sandeep sharkhan project

8/2/2019 Sandeep Sharkhan Project

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A

Project Study Report

on

A study of the impact of monetary policies and announcement on

the valuation of banking stock- A behavior analysis of clients of

Share Khan pvt.ltd.

Submitted in partial fulfillment for the Award of degree of

Master of Business Administration

Submitted By

Sandeep Kumar

MBA-IV Semester

Poornima School of Management

ISI-2, RIICO Institutional Area, Goner Road, Sitapura, Jaipur


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DECLARATION

Hereby I declare that the project report entitled A study of the impact of monetary

policies and announcement on the valuation of banking stock- A behavior

analysis of clients of Share khan pvt.ltd. submitted for the degree of master of

business administration is my original work and the project report has not formed the

basis for the award of any diploma, degree associate ship, fellowship or similar other

titles.

It has not been submitted to any other university or institution for the award of any

degree or diploma.

Place: Sandeep Kumar

Date: MBA Part II.

(DMS-PSOM)


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CERTIFICATE

Poornima School of Management

(ISI-2, Goner Road, Sitapura, Jaipur)

This is certified that Mr. Sandeep Kumar, student of Master of Business

Administration, Fourth Semester of Poornima School of Management, and Jaipur

has completed his Project report on the topic of A study of the impact of

monetary policies and announcement on the valuation of banking stock- Abehavior analysis of clients of Share khan pvt.ltd. under supervision of Mrs.

Garima Sharma and Miss EtiKhatri Faculty member, DMS-PSOM.

To best of my knowledge the report is original and has not been copied or submitted

anywhere else. It is an independent work done by him.

Dr. Vandana Sharma

Director, PSOM


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PREFACE

A good monetary policy system must be able to cope with

an extremely complex and dynamic environment.

The microstructure of the stock market in which brokers work is highly dynamic and

volatile. Many stocks are available to be bought and sold, each exhibiting its own

patterns and characteristics that are highly unpredictable. With so many options and

considerations that need to be taken into account, it is an extremely arduous task for

a broker to investigate aspects of the stock market and consistently provide effective

advice to their clients.

In the past decade, significant changes in the design and conduct of monetary policy

have occurred around the world. Many developing countries, including India have

adopted an inflation targeting regime. Monetary policy objectives have traditionally

included promoting growth, achieving full employment, smoothing the business

cycles, preventing financial crisis and stabilizing long term interest rates and the real

exchange rate also the valuation of the banking stocks.

The purpose of this study is to investigate the impact of monetary policy on the

valuation of the banking stocks in the context of financial sector reforms in India. We

discuss the financial sector reforms and the implication of the banks, the various

instruments of monetary policy in India, and the impact of monetary policy on the

profitability of banks .

.


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Acknowledgement

I express my sincere thanks to my project guide, Ms. Garima Sharma

and Miss Eti Khatri Faculty of PGC Dept. of Management studies. Forguiding me right from the inception till the successful completion of the

project. I sincerely acknowledge her for extending their valuable

guidance, support for literature, critical reviews of project and the report

and above all the moral support they had provided me with all stages of

this project.

Sandeep kumar


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Executive Summary

There is growing complexity in the mind of the investors to take investment decision

due to the change in the monetary policy of the India as well as the world and it

poses impact on the stock market.

Research was carried out to find what is the impact of the monetary policy and

announcement on the valuation of the banking stocks. And also what investors

prefer and to figure out while investing in stock market.

This study suggest that people are reluctant while investing in banking sectors stock

and other stocks market due to lack of knowledge

Main purpose of investment is returns and liquidity, commodity market is less

preferred by investors due to lack of awareness. The major findings of this study are

that people are interested to invest in stock market but they lack knowledge and the

impact of monetary policy on the valuation of banking stocks.

Through this report we were also able to understand, how investor take decision to

invest in the banking stocks due to change in monetary policy and announcements

with the help of the client behavior of share khan pvt.ltd. In this report study ofdifferent types of the banking product and impact of monetary policy on them are

analyzed and also the valuation of stock due to change in policy and announcement.


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TABLE OF CONTENTS

1. Introduction to Industry 1-7

2. Introduction to Organization and impact of

monetary policy on banking stocks.

8-61

3. Review of Literature 62-68

4. Research Methodology 69-95

4.1 Title of the Study

4.2 Duration of Project

4.3 Objective of Study

4.4 Type of Research

4.5 Sample size & Method of selecting sample

4.6 Scope of the Study

4.7 Limitations

5. Analysis and Interpretations 96-103

6. Facts and Findings 104

7. Conclusion 105

8. Suggestions 106

9. Appendix 107-108

10. Bibliography 109-110

S. No. Contents Page No.


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INTRODUCTIONINDUSTRY PROFILE


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OVERVIEW OF THE BANKING INDUSTRY: Banking in India originated in the last decades of the 18th century. The oldest bank

in existence in India is the State Bank of India, a government-owned bank that traces

its origins back to June 1806 and that is the largest commercial bank in the country.

Central banking is the responsibility of the Reserve Bank of India, which in 1935

formally took over these responsibilities from the then Imperial Bank of India,

relegating it to commercial banking functions. After India's independence in 1947, the

Reserve Bank was nationalized and given broader powers. In 1969 the government

nationalized the 14 largest commercial banks; the government nationalized the six

next largest in 1980.

Currently, India has 88 scheduled commercial banks (SCBs) - 27 public sector banks

(that is with the Government of India holding a stake), 29 private banks (these do not

have government stake; they may be publicly listed and traded on stock exchanges)

and 31 foreign banks. They have a combined network of over 53,000 branches and

17,000 ATMs. According to a report by ICRA Limited, a rating agency, the public

sector banks hold over 75 percent of total assets of the banking industry, with the

private and foreign banks holding 18.2% and 6.5% respectively.

Early History:

Banking in India originated in the last decades of the 18th century. The first banks

were The General Bank of India, which started in 1786, and the Bank of Hindustan,

both of which are now defunct. The oldest bank in existence in India is the State

Bank of India, which originated in the Bank of Calcutta in June 1806, which almost

immediately became the Bank of Bengal. This was one of the three presidencybanks, the other two being the Bank of Bombay and the Bank of Madras, all three of

which were established under charters from the British East India Company. For

many years the Presidency banks acted as quasi-central banks, as did their

successors. The three banks merged in 1925 to form the Imperial Bank of India,

which, upon India's independence, became the State Bank of India.

Indian merchants in Calcutta established the Union Bank in 1839, but it failed in

1848 as a consequence of the economic crisis of 1848-49. The Allahabad Bank,


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established in 1865 and still functioning today, is the oldest Joint Stock bank in India.

When the American Civil War stopped the supply of cotton to Lancashire from the

Confederate States, promoters opened banks to finance trading in Indian cotton.

With large exposure to speculative ventures, most of the banks opened in India

during that period failed. The depositors lost money and lost interest in keeping

deposits with banks. Subsequently, banking in India remained the exclusive domain

of Europeans for next several decades until the beginning of the 20th century.

Foreign banks too started to arrive, particularly in Calcutta, in the 1860s. The

Comptoired'Escompte de Paris opened a branch in Calcutta in 1860, and another in

Bombay in 1862; branches in Madras and Pondicherry, then a French colony,

followed. Calcutta was the most active trading port in India, mainly due to the tradeof the British Empire, and so became a banking center.

Around the turn of the 20th Century, the Indian economy was passing through a

relative period of stability. Around five decades had elapsed since the Indian Mutiny,

and the social, industrial and other infrastructure had improved. Indians had

established small banks, most of which served particular ethnic and religious

communities.

The presidency banks dominated banking in India but there were also some

exchange banks and a number of Indian joint stock banks. All these banks operated

in different segments of the economy. The exchange banks, mostly owned by

Europeans, concentrated on financing foreign trade. Indian joint stock banks were

generally undercapitalized and lacked the experience and maturity to compete with

the presidency and exchange banks. This segmentation let Lord Curzon to observe,

"In respect of banking it seems we are behind the times. We are like some oldfashioned sailing ship, divided by solid wooden bulkheads into separate and

cumbersome compartments."

By the 1900s, the market expanded with the establishment of banks such as Punjab

National Bank, in 1895 in Lahore and Bank of India, in 1906, in Mumbai - both of

which were founded under private ownership. Punjab National Bank is the first

Swadeshi Bank founded by the leaders like LalaLajpatRai, SardarDhyal Singh

Majithia. The Swadeshi movement in particular inspired local businessmen and


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political figures to found banks of and for the Indian community. A number of banks

established then have survived to the present such as Bank of India, Corporation

Bank, Indian Bank, Bank of Baroda, Canara Bank and India. The fervour of

Swadeshi movement lead to establishing of many private banks in Dakshina

Kannada and Udupi district which were unified earlier and known by the name South

Canara ( South Kanara ) district.Fournationalised banks started in this district and

also a leading private sector bank. Hence undivided Dakshina Kannada district is

known as "Cradle of Indian Banking".

From World War I to Independence:

The period during the First World War (1914-1918) through the end of the SecondWorld War (1939-1945), and two years thereafter until the independence of India

were challenging for Indian banking. The years of the First World War were

turbulent, and it took its toll with banks simply collapsing despite the Indian economy

gaining indirect boost due to war-related economic activities. At least 94 banks in

India failed between 1913 and 1918 as indicated in the following table:

Years Number of banksthat failed

Authorized capital(Rs. Lakhs)

Paid-up Capital(Rs. Lakhs)

1913 12 274 35

1914 42 710 109

1915 11 56 5

1916 13 231 4

1917 9 76 25


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1918 7 209 1

Post-independence:

The partition of India in 1947 adversely impacted the economies of Punjab and West

Bengal, paralyzing banking activities for months. India's independence marked the

end of a regime of the Laissez-faire for the Indian banking. The Government of India

initiated measures to play an active role in the economic life of the nation, and the

Industrial Policy Resolution adopted by the government in 1948 envisaged a mixed

economy. This resulted into greater involvement of the state in different segments of

the economy including banking and finance. The major steps to regulate banking

included:

In 1948, the Reserve Bank of India, India's central banking authority, was

nationalized, and it became an institution owned by the Government of India.

In 1949, the Banking Regulation Act was enacted which empowered the

Reserve Bank of India (RBI) "to regulate, control, and inspect the banks inIndia."

The Banking Regulation Act also provided that no new bank or branch of an

existing bank could be opened without a license from the RBI, and no two

banks could have common directors.

However, despite these provisions, control and regulations, banks in India except the

State Bank of India, continued to be owned and operated by private persons. This

changed with the nationalization of major banks in India on 19 July, 1969.

Nationalization:

By the 1960s, the Indian banking industry has become an important tool to facilitate

the development of the Indian economy. At the same time, it has emerged as a large

employer, and a debate has ensued about the possibility to nationalize the banking

industry. Indira Gandhi, the-then Prime Minister of India expressed the intention ofthe GOI in the annual conference of the All India Congress Meeting in a paper


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entitled "Stray thoughts on Bank Nationalization." The paper was received with

positive enthusiasm. Thereafter, her move was swift and sudden, and the GOI

issued an ordinance and nationalized the 14 largest commercial banks with effect

from the midnight of July 19, 1969. Jayprakash Narayan, a national leader of India,

described the step as a "masterstroke of political sagacity." Within two weeks of the

issue of the ordinance, the Parliament passed the Banking Companies (Acquisition

and Transfer of Undertaking) Bill, and it received the presidential approval on 9

August, 1969.

A second dose of nationalization of 6 more commercial banks followed in 1980. The

stated reason for the nationalization was to give the government more control of

credit delivery. With the second dose of nationalization, the GOI controlled around91% of the banking business of India. Later on, in the year 1993, the government

merged New Bank of India with Punjab National Bank. It was the only merger

between nationalized banks and resulted in the reduction of the number of

nationalized banks from 20 to 19. After this, until the 1990s, the nationalized banks

grew at a pace of around 4%, closer to the average growth rate of the Indian

economy.

The nationalized banks were credited by some, including Home ministerP.

Chidambaram, to have helped the Indian economy withstand the global financial

crisis of 2007-2009.

Liberalization:

In the early 1990s, the then NarsimhaRao government embarked on a policy of

liberalization, licensing a small number of private banks. These came to be known asNew Generation tech-savvy banks , and included Global Trust Bank (the first of such

new generation banks to be set up), which later amalgamated with Oriental Bank of

Commerce, UTI Bank(now re-named as Axis Bank), ICICI Bank and HDFC Bank.

This move, along with the rapid growth in the economy of India, revitalized the

banking sector in India, which has seen rapid growth with strong contribution from all

the three sectors of banks, namely, government banks, private banks and foreign

banks.


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The next stage for the Indian banking has been setup with the proposed relaxation in

the norms for Foreign Direct Investment, where all Foreign Investors in banks may

be given voting rights which could exceed the present cap of 10%, at present it has

gone up to 49% with some restrictions.

The new policy shook the Banking sector in India completely. Bankers, till this time,

were used to the 4-6-4 method (Borrow at 4%; Lend at 6%; Go home at 4) of

functioning. The new wave ushered in a modern outlook and tech-savvy methods of

working for traditional banks. All this led to the retail boom in India. People not just

demanded more from their banks but also received more.

Currently (2007), banking in India is generally fairly mature in terms of supply,product range and reach-even though reach in rural India still remains a challenge

for the private sector and foreign banks. In terms of quality of assets and capital

adequacy, Indian banks are considered to have clean, strong and transparent

balance sheets relative to other banks in comparable economies in its region. The

Reserve Bank of India is an autonomous body, with minimal pressure from the

government. The stated policy of the Bank on the Indian Rupee is to manage

volatility but without any fixed exchange rate-and this has mostly been true.

With the growth in the Indian economy expected to be strong for quite some time-

especially in its services sector-the demand for banking services, especially retail

banking, mortgages and investment services are expected to be strong. One may

also expect M&As, takeovers, and asset sales.

In March 2006, the Reserve Bank of India allowed Warburg Pincus to increase its

stake in Kotak Mahindra Bank (a private sector bank) to 10%. This is the first time aninvestor has been allowed to hold more than 5% in a private sector bank since the

RBI announced norms in 2005 that any stake exceeding 5% in the private sector

banks would need to be vetted by them.

In recent years critics have charged that the non-government owned banks are too

aggresive in their loan recovery efforts in connection with housing, vehicle and

personal loans. There are press reports that the banks' loan recovery efforts have

driven defaulting borrowers to suicide.


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INTRODUCTION

COMPANY PROFILE


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INTRODUCTION OF THE COMPANY

Share khan is one of the leading retail brokerage of City Venture which is running

successfully since 1922 in the country. Earlier it was the retail broking arm of the

Mumbai-based SSKI Group, which has over eight decades of experience in the stockbroking business. Share khan offers its customers a wide range of equity related

services including trade execution on BSE, NSE, Derivatives, depository services,

online trading, investment advice etc.

Earlier with a legacy of more than 80 years in the stock markets, the SSKI group

ventured into institutional broking and corporate finance 18 years ago. SSKI is one of

the leading players in institutional broking and corporate finance activities. SSKI

holds a sizeable portion of the market in each of these segments. SSKIs institutional

broking arm accounts for 7% of the market for Foreign Institutional portfolio

investment and 5% of all Domestic Institutional portfolio investment in the country. It

has 60 institutional clients spread over India, Far East, UK and US. Foreign

Institutional Investors generate about 65% of the organizations revenue, with a daily

turnover of over US$ 2 million.

The content-rich and research oriented portal has stood out among itscontemporaries because of its steadfast dedication to offering customers best-of-

breed technology and superior market information. The objective has been to let

customers make informed decisions and to simplify the process of investing in

stocks.

WORK STRUCTURE OF SHAREKHAN

Share khan has always believed in investing in technology to build its business. The

company has used some of the best-known names in the IT industry, like Sun

Microsystems, Oracle, Microsoft, Cambridge Technologies, Nexgenix, Vignette,

Verisign Financial Technologies India Ltd, Spider Software Pvt Ltd. to build its

trading engine and content. The City Venture holds a majority stake in the company.

HSBC, Intel & Carlyle are the other investors.


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On April 17, 2002Sharekhan launched Speed Trade and Trade Tiger, are net-based

executable application that emulates the broker terminals along with host of other

information relevant to the Day Traders. This was for the first time that a net-based

trading station of this caliber was offered to the traders. In the last six months Speed

Trade has become a de facto standard for the Day Trading community over the net.

Share khans ground network includes over 700+ Share shops in 130+ cities in India.

The firms online trading and investment site - www.sharekhan.com - was launched

on Feb 8, 2000. The site gives access to superior content and transaction facility to

retail customers across the country. Known for its jargon-free, investor friendly

language and high quality research, the site has a registered base of over 3 Lacs

customers. The number of trading members currently stands at over 7 Lacs. While

online trading currently accounts for just over 5 per cent of the daily trading in stocks

in India, Share khan alone accounts for 27 per cent of the volumes traded online.

The Corporate Finance section has a list of very prestigious clients and has many

firsts to its credit, in terms of the size of deal, sect or tapped etc. The group has

placed over US$ 5 billion in private equity deals. Some of the clients include BPL

Cellular Holding, Gujarat Pipavav, Essar, Hutchison, Planetasia, and ShoppersStop.

Finally, Share khan shifted hands and City venture get holds on it.

PRODUCTS OFFERED BY SHAREKHAN

1- Equity Trading Platform (Online/Offline).

2- Commodities Trading Platform (Online/Offline).

3- Portfolio Management Service.

4- Mutual Fund Advisory and Distribution.

5- Insurance Distribution.


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REASONS TO CHOOSE SHAREKHAN LIMITED

Experience

SSKI has more than eight decades of trust and credibility in the Indian stock market.

In the Asia Money broker's poll held recently, SSKI won the 'India's best broking

house for 2004' award. Ever since it launched Sharekhan as its retail broking

division in February 2000, it has been providing institutional-level research and

broking services to individual investors.

Technology

With their online trading account one can buy and sell shares in an instant from any

PC with an internet connection. Customers get access to the powerful online trading

tools that will help them to take complete control over their investment in shares.

Accessibility

Sharekhan provides ADVICE, EDUCATION, TOOLS AND EXECUTION services for

investors. These services are accessible through many centers across the country

(Over 650 locations in 150 cities), over the Internet (through the website

www.sharekhan.com) as well as over the Voice Tool.

Knowledge

In a business where the right information at the right time can translate into direct

profits, investors get access to a wide range of information on the content-rich portal,

www.sharekhan.com. Investors will also get a useful set of knowledge-based tools

that will empower them to take informed decisions.

Convenience

One can call Share khans Dial -N-Trade number to get investment advice and

execute his/her transactions. They have a dedicated call-center to provide this

service via a Toll Free Number 1800-22-7500&39707500 from anywhere in India.

Customer Service


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Its customer service team assist their customer for any help that they need relating

to transactions, billing, demat and other queries. Their customer service can be

contacted via a toll-free number, email or live chat on www.sharekhan.com.

Investment Advice

Share khan has dedicated research teams of more than 30 people for fundamental

and technical research. Their analysts constantly track the pulse of the market and

provide timely investment advice to customer in the form of daily research emails,

online chat, printed reports etc

Benefits

Free Depository A/c

Instant Cash Transfer

Multiple Bank Option.

Secure Order by Voice Tool Dial-n-Trade.

Automated Portfolio to keep track of the value of your actual purchases.

24x7 Voice Tool access to your trading account.

Personalized Price and Account Alerts delivered instantly to your Mobile Phone &

E-mail address.

Live Chat facility with Relationship Manager on Yahoo Messenger

Special Personal Inbox for order and trade confirmations.

On-line Customer Service via Web Chat.

Enjoy Automated Portfolio.

Buy or sell even single share

Anytime Ordering.


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Share khan offers the following products

CLASSIC ACCOUNT This is a User Friendly Product which allows the client to trade

through website www.sharekhan.com and is suitable for the retail investors who is

risk-averse and hence prefers to invest in stocks or who do not trade too frequently.

Features

Online trading account for investing in Equity and Derivatives via

www.sharekhan.com

Live Terminal and Single terminal for NSE Cash, NSE F&O & BSE.

Integration of On-line trading, Saving Bank and Demat Account.

Instant cash transfer facility against purchase & sale of shares.

Competitive transaction charges.

Instant order and trade confirmation by E-mail.

Streaming Quotes (Cash & Derivatives).

Personalized market watch.

Single screen interface for Cash and derivatives and more.

Provision to enter price trigger and view the same online in market watch.

SPEEDTRADE

SPEEDTRADE is an internet-based software application that enables you to buy and

sell in an instant.

It is ideal for active traders and jobbers who transact frequently during days session

to capitalize on intra-day price movement.

Features

Instant order Execution and Confirmation.

Single screen trading terminal for NSE Cash, NSE F&O & BSE.


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Technical Studies.

Multiple Charting.

Real-time streaming quotes, tic-by-tic charts.

Market summary (Cost traded scrip, highest clue etc.)

Hot keys similar to brokers terminal.

Alerts and reminders.

Back-up facility to place trades on Direct Phone lines.

Live market debts.


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INTRODUCTION OF MONETARYPOLICIES AND ITS IMPACT ON THE

BANKING STOCKS


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INTRODUCTION

Monetary policy is the process by which the monetary authority of a country

controls the supply of money, often targeting a rate of interest for the purpose of

promoting economic growth and stability. The official goals usually include relatively

stable prices and low unemployment. Monetary theory provides insight into how to

craft optimal monetary policy.

Monetary policy is referred to as either being expansionary or contractionary, where

an expansionary policy increases the total supply of money in the economy more

rapidly than usual, and contractionary policy expands the money supply more slowly

than usual or even shrinks it. Expansionary policy is traditionally used to try tocombat unemployment in a recession by lowering interest rates in the hope that easy

credit will entice businesses into expanding. Contractionary policy is intended to slow

inflation in hopes of avoiding the resulting distortions and deterioration of asset

values.

Monetary policy differs from fiscal policy, which refers to taxation, government

spending, and associated borrowing.

OVERVIEW

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, orwhere 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 (to achieve policy goals). 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

increases it only slowly, or if it raises the interest rate. An expansionary policy
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increases the size of the money supply more rapidly, or decreases the interest rate.

Furthermore, monetary policies are described as follows: 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.

There are several monetary policy tools available to achieve these ends: increasing

interest rates by fiat; reducing the monetary base; and increasing reserve

requirements. All have the effect of contracting the money supply; and, if reversed,

expand the money supply. Since the 1970s, monetary policy has generally been

formed separately from fiscal policy. Even prior to the 1970s, the Britton Woods

system still ensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Federal Reserve

System in the United States, the Bank of England, the European Central Bank, the

People's Bank of China, and the Bank of Japan) exist which have the task of

executing the monetary policy and often independently of the executive. In general,

these institutions are called central banks and often have other responsibilities such

as supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails

managing the quantity of money in circulation through the buying and selling of

various financial instruments, such as treasury bills, company bonds, or foreign

currencies. All of these purchases or sales result in more or less base currency

entering or leaving market circulation.

Usually, the short term goal of open market operations is to achieve a specific shortterm interest rate target. In other instances, monetary policy might instead entail the

targeting of a specific exchange rate relative to some foreign currency or else

relative to gold. For example, in the case of the USA the Federal Reserve targets the

federal funds rate, the rate at which member banks lend to one another overnight;

however, the monetary policy of China is to target the exchange rate between the

Chinese renminbi and a basket of foreign currencies.
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The other primary means of conducting monetary policy include: (i) Discount window

lending (lender of last resort) ; (ii) Fractional deposit lending (changes in the reserve

requirement); (iii) Moral suasion (cajoling certain market players to achieve specified

outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).

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 to attain a set of objectives oriented towards the

growth and stability of the economy.[1] Monetary theory provides insight into how to

craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in aneconomy, 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 (to achieve policy goals).

It is important for policymakers to make credible announcements. If private agents

(consumers and firms) believe that policymakers are committed to lowering inflation,

they will anticipate future prices to be lower than otherwise (how those expectations

are formed is an entirely different matter; compare for instance rational expectations

with adaptive expectations) . If an employee expects prices to be high in the future,

he or she will draw up a wage contract with a high wage to match these prices.

Hence, the expectation of lower wages is reflected in wage-setting behavior betweenemployees and employers (lower wages since prices are expected to be lower) and

since wages are in fact lower there is no demand pull inflation because employees

are receiving a smaller wage and there is no cost push inflation because employers

are paying out less in wages.

To achieve this low level of inflation, policymakers must have credible

announcements; that is, private agents must believe that these announcements will

reflect actual future policy. If an announcement about low-level inflation targets is
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made but not believed by private agents, wage-setting will anticipate high-level

inflation and so wages will be higher and inflation will rise. A high wage will increase

a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation) ,

so inflation rises. Hence, if a policymaker's announcements regarding monetary

policy are not credible, policy will not have the desired effect.

If policymakers believe that private agents anticipate low inflation, they have an

incentive to adopt an expansionist monetary policy (where the marginal benefit of

increasing economic output outweighs the marginal cost of inflation); however,

assuming private agents have rational expectations, they know that policymakers

have this incentive. Hence, private agents know that if they anticipate low inflation,

an expansionist policy will be adopted that causes a rise in inflation. Consequently,(unless policymakers can make their announcement of low inflation credible ), private

agents expect high inflation. This anticipation is fulfilled through adaptive expectation

(wage-setting behavior);so, there is higher inflation (without the benefit of increased

output). Hence, unless credible announcements can be made, expansionary

monetary policy will fail.

Announcements can be made credible in various ways. One is to establish an

independent central bank with low inflation targets (but no output targets). Hence,

private agents know that inflation will be low because it is set by an independent

body. Central banks can be given incentives to meet targets (for example, larger

budgets, a wage bonus for the head of the bank) to increase their reputation and

signal a strong commitment to a policy goal. Reputation is an important element in

monetary policy implementation. But the idea of reputation should not be confused

with commitment.

While a central bank might have a favorable reputation due to good performance in

conducting monetary policy, the same central bank might not have chosen any

particular form of commitment (such as targeting a certain range for inflation).

Reputation plays a crucial role in determining how much markets would believe the

announcement of a particular commitment to a policy goal but both concepts should

not be assimilated. Also, note that under rational expectations, it is not necessary for

the policymaker to have established its reputation through past policy actions; as an
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example, the reputation of the head of the central bank might be derived entirely

from his or her ideology, professional background, public statements, etc.

In fact it has been argued that to prevent some pathology related to the time

inconsistency of monetary policy implementation (in particular excessive inflation),

the head of a central bank should have a larger distaste for inflation than the rest of

the economy on average. Hence the reputation of a particular central bank is not

necessary tied to past performance, but rather to particular institutional

arrangements that the markets can use to form inflation expectations.

Despite the frequent discussion of credibility as it relates to monetary policy, the

exact meaning of credibility is rarely defined. Such lack of clarity can serve to leadpolicy away from what is believed to be the most beneficial. For example, capability

to serve the public interest is one definition of credibility often associated with central

banks. The reliability with which a central bank keeps its promises is also a common

definition. While everyone most likely agrees a central bank should not lie to the

public, wide disagreement exists on how a central bank can best serve the public

interest. Therefore, lack of definition can lead people to believe they are supporting

one particular policy of credibility when they are really supporting another.

Banking Sector and Monetary Policy in India

Banking Sector

Independent India inherited a weak financial system. Commercial banks mobilized

household savings through demand and term deposits, and disbursed the credit

primarily to large corporations (Ghosh,1988). This lop-sided pattern of credit

disbursal, and perhaps a spate of bank failures that reduced the number of banks

from 566 in 1951 to 90 in 1968, led the government to nationalize the banks in 1969.

The main thrust of nationalization was social banking, with the stated objective of

increasing the geographical coverage of the banking system, and extension of credit

to the priority sector that comprised largely of agriculture, agro-processing, and

small-scale industries. This phase of banking in

India was characterized by administered interest rates, mandatory syndicated

lending, and pre- emption of the banks deposit base by the government in the form

of measures like high cash reserve ratio (CRR) and statutory liquidity ratio (SLR).
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Banks were required to invest a significant proportion of their deposits in bonds

issued by the government and approved (quasi -government) institutions. At the

same time, between 1969 and 1990, the nationalized banks added over 55,000

branches to their network (Sarkar and Agarwal, 1997).

While the social agenda of the banking sector, measured in terms of geographical

and sectoral coverage, was arguably a success, the Indian banking sector, about 88

percent of whose assets were managed by state-owned banks, was in distress.

While the ratio of gross operating profit of the scheduled commercial banks rose

from 0.8 percent (of assets) in the seventies to 1.5 percent in the early nineties, the

net profit of the banks declined. More importantly, perhaps, financial repression

involving state-owned banks was not in harmony with the agenda of real sector

reforms that the government of India unleashed in the aftermath of the balance of

payments crisis of 1991. The RBI, therefore, initiated reform of the banking sector in

1992, based on the recommendations of Narasimham Committee I (Reddy, 1998).

Between 1992 and 1997, the CRR was reduced from 15 percent to about 10

percent, and the SLR was reduced from 38.5 percent to 25 percent over the same

period. The interest rates were gradually liberalized. Prior to 1992, the lending rates

structure consisted of six categories based on the size of advances. During the

1992-94 period, the lending rates structure was rationalized to three categories, and

in 1994 banks were given the freedom to determine interest rates on all loans

exceeding 200,000 Indian rupees (INR). By 1998, banks were free to determine the

interest rates for all loans, with the understanding that the lending rates on loans up

to INR 200,000 would not exceed the declared prime lending rates (PLR) of the

banks.

Prior to the initiation of reforms, banks were required to refer all loans above a size

threshold to the RBI for authorization, and formation of a consortium was mandatoryfor all loans exceeding INR 50 million. Bank credit was delivered primarily in the form

of cash credit for use as working capital, and there were significant restrictions on

the ability of banks to deliver term credit for projects.

Finally, the RBI implemented selective credit controls on sensitive commodities.

In the wake of the reforms, as early as in 1993, the threshold for the mandatory

formation of consortiums was raised tenfold from INR 50 million to INR 500 million.

Further, banks within 9 consortiums were permitted to frame the rules or contractual


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agreements governing the consortium lending. In 1996, selective credit controls on

all sensitive commodities except sugar were removed.

Banks were also allowed much greater flexibility about the proportion of the cash

credit component of the loans, the new floor being 25 percent. The following year

witnessed further elimination of credit controls: Banks were no longer subjected to

the instructions pertaining to Maximum Permissible Bank

Finance (MPBF), and were allowed to evolve their own methods for assessing the

credit needs of the potential borrowers. Further, banks were no longer required to

form consortiums to lend in excess of

INR 500 million, and restrictions on their ability to provide term loan for projects were

withdrawn.

However, prudential regulations required that an individual bank not be over-

exposed to any one (or group of) creditor(s).

Finally, in 1998, the RBI initiated the second generation of banking reforms, in

keeping with the recommendations of Narasimham Committee II. The most

important recommendation of the

Committee was the creation of asset reconstruction companies (ARCs) to

simultaneously improve the quality of the balance sheets of the banks and to

facilitate recovery of loans. In a separate development, after a prolonged period of

legal disputes, debt recovery tribunals (DRTs) began functioning in India, in earnest,

by 1999.

To summarize, by 1996, banks operating in India, were, by and large, in a position to

take independent decisions on the composition of their asset portfolio, and on the

choice of potential borrowers. Furthermore, there is evidence to suggest that these

banks, including the state-owned ones, allocated resources in a way that was

consistent with optimization of risk-return tradeoffs. There are, however, significantdifferences across credit market behavior of banks of different ownership.

Berger et al. (2008) find that comparative advantage of Indian banks, with respect to

relationship with potential borrowers, vary considerably with ownership. State-owned

banks typically have banking relationship with small firms, state-owned firms and

rural firms, domestic private banks have comparative advantage with respect to

opaque closely held firms, and foreign banks have banking relationship with large,

listed and foreign firms. The likelihood of adverse selection, therefore, variesconsiderably across banks, by ownership type. Bhaumik and Piesse (2008)


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demonstrate that bank ownership also has an impact on risk aversion among Indian

banks, with foreign banks being 10 significantly more risk averse than domestic

banks. Finally, state-owned banks retained, in principle, the ability to raise capital

without being exposed to market forces. Since the impact of monetary policy on bank

lending depends in large measure on the risk of adverse selection the extent of risk

aversion of banks, and also on their ability to raise affordable capital, we should

expect to see considerable differences in the impact of such policy on banks of

different ownership.

The authority to implement monetary policy in India rests with the RBI. It was

established under the Reserve Bank of India Act of 1934, as a private shareholders

bank, and was subsequently nationalized in 1949. Unlike the Bank of England, which

was formally granted independence in 1997, the RBI does not have de jure

independence from the Government of India. However, with the phasing out of

automatic monetization of fiscal deficit by 1997 by way of ad hoc treasury bills, the

central bank was granted de facto independence. There are strict limits on the ways

and means advances by the RBI to the government, and the former does not

participate in primary market auctions of government securities. While the RBI takes

into cognizance the federal governments views about the state of the economy, it de

facto sets monetary policy independently.

Originally, the bank rate and open market operations were the RBIs instruments of

choice for conducting monetary policy. In the seventies and eighties, with increased

accommodation of the federal governments fiscal policies by the central bank, these

instruments lost their efficacy, and the cash reserve ratio (CRR) became the primary

instrument for conducting monetary policy.

In 1998, in light of the realization that in an increasingly complex environment broad

money supply in the medium term cannot be the sole intermediate target ofmonetary policy, the RBI formally adopted a multifactor approach to monetary policy.

This resulted in a focus on the use of short term interest rates as the instruments of

monetary policy, facilitated by the deregulation of interest rates, which was initiated

as early as 1989. The bank rate, therefore, made a comeback in 1997-98, and was

complemented by the rates for reverse repo (and, from 2000-01, repo) transactions.

The repo and reverse repo rates have emerged as the primary instruments of

monetary policy since the turn of the century.


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The CRR, which was reduced steadily from 15 percent in the early nineties to 5

percent by11 2004, has not completely been abandoned. It is still used in situations

that demand significant monetary response, or when other monetary policy options

have been exhausted. The use of all monetary policy instruments of the RBI are

summarized It is evident from Table 1 that it is difficult to select any one instrument

as the indicator of monetary policy of the RBI. This poses a problem because

empirical analysis requires the use of a single monetary policy signal; the US

literature on the lending channel of monetary policy focuses on changes in the

federal funds rate (Kashyap and Stein, 1995, 2000), while the European literature

uses short-term interest rates (Erhmann et al., 2001) or the refinancing rate

(Gambacorta, 2005).

Fortunately, Indian banks declare their respective prime lending rates (PLR) the

rate at which they are prepared to lend to the most credit-worthy borrowers that is

linked to their cost of funds. The average PLR of the five largest banks is quoted by

the RBI. As evident from Figure 1, movements of this average PLR closely replicates

movements in the bank rate, and, to a somewhat lesser extent, also the repo and

reverse repo rates. Hence, we use the average PLR reported by the RBI as the

basis for our measure of monetary policy. We are not alone in our use of such

constructs as the basis for the measure for monetary policy. In the British context,

Huang (2003) used the average of the base rates

of selected banks as the indicator of monetary policy, while Hofman and Mizen

(2004) eschewed the official Bank of England rate in favour of the average of the

base rates of four major clearing banks.

Investors and traders are time and again flummoxed by the violent moves in bank

stocks. The Bank Nifty, which is an index comprised of the most liquid and largecapitalized Indian bank stocks, has moved up 44% from March 2010 to November

2010 and has fallen by 18% from November 2010 to present. In the last one month,

the index has moved up by 6% from lows.

What factors cause these large moves, and how do investors and traders study

these factors to take a decision on buying or selling bank stocks or the bank index.

Banks are highly regulated as they take deposits from the public. Banks in Indiahave to maintain reserves in the form of SLR (Statutory Liquidity Ratio) and CRR


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(Cash Reserve Ratio). The government is the single largest owner of bank

stocks. Hence the macro noise levels around the banking sector are high. The sector

is affected by policy actions by the regulator the RBI, levels of inflation in the

economy, deposit growth, credit off take, system liquidity, government policy

decisions, FII flows into the sector etc. Let us look at how each such macro factors

affect bank stock prices.

Banks have to maintain 24% of their net demand and time deposits (NDTL) in

government bonds as SLR and 6% of their NDTL as cash balance with the RBI as

CRR. Banks earn risk free rate of interest on SLR while they earn nothing on CRR.

At present government bond yields are at around 8%. Banks profitability depends on

a) movement of government bond yields and b) cost of their funds. If governmentbond yields move up, the inference is that the value of banks holdings in government

bonds falls.

However, as banks can hold government bonds at cost (to the extent of SLR), their

profitability will fall to the extent of loss in value of banks holdings in government

bonds over and above the SLR limit. The reverse is true when government bond

yields move down, then banks profitability moves up to the extent of their excess

SLR. The second factor is the cost of funds for the banks. If banks cost of funds is

lower than government bond yields, banks make money in the form of positive

difference between the borrowing rate and the lending rate.

At present banks are raising deposits at over 8.5% levels while government bond

yields are at 8%. Banks are actually earning negative interest rates on their

incremental investments in government bonds, which is not good for the profitability

of the banks. Investors should closely watch movements in government bond yieldsand the cost of funds for banks to determine the future profitability of banks.

The budget, which projected a lower than expected net borrowing for the

government for fiscal 2011-12 is positive for government bond yields and hence

positive for bank stocks. However, if there is a threat of additional supply due to

higher subsidy outgo on account of high oil prices, then it is negative for bank stocks.

Oil prices ruling at high levels of USD 115/bbl is negative for banks.


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The RBI tries to control the liquidity in the system using CRR as a tool. CRR is a cost

for banks as it does not earn any interest. If the RBI increases CRR, then banks cost

increases as they have to keep more cash as reserves with the RBI. Banks liquidity

also decreases and they will have that much less to lend. This affects the profitability

of banks. The reverse is true in case of CRR being reduced which leads to an

increase in the profitability of banks.

In the last one year, the RBI has raised policy rates of repo and reverse repo as well

as CRR to bring down inflation expectations. The policy rate hikes has raised cost of

funds for the banks as well as taken up government bond yields, and this has led to

expectations of banks profitability decreasing. Banks stocks initially did not react to

RBI policy moves hence the fall from highs was large. Going forward, inflationexpectations are still high and RBI is expected to raise policy rates further, which is

negative for bank stocks.

Banks profitability is dependent on many other factors. Banks earn from raising

deposits and lending to the economy, banks earn fee income from services and

transactions rendered and banks earn from treasury. High deposit growth coupled

with high credit growth is good for bank stocks as it improves the profitability of

banks.

However if credit growth is excessive (as seen in the 2005-07 period when credit

grew in excess of 25% consistently with real estate forming at least 30% of

incremental credit growth) it is seen as risky. Banks suffer from non repayment of

loans when the economy turns bad as seen in the real estate sector debacle in the

post 2008 crisis period.

Rising default on loans eat into the banks capital as deposits that go into funding

credit have to be serviced and repaid. Investors should watch out for high credit

growth and where the credit is going. Banks lent to the telecom sector for funding 2G

and 3G licenses and after the scam broke out in late 2010, there are apprehensions

on these loans defaulting. This is reflected in the falling prices of bank stocks.

Other factors that affect bank stocks include government policy decisions. If the

government forces banks to lend more to agriculture, or waives loans given to


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favored industries, banks profitability suffers. FIIs too provide a lot of liquidity to

banking stocks. FII buying in 2010 (they brought in USD 28 billion) lifted bank stocks

and FII selling in 2011 (USD 2billion year to date) has brought down bank stocks.

Investors will have to closely watch government policies and FII flows and their

potential impact on bank stocks.

Obviously other fundamentals such as fee based income as percentage of total

income, higher sticky deposits in the form of current and savings accounts, low non

performing loans, higher treasury profits, higher return on assets etc also plays large

part in valuations of bank stocks. These are longer term in nature and usually do not

account for such sharp rise and fall in bank stock prices as seen in the past one

year.In this attempt to contain the monster that eats into our savings, the Reserve Bank

of India ( RBI) has raised interest rates five times since March this year. Taking the

cue, banks too have followed suit and raised interest rates just a few days ago. Last

week, in its policy review, the central bank left rates unchanged, merely reducing the

SLR to 24% from 25%. However, this is certainly not the end of the taming of

inflation story. We are in a rising interest rate scenario and there is a consensus

amongst market players that the RBI will hike rates in January.

So what does this rising interest rate mean for the stock market investors? And why

do money market participants bet on further rate hikes? As long as the inflation

doesn't show signs of easing, the central bank has no option but to hike rates. This is

because when interest rates are low, there are more borrowers willing to take loans.

This means more money in the system and higher inflation. To reduce the chance of

inflation, the central bank raises key interest rates, following which banks too hike

rates. The opposite is also true. For example, when the economy exhibits low growth

or in times of recession, central banks across the globe lower interest rates which, in

turn, forces banks to reduce interest rates.

Reforms had significant impact on monetary policy RBI report

MUMBAI, DEC. 23. The Reserve Bank of India today stated that structural reforms

initiated in the Indian economy in the early 1990s had a significant impact on theconduct of monetary policy in terms of its objectives, strategies and tactics.


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"An assessment of monetary management since early 1990s shows that monetary

policy has been reasonably successful in meeting its key objectives, price stability,

flow of credit to productive sectors and ensuring financial stability,'' the RBI stated in

its "Report on Currency and Finance 2003-04,'' which is prepared by the RBI's

Department of Economic Analysis and Policy.

In assessing the conduct of monetary policy during the recent years, it needs to be

stressed that during this period, the Indian economy witnessed a large number of

shocks, both global and domestic.

These shocks included a series of financial crisis in Asia, Brazil and Russia,

September 11 terrorist attacks in the U.S., border tensions, sanctions imposed in theaftermath of nuclear tests, political uncertainties and changes in the Government.

The monetary policy in India had to manage all such shocks, and, viewed in this

light, the success in maintaining price and financial stability is all the more credible.

In this regard, it needs to be noted that financial stability does not exclude interest

rate cycles. Accordingly, the RBI has been preparing market participants for these

cycles and they have also been advised to hedge their exposures. As theinternational experience indicates, a prudent fiscal policy remains the single

largestpre-requisite for monetary stability. Reforms in the monetary-fiscal interface

during the 1990s have been a key factor that imparted greater flexibility to monetary

policy.

These reforms have taken a significant step forward with the enactment of the Fiscal

Responsibility and Budget Management Act, 2003. Strict adherence to these fiscal

rules in letter and spirit will help stabilize inflation expectations and, in turn, keep

inflation low and stable in the country while gradually providing increasing flexibility

to the RBI.

Fiscal discipline creates enabling conditions for monetary and financial stability.

Monetary policy will have, however, still to grapple with uncertainty in the

environment it operates. Uncertainty about how economies operate and about

monetary policy itself is, however, no excuse for not pursuing price stability. An


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environment of sustained low and stable inflation is conducive for financial savings,

with beneficial impact on investment in the economy and for sustained growth and

employment. Price stability is all the more important for an economy like India, with a

large proportion of poor population that has no hedges against inflation.

Corporate Travails:

Most businesses need capital to run their day-to-day operations that require a

mixture of debt and equity. Companies that carry a huge debt on their balance

sheets, and those which need more capital in the form of debt for expansion are the

worst affected. This is because when interest rates rise, the cost of borrowing also

rises. So, you have to pay a higher interest cost to service that debt. In such ascenario, a company has two options be-fore it: either to pass on the rise in interest

cost to the end-user or customer, or absorb the burden itself.

Since it is a competitive market, it is difficult at most times to pass on the increased

cost entirely to the customers or end-users. In such a scenario, profits could come

down. From an investor's perspective, when profits come down, the stock becomes

less attractive to potential as well as existing investors and the stock price falls.

Rising interest rates affect the fundamentals of corporate in the long term.

Stock Shock

Rising interest rates generally hit markets negatively. They affect some industries

more than the other. For example, investors may sell any shares in interest-sensitive

stocks that they hold. Interest-sensitive industries include automobiles, real estate

and the banking sector. A rising interest rate scenario has a higher effect in the long

term. While in the short term, it is liquidity that could help markets tide over, in thelonger term, higher interest costs bring down the P/E (price-to-earnings) ratio of

companies. Investors who favour increased current income compared to waiting for

an investment to grow in value and sell later are attracted to investment vehicles that

offer a higher rate of return. Higher interest rates can make investors switch from

stocks to fixed-income instruments such as bonds and fixed deposits.

In addition, high interest rates can have a negative impact on an investor's total

finances. When an investor pays higher interest on his credit card, home loan or


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automobile loan, he may sell some stocks to pay off some of his high-interest debt.

In order to do so, he could sell some of his stocks. Selling stocks to service debt is a

common practice and can hurt stock prices. This dissertation documents the

reactions of bank stocks to monetary policy actions, which include the changes in

Federal funds rate target and the FOMC meetings without adjustment in target rate.

As the key policy tool used by the Federal Reserve, the changes in Federal funds

rate target are considered by the market participants to convey important information

of monetary policy. On the one hand, I examine the state dependency of the effect of

target changes on bank stocks. On the other hand, I conduct a cross-sectional

analysis to investigate if banks of different characteristics react differently to the

changes in funds rate target.

I find supportive evidence that the responses of bank stocks to monetary actions are

conditional on the context in which the policy change takes place. Specifically, I

observe that bank stocks are more adversely affected by the target changes

accompanied by a simultaneous discount rate change, which is different with existing

evidence. In addition, I find that the target changes that start a new policy direction

elicit more market reaction, bank stocks react more vigorously to small surprises

than to big surprises, and the direction of the target change does not matter.

From the cross-sectional analysis, I find that monetary shocks have more

pronounced impact on the banks with larger size, lower capital ratio, higher level of

business diversification and higher level of international exposure.

The results of this study benefit investors, depositors, bank managers and policy

makers.

Sectoral Slips

Interest- rate sensitives such as auto and auto ancillaries, banks, and real estate are

the first ones to be affected in a rising interest rate scenario. We have already seen

several banking stocks taking a beating in the recent past. The largest of them all

State Bank of India has lost 22% from its peak price of 3,515, while ICICI Bank

has lost 13% from its high of 2,520. Bank of India has lost 25% from its high of 589.

Auto stocks too have taken a hit. Maruti Suzuki has lost 15% from its high of 1,625.

Real estate stocks have also been beaten down as higher interest rates could


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dampen consumer interest. Prospective buyers may feel it safer to continue staying

on rent than buying a house. Construction companies and infrastructure companies

that guzzle down huge amounts of cash could be affected. We are underweight on

banks, autos and real estate.

Safe Haven: Sectors such as pharmaceuticals, FMCG and IT are considered non-

interest rate sensitive by investors and are safe to park your money during a high

rate regime. You can postpone buying a house, but you cannot postpone buying

things like soaps, detergents and toothpaste, which are a daily necessity. Similar is

the case with medicines, where consumption is interest-rate neutral. We have

increased our exposure to IT from 4% to 6% in our portfolio.

As of now, it looks more likely that interest rates will inch upwards in the near

future. Investors are advised to keep that in mind and position their portfolio

accordingly.

Developing Countries

Developing countries may have problems establishing an effective operating

monetary policy. The primary difficulty is that few developing countries have deep

markets in government debt. The matter is further complicated by the difficulties in

forecasting money demand and fiscal pressure to levy the inflation tax by expanding

the monetary base rapidly. In general, the central banks in many developing

countries have poor records in managing monetary policy.

This is often because the monetary authority in a developing country is not

independent of government, so good monetary policy takes a backseat to thepolitical desires of the government or is used to pursue other non-monetary goals.

For this and other reasons, developing countries that want to establish credible

monetary policy may institute a currency board or adopt dollarization. Such forms of

monetary institutions thus essentially tie the hands of the government from

interference and, it is hoped, that such policies will import the monetary policy of the

anchor nation.
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Recent attempts at liberalizing and reforming financial markets (particularly the

recapitalization of banks and other financial institutions in Nigeria and elsewhere)

aregradually providing the latitude required to implement monetary policy

frameworks by the relevant central banks.

Types of monetary policy

In practice, to implement any type of monetary policy the main tool used is modifying

the amount of base money in circulation. The monetary authority does this by buying

or selling financial assets (usually government obligations). These open market

operations change either the amount of money or its liquidity (if less liquid forms of

money are bought or sold). The multiplier effect of fractional reserve bankingamplifies the effects of these actions.

Constant market transactions by the monetary authority modify the supply of

currency and this impacts other market variables such as short term interest rates

and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the

set of instruments and target variables that are used by the monetary authority toachieve their goals.

Monetary Policy: Target Market Variable: Long Term Objective:

Inflation TargetingInterest rate on overnight

debtA given rate of change in the CPI

Price Level

Targeting

Interest rate on overnight

debtA specific CPI number

Monetary

Aggregates

The growth in money

supplyA given rate of change in the CPI

Fixed Exchange

Rate

The spot price of the

currencyThe spot price of the currency

Gold Standard The spot price of goldLow inflation as measured by the

gold price

Mixed Policy Usually interest rates Usually unemployment + CPI
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change

The different types of policy are also called monetary regimes , in parallel to

exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The

Gold standard results in a relatively fixed regime towards the currency of other

countries on the gold standard and a floating regime towards those that are not.

Targeting inflation, the price level or other monetary aggregates implies floating

exchange rate unless the management of the relevant foreign currencies is tracking

exactly the same variables (such as a harmonized consumer price index).

Inflation Targeting

Inflation targeting under this policy approach the target is to keep inflation, under a

particular definition such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank

interest rate target. The interest rate used is generally the interbank rate at which

banks lend to each other overnight for cash flow purposes. Depending on the

country this particular interest rate might be called the cash rate or something

similar.

The interest rate target is maintained for a specific duration using open market

operations. Typically the duration that the interest rate target is kept constant will

vary between months and years. This interest rate target is usually reviewed on a

monthly or quarterly basis by a policy committee.

Changes to the interest rate target are made in response to various market

indicators in an attempt to forecast economic trends and in so doing keep the market

on track towards achieving the defined inflation target. For example, one simple

method of inflation targeting called the Taylor rule adjusts the interest rate in

response to changes in the inflation rate and the output gap. The rule was proposed

by John B. Taylor of Stanford University .[14]

The inflation targeting approach to monetary policy approach was pioneered in New

Zealand. It is currently used in Australia, Brazil, Canada, Chile, Colombia, the Czech
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Republic, New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa,

Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year

over or under the long term price level target is offset in subsequent years such that

a targeted price-level is reached over time, e.g. five years, giving more certainty

about future price increases to consumers. Under inflation targeting what happenedin the immediate past years is not taken into account or adjusted for in the current

and future years.

Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the

money supply. This approach was refined to include different classes of money and

credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued

with the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism. While most monetary policy

focuses on a price signal of one form or another, this approach is focused on

monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency.

There are varying degrees of fixed exchange rates, which can be ranked in relation

to how rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority

declares a fixed exchange rate but does not actively buy or sell currency to maintain

the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital
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controls, import/export licenses, etc.). In this case there is a black market exchange

rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central

bank or monetary authority on a daily basis to achieve the target exchange rate. This

target rate may be a fixed level or a fixed band within which the exchange rate may

fluctuate until the monetary authority intervenes to buy or sell as necessary to

maintain the exchange rate within the band. (In this case, the fixed exchange rate

with a fixed level can be seen as a special case of the fixed exchange rate with

bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unitof local currency must be backed by a unit of foreign currency (correcting for the

exchange rate). This ensures that the local monetary base does not inflate without

being backed by hard currency and eliminates any worries about a run on the local

currency by those wishing to convert the local currency to the hard (anchor)

currency.

Under dollarization, foreign currency (usually the US dollar, hence the term

"dollarization") is used freely as the medium of exchange either exclusively or in

parallel with local currency. This outcome can come about because the local

population has lost all faith in the local currency, or it may also be a policy of the

government (usually to rein in inflation and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authority or

government as monetary policy in the pegging nation must align with monetary

policy in the anchor nation to maintain the exchange rate. The degree to which localmonetary policy becomes dependent on the anchor nation depends on factors such

as capital mobility, openness, credit channels and other economic factors.

Gold standard

The gold standard is a system under which the price of the national currency is

measured in units of gold bars and is kept constant by the government's promise to

buy or sell gold at a fixed price in terms of the base currency. The gold standard
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might be regarded as a special case of "fixed exchange rate" policy, or as a special

type of commodity price level targeting.

The minimal gold standard would be a long-term commitment to tighten monetary

policy enough to prevent the price of gold from permanently rising above parity. A full

gold standard would be a commitment to sell unlimited amounts of gold at parity and

maintain a reserve of gold sufficient to redeem the entire monetary base.

Today this type of monetary policy is no longer used by any country, although the

gold standard was widely used across the world between the mid-19th century

through 1971. Its major advantages were simplicity and transparency. The gold

standard was abandoned during the Great Depression, as countries sought toreinvigorate their economies by increasing their money supply . [16] The Britton Woods

system, which was a modified gold standard, replaced it in the aftermath of World

War II. However, this system too broke down during the Nixon shock of 1971.

The gold standard induces deflation, as the economy usually grows faster than the

supply of gold. When an economy grows faster than its money supply, the same

amount of money is used to execute a larger number of transactions. The only way

to make this possible is to lower the nominal cost of each transaction, which means

that prices of goods and services fall, and each unit of money increases in value.

Absent precautionary measures, deflation would tend to increase the ratio of the real

value of nominal debts to physical assets over time.

For example, during deflation, nominal debt and the monthly nominal cost of a fixed-

rate home mortgage stays the same, even while the dollar value of the house falls,

and the value of the dollars required to pay the mortgage goes up. Mainstreameconomics consid

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