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Chapter 6

The Reserve Bank of India

To discuss the organisation, role, functions & monetary policy of Reserve Bank of India (RBI)

Central Banking : Protection of trust and Financial regulation in the Financial System Indian Financial sector regulatory Framework: Ministry of Finance of Govt. of India Reserve Bank of India(RBI) & Board of Financial Supervision(BFS) Securities Exchange Board of India (SEBI) RBI was established in 1935 1949 ( RBI Act 1948)
(RBI Act,1934) and

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nationalised in

Managed by a Central Board of Directors, four Local Board of Directors and a committee of the Central Board of Directors
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1.

2. 3. 4. 5. 6. 7. 8.

The monetary functions: Formulates, implements and monitors the monetary policy To maintain Financial Stability Monitoring & supervision of financial institutions Maintain stable payment systems in the country Strengthening of the role of financial institutions To regulate overall volume and credit in the economy To ensure credit allocation as per national economic policy To promote the development of financial infrastructure of markets & system

 Note Issuing Authority  Government Banker  Ways & Means Advances  Overdrafts  Bankers Bank  Supervising Authority  Exchange Control Authority

      

Promoter of the Financial System Money Market Agricultural Sector Financing Industrial Finance Credit Delivery Formulating Prudential Norms Regulator of Money & Credit
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Monetary Policy: Techniques of monetary control at the disposal of the central Bank for achieving following objectives
Expansion of Bank Credit & Money supply To accelerate economic development Reasonable Price stability To develop appropriate institutional set-up for effective policy transmission Export promotion and Exchange rate policy

1. 2. 3. 4.

5.

contd...

6. 7. 8. 9. 10. 11.

Introduce new money market instruments Reducing rigidities from the Financial System Introducing Flexibility in the Financial System Encouraging diversion Promoting more Competitive environment Imparting greater discipline and prudence in the financial system

The Indian Money Market till mid-1980s was relatively underdeveloped (Objectives: 1,2 & 3) Major policy initiative responsible for broadening the Monetary Policy objective of RBI (Objectives: 4 to 11) 1. S. Chakravarty Committee on working of the Monetary System (1985) 2. N. Vaghul Committee Report on the Money Market (1987) 3. Narasimham Committee on Banking Sector Reforms (1998) 4. Narasimham Committee on Financial Sector Reforms (1991)
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Open Market Operation (OMO) Bank Rate Discretionary Control of Refinance and rediscounting Direct Regulation of interest rates on Commercial Banks deposits and loans Cash Reserve Ratio (CRR) Statutory Liquidity Ratio (SLR) Direct Credit Allocation and Credit Rationing Selective Credit Controls Credit Authorisation Scheme (CAS) Fixation of Inventory and credit Norms Credit Planning and Moral Suasion Liquidity Adjustment Facility (LAF)
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The basic cost of refinance and rediscounting facility The techniques of Bank rate and discretionary control of refinance are used to regulate the cost and availability of refinance and to change volume of lendable resources
Bank Rate in Different Periods of Time
Major Changes

1951-1960 1960-1964 1964-1975 1975-1980 1981-1990 1991-1996 1997-2004 2004-2007

3 to 4 % 4 to 5 % 5 to 9% 9% 9 to 10% 10 to 12% 10 to 6 % 6%

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Primary reserve requirement Does not restrain total expenditure in the economy. It restricts private sector expenditure while increasing govt. expenditure
SLR in Different Periods of Time
Major Changes

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Objectives: Bank solvency Bank credit control Investment in Govt. Securities

1950-1964 1964-1969 1970-1981 1981-1990 1991-1996 1997-2007

20 % 20 to 25 % 28 to 35% 35 to 38 % Multiple Rates 25%

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To ensure stability in short-term interest rates For signalling the Reserve Bank's stance on interest rates Control the Intermediate Variables: Money supply and the volume of bank credit Open Market Operations (OMO) Liquidity Adjustment Facility (LAF) Market Stabilisation Scheme (MSS)

1. 2. 3.

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Monetary control mechanism Central bank can conduct OMOs in treasury bills, state govt. securities and central Govt. securities OMOs have both monetary policy and fiscal policy goals:
To control the amount of and changes in bank credit and monetary supply through controlling reserve base of banks To make bank rate policy more effective To maintain stability in Govt. securities market To support Govt. borrowing programme
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Introduced since 2000 and operates through repo and reverse repo rates Suitable for surplus liquidity of 'temporary' nature rather than surplus liquidity of a somewhat 'enduring' nature RBI reverse repo rate has become the benchmark rate for call rates Facilitates Interest rate corridor in the interbank call money market : repo rate as a floor rate, Bank rate as ceiling rate and call rate as middle rate
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Absorption of excess liquidity surplus from money market MSS started operation since April 2004 MSS securities (T-bills and dated securities) are eligible securities for SLR, repo and LAF Helps in Central Banks exchange rate and monetary management function
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`Whether monetary policy should have only price stability as its sole objective? ` Inflation Targeting Vs. Economic Growth

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Record of moderate inflation, with double-digit inflation being socially unacceptable.

Inflationary pressures still often emanate from significant supply shocks With various regional differences, and continued existence of market imperfections in factor and product markets

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Automatic monetization has been discontinued Treasury bill market has been rationalized. Introduction of delivery versus payment system & inter-bank repo market is deepened. Primary Dealers in the government securities market Amendment of Securities Contracts Regulation Act (SCRA) Introduction of government securities auction A risk-free credible yield curve in the government securities market as a benchmark for related markets.
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contd...

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Non-bank participants are allowed Automated screen-based trading through Negotiated Dealing System (NDS) in government securities Risk-free payments and system in government securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time Gross Settlement (RTGS) System Autonomy in Forex market has been deepened Setting up of Technical Advisory Committee on Monetary Policy A separate Financial Market Department within the RBI . Liquidity Adjustment Facility (LAF)
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Price stability issues: in a globally integrated economy Greater national & international integration of financial markets Difficulty in detecting and measuring core inflation& inflation expectations. Limited instrument choice option for sterilization and other policy responses in large and uncertain capital flows
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contd...
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Aligning the operations of large financial conglomerates and foreign institutions with local public policy priorities in the Concentration risk by the dominance of all big financial intermediaries Volatile increasing capital flows relative to domestic absorptive capacity Politicisation of economic policy and the dominance of fiscal policy Spread of e-money Sterilising the higher level of foreign capital inflows and the resultant market volatility
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monetary policy Vs. fiscal policy goal independence Vs. Instrument independence.

Theories of central banks autonomy 1. dynamic or time inconsistency theory


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conservative central banker approach Vs. optimal contract approach

2. theory of political business cycle 3. theory of public choice

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contd...

 An inverse relationship between central bank independence and the level of inflation is supported by most empirical studies, but the causality between the rate of inflation and the degree of independence of the central bank may be viewed as bidirectional

the autonomy of a central bank is best set by convention rather than by statue, specially in emerging countries Dr. Bimal Jalan, RBI Governor,2003

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In terms of managerial autonomy of RBI: Central board of governors The sources of autonomy involve : statutory provisions, the constitution & power of governing board ,spirit of staff & peoples perception Milestones:
 The phasing out of automatic monetisation of fiscal deficits (1997)  The enactment of the Fiscal Responsibility & Budget Management ( FRBM, 2003)  The enactment of Ways & Means Advance (WMA) by the RBI to Govt. By issuing ad hoc treasury bills
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contd...
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For the RBI to become really autonomous, a rethinking on the role of the state in the economy, on globalisation & a significant change in the attitude of the staff are pre requisite. Fundamental challenges in the area of real autonomy: Desirability of a sift from direct to indirect techniques of monetary policy Gradual diminishing trend of banks in the monetary policy transmission mechanism Interest rate implication towards long-term domestic investment Increase in the velocity of money due to international financial integration Money supply in the context of demand for money function in a developing country like India
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The objectives, targets and operating procedures of monetary policy worldwide have witnessed considerable shifts in tune with the evolution of monetary theory, central banking regimes and the changing macroeconomic conditions over time.

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contd...
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Central banks in developed countries such as New Zealand, Australia and in UK & some emerging market economies (EMEs) such as South Africa, Thailand, Korea and Mexico Inflation targeting framework for price stability Monetary policy of central banks throughout the world focus on intermediate targets that bear close relationship with the final objective. The selection of intermediate targets is conditional on the channels of monetary policy transmission Allowing the volatility in the overnight inter-bank rate (refrained from strict control of interest rates) to absorb temporary pressure : preserve stability in other money market segments.
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Country

Objective

Intermediate Key Policy /Operating Indicators Target

Key Instruments of Discretionary Liquidity


CRR OMO REPO Standing Facilities Yes Yes Yes Yes Others

Frequency of Market Operations

USA

Maximum Sustainable Output , employment And stable prices Price stability & to contribute to the sound development of national economy Low and stable inflation Stability of the currency & thereby promote economic growth Growth , price and financial stability

Federal Funds rate

Multiple Indicators Of current & Prospective Economic developments Overall economic and financial indicators wholesale prices , corporate service prices & money stock Output gap & wide range of indicators in various markets

Daily

Japan

Overnight call money rate

Yes

Yes Yes

Yes More than one per day

Canada China

Overnight rate Money supply / excess reserves

Yes

Yes Twice a day

Yes

Yes Yes

India

Overnight rate

Multiple indicators : broad money, interest rates , data on currency , credit , fiscal Position, trade, capital flows ,inflation rate, Exchange rate , output Data, etc.

Yes

Yes Yes

Yes Policy oriented financial 1 or 2 per week bonds & central bank bonds Yes Market Twice a day Stabiliza Repo tion Scheme

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contd...

The marked international trend during the 1990s towards the operating procedures of monetary policy and liquidity management :
 Greater interest rate flexibility & Reduction in reserve requirements  Narrowing of differentials between rates of return in different currencies  Growing emphasis on active liquidity management in the presence international capital flow  Indirect ways (price oriented as opposed to quantity-oriented instruments) to control the non-monetary components of liquidity in the financial system.  Repos have almost become the main policy tool
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