IMPACT OF MONETARY POLICY ONINDUSTRIAL GROWTH – A CASESTUDY OF INDIA FROM 2004-05

TO 2012-13

Submitted to: Submitted by:

Dr. Jagdish Shettigar Udit JainSreevatsan NatarajanTarun MangalSonakshi GovilVanshika GuptaShruti Mittal

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CONTENTS

S.No. TOPIC PAGE No.1. Monetary Policy of India 3

2. Instruments of Monetary Policy 3-10

3. Industrial growth 10

4. Impact of monetary policy on industrial growth 11-13

5.Impact of monetary Policy on industrial growth viainflation control 14-15

6.Impact of monetary Policy on industrial growth viaimports 15-16

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Monetary Policy of IndiaMonetary policy is the process by which monetary authority of a country, generally a centralbank controls the supply of money in the economy by exercising its control over interestrates in order to maintain price stability and achieve high economic growth.

In India, the central monetary authority is the Reserve Bank of India (RBI), is so designed asto maintain the price stability in the economy. Other objectives of the monetary policy ofIndia, as stated by RBI, are:

Price Stability

Price Stability implies promoting economic development with considerable emphasis onprice stability. The centre of focus is to facilitate the environment which is favourable to thearchitecture that enables the developmental projects to run swiftly while also maintainingreasonable price stability.

Controlled Expansion Of Bank Credit

One of the important functions of RBI is the controlled expansion of bank credit and moneysupply with special attention to seasonal requirement for credit without affecting theoutput.

Promotion of Fixed Investment

The aim here is to increase the productivity of investment by restraining non essential fixedinvestment.

Promotion of Exports and Food Procurement Operations

Monetary policy pays special attention in order to boost exports and facilitate the trade. It isan independent objective of monetary policy.

Desired Distribution of Credit

Monetary authority has control over the decisions regarding the allocation of credit topriority sector and small borrowers. This policy decides over the specified percentage ofcredit that is to be allocated to priority sector and small borrowers.

Equitable Distribution of Credit

The policy of Reserve Bank aims equitable distribution to all sectors of the economy and allsocial and economic class of people

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Instruments of Monetary Policy

Among the various techniques and methods, we have taken into account the mostimportant and selected monetary instruments such as Bank rate, CRR(Cash Reserve Ratio),SLR(Statutory Liquidity Ration), OMO(open Market Operations), and Repo and Reverse Reporates.

1. Bank Rate

The dictionary meaning of Bank Rate is the discount rate of a central bank. Now it is knownas the base rate and it is also called as the Minimum Lending Rate (MLR). It is the rate atwhich the central bank lent to the other banks.

The Reserve Bank of India Act defines Bank Rate as the standard rate on which it is preparedto buy or rediscounts bills of exchange or other commercial papers eligible for purchaseunder this Act‖. That is why Bank Rate is known as the ‘Rediscount Rate‘.

In India, the Bill market is not so well developed and the RBI makes advances to banksmainly in other forms such as against Government securities and as refinance. Hence, the

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bank rate is not the key lending rate, though it does form the basis for multiplicity of theRBI‘s lending rates charged for various types of advances. However, the efficiency of this asa tool of credit control has often been questioned. Current bank rate in 8.75%.

Bank Rate Graph from 1991 to 2011

2. Cash Reserve Ratio (CRR)

Cash Reserve Ratio is a certain percentage of bank deposits which banks are required tokeep with RBI in the form of reserves or balances. Banks have to keep a certain proportionof their total assets in the form of cash, partly to meet the statutory reserve requirementand partly to meet their own day-to-day needs for making cash payments. Cash is heldpartly in the form of ‘cash on hand’ and partly in the form of ‘balances with the RBI‘. All suchcash is cash reserves and can be classified into two such as required reserves and excessreserves. Required reserves are cash balances which a bank is required statutorily to holdwith the RBI. They are calculated on average daily basis over a fortnight.

CRR Graph from 1992 to 2011

Higher the CRR with the RBI lower will be the liquidity in the system and vice-versa. RBI isempowered to vary CRR between 15 percent and 3 percent. But as per the suggestion bythe committee Report the CRR was reduced from 15% in the 1990 to 5 percent in 2002. Asof October 2013, the CRR is 4.00 percent.

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3. Statutory Liquidity Ratio (SLR).

Every bank is required to maintain a minimum percentage of their net demand and timeliabilities as liquid assets in the form of cash, gold and unencumbered approved securities.This ratio of liquid assets to demand and time liabilities is known as statutory Liquidity Ratio(SLR).

The difference between CRR and SLR is that cash Reserves are to be kept with the CentralBank whereas statutory ratio is maintained by the commercial banks concerned. CurrentSLR rate is 23%.

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4. OPO (Open Market Operations)

The term, ‘open market operations’ stands for the purchase and sale of Governmentsecurities by the RBI from/to the public and banks on its own account. In its capacity as theGovernment‘s banker and as the manager of public debt, the RBI buys all the unsold stock ofnew Government loans at the end of the subscription period and thereafter keeps them onsale in the market on its own account.

The open market operation policy is that policy by which the central bank contracts orexpands the credit by sale or purchase of securities in the open market. Hence, it attemptsto increase or decrease the credit in the system by directly influencing the cash reserveswith the banking system.

Credit Ceiling

In this operation RBI issues prior information or direction that loans to the commercialbanks will be given up to a certain limit. In this case commercial bank will be tight inadvancing loans to the public. They will allocate loans to limited sectors. Few example ofceiling are agriculture sector advances, priority sector lending.

Credit Authorization Scheme

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Credit Authorization Scheme was introduced in November, 1965 when P C Bhattacharyawas the chairman of RBI. Under this instrument of credit regulation RBI as per the guidelineauthorizes the banks to advance loans to desired sectors.

Moral Suasion

Moral Suasion is just as a request by the RBI to the commercial banks to take so and soaction and measures in so and so trend of the economy. RBI may request commercial banksnot to give loans for unproductive purpose which does not add to economic growth butincreases inflation.

Reforms in the Government Securities Market

Year Reform Initiated Objective Outcomes

5. Repo Rate

Repo rate is the rate at which the RBI lends short term money to banks. When the reporate increases, borrowing from RBI becomes more expensive. Therefore, we can say that

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in case, RBI wants to make it more expensive for the banks to borrow money, itincreases the repo rate. Similarly, if it wants to make it cheaper for banks to borrowmoney, it reduces the repo rate. Current Repo rate is 7.75%.

6. Reverse Repo Rate

Thus Reverse repo rate is the rate at which RBI borrows money from banks. Banks arealways happy to lend money to RBI, since their money is in safe hands with a goodinterest. An increase in reverse repo rate can cause the banks to transfer more funds toRBI due to these attractive interest rates. It can cause money to be drawn out of the

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banking system. Due to this fine-tuning of RBI using its tools of CRR, Bank Rate, RepoRate and Reverse Repo rate, our banks adjust their lending or investment rates forcommon man. Current Reverse Repo rate is 6.75%.

INDUSTRIAL GROWTH

Industrial Production Index is an economic indicator that measures changes in output forthe manufacturing, mining, and utilities. Although these sectors contribute only a smallportion of GDP, they are highly sensitive to interest rates and consumer demand. Thismakes Industrial Production an important tool for forecasting future GDP and economicperformance. Industrial Production figures are also used by central banks to measureinflation, as high levels of industrial production can lead to uncontrolled levels ofconsumption and rapid inflation.

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IMPACT OF MONETARY POLICY ON INDUSTRIAL GROWTH

Impact of Bank Rate

Graph- A

Graph- B

Graph- C

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When RBI increases bank rate, interest charged by banks also rises. This in turn leads todecline in investment expenditure, which in turn reduces the industrial growth along withthe GDP. From Graph- A, it is clear that RBI kept bank rate constant from 2004-10 at 6%.This maintained the growth while the recessionary trend was taken care of by the othermonetary tools. To check the rapid increase in inflation, RBI increased the bank rate to8.75%, thus leading to reduction in investment. This has affected the industrial growthadversely, which has declined since the increase in bank rate.

Impact of Lending Rate on Industry Growth

India’s prime lending rate is the rate at which banks lend to companies and individuals. Thusit decides the investment in the economy as high lending rates will attract less investmentsand vice-versa. By comparing Graph- A and B, we can see that till January 2007, interest rateswere pretty much stable. This was because economy was in a sound condition and industrialproduction was also consistently rising. The fluctuations in the interest rate came afterrecession hit United States of America and the slowdown followed in the other parts of theworld.

Impact of Industry Growth on Lending Rate

In 2007, India saw high industrial growth which in turn led to inflation. This is when theinterest rates were increased so as to reduce the money supply and discourage excessiveinvestments in the economy. India saw the effects of US recession on its economy byJanuary 2009, when industrial production hit extremely low.

To fight this, in 2010, RBI started reducing interest rates in order to encourage investment inthe economy and boost production and industrial growth. This in turn saw increase in theindustrial production.

Impact of Repo Rate

Graph- A

G

Graph- A

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Graph- B

Interest rate in the graph-A, refers to the Repo rate. As we can see, in 2004, Repo rate wasaround 4.5 %, thus RBI tried increasing the money supply in the economy, which in turnincreased the production. In the coming years, Repo rate was increased to maintain stabilityand prevent inflation. Though when recession hit the country, the rates were again broughtdown to induce lending by banks at a lower rate of interest. This helped in improving theindustrial growth. But then as inflation crept in, RBI is following a tight monetary policyunder which Repo rate has been increased to 7.75%. This is affecting the industrial growth,which has declined over the years.

Impact of Open Market Operations

An open market operation is an instrument of monetary policy which involves buying orselling of government securities from or to the public and banks. This mechanism influencesthe reserve position of the banks, yield on government securities and cost of bank credit.

The RBI sells government securities to commercial banks to contract the flow of credit andin turn downgrade the industrial growth as investment decreases. It buys governmentsecurities to increase credit flow and increase the industry growth. Open market operationmakes bank rate policy more effective and maintains stability in government securitiesmarket.

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Impact of monetary Policy on industrial growth via inflation control

Graph- A

Graph- B

The inflation condition in country forces the RBI to apply contractionary policy to controlinflation, which is done by increasing the Repo rate, Bank rate and Cash reserve ratio andincrease Statutory Liquidity Ratio. This in turn decrease the money supply in the market anddecrease the investment, which downgrade the industrial growth.

From graph- A the inflation is clearly seen in Jan 2009 and March 2011 and from graph-B theindustrial growth shows dip in year Jan 2009 and March 2011.

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Similarly, in case of disinflation, the RBI uses expansionary policy to increase money supplyin the market, which in turn allow people to invest more and support the industrial growth.From graph- A in late 2009, it is clear that country face the recession but industrial growthtook a positive trend which was in trough till 2009. There is some delay seen in theimprovement of industry because the policies take some time to shows their effect.

Impact of monetary Policy on industrial growth via imports

Monetary policy has an indirect impact on imports of country as in contractionary policy isbeing applied by RBI, the purchasing power is less and the import of raw material or semifinish goods, machine and their parts and technology would decrease to a great extent.

This decrease will directly impact the industries which are majorly dependent on theimports of one or many things. On the other hand, if the expansionary policy is being usedby RBI, the imports will be favoured and the industrial growth is better.

This could be validated from the table- 1, where if we compare the data of industrial GDPgrowth and inflation growth, we can find a direct relation between import and industrialgrowth.

In the year 2007-08 to 2008-09, the industrial GDP growth was decreased from 9.64 to 4.44and imports were also decreased from 35.10% to 19.80% and similarly in the year theindustrial GDP was increased from 7.32 to 9.81 and import were also increased from 24.1 to48.60.

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Table- 1