Prof.M.Guruprasad / 12:21 , Feb 16, 2009
Economics for Everyone -Creating Credit- Credit Policy Part II
Home, consumer and corporate loan rates are likely to ease in the near future, with the Reserve Bank of India (RBI) announcing a slew of monetary measures including a cut in cash reserve and statutory liquidity ratios besides a cut in its short term lending rate.
Key Concept- Impact of Interest Rate
A reduction in interest rates would force banks to lower their lending rates and borrowing rates. So if you want to place a deposit with a bank or take a loan, it would offer it at a lower rate of interest.
On the other hand, if there were to be an increase in interest rates, banks would immediately increase their lending and borrowing rates. Since the rates of interest affect the borrowing costs of corporates and as a result, their bottomlines (profits), the monetary policy is very important to them also.
Earlier, depending on the rates announced by the RBI, the interest costs of banks would immediately either increase or decrease. . Since the financial sector reforms commenced, the RBI has moved towards a market-determined interest rate scenario. This means that banks are free to decide on interest rates on term deposits and loans. Being the central bank, however, the RBI would have a say and determine direction on interest rates, as it is an important tool to control inflation. The bank rate is a tool used by RBI for this purpose as it refinances banks at this rate. In other words, the bank rate is the rate at which banks borrow from the RBI.
The Reserve Bank of India has taken a string of measures over the past few weeks to improve liquidity and boost growth, cutting its key lending rate - the repo - by 150 basis points to 7.5 per cent and lowering banks' reserve requirements signaling a soft interest rate regime RBI asks banks to seek refinance credit to fund small units
Key Concept-
Understanding the concept and the relevance of the credit
policy
Definition
The regulation of the money supply and interest rates by a central bank, such as the Reserve Bank of India and Federal Reserve Board in the U.S., in order to control inflation and stabilize currency. Monetary policy is one the ways the government can impact the economy. By impacting the effective cost of money, the Federal Reserve can affect the amount of money that is spent by consumers and businesses.
It regulates the supply of money and the cost and availability of credit in the economy. It deals with both the lending and borrowing rates of interest for commercial banks. The Monetary Policy aims to maintain price stability, full employment and economic growth. The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. It can increase or decrease the supply of currency as well as interest rate, carry out open market operations, control credit and vary the reserve requirements.
Role of Reserve Bank of India:
Relevance of Monetary and Credit Policy
Historically, the Monetary Policy is announced twice a year - a slack season policy (April-September) and a busy season policy (October-March) in accordance with agricultural cycles. These cycles also coincide with the halves of the financial year. However, with the share of credit to agriculture coming down and credit towards the industry being granted whole year around, the RBI since 1998-99 has moved in for just one policy in April-end. However a review of the policy does take place later in the year.
The monetary and credit policy is half yearly affair of the Reserve Bank of India Traditionally, RBI, in this monetary and credit policy, announces structural and monetary measures to improve the functioning of the banking system and also functioning of the economy as whole. There are some key sets of indicators to ensure stability in the economy. These include money supply, interest rates, and inflation, amongst others. The RBI uses various tools to regulate or influence these indicators. The policy also provides a platform for the RBI to announce norms for financial entities including banks, financial institutions (FIs), non-banking financial companies (NFBCs), nidhis, primary dealers (PDs) in the money market, authorized dealers in the foreign exchange markets, which are regulated by the apex bank.
The monetary authority uses various instruments to control the supply of money. These instruments are known as instruments of credit control. These instruments can be divided into two categories; quantitative and qualitative credit control, viz, bank rate policy, open market operation and changes in statutory reserve requirements. These methods are used to control the quantum methods of credit control are also known as selective credit control methods. These include credit rationing, direct action, changes in margin requirements moral suasion etc.
The credit policy gives indication about the economy and the banking system in the country and it also provides an opportunity for the RBI to spell out on overview on the economy. The RBI now prefers to announce monetary measures as and when the situation demands.
Channels of Management:
There are four main ?channels?, which the RBI looks at:
- Quantum channel: money supply and credit (affects real output and price level through changes in reserves money, money supply and credit aggregates).
- Interest rate channel.
- Exchange rate channel (linked to the currency).
- Asset price.
RBI?s Conduct of Monetary Policy:
The RBI uses the interest rate, OMO, changes in banks' CRR and primary placements of government debt to control the money supply. OMO, primary placements and changes in the CRR are the most popular instruments used.
RBI since October has taken a host of steps like reduction in mandatory deposits that banks keep with the central bank and the amount they are required to invest in government securities. In the last one month, RBI has infused liquidity to the tune of Rs. 2,70,000 crore by cutting the Cash Reserve Ratio (CRR) by 350 basis points and Statutory Liquidity Ratio (SLR) by 100 basis points.
Key Concepts- Instruments of Credit Control (Money Supply)
Open Market Operations (OMO)
Under the OMO, the RBI buys or sells government bonds in the secondary market. By absorbing bonds, it drives up bond yields and injects money into the market. When it sells bonds, it does so to suck money out of the system.
Primary deals in government bonds are a method to intervene directly in markets, followed by the RBI. By directly buying new bonds from the government at lower than market rates, the RBI tries to limit the rise in interest rates that higher government borrowings would lead to.
CRR Cash Reserve Ratio
All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the cash reserve ratio. The changes in CRR affect the amount of free cash that banks can use to lend - reducing the amount of money for lending cuts into overall liquidity, driving interest rates up, lowering inflation and sucking money out of markets. The CRR is the proportion of their deposits, which banks have to keep with the RBI. Raising the CRR is one of the most effective ways for the RBI to suck liquidity out of the financial system, which reduces demand in the economy and therefore helps curb inflation.
Statutory Liquidity Ratio
Banks in India are required to maintain 25 per cent of their demand and time liabilities in government securities and certain approved securities. These are collectively known as SLR securities. Add to that, the series of steps announced by the RBI during the first week of December is expected to bring property developers back from the brink of bankruptcy and possibly infuse life in the dormant housing sector, should banks lower home loan rates taking cue from the central bank?s action. In order to help real estate companies tide over the current credit crunch and weak demand, RBI has cut repo and reverse repo rate by 100 bps each and allowed restructuring of commercial real estate loans up to June 30, 2009.
KEY CONCEPTS- LAF (THE LIQUIDITY ADJUSTMENT FACILITY)
The LAF can be thought of as a way for the RBI to lend and borrow to banks for very short periods, typically just a day. The repo rate is the RBI's lending rate and reverse repo rate is the RBI's borrowing rate. These two rates help the RBI influence short-term interest rates in the rest of the financial system.
Thus Liquidity Adjustment Facility (LAF) is a facility by which the RBI adjusts the daily liquidity in the domestic markets (India) either by injecting funds or by withdrawing them out.
Thus, Central bank/s can use repo as an integral part of their open market operations with the objective of injecting/withdrawing liquidity into and from the market and also to reduce volatility in short term in particular in call money rates.
- It is considered as short-term money market instrument.
- It can be used as: secured lending and securities lending.
- Legal title is transferred.
- An effective instrument to manage liquidity position.
- Use as an instrument to obtain security to maintain SLR.
- It will help to increase in turnover in the money market thereby improving liquidity and depth of the market.
- A large number of repo transactions for varying tenors will effectively result in a term interest rate structure.
REPO
A repurchase agreement or ready forward deal is a secured short-term (usually 15 days) loan by one bank to another against government securities.
Legally, the borrower sells the securities to the lending bank for cash, with the stipulation that at the end of the borrowing term, it will buy back the securities at a slightly higher price, the difference in price representing the interest.
Thus, Repo means an instrument for borrowing funds by selling securities of the Central Government or a State Government or of such securities of a local authority as may be specified in this behalf by the Central Government or foreign securities, with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the fund borrowed.
Repo rate is the return earned on a repo transaction expressed as an annual interest rate.
Repo/Reverse Repo
Reverse Repo means an instrument for lending funds by purchasing securities of the Central Government or a State Government or of such securities of a local authority as may be specified in this behalf by the Central Government or foreign securities, with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the fund lent.
Also the loans granted by banks to Housing Finance Companies (HFCs) with a ticket value of up to Rs. 20 lakh to home buyers will be classified under priority sector. This means a home buyer gets a loan upto Rs. 20 lakh at a lower rate even from HFCs, thus getting a wider choice of lenders.
RBI?S POLICY SIGNPOSTS ( Source: Times of India)
MEASURE
IMPLICATION
Repo rate cut to 6.5% from 7.5%; reverse repo rate to 5%
Signal to banks to cut rates, start lending to industry
Bank loans to housing finance firms under priority sector now
Should lead to increased supply of home loans
Safety net for loans to commercial property projects
Banks avoid NPA stigma, developers get a breather Non Performing Asset means an asset or account of borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the directions or guidelines relating to asset classification issued by RBI.
SIDBI(SMALL INDUSTRIES DEVELOPMENT BANK OF INDIA)gets Rs. 7,000 cr Origin & Objectives Small Industries Development Bank of India (SIDBI) was established in April 1990 under an Act of Indian Parliament as the principal financial institution for : Promotion Financing Development of industry in the small scale sector Co-ordinating the functions of other institutions engaged in similar activities Since its inception, SIDBI has been assisting the entire spectrum of SSI Sector including the tiny, village and cottage industries through suitable schemes tailored to meet the requirement of setting up of new projects, expansion, diversification, modernisation and rehabilitation of existing units.
To help funding of SMEs(SMALL AND MEDIUM ENTERPRISES)
Cheap funds for exporters facing payment problems
Helps exporters keep operations running
Premature buyback of Foreign Currency Convertible Bonds
Helps many companies purge costly foreign debt
Key meaSures (Since October 2008)
- In October, the RBI had reduced CRR by a cumulative 250 basis points to augment liquidity. Besides, a special 14-day repo window for Rs. 20,000 crore was opened to enable mutual funds access to funding. Banks were also allowed temporary access to SLR eligible securities by an additional 0.5% of their net demand and time liabilities.
- The RBI earlier in the month allowed banks to seek refinance from the central bank up to 1.0 per cent of their deposits at 7.5 per cent (repo rate) under the liquidity adjustment facility (LAF) up to 90 days. The decision was aimed at addressing the liquidity crunch being faced by small and micro enterprises and formed part of the steps being taken by the central bank to infuse liquidity in the system. To ensure there is funding for employment intensive sectors, the RBI has decided to allocate to SIDBI and the NHB a sum of Rs. 2,000 crore and Rs. 1,000 crore, respectively.
- In the context of forex outflows in the recent period, it has been decided to conduct buy-back ofMSS dated securities so as to provide another avenue for injecting liquidity of a more durable nature into the system. This will be calibrated with the market borrowing programme of the government of India"
Key Concpts: MSS Dated Securities
Buy-back of MSS Dated securities: - In order to sterilise the expansionary effect of forex inflows into country, RBI has been issuing government securities under the Market Stabilisation Scheme or MSS.
Owing to the exodus of forex reserves from the country recently, the RBI has decided to buy back dated securities issued under MSS which will add to the liquidity in the market. This buy-back will be calibrated against the market-borrowing programme of the government of India. It means the amount of buy-back will be decided based on the government?s need to spend. If the government?s market borrowing is less, then the buy-back will be more and vice-versa.
- To boost dollar inflows and to ensure more liquidity for the real estate sector, the RBI has allowed housing finance companies to borrow abroad and raised the ceiling on interest rates that banks could offer on non-resident deposits. The refinance facility aimed at encouraging banks to lend to mutual funds and finance companies has been extended to end March and corporates have been allowed to buy back foreign currency convertible bonds which are now quoting at dirt cheap rates. The decision will also help the country shore up its declining forex reserves, which according to the latest data, has slipped to about $250 billion from a high of $314 billion in April-May.
-In addition, the RBI also permitted Indian banks to offer better interest rates for foreign currency deposits by the non-residents. Henceforth, the banks can offer rates up to 100 basis points over London Interbank Offered Rate (LIBOR) under Foreign Currency Non-Resident (Banks) scheme and 175 basis over LIBOR on Non-Resident (External) Rupee Accounts deposits.
Key Concepts: Libor
The London Interbank Offered Rate (or LIBOR, pronounced is a daily reference rate based on the interest rate at which banks borrow unsecured funds from banks in the London wholesale money market (or interbank market).
Technical features
LIBOR is published by the British Bankers Association (BBA) after 11:00 am (and generally around 11:45 am) each day (London time). It is a trimmed
average of inter-bank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. LIBOR is calculated for 10 currencies. The rates are a benchmark rather than a tradable rate; the actual rate at which banks will lend to one another continues to vary throughout the day.
LIBOR is often used as a rate of reference for Pound sterling and other currencies.
KEY CONCEPTS: FCNR (Foreign Currency Non-Resident (Banks) accounts scheme)
Foreign Currency Non-Resident (Banks) Accounts - "FCNR"
Non-Resident Indians can open accounts under this scheme. The account should be opened by the non-resident account holder himself and not by the holder of power of attorney in India.
These deposits can be maintained in 5 designated currencies i.e. U.S. Dollar (USD), Pound Sterling (GBP) and Euro, Australian Dollar (AUD) & Canadian Dollar (CAD).
These accounts can only be maintained in the form of terms deposits for maturities of minimum 1 year to maximum 5 years. These deposits can be opened with funds remitted from abroad in convertible foreign currency through normal banking channel, which are of repatriable nature in terms of general or special permission granted by Reserve Bank of India. These accounts can be maintained with our branches, which are authorised for handling foreign exchange business. (List of branches authorised for handling foreign exchange business linked at the end).
The central bank removed the additional capital requirement placed on lending to real estate and provided an additional Rs. 22,500 cr for cheap export refinance.
RBI allowed the registered housing finance companies to raise short-term funds from overseas markets. Announcing the measures, the RBI today reduced risk weights for corporate and commercial real estate to 100 per cent from the earlier 150 per cent. This measure is expected to encourage banks to lend more to these fund-starved sectors, experts said.
Analysis
According to Economists, the slew of measures would help to prop up growth, particularly considering that the inflation has started falling drastically on the back of declining global crude oil and other commodity prices. Banks may soon look at reducing their lending and deposit rates in the near future
It is to be noted that, the day after the G20 global leaders? meet on tackling the financial crisis, the Reserve Bank of India took the lead among central banks in moving to boost credit markets.
The RBI?s measures are also aimed at preventing the flight of capital hurting the real sector. As global financial conditions continue to be uncertain and unsettled with ripple effects on domestic money, forex and credit markets. There are indications that the global slow down is deepening with a larger than originally expected impact on the domestic economy. These measures were aimed at arresting the slowdown by injecting more liquidity into the markets and push the economy upwards.
According to RBI, the apex bank will continue to closely monitor the developments in the global and domestic markets and will take swift and effective action as appropriate.
A good part of the measures announced were demands by industry at their interaction at various levels with the government The higher risk weightage on real estate was introduced as a counter cyclical measure and was being rolled back keeping in mind the global macro economic situation.
All these measures come less than 24 hours after Federal Reserve chairman Ben Bernanke said that global policy makers would remain in close contact, monitor developments closely and stand ready to take additional steps.
Key Concept- G 20
The Group of Twenty (G-20) Finance Ministers and Central Bank Governors was established in 1999 to bring together systemically important industrialized and developing economies to discuss key issues in the global economy. The inaugural meeting of the G-20 took place in Berlin, on December 15-16, 1999, hosted by German and Canadian finance ministers.
Some Monetary Policy Terms:
Bank Rate
Bank rate is the minimum rate at which the central bank provides loans to the commercial banks. It is also called the discount rate.
Usually, an increase in bank rate results in commercial banks increasing their lending rates. Changes in bank rate affect credit creation by banks through altering the cost of credit.
Money Supply Measures
The RBI has adopted various concepts of measuring money supply. The first one is M1, which equals the sum of currency with the public, demand deposits with the public and other deposits with the public. Thus it includes all coins and notes in circulation, and personal current accounts.
M2, is a measure of money, supply, including M1, plus personal deposit accounts - plus government deposits and deposits in currencies other than rupee.
The third concept M3 or the broad money concept, as it is also known, is quite popular. M3 includes net time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1.
Impact on Stock Markets
The financial markets pay obsessive attention to the actions of the RBI. Any changes in monetary policy has an immediate impact on financial markets.
In general a tighter policy will hurt investor sentiment and stock prices. There will be less liquidity floating around and higher interest rates will raise the cost of capital for companies hurting their bottom lines and stock prices. Companies, which have high levels of debt, are especially vulnerable (Vice- versa).
A tighter policy will harm some sectors like banking and real estate more than others. For example banks don't earn interest on the reserves they keep with the RBI; therefore an increase in the CRR immediately hurts their bottom line. Similarly if tighter policy leads to higher interest rates, this will reduce demand for housing as home loans become more expensive (Vice -versa).
Impact on Exchange Rates
The RBI's monetary policy will also have an impact on exchange rates. In particular if Indian interest rates rise because of tighter policy, the demand for Indian interest-paying assets will also rise, leading to an increase in the value of the rupee (Vice- versa).
Prof.M.Guruprasad
Aicar Business School
[email protected]
9850981448