Prologue

• Next article is about RBI appointed Urjit Patel Committee on Monetary policy
framework.
• But before dwelling into that, we must recap the basic concepts of what is monetary
policy: its tools and limitations. Otherwise Urjit won’t make much sense.
• Hence in a way, this whole article is a prologue to next article.

Why RBI and Why Monetary policy?

Initially people used barter system for trading. But the barter system had many problems (click
me). Therefore, people switched to money system.

• Financial intermediates = middlemen who help in the circular flow of money between
households and business firms.
• There are two types of financial intermediaries: banking institution and non-banking
financial institutions.
• RBI controls (all) banks and (some) non-banking financial institutions.
• RBI’s main job is to control Money supply in this game, and thereby fight inflation and
deflation.
• Inflation = price rise = bad for economy, you know that by common sense.

But Deflation = price decrease = we can buy things at a lower price. Isn’t that good? Why is
deflation bad for economy?

• Ans. Every business has ‘fixed cost of production’ say minimum light bill, phone bill,
office rent, staff salary etc. So, if prices keep falling and falling (say of Nano car), then
car marker will suffer losses. He has no motivation to expand business. He wants to cut
down his production costs, by firing some of the employees= less new jobs created=
unemployment = social unrest.
• If prices of everything fall- then custom duty, VAT, excise duty, service tax- their
collection will also decrease. Then government has less money to spend on education,
healthcare, social sector, defense, law and order = poverty, disease, crime.

by the way

TERM meaning Does RBI want it?

DEFLATION fall in the prices (and fall IN employment.) No.
yes (while fighting
DISINFLATION Fall in the prices but without causing unemployment.
inflation)
stagnation + inflation
STAGFLATION No
• prices and wages rise
• but people can’t find jobs, companies can’t find
 customers.

policy to stop the fall in price levels, but without causing

REFLATION yes
rise in the price levels (inflation).

What is monetary policy?

• Policy made by the central bank.
• To control money supply in the economy. (and thereby fight both inflation and deflation).

RBI implements monetary policy using certain tools. Two types

quantitative tool qualitative tools

Let’s start from here.

Quantitative Tools
#1: Reserve Ratios (SLR and CRR)

SLR A Bank has to set aside this much money into gold or RBI approved securities. 23%
A Bank has to set aside this much as reserve. Bank cannot lend it to anyone. Bank
CRR 4%
earns no interest rate or profit on this.

Reserve ratio: SLR, CRR

• Suppose economy is showing inflationary trend. Prices of all goods and services are
increasing day by day.
• How can RBI stop it using Reserve ratio as a tool?
• In this case, RBI should RAISE the reserve ratios.

Observe:

Right now
People deposited total this much money in SBI (net demand & TIME
100 cr.
liabilities NDTL)
CRR (4%) [SBI has to keep this much cash aside for reserve] -4 cr
SLR (23%) [SBI has to invest this much money in RBI approved securities] -23 cr.
100-4-23=73
Money left with SBI
Cores.

Say RBI raises SRL to 40% and CRR to 15% then?

Originally 100 cr
SLR 40 -40
CRR 15 -15
Money left with SBI 45 cr.

You can see, when Rajan has raised reserve ratio, money with SBI is reduced (from 73 crores to
just 45 crores.)

What will be its implication?

• Imagine you’re a money lender. You’ve 100 crore rupees and you must make Rs.1 crore
profit in a year.
• Obviously, you should lend it @1% interest rate. (because 1% of 100 crore = 1 crore.)
• But what if you’ve only 2 crore rupees, and you still want to make Rs.1 croer profit in a
year?
• Now you must lend it @50% interest rate. (because 50% of 2 cores = 1 crore.)
• Observe that as money decreased (from 100 to 2), loan interest rate increased (from 1%
to 50%).

Same happens when SBI is left with less money (after RBI increases reserve ratio).

Let’s prepare a flow chart.

Situation: Economy has inflationary trend. Prices of goods and services increasing every day.

Solution: RBI raised reserve ratio (CRR, SLR)

Result: SBI is left with less money to lend.

Consequences:

1. SBI raises its loan interest rate

2. Businessmen borrow less money from SBI
3. Businessmen donot start new business. Donot expand existing business
4. Result=Less jobs. Even existing employees discharged. If anyone remains in the job, he
doesn’t get pay raise. He starts cutting down unnecessary expenditure (e.g. buying two
newspapers, getting his shirts ironed, drinking tea @4PM in office and so on. Thus even
paper-wall, dhobi, chai-walla- everyone’s income reduced.)
5. Result= Less income (Because of above reasons)
6. Result= Less demand of goods and services (because less income).
7. Ultimately shopkeeper will bring down the prices to attract people into buying more
things.

Thus inflation is reduced.

You may doubt- what about supply side bottlenecks, what about cost push and demand pull
inflation : I’m not going into all that details at the moment, else this article will become longer
than five kilometers.

Let’s just prepare a summary table:

Policy dear money cheap money

Tool To fight inflation To fight deflation
Reserve Ratio (CRR, SLR) Increase them. Decrease them.

Moving to the next (Quantitative) tool. Under monetary policy

#2: Open Market Operation (OMO)

• Open Market Operation= when RBI starts buying/selling government securities to control
money supply.
• Government securities= piece of paper. It says something like this “give me Rs.100, I’ll
give you 8% interest rate for next ten years and after that I’ll repay the principle of
Rs.100.” This is how government borrows from others.
• Situation: Economy has inflationary trend. Prices of goods and services increasing every
day.
• Solution: RBI starts selling government securities in open market.
• Result: SBI buys them and thus SBI’s lending money is reduced. Wait. How?

Imagine Rajan is selling “sabzi” (vegetables). If SBI’s chairman Arundhati Madam goes to buy
vegetables. Obviously madam’s money will decrease when she buys vegetables.

Then same as usual:

1. SBI left with less money to lend.

2. SBI raises its loan interest rate (to keep profit margin same)
3. Businessmen borrow less money from SBI.
4. Businessmen donot start new business. Donot expand existing business
5. Less jobs
6. Less income
7. Less demand
8. Ultimately shopkeeper will bring down the prices to attract people into buying more
things.

Thus inflation is reduced.

During deflation, RBI will do the reverse. (i.e. RBI buys “Sabzi” from SBI). How will it stop
deflation? Think in your head.

Let’s update our table

 Policy dear money cheap money
Tool To fight inflation To fight deflation
Reserve Ratio (CRR, SLR) Increase them. Decrease them.
Open Market Operation (OMO) RBI sell securities RBI buy securities

#3: Policy Rate

“Policy rate”= in case of India its Repo rate. Before moving further, let’s refresh our concepts of
Bank rate, LAF, MSF, Repo and Reverse repo.

Bank Rate

• When banks borrow long term funds from RBI. They’ve to pay this much interest rate to
RBI. [Note: different books give different explanation of Bank Rate. I’ve used NDTV’s
definition]
• At present, Bank rate= 9%
• Collateral: nothing. (Bank can borrow money without pledging government securities to
RBI)
• Bank rate is not the main tool to control money supply these days.
• Nowadays, RBI uses LAF Repo rate as the main tool, to control money supply.

Ok then What’s the use of Bank rate?

• Penal rates are linked with Bank rate. For example, If a bank doesn’t maintain CRR, SLR
as per the prescribed limit.
• Then RBI can impose penalty interest on such notorious bank.
• At present, Penalty rate = Bank rate + 3% (or 5% in some cases)
• Meaning if Bank rate = 9% then penalty rate=9+3=12%

Anyways, what if RBI wants to fight inflation using bank rate as a “tool”?

Obviously they should increase bank rate. That way it becomes harder (more expensive) for
banks to borrow from RBI.=> SBI increases its loan rates (to keep the profit margin same).
Result?

• Less people get home loan, bike loan, business loans.

• Less business expansion
• Less jobs
• Less incomes
• Less demand
• Ultimately shopkeeper will bring down the prices to attract people into buying more
things.

Thus inflation is reduced.

Let’s update our (stupid) table

Policy dear money cheap money

Tool To fight inflation To fight deflation
Reserve Ratio (CRR, SLR) Increase them. Decrease them.
Open Market Operation (OMO) RBI sell securities RBI buy securities
Bank rate Increase decrease

Liquidity Adjustment facility (LAF)

• Liquidity Adjustment facility
• RBI started this in 2000. You can imagine it as a “Adda/gambling den/gang-hideout”
where RBI’s clients gather, consumer desi liquor, play cards, watch item songs and
borrow money from RBI (or lend Money to RBI).
• By the way, who are the clients of RBI?= Central and state governments, Banks and non-
banking financial institutions (NBFI). NBFI further includes:
o AIFI (all India finance institutions) NABARD, SIDBI, EXIM Bank and National
Housing Bank.
o Primary dealers (Morgan Stanley , Goldman Sachs, JP Morgan Chase, Standard
Chartered Bank, HSBC etc.)
o Non-Banking financial companies.
• Anyways, Under this LAF “adda”, RBI has two tools:

If client borrows money from RBI (for short term) then client has to pay this much
Repo
interest rate to RBI. At present Repo is 8%. (article written on 29th Jan 2014)
If client lends money to RBI (for short term) then RBI has to pay this much interest
Reverse
rate to client. RBI doesn’t like headache. So they made a simple formula: Reverse
Repo
repo rate= Repo MINUS 1%=8-1=7%.

Collateral:

• Problem with running a “adda/gambling-den” = sometimes client drinks too much desi
liquor and passes out on floor. Sometimes he even dies because of ‘hooch’. Sometimes
police raids the den, and clients run away with cash and register.
• If such things happen, Rajan will be at loss. So, he demands “government securities” as
collataral. So even if client doesn’t repay money on time, Rajan can sell those securities
(in open market operations) and recover money.

LAF Repo Rate

Let’s get a bit technically correct now. Observe following image
Scenario

• SBI chairman Arundhati ma’m wants to borrow Rs.100 crore (for short term).
• She gives her stash of government securities to Rajan.
• Rajan gives her Rs.100 crore.
• Madam Also signs an agreement
• “I, Arundhati Bhattacharya, agree to buy same securities from Rajan, at 108 crores after
14 days.”
• Notice that she has agreed to “re-purchase” same securities from Rajan. Therefore its
called “Repo.”
• And how much interest rate did she pay on this “loan”? [108-100]/100=8%. That’s our
repo rate.
• Important:
• Recall that SBI also has to keep part of her money in RBI approved securities (under
SLR).
• So Madam cannot USE those government securities to borrow under Repo Rate from
Rajan.

That leads to a new topic

Marginal Standing facility (MSF)
MSF mechanism is same as repo. But some differences
LAF (Repo) MSF
Rajan says “don’t come here unless
you want to borrow minimum Rs.5 Minimum Rs. 1 crore.
crores.”
All clients are welcome i.e.
• Sorry. Not all clients welcome here.
• Central and state governments
• Only scheduled commercial banks can borrow
• Banks – be it commercial
under this window. SBI, PNB, BoB, ICICI etc.
bank or RRB or cooperative
• This MSF facility is specially created to help them
bank
solve short-term cash mis-match.
• Non-banking financial
institutions.

You (bankers) cannot pledge

securities from SLR quota to borrow Can use securities from SLR quota.
from this window.
No limit. You may borrow as much Maximum 0.75% of NTDL. To put this in crude words, if
as you want. (as long as you have SBI received 100 crores from aam-admi under savings
government securities to pledge to account, current account, fixed deposit etc. then SBI can
me.) borrow only upto Rs.75 lakhs from RBI.
Rajan decides Repo rate (8% right MSF = Repo Rate +1% = 8+1=9%. (earlier this margin of
now) 1% used to be higher. But nowadays just 1%!)

for those who still have doubt about Repo vs MSF:

for repo borrowing, bank will need to pledge securities to Rajan. But bank cannot use SLR-
reserved securities for this.
so, imagine if a bank is in dire need of cash, but doesn’t have spare government securities- then
they can borrow using MSF by pledging those SLR securities. (and under MSF window, Rajan
will demand 1% higher than Repo as one type of ‘punishment’ for pledging SLR securities.)

Reverse repo Rate

• Although self-explanatory. But let’s check
• Repo = clients borrow from Rajan and pay this much interest rate. (short term loan)
• Reverse repo= when Rajan himself borrows from clients, then he has to pay this much
interest rate to clients.
• Collateral = yes. What if police raids this gambling-den, and Rajan runs away to Nepal?
Clients can sell Rajan’s Government securities and recover their money.
• Reverse repo = Repo MINUS 1% = 8-1% =7%.
• Note: in official parlance, they call percentages in “basis points” so 1%=100 basis points.
So in that ‘official language’, Reverse repo = Repo MINUS 100 basis points.
Enough cheap jokes. What have we learned so far?

• That Rajan controls money supply using monetary policy.

• Under Monetary policy, Rajan has various “weapons” (or tools)
1. Reserve ratios (SLR, CRR)
2. OMO: Open market operation
3. Rates: Bank rate, LAF (Repo, Reverse repo), MSF.

We already know how to apply SLR, CRR and OMO to fight inflation (and deflation.) let me
paste the table again.

Policy dear money cheap money

Tool To fight inflation To fight deflation
Reserve Ratio
Increase them. Decrease them.
(CRR, SLR)
Open Market
RBI sell securities RBI buy securities
Operation (OMO)
Bank Rate increase it decrease it
Repo rate increase it decrease it
it’s value is linked with Repo, hence cannot be increased/decreased
Reverse Repo
independently.
Marginal Standing it’s value is linked with Repo, hence cannot be increased/decreased
Facility independently. Besides MSF= temporary firefighting, cash mismanagement.

• We learned that Rajan doesn’t use Bank rate much, to control money supply.
• We learned that Rajan doesn’t decide Reverse repo and MSF. (they’re automatically -1%
and +1% of Repo rate).
• Thus the only thing Rajan has to decide under monetary policy= Repo rate. Therefore,
Repo rate is called the “policy rate”

Let’s revisit out flow chart:

• Situation: Economy has inflationary trend. Prices of goods and services increasing every
day.
• Solution: Rajan increases “Repo rate”. (say from 7.75% to 8%).
• Result: it becomes expensive for SBI to borrow from Rajan. They’ll increase their own
rates as well.
• Wait. How?

Just like how things roll in Onion biz.

If prices of Onion rise in Maharashtra’s wholesale yard (in Lasangaon), then immediately, retail
veggie @Ahmedabad will also raise their onion prices to keep the profit margin same.

What’ll be the consequences (if repo rate is hiked / increased)?

Consequences:

1. SBI raises its loan interest rate (to keep profit margin same)
2. Businessmen borrow less money from SBI.
3. Businessmen donot start new business. Donot expand existing business.
4. Less jobs
5. Less income
6. Less demand
7. Ultimately shopkeeper will bring down the prices to attract people into buying more
things.

Thus inflation is reduced.

Policy dear money cheap money

Tool To fight inflation To fight deflation
Reserve Ratio (CRR, SLR) Increase them. Decrease them.
Open Market Operation (OMO) RBI sell securities RBI buy securities
Policy Rate (Repo Rate) Increase it Decrease it

Repo Rate in recent years:

Let’s observe with a graph: how RBI fought inflation/deflation in recent times using Repo rate as
the “main-weapon” of monetary policy.
From above above graph, you can see RBI has frequently changed its repo rate to combat both
inflationary and deflationary trend. But You’d agree that inflation has not been contained. No
matter what number juggling or statistical interpretations are given- the hardship of common
man has not stopped- be it milk, petrol, onion, LPG anything.

• Agreed that prices of onion, sugar, pulses and food are subject to vagaries of monsoon
and black marketeering. Rajan cannot do anything about it.
• Agreed that crude oil prices are subject to rupee-Dollar exchange rate, external factors
and government’s de-regulation of their prices. Rajan doesn’t have much control over
this.

But still even in the non-food, non-fuel type commodities- RBI’s monetary policies have failed
to curb inflation. WHY? Observe the following image.
Suppose Vijay Mallay got 100 crore loan from State Bank of India. If you trace the ‘source’ of
that money, it’ll turnout 60-70 crores came from bank’s savings account, fixed deposit etc. Rajan
lends money in repo rate –yes, but that doesn’t mean banks depend only on Rajan to arrange the
cash for its clients.

Suppose Rajan reduces repo rate from 8% to 5%. Banks are not legally required to reduce their
loan interest rates.

• The current system is following:

• Banks are free to decide their base rate. E.g. SBI’s base rate is 10%.
• It means SBI won’t loan money to anyone at an interest rate lower than 10% (except
those farmers under Interest subvention scheme.)
• SBI will link all of its loan products with Base rate. For example

SBI Base rate =10% Calculation Result

Car loan 0.75% above Base rate 10.75%
Two wheeler loan 8.25% above base rate 18.25%
Education loan (upto 4 lakh) 3.5% above base rate 13.5%
Home loan for women (upto 75 lakh) 0.10% above base rate 10.10%

Meaning if SBI changes her Base rate then all of above loan interest rates will change
automatically.

If Rajan changes his repo rate, will SBI change her base rate?

Not always.

• Because those common men are the main suppliers of money to SBI.
• RBI is not the main supplier of money to SBI.
• SBI will only change its base rate, when she feels necessary for its own profit / loss
compared to its competitors.

Does it mean Repo rate system is bogus and ineffective?

Not always.

• In developing countries like India, most people park their money in only four things:
savings account, fixed deposit (FD), provident fund and LIC. We’ve mutual funds, we’ve
NPS, we’ve ULIPs, we’ve Rajiv Gandhi equity savings scheme –
• but most people (particularly the older generation) feels insecure in into such new things.
Therefore lot of money flows into Savings accounts and fixed deposits= SBI’s main
source of money.
• But, In advanced economies, like USA, people don’t invest large portion their income in
savings account or FD. They’ve variety of investment options. So, for those American
banks, their own Central bank (US Feds) is a significant money supplier.
• Hence US Feds’ monetary policy shows faster impact on their American Banks, THAN
Rajan’s monetary policy on Desi banks.