• UGI USER
  • May 09, 2024
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RBI AND MONETARY POLICY IN INDIA

Meaning of Central Bank

  • A central bank is the primary financial institution of a country responsible for managing the nation’s monetary policy and regulating its banking system. Unlike commercial banks, a central bank has the exclusive authority to expand the nation’s monetary base. Central banks worldwide are tasked with ensuring the stability of the financial system, preventing bank runs, and preventing fraudulent activities by member banks and financial institutions. In developed countries, central banks often operate with institutional independence from political interference.

History of the Reserve Bank of India (RBI):

  • Establishment: The RBI was established on April 1, 1935, as a shareholder’s bank, following the recommendations of the Hilton Young Commission (1926).
  • Statutory Body: It is a statutory body established under the RBI Act of 1934, not a constitutional body.
  • Relocation: Initially founded in Kolkata, the RBI’s headquarters were permanently relocated to Mumbai in 1937.
  • Monetary Authority: It is the highest monetary authority in India and represents the country in the International Monetary Fund (IMF).
  • Monetary Policy: The RBI is responsible for conducting monetary policy in India.
  • Nationalization: On January 1, 1949, the RBI was nationalized and has since remained wholly state-owned, falling under the control of the Ministry of Finance, Government of India.
  • Banking Role: After nationalization, the RBI ceased to be a ‘bank’ in the technical sense, as it no longer accepts deposits from the public.
  • Regional Representations: The RBI has four regional representations: North in New Delhi, South in Chennai, East in Kolkata, and West in Mumbai.
Evolutionary History of the Reserve Bank of India (RBI)
Period Key Developments
1950–1960 Focus on centrally planned economic strategy, prioritizing agriculture.
Enactment of the Banking Companies Act of 1949 (later the Banking Regulation Act), leading to nationalization of commercial banks.
1961–1968 Establishment of a deposit insurance system by the RBI to restore confidence in the banking network.
Reorganization of the banking sector and nationalization of several financial institutions.
1969–1984 Nationalization of 14 major commercial banks in 1969, followed by six more in 1980.
Expansion of RBI policies on interest rates, reserve ratios, and visible deposits.
Establishment of the Banking Commission on January 29, 1969.
1985–1990 Financial reforms adding security measures and liberalization.
Establishment of the Discount and Finance House of India and the National Housing Bank.
1991–1999 Economic contraction in 1991, leading to devaluation of the Indian rupee.
Recommendations by the Narasimham Committee to change banking sector ratios.
Deregulation of bank interest rates and certain financial market sectors by the RBI.
From 2010 Establishment of the Monetary Policy Committee in 2016 to limit the RBI’s role in setting interest rates.
RBI’s prohibition in 2018 on regulated entities dealing with virtual currencies, including cryptocurrencies like Bitcoin.

Organizational Structure of the Reserve Bank of India (RBI)

  • Central Board of Directors: The main committee of the RBI.
  • Governor: The head of the RBI.
  • Deputy Governors: Assist the Governor in overseeing various functions.
  • Executive Directors: Responsible for specific areas of the bank’s operations.
  • Principal Chief General Managers: Manage major departments or functions.
  • Chief General Managers: Oversee various departments or regional offices.
  • General Managers: Handle key responsibilities within departments.
  • Deputy General Managers: Assist in managing departments or functions.
  • Assistant General Managers: Involved in supervisory roles within departments.
  • Managers: Manage teams or sections within departments.
  • Assistant Managers: Assist in managing teams or sections.
  • Support Staff: Provide administrative and operational support.
Key Points Regarding the Institutional Organization of RB
·    Board Composition: The Central Board of Directors includes the Governor, not more than four Deputy Governors, four directors representing regional boards, two directors from the Economic Affairs and Financial Services Secretaries, and ten other directors from various fields.

·    Appointment of Governor: The Governor is recommended by the Financial Sector Regulatory Appointments Search Committee (FSRASC) and appointed by the Government of India for a term not exceeding five years, with eligibility for re-appointment.

·    Deputy Governors: Two Deputy Governors are typically from RBI ranks, selected among the bank’s Executive Directors. One is nominated from among the chairpersons of public sector banks, and the other is an eminent economist.

·    Qualifications and Removal: The RBI Act does not specify any qualifications for the Governor. The Governor can be removed by the Central Government.

Functions of RBI

Function Description
Issuance of Currency Notes The RBI has exclusive authority to issue currency notes in India, except for one-rupee notes and subsidiary coins. All currency notes issued by the RBI are legal tender in the economy.
Banker to the Government The RBI acts as a banker to both Central and State governments, providing various banking services including money deposits, fund withdrawals, and fund transfers.
Bankers’ Bank The RBI provides financial support to commercial and other banks through rediscounting of bills, loans, and advances against approved securities.
Foreign Exchange Management and Control The RBI is responsible for maintaining the external value of the currency, managing external reserves, and controlling foreign exchange as per the Foreign Exchange Regulation Act of 1973.
Credit Control The RBI regulates credit in the economy through monetary policy tools such as CRR, SLR, Repo Rate, and Reverse Repo Rate, using both quantitative and qualitative techniques.
Lender of Last Resort The RBI acts as the lender of last resort, providing liquidity to solvent banks facing short-term liquidity issues to protect depositors’ interests and maintain financial stability.

Supervisory Functions of the RBI: Control and Supervision of Banks

  • Legislative Authority: Under the RBI Act, 1934, and the Banking Regulation Act, 1949, the RBI has extensive powers to control commercial banks.
  • Regulatory Oversight: The RBI oversees commercial banks’ licensing, branch expansion, asset liquidity, management and operational procedures, mergers, reconstruction, and liquidation.
  • Inspections: The RBI conducts inspections of banks and calls for returns and information from them.
  • Remedial Measures: If a bank’s operations are found unsatisfactory, the RBI may recommend measures to improve its functioning.

Promotional Functions of the RBI

  • Promotion of Banking Habit: The RBI mobilizes savings for investment and has expanded the banking system nationwide by setting up institutions like UTI, IDBI, IRCI, NABARD, etc.
  • Refinance for Exports: The RBI provides refinance for export promotion. Initially, it established ECGC and EXIM Bank to finance foreign trade, which now function separately.
  • Credit to Agriculture: The RBI makes institutional arrangements for rural or agricultural finance, such as setting up Agricultural Credit Cells and promoting Regional Rural Banks and NABARD.
  • Credit to Small Scale Industrial Units: The RBI encourages commercial banks to provide loans and guarantee services to small-scale industrial units, considering these as priority sector advances.
  • Indirect Finance to the Cooperative Sector: The RBI instructs NABARD to issue loans to State Cooperative Banks, which in turn lend to the cooperative sector.
  • Industrial Finance Arrangements: The RBI has established development banks like IFC and IDBI to provide long-term finance to industries.

Subsidiaries of RBI
National Centre for Financial Education (NCFE)

  • Objective: The NCFE aims to promote financial literacy among all demographic groups in India, as per the Financial Stability and Development Council’s (FSDC) National Strategy for Financial Education.
  • Activities: It conducts financial education campaigns across the nation, including seminars, workshops, programs, campaigns, and discussion forums, to enhance the knowledge and understanding of the population.
  • Structure: NCFE is a non-profit organization supported by the Reserve Bank of India and registered as a Section 8 company.
National Strategy for Financial Education (NSFE) 2020-2025
·    Development: Developed by the NCFE under the guidance of the Technical Group on Financial Inclusion and Financial Literacy (TGFIFL), in consultation with financial sector regulators including RBI, SEBI, IRDAI, and PFRDA.

·    ‘5 C’ Method: The strategy proposes a ‘5 C’ method for the diffusion of financial education across the country:

·    Communication: Utilizing technology, media, and innovative communication methods for the dissemination of financial education messages.

·    Collaboration: Streamlining efforts of other stakeholders for financial literacy.

·    Capacity: Developing the capacity and ‘Code of Conduct’ for financial education providers.

·    Content: Creating financial literacy content for various sections of the population.

·    Community: Evolving community-led approaches for sustainably disseminating financial literacy.

Deposit Insurance and Credit Guarantee Corporation of India (DICGC)

  • Establishment: Formed on July 15, 1978, by merging the Deposit Insurance Corporation (DIC) and Credit Guarantee Corporation of India Ltd. (CGCI).
  • Functions: Governed by the provisions of the DICGC Act, 1961, and fully owned subsidiary of the RBI.
  • Purpose: Provides insurance for deposits and guarantees credit facilities.
  • Insurance Coverage: Insures each depositor of a registered insured bank up to a maximum of ₹5 lakh for all bank deposits.
  • Exclusions: Does not cover deposits of foreign governments, central/state governments, interbank deposits, deposits made outside India, and certain other exemptions.
  • Registration Cancellation: Can cancel the registration of an insured bank for non-payment of premiums.
  • Funds: Maintains Deposit Insurance Fund, Credit Guarantee Fund, and General Fund for corresponding claims and administrative expenses.

Reserve Bank Information Technology Private Limited (ReBIT)

  • Establishment: Formed in 2016 by the RBI.
  • Purpose: Manages RBI’s IT and cybersecurity needs, ensures cyber resilience of Indian banking, and supports risk-based supervision and IT project management for RBI.
  • Verticals: Comprises four verticals: Cyber Security, Research and Innovation, Systems Audit, and Project Management.

Indian Financial Technology and Allied Services (IFTAS)

  • Establishment: A wholly-owned subsidiary of the RBI, registered under the Companies Act, 2013.
  • Functions: Provides IT-related services to banks, financial institutions, and the RBI, manages the Financial Messaging Platform (FMS), operates the Indian Banking Community Cloud (IBCC), and has taken over INFINET, SFMS, and IBCC from IDRBT since 2016.
  • Services: Offers the Indian Financial Network (INFINET), Structured Financial Messaging System (SFMS), Indian Banking Community Cloud (IBCC), and Global Interchange for Financial Transactions (GIFT).

Reserve Bank Innovation Hub (RBIH)

  • Establishment: Registered as a Section 8 company under the Companies Act 2013, with an initial capital contribution of ₹100 crore.
  • Purpose: Aims to promote access to financial services for low-income populations, encourage innovation in the financial sector, and enhance women’s digital financial inclusion in India.
  • Management: Guided and managed by a Governing Council (GC) led by a Chairperson.
  • Initiatives: Organized Swanari TechSprint to develop solutions for women-owned businesses and increase digital financial inclusion.
Publications of RBI
Publication Type Publication Name
Annual Branch Banking Statistics
Handbook of Statistics on Indian States
Handbook of Statistics on Indian Economy
Report on Currency and Finance
State Finances: A Study of Budgets
Primary (Urban) Co-operative Banks’ Outlook
Half-Yearly Financial Stability Report
Report on Foreign Exchange Reserves
Quarterly Quarterly Industrial Outlook Survey
Monetary Policy Report
Bank Lending Survey
Consumer Confidence Survey
Services and Infrastructure Outlook Survey

Minimum Reserve System (MRS) of RBI

  • Establishment: Introduced in 1957.
  • Requirement: The RBI must maintain a minimum reserve of ₹200 crore, including foreign currency, gold coins, and gold bullion, with at least ₹115 crore in gold.
  • Purpose: Allows the RBI to issue currencies without a limit, provided it maintains this minimum reserve.
  • Objectives of Minimum Reserve System (MRS):
    • Money Supply Management: To manage the economy’s money supply while avoiding inflationary pressures and maintaining public confidence in the currency.
    • Legal Tender Assurance: To assure Indian currency holders that the rupee in their possession is legal tender.
    • Economic Flow: To ensure a sufficient flow of money into the economy through the MRS.
    • Economic Growth: To increase the country’s economic growth without raising the inflation rate.

Sources of Income of RBI

  • Open Market Operations (OMO): A major source of income, where the RBI buys or sells bonds in the open market to regulate the money supply.
  • Interest Income: Receives substantial interest from bonds purchased from the government and international currency.
  • Foreign Exchange: Profits from dealings in the foreign exchange market, potentially buying dollars cheaply and selling them at a higher price in the future.
  • Primary Mandate: The primary mandate of the RBI is to preserve the value of the rupee, not to earn profits. Profits or losses generated are a side effect of its operations in shaping monetary policy.

Assets of the Reserve Bank

  • Foreign Currency Assets (FCA): Includes investments in US Treasury bonds, other governments’ Treasury Bills, deposits with foreign central banks, and foreign commercial banks.
  • Gold Coin Bullion: Represents the gold coin bullion of the Issue Department and Banking Department, valued at monthly prices.
  • Rupee Securities: Consists of government securities and investments in government securities of the Banking Department.
  • Loans and Advances: Provided to Central & State Governments, commercial and cooperative banks, and others under Sections 17 and 18 of the RBI Act, 1934.
  • Loans and Advances to Scheduled Commercial Banks and State Co-operative Banks: Refinance facilities provided to banks, mainly due to an increase in export credit refinance.
  • Loans and Advances to Others: Includes loans under special refinance schemes to EXIM Bank and collateralized loans to primary dealers.
  • Bill Purchased and Discounted: Includes discounted and purchased Treasury bills.
  • Investment: Represents investments in Non-Government securities, including share capital in DICGC, Bharatiya Reserve Bank Note Mudran, NABARD, and National Housing Bank.
  • Other Assets: Includes fixed assets, accrued income, and Rupee coins.

Liabilities of the Reserve Bank of India (RBI)
Notes Issued:

  • Notes in Circulation: Currency notes issued by the RBI are liabilities, including notes issued by the Government of India before 1935 and by the RBI since then, minus notes held outside the Banking Department.
  • Notes Held in the Banking Department: Reflects the number of notes maintained by the Banking Department for day-to-day needs.
  • Deposits: Represents cash balances maintained with the RBI by the Central and State Governments, banks, and financial institutions.

Market Stabilisation Scheme (MSS):

  • Introduced in April 2004 for sterilization operations, where the Government issues securities to absorb excess rupee liquidity from enduring capital flows. The proceeds are parked in a separate deposit account with the RBI.

Other Liabilities:

  • Include internal reserves and provisions such as the Currency and Gold Revaluation Account, Exchange Equalisation Account, Contingency Reserve, and Asset Development Reserve.
  • Contingency Reserve: Set aside for unexpected contingencies, including depreciation in securities’ value and risks from monetary/exchange rate policy.
  • Currency and Gold Revaluation Account (CGRA): Records unrealized gains/losses on the valuation of Foreign Currency Assets and gold due to exchange rate and gold price movements.
  • Investment Revaluation Account (IRA): Records appreciation or depreciation arising from the valuation of foreign-dated securities at market prices.

RBI Surplus Transfer

  • Central Board Decision (2018-19): The RBI’s Central Board decided to transfer a sum of ₹1,76,051 crore to the government, comprising ₹1,23,414 crore of surplus for the fiscal year 2018-19 and ₹52,637 crores of excess provisions as per the revised Economic Capital Framework (ECF).
  • Bimal Jalan Committee: Established to review the RBI’s Economic Capital Framework, recommended that the Contingent Risk Buffer (CRB) be maintained between 5.5% and 6.5% of the RBI’s balance sheet. The surplus transfer policy became formula-based and transparent, with the degree of risk provisioning determined by the RBI’s central board.
  • Key Parameters: The committee’s recommendations were based on the review of central banks’ financial resilience, cross-country practices, legislative provisions, and the impact of the RBI’s public policy mission on its balance sheet and associated risks.
  • Financial Stability: The RBI, as a lender of last resort, must retain some CRB to protect the economy from any financial stability crisis.

Surplus Transfer:

  • 1934 Act: According to Section 47 (Allocation of Surplus Profits) of the RBI Act, 1934, the RBI allocates the surplus (excess of income over expenditure) to the government.
  • Malegam Committee (2013): Suggested a greater transfer to the government, with excess transfer averaging approximately 0.5% of GDP.

Reason for Huge Transfer:

  • Overcapitalised RBI: The narrative that the RBI is overcapitalised has been debated, with the Economic Survey 2016–17 noting that the RBI is one of the most capitalised central banks globally.
  • Comparative Capitalisation: Some central banks, like those in the US and UK, hold 13% to 14% of their assets as reserves, compared to the RBI’s 27%, while others, like Russia, keep more.
  • Constructive Use: Economists have advocated for the RBI to release “excess” capital for constructive use by the government. In 2013, the Malegam Committee also discussed this issue.

Autonomy and Independence of the RBI
Need for Independence

  • Separation of Powers: As per Montesquieu’s view, the separation of powers ensures the effective functioning of governmental institutions by preventing any one entity from monopolizing power and abusing authority.
  • Inclusive Structures: According to Acemoglu and Robinson in “Why Nations Fail,” inclusive political and economic structures support the rule of law and encourage innovation through diverse viewpoints.
  • Extractive Institutions: In contrast, extractive institutions lead to the concentration of resources in the hands of elites, hindering change and innovation.

Autonomy of the Central Bank

  • Functional Independence: About twenty years ago, central bank independence was primarily understood as ‘functional’ independence, meaning the bank’s operations, including its methods and tools, would not be constrained by the government.
  • Goal Independence: However, the central bank’s independence did not extend to “goal” independence. The government, without consulting the bank, would determine the central bank’s objectives, such as whether to prioritize employment levels alongside inflation.
  • Inflation Targeting: After a decade of discussion, it was agreed that monetary policy would focus primarily on inflation targeting, leaving employment levels to receive all attention.

Autonomy of RBI

  • Financial Liberalization: Post-1991, the independence of the RBI became crucial for financial liberalization.
  • Economic Policy: Monetary policy is considered part of the broader economic policy, with the central bank responsible for ensuring the health and efficiency of the banking system.
  • Ownership vs. Control: The RBI’s ownership by the government must be distinguished from its control over the monetary and financial system.
  • Section 7 of RBI Act: Specifies that the Central Government may give directions to the RBI after consulting with the Governor, indicating a hierarchy of authority.

Reasons for Diminishing Autonomy of RBI

  • Independent: In 2014, the RBI was ranked as the least independent among 89 central banks analyzed by the International Journal of Central Banking.
  • Monetary Policy Committee: The establishment of the Monetary Policy Committee and the implementation of inflation targeting have likely improved these rankings.
  • Commission on Financial Sector Legislative Reforms: Proposed suggestions to reduce the authority of the RBI.
  • Financial Stability Development Council: Established in 2013, chaired by the finance minister, to oversee the financial sector.
  • Limited Authority: While the RBI Act of 1934 does not grant unlimited authority to the RBI, it does provide significant independence in its monetary and regulatory functions.

Issues Between RBI and Government

Easing Norms of Prompt Corrective Action (PCA):

  • Electricity Firms: The government has requested the RBI to exclude electricity firms from the PCA framework.
  • Credit Availability: The government wants the RBI to relax lending regulations under PCA to increase credit availability for MSMEs.
  • NPA Concerns: The RBI argues that relaxing PCA norms could jeopardize efforts to address the country’s Non-Performing Asset (NPA) crisis.

Section 7 of the RBI Act of 1934:

  • Directives: The government, which owns 21 public sector banks, is issuing directives to the RBI, the banking regulator.
  • Public Interest: This clause gives the government the authority to issue directives to the RBI in the public interest.
  • Consultation Clause: Orders must be issued following consultation with the RBI governor.

RBI Surpluses:

  • Surplus Income: The RBI earns income on its domestic and international bonds. After covering operational expenses, the remainder is treated as surplus.
  • Risk Assessments: In 2015, the RBI determined that its equity position of about ₹10 lakh crore was appropriate based on risk assessments and chose to transfer its entire surplus to the government.
  • Government’s View: The government believes that the RBI should pay larger dividends, arguing that it has built up buffers such as the Contingency Fund and Asset Reserve in excess of what is necessary to sustain creditworthiness.
  • Inflation Concerns: The RBI argues that increasing the dividend payment to the government may cause inflation, as there would be more money in the market, potentially impairing the RBI’s main objective of macroeconomic stability.
  • Contingency Fund: The surplus is also intended to cover scenarios where the rupee appreciates against other currencies or the rupee value of gold falls.
New Initiatives by RBI
Scheme Description
RBI Retail Direct Scheme – A one-stop solution to facilitate investment in Government Securities by individual investors.
– Individual retail investors can open an RDG (Retail Direct Gilt) Account with the RBI for a Gilt Securities Account.
Integrated Ombudsman Scheme

 

 

 

 

 

 

 

 

 – Combines three RBI schemes: the 2006 Banking Ombudsman Scheme, the 2018 Ombudsman Scheme for NBFCs, and the 2019 Ombudsman Scheme for Digital Transactions.
– Built on the concept of “One Nation-One Ombudsman,” with a single site, email, and address for customer complaints.
– Includes non-scheduled primary co-operative banks with deposits of ₹50 crore or more.
– The Principal Nodal Officer, a General Manager at a Public Sector Bank or similar, is responsible for representing the Regulated Entity and responding to customer complaints.
– Aims to strengthen the grievance redress procedure for consumer complaints against RBI-regulated firms.
– The RBI’s Executive Director in charge of the Consumer Education and Protection Department oversees the scheme.
– Customers can use a single email account to raise complaints, send documents, track status, and provide feedback.
– A toll-free hotline in multiple languages will provide information on grievance remedies, free for bank customers and the public.

Monetary Policy of the Reserve Bank of India (RBI)

  • Definition: Monetary policy involves the use of central bank instruments to regulate the cost, availability, and use of money and credit.
  • Significance: In India, a growing market economy, the development of sound monetary policies is crucial.
  • Statutory Foundation: The policy was revised in 2016 to establish a statutory foundation for implementation, ensuring accountability and transparency.
  • Relation to Fiscal Policy: While monetary policy regulates the money supply in the economy, fiscal policy focuses on government taxation and spending.
  • Objective: The RBI aims to maintain price stability and promote economic growth by controlling the money supply.
  • Functions:
    • Inflation Management: Helps regulate business cycles, such as inflation and deflation.
    • Economic Growth: Influences the country’s growth by managing the money supply and interest rates.
    • Money Control: Controls the amount of money and credit in circulation.
    • Economic Objectives: Directs money to areas most needed for overall economic goals.
  • Objectives of Monetary Policy:
    • Economic Growth: Encourages investment by controlling prices and income, boosting growth.
    • Employment Generation: Central banks play a key role in creating jobs through effective monetary policy management.
    • Price Stability: Aims to achieve stable prices by controlling the value of money.
    • Exchange Rate Stability: Maintains stability in exchange rates to build trust in global trade.
    • Balance of Payments Equilibrium: Manages the balance of payments through monetary policy.
    • Financial Stability: Aims to maintain stability in the economy and reduce volatility in financial markets.
    • Inflation Target: Sets an inflation target every five years in consultation with the RBI.
  • Characteristics of Monetary Policy in India:
    • Dynamic: Updated four times a year to respond to economic changes.
    • Flexible: Adaptable to market conditions by altering rates.
    • Promotes Saving and Investing: Encourages a culture of saving and investing.
    • Tools and Methods: Offers various tools for credit control.
    • Role of the RBI in Monetary Policy:
    • Supreme Authority: The RBI is the central bank of India, overseeing the banking sector and managing monetary policy.
    • Banker’s Bank: Functions as a banker’s bank, avoiding micro or macro banking.
    • Economic Stabilization: Aims to stabilize the economy and create a favorable environment for growth.
    • Interest and Exchange Rate Stability: Ensures stability in interest rates and exchange rates.
    • Financial Institution Growth: Tracks credit flow to different economic sectors and supports monetary stability.

Types of Monetary Policy

Expansionary Monetary Policy A particular economy’s money supply is to be increased by an expansionary monetary policy. Reduced key interest rates and increased market liquidity are used to implement an expansionary monetary policy. Implemented to raise the money supply, boost consumption, and create demand. Also known as “Dovish Monetary Policy.”
Contractionary Monetary Policy Aims to reduce (decrease) the money supply in an economy. Achieved by raising key interest rates, which decreases market liquidity. Used to lower the money supply, lower demand, and lower consumption during inflation. Also known as “Hawkish Monetary Policy.”

Monetary Policy Stance

Monetary Policy Stance Description
Neutral stance Implies that interest rates can move in either direction—upward or downward.
Calibrated tightening Implies that interest rates can only rise.
Accommodative/ Expansionary stance Refers to the insertion of additional funds into the financial system. Motivated by falling ‘headline inflation’, this stance is intended to increase lending, investment, and growth.
Contractionary stance Entails removing cash from the financial system. When more than optimal funds are believed to be available in the financial system, such a stance is generally taken. It is sometimes also aimed at long-term inflation control.
Hawkish stance Denotes a contractionary stance aimed at preventing inflation from rising, related to the statutory inflation targets of ‘headline inflation’.

Monetary Policy Tools of the Reserve Bank of India (RBI)

Quantitative Monetary Policy Tool Description
Bank Rate Long-term interest rate charged by RBI for lending to commercial banks. Directly impacts money supply, with an increase leading to higher lending rates and reduced borrowing, and vice versa.
Repo Rate Short-term interest rate at which RBI lends to commercial banks, typically against government securities. Lowering it reduces borrowing costs, increasing money circulation; raising it controls inflation by making borrowing expensive.
Reverse Repo Rate Interest rate at which RBI borrows from commercial banks on a short-term basis. An increase incentivizes banks to park funds with RBI, leading to higher lending rates for customers, used to manage liquidity and stabilize interest rates.
Cash Reserve Ratio (CRR) Mandatory requirement for banks to maintain a percentage of their deposits with RBI. Used to control credit expansion (higher CRR reduces liquidity) or contraction (lower CRR increases liquidity) in the economy.
Statutory Liquidity Ratio Requirement for financial institutions to maintain a percentage of their total demand and time liabilities in non-cash or liquid assets. Ensures banks can meet depositors’ demands and impacts fund availability for private sector lending.
Open Market Operations (OMO) Buying and selling of government securities in the open market to expand or contract credit. Buying injects money into the economy; selling removes money. A key tool for RBI in managing money supply and interest rates.
Market Stabilisation Program Launched to absorb excess liquidity from large capital inflows by selling short-dated government securities. Helps stabilize interest rates and manage liquidity, with funds maintained in a separate government account with RBI.
Call Money Market (CMM) Interbank money market for borrowing and lending funds for short durations, primarily overnight or up to 14 days. Rates vary around the repo rate based on fund demand and supply, impacting short-term borrowing costs.
Liquidity Adjustment Facility Introduced in June 2000, allowing RBI to lend to or borrow from banks at fixed rates (repo and reverse repo rates) daily. Helps moderate fund mismatches and transmit interest rate signals effectively.
Standing Deposit Facility Proposed scheme aimed at assisting RBI in managing liquidity, especially during excess cash periods like post-demonetization. Aids in better liquidity management by providing a facility for banks to park surplus funds.

 

 

Qualitative or Selective Measures

  

Credit regulation or control with regard to certain programmes, places, or commodities.
 

Loan Margin Requirement

  

The difference between the loan value and the value of the security used to secure the loan. If the lending margin requirement is 20%, commercial banks can authorize loans of up to 80% of the market value of a security. But collateral for agriculture and personal loans will be different. If a person wants to borrow ₹80,000, he or she must furnish a ₹1,00,000 security (market value). If the RBI lifts this margin, the general public will be able to get lower-interest loans against comparable-valued assets.
 

Directions

  

The Banking Regulation Act of 1949 authorizes the RBI to provide instructions to commercial banks to help them in setting lending policies. Through directives, the central bank can affect the credit structure and supply of credit to a certain extent for a specific purpose.
 

Credit Limit

  

The RBI has the authority to restrict commercial bank loans to a specified level. Commercial banks will be hesitant to issue public loans in this situation. Banks will lend to certain industries, such as agriculture and priority sectors.
 

Moral Suasion

  

On occasion, the RBI requests and persuades commercial banks not to provide loans for unproductive reasons that promote inflation and do not contribute to economic growth. It urges banks to limit credit availability for speculative purposes.
 

Direct Action

  

The RBI has the right to impose sanctions on a bank that fails to comply with its instructions. The Reserve Bank of India has the option of refusing to rediscount its bills and securities. The central bank can even forbid an individual bank from operating if it does not execute its directions and violates monetary policy objectives.
 

Credit Monitoring

  

All commercial bank loans of ₹5 crores or more given to a single party are reviewed by the RBI.

Monetary Policy in India

  • Historical Context:
    • In the early years, India focused on infrastructure and manufacturing capacity, with fiscal policy playing a more significant role than monetary policy.
    • The government often ran large budget deficits, covered by ad-hoc treasury bills or borrowings from public-sector banks, leading to inflationary pressures.
    • In 1986, the monetary policy framework shifted towards controlling the M3 money supply to counter inflation.
  • Post-1991 Reforms:
    • The 1991 economic reforms brought significant changes, with steps taken to limit the monetization of the budget deficit.
    • From 2006, the RBI was prohibited from subscribing to the principal issue of public debt.
    • The Narasimham Committee’s recommendations led to the establishment of the Interim Liquidity Adjustment Facility (ILAF) in 1999, making repo and reverse repo rates the key policy rates.
  • Current Framework:
    • The Revised Liquidity Adjustment Framework (RLAF) since May 2011 focuses on the repo rate as the primary independent rate.
    • In 2016, the Monetary Policy Framework Agreement (MPFA) between the GOI and the RBI set an inflation target of 4% for the fiscal year 2016–17, with a 2% tolerance zone.
    • The Monetary Policy Committee (MPC), established in 2016, is responsible for setting the policy repo rate to achieve the inflation target.
    • The RBI is accountable to the government if it fails to meet the inflation targets and must explain its future plans to achieve them.

Monetary Policy Committee (MPC)

  • Formation:
    • Recommended by the Urjit Patel Committee in 2014.
    • Established under the Reserve Bank of India Act of 1934 to maintain price stability while considering growth.
  • Objective:
    • Determines the policy repo rate required to achieve the inflation target of 4%.
  • Composition:
    • Six members: RBI Governor (Chairperson, ex-officio), Deputy Governor of the RBI in charge of monetary policy (Member, ex-officio), one officer of the RBI nominated by the Central Board (Member, ex-officio), and three external experts in economics, banking, finance, or monetary policy.
    • Members have a four-year term.
  • Decision-Making:
    • Decisions are taken by majority vote, with the RBI Governor having the casting vote in case of a tie.
  • Urjit Patel Committee Recommendations:
    • Headline CPI as the nominal anchor for monetary policy.
    • Inflation target set at 4% with a 2% margin of error.
    • Fiscal deficit reduction to 3.0% of GDP by 2016-17.
    • Formation of an MPC for decision-making.
    • Accountability for failure to meet the inflation target for three consecutive quarters.
    • Real policy rates should be positive.
    • Introduction of a compensated standing deposit facility to manage excess liquidity.
    • Transfer of government debt and cash management to the government’s Debt Management Office.
    • Phasing out of sector-specific refinancing.
  • Government’s Response:
    • Formal adoption of the Flexible Inflation Targeting (FIT) framework in 2016.
    • Establishment of a six-member MPC to set the policy repo rate.
    • Inflation target announced as 4% with a 2% tolerance range for the period from August 5, 2016, to March 31, 2021.
    • Amendment to the RBI Act of 1934 in May 2016 to provide a legislative foundation for the FIT framework.

Advantages of Monetary Policy

Advantage Explanation
Quick Implementation Monetary policy can be implemented quickly with immediate effects on rates and ratios.
Year-Round Adjustability Changes in monetary policy can be made at any time of the year.

Limitations of Monetary Policy

Limitation Explanation
Non-Banking Loans A significant portion of credit is provided by Non-Banking Institutions (NBIs), which are not affected by changes in bank rates or ratios.
Instrument Limitations Frequent adjustments in monetary policy rates can create uncertainty for productive investment. The RBI must consider global developments due to the integration of the Indian financial sector with the global financial system.
Effects of New Financial Institutions Institutions like mutual funds and venture capital firms significantly impact the economy’s total liquidity, leading to disintermediation and reducing the impact of RBI’s actions.
High Currency-Deposit Ratio In rural areas with low banking penetration, the currency-deposit ratio remains high, limiting the effectiveness of monetary policy instruments.
Weak Monitoring System The lack of a robust monitoring system and preferential rediscount facilities for certain sectors can lead to ineffective monetary regulation.
Rigid Policies and Fiscal Needs The credit policy often relies on previous years’ data, while there’s a need to forecast credit needs based on expected real output growth. The monetization of budget deficits also contradicts fiscal and monetary policy objectives.
Autonomy of RBI The gap between the RBI’s responsibility to manage the monetary system and the authority required to do so raises concerns about the central bank’s autonomy.

Unconventional Monetary Policy

  • For several decades, central banks in developed economies primarily used a policy interest rate as their primary monetary policy tool. However, in the wake of the global financial crisis (GFC) of 2007-2009 and the subsequent deep recession, many central banks in these countries reduced interest rates to near-zero levels.
  • As economic growth remained sluggish and interest rates hovered around zero, various central banks resorted to ‘unconventional’ monetary policy measures to stimulate economic activity. These unconventional approaches have gained renewed attention as central banks worldwide grapple with the economic fallout from the COVID-19 pandemic.

Negative Interest Rate Policies (NIRPs)

  • Negative interest rates are a relatively rare phenomenon, as it seems counterintuitive to penalize depositors for placing their money in banks. Traditionally, it was believed that policy rates had a “Zero Lower Bound” (ZLB), implying that interest rates could not drop below zero. However, this was not an absolute constraint, as several central banks in advanced economies, including those in Denmark, Sweden, Switzerland, and the Eurozone, opted to implement NIRPs following the GFC.
  • Despite this, commercial banks generally avoided passing on negative rates to retail depositors by setting a floor of zero on retail deposit rates. In emerging market economies (EMEs), however, NIRPs can lead to significant cross-border spillovers in the form of capital inflows seeking higher yields, posing considerable challenges for monetary policy and financial stability.
Negative Interest Rate Policies (NIRPs): Pro Vs Cons
Pro Cons
Reduces borrowing expenses. Negative interest rates pressurize the whole yield curve.
Helps contribute to a nation’s currency’s depreciation by making it a less appealing investment than other currencies. Reduce the profit margins that financial firms get from lending.
A lower currency gives a country’s exports a competitive advantage while also increasing inflation by raising import costs.
If sustained ultra-low rates harm the health of financial institutions, they may delay lending and harm the economy.

Zero Interest Rate Policy (ZIRP)

  • ZIRP is a monetary policy approach aimed at stimulating economic growth by maintaining interest rates close to zero. Under this strategy, the central bank can no longer reduce interest rates, rendering traditional monetary policy ineffective.
  • To expand the monetary base, unconventional monetary policy measures, such as quantitative easing, are employed. However, excessively relying on a zero-interest-rate strategy, as seen in the Eurozone, can lead to negative interest rates.
  • The effectiveness of zero-interest rate policies has been debated by many economists, who point out potential risks like liquidity traps. In extreme cases, a negative interest rate policy (NIRP) may be used as an emergency measure.

Helicopter Money

  • Helicopter money, also known as a helicopter drop, is a unique monetary policy tool that involves printing large amounts of money and distributing it to the general public to stimulate economic growth during a recession. The term was coined by American economist Milton Friedman in his 1969 article “The Optimum Quantity of Money.”
  • The concept behind helicopter money is that by increasing the disposable income of consumers, their spending will rise, leading to higher economic output. Helicopter money is considered a last-resort monetary policy instrument when conventional stimuli have failed to revive the economy.

Helicopter Money Compared to Quantitative Easing

  • Helicopter money is often confused with quantitative easing, but they have different effects on the central bank’s balance sheet. Quantitative easing involves the central bank creating reserves by purchasing government securities from commercial banks and other financial institutions.
  • In contrast, helicopter money involves distributing cash directly to the general public, which does not result in the addition of assets to the central bank’s balance sheet. Essentially, quantitative easing increases the money supply by acquiring government assets, while helicopter money increases the money supply by distributing cash to the general populace.
  • The main concerns with helicopter money include its irreversible nature, the risk of hyperinflation, and the potential depreciation of the domestic currency.

Monetary Policy Transmission

  • In the Indian context, the repo rate significantly influences short-term policy transmission. The repo rate serves as a benchmark for determining interest rates in the economy. The ability of a change in the repo rate to induce a corresponding change in bank interest rates is now contingent upon the financial health of the banking system.
  • Monetary policy plays a crucial role in reallocating funds within the financial system. For this to be effective, bank lending rates need to be responsive to the central bank’s policy rates, a process known as monetary transmission. However, in recent years, the system has exhibited a weak monetary transmission. Since 2015-16, the RBI has expressed concerns about the general lack of monetary transmission in the banking sector.
  • To address this issue, the RBI has implemented measures such as the introduction of the Marginal Cost of Funds based Lending Rate (MCLR) and external benchmarks for banks to determine their lending rates until April 2020.

Importance of Monetary Policy Transmission:

  • Multiple impacts: Monetary policy transmission affects economic growth, pricing, and other aspects of the economy.
  • Interest rate: Bank lending rates and bond yields increase when central banks raise the official interest rate.
  • Cost of borrowing: Changes in the official interest rate can affect the cost of borrowing for businesses and consumers.
  • Cash flow: The official interest rate changes influence the discount rates used to calculate the present value of cash flows, which are utilized to assess the value of securities.
  • Economic players: Changes in official interest rates significantly impact the expectations of economic players.
  • Economic agents: They would expect more lending due to lower borrowing costs, or increased asset values due to lower discount rates and forecasts of accelerated growth if official interest rates were reduced.
  • Exchange rates: Changes in the official interest rate affect exchange rates. When a country’s interest rates rise, investing in that country becomes more attractive, all else being equal.
Difficulties in Transmission of Monetary Policy
Unchangeable Funding Costs Most funds for banks in India come from fixed-rate customer deposits, leading to stable funding costs. Interest rates on small deposits remain high compared to bank rates, reducing bank deposits. Banks struggle to lend at reduced rates due to capital shortage.
Policy Rates are Not Market-Linked Repo rate, managed by the Monetary Policy Committee, is not market-determined. Banks must link lending rates to the repo rate, regardless of actual borrowing costs.
Large Proportion of Loans Not Tied to External Benchmarks Only 28.5% of outstanding loans are linked to external benchmarks, while the majority are not.
High Non-Performing Assets (NPAs) Accumulation of large NPAs has reduced bank profitability. Banks maintain higher lending rates to compensate for NPAs, impacting monetary policy transmission.
Four Balance Sheet Issues India faces a “four balance sheet issue,” hindering credit growth and monetary policy transmission.

RBI and Digital Currency

  • Cryptocurrency:
    • It is a digital or virtual currency that uses cryptography for security and operates independently of a central bank.
    • Cryptocurrencies are decentralized and run on a distributed ledger technology called blockchain.
    • Bitcoin, created by Satoshi Nakamoto in 2009, was the first cryptocurrency.
    • The Central African Republic (CAR) recently became the second country, after El Salvador, to recognize Bitcoin as legal tender.
    • India’s Union Budget 2022-2023 proposed the introduction of a digital currency.
  • Digital Rupee:
    • The Reserve Bank of India (RBI) plans to introduce a digital currency called the Digital Rupee in the upcoming fiscal year.
    • A central bank digital currency (CBDC) is a digital form of a country’s fiat currency.
    • The Digital Rupee will enable consumers to transfer money from their bank accounts into smartphone wallets as digital tokens, which will be a liability of the RBI, similar to cash.
    • Unlike banknotes, the Digital Rupee will not require ATMs for transactions.

Central Bank Digital Currency (CBDC)

  • Definition: A CBDC is a digital form of a country’s fiat currency, existing in a digital wallet supervised by the central bank. In India, the RBI will oversee the digital rupee, potentially delegating some authority to banks.
  • Replacement: The RBI’s digital rupee is not intended to immediately replace bank demand deposits. Physical currency will still be used by banks, and consumers can convert their bank deposits into the digital rupee.
  • Technology: The RBI must carefully evaluate the technology ecosystem to select the appropriate technology for implementing CBDCs. The financial data from digital currency transactions will be sensitive, requiring careful regulatory design and close collaboration between banking and data protection regulators.
  • Objectives: The primary goal is to reduce the risks and costs associated with handling physical cash, such as phasing out soiled notes and logistics. It also aims to discourage the use of cryptocurrency for money transmission.
  • Benefits:
    • Reduced Entry Barriers: No entrance barriers for traditional banking institutions. Transactions are immediate and global.
    • Universal Acceptance: Many cryptocurrencies are legal in different countries.
    • Low Transaction Cost: Minimal fees and levies.
    • Security: Use of pseudonyms and ledger systems for identity concealment. Cryptographic technology is nearly impossible to crack.
    • Absence of Banking System Interference: Users are responsible for all transactions, as there is no central authority like the government or central banks.
  • Concerns:
    • Security Threats: Wallet cyber-attacks, Cryptojacking, Routing Attacks, and DDoS attacks.
    • Price Turbulence: Common occurrences of price volatility.
    • Inadequate Consumer Protection: Lack of dispute resolution mechanisms.
    • Global Trends: Countries like The Bahamas, Nigeria, China, Korea, Sweden, Jamaica, and Ukraine have started using digital currencies or are in the process of launching them.
  • Way Forward:
    • Payment-Focused: Use should be focused on improving the payment and settlement system to address some of CBDC’s shortcomings.
    • Disintermediation: By focusing on payment rather than a store of value, risks of disintermediation and its monetary policy implications can be avoided.
    • Data Security: Comprehensive data security solutions are needed to prevent data breaches in a centralized structure.
    • Technology: Selecting the appropriate technology is critical for supporting the CBDC issue.
    • Infrastructure: Scaling the infrastructure for CBDC will be challenging if payment transactions use the same approach.
    • Ecosystem: A thorough examination of the technology ecosystem is necessary before introducing CBDCs.
    • Regulation: Careful consideration of the regulatory design is needed for the financial data acquired from digital currency transactions.
    • Collaboration: Close collaboration between banking and data protection regulators is required.

 

UPSC PREVIOUS YEAR QUESTIONS

 

1.  Consider the following statements: (2023)

1.  Statement-I: In the post-pandemic recent past, many Central Banks worldwide had carried out interest rate hikes.
2.  Statement-II: Central Banks generally assume that they have the ability to counteract the rising consumer prices via monetary policy means.

Which one of the following is correct in respect of the above statements?

(a) Both Statement-I and Statement-II are correct and Statement-II is the correct explanation for Statement-1
(b) Both Statement-I and Statement-II are correct and Statement-II is not the correct explanation for Statement-1
(c) Statement-I is correct but Statement-II is incorrect
(d) Statement-I is incorrect but Statement-II is correct

2.  Which one of the following activities of the Reserve Bank of India is considered to be part of ‘sterilization’? (2023)

(a) Conducting ‘Open Market Operations’
(b) Oversight of settlement and payment systems
(c) Debt and cash management for the Central and State Governments
(d) Regulating the functions of Non-banking Financial Institutions

3.  With reference to Central Bank digital currencies, consider the following statements (2023)

1.  It is possible to make payments in a digital currency without using US dollar or SWIFT system.
2.  A digital currency can be distributed with condition programmed into it such as a time-frame for spending it.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

4.  Consider the following statements: (2021)

1.  The Governor of the Reserve Bank of India (RBI) is appointed by the Central Government.
2.  Certain provisions in the Constitution of India give the Central Government the right to issue directions to the RBI in the public interest.
3.  The Governor of the RBI draws his power from the RBI Act.

Which of the above statements are correct?

(a) 1 and 2 only
(b) 2 and 3 only
(c) 1 and 3 only
(d) 1, 2 and 3

5.  In India, the central bank’s function as the ‘lender of last resort’ usually refers to which of the following? (2021)

1.  Lending to trade and industry bodies when they fail to borrow from other sources.
2.  Providing liquidity to the banks having a temporary crisis.
3.  Lending to governments to finance budgetary deficits.

Select the correct answer using the code given below.

(a) 1 and 2
(b) 2 only
(c) 2 and 3
(d) 3 only

6.  Which one of the phenomena essentially correctly describes the meaning of legal tender money? (2018)

1.  The money which is tendered in courts of law to defray the fee of legal cases
2.  The money which a creditor is under compulsion to accept in settlement of his claims
3.  The bank money in the form of cheques, drafts, bills of exchange etc.
4.  The metallic money in circulation in a country

7.  The Reserve Bank of India regulates the commercial banks in matters of ____________ (2013)

1.  Liquidity of assets
2.  Branch expansion
3.  Merger of banks
4.  Winding-up of banks

Select the correct answer using the codes given below:

(a) 1 and 4 only
(b) 2, 3 and 4 only
(c) 1, 2 and 3 only
(d) 1, 2, 3 and 4

8.  Consider the following liquid assets: (2013)

1.  Demand deposits with the banks
2.  Time deposits with the banks
3.  Savings deposits with the banks
4.  Currency

The correct sequence of these assets in the decreasing order of liquidity is-

(a) 1–4–3–2
(b) 4–3–2–1
(c) 2–3–1–4
(d) 4–1–3–2

9.  The Reserve Bank of India (RBI) acts as a bankers’ bank. This would imply which of the following? (2012)

1.  Other banks retain their deposits with the RBI.
2.  The RBI lends funds to commercial banks in times of need.
3.  The RBI advises commercial banks on monetary matters.

Select the correct answer using the codes given below:

(a) 2 and 3 only
(b) 1 and 2 only
(c) 1 and 3 only
(d) 1, 2 and 3

10.  If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do? (2020)

1.  Cut and optimise the Statutory Liquidity Ratio
2.  Increase the Marginal Standing Facility Rate
3.  Cut the Bank Rate and Repo Rate

Select the correct answer using the code given below:

(a) 1 and 2 only
(b) 2 only
(c) 1 and 3 only
(d) 1, 2 and 3

11.  Which one of the following is not the most likely measure the Government/RBI takes to stop the slide of the Indian rupee? (2019)

1.  Curbing imports of nonessential goods and promoting exports
2.  Encouraging Indian borrowers to issue rupee-denominated Masala Bonds
3.  Easing conditions relating to external commercial borrowing
4.  Following an expansionary monetary policy

12.  With reference to the Indian economy, demand-pull inflation can be caused/increased by which of the following? (2021)

1. Expansionary policies
2.  Fiscal stimulus
3.   Inflation-indexing wages
4.  Higher purchasing power
5.  Rising interest rates

Select the correct answer using the code given below.

(a) 1, 2 and 4 only
(b) 3, 4 and 5 only
(c) 1, 2, 3 and 5 only
(d) 1, 2, 3, 4 and 5

13.  In the context of the Indian economy, ‘Open Market Operations’ refers to ______ (2013)

1.  Borrowing by scheduled banks from the RBI
2.  Lending by commercial banks to industry and trade
3.  Purchase and sale of government securities by the RBI
4.  None of the above

14.  Which of the following statements is/are correct regarding the ‘Monetary Policy Committee (MPC)? (2017)

1.  It decides the RBI’s benchmark interest rates.
2.  It is a 12-member body including the Governor of RBI and is reconstituted every year.
3.  It functions under the chairmanship of the Union Finance Minister.

Select the correct answer using the code given below:

(a) 1 only
(b) 1 and 2 only
(c) 3 only
(d) 2 and 3 only

15.  With reference to the Indian economy, consider the following: (2015)

1.  Bank rate
2.  Open market operations
3.  Public debt
4.  Public Revenue

Which of the above is/are component/components of Monetary Policy?

(a) 1 only
(b) 2, 3 and 4
(c) 1 and 2
(d) 1, 3 and 4

16.  With reference to ‘Bitcoins’, sometimes seen in the news, which of the following statements is/are correct? (2016)

1.  Bitcoins are tracked by the Central Banks of the countries.
2.  Anyone with a Bitcoin address can send and receive Bitcoins from anyone else with a Bitcoin address.
3.  Online payments can be sent without either side knowing the identity of the other.

Select the correct answer using the code given below.

(a) 1 and 2 only
(b) 2 and 3 only
(c) 3 only
(d) 1, 2 and 3