introduction to indian economy final

8/12/2019 Introduction to Indian Economy Final

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Role of Central Bank in India Page 1

Introduction to Indian Economy

The economy ofIndia 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 policies for an entire generation from the 1950s until the

1980s. The economy was characterized by extensive regulation,protectionism, and public

ownership, leading topervasive corruption andslow growth.Since 1991,continuing economic

liberalization has moved the economy towards amarket-based system.

Previously a closed economy, India's trade has grown fast. According to the 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.

The Indian economy has undergone substantial changes since the introduction of

economic reforms in 1991. These reforms were a comprehensive effort consisting of three main
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Banking Sector from 1991 onwards

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 withforeign banks and their ATM stations. Efforts are being put to give a satisfactory service to

customers. Phone banking and net banking is introduced. The entire system became 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 limitedforeign exchange

exposure.
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The industrial sector has been going through a process of restructuring and consolidation

after liberalization. The industries have responded to the reforms through mergers and

acquisitions, adoption of cost cutting measures, foreign collaboration, technology up gradation

and outward orientation in sectors such as cement, steel, aluminium, pharmaceuticals, 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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Reserve Bank of India

INTRODUCTION

The RBI, as the central bank of the country, is the centre of the Indian financial and

monetary system. As an institution, it has been guiding, monitoring, regulating, controlling, and

promoting the destiny of the Indian financial system. However, it is an oldest among the central

banks in the developing countries. It started functioning from April 1, 1935 on the terms of the

Reserve Bank of India Act, 1934. It was a private shareholders institution 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 each fully paid which was entirely owned by private

shareholders in the beginning. The Government held shares of nominal value of Rs. 2, 20,000.

The Bank is managed by a Central Board of Directors, four Local Boards of Directors,

and a committee of the central board of directors. The 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


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Central Board which comprises the Governor, four Deputy Governors, and fifteen Directors

nominated by the Central government.

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 Banks activities. The

principle of the internal organization is functional specialization with adequate 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

empower the Reserve Bank with supervisory control over banks in order to ensure 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 Banks functions became more

diversified in terms of Plan financing, establishment of specialized institutions to promote

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

agriculture. Other institutional developments included setting up of the Industrial Finance

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 ofad 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


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private savings through the banks and paved the way for nationalization of six more private

sector banks in 1980.

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

incorporated necessary changes for effective implementation of Government 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.


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Functions of RBI

The RBI functions within the framework of a mixed economic system. With 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 of opinion or conflict, the governmentview or position can always be expected to prevail.

Main functions of the RBI

(i) To maintain monetary stability so that the business and economic life can deliver welfaregains of a property functioning mixed economy.

(ii) To maintain financial stability and ensure sound financial institutions so that monetarystability can be safely pursued and economic units can conduct their business with

confidence.

(iii)To maintain stable payments system so that financial transactions can be safely andefficiently executed.

(iv) To promote the development of financial infrastructure of markets and systems, and toenable 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 nationaleconomic priorities and social concerns.

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


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Roles of RBI

1. Note Issuing AuthorityThe RBI has the sole right or authority or monopoly of issuing currency notes other than

one rupee notes and coins, and coins of smaller denominations. The issue of currency notes

is one of its basic functions.

2. Government BankerThe RBI is the banker to the Central and State governments. It provides to 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. Bankers BankThe 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 banks. The bank controls the volume of reserves of commercial banks and thereby

determines the deposits creating ability of the banks. The banks hold a part or all of their

reserves with the RBI. Similarly, in times of need, the banks borrow funds from the RBI. It is

therefore, called the bank of last resort.

4. Supervising AuthorityThe RBI has vast powers to supervise and control commercial and co-operative banks

with a view to developing an adequate and sound banking 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.(b) To prescribe minimum requirements regarding paid-up capital and reserves, transfer to

reserve fund, and maintenance of cash reserves and others.


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(c) To inspect the working of banks in India as well as abroad in respect of their organizationalsetup, branch expansion, mobilization of deposits, investments, and credit portfolio

management, credit appraisal, region-wise performance, profit planning, manpower

planning, and so on.

5. Exchange ControlOne of the essential functions of the RBI is to maintain the stability of the external value

of the rupee. It pursues this objective through its domestic policies and the regulation of the

foreign exchange market. As far as the external sector is concerned, the task of the RBI has the

following dimensions:

(a) To administer the foreign exchange control.(b) To choose the exchange rate system and fix or manage the exchange rate between therupee and other currencies.

(c) To manage exchange reserves.(d) To interact with the monetary authorities of other countries and with internationalfinancial institutions such as IMF.

6. Promoter of the financial systemApart from performing the functions already mentioned, the RBI has been rendering

developmental services which have strengthened the countrys banking and financial 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.


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Monetary Policy

Monetary policy is the management of money supply and interest rates by central banks

to influence prices and employment. Monetary policy works through expansion or contraction of

investment and consumption expenditure. Monetary policy is the process by which the

government,central bank,or monetary authority of a country controls (i) the supply of 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 economy.Monetary policy is referred to as either being anexpansionary 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, while contractionary policy

involves raisinginterest rates in order to stopinflation.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, exchange rates with other currencies and 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 asfollows: 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.
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On the external front, rupee value has been linked to the market forces. Current account

convertibility was achieved in August 1994. FERA was repealed and replaced by a new

legislation - Foreign Exchange Management Act (FEMA), in 1999. Further, the Exchange

Control Department of the Reserve Bank was renamed as Foreign Exchange Department.

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.

Authorized dealers could use cross-currency options, interest rate and currency swaps,

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 engendered by the growing integration of financial markets, domestically and

internationally. With the near total deregulation of interest rates, the Bank Rate has beenreactivated 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 stress due to increasing liquidity mainly on account of increased capital inflows,

necessitating a review of the monetary policy framework and the Reserve Bank switched over to

a more broad-based "multiple indicators approach" since 1998 in monetary policy formulation.

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


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of the liquidity conditions and recommends strategies for intervention in the money and

securities markets.

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.

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. The Reserve Bank had also indicated that the 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 2008. The aim of 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 thefollowing measures:


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Enhancing Rupee Liquidity

The special term repo facility, introduced for the purpose of meeting the liquidity requirementsof mutual funds and non-banking finance companies would continue till end-march 2009. Banks

can avail of this facility either on incremental or on rollover basis 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 economic growth in the context of significant global stress. Accordingly, for policy

purposes, money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this,

aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent. Thegrowth 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

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.


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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 its national money supplyby buying and selling governmentsecurities,or

otherfinancial instruments.Monetary targets, such asinterest rates orexchange rates,are used to

guide this implementation. Since most money is now in the form of electronic records, rather

than paper records such as banknotes, open market operations are conducted simply 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,foreign currency,orgold.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 bonds in secondary market. By absorbing

bonds, it drives up bond yields and 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, 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 touse it. There is no restriction the quantity or maturity of government securities which it 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.
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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 Reserve Bank has introduced a Second Liquidity Adjustment Facility (SLAF) 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 sterilization is borne by the Government. Under this program, the

RBI injected more than Rs. 60, 000 crores in one weeks 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

pressure on distribution channels, regular reviews of security features of bank 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. Their multiple objectives

include: (a) To control the amount of and changes in bank credit and monetary supply throughcontrolling 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.


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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 of monetary policy. The fact that government securities

market in India is not well-organized, broad-based and deep, and also that interest rates on

government securities, like other interest rates, were administered have reduced the efficacy of

OMOs so far. However, the authorities are now determined to make OMOs a major tool of

monetary policy. Similarly, the coupon rates of government securities have been raised and

made market-related and competitive, and a large number of measures have been taken to

develop and activise the government securities market in India.

This does not mean that OMOs did not contribute anything at all to monetary

management in the past. They have indirectly helped 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 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 of monetary policy. Second, the volume of the Banks net sales of 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-determined date and rate. Repo is money market instrument which enables short-term

borrowing and lending through sale/purchase operation. It introduced in December 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 at3.25 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


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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 makes a decision 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. It introduced by RBI during 1994 95. Banks are always happy to lend money to RBIsince 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 interest rates. It can cause

the money to be drawn out of the banking system. The reverse repo rate or reverse 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%.


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Bank Rate

Bank rate, also referred to as the discount rate, is therate of interest which acentral 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. The term bank rate is commonly used by consumers to refer to the current 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 co-

operative banks 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 discounting facilities. Section 49 of the RBI Act, 1934 defines it 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. Subsequently, owing to differential rates prescribed for various

sector-specific refinance facilities as 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 requirements.

Cash Reserve Ratio

The present banking system is called a fractional reserve banking system, because the

banks need 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 years, 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.

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
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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, the RBI has the option of increasing the CRR thereby reducing the deposits 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 withdrawal demands,

and would normally be in the form of fiat currency stored in a central bank.

The reserve ratio is sometimes used as a tool in monetary policy, influencing the

countrys 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

Peoples Bank of China does use changes in reserve requirements as an inflation-fighting 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

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


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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. Till 1962, a separate CRR was fixed in respect

of demand liabilities (5 percent) and time liabilities (2 percent). The Bank had powers to vary

these ratios up to a maximum of 20 percent and 8 percent respectively. Subject to these ceilings,

the RBI could ask banks to maintain with itself additional reserves as a specified percentage of

additional demand and time liabilities after certain specified date. This marginal CRR cannotexceed 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 not changed. 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. However, co-operative banks,

RRBs, and non scheduled banks have to maintain the CRR of merely 3 per cent, and so far it hasnot been changed by the RBI. The CRR is applicable to various NRI deposit accounts also but

the level of 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 percent above the Bank rate for the

first week of default and 5 percent for the subsequent weeks till the 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 in CRR. In addition, from January 1985, default in CRR

results in graduated penalty by way of loss of interest on the defaulting banks cash balances.


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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 in respect of maintaining the prescribed CRR. 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 to maintain minimum CRR balances upto 70 per cent of the total CRR requirement on

all days of the fortnight. If any Scheduled Commercial Bank fails to observe 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

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

three objectives behind the use of SLR: (a) to restrict expansion of bank credit (b) to increase

banks investment in government securities, and (c) to ensure solvency of banks. Through

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 ofbanking inIndia.It is

the amount which a bank has to maintain in the form:

1. Cash2. Gold valued at a price not exceeding the current market price3. Unencumbered approved securities (Government securities or Gilts come under this)

valued at a price as specified by theRBI from time to time.
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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 months time due to maturity) of a bank. This percentage is fixed by theReserve

Bank of 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

securities to total DTL of banks. Between years 1949 to 1962, while calculating SLR, no

distinction was made between cash on hand and balances held with the RBI to meet CRR

requirements. The SLR, like CRR, is applicable to co-operative banks, non-scheduled banks,

and the RRBs, but it is maintained at a constant level of 25 percent. While the SLR defaults do

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 percent.

The SLR remained at the level of 20 percent between years 1949 to 1962 in terms of the

definition then prevailing. Thereafter, it has been raised frequently and substantially. In 1990,

SLR has been increased from 20 percent to 38.5 percent. The significant increase in the SLR

does not mean that the monetary policy became quite restrictive during 1963 to 1990. An

increase in the SLR does not restrain total expenditure in the 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, not correct to 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 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 percent, 38 percent and 37.25 percent of net DTL as on 3 April
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1992 with effect from fortnights beginning 9 January 1993, 6 February 1993, and 6 March 1993

respectively. The October 1997 credit policy rationalized this system of multiple rates of SLR

by collapsing them into a single prescription of 25 percent of banks. SLR has 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 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

India in order to control the expansion of bank credit. Statutory Liquidity Ratio refers to the

amount that all banks require maintaining in cash or in the form of Gold or approved securities.

Here by approved securities we mean, bond and shares of different companies.

This Statutory Liquidity Ratio is determined as percentage of total demand 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)

based on their actual cost of funds, operating expenses and a minimum margin to cover

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

basis points to 4.75 per cent from October 27, 2004. The spread between reverse repo and repo

was narrowed by 25 basis points to 125 basis points.


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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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Equities in India

Lets 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 1991-

2001.

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:


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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 underperformed 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 extremelybearish at the end of the decade.

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.


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3. The excessive volatility of the Indian stock market has perhaps driven away long-term

investors who can contribute to grater rationality in price movement.

4. The periodic scams that occurred during this period have shaken investorsconfidence.


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The Crisis and India

Like all emerging 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 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 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

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, the amount can be flexibly drawn and repaid. At the end of the 90-day period,

the withdrawal can also be rolled over. This refinance facility will be available up to March 31,


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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

3.25% with immediate effect. Keep the CRR unchanged at 5.0% of net demand and time

liabilities (NDTL).

Reserve Banks Policy thrust

The thrust of the Reserve Bank's policy stance since mid-September 2008 has been aimed

at providing ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining

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 measures have added actual/potential liquidity in the financial system by over Rs.


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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 of the MSS securities, open market operations and monetary easing. Admittedly,

yields had increased. But for the offsetting liquidity easing done by the 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

monetary stimulus measures initiated during 2008-09 coupled with lower commodity prices willcushion the downturn by stabilizing domestic economic activity. On balance, with the

assumption of a normal monsoon, for policy purpose real GDP growth for 2009-10 is placed at

around 6.0 per cent.


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Inflation Outlook

On the price stability front, India's performance has been fairly good. Since

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 to many developing countries, 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 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-basedfiscal consolidation from the year 2004-05 under the Fiscal Responsibility and Budget

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

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


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payment crisis in the early 1990s, several stabilization and structural reform measures were

undertaken. Keeping in view the global trend in commodity prices and domestic demand-

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.

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


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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

There are several immediate challenges facing the economy. These include: (a)

supporting the drivers of aggregate demand to enable the economy to return to its high growth

path; (b) boosting the flow of credit to all 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 Bank and the Government. Notwithstanding the contraction of global demand, growthprospects 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

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 inventories by the corporate and decline in commodity prices. The expansion in credit,


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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

approach, due diligence and balanced judgment by 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 programme in 2009-10 in a non-disruptive 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

Reserve Bank, therefore, would continue to use a combination of monetary and 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 unwinding will add primary liquidity of about Rs.1,20,000 crores 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.

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,


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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. It has reduced the CRR significantly and instituted some sector-specific facilities 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.

Finally, we will have to address the key challenge of ensuring an interest 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


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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

inflation expected to moderate, inflationary risks have clearly abated. The Reserve Banks

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, therefore, be overly apprehensive about reducing deposit interest rates for 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

domestic economic situation. On the positive side, inflationary pressures have eased

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 2008-

January 2009, has yet to show moderation. Consumer price inflation has remained at elevated

level due to increase in primary articles prices.

With WPI inflation having moderated significantly, consumer price inflation may also be

expected to decline, though with a lag.

At the same time, there is evidence of further slowing down of economic activity.

Exports registered negative growth for the four recent consecutive months, October 2008-

January 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


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industrial production (IIP) registered a negative growth of 2.0 per cent during 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 significantly and investment demand has decelerated.


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I nflation in I ndia

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.

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, leads to criticism from mainstream economists. In its effort to balance many


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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 to 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 Generall y Taken By the RBI to Tackle I nf lation

According to the Annual Statement on Monetary Policy for the Year 2007- 08, a careful

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 rates and to reduce the amount of credit disbursed. The RBI's 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 objectiveto keep the rupee devaluedwhich 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 state-

owned 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

more attractive for foreign capital flows that seek better returns and a vicious cycle follows. RBI

has to buy more foreign currency and sterilize.


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Consequences of RBI 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.

The last time that the RBI had imposed its policy, the markets had signaled their

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

infrastructure sector. Big corporate may ask for, and get, access to external commercial

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 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 aVis the supply in the economy. The

demand must be effectively curtailed or pushe

introduction to indian economy final

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