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Monetary Policy
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. |
