This macroeconomic policy, which is related to monetary matters and is primarily aimed at regulating the size and cost of funds/money in the economic system, is considered the most dynamic and sensitive function of a central bank (i.e., RBI in the case of India). After the monetary policy committee (MPC) was established in 2016, the policy was announced twice a year (before the slack and busy seasons) and is now announced six times in a financial year. With statutory responsibility for targeting inflation (CPI-C) while keeping the goal of growth in mind, a committee-based approach to monetary policy is supposed to add value and transparency to monetary policy.
The Monetary Policy Committee
The MPC (which meets at least four times a year) consists of six members nominated in equal numbers by the RBI and the Ministry of Finance, including the RBI Governor as Chairman, who has the casting vote in the event of a tie. The actual tone of the RBI’s monetary policy stance is set by its first monetary policy of the year, which is announced at the start of each fiscal year and is informed by the annual budget announcements. There are a few different types of monetary policy positions that appear in the media from time to time:
- A neutral stance means interest rates may move either way—upward or downward.
- Calibrated tightening means interest rates can only move upward.
- An accommodative stance (also known as an expansionary stance) means the injection of more funds into the financial system. Falling ‘headline inflation’ inspires RBI for it and such a stance is aimed at expansion in lending, investment, and growth.
- A contractionary stance means siphoning out funds from the financial system. Such a stance is generally followed once more than the optimum fund is believed to be available in the financial system. At times, it is also aimed at taming inflation in long term.
- A hawkish stance means a contractionary stance aimed at checking inflation from rising (linked to the statutory goals of inflation targeting the ‘headline inflation).
To put in place the desired kind of monetary policy, RBI uses a range of instruments and tools —a brief description follows:
Cash Reserve Ratio
Banks operating in the country are required by law to maintain two types of reserve ratios, of which is the cash reserve ratio and the other is the statutory liquidity ratio. The cash reserve ratio requires all scheduled commercial banks operating in the country to keep a portion of their total deposits with the RBI in cash form (CRR). The RBI could set the rate at 3 to 15% of the banks ‘net demand and time liabilities (NDTL). Since the late 1990s, the RBI has made some changes in relation to the ratio as part of the ongoing banking reform process.-
(i) The RBI began paying banks interest income on their CRR in 1999-2000, with the goal of enabling banks to lend more and lower interest rates on loans they offer. Interest payments were stopped in late 2007 as a result of rising prices (to check aggregate demand in the economy).
(ii) The ratio which used to be generally on the higher side, was drastically cut down to 4.5 percent in 2003 (from the peak of 15 percent in 1992).
(iii) A major development came in 2007 when by an amendment (in the RBI Act, 1949), the Government abolished the lower ceiling (called ‘floor’) on the CRR and gave the RBI greater flexibility in fixing this ratio. It means, it is now possible for the RBI to fix the CRR below 3 percent also.
The RBI allowed 11 banks to lend to automobiles, residential housing, and micro, small, and medium enterprises (MSMEs) without maintaining the mandatory CRR in February 2020, in a first of its kind move. This option will be available until July 31, 2020. The move aims to boost lending activity in these sectors, which have been hit hard by the recent slowdown. Simply put, the RBI allowed banks to use CRR funds that would have otherwise been deposited with the RBI. Because the RBI uses CRR deposits in its daily business operations, the RBI will lose a portion of its revenue as a result of the exemption granted to banks.
The CRR was 1% of the banks’ NDTL in March 2020; a 1% change today would affect the cash flow in the financial system by around Rs. 1.37 lakh crore.
Statutory Liquidity Ratio
Banks operating in the country are required by law to maintain two types of “reserve ratios,” which is the statutory liquidity ratio and the other is the “cash reserve ratio.” All scheduled commercial banks in the country are required to keep a portion of their total deposits (i.e., their NDTL) in non-cash form (i.e., in ‘liquid assets’)—the ratio could be set by the RBI anywhere between 25 and 40%. In practice, banks are unable to invest this fund in liquid assets of their choice, instead of being forced to invest in various types of government securities (i.e., G-Secs).
Banks profit from this investment based on the configuration of their G-Secs holdings. Since the late 1990s, the RBI has made certain changes in relation to the ratio as part of the ongoing banking reform process.
- The ratio was drastically cut down to 25 percent (the floor) in 1997 from the existing level of 32 percent.
- By an amendment (in the RBI Act, 1949) done in 2007, the lower ceiling (the floor) of 25 percent was removed by the Government. This way, the SLR may be fixed by the RBI below 25 percent also. Since then the SLR has shown a falling tendency.
In March 2020, the SLR was at 18.25 percent of the NDTL of the banks. With one percent change in this ratio today banks either lose or gain a choice of investing around a fund of Rs. 1.37 lakh crores.
The Bank Rate is the interest rate that the RBI charges on its long-term loans. The Government of India, state governments, banks, financial institutions, cooperative banks, NBFCs, and others are among the clients who borrow through this channel. The rate has a direct impact on the concerned lending bodies’ long-term lending activities in the Indian financial system. In February 2012, the RBI realigned the rate with the MSF (Marginal Standing Facility). By March 2020, it had risen to 4.65%.
The repo rate in India is the interest rate that the RBI charges its clients on short-term borrowing. This is an abbreviated form of the ‘rate of repurchase,’ which is known as the ‘rate of discount’ in western economies.
In practice, it is referred to as a discount on dated government securities that are deposited by institutions in order to borrow for the short term. When they get their securities released from the RBI, the current repo rate reduces the value of the securities. This rate is used in India’s Call Money Market (inter-bank market), which banks use for overnight borrowings. This rate is proportional to the interest rates charged by banks on the loans they provide (as it affects the operational cost of the banks). In March 2021, the rate was 4.40 percent.
RBI introduced term repos (of various tenors, such as 7/14/28 days) in October 2013 to inject liquidity over a longer period than overnight. Its goals include a stronger money market, greater stability, and better costing and signaling of loan products.
Long Term Repo
In February 2020 (6th Bi-monthly Monetary Policy of 2019-20), the RBI announced a first-of-its-kind long-term repo operation (LTRO) of Rs. 1.50 lakh crores at a fixed rate, aimed at promoting enhanced lending and lowering the cost of short-term funds for banks (i.e., at the Repo rate). The LTRO will be in place for one to three years. This was done to ensure long-term and deeper liquidity in the financial system, as well as to increase lending by lowering banks’ funding costs (enabling them to lend cheaper loans).
Reverse Repo Rate
It is the rate of interest paid by the RBI to its clients who provide it with short-term loans. The rate is currently 4.00 percent (March 2020). It is the inverse of the repo rate and was introduced by the RBI in November 1996 as part of the Liquidity Adjustment Facility (LAF). In practice, Indian financial institutions park their excess funds with the RBI for a short period of time and earn money. It has a direct impact on the interest rates that banks and financial institutions charge on various types of loans.
The RBI used this tool in response to the excess money supply in Indian banks and lower loan disbursal, with the dual goal of reducing bank losses and the current interest rate. It has emerged as a critical tool in the direction of the RBI’s general policy of low-interest rates since the reform process began.
Marginal Standing Facility (MSF)
MSF is a new scheme announced by the Reserve Bank of India in its Monetary Policy 2011-12, which took effect in May 2011. Banks can borrow up to 1% of their net demand and time liabilities (NDTL) from the RBI overnight under this scheme, at a rate that is 1% (100 basis points) higher than the current repo rate. The RBI increased the gap between repo and MSF to 3% in an attempt to strengthen the rupee and control its falling exchange rate (late July 2013).
The MSF rate was introduced as a penal rate, and the RBI has kept it at 1% above the current repo rate since mid-2015. It will be 4.65% by the end of March 2020, fully aligned with the Bank rate (i.e., equal to the Bank rate).
Other than the above-given instruments, RBI uses some other important, too to activate the right kind of the credit and monetary policy-
Call Money Market
The call money market is a vital part of the money market where funds are borrowed and lent on an overnight basis. Scheduled commercial banks (SCBs) excluding regional rural banks, cooperative banks (other than land development banks), and insurance companies are currently participants in India’s call money market. The RBI sets prudential limits for each of these entities in terms of outstanding borrowing and lending transactions in the call money market.
The RBI has made several changes to this market recently. Banks were only allowed to borrow 1% of their NDTL (net demand and time liabilities, or total deposit of the banks, in layman terms) under the overnight facility at repo rate until April 2016. They can use term repos of various tenors for the remaining 0.75 percent of their NDTL. In a sense, the RBI has been discouraging banks from using repo and encouraging them to use term repos for their short-term funding needs since late 2013. The main goals of this new stance are to promote stability and signal a lower cost of borrowing.
Open Market Operations (OMOs)
The RBI conducts OMOs by selling and buying government securities (G-Sec) in the market, with the primary goal of adjusting rupee liquidity conditions in the market. OMOs are a useful quantitative policy tool in the RBI’s arsenal, but they are limited by the number of government securities it has on hand at any given time. Individuals, in addition to institutions, will now be able to participate in this market (the decision was taken in 2017 while it is yet to be implemented).
Liquidity Adjustment Facility (LAF)
The LAF is a critical component of the RBI’s monetary policy framework (introduced in June 2000). The RBI is ready to lend to or borrow money from the banking system on a daily basis, depending on the needs of the time, at fixed interest rates (repo and reverse repo rates). LAF operations assist the RBI in effectively transmitting interest rate signals to the market by moderating bank fund mismatches. After 2013, the recent changes regarding a repo borrowing cap and the availability of term repo changed the very dynamics of this facility.
Market Stabilisation Scheme (MSS)
This monetary management tool was first introduced in 2004. Short-dated government securities and treasury bills are sold to absorb more long-term surplus liquidity resulting from large capital inflows. The cash that has been mobilized is kept in a separate government account at the Reserve Bank. As a result, the instrument has both SLR and CRR characteristics.
Standing Deposit Facility Scheme (SDFS)
The Union Budget for 2018-19 proposed the new scheme. The RBI first proposed such a tool in November 2015. The scheme aims to assist RBI in better managing liquidity, particularly when the economy is flush with excess funds (as was seen after the demonetization of the high-value currency notes post-November 2016).
Previous Year Questions of UPSC Prelims
Ques 1: When RBI reduces the Statutory Liquidity Ratio by 50 basis points, which of the following is likely to happen? (UPSC Prelims 2015)
(a) India’s GDP growth rate increases drastically.
(b) Foreign Institutional Investors may bring more capital into our country.
(c) Scheduled Commercial Banks may cut their lending rates.
(d) It may drastically reduce the liquidity to the banking system.
Answer: Option C
Explanation: Scheduled Commercial Banks may cut their lending rates. The RBI reduces SLR in an attempt to provide more liquidity to the banking system. Banks should use this headroom to increase their lending to productive sectors on competitive terms so as to support investment and growth. In order to increase their lending, SCBs will have to reduce their lending rates.
Ques 2: What is/are the purpose(s) of the Marginal Cost of Funds Lending Rate(MCLR) announced by RBI? (UPSC Prelims 2016)
i) These guidelines help improve the transparency in the methodology followed by banks for determining the interest rates on advances.
ii) These guidelines help ensure the availability of bank credit at interest rates that are fair to the borrowers as well as banks.
Select the correct answer using the code given below:
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2
Answer: Option A
Explanation: As per the RBI, the MCLR will bring in the following benefits:
i) transmission of policy rate into the lending rates of banks to improve;
ii) computation of the interest rates by banks will get more transparent;
iii) cost of loan will be fairer to the borrowers as well as the banks.
iv) it will help the banks to become more competitive and enhance their long-run value.
Ques 3: An increase in Bank Rate generally indicates that the market rate of interest is likely to fall. (UPSC Prelims 2013)
(a) Market rate of interest is likely to fall.
(b) Central bank is no longer making loans to commercial banks.
(c) Central bank is following an easy money policy.
(d) Central bank is following a tight money policy.
Answer: Option D
Explanation: Central Bank is following a tight money policy. When RBI increases the bank rate, the cost of borrowing for banks rises, and this credit volume gets reduced leading to declining in the supply of money. Thus, an increase in the Bank rate reflects the tightening of RBI monetary policy.
Quick Questions on RBI Monetary Policy for UPSC Preparation
The RBI makes the Monetary policy of India reach the inflation target. Section 45ZB of the RBI Act provides 6-member Monetary Policy Committee to make policy rate.
The Monetary Policy Committee determines repo rate to meet the inflation target. The MPC meet at least 4 times in a year to check the policy.
The RBI i.e. Reserve Bank of India was initially established in Kolkata in 1935. But in the year 1937 RBI was permanently shifted to Mumbai. RBI has more than 31 Regional offices in India.