Monetary and Credit Policy of RBI | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• Credit and monetary policy, established by the central bank, is a macroeconomic strategy that involves the regulation of money supply and interest rates. This policy, serving as a demand-side tool, is employed by the government to achieve various macroeconomic goals such as controlling inflation, encouraging consumption, fostering growth, and ensuring liquidity. In India, the Reserve Bank of India (RBI) shapes its monetary policy with the aim of managing the money supply to cater to different sectors of the economy and to accelerate economic growth. The implementation of monetary policy by the RBI utilizes various tools including open market operations, bank rate policy, reserve system, credit control policy, moral persuasion, and other instruments. Any adjustment with these instruments results in changes to interest rates or the overall money supply within the economy.
• Monetary policy can take on either an expansionary or contractionary nature. An expansionary policy is characterized by an increase in money supply and a reduction in interest rates, while a contractionary policy is the opposite. Liquidity, crucial for economic growth, is maintained through the RBI's reliance on monetary policy. For example, to bolster liquidity, the RBI engages in open market operations by purchasing bonds, injecting money into the system, and lowering interest rates.

Main objectives of Monetary Policy

• To maintain price stability.
• To ensure adequate flow of credit to productive sectors so as to assist growth.
• Arrangement of full employment.
• Expansion of credit facility
• Equality & Justice Stability in exchange rate.
• Promotion of Fixed Deposit.
• Equitable distribution of Credit.

Two Types of Instruments of the Monetary Policy

1. Quantitative

• Cash Reserve Ratio (CRR) is the mandated percentage of deposits that commercial banks must keep in the form of cash with the RBI. It serves as a tool for the RBI to manage liquidity in the economy, either by absorbing excess funds or releasing additional funds for economic growth. For instance, a reduction in CRR implies that banks need to keep a smaller portion of their deposits with the RBI, thereby increasing the money available for business. Conversely, an increase in CRR reduces the funds available to banks. The current CRR stands at 4%.
• Statutory Liquidity Ratio (SLR) is the portion of deposits that commercial banks must maintain in the form of gold or approved securities before extending credit to customers. Set as a percentage of total deposits, SLR is regulated by the RBI to control the expansion of bank credit. The current SLR is 19.5%.
• Bank Rate is the interest rate at which the RBI provides long-term loans to commercial banks. It serves as a tool for regulating the money supply. A change in the bank rate signals banks to adjust deposit and prime lending rates. The current Bank Rate is 6.25%.
• Repo Rate is the interest rate at which the RBI offers short-term loans to commercial banks against securities. An increase in Repo Rate makes borrowing costlier for banks, curbing inflation by restricting money availability. Conversely, during deflation, the RBI may lower the Repo Rate to encourage growth. The current Repo Rate is 6%.
• Reverse Repo Rate is the interest rate at which the RBI borrows from commercial banks. An increase in the reverse repo rate indicates that the RBI is offering an attractive interest rate to banks for parking their funds with the central bank. This leads to a reduction in the funds available to the bank's customers, as banks prefer the higher safety of parking money with the RBI. Consequently, banks demand higher interest rates from their customers when lending. The current Reverse Repo Rate is 5.75%.
• Marginal Standing Facility (MSF) is a short-term borrowing scheme for scheduled commercial banks. It allows banks to borrow funds from the RBI during cash shortages or liquidity crises. Banks facing liquidity shortfalls due to mismatches in their deposit and loan portfolios can borrow funds overnight by offering government securities. MSF was introduced to stabilize overnight lending rates and facilitate smooth monetary transmission. Banks can borrow up to 1% of their net demand and time liabilities (NDTL) under MSF. The current MSF is 6.25%.
• Base Rate is the minimum interest rate at which scheduled commercial banks lend to their customers. It serves as a floor rate, below which banks will not offer loans. The current Base Rate ranges from 8.65% to 9.45%.
• Marginal Cost of Funds Lending Rate (MCLR) is a methodology introduced by the RBI in 2016 to compute lending rates. MCLR is a tenor-linked internal benchmark that determines actual lending rates by adding a spread. It is reviewed monthly, with existing borrowers having the option to transition to it. Banks continue to publish and review the Base Rate alongside MCLR. The current MCLR is in the range of 7.65% to 8.05%.
• The call money market is a significant component of the money market where overnight borrowing and lending of funds occur. Participants include scheduled commercial banks (excluding regional rural banks), cooperative banks (excluding land development banks), and insurance companies. The RBI specifies prudential limits for both outstanding borrowing and lending transactions in the call money market for each of these entities. The current rate in the call money market is in the range of 4.90% to 6.10%.
• Open Market Operations (OMOs) are conducted by the RBI through the sale/purchase of government securities (G-Sec) in the market. The primary objective is to adjust rupee liquidity conditions. OMOs serve as a quantitative policy tool for the RBI, contingent on the available stock of government securities. Individuals, in addition to institutions, can participate in this market, following the Union Budget 2016-17.
• Liquidity Adjustment Framework (LAF) is a crucial element in the RBI's monetary policy operating framework introduced in June 2000. It involves the RBI lending to or borrowing from the banking system daily at fixed interest rates (repo and reverse repo rates). LAF operations, in conjunction with addressing banks' fund mismatches, enable the effective transmission of interest rate signals to the market. Recent changes, such as capping repo borrowing and introducing term repo, have altered the dynamics of this facility since 2013.
• Market Stabilisation Scheme (MSS) was introduced in 2004 as an instrument for monetary management. It addresses surplus liquidity resulting from sustained capital inflows by selling short-dated government securities and treasury bills. The mobilized cash is held in a separate government account with the Reserve Bank. MSS combines features of both SLR and CRR.

2. Qualitative

• Setting Margin Requirements: Margin refers to the portion of the loan amount that is not financed by the bank, requiring the borrower to contribute a certain percentage of the loan for their purpose. Adjusting margin requirements is a method used to influence credit supply, aiming to encourage lending to specific sectors and discourage it in non-essential areas. For instance, if the RBI wants to boost credit in the agriculture sector, it may reduce the margin, allowing for a higher percentage of the loan amount to be provided (e.g., 85-90%).
• Consumer Credit Regulation: This approach involves regulating consumer credit, particularly in the context of hire-purchase and installment sales of consumer goods. Key parameters such as down payment, installment amounts, and loan duration are predetermined. This method helps control credit usage and curb inflation by defining and regulating terms related to consumer credit.
• Publicity: Publicity serves as another selective credit control method, where the central bank (RBI) publishes reports highlighting what is deemed beneficial or detrimental within the financial system. This information, disseminated through weekly and monthly bulletins, enables commercial banks to align their credit supply with the objectives of monetary policy. By making such information publicly available, banks can use it to guide their lending decisions and contribute to the central bank's monetary goals.
• Credit Rationing: In this approach, the central bank determines the amount of credit to be granted and imposes a limit on each commercial bank. This method extends control over bill rediscounting as well. By setting an upper limit for credit purposes, banks are directed to adhere to this cap, helping to reduce credit exposure to undesirable sectors.
• Moral Suasion: Moral suasion involves the exertion of pressure by the RBI on the Indian banking system through suggestions rather than strict actions. It serves as a form of guidance to banks and is particularly useful in restraining credit during inflationary periods. The central bank communicates its expectations to commercial banks through monetary policies, issuing directives, guidelines, and suggestions to encourage banks to limit credit supply for speculative purposes.
• Control Through Directives: Under this method, the central bank issues frequent directives to commercial banks, guiding them in formulating their lending policies. These directives influence credit structures and limit the supply of credit for specific purposes. For instance, the RBI may instruct commercial banks not to lend beyond a certain limit to speculative sectors like securities.
• Direct Action: This method involves the imposition of actions against a bank by the RBI. If certain banks fail to comply with RBI directives, the central bank may refuse to rediscount their bills and securities. Additionally, the RBI can deny credit supply to banks that exceed their borrowing limits relative to their capital. The central bank can impose penalties by adjusting rates and, in extreme cases, may even impose a ban on a specific bank if it consistently works against the objectives of monetary policy.

These selective instruments of monetary policy offer a range of options for central banks to influence economic conditions. However, their effectiveness can be constrained by several factors. The availability of alternative sources of credit in the economy, the operations of Non-Banking Financial Institutions (NBFIs), the profit motive of commercial banks, and the undemocratic nature of these tools can pose limitations.