Re: Monetary policy of India -
January 23rd, 2010
Introduction
In mid 90s the thrust of monetary policy was to reduce the annual inflation rate and provide credit support for production. Money supply (M3) was reduced considerably, mainly because of a slow growth in bank deposits and a decline in the growth of reserve money.
Slow growth
Another major factor in controlling this growth was the lower level of foreign exchange inflows. Slower monetary growth was accompanied by lower bank credit to the commercial sector. These trends were compounded by a decline in other sources of finance to industry, such as primary issues in the domestic stock market and GDR issues in Euro markets.
Other reasons
Funds raised from capital markets declined and the amount raised through Euro issue loans also fell down nearly 70 percent over the same period. Continued high levels of government borrowing associated with a large and over-budget fiscal deficit kept money markets tight throughout the period. This in turn put increasing pressure on interest rates.
Monetary Growth
Despite falling inflation, real rates faced by industry remained high, and the prime lending rate of most of the banks was 16.5 percent. Based on an inflation rate of 6 percent and projected GDP growth of 6.6 percent for 1996-97, monetary growth had been targeted at 15.5-16 percent for 1996-97.
RBI measures
The RBI reduced banks' cash reserve requirements by one percentage point, freed bank deposit interest rates of over one year term and shortened the minimum term for deposits from 46 days to 30 days. It also withdrew a refinancing facility for banks' investments in government securities. These steps were to add the equivalent of USD 1.2 billion to the banking sector. Short-term call money market rates of interest and forward premiums on the dollar have dropped sharply.
Response
While financial and industry sources have welcomed the liquidity-easing measures, they remain worried at the rigidity of high lending rates of interest and suspect that the Government will soon absorb this new bank liquidity by increasing Government borrowing from the market.
Growth of M3
Growth in broad money (M3) in 1997-98 registered an increase, higher than the RBI's growth target. The increase was due to a substantial expansion of domestic credit to the government and the business sector, and an increase in net foreign exchange assets. Bank credit to business increased, net RBI credit to the government increased and strong foreign exchange inflows during the first half of 1997-98 coupled with sluggish credit creation ensured that the money market was awash with liquidity. Banks investment in government securities increased by 17.7 percent in 1997-98, and non-food credit to business increased by 14.2 percent.
Credit policy
The credit policy for April-October 1998, aimed to accelerate industrial investment and output, keep inflation under control, continue financial sector reforms, reduce interest rates and improve credit availability to meet business requirements. Key reference rates were reduced by one percentage point each, sending a strong signal that commercial banks should lower interest rates for commercial borrowers. Banks responded by reducing prime lending rates to 13 percent. The Cash Reserve Ratio requirement was left unchanged at 10 percent.
Under the new credit policy, FIIs were allowed to invest up to 30 percent of their assets in treasury bills, and banks were given freedom to fix penalties on premature withdrawal of deposits. In January 1998, the rupee hit a low of Rs 40.45/ dollar, due in large part to concerns about the Asian currency crisis.
RBI measures
The RBI adopted a number of measures that stopped the rupee's slide and actually led to some appreciation. These measures included an increase in banks' cash reserve ratio and an increase in the RBI's bank rate. Once the rupee had stabilized, the RBI announced a two-phase rollback of the bank rate to 10 percent, and of the CRR to 10 percent. In both cases, the first phase was to be effective from late March and the second in early April. The interest rate on short-term domestic deposits was also deregulated and banks were allowed to set different prime lending rates. | 
Re: Monetary policy of India -
January 31st, 2010
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