Wednesday, 7 August 2013

RBI and its Monetary Policy

Any developing economy has mature regulating agencies which oversee the functioning of the nation’s economy as a whole and who have various checks and balances at their command exercise adequate control over the economic conditions when situation demands.

In our post on Current Account Deficit - How it Affects India’s Economy, we hinted on what measures the Govt. of India takes to revive the economy. The Reserve Bank of India, which is the nation’s apex bank or central bank is another agency which can regulate the economy. We have discussed about the effects of Rupee and its Value Depreciation in our earlier post. The RBI is the agency which has the power and tools at its disposal to tackle situations like the currency depreciation & inflation.

In a simplistic view, if we think about the economy as a fuel powered vehicle, then the RBI decides how much fuel should be filled in the vehicle and what should be the speed limits.

The RBI regulates the economy mainly by controlling the amount of free money available in the system. It does this by varying the different interest rates which affect the nation’s banking system as is reflected in the periodic monetary policy reviews released by RBI.

In this post we will discuss the various tools that the RBI has to regulate the financial system of the economy. The following will be discussed in this post as they form the crux of the RBI monetary policy :

And finally a note on Effects of Policy Rates on Economy,

Repo Rate:

It is the benchmark interest rate at which the RBI lends money to banks for the short-term.

If there is an increase in the repo rate, banks will have to borrow money at higher lending rates from RBI to meet their liquidity demands. Consequently, a higher repo rate will discourage banks to borrow as cost of borrowing increases, thus decreasing credit flow. A decrease in credit flow decreases demand and in-turn helps in capping inflation.

Reverse Repo Rate:

Interest rate at which banks park their money with the RBI. It moves in tandem with repo rate and is used to decrease liquidity from the economy when the reverse repo rate is increased.

In high interest rate scenario, banks too increase their deposit rates and lure customers to build up deposits.

Cash Reserve Ratio (CRR):

It is the percentage of outstanding deposits available in the banks which have to be maintained with the RBI.

An increase in CRR means that banks have to park a higher percentage of their funds with the RBI as reserve thus reducing the amount of free money available with the banks. In other words, an increase or decrease of CRR will reduce or increase the banking system liquidity accordingly.

Statutory Liquidity Ratio (SLR):

It is the amount of liquid assets as a percentage of NDTL (Net Demand and Time Liabilities) which have to be kept by the bank in the form of approved non-encumbered securities like central & state govt. securities, precious metals and cash  etc.

Increase in SLR will force bank to maintain more liquid assets as percentage of deposits(NDTL) and also restrict their leverage used by the bank to increase money flow in the economy.

Base Rate:

This is the minimum rate at which the banks can lend money to borrowers. As the policy rates increase the base rate too will increase as the banks have to protect their margins. The base rate will always be above the benchmark rates.

Capital Adequacy Ratio (CAR):

It is the amount of capital provided by the bank as a percentage of risk weighted asset exposure (credit exposure) which acts as a buffer against losses related to credit risk. The percentage that the bank should maintain as CAR is mandated by RBI.

A well capitalised bank is more stable financially which is reflected by its high CAR and is able to absorb losses better thereby providing safeguard for the depositors and reducing insolvency.

Effects of Policy Rates on Economy:

As we can see from the above, all these tools which are controlled by the RBI serve to regulate the flow of money in the economy. As a matter of fact, when the RBI decreases the various policy rates, the economy feels that the liquidity easing is done to give a stimulus to growth. But a side effect of more liquidity is increase in inflation and inherent depreciation in currency value.

If the RBI increases the rates to control the depreciating rupee in forex market (which affects CAD) and put a cap on inflation, growth suffers as a side effect due to the resulting high interest rate regime and tight liquidity situations.

Visit RBI to know about the current policy rates.

Thus, the monetary policy of the RBI is always a balancing act between stimulating growth and controlling inflation. Actions taken by the RBI, when backed by reformative policies by the Govt. will help in reviving the economy in a smooth and steady manner.