international financial management1

8/7/2019 INTERNATIONAL FINANCIAL MANAGEMENT1

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Monetary Policy:

It is the process by which the government, central bank , or monetary authority manages the

supply of money, or trading in foreign exchange markets. Monetary theory provides insight

into how to craft optimal monetary policy. Monetary policy is referred to as either being an

expansionary policy, or a contractionary policy, where an expansionary policy increases thetotal supply of money in the economy rapidly, and a contractionary policy decreases the total

money supply, or increases it slowly. Expansionary policy is traditionally used to combatunemployment in a recession by lowering interest rates, while contractionary policy involves

raising interest rates to combat inflation. Monetary policy is contrasted with fiscal policy,

which refers to government borrowing, spending and taxation.

Monetary policy is generally referred to as either being an expansionary policy, o r a

concretionary policy, where as expansionary policy increases the total supply of money in theeconomy, and a contractionary policy decreases the total money supply. Expansionary policy is

traditionally used to combat unemployment in a recession by lowering interest rates, while

contractionary policy has the goal of raising interest rates to combat inflation.

Historically, the Monetary Policy is announced twice a year - a slack season policy (April-

September) and a busy season policy (October-March) in accordance with agricultural cycles.

These cycles also coincide with the halves of the financial year.

Initially, the Reserve Bank of India announced all its monetary measures twice a year in the

Monetary and Credit Policy. The Monetary Policy has become dynamic in nature as RBIreserves its right to alter it from time to time, depending on the state of the economy. Now, it is

announced three times in a year.

Factors Influencing Monetary Policy:

Manufacturing and Industrial Growth:

Earlier we needed to increase growth (popularly known as GDP growth) by our monetary

policy. Presently we need to maintain them.

Foreign Trade:

The policy should take a look at the present exports and imports and specially the Oil imports.

The exchange rates have a huge bearing on the export/imports.

Credit Growth:

RBI has to worry about high growth in non-food credit. It has a bearing on the money supply.

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http://en.wikipedia.org/wiki/Monetary_theory

http://en.wikipedia.org/wiki/Expansionary_monetary_policy

http://en.wikipedia.org/wiki/Contractionary_monetary_policy

http://en.wikipedia.org/wiki/Unemployment

http://en.wikipedia.org/wiki/Recession

http://en.wikipedia.org/wiki/Interest_rates

http://en.wikipedia.org/wiki/Inflation

http://en.wikipedia.org/wiki/Fiscal_policy










http://en.wikipedia.org/wiki/Government

http://en.wikipedia.org/wiki/Central_bank

http://en.wikipedia.org/wiki/Money

http://en.wikipedia.org/wiki/Foreign_exchange_market

http://en.wikipedia.org/wiki/Monetary_theory







http://en.wikipedia.org/wiki/Fiscal_policy










Instruments Of Monetary Policy:

A. Quantitative Measures:

1. Open Market Operations:

Here, the RBI enters into sale and purchase of government securities and treasury bills. Sothe RBI can pump money into circulation by buying back the securities and vice versa. In

absence of an independent security market (all Banks are state owned), this is not really

effective in India

2. Bank Rate Policy:

Popularly known as repo rate and reverse repo rate, it is the rate at which the RBI and the

Banks buy or exchange money. This results into the flow of bank credit and thus affects the

money supply.

3. Cash Reserve Ratio (CRR):

This is the percentage of total deposits that the banks have to keep with RBI. And this

instrument can change the money supply overnight.

4. Statutory Liquidity Requirement (SLR):

This is the proportion of deposits which Banks have to keep liquid in addition to CRR. This

also has a bearing on money supply

B . Qualitative Measures:

1. Credit Rationing:

It means imposing limits and charging higher/lower rates of interests in selective sectorsare what you see is being done by RBI.

2. Change In Lending Margins:

It is the risk weightage assigned for the various lending.

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3. Moral Suasion:

It is the psychological means and informal means of selective credit control.

Monetary Policy Of The RBI:

Objectives:

The objectives of monetary policy have undergone a change over the years. The primary and

secondary objectives of economic planning in India were many, but, in a nutshell, they were

aimed at growth, stability, and social justice.

Accordingly, the objectives of monetary policy in India were:

(a) to accelerate economic development in an environment of reasonable price stability, and

(b) to develop appropriate institutional set-up to aid this process.

By influencing the cost, volume, and direction of credit, monetary policy has been encouragingsectoral and overall development, and supporting programmes that aimed at social justice. The

bank has been directing its attention to ensure that credit expansion takes place in the light of

price variations without affecting the output, particularly the industrial output adversely. Theauthorities have come up with the opinion that monetary policy is able to make a more

effective 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 wastage of resources because inflation results in wastage by increasing uncertaintyabout the future

(b) Create an environment in which efficient decisions are taken and greater employment,poverty alleviation, and equitable and balanced growth are achieved.

"Promotion of exports" used to be an independent objective of India's monetary policy,

because of which special emphasis was laid to boost the level of exports. Another distinct

objective, since the middle of the 1960s, has been the ''promotion of food procurementoperations''. But with the passage of time, desired distribution of credit has also assumed great

importance and it has come to be clearly defined in terms of the percentage of credit to be paid

out to priority sectors and small borrowers. Towards this end, steps have been initiated to

deregulate interest rates, to ease operational constraints in the credit delivery system, tointroduce new money market instruments.

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The monetary policy is now aiming 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.

Monetary Policy Framework In India:

Framework:

In India, the broad money emerged as the nominal anchor from the mid-1980s based on the

premise of a stable relationship between money, output and prices. In the late 1990s, in view of ongoing financial openness and increasing evidence of changes in underlying transmission

mechanism with interest rates and exchange rates gaining importance, it was felt that monetary

policy exclusively based on the demand function for money could lack precision. The ReserveBank, therefore, formally adopted a multiple indicator approach in April 1998 whereby interest

rates or rates of return in different financial markets along with data on currency, credit, trade,

capital flows, fiscal position, inflation, exchange rate, etc., are together with the output data for drawing policy perspectives.

The armory of instruments to manage, in the context of large capital flows and sterilization, has

been strengthened with open market operations through Market Stabilization Scheme (MSS),which was introduced in April 2004. Under the MSS, the Reserve Bank was allowed to issue

government securities as part of liquidity sterilization operations in the wake of large capital

inflows and surplus liquidity conditions.

There are occasions when the medium-term goals, say reduction in cash reserve ratios for

banks, conflict with short-term compulsions of monetary management requiring actions in bothdirections. Such operations do warrant attention to appropriate articulation to ensure policy

credibility.

Some of the important factors that shaped the changes in monetary policy framework and

operating procedures in India during the 1990s were deregulation of interest rates, development

of the financial markets with reduced segmentation through better linkages and development of

appropriate trading, payments and settlement systems along with technological infrastructure.With the enactment of the Fiscal Responsibility and Budget Management Act in 2003, the

Reserve Bank has withdrawn from participating in the primary issues of Central Government

securities with effect from April 2006. The recent legislative amendments enable a flexible use

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of the CRR for monetary management, without being constrained by a statutory floor or ceiling

on the level of the CRR. The amendments also enable the lowering of the Statutory LiquidityRatio (SLR) to the level minimum of 25 per cent of net demand and time liabilities of banks –

which would further improve the scope for flexible liquidity management.

Institutional Mechanisms:

Monetary policy formulation is carried out by the Reserve Bank in a consultative manner. The

Monetary Policy Department holds monthly meetings with select major banks and financial

institutions, which provide a consultative platform for issues concerning monetary, credit,regulatory and supervisory policies of the Bank. Decisions on day-to-day market operations,

including management of liquidity, are taken by a Financial Markets Committee (FMC), which

includes senior officials of the Bank responsible for monetary policy and related operations inmoney, government securities and foreign exchange markets. The Deputy Governor, Executive

Director(s) and heads of four departments in charge of monetary policy and related marketoperations meet every morning as financial markets open for trading. In addition, a Technical

Advisory Committee on Money, Foreign Exchange and Government Securities Marketscomprising academics and financial market experts, including those from depositories and

credit rating agencies, provides support to the consultative process. The Committee meets once

a quarter and discusses proposals on instruments and institutional practices relating to financialmarkets. Besides FMC meetings, Monetary Policy Strategy Meetings take place regularly. The

strategy meetings take a relatively medium-term view of the monetary policy and consider key

projections and parameters that can affect the stance of the monetary policy. In pursuance of the objective of further strengthening the consultative process in monetary policy, a Technical

Advisory Committee (TAC) on Monetary Policy has been set up with Governor as Chairman

and Deputy Governor in charge of monetary policy as Vice Chairman, three DeputyGovernors, two Members of the Committee of the Central Board and five specialists drawnfrom the areas of monetary economics, central banking, financial markets and public finance,

as Members. The TAC meets ahead of the Annual Policy and the quarterly reviews of annual

policy. The TAC reviews macroeconomic and monetary developments and advises on thestance of monetary policy.

Relevance Of Money Supply:

A great deal of concern has been shown with changes in the volume and the rate of growth of money supply. Relevant official documents always make a reference to the trends in the

growth of money supply and emphasize the necessity of its appropriate rate of growth.Monetary authorities in India, believe in discretionary monetary policy and have refrained from

prescribing any rigid monetary rule or rate of growth of money supply as a target in the course

of monetary. The following quotations from various RBI publications reveal its points of view:''The approach to the question of the right quantum of monetary expansion is essentially an

exercise in discretion rather than an application of mechanistic formula''. ''Money supply does

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matter…however money supply is only an indicator of the demand pressures on the economy.

The monetary authorities have not only refrained from fixing any exact monetary rule but theyalso seem to regard any such rule as harmful, for monetary policy should be responsive to

changing circumstances. Hence any precise or detailed monetary targets set for relatively short

horizons are likely to become counter-productive, in the sense that they may hide the need for the introduction of timely correctives.

Money Supply ‘Not’ Being The Control

Variable Of Monetary Policy:

Reasons:

What could be the reasons for not making money supply the only control variable of monetary

policy? The authorities' realisation that it is not exogenous i.e., it is not fully under their control

must have led them to adopt the approach as indicated. Thus, ''the problem of curbingmonetary expansion is that, there are two major elements which are virtually outside our control, namely:

(a) the increase in monetary supply corresponding to inward remittances of foreign exchange,

and

(b) the requirement of credit for financing the purchase of food grains.

The problem is further enhanced by the need to support prices of commodities other than wheat

and rice.'' There are severe constraints to controlling money supply even while operating onmain ''levers'', such as regulation of bank credit to the commercial sector and the extent of

budgetary deficit of the government. For ''the reduction of bank credit to industry tends toaffect production, the Government deficit can usually be reduced only by curbing plan outlay.''Thus it can be said that money supply is being used as an indicator, and secondary or financial

target of monetary policy in India.

Major Intermediate Variables:

The RBI regards money supply and the volume of bank credit as the two major variables, but itseeks to control the former through the latter. There is a belief that money supply does not

change on its own, it changes because of certain underlying developments with regard to bank credit, and the expansion of money supply and bank credit are two sides of the same coin. Thebasic tener of the Bank's policy has been that variations in the bank credit are the major factor

that influences economic activity in India. The volume of borrowings by banks from the RBI is

also used as an indicator or target. The Bank attempt to reduce bank borrowing from itself and

to encourage the liquidation of their earlier obligations in an inflationary period. The level of inventories with the industrial and commercial sector has also come to be actively used as an

indicator or target of monetary policy.

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There are certain finer points about the policy of controlling bank credit which need to be

noted in this context. First, the RBI seeks to regulate the volume and direction of the flow of bank credit in the light of its return flow in the slack season and demand for it in the busy

season. Second, one discovers that of late, the Bank has made the concept of "banks being in

credit bind" as the basis of the formulation of its policy. That is, the action is taken in the lightof the estimate and judgement about the capacity of banks to advance credit which, in turn, is

based on information about the rate of growth of resources, particularly deposits, of banks.When it is found that the banks' deposits have grown at a slower rate, it is feared that the banksare in a "credit bind", and therefore monetary policy is relaxed by, say, reducing the Cash

Reserve Ratio. Third, although the aggregate bank credit, no doubt, has received attention, it is

particularly the credit to the private or commercial sector which has often borne the brunt of

regulation.

The Bank, of late, has sought to widen the scope of its regulation, monitoring, and oversightbeyond banks so as to gradually encompass all the financial institutions. It has realized that

changes in the structure of financial institutions which have now taken place necessitate that it

should develop a macro-perspective on credit policy. It, therefore, now advocates that an

integrated review of the operations of financial institutions and banks should be undertakenevery time so as to pave the way for a comprehensive monetary and credit policy. It also wants

all players in the financial system to operate under broadly similar fiscal and regulatoryframework.

Techniques Of Monetary Control In India:

Many techniques of monetary control - some old and well known, others specially devised and

adapted - have been used in India. Among these are:

a. Open market Operations (OMO),

b. Bank Rate,

c. Discretionary Control of Refinance and Rediscounting,

d. Direct Regulation of Interest Rates on Commercial Banks' Deposits and Loans

e. Cash Reserve Ration (CRR),

f. Statutory Liquidity Ratio (SLR),

g. Direct Credit Allocation and Credit Rationing.

h. Selective Credit Controls (SCC),

i. Credit Authorisation Scheme (CAS),

j. Fixation of Inventory and Credit Norms,

k. Credit Planning,

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l. Moral Suasion, and

m. Liquidity Adjustment Facility (LAF).

This list shows that the Bank has not only relied on the old techniques in their traditional form

and simplicity: but it has also considerably broadened their content and meaning by way of extensive experimentation in their application. These techniques have not been used equally

actively in past years. These are discussed below:

1. Open Market Operations:

OMOs are 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, the RBI can

affect the reserve position of banks, yields on government securities, and volume and cost of

bank credit. There is no restriction on the quantity or maturity of government securities whichit can buy or sell or hold. Technically, the Bank can conduct OMOs in treasury bills, state

government securities, and central government securities; but, in practice, they are conducted

only in Central government securities of all maturities. The securities directly bought by theRBI at the time of issue of loans are excluded from the definition of OMOs. It purchases and

sells government securities from time to time out of the surplus funds of the IDBI, EXIM bank,

and NABARD.

OMO: Goals And Objectives:

The OMOs have both monetary policy and fiscal policy goals. Their multiple 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 maintain stability in government securities market,

d. To support government borrowing programme, and

e. To smoothen the seasonal flow of funds in the bank credit market.

In India, OMOs have mostly been used for the purpose of debt management, and this hasundermined their effectiveness as a tool of monetary policy. However, the authorities are now

determined to make OMOs a major tool of monetary policy. This does not mean that OMOs

did not contribute anything at all to monetary management in the past. They have indirectlyhelped in the regulation of supply of bank credit to the private sector in two ways. First, the

Bank has often conducted OMOs for switching operations, i.e., the sale of long-term scripts 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 of monetary policy. Second, thevolume of the Bank's net sales (sales- purchases) of government securities has increased over

the years. Table 6.2 shows the Bank's purchases, sales, and net sales of government securities

during 1951-52 to 2002-03. To the extent that net sales were positive and have increased

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SOURCE- RBI

2. Bank Rate And Discretionary Control Of

Refinance:

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 co-operativebanks, SFCs, IDBI, IFC, EXIM Bank and other approved financial institutions for financing

bonafide internal and external commercial, trade and production transactions. The Bank rate is

the basic cost of refinance and rediscounting facilities. Section 49 of the RCI Act, 1934 definesit as the standard rate at which the Bank is prepared to buy or rediscount bills of exchange or

other eligible commercial paper. In the early years, financial accommodation from the Bank

was largely provided at the Bank rate. But owing to differential rates prescribed for various

sector-specific refinance facilities and

also due to the absence of a genuine bill market, the Bank rate application was confined to:

a. the ways and means advances to the state governments

b. advances to primary co-operative banks for SSI, and

c. state financial corporations besides penal rates on shortfalls in reserve requirement.

The techniques of Bank rate and discretionary control of refinance are used to regulate the costand availability of refinance, and to change the volume of lendable resources of banks and

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other financial institutions. The refinance policy has to take care of seasonal need for funds

also.

1997-2004: This is a unique period in the history of use of Bank rate in India because itwitnessed unprecedented reduction in the Bank rate. It was reduced from 10 percent to 6

percent through active and frequent changes. It reached the lowest level in 2003 since 1974.

The Bank rate was changed as many as 16 times in about 7 years beginning with 1997.

3. Direct Regulation Of Interest Rates:

The weakening of the Bank rate technique till 1991 had compelled the RBI to directly regulate

interest rates on bank deposits and credit. Normally, change in the Bank rate is expected to

lead to appropriate changes in all market rates of interest and help to achieve the givenobjective of monetary action. But when the Bank rate lost its significance as a cost factor and

signal value, the RBI used to salvage the situation by regulating market rates of interest

directly. Since 1964 it has been fixing all deposit rates of commercial banks, and since 1960,their lending rates. The RBI and some other authorities in India have been directly fixing many

other interest rates also. Till about 1975, the deposits and lending rates were normally changed

along with the change in the Bank rate, with the objective of bringing about an appropriatealignment between the Bank rate and other interest rates. After 1975, however, the other rates

have very often been changed without changing the Bank rate. This shows official reluctance

to change the Bank rate and their acceptance of the defunctness of the Bank rate as the pace

setter of the structure of interest rates in the economy. On the whole, over the years, elaboratesystem of fixing either the maximum (ceiling) or minimum or differential or dual interest rates

had evolved in India.

This picture began to change around 1985 after the submission of the Chakravarty Committeereport. Within the overall framework of administered interest rates, the authorities partiallyderegulated certain interest rates. In July 1989, all term loans which earlier carried a fixed rate

of 15 per cent were subjected to a minimum rate of 15 per cent without any ceiling rate being

stipulated. The real thrust to the process of deregulation of interest rate was given after 1991.Industrial debenture rates, lending rates, deposits rates and other interest rates came to be

deregulated or market-determined, or market-related during this period.

4. Cash Reserve Ratio:

The present banking system is called a "fractional reserve banking system", because the banksneed to keep only a fraction of their deposit liabilities in the form of liquid cash. The

authorities earlier used to change this fraction mainly for the purpose of ensuring the safety and

liquidity of deposits. Over the year, however, it has become an important and effective tool for directly regulating the lending capacity of banks. The RBI has been using two ratios- the Cash

Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR) - as instruments of credit

control.

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The CRR refers to the cash, which banks have to maintain with the RBI as a certain percentage

of their demand and time liabilities. Till 1962, a separate CRR was fixed in respect of demandliabilities (5 per cent) and time liabilities (2 per cent). The Bank had powers to vary these ratios

up to a maximum of 20 per cent and 8 per cent respectively. Subject to these ceilings, the RBI

could asks banks to maintain with itself additional reserves as a specified percentage of additional demand and time liabilities after a certain specified date. This marginal or

incremental CRR cannot exceed 100%. 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 maximumof 15%. The actual minimum CRR fixed in 1962 was 3 per cent. The CRR is applicable to all

scheduled banks including scheduled cooperative banks and the Regional Rural Banks (RRBs),

and non-scheduled banks have to maintain the CRR or merely 3per cent, and so far it has not

been changed by the RBI. The is applicable to various NRI deposit accounts also but the levelof CRR in their case differs from the CRR for domestic deposits, and also among themselves.

The RBI has powers to impose penal interest rates on banks in respect of their shortfall in the

prescribed CRR. The penal interest rate is normally 3 per cent above the Bank rate for the firstweek of default and 5 per cent for the subsequent week till the default is 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 accommodationavailed of, and which is equal to the short full in CRR. The RBI pays, since 1973, at its

discretion, interest on that portion of cash reserves which is the difference between the

prescribed CRR (average plus marginal) and the minimum CRR of 3 per cent, provided the

bank has not defaulted in respect of maintaining the prescribed CRR. Interest is not paid onexcess reserves.

Statutory Liquidity Ratio:

In addition to the CRR, the RBI has made active use of another ratio, namely the SLR. Whilethe CRR enables the Bank to impose primary reserve requirements, the SLR enables it to

impose secondary and supplementary reserve requirements, on the banking system. There are

three objectives behind the use of SLR:

to restrict expansion of bank credit,

to augment banks' investment in government securities, and

to ensure solvency of banks.

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, itssubsidiaries, other nationalized banks and the RBI; gold, approved securities i.e. Central and

state government securities, securities of local bodies and government, guaranteed securities to

total DTL of banks. Between 1949 to 1962, while calculating SLR, no distinction was madebetween cash on hand and balances held with the RBI to meet CRR requirements. In 1962, a

new definition of liquid assets as given above was adopted. The SLR, like CRR, is applicable

to co-operative banks, non - scheduled banks, and the RRBs, but it is maintained at a constantlevel of 25 percent in their5 case. It is also applicable to Foreign Currency (Non-Resident)

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Accounts (FCNRA) and Non-Resident (External) Rupee Account (NRERA) deposits, but the

levels in their case differ from each other and from the general level. While the SLR defaultsdo not invite penal interest payment and the loss of interest on cash reserves, they do result in

restrictions on the access 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 %. The

SLR remained at the level of 20 percent between 1949 to 1962 in terms of the definition thenprevailing. Thereafter it has been raised frequently and substantially.

SLR

0

510

15

20

25

30

35

40

45

16-03-

5/2/1970

28-08-

17-11-

1/7/1974

25-09-

28-07-

8/6/1985

25-04-

22-09-

9/1/1993

6/3/1993

18-09-

20-08-

29-10-

time period

SLR rate

SLR

The significant increase in the SLR does not mean that the monetary policy became quite

destructive during 1963 to 1990. An increase in the SLR does not restrain total expenditure inthe economy; it may restrict only the private sector expenditure while helping to increase the

government expenditure. In a sense, therefore, the SLR is not a technique of monetary control;

it only distributes bank resources in favour of the Government sector. It is, therefore, notcorrect to indicate, as is 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 characterised by a declining phase for SLR

also; its level was reduced and it came to be much criticised during this phase. After 1992,banks were required to maintain SLR based on multiple prescriptions. For example, in October

1992, the SLR was fixed at 38.25 per cent, 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 6March 1993 respectively. The October 1997 credit policy rationalized this system of multiple

rates of SLR by collapsing them into a single prescription (or a uniform SLR) of 25 percent of

banks' entire net DTL SLR has remained uncharged at 25 percent since 1997 till today.

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5. Direct Credit Al location And Credit

Rationing:

The weakening of the Bank rate technique and the direct administration of interest rates in theeconomy had necessitated the use of a complex system of quantitative credit controls ceiling as

a means of monetary policy in India. With the passage of time, the distribution or allocation of credit among different sectors, borrowers, and users was increasingly achieved through the

fixation of specific and direct quantitative credit ceilings or credit targets. This technique was

first introduced in November 1973 when the RBI stipulated a ceiling of 10 percent on the

increase in non-food credit by the banking system for the busy season of 1973-74 over theoutstanding amount, as at the end of September 1973. A variant of this technique which has

been very much used is to prescribe average and incremental credit -deposit ratios, For

example, the Bank stipulated in July 1989 that the incremental non-food credit-deposit ratioshould not exceed 60 percent during 1989. In April 1991, this ratio was brought down to 45

percent. Banks which exceeded this ratio were charged an additional interest of 3 percent on

all types of refinance used by them to the extent of the excess over credit - deposit ratio. TheBank has also directed banks to restrict drawing power of borrowers under cash credit limits.

Further, the RBI has been stipulating certain targets for credit distribution to various sectors.

For example, in November 1974, banks were advised that their priority sector leading should

reach a level of not less than one -third of their outstanding cvredit by March 1979.Subsequently, in October, 1980, the banks were instructed that their

(a) priority sector advances should constitute 40 per cent of aggregate bank advances by 1985,

(b) advances to the agricultural sector should be 40 percent of the priority sector advances, or

at least 16 percent of total bank advances by 1985,

(c) direct advances to weaker sections in the agricultural sector should be at least 50 percent of

total direct lending to agriculture by 1983, and

(d) advances to rural artisans , village craftsmen and cottage industries should be 12.5 percentof the total advances to small-scale industries by 1985.

In order to achieve regional or geographical balance in respect of credit disbursal, the RBI has

been asking banks to achieve a certain prescribed credit - deposit ratio in respect of their rural

and Semi -urban branches separately. Normally, they have been asked to achieve a credit-deposit ratio of 60 percent in this context.

6. Selective Credit Controls:

This is the most actively used technique in India. The seasonal nature of the Indian economy

and the nature of inflation therein, have made SCCs particularly useful in our context SCCsseek to change the composition of credit; they are used to reduce the supply of credit in certain

directions and to encourage it in desired directions. They have been used particularly to prevent

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speculative hoarding of sensitive commodities such as paddy, rice, wheat, pulses, oil-seed, oils

and vanaspati, cotton sugar, gur, and so on. They are also applied to unsecured or clean creditby banks and to credit given for trading in shares. They are now applied both to commercial

and co-operative banks. In 1967, they were confined to commercial banks only. SCCs are

applied to private sector trading, while public sector trading is mostly exempt from their coverage.

The RBI uses SCCFs normally in three forms:

a) fixation of margin requirements

b) fixation of separate minimum lending rates on credit covered by SCCs and

c) fixation of ceiling on ex ante flows of credit.

The fixation of margins and ceilings are done with a great deal of differentiation depending

upon the purpose, security, party, state, and time dimensions of credit. With the introduction of

minimum lending rates in 1970-71, SCCs now regulate not only the availability but also the

cost of credit. The minimum lending rates under SCCs are separate from, and usually higher

than the general minimum lending rate.

7. Credit Authorization Scheme:

This technique was introduced in November 1965 with a view to regulate the volume and

terms of credit supplied to large borrowers. It has the following objectives:

a) to regulate credit to control inflation,

b) to enforce financial discipline on large borrowers;

c) to ensure that end - use of credit is for genuinely productive purposes.

d) to ensure that large borrowers do not pre-empt or monopolise scarce bank credit, and

e) to ensure that credit is supplied in accordance with the needs of borrowers and the goalsof planning.

The measure was applicable to commercial banks, co-operative banks, public sector as well as

private sector units, and short term as well as long term loans. As per this scheme, if the fresh

working capital limit inclusive of bill finance) to be sanctioned to any single party by any one

bank or the entire banking system exceeded a stipulated level, the bank would require prior authorization of the RBI for sanctioning such a loan. This stipulated level or cut-off point was

fixed at Rs. 1 crore in the beginning; it was subsequently increased in Rs. 2 crore in November

1975, to Rs. 3 crore in July 1982, to Rs. 4 crore in October, 1983, and to Rs. 6 crore, thereafter.The cut-off level used to be fixed at a higher level for the public sector units.

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The scheme was in operation for more than 20 years, but in the second half of 1988, the RBIdecided to withdraw the scheme after a review of its working, In its place, a system of post

sanction scrutiny, namely Credit Monitory Arrangement (CMA) was introduced. As per thisscheme, credit proposals for Rs. 5 crore and above in the case of working capital, and Rs. 2

crore and above in the case of term loans, had to be submitted to the RBI for post sanction

scrutiny. If it was found that a particular bank was not enforcing basic credit discipline, theRBI could instruct such a bank to refer the cases of large borrowers to itself for prior

authorization.

8. Credit Planning:

This innovative, unconventional, and unique tool of credit management was introduced by the

RBI in 1967-68. It was a product of the environment of economic planning. It was a very

general tool for macro-management of credit, and it provided a wider frame work within which

specific instruments operated. Its objectives were:

a) to regulate the expansion in the overall quantum of funds to a desired level, and

b) to direct flows of funds to desired sectors, areas, purposes, uses, so that the objectivesof monetary policy are achieved.

In order words, the quantum and distribution (allocation) of credit in qualitative and directionalaspects were envisaged, regulated and monitored through credit planning. National Credit

planning was an input for national monetary plan (budget), fiscal plan and economic plan. It, inturn, was a combination of plans of individual banks. The credit plan of a bank was formulated

on the basis of its quarterly and annual credit budgets respectively. The national credit plan and

a bank's credit plan were five-year plans. There was also a move to prepare a perspective (long-term) credit plan at the national level. District credit plans, lead bank schemes and service area

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approach provided inputs and institutional support to credit planning at the bank level and

national level.

Process Of Credit Planning:

At the bank level, each bank is required to prepare realistic annual, credit budget incorporating

estimates of volume and growth of deposits and other resources, and of demand for credit.These budgets are submitted to the RBI, and after discussion with banks in May/June every

year, they are finalised. The budgets are revised from time to time in the light of changes in

credit policy, banking trends, and so on. Through continuous monitoring and discussions, the

RBI tries to ensure that actual credit operations of banks and their credit plans resemble, so thatbanks do not have over - extended position of their credit and they do not face liquidity

problems. It must be stated at this juncture that the relevance and the extent of use of

techniques such as direct credit allocation or credit rationing, credit authorization scheme,fixation of inventory and credit norms, and credit planning have diminished after the

introduction of the policy of liberalization and deregulation in 1991. In the new system whichemphasizes competition among banks and financial institutions, and the shift from the direct toindirect techniques, the authorities are also giving less emphasis on their relevance.

Reforms In The Monetary Policy Framework:

Objectives:

1. Twin objectives of “maintaining price stability” and “ensuring availability of adequate

credit to productive sectors of the economy to support growth” continue to govern thestance of monetary policy, though the relative emphasis on these objectives has varied

depending on the importance of maintaining an appropriate balance.

2. Reflecting the increasing development of financial market and greater liberalisation,

use of broad money as an intermediate target has been de-emphasised and a multiple

indicator approach has been adopted.

3. Emphasis has been put on development of multiple instruments to transmit liquidity

and interest rate signals in the short-term in a flexible and bi-directional manner.

4. Increase of the interlinkage between various segments of the financial market including

money, government security and forex markets.

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Instruments:

1. Move from direct instruments (such as, administered interest rates, reserverequirements, selective credit control) to indirect instruments (such as, open market

operations, purchase and repurchase of government securities) for the conduct of

monetary policy

2. Introduction of Liquidity Adjustment Facility (LAF), which operates through repo and

reverse repo auctions, effectively provide a corridor for short-term interest rate. LAFhas emerged as the tool for both liquidity management and also as a signaling devise

for interest rate in the overnight market.

3. Use of open market operations to deal with overall market liquidity situation especiallythose emanating from capital flows.

4. Introduction of Market Stabilisation Scheme (MSS) as an additional instrument to deal

with enduring capital inflows without affecting short-term liquidity management role of LAF.S

Developmental Measures:

1. Discontinuation of automatic monetization through an agreement between theGovernment and the Reserve Bank. Rationalization of Treasury Bill market.

Introduction of delivery versus payment system and deepening of inter-bank repo

market.

2. Introduction of Primary Dealers in the government securities market to play the role of market maker.

3. Amendment of Securities Contracts Regulation Act (SCRA), to create the regulatory

framework.

4. Deepening of government securities market by making the interest rates on such

securities market related. Introduction of auction of government securities.

Development of a risk-free credible yield curve in the government securities market asa benchmark for related markets.

5. Development of pure inter-bank call money market. Non-bank participants toparticipate in other money market instruments.

6. Introduction of automated screen-based trading in government securities through

Negotiated Dealing System (NDS). Setting up of risk-free payments and system ingovernment securities through Clearing Corporation of India Limited (CCIL). Phased

introduction of Real Time Gross Settlement (RTGS) System.

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7. Deepening of forex market and increased autonomy of Authorised Dealers.

Institutional Measures:

1. Setting up of Technical Advisory Committee on Monetary Policy with outside

experts to review macroeconomic and monetary developments and advise the

Reserve Bank on the stance of monetary policy.

2. Creation of a separate Financial Market Department within the RBI.

Recent Policy Developments:

Although the above given account of the long-term evolution of monetary policy has referredto certain recent charges, a brief critical update of the RBI policy will be useful for purposes of

study.

Major Changes:

The recent monetary policy, particularly the one announced in April 1997 and October 1997can be said to have ushered in the following changes:

a) It has encouraged great market orientation in the financial sector by empowering banks

with greater operational flexibility. Although the RBI will continue to prescribe

prudential guidelines, it has now moved out of micro regulation.

b) The borrowers also have been empowered to reinforce mercerization, and this is boundto change the relationship between borrowers and bankers.

c) The interest rates are now sought to be emphasized as potential instruments for

influencing the liquidity in the system. The Bank rate is being made an important signal

and reference rate to define/determine the stance of monetary policy and the cost funds

in the economy.

d) The policy is directed to integrate further the money market, the government securitiesmarket, and the forex markets.

e) The government securities market is being made an active segment of the IFS so that

the conduct of monetary policy could be rendered effective.

f) Fiscal-monetary relationship has been reformed in a major way by abolishing the

system of automatic magnetization of fiscal deficit which was taking place through theissuance of ad hoc treasury bills. This has been achieved through the signing of two

agreements between the GOI and the RBI.

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g) Interest rates structure has been simplified and deregulated.

h) Far-reaching changes in the external sector of the economy have been effected.

Substantial elimination of imports and exchange controls, introduction of market-determined exchange rate system, rupee convertibility, encouragement to FDI, and

greater access to external capital markets are some of these changes.

Credit Policy - Impact Analysis:

Third Quarter Review Of The Monetary Policy:

Summary

Inflation:

While the current inflation is within the RBI’s comfort zone, there are upward pressures,

particularly from rising international oil and firm food prices. However, we expect the average

inflation for the year 2007-08 to settle around 5 per cent.

Interest Rates:

Liquidity situation will continue to be influenced by the extent of foreign inflow andgovernment expenditure. Given comfortable domestic liquidity situation resulting from the

strong deposit growth, we expect the rate to stay within the range of 7.8 to 8.0 per cent.

Exchange Rate:

Given the current uncertain global situation, the exchange rate is expected to be volatile in thenear future. The RBI would continue its intervention in the market to curb volatility and will

try to maintain the exchange rate at around Rs. 39.5 to 40.0 a dollar.

Deposits:

Term deposits are expected to grow 23 - 25 per cent during 2007-08.

Advances:

Non-food credit is expected to grow 23 – 25 per cent during 2007-08.

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Third Quarter Review Of The Monetary Policy

2007-08:

Highlights:

1. Repo rate unchanged at 7.75 per cent

2. Reverse repo rate unchanged at 6 per cent

3. Bank rate unchanged at 6 per cent

4. Cash reserve ratio unchanged at 7.5 per cent

5. No change in the inflation target for 2007-08 — aims for inflation close to 5 per cent,

while conditioning expectations in the range of 4.0 – 4.5 per cent

6. No change in GDP growth forecast for 2007-08 at 8.5 per cent

7. Emphasis on credit quality and credit delivery to employment-intensive sectors

8. Moderating the money supply growth to the target level of 17-17.5 per cent would beaimed

9. No immediate threat to financial stability due to global developments, but carefulmonitoring of the situation to continue

10. Priority to management of capital flows and liquidity consistent with macrofundamentals to enhance capital quality and transparency in sources of capital

11. Banks urged to review large foreign currency exposures, monitor unhedged exposures

and the corporate treasury activity to minimise financial instability

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Policy Stance:

The third quarter review of the monetary policy was carried out against the backdrop of

heightened uncertainties in the global scenario triggered by the US slowdown and rising oil

and food prices worldwide. RBI’s assessment of the overall global scenario was that of no

immediate impact on the economy, albeit, with increased vigilance and a possible impact in thefuture. Given that the overhang in the domestic liquidity situation continues as a result of the

continued FII inflows, the key policy rates-bank rate, repo rate, reverse repo rate and CRR

were kept unchanged. By adopting a neutral stance, the RBI has clearly indicated that domesticpressures, like, increasing inflationary tendencies in the economy, growth of money supply

above the RBI’s projected levels and continued deceleration in the credit growth have all

weighed heavily then the global factors in the status quo decision.

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Annual Monetary Policy 2010 –

Highlights:

RBI Governor Dr D Subbarao announced the annual monetary policy on

Tuesday. RBI seems to have taken a more dovish stance than expected. Many analysts and

market participants had expected a 50 bps hike in the policy rates. As expected, RBI took

cognizance of the fact that inflation seems to be moderating and has opted to raise rates in steps

rather than at one go. Inflation is the primary concern but at the same time it needs to ensure

that high policy rates do not become a hindrance for growth. Following are the highlights of

the monetary policy. Equity markets along with Government securities bounced back from the

falling spree of last few days following the announcement of the policy.

• CRR hiked by 25 bps; to absorb Rs. 125 billion from the system

• Benchmark Repo and Reverse Repo rates hiked by 25 bps each to 5.25% and 3.75%

respectively

• SLR and Bank Rate kept unchanged at 25% and 6%, respectively

• Bank credit growth expectations increased to 20% in fiscal 2011, compared to 17% in

fiscal 2010

• Bank deposit growth expectations increased to 18%, marginally higher than 17%reported in fiscal 2010

• GDP forecast hiked to 8.0% with a positive bias for fiscal 2010-11 as compared with

expected 7.2-7.5% in fiscal 2010

• Inflation, as mesured by WPI, estimated to moderate to 5.5% by March 2011

• Policy stance is to support “non-disruptive” growth in demand for credit while

anchoring inflation expectations; to maintain an interest rate regime consistent withprice, output and financial stability

• Banks investments in Non-SLR Bonds of infrastructure companies with residual

maturity of more than 7 years allowed to be classified under HTM category

• Provisioning requirement for sub-standard unsecured infrastructure exposures reduced

to 15% from 20%

• Scheduled Commercial Banks (SCBs) and Non Bank Finance Companies(NBFCs) withnetworth more than Rs. 10 billion to migrate to IFRS converged Accounting Standards

by April 2013

• Discussion paper on mode of presence of foreign banks by September 2010

• Discussion paper on guidelines for new bank to be placed

• Differential regulatory treatment for Core Investment Companies with asset size of over

Rs. 1 billion

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