells these bonds to banks. Economists  point out that there has not been much success in such sterilization attempts in India. The central  bank's attempt to offload Government bonds on banks has not been too successful in as much as the banks sell the bonds and get rupees instead. Economists also contrast this with the successful experience of China, where the stateowned banks strictly abide by the central bank's dictates and absorb the sterilization bonds. That discipline is lacking in India. The net effect is that the RBI has to resort to indirect methods of  sterilization, such as raising interest rates and raising CRR to contract liquidity. This makes India 68

more attractive for foreign capital flows that seek better returns and a vicious cycle follows. RBI has to buy more foreign currency and sterilize.

Conseq Consequen uences ces of RBI Policy Policy The economy was growing at a stupendous 9 per cent, second only to China worldwide, however  the brakes have been firmly pressed by the RBI due to their anti – inflationary policy. If the CRR  and REPO rate are hiked frequently, the economy may take a U - turn, as most commercial  banks religiously increase their lending rates, without actually studying the impact. Thee last Th last time time that that the the RBI RBI had impos imposed ed its its polic policy, y, the the mark market etss had had sign signal aled ed thei their  r  resounding reaction by a sharp fall in the Sensex by nearly 500 points. The impact on economic growth is also likely to be sharp, judging by effects of similar therapy applied with disastrous effect in the mid-1990s. This would reduce the level of investment activity in the economy, particularly in the infras infrastru tructu cture re sector sector.. Big corpor corporate ate may ask for, for, and get, get, access access to extern external al commer commercia ciall  borrowing, but not so favored are the bulk of small and medium entrepreneurs (SME). Housing activity will suffer an impact because most loanees are on floating rates and will face increased equated installments. These measures generally taken by the RBI do not effectively tackle inflation but on the other hand effectively effectively stunts the growth pattern of the economy. The RBI seems to believe that  by merely reducing the credit flow and money flow in the economy, inflation can be curtailed. Inflation is a consequence of increasing demand Vis – a – Vis the supply in the economy. The demand must be effectively curtailed or pushed down, which the present CRR policy is not managing to do effectively. The RBI, in an ideal world, would have also looked towards a mechanism to bolster the supply forces to meet the requirements of the consumers and thereby combat inflation. Economists admit that while RBI’s efforts to contain inflation will reduce borrowings,   prices would continue to rise. Inflation, according to Bimal Jalan, a former governor of the central bank himself and now a member of India’s upper house of parliament, is yet to peak.

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“Inflation is a function of rising expectations and going by that, we have some amount of  inflationary steam left in the economy.” While the central bank’s efforts may have achieved part of their objective, of slowing down credit growth, it clearly may not have done enough to curb inflation. Chetan Ahya, an economist at Morgan Stanley, estimates that growth in bank credit will slow to between 20% and 22% by the end of 2007 from the earlier level of 30%.

There are two major drawbacks in the CRR – REPO policy adopted by the RBI to combat inflation. Firstly, monetary tools have proved more effective in economies with greater financial inclusion. They are less effective in economies such as India's, where the majority of the population still has no access to banks, and those with access barely have the resources to open bank accounts. The increasing cost of funds and rising interest rates are of little consequence in the econom economic ic life life of a financ financial ially ly exclude excluded d populat population ion.. The impact impact will will be criti critical cal on smalle smaller  r  segments and will take a while to yield results for the economy. Much more remains to be achieved on the financial inclusion front. To cite Mr V. Leeladhar, Deputy Governor of the RBI, from a recent speech: "Compared to the developed world, the coverage of our financial services is quite low. As per a recent survey commissioned by the British Bankers' Association, 92-94 per  cent of the population of the UK has either a current or a savings bank account." This contrasts poorly with India, where the ratio of deposit accounts to total adult  population is only 59 percent. But even this figure is suspect, as the average urban middle-class income-earner often has more than one bank account. This is bound to reduce further the  percentage of people with bank accounts. Most account holders are urban-centric, leaving large segments of the rural population with no access to banks or the means to save or borrow.

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Thei Th eirr huge huge numb number erss are are atte attest sted ed to by the the RBI RBI figur figures es,, whic which h reve reveal al that that the the 85 commercial banks, with a predominant presence in urban India, account for 78 per cent of the country's financial assets. The 3,000 cooperative banks and Regional Rural Banks, with greater   presence in semi-urban and rural pockets, contribute a meager nine per cent and three per cent respectively. Secondly, in spite of its being an indirect weapon of credit control, CRR does impact the level of money supply in the economy and plays some role in the fight against inflation. But the impact of the CRR hike will not distinguish as between productive credit and credit meant for  consumption. This will hurt growth and the creation of assets in the economy. Farmers today keep several acres of land uncultivated as the financial returns are not commensurat commensuratee with the expenses expenses incurred incurred for cultivation. cultivation. Irrespective Irrespective of the increasing increasing cost of  funds, large segments of the borrowing public, especially the small, medium and large farmers, have no option but to approach the commercial and cooperative banks, or the multitude of  unregulated moneylenders at the beginning of every crop cycle. As a result, lendable resources of the system will be reduced to that extent and bank  credit will be dearer. This hike will result in increase of the lending rates, whether for production or consumption. The RBI can address only the demand side through such an approach. The need of the hour is to curb only consumption credit and not production. On the other hand, there is urgent need to increase supplies of food products and manufactured goods, for which credit flow to the farm sector and industry must increase. The combined effect of the CRR hike and the REPO rate hike will tell upon expansion of   productive credit as well and this is not desirable at this this stage. The monetary measures are meant to increase the cost of funds for banks, make loans dearer and temper the demand for credit. While there is a greater possibility of banks passing on the increased costs to the consumer, it is debatable whether this will choke the demand for funds in some specific inflation-impacting sectors.

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Suggestions

Based on the data and opinions mentioned above, this paper comes to the conclusion that, the CRR – REPO mechanism adopted by the RBI has overshot its utility. No doubt, the RBI is the only authority which is empowered as well as capable to handle the situation. It is also not disputed that the monetary policy is important to fight inflation. Right now, the RBI seems to be concentrating only on the Demand end of inflation, as a result the entire perspective of supply is completely ignored. Inflation may also be curtailed if the supply is bolstered to meet the demands of the people. With the increase in supply, prices would inevitably come down and thus inflation may be controlled. Grante Granted, d, the supply side would would not be streng strengthe thened ned so easily easily,, as it would would requir requiree infrastructure development, planning, large scale investments etc. However, this is where the RBI could play an extremely important role. The RBI already regularly issues master circulars, through which they direct various aspects of banking and certain corporate matters. The RBI also regulates and governs matters regarding inflow of foreign funds, foreign institutional investment (FII) into India, Utilization of  External External Commercial Borrowings Borrowings etc. The RBI does so for various reasons, especially especially because because not all sectors and industries are at the same level. Some would benefit from external input while some would be best left alone. For the purpose purpose of bolstering bolstering agricultural agricultural growth, development development of infrastru infrastructure cture and all other avenues which the RBI may deem fit; it may lay down regulation regulationss to direct money either  directly or indirectly with special importance to these sectors. To direct foreign capital in these fields and thus bolster infrastructure would not be a difficult task, as the RBI already does this function. Only this time it shall do it with the purpose of meeting the ever – rising demand. This would serve a twin purpose. With the RBI increasing the CRR and other interest rates, it becomes difficult for the farmers to get their loans before their projects. It also becomes difficult for SME to obtain loans to fulfill their targets as well. Through this carefully routed

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capital, there may be an access ac cess to the required finance for these groups of people notwithstanding the high interest rate. Secondly and most importantly this would also enable the government to lay down measures to utilize this money to develop the infrastructure which would bolster supply and thus would be a huge boost in the fight against inflation in the long run. The gov govern ernmen mentt would would also also have to play play an import important ant role role in control controllin ling g inflat inflation ion without harming the economic growth by ensuring greater transparency in the RBI's sterilization operations. The Governments at the Centre and the States should take urgent action to make available adequate credit at competitive interest rates and offer other incentives. Inflation can be contained only if supply-side and demand issues are effectively addressed, apart from initiating appropriate fiscal and monetary measures. The practice adopted by the Central bank right now seems to be an ostrich approach. It is sufficiently clear that the reason that we have inflation is because the economic status and mindsets of the people of India are advancing. The Indian consumer is no longer afraid to spend tomorrow’s money today. The average Indian consumer has reached a comfortable economic  position where he now starts to demand products and services which were earlier not available to him. This is an indicator of an improved standard of living. Why should this be considered a disadvantage? The problem here is that the country’s infrastructure is not capable of meeting these requirements. But, But, surpri surprisin singly gly,, instea instead d of giving giving any attent attention ion to the supply supply factors, factors, by simply simply lowering money and credit in the market, the RBI is artificially pushing demand down. It is stifling the needs and requirements of the consumers and is attempting to create an illusion that there is no demand.

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The evolution of central banking, not only in India but also globally, indicates that the central banks have continued to adapt to the changing economic environment. In the interaction  between  between the financial financial intermediari intermediaries es and the central bank, the focus has been the welfare of the general public. The central banks carefully watch the market trends and monitor numerous variab variables les,, both both quantit quantity y and rates, rates, in the domest domestic ic and global global econom economy. y. The inform informati ation on contai contained ned in these these indica indicator torss and the direct direct feedbac feedback k from from the market market partic participa ipants nts helps helps in calibratin calibrating g and crafting crafting an appropriate appropriate monetary monetary policy policy to ensure financial financial stability. stability. In the last hundred years, a period of time when most central banks were established, the markets, the objectives and instruments of monetary policy have changed. Despite these changes, the central  banks have established themselves as necessary and permanent part of the financial system. The Reserve Bank of India had a fair degree of success in achieving the twin objectives of growth with stability, especially in the post-reform period. The well calibrated strategie strategiess of the Reserve Reserve Bank in refining refining monetary policy operating procedures, procedures, managing the capital capital flows, flows, ensuring ensuring evolution of competitive competitive markets and sustaining sustaining a healthy healthy financial financial system system,, while while also also perfor performin ming g the develop developmen mental tal role role have yielde yielded d visibl visiblee result results. s. While While successfully facing the challenges of globalization, the Reserve Bank has earned international credibility in terms of efficacy of its policies. The Reserve Bank of India has achieved transparency in its operations, especially in terms terms of evolvin evolving g commun communica icatio tion n policy policy aimed aimed at address addressing ing a wide wide range range of audienc audiences. es.  Notwithstanding the changing challenges of different regimes, the Reserve Bank has managed to evolve constructively on a continuous basis to cope with demands for stable macroeconomic manage management ment and financ financial ial stabil stability ity,, while while meeti meeting ng the object objective ivess of econom economic ic growth growth and development. As the economy becomes increasingly open and global, the role of the Reserve Bank will undergo further change and it will need to equip it for coping with these emerging challenges on a continuous basis.

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In sum, the changing role of financial regulation and supervision of the Reserve Bank  focuses on prudential supervision, while emphasizing the creation of an environment in which the banks think freely and innovate. More importance is being given to ‘principles’ and greater  attention to ‘risk assessment and risk containment’. In future, the regulatory and supervisory role would not only be ‘friendly’ and ‘frank’, but also ‘prompt’ and ‘firm’. The changing face of  regula regulatio tion n and superv supervisi ision on would would accord accord import importanc ancee to intens intensifi ified ed use of technol technology ogy in supervisory processes and substantially enhance the skills and capacities of the supervisors. While fully meeting the socio-economic objectives, it would continue to maintain stable and orderly conditions in the financial system.

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Conclusion To concl conclude ude,, the the role role of RBI RBI has has been been rede redefi fine ned d thro throug ugh h gradu gradual al evol evolut utio ion n and and adapta adaptatio tion, n, along along with with some some statut statutory ory changes changes,, and not throug through h any radica radicall restru restructu cturin ring. g. Further, while assessing the autonomy of the RBI, one should recognize that RBI is not a pure monetary authority but is responsible for several other functions also, as a central bank. The deve develo lopm pment entss in the the rece recent nt past past lead lead one one to the the concl conclus usio ion n that that,, de fact facto o , there has been enhancement of the autonomy of the RBI. As regards monetary policy framework, the objectives remained the same but the framework has been changed from time to time in a gradual fashion in response to the evolving circumstances.

Contextually, there are three important issues in the conduct of monetary policy viz., the assessment assessment of potential potential output, the measurement measurement of unemployment unemployment and appropriate appropriate measure of  inflation inflation.. While While the policy tries tries to cope with these issues, issues, a combination combination of instruments instruments is necessarily used in a flexible manner to meet these complexities. Every effort has been made to improv improvee the transm transmiss ission ion channel channelss especi especiall ally y through through the financ financial ial market markets, s, and through through regulatory and institutional reforms. In addition, there are some constraints in the conduct of  monetary policy, in particular, the fiscal impact, predominant public ownership, prevalence of  administered interest rate, etc. While these challenges and dilemmas persist in the Indian context, every effort is made by the RBI to meet the broader objectives set forth, from time to time.

The endeavour of the RBI is to create conditions for the common person to pay Government dues at his/her bank branch of choice, while ensuring instantaneous credit to the Gove Govern rnme ment nt acco account unt with with Rese Reserv rvee Bank. Bank. Th This is can can be achi achiev eved ed with with a high high degr degree ee of  comput computeri erizat zation ion with with appropr appropriat iatee connect connectivi ivity ty / net-wo net-worki rking, ng, encomp encompass assing ing agency agency banks, banks, Government Departments and Central Bank for expeditious, cost effective and seamless financial flows, flows, in a paperless paperless environment. environment. This arrangement arrangement will will be analogous to the Cash and Debt Management Group in which Government of India and the RBI are involved.

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Bibliography

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www.wikipedia.com

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www.questia.com

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www.bis.org

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www.ecb.int

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www.bos.frb.org

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www.icfai.org

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www.nyif.com

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www.rbi.org.in

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www.google.com

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Fina Financ ncia iall Ins Insti titu tuti tion onss and and Mark Market etss

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Indi Indian an Fina Financ nciial Sys System tem

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The Economi omic Times

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