Credit and Monetary policy is the macroeconomic policy laid down
by the central bank. It involves management of money supply and
interest rate and is the demand side economic policy used by the
government of a country to achieve macroeconomic objectives like
inflation, consumption, growth and liquidity. In India, monetary
policy of the Reserve Bank of India is aimed at managing the
quantity of money in order to meet the requirements of different
sectors of the economy and to increase the pace of economic growth.
The RBI implements the monetary policy through open market
operations, bank rate policy, reserve system, credit control
policy, moral persuasion and through many other instruments. Using
any of these instruments will lead to changes in the interest rate,
or the money supply in the economy. Monetary policy can be
expansionary and contractionary in nature. Increasing money supply
and reducing interest rates indicate an expansionary policy. The
reverse of this is a contractionary monetary policy. For instance,
liquidity is important for an economy to spur growth. To maintain
liquidity, the RBI is dependent on the monetary policy. By
purchasing bonds through open market operations, the RBI introduces
money in the system and reduces the interest rate.
The main objectives of Monetary Policy are:
- To maintain price stability.
- To ensure adequate flow of credit to productive sectors so as
to assist growth.
- Arrangement of full employment.
- Expansion of credit facility
- Equality & Justice Stability in exchange rate.
- Promotion of Fixed Deposit.
- Equitable distribution of Credit.
There are two types of instruments of the monetary policy
a) Quantitative and b) Qualitative.
Let us understand each of these instruments in detail,
Quantitative:
- Cash Reserve Ratio(CRR): Commercial Banks are
required to hold a certain proportion of their deposits in the form
of cash with RBI. CRR is the minimum amount of cash that commercial
banks have to keep with the RBI at any given point in time. RBI
uses CRR either to drain excess liquidity from the economy or to
release additional funds needed for the growth of the economy. For
example, if the RBI reduces the CRR from 5% to 4%, it means that
commercial banks will now have to keep a lesser proportion of their
total deposits with the RBI making more money available for
business. Similarly, if RBI decides to increase the CRR, the amount
available with the banks goes down. Current CRR: 4%.
- Statutory Liquidity Ratio (SLR): SLR is the
amount that commercial banks are required to maintain in the form
of gold or government approved securities before providing credit
to the customers. SLR is stated in terms of a percentage of total
deposits available with a commercial bank and is determined and
maintained by the RBI in order to control the expansion of bank
credit. Current SLR: 19.5%
- Bank Rate: It is a rate at which RBI lend long
term loan to commercial banks. Bank rate is a tool which RBI uses
for maintaining money supply. Any revision in bank rate by RBI is a
signal to banks to revise deposit rates as well as prime lending
rate (PLR is the rate at which bank lend to the bank customers).
Current Bank Rate: 6.25%
- Repo Rate: The rate at which the RBI is
willing to lend short-term loans to commercial banks is called Repo
Rate. Whenever commercial banks have any shortage of funds they can
borrow from the RBI, against securities. If the RBI increases the
Repo Rate, it makes borrowing expensive for commercial banks and
vice versa. As a tool to control inflation, RBI increases the Repo
Rate, making it more expensive for the banks to borrow from the RBI
with a view to restrict the availability of money. The RBI will do
the exact opposite in a deflationary environment when it wants to
encourage growth. Current Repo Rate: 6%
- Reverse Repo Rate: The rate at which the RBI
is willing to borrow from the commercial banks is called reverse
repo rate. If the RBI increases the reverse repo rate, it means
that the RBI is willing to offer lucrative interest rate to
commercial banks to park their money with the RBI. This results in
a reduction in the amount of money available for the bank’s
customers as banks prefer to park their money with the RBI as it
involves higher safety. This naturally leads to a higher rate of
interest which the banks will demand from their customers for
lending money to them. Current Rate: 5.75%
- Marginal Standing Facility(MSF): MSF is a very
short term borrowing scheme for scheduled commercial banks. Banks
may borrow funds through MSF during severe cash shortage or acute
shortage of liquidity. Banks often face liquidity shortfalls due to
mismatch in their deposit and loan portfolios. These are usually
very short term and banks can borrow from RBI for one day period by
offering dated government securities. MSF had been introduced by
RBI to reduce volatility in the overnight lending rates in the
inter-bank market and to enable smooth monetary transmission in the
financial system. Under MSF, banks can borrow funds overnight up to
1% (100 basis points) of their net demand and time liabilities
(NDTL) i.e. 1% of the aggregate deposits and other liabilities of
the banks. NDTL liabilities represent a bank’s deposits and
borrowings from others. In a move to stem the continuing fall of
rupee, the RBI raised the MSF rate to 300 basis points (i.e. 3%)
above the repo rate in July 2013. Thus, both rate of borrowing and
percent of borrowing allowed under MSF can be varied by RBI.
Current MSF: 6.25%
- Base Rate: Base Rate is the interest rate
below which Scheduled Commercial Banks (SCBs) will lend no loans to
its customers—its means it is like prime lending rate (PLR) and the
benchmark prime lending Rate (BPLR) of the past and is basically a
floor rate of interest. Current Base Rate: 8.65% – 9.45%
- Marginal Cost of Funds Lending Rate(MCLR):
From the financial year 2016-17 (i.e., from 1st April, 2016), banks
in the country have shifted to a new methodology to compute their
lending rate. The new methodology—MCLR (Marginal Cost of funds
based Lending Rate)— which was articulated by the RBI in December
2015. The main features of the MCLR are as follows:
i) it will be a tenor linked internal benchmark, to be reset on
annual basis.
ii) actual lending rates will be fixed by adding a spread to the
MCLR.
iii) to be reviewed every month on a pre-announced date.
iv) existing borrowers will have the option to move to it.
v) banks will continue to review and publish ‘Base Rate’ as
hitherto. Current rate: 7.65% – 8.05%.
- Call Money Market: The call money market is an
important segment of the money market where borrowing and lending
of funds take place on over night basis. Participants in the call
money market in India currently include scheduled commercial banks
(SCBs)—excluding regional rural banks), cooperative banks (other
than land development banks), insurance. Prudential limits, in
respect of both outstanding borrowing and lending transactions in
the call money market for each of these entities, are specified by
the RBI. Current Rate: 4.90 % – 6.10%
- Open Market Operations (OMOs): OMOs are
conducted by the RBI via the sale/purchase of government securities
(G-Sec) to/from the market with the primary aim of modulating rupee
liquidity conditions in the market. OMOs are an effective
quantitative policy tool in the armoury of the RBI, but are
constrained by the stock of government securities available with it
at a point in time. Other than the institutions, now individuals
will also be able to participate in this market (as per the Union
Budget 2016–17).
- Liquidity Adjustment Framework(LAF): The LAF
is the key element in the monetary policy operating framework of
the RBI (introduced in June 2000). On daily basis, the RBI stands
ready to lend to or borrow money from the banking system, as per
the need of the time, at fixed interest rates (repo and reverse
repo rates). Together with moderating the fund mismatches of the
banks, LAF operations help the RBI to effectively transmit interest
rate signals to the market. The recent changes regarding a cap on
the repo borrowing and provision of the term repo have changed the
very dynamics of this facility after 2013.
- Market Stabilisation Scheme(MSS): This
instrument for monetary management was introduced in 2004. Surplus
liquidity of a more enduring nature arising from large capital
inflows is absorbed through sale of short-dated government
securities and treasury bills. The mobilised cash is held in a
separate government account with the Reserve Bank. The instrument
thus has features of both, SLR and CRR.
Qualitative:
- Fixing Margin Requirements: The margin refers
to the “proportion of the loan amount which is not financed by the
bank”. Or in other words, it is that part of a loan which a
borrower has to raise in order to get finance for his purpose. A
change in a margin implies a change in the loan size. This method
is used to encourage credit supply for the needy sector and
discourage it for other non-necessary sectors. This can be done by
increasing margin for the non-necessary sectors and by reducing it
for other needy sectors. Example:- If the RBI feels that more
credit supply should be allocated to agriculture sector, then it
will reduce the margin and even 85-90 percent loan can be
given.
Consumer Credit Regulation: Under this method, consumer credit
supply is regulated through hire-purchase and installment sale of
consumer goods. Under this method the down payment, installment
amount, loan duration, etc is fixed in advance. This can help in
checking the credit use and then inflation in a country.
- Publicity: This is yet another method of
selective credit control. Through it Central Bank (RBI) publishes
various reports stating what is good and what is bad in the system.
This published information can help commercial banks to direct
credit supply in the desired sectors. Through its weekly and
monthly bulletins, the information is made public and banks can use
it for attaining goals of monetary policy.
- Credit Rationing: Central Bank fixes credit
amount to be granted. Credit is rationed by limiting the amount
available for each commercial bank. This method controls even bill
rediscounting. For certain purpose, upper limit of credit can be
fixed and banks are told to stick to this limit. This can help in
lowering banks credit exposure to unwanted sectors.
- Moral Suasion: It implies to pressure exerted
by the RBI on the indian banking system without any strict action
for compliance of the rules. It is a suggestion to banks. It helps
in restraining credit during inflationary periods. Commercial banks
are informed about the expectations of the central bank through a
monetary policy. Under moral suasion central banks can issue
directives, guidelines and suggestions for commercial banks
regarding reducing credit supply for speculative purposes.
- Control Through Directives: Under this method
the central bank issue frequent directives to commercial banks.
These directives guide commercial banks in framing their lending
policy. Through a directive the central bank can influence credit
structures, supply of credit to certain limit for a specific
purpose. The RBI issues directives to commercial banks for not
lending loans to speculative sector such as securities, etc beyond
a certain limit.
- Direct Action: Under this method the RBI can
impose an action against a bank. If certain banks are not adhering
to the RBI’s directives, the RBI may refuse to rediscount their
bills and securities. Secondly, RBI may refuse credit supply to
those banks whose borrowings are in excess to their capital.
Central bank can penalize a bank by changing some rates. At last it
can even put a ban on a particular bank if it does not follow its
directives and work against the objectives of the monetary
policy.
These are various selective instruments of the monetary policy.
However the success of these tools is limited by the availability
of alternative sources of credit in economy, working of the
Non-Banking Financial Institutions (NBFIs), profit motive of
commercial banks and undemocratic nature off these tools. But a
right mix of both quantitative and qualitative tools of monetary
policy can give the desired results.