7. THE RESERVE BANK OF INDIA AND MONETARY MANAGEMENT
Reserve Bank of India (RBI) is India’s Central bank. It plays a multi-facet role by executing multiple functions such as overseeing monetary policy, issuing currency, managing foreign exchange, working as a bank of government.
RBI played a vital role in ensuring economic and financial stability.
RBI’s Previous Functions
- Before inflation targeting was formally introduced in 2016, RBI was doing multiple roles.
- They were responsible for growth by managing liquidity as well as interest rates.
- They contributed in inflation management by adjusting liquidity and interest rates.
- They borrowed money on behalf of the government to keep them functioning.
- They also took care of the financial system’s stability by supervising banks and NBFCs.
- Nobel laureate Joseph Stiglitz made a statement that if RBI Governor was the governor of the US Fed then the sub-prime crisis would not have occurred.
Role of Reserve Bank of India
- The central bank issues and regulates currency notes.
- It keeps reserves with a view to securing monetary stability and is called banker to banks.
- The RBI plays a vital role in economic growth of the country and maintaining price stability.
- Monetary Policy of the Country: The RBI has been tasked to have a monetary policy framework to meet the challenges of the economy and to maintain price stability while keeping in mind the objective of growth.
- Inflation control: The RBI has targeted to keep the mid-term inflation at 4 four percent (+/- 2 percent).
- Decides benchmark interest rate: A six-member Monetary Policy Committee, headed by RBI Governor, decides the benchmark repo rate
- Government’s banker: RBI acts as a banker for both the central as well as state governments. It sells and purchases government securities on their behalf.
- Regulator of Foreign Exchange: Foreign Exchange Management Act (“FEMA”) envisages that RBI will have a key role in management of foreign exchange
- The central bank plays a key role in creating financial awareness among the masses.
- It also supervises if the banks and other financial institutions are doing the job assigned to them regarding financial inclusion.
Definition of monetary policy
- The term ‘Monetary Policy’ is the Reserve Bank of India’s policy pertaining to the deployment of monetary resources under its control for the purpose of achieving GDP growth and lowering the inflation rate
- The Reserve Bank of India Act 1934 empowers the RBI to make the monetary policy.
- While the Government of India tries to accelerate the GDP growth rate of India, the RBI keeps trying to bring down the rate of inflation within a sustainable limit.
- In order to achieve its main objectives, the Monetary Policy Committee determines the ideal policy interest rate that will help achieve the inflation target in front of the country.
Types of Monetary Policy
Monetary policy is of the following two types:
- Expansionary policy – It increases the total supply of money in the economy by easing its availability by lowering interest rates. It is used to stimulate economic growth.
- Contractionary policy – It decreases the total supply of money in the economy by raising interest rates. It is used to reduce prices caused by an excess of money supply.
Objective of Monetary Policy
• Monetary policy is concerned with making money available to the market at reasonable rates and in sufficient quantities at the appropriate time in order to achieve:
- Price stability
- Accelerating growth of economy
- Exchange rate stabilization
- Balancing savings and investment
- Generating employment
- Financial stability
• The primary goal of monetary policy is to maintain price stability while keeping growth in mind. Price stability is a prerequisite for long-term growth.
• In order to maintain price stability, inflation must be kept under control.
• Every five years, the Indian government sets an inflation target. The Reserve Bank of India (RBI) plays an important role in the consultation process for inflation targeting. The current inflation-targeting framework in India is flexible.
Monetary Policy Framework (MPF
- While the Government of India establishes the Flexible Inflation Targeting Framework in India, the Reserve Bank of India (RBI) is in charge of the country's Monetary Policy Framework
- The amended RBI Act explicitly gives the Reserve Bank the legislative mandate to run the country's monetary policy framework
- The framework aims to set the policy (repo) rate based on an assessment of the current and evolving macroeconomic situation, as well as to modulate liquidity conditions in order to anchor money market rates at or near the repo rate
- Changes in repo rates are transmitted through the money market to the entire financial system, influencing aggregate demand – a key determinant of inflation and growth
- • Once the repo rate is announced, the Reserve Bank's operating framework envisions day-to-day liquidity management through appropriate actions aimed at anchoring the operating target - the weighted average call rate (WACR) – around the repo rate
Monetary Policy Committee (MPC)
- The Monetary Policy Committee now determines the policy interest rate required to achieve the inflation target in India.
- The MPC is a six-person committee appointed by the Central Government (Section 45ZB of the amended RBI Act, 1934).
- The MPC must meet at least four times per year. The MPC meeting requires a quorum of four members. Each MPC member has one vote, and in the event of a tie, the Governor has a second or casting vote.
- Following the conclusion of each MPC meeting, the resolution adopted by the MPC is published
- The Reserve Bank is required to publish a document called the Monetary Policy Report once every six months to explain:
◦ the sources of inflation; and
◦ the forecast of inflation for the next 6-18 months
Monetary Policy Instrument
Monetary policy is implemented using a variety of direct and indirect instruments.
Repo Rate
The (fixed) interest rate at which the Reserve Bank provides overnight liquidity to banks in exchange for the government and other approved securities as collateral under the liquidity adjustment facility (LAF).
Reverse Repo Rate
The (fixed) interest rate at which the Reserve Bank absorbs liquidity from banks on an overnight basis in exchange for eligible government securities under the LAF.
Liquidity Adjustment Facility (LAF)
- The LAF is made up of both overnight and term repo auctions.
- The Reserve Bank has gradually increased the proportion of liquidity injected through fine-tuning variable rate repo auctions of various tenors.
- The goal of the term repo is to help develop the inter-bank term money market, which in turn can set market-based benchmarks for loan and deposit pricing and thus improve monetary policy transmission.
- The Reserve Bank also conducts variable interest rate reverse repo auctions as market conditions dictate
Marginal Standing Facility (MSF)
- A facility through which scheduled commercial banks can borrow an additional amount of overnight money from the Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up to a certain limit at a penal rate of interest.
- This acts as a safety valve for the banking system in the event of unexpected liquidity shocks
CorridorThe corridor for the daily movement in the weighted average call money rate is determined by the MSF rate and the reverse repo rate.
Bank Rate
- It is the rate at which the Reserve Bank is willing to purchase or rediscount bills of exchange or other commercial papers
- Section 49 of the Reserve Bank of India Act, 1934 mandates the publication of the Bank Rate
- This rate has been aligned with the MSF rate and, as a result, changes automatically when the MSF rate and the policy repo rate change
Cash Reserve Ratio (CRR)
The average daily balance that a bank is required to maintain with the Reserve Bank as a share of such percentage of its Net demand and time liabilities (NDTL) as specified by the Reserve Bank in the Gazette of India from time to time.
Statutory Liquidity Ratio (SLR)
- The percentage of NDTL that a bank must keep in safe and liquid assets such as unencumbered government securities, cash, and gold
- SLR changes frequently have an impact on the availability of resources in the banking system for lending to the private sector
Open Market Operations (OMOs)
These include the outright purchase and sale of government securities for the purpose of injecting and absorbing long-term liquidity, respectively.
Market Stabilisation Scheme (MSS)
- This monetary management tool was introduced in 2004
- Short-term government securities and treasury bills are sold to absorb longer-term surplus liquidity resulting from large capital inflows
- The money raised in this manner is kept in a separate government account of the Reserve Bank
An objective analysis on the efficacy of monetary policy in India
Inflation Targeting(IT) is a central banking policy that revolves around adjusting monetary policy to achieve a specified annual rate of inflation. The principle of inflation targeting is based on the belief that long-term economic growth is best achieved by maintaining price stability, and price stability is achieved by controlling inflation. It is in-line with Urjit Patel Committee recommendations. An amendment to RBI Act by the Finance Bill, 2016, has made IT as the primary objective of RBI and it is also accountable in case of failure.
The Central Government has notified 4 percent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016, to March 31, 2021, with the upper tolerance limit of 6 percent and the lower tolerance limit of 2 percent.
The Reserve Bank of India, recently in the Report on Currency and Finance for FY21, has said the current inflation target of 4% with a +/-2% tolerance band is appropriate for the next five years.
Important observations made:
- Trend inflation had fallen from above 9% before flexible-inflation targeting (FIT) to a range of 3.8-4.3 % during FIT, indicating that 4% is the appropriate level of the inflation target
- An inflation rate of 6% is the appropriate upper tolerance limit for the target.
- A lower bound above 2% can lead to actual inflation frequently dipping below the tolerance band while a lower bound below 2% will hamper growth, indicating that an inflation rate of 2 % is the appropriate lower tolerance bound
Concerns over efficacy in inflation targeting:
- Logical vulnerabilities:
◦ However, what has remained hidden in public discourse is the economic model that underlies inflation targeting.
◦ This model revolves around the proposition that inflation reflects “overheating”, or economic activity at a level greater than the “natural” level of output, having been taken there by central banks that have kept interest rates too low, at a level lower than the “natural” rate of interest.
◦ From this follows the recommendation that the cure to inflation is to raise the rate of interest set by the central bank, the so-called policy rate, which in India is termed ‘repo’ rate.
◦ A feature of this theory of inflation is that its central construct, the natural level of output, is unobservable.
◦ This makes it next to impossible to verify the explanation, which is also self-referential.
◦ Despite this logical vulnerability, inflation targeting is a reality in that it is the Centre’s stated policy of inflation control. - Mirage of success:
◦ Inflation targeting has been successful on the grounds that the inflation rate has remained within the band agreed to between the government and the RBI, and whether it has been achieved by “anchoring inflation expectations”.
◦ However, Inflation in India entered the prescribed band of 2% to 6% two years before inflation targeting was adopted in 2016-17.
◦ In fact, inflation had fallen steadily since 2011-12, halving by 2015-16.
◦ This by itself suggests that there is a mechanism driving inflation other than what is imagined in inflation targeting.
◦ The view is further strengthened by the finding that the decline in inflation over the five years concerned was led by the relative price of food.
◦ While falling food-price inflation per se does not rule out the possibility that expectations of inflation may have fallen in this period.
◦ But it would be difficult to explain why expectations would have fallen so sharply even in the absence of inflation targeting, considered essential for anchoring expectations.
◦ Finally, it is the flaring up of both inflation and inflation expectations after March 2020, when the COVID-19 lockdown was announced, that makes it difficult to believe the thesis of an “overheating” economy.
◦ On the other hand, we can explain the flaring up of inflation in terms of food prices, as supply chains were disrupted due to the lockdown - Conflicting patterns shown:
◦ Over the past five years, inflation in India has been controlled via inflation targeting and its benefits will be analyzed through five variables, namely growth, private investment, exports, non-performing assets (NPAs) of commercial banks, and employment. - Growth:
◦ The economy’s trend rate of growth actually began to decline after 2010-11.
◦ So, inflation targeting could not have caused it, but it is of interest that sharply falling inflation could do nothing to revive growth, belying the proposition that low inflation is conducive to growth. - Investment:
◦ For investment, there is reason to believe that higher interest rates, the toolkit for inflation targeting, may have been harmful.
◦ The swing in the real interest rate of over 5 percentage points in 2013-14 was powered further in 2016, when inflation targeting was adopted and could have contributed to a declining private investment rate.
◦ It is interesting that policy entrepreneurs assert that the benefits of low inflation may be considerable for private investment. - Export and employment:
◦ Exports and employment performed fairly poor since inflation targeting became official. - NPA’s (non-performing assets):
◦ It has long been recognized that a central bank focusing on inflation may lose control of financial stability
NPAs have grown since 2016, and the cases of IL&FS, PMC Bank, PNB, and YES Bank suggest that poor management and malfeasance in the financial sector could escape scrutiny when the central bank hunkers down to inflation targeting.
Recommendations
- As per the suggestions made by Chakravarty Committee, aspects such as price stability, economic growth, equity, social justice, and encouraging the growth of new financial enterprises are some crucial roles connected to the monetary policy of India.
- As per Urjit Patel’s report inflation should be the nominal anchor for the Monetary Policy framework, which should be set at 4 % with + /- 2 %. It seems logical, because what hamper poor people is food and fuel, which is necessity of life and which amounts to more than 50 % of consumer price index.
- In the conduct of monetary policy in an open economy setting, foreign exchange reserves and associated liquidity management are key, there is a need to enhance the RBI’s sterilization capacity to deal with surges in capital flows
- The primary focus of FIT on price stability augurs well for further liberalization of the capital account and eventual internationalization of the Indian rupees
Issues associated with RBI functioning
The RBI suggests that its independence is being violated while the government rationalises its intervention in terms of its concern for the economy.
Defining autonomy From the Side of Central bank or from the Government:The idea of central bank independence began to germinate some two decades ago, this was understood to mean a ‘functional’ independence.
That is, the bank would be unconstrained by the government in its functioning, which includes both the instruments it uses and how it uses them.
However, its autonomy was not to extend to ‘goal’ independence. What the goals of the central bank should be were to be chosen by the government without reference to the bank.The main issue here was whether the bank should focus on inflation alone or also on the level of employment.
Within a decade of this debate, it had been conceded that the focus would be exclusively on the former, and monetary policy came to be identified with ‘inflation targeting’.
Where Does RBI Stand in Terms of Autonomy?
According to a paper published in the International Journal of Central Banking in 2014, RBI was listed as the least independent among 89 central banks considered under the study.
These rankings are likely to have improved since the adoption of inflation targeting in February 2015 and formation of Monetary policy committee in October 2016.
However, vacancies in RBI’s board and government’s reluctance to fill them up raises questions about the decisions taken and whether proper deliberations on those decisions are being held.
During the previous government, a Financial Sector Legislative Reforms Commission was formed which made various recommendations to cut down RBI’s powers.
In 2013, a financial sector monitoring body, called Financial Stability Development Council was established which was to be chaired by the Finance Minister.
In essence, the RBI Act 1934, does not empower RBI absolute autonomy. However, it does enjoy some independence when it comes to performing its regulatory and monetary functions.
What is the RBI aggrieved about?
- One, the Reserve Bank of India wants more powers over regulating public sector banks (PSBs)
- Two, it feels that the government should not dictate the quantum of its surplus that can be paid as annual dividend
- And three, it is miffed that the Centre has suggested a separate payments regulator.
RBI Governor Urjit Patel told a parliamentary panel in June that it does not have enough powers over PSBs. But the RBI does have nominee directors on bank boards.
It leads physical inspection at banks and financial audits. It has also orchestrated mergers between banks whenever a bank has been on the verge of collapse (for instance, Global Trust Bank merged with Oriental Bank of Commerce).
So, the RBI does have adequate control over PSBs but may not be exercising it fully.
Other issue came up few years back, public spat between RBI and central government over interference of later in policy formulation of RBI has come to limelight. The government had threatened to invoke section 7 of the RBI Act which empowers government to issue directions to RBI to take some action in public interest.
What section 7 says?
Clause 1: government can issue instructions to RBI from time to time in public interest.
2. Clause 2: board of directors shall have all powers and do all acts as are done by a bank.
3. Clause 3: the governor shall also have the same powers and functions as board of directors.
From above clauses, it can be discerned that RBI board and Governor have concurrent powers.
There are two issues involved1. Issue of relationship between RBI and the government i.e. how far government can go and issue instructions to RBI in public interest so that autonomy of the RBI is not breached.
2. Issue of relationship between the RBI management headed by the Governor and the board i.e. whether the board can override the decisions of Governor according to majority view.
The government has never issued instructions under section 7 to RBI till now although it has interfered in its functioning from time to time. As per convention RBI board functions as an advisory body and does not pass resolutions binding on the Governor, which should continue as the board has members nominated by the Central government.