Monetary Policy Framework in India

Abstract

In 2016, the monetary policy framework moved towards flexible inflation targeting and a six-member Monetary Policy Committee (MPC) was constituted for setting the policy rate. With this step towards modernization of the monetary policy process, India joined the set of countries that have adopted inflation targeting as their monetary policy framework. The Consumer Price Index (CPI combined) inflation target was set by the Government of India at 4% with ± 2% tolerance band for the period from August 5, 2016, to March 31, 2021. In this backdrop, the paper reviews the evolution of monetary policy frameworks in India since the mid-1980s. It also describes the monetary policy transmission process and its limitations in terms of lags and rigidities. It highlights the importance of unconventional monetary policy measures in supplementing conventional tools, especially during the easing cycle. Further, it examines the voting pattern of the MPC in India and compares this with that of various developed and emerging economies. The synchronization of cuts in the policy rate by MPCs of various countries during the global slowdown in 2019 and the COVID-19 pandemic in the early 2020s is also analysed.

Reprinted from Indian Economic Review, Vol. 55, 117–154.

Appendices

Annexure 1

Glossary—Figs. 2 and 5.

Repo rate is the (fixed) interest rate at which the RBI provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF)

Reverse repo rate is the (fixed) interest rate at which the RBI absorbs liquidity, on an overnight basis, from banks against the collateral of eligible government securities under the LAF

Liquidity Adjustment Facility (LAF) enables the RBI to modulate short-term liquidity under varied financial market conditions in order to ensure stable conditions in the overnight (call) money market. The LAF operates through daily repo and reverse repo auctions, thereby setting a corridor for the short-term interest rate consistent with policy objectives

Corridor is determined by the MSF rate as ceiling and reverse repo rate as the floor of the corridor for the daily movement in the weighted average call money rate

Marginal Standing Facility (MSF) is the facility under which scheduled commercial banks can borrow additional amount of overnight money from the RBI at a penal rate against eligible securities. Banks are allowed to dip into their Statutory Liquidity Ratio (SLR) portfolio to borrow funds under this facility up to a limit decided by the RBI. This provides a safety valve against unanticipated liquidity shocks to the banking system

Bank rate is the standard rate at which the RBI is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under the Reserve Bank of India Act, 1934

Cash Reserve Ratio (CRR) is the minimum cash balance that a scheduled commercial bank is required to maintain with the RBI as a certain percentage of its net demand and time liabilities (NDTL) relating to the second preceding fortnight. It is prescribed by RBI from time to time

Statutory Liquidity Ratio (SLR) is the share of NDTL that the scheduled commercial banks are required to maintain on a daily basis in safe and liquid assets, such as unencumbered government securities and other approved securities, cash and gold

Open market operations (OMOs) are conducted by the RBI by way of sale/purchase of Government securities to/from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis

Market Stabilization Scheme (MSS) was introduced as an instrument for monetary management in April 2004. Surplus liquidity of a more enduring nature arising from large capital inflows is absorbed through sale of short-dated government securities and treasury bills. The cash so mobilized is held in a separate government account with the RBI

Monetary Base (Reserve Money/M0) = Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI

M1  = Currency with the public + Demand deposits with the banking system + ‘Other’ deposits with the RBI

M2  = M1 + Saving deposits of post office saving banks

M3  = M1 + Time deposits with the banking system

Call money rate is the rate at which overnight money are lent and borrowed in the money market

Weighted average call money rate (WACR) is volume weighted average of rates at which overnight money or money at short notice (up to a period of 14 days) are lent and borrowed in the money market. This weighted average rate can be computed for any period such as, daily, weekly, yearly

Refinance facility under Monetary Targeting Framework was provided by RBI as an additional source of reserves. The two types of refinance facility provided to banks include export credit refinance (extended against bank’s outstanding export credit eligible for refinance) and general refinance (provided to banks to tide over their temporary liquidity shortages)

1. Source Handbook on RBI’s Weekly Statistical Supplement; Reserve Bank of India Website

Annexure 2

Glossary—Fig. 8.

Marginal Cost of Funds based Lending Rate (MCLR): An internal benchmark rate for determining the interest rate on all floating rate rupee loans.2 It was introduced on April 1, 2016, after replacing the base rate system. MCLR comprises of marginal costs of funds (92% share of Marginal Cost of Deposits and Other Borrowings + 8% share of return on net worth)3 + negative carry-on account of CRR + operating costs + tenor premium

Weighted Average Lending Rate (WALR): The weighted average of the lending rates of all SCBs (excluding RRBs, payment banks and small finance banks) on the outstanding rupee loans and fresh rupee loans sanctioned by the banks. It is based on lending rates to different sectors with weights based on credit extended to different sectors

Money Market: Market for lending and borrowing of short-term funds which are highly liquid. It covers money and financial assets that are close substitutes for money including call money, repo, Tri-party repo, T-bills, Cash Management Bills, Commercial Paper and Certificate of Deposit

Call Money Market Instrument: Overnight money and money at short notice (up to a period of 14 days) is lent and borrowed without collateral. Call money is liquid and can be turned into money quickly at low cost and provides an avenue for equilibrating the short-term surplus funds of lenders and the requirements of borrowers Borrowers: Scheduled Commercial Banks (excluding RRBs), Co-operative Banks (other than Land Development Banks), and Primary Dealers (PDs) Lenders: Same as borrowers

Market Repo: Instruments: Repurchase agreement (Repo) which is used for borrowing funds by selling securities with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed. Government securities, CPs, CDs, Units of Debt ETFs, listed corporate bonds and debentures are eligible securities for repo. Repo against corporate bonds is called repo in corporate bond Participants: Banks, PDs, mutual funds, listed corporates, All India Financial Institutions, any other entity approved by the RBI

Tri-Party Repo Market Instrument: Tri-party repo, a repo contract where a third entity (apart from the borrower and lender), called a Tri-Party Agent, acts as an intermediary between the two parties to the repo to facilitate services like collateral selection, payment and settlement, custody and management during the life of the transaction Participants: Scheduled commercial banks, recognized stock exchanges and clearing corporations of stock exchanges or clearing corporations authorized under PSS Act and any other entity regulated by RBI or SEBI are eligible subject to certain criterion. All the repo market eligible entities are permitted to participate in Tri-party repo market

Treasury Bills Market Instrument: Short-term debt instruments issued by the GOI and sold by RBI on an auction basis. Treasury bills are zero coupon securities that pay no interest, issued at a discount and redeemed at the face value at maturity. They are currently issued in three tenors, namely 91, 182 and 364 day. They are also traded in the secondary market Investors: Any person resident of India, including firms, companies, corporate bodies, institutions and Trusts along with Non-Resident Indians and Foreign Investors (subject to approval by Government) can invest through a competitive route

Certificate of Deposits Market Instrument: A negotiable money market instrument issued in dematerialized form or as a usance promissory note against funds deposited at a bank or other eligible financial institution for a specified time period. Maturity ranges from 7 days to three years. CDs can be traded in the secondary market Issuers: Banks and Financial Institutions Investors: Individuals, corporations, companies (including banks and PDs), trusts, funds, associations and non-resident Indians (but only on non-repatriable basis)

Commercial Paper Market Instrument: An unsecured money market instrument issued in the form of a promissory note. They are issued for the maturities between a minimum of 7 days and a maximum of up to one year from the date of issue (given that the credit rating of the issuer is valid in the period). CPs can be traded in the secondary market Issuers: Corporates, PDs and All India Financial Institutions (FIs) Investors: Individuals, banks, other corporate bodies (registered and incorporated in India), non-resident Indians,

Bond Market Instrument: A debt instrument whereby an investor loans money to an entity (typically corporate or government) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities Issuers: Government or Corporates Investors: Banks, Mutual Funds, Foreign Institutional Investors, Provident Funds, Pension Funds

Government Securities Market Instrument: A tradeable instrument issued by the Central or the State Governments. It acknowledges the Government’s debt obligation. Securities issued by State Governments in India are known as State Development Loan (SDL). The short-term G-Secs (Treasury Bills) have original maturities of less than one year while long-term G-Secs (Government Bonds or dated securities) have original maturity of one year or more. There is an active secondary market in G-Secs Participants: Commercial banks, PDs, institutional investors like insurance companies, other banks including cooperative banks, regional rural banks, mutual funds, provident and pension funds, foreign portfolio investors (allowed with quantitative limits prescribed from time to time) and corporates

Corporate Bond Market Instrument: Debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. The stock exchanges have a dedicated debt segment in their trading platforms to facilitate the needs of retail investors. A corporate bond is generally priced on the basis of price of G-sec of comparable tenure with a spread added to it. They are also traded in secondary market Participants: Corporates, banks, retail investors and institutional investors including insurance companies and mutual funds, foreign investors

1. Source Handbook on RBI’s Weekly Statistical Supplement; Reserve Bank of India Website

Annexure 3: Constitution of the Monetary Policy Committee

The Gazette Notification of the Ministry of Finance dated September 29, 2016, notes the following: “In exercise of the powers conferred by section 45ZB of the Reserve Bank of India Act, 1934 (2 of 1934), the Central Government hereby constitutes the Monetary Policy Committee of the Reserve Bank of India, consisting of the following, namely: i. The Governor of the Bank—Chairperson, ex officio; ii. Deputy Governor of the Bank, in charge of Monetary Policy—Member, ex officio; iii. One officer of the Bank to be nominated by the Central Board—Member, ex officio; iv. Shri Chetan Ghate, Professor, Indian Statistical Institute (ISI)—Member; v. Professor Pami Dua, Director, Delhi School of Economics (DSE)—Member; and vi. Dr. Ravindra H. Dholakia, Professor, Indian Institute of Management, Ahmedabad, Member.”

The three external members have served on the Committee since its inception and continue to serve. There have been some changes in the RBI members as follows: • Former Governor, Dr. Urjit Patel chaired the Committee from October 2016 to December 2018. Governor, Shri Shaktikanta Das presided from the February 2019 meeting onwards • Shri R. Gandhi, Former Deputy Governor, attended the October and December meetings in 2016 • Dr. Viral Acharya, Former Deputy Governor in charge of Monetary Policy attended the meetings from February 2017 to June 2019 • Shri Bibhu Prasad Kanungo, Deputy Governor, attended the meetings from August to December 2019 • Dr. Michael Patra attended all the meetings, first as Executive Director till December 2019 and continues to attend meetings as Deputy Governor in charge of Monetary Policy • Dr. Janak Raj has attended meetings since February 2020 as Executive Director