EXECUTIVE SUMMARY

Established in 1985, the Kotak Mahindra group has been one of India's most
reputed financial conglomerates. In February 2003, Kotak Mahindra Finance Ltd,
the group's flagship company was given the license to carry on banking business
by the Reserve Bank of India (RBI) Kotak Mahindra Bank Limited (the Bank) is a
commercial bank. The Bank operates in four business segments: Treasury and
Balance Sheet Management Unit (BMU), which includes dealing in money
market, forex market, derivatives, investments and primary dealership of
government securities; Retail Banking, which includes lending, commercial
vehicle finance, personal loans, agriculture finance, other loans and home loans,
branch banking, which includes retail borrowings covering savings, current, term
deposit accounts and branch banking network/services including distribution of
financial products, and credit cards; Corporate Banking, which comprises
wholesale borrowings and lendings and other related services to the corporate
sector. As of March 31, 2010, it had a network of 249 branches.
The Reserve Bank, established through the Reserve Bank of India Act, 1934
commenced its operations in 1935. It draws its powers and responsibilities
through other legislations also such as the Banking Regulation Act, 1949. The
RBI has over the years been responding to changing economic Circumstances.
The Reserve Bank of India is the main monetary authority of the country and
beside that the central bank acts as the bank of the national and state
governments. It formulates, implements and monitors the monetary policy as well
as it has to ensure an adequate flow of credit to productive sectors. Objectives
are maintaining price stability and ensuring adequate flow of credit to productive
sectors. The institution is also the regulator and supervisor of the financial system
and prescribes broad parameters of banking operations within which the
country's banking and financial system functions.
The objective of the project is to understand the money supply in the economy
and how RBI controls it RBI’s management of interest rates and liquidity through
various tools and its impact, also how RBI combats with inflation and recession
The changes made by RBI in various policy measures affecting liquidity have
been discussed.

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 CHAPTER 1

COMPANY PROFILE – KOTAK MAHINDRA

Kotak Mahindra Group was established in 1985 as Kotak Capital Management

Finance. The name was changed into Mahindra Finance. It was engaged in bill
discounting activities. Later it entered into lease and hire purchase market, auto
finance, investment banking and other banking activities.

Kotak Mahindra Bank is part of the Kotak Mahindra Group with a net worth of
over Rs. 5,997 crore.

It employs over 20,000 people in India and aboard. Today the group provides
services to around 5 million customers .

Presently it is engaged in commercial banking, stock broking, mutual funds, life

insurance and investment banking. It caters to the financial needs of individuals
and corporates.

Kotak Bank has an international presence through its subsidiaries with offices in
London, New York, Dubai, Mauritius, San Francisco and Singapore that
specialize in providing services to overseas investors seeking to invest into India.

2
 ESTABLISHMENT

The company was incorporated on 21st November, 1985 under the

name Kotak Capital Management Finance Ltd. The Company has been
Promoted by Mr. Uday S Kotak, Mr. S.A.A Pinto and Kotak & Company. The
Company obtained the certificate of commencement of business on 11th
February, 1986 and the Existing promoters were joined by Mr. Harish Mahindra
and Mr. Anand Mahindra. The Company's name was changed on 8th April, 1986
to its present name Kotak Mahindra Finance Ltd.

Fig 1.1
Journey of Kotak Mahindra

3
Table 1.1

Year Milestone

1986 Mahindra Finance Limited starts the activity of Bill Discounting

1987 Mahindra Finance Limited enters the Lease and Hire Purchase market

1990 The Auto Finance division is started

The Investment Banking Division is started. Takes over FICOM, one of

1991
India's largest financial retail marketing networks

1992 Enters the Funds Syndication sector

Brokerage and Distribution businesses incorporated into a separate

1995 company - Securities. Investment Banking division incorporated into a
separate company - Mahindra Capital Company

The Auto Finance Business is hived off into a separate company -

Mahindra Prime Limited (formerly known as Mahindra Primus Limited).
1996 Mahindra takes a significant stake in Ford Credit Mahindra Limited, for
financing Ford vehicles. The launch of Matrix Information Services
Limited marks the Group's entry into information distribution.

Enters the mutual fund market with the launch of Mahindra Asset
1998
Management Company.

4
2000 Mahindra ties up with Old Mutual plc. for the Life Insurance business.

Securities launch its on-line broking site (now www.securities.com).

2000 Commencement of private equity activity through setting up of Mahindra
Venture Capital Fund.

2001 Matrix sold to Friday Corporation

2001 Launches Insurance Services

Mahindra Finance Ltd. converts to a commercial bank - the first Indian

2003
company to do so.

2004 Launches India Growth Fund, a private equity fund.

Group realigns joint venture in Ford Credit; Buys Mahindra Prime

2005 (formerly known as Mahindra Primus Limited) and sells Ford credit
Mahindra.

2005 Launches a real estate fund

Bought the 25% stake held by Goldman Sachs in Mahindra Capital

2006
Company and Securities

KOTAK MAHINDRA BANK

KEY EXECUTIVES

5
1 Shankar Acharya Chairman

2 Uday Kotak Managing Director& Executive Vice Chairman

3 Bina Chandarana Company Secretary

4 Dipak Gupta Executive Director

5 Jaimin Bhatt Group Chief Financial Officer

BROAD BUSINESS SEGMENTS OF KOTAK MAHINDRA BANK

6
 Fig 1.2

VENTURE FUND MANAGEMENT

SEAF is currently operating in India through the India Growth Fund in partnership
with Kotak Mahindra Bank. The Fund invests in Indian companies with high-
growth potential and sustainable competitive advantages.These investments are
in high growth sectors of home retail, logistics, home textiles, airline, life sciences
and software information technology.

RETAIL LIABILITIES

This refers to the wide range of products and services targeted at retail
customers and offered through branch operations and other direct banking
channels such as telephone banking, internet banking, mobile banking direct pay
services ,payment gateway for online shopping .The product range also includes
Global Debit Card and Visa Money Transfer.

LENDING

7
This includes all the advances and lending operations for commercial vehicles
and construction equipments, personal loans, home loans and other lending.

TREASURY AND INVESTMENTS

Treasury operations refer to the use of surplus capital in the form of call money,
RBI auctions, G –sec yields etc.. The bank focuses on garnering client flows from
derivatives and foreign exchange remittances

CORPORATE BANKING

Corporate Banking provides a broad range of financial services to domestic and

international corporations, financial instititutions and government entities . The
Bank’s services include working capital, trade services, transaction banking,
money market and foreign exchange services offered to corporate and small and
medium enterprises.

ACHIEVEMENTS

8
 Kotak Mahindra Bank was awarded Hewitt Best Employers in India 2009
 Kotak Mahindra Bank was ranked in the top 5 of companies with “Best
Corporate Governance Practices” in Asia/Pacific - IR Global Rankings
2009
 Kotak Mahindra Bank and Oracle Siebel won the “Best CRM/Applications
Project Award 2009” at the IT Implementation Awards 2009 by The Asian
Banker
 Kotak Mahindra was adjudged India’s overall the “Best Private Banking
Services” award by Euro money 2009
 Kotak Credit Cards- Kotak Royal Signature’s card is chosen “Product of
the Year” by Nielsen who surveyed 40,000 consumers.
 Kotak Life Insurance plans were rated amongst the best in the industry for
a second year in a row in the annual ULIP Ranking carried out by Outlook
Money.
o Outlook Money awarded the 1st Rank to Kotak Platinum Advantage
Plan in Type II ULIPs category
o Outlook Money awarded 4th Rank to Kotak Long Life Wealth Plus
plans in the Type I ULIPs category, concluding that “Kotak Life has
a product portfolio which delivers what customers want.”
 Kotak Life Insurance plans were rated amongst the best in the industry for
a second year in a row in the annual ULIP Ranking carried out by Outlook
Money.
 Kotak Investment Banking was named “Best Investment Bank” and “Best
Equity House in India” by Finance Asia Best Bank Awards 2008 and was
named “Best Domestic Equity House” by Asia Money Best Bank Awards
2008.
 Awarded the Best Domestic Investment Bank and the Best Equity House
in The Asset Triple A Country Awards for the period October 1, 2007 to
September 30, 2008.

CHAPTER 2

9
 INTRODUCTION TO TOPIC

Reserve Bank of India is the apex final institution of India. It controls the monetary
system of the economy and ensures liquidity in the system.In the project I have
discussed money supply in an economy and how RBI manages liquidity (money
supply) during various economic conditions.

OBJECTIVES OF THE PROJECT

Objective of the project is to understand the management of policy rates and

liquidity by the Reserve bank of India. Also how RBI uses monetary policy as a
tool to control money supply in an economy to combat with inflation or recession.

RESEARCH METHODOLOGY

The research is a systematic collection, recoding and analyzing of data. It

involves the diagnosis of information needs and the selection of relevant inter-
related variables about which valid and reliable information is gathered, recorded
and analyzed.

Data Collection
After making the list of the needed information and the source of data the next
step is the collection of data. In this study of the data is collected secondary data.
The details of the source of the data are

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Secondary Data: 

Secondary data was collected with the help of:

 From the company website

 From Reserve Bank of India website
 Various other websites

STRUCTURE OF BANKING IN INDIA

11
BANKING REGULATOR

The Reserve Bank of India (RBI) is the central banking and monetary authority of
India, and also acts as the regulator and supervisor of commercial banks.

SCHEDULED BANKS IN INDIA

Scheduled banks comprise scheduled commercial banks and scheduled co-

operative banks. Scheduled commercial banks form the bedrock of the Indian
financial system, currently accounting for more than three-fourths of all financial
institutions' assets. SCBs are present throughout India, and their branches,
having grown more than four-fold in the last 40 years.

Fig 2.1

PUBLIC SECTOR BANKS

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Public sector banks are those in which the majority stake is held by the
Government of India (GoI). Public sector banks together make up the largest
category in the Indian banking system. There are currently 27 public sector banks
in India. They include the SBI and its 6 associate banks (such as State Bank of
Indore, State Bank of Bikaner and Jaipur etc), 19 nationalized banks (such as
Allahabad Bank, Canara Bank etc) and IDBI Bank Ltd.Public sector banks have
taken the lead role in branch expansion, particularly in the rural areas.

REGIONAL RURAL BANKS

Regional Rural Banks (RRBs) were established during 1976-1987 with a view to
develop the rural economy. Each RRB is owned jointly by the Central
Government, concerned State Government and a sponsoring public sector
commercial bank. RRBs provide credit to small farmers, artisans, small
entrepreneurs and agricultural laborers. Over the years, the Government has
introduced a number of measures of improve viability and profitability of RRBs,
one of them being the amalgamation of the RRBs of the same sponsored bank
within a State.

PRIVATE SECTOR BANKS

In this type of banks, the majority of share capital is held by private individuals
and corporates. Not all private sector banks were nationalized in 1969, and 1980.
The private banks which were not nationalized are collectively known as the old
private sector banks and include banks such as The Jammu and Kashmir Bank
Ltd., Lord Krishna Bank Ltd etc. Entry of private sector banks was however
prohibited during the post-nationalization period. In July 1993, as part of the
banking reform process and as a measure to induce competition in the banking
sector, RBI permitted the private sector to enter into the banking system. This
resulted in the creation of
a new set of private sector banks, which are collectively known as the new private
sector banks. As at end March, 2009 there were 7 new private sector banks and
15 old private sector banks operating in India.

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FOREIGN BANKS

Foreign banks have their registered and head offices in a foreign country but
operate their branches in India. The RBI permits these banks to operate either
through branches; or through wholly-owned subsidiaries. The primary activity of
most foreign banks in India has been in the corporate segment. However, some
of the larger foreign banks have also made consumer financing a significant part
of their portfolios. These banks offer products such as automobile finance, home
loans, credit cards, household consumer finance etc.

CO-OPERATIVE BANKS

Co-operative banks are a group of financial institutions organized under the

provisions of the Co-operative societies Act of the states. The main objective of
co-operative banks is to provide cheap credits to their members. They are based
on the principle of self-reliance and mutual cooperation.

RESERVE BANK OF INDIA

OVERVIEW

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Reserve Bank of India is the apex financial institution of India. It is needed to
regulate and control the monetary system of an economy. The need for a central
bank in India was felt during the 18 th century. The earliest attempt to set up a
central bank dates back to 1773 when Warren Hastings recommended to
establish “The General Bank of Bengal and Bihar” as central bank of India. The
Reserve Bank of India was set up on the recommendations of the Hilton Young
Commission. It was established on April 1, 1935 in accordance with the
provisions of the Reserve Bank of India Act, 1934. The Central Office of the
Reserve Bank was initially established in Kolkata but was permanently moved to
Mumbai in 1937. Though originally privately owned, the RBI has been fully owned
by the Government of India since nationalization in 1949. RBI is governed by a
central board (board headed by a governor) appointed by the Central
Government of India. Duvvuri Subbarao who succeeded Yaga Venugopal Reddy
on September 2, 2008 is the current Governor of RBI. RBI has 22 regional offices
across India.

PREAMBLE

The Preamble of the Reserve Bank of India describes the basic functions of the
Reserve Bank as: "...to regulate the issue of Bank Notes and keeping of reserves
with a view to securing monetary stability in India and generally to operate the
currency and credit system of the country to its advantage."

OBJECTIVES AND REASONS FOR THE ESTABLISHMENT OF RBI

 To manage the monetary and credit system of the economy

 To stabilize internal and external value of rupee.
 For balanced and systematic development of banking in the country. For
Development of organized money market in India.
 For Proper arrangement of agricultural finance.
 For proper arrangement of industrial finance.
 For proper management of public debts.

15
  To establish monetary relations with other countries and international
financial institutions.
 Centralization of cash reserves of commercial banks
 To maintain balance between demand and supply of currency

CENTRAL BOARD

 The Reserve Bank's affairs are governed by a central board of directors. The
board is appointed by the Government of India in keeping with the Reserve
Bank of India Act.
Appointed/nominated for a period of four years
Functions: General superintendence and direction of the Bank's affairs

LOCAL BOARDS

One each for the four regions of the country in Mumbai, Calcutta, Chennai and
New Delhi.
Functions: To advise the Central Board on local matters and to represent
territorial and economic interests of local cooperative and indigenous banks; to
perform such other functions as delegated by Central Board from time to time.

FINANCIAL SUPERVISION

The Reserve Bank of India performs this function under the guidance of the
Board for Financial Supervision (BFS). The Board was constituted in November
1994 as a committee of the Central Board of Directors of the Reserve Bank of
India.

OBJECTIVE

16
Primary objective of BFS is to undertake consolidated supervision of the financial
sector comprising commercial banks, financial institutions and non-banking
finance companies.

CONSTITUTION

The Board is constituted by co-opting four Directors from the Central Board as
members for a term of two years and is chaired by the Governor. The Deputy
Governors of the Reserve Bank are ex-officio members. One Deputy Governor,
usually, the Deputy Governor in charge of banking regulation and supervision, is
nominated as the Vice-Chairman of the Board.

BFS MEETINGS

The Board is required to meet normally once every month. It considers inspection
reports and other supervisory issues placed before it by the supervisory
departments.

BFS through the Audit Sub-Committee also aims at upgrading the quality of the
statutory audit and internal audit functions in banks and financial institutions. The
audit sub-committee includes Deputy Governor as the chairman and two
Directors of the Central Board as members.

The BFS oversees the functioning of Department of Banking Supervision (DBS),

Department of Non-Banking Supervision (DNBS) and Financial Institutions
Division (FID) and gives directions on the regulatory and supervisory issues.

FUNCTIONS

Some of the initiatives taken by BFS include:

17
  Restructuring of the system of bank inspections
 Introduction of off-site surveillance,
 Strengthening of the role of statutory auditors and
 Strengthening of the internal defences of supervised institutions.

LEGAL FRAMEWORK

Umbrella Acts
 Reserve Bank of India Act, 1934: governs the Reserve Bank functions
 Banking Regulation Act, 1949: governs the financial sector Acts governing
specific functions.
 Public Debt Act, 1944/Government Securities Act (Proposed): Governs
government debt market.
 Securities Contract (Regulation) Act, 1956: Regulates government securities
market
 Indian Coinage Act, 1906:Governs currency and coins
 Foreign Exchange Regulation Act, 1973/Foreign Exchange Management Act,
 1999: Governs trade and foreign exchange market
 Acts governing Banking Operations
 Companies Act, 1956:Governs banks as companies
 Banking Companies (Acquisition and Transfer of Undertakings) Act,
1970/1980: Relates to nationalization of banks
 Bankers' Books Evidence Act
 Banking Secrecy Act
 Negotiable Instruments Act, 1881

Acts governing Individual Institutions

 State Bank of India Act, 1954
 The Industrial Development Bank (Transfer of Undertaking and Repeal) Act,
2003
 The Industrial Finance Corporation (Transfer of Undertaking and Repeal) Act,
1993

18
 National Bank for Agriculture and Rural Development Act
 National Housing Bank Act
 Deposit Insurance and Credit Guarantee Corporation Act

FUNCTIONS PERFORMED BY RBI:-

1. Monetary Authority:-

19
The Reserve Bank of India Formulates implements and monitors the monetary
policy. Its main objective is maintaining price stability and ensuring adequate flow
of credit to productive sectors. The Reserve Bank of India is the controller of
credit i.e. it has the power to influence the volume of credit created by banks in
India. It can do so through changing the Bank rate or through open market
operations.

2. Regulator and supervisor of the financial system:-

Prescribes broad parameters of banking operations within which the country’s

banking and financial system functions. Their main objective is to maintain public
confidence in the system, protect depositors’ interest and provide cost-effective
banking services to the public.

3. Manager of Exchange Control:-

The manager of the exchange control department manages the Foreign

Exchange Management Act, 1999. Its main objective is to facilitate external trade
and payment and promote orderly development and maintenance of foreign
exchange market in India.

4. Issuer of currency:- ,
RBI is the sole authority for the issue of currency in India. The Indian government
issues one rupee notes and coins. Major currency is in the form of RBI notes,
such as notes in the denominations of two, five, ten, twenty, fifty, one hundred,
five hundred, and one thousand.

5. Banker to the Government:-

Reserve Bank of India is to act as Government banker agent and adviser. The
Reserve Bank is agent of Central Government and of all State Governments in

20
India excepting that of Jammu and Kashmir. The Reserve Bank has the
obligation to transact Government business, via. to keep the cash balances as
deposits free of interest, to receive and to make payment exchange remittances
and other banking operations. The Reserve Bank of India helps the Government -
both the Union and the States to float new loans and to manage public debt

6. Bankers' Bank and Lender of the Last Resort

The Reserve Bank of India acts as the bankers' bank. The scheduled banks can
borrow from the Reserve Bank of India on the basis of eligible securities or get
financial accommodation in times of need or stringency by rediscounting bills of
exchange. Since commercial banks can always expect the Reserve Bank of India
to come to their help in times of banking crisis the Reserve Bank becomes not
only the banker's bank but also the lender of the last resort.

7. Supervisory functions:-

The Reserve Bank act, 1934 and the Banking Regulation act, 1949 have given
the RBI wide powers of supervision and control over commercial and co-
operative banks, relating to licensing and establishments, branch expansion,
liquidity of their asset, management and methods of working, amalgamation,
reconstruction, and liquidation. The RBI is authorized to carry out periodical
inspections of\ banks and to call for returns and necessary information from them.
The supervisory functions of the RBI have helped a great deal in improving the
standard of banking in India to develop on sound lines and to improve the
methods of their operation.

8. Promotional functions:-

With economic growth assuming a new urgency since Independence, the range
of the Reserve Bank’s functions has steadily widened. The bank now performs a

21
variety of developmental and promotional functions, which, at one time were
regarded as outside the normal scope of central banking. The RBI was asked to
promote banking habit, extend banking facilities to rural and semi-urban areas,
and establish and promote new specialized financing agencies.

Fig 2.2

CHAPTER 3
MONEY SUPPLY

22
Money Supply Theory in macroeconomics refers to the study of the quantity of
money available at the hands of people within the economy to buy goods,
services and securities. The interest rate is the value of money over time that is
the price paid for acceding payment of monetary debts. These two are inversely
proportional as the supply of money increases the interest rate decreases. The
equilibrium at the money market is reached when the quantity of money
demanded and supplied becomes equal to the rate of interest.

Money involves both coins and banknotes; therefore the supply of money in an
economy will consist of both the supply of banknotes and coins. Precisely the
concept of money supply involves the sum total of all electronic, credit-based
bank deposits balance accounts along with the printed-paper notes and minted
coins. According to the principle, money is a medium of transaction that is utilized
in settling a debt. Money supply can take place in varying measures. The
narrowest measure counts only liquid money while the broader measure takes
into account the form that deals money as a store of value. The situation of
inflation occurs when the supply of money increases to an extreme level.

EXCESS MONEY SUPPLY

Talking in terms of aggregates, an excess of money supply over the supply of

goods and services will always result in an immediate upsurge in prices. This is
because an effective demand increases at the given level of supply.

EMPIRICAL MEASURES

23
Different functions of money are associated with different empirical measures of
the money supply. Since most modern economic systems are regulated by
governments through monetary policy, the supply of money is broken down into
types of money based on how much of an effect monetary policy can have on
each. Narrow measures include those more directly affected by monetary policy,
whereas broader measures are less closely related to monetary-policy actions.
Each measure can be classified by placing it along a spectrum between narrow
and broad monetary aggregates. The different types of money are typically
classified as Ms. the number of Ms usually range from M0 (narrowest) to M3
(broadest) but which Ms are actually used depends on the system.

The typical layout for each of the Ms is as follows:

M0: Physical currency. A measure of the money supply which combines any
liquid or cash assets held within a central bank and the amount of physical
currency circulating in the economy. M0 is the most liquid measure of the money
supply. It only includes cash or assets that could quickly be converted into
currency.

M1: Physical currency circulating in the economy + demand deposits of all

commercial and cooperative banks. This is a measure used by economists trying
to quantify the amount of money in circulation. M1 is a very liquid measure of the
money supply, as it only contains cash and assets that can also be used for
payments.

M2: M1 + time deposits, savings deposits, and non-institutional money-market

funds. M2 is a broader classification of money than M1. Economists also use M2
when looking to quantify the amount of money in circulation and trying to explain
different economic monetary conditions. M2 is a key economic indicator used to
forecast inflation.

M3: M2 + large time deposits, institutional money-market funds, short-term

repurchase agreements, along with other larger liquid assets. This is the broadest
measure of money commonly used and is used by economists to estimate the
entire supply of money within an economy

24
In economics, money supply, or money stock, is the total amount of money
available in an economy at a particular point in time. There are several ways to
define "money", but each includes currency in circulation and demand deposits.

HOW TO CONTROL MONEY SUPPLY

25
The money supply is an important piece of the puzzle to maintain economic
balance and if this does not happen, it can lead to inflation or deflation.

When there is a heavy injection of money supply into our monetary system,
known as "loosening", inflation will be the result. When people have more money
to spend, higher prices for the consumer will result. Reducing the money supply
by increasing the "reserve requirement", referred to as "tightening", requires the
banks to hold more in with RBI .

The RBI can also use the treasury auctions to expand and contract the money
supply. When it sells treasury bills, notes, and bonds, they are essentially pulling
money out of the system and issuing a security in its place. This security does not
count as part of the money supply equation. Conversely, when the RBI conducts
buybacks, they are buying the securities back and returning principal to the
security holders. This increases the money supply.

Finally, another very important means of controlling the money supply is through
moving the interest rates up and down. The RBI moves the discount rate up and
reserve funds rate up to tighten money supply by discouraging borrowers from
taking loans. This will occur to keep inflationary pressures in check. Conversely,
by moving the rates lower, the RBI is attempting to stimulate the economy by
encouraging borrowers to take new loans.

The role of money supply is also very crucial in causing inflation. Increase in
money supply causes inflation. Overall, inflation badly affects any economy.
Inflation is defined as an increase in the price of bunch of Goods and services
that projects the Indian economy.

In financial markets, the emergence of futures trading and derivatives has created
very complex webs of liquidity creation. In fact, there are new forms of liquidity
emerging all the time.

Over time, the components of broad money and narrow money have been
changing in practice. Narrow money (M1) is primarily concerned with the price

26
level of goods and services, whereas broad money is concerned also with the
prices of various assets, especially financial and stock market assets. The
components of broad and narrow money keep getting altered, depending upon
institutional practice. This is very much so in India. There have been three money
supply reports from the RBI, each of which tried to define and redefine the
empirical concept of money, broad and narrow. In the process, the number of
money magnitudes kept expanding.

The stock of broad money consists of the volume of currency with the public and
the volume of bank deposits with the public. The currency with the public is the
monetary liability of the monetary authorities, consisting of the Government and
the country’s central bank, the RBI. The bank deposits are the monetary liability
of the banks.

The monetary liability of the monetary authorities is corresponded by the holding

of monetary assets by the RBI, consisting of foreign exchange reserves, bills and
bonds issued by the government, bills and bonds kept by the commercial banks
with the central bank as pledge or collateral for refinance, bills rediscounted by
the central bank, bonds kept by the central bank for private placement by the
government, bonds of specific financial or other institutions, gold, etc.

The banks hold cash with themselves and with the RBI. Together, these are the
cash balances or cash reserves of the banks. These have to form a particular
proportion of their deposit liabilities. This proportion is the cash reserves ratio
(CRR) and is regulated by the RBI. The banks often keep more reserves with
them than are required by the statutory ratio. By varying the CRR, the central
bank can regulate the volume of deposits with the banks.

Since the credit assets and securities owned by the banks plus cash in the vaults
and deposits with the RBI have to equal the deposit liabilities, a regulation of the
CRR, or the cash deposits ratio, also empowers the central bank to regulate the
assets portfolio of banks. A sharp rise in the ratio would mean loans will have to
be called back or securities sold by the banks. If the ratio is raised on an
incremental basis for a forward period, the banks will buy less loan assets and
securities.

27
The currency with the public and cash reserves of banks and other deposits with
the RBI are included in reserve money. The sources of reserve money are: the
RBI's net claims on Government plus the central bank's claims on banks plus the
central bank's claims on the commercial sector plus net foreign exchange assets
of the central banks plus Government's currency liabilities to the public, minus the
net non-monetary liabilities of the central bank. The ratio of money stock to
reserve money is the money multiplier.

Broad money multiplier is the ratio of M3 or broad money to reserve money.

Narrow money multiplier is the ratio of M1 to reserve money. By regulating the
reserves ratio, the RBI can vary the money multiplier. When prices are rising or
expected to be rising, the RBI can raise the reserves ratio and reduce the money
multiplier. If commodity supplies are abundant or expected to become abundant
in relation to the money stock, the RBI may reduce the reserves ratio and thus
augment money stock and prevent prices from falling.

As reserves with the RBI may not earn interest, the banks find their profitability
affected by a rise in the CRR. The banks have an interest in lower CRRs so long
as they can get ready refinance at low rates from the central bank. Often, the
central bank gives some interest on the reserves or excess reserves over the
statutory minimum maintained by it. A sharp rise in the reserves ratio means that
interest rates will go up.

The lending rates of banks and the deposit rates will tend to move up when the
reserves ratio is raised. On the other hand, when the reserves ratio is lowered,
the interest rates will go down. The banks now have more lendable and investible
resources. As the supply of loanable funds gets enlarged, interest rates will fall,
and the balance between the supply of loanable funds and demand for loanable
funds will be struck at a lower interest rate.

In developed countries, the government does not directly borrow from the central
bank. Hence a rise in the reserves ratio will definitely imply a sale of securities by
the banks, and yields will go up. Governments will have to borrow now at higher
coupon rates. When the reserves ratio is lowered, yields will fall and the
governments can borrow at lower coupon rates. In both cases the prime lending
rates will be affected.

28
The bank rate is the rate of ultimate refinancing and rediscounting by the central
bank. When it is raised, it is a signal to the money market that credit will become
scarcer. A rise in the bank rate in developed countries definitely tends to reduce
the supply of loanable funds and force the banks to sell securities, thus forcing
yields up. If there is enough liquidity in the money market, the banks may not go
to the central bank for refinancing or rediscounting but the rise in the rate acts as
a signal on the immediate future. It also means that the central bank may opt to
sell securities in the market, forcing yields to go up.

INFLATION AND MONEY SUPPLY

29
The level of money supply is determined by the workings of the system, by the
level of economic activity and the prices at which goods and services are traded.
Inflation is an upward movement in the average level of prices. It is caused by a
combination of four factors:
 The supply of money goes up.
 The supply of other goods goes down.
 Demand for money goes down.
 Demand for other goods goes up

Excess money supply in an economy leads to rise in the level of prices inflation.
Quantity theory of money states that the central bank, which controls the money
supply, has ultimate control over the rate of inflation.

If the central bank keeps the money supply stable, the price level will be stable. If
the central bank increases the money supply rapidly, the price level will rise
rapidly.

When the supply of money in an economy increases, the purchasing power of

people increase , they have more money at their disposal. The demand for goods
increases, the supply of goods remaining constant. This demand and supply
imbalance leads to increase in price level of goods thereby causing inflation.

OBJECTIVE OF CREDIT CONTROL

30
Reserve Bank of India makes efforts to control the expansion or contraction of
credit in order to keep it at the required level with a view to achieving the following
ends.

 To save Gold Reserves: The central bank adopts various measures of

credit control to safe guard the gold reserves against internal and external
drains.

 To achieve stability in the Price level: Frequently changes in prices

adversely affect the economy. Inflationary and deflationary trends need to
be prevented. This can be achieved by adopting a judicious of credit
control.

 To achieve stability in the Foreign Exchange Rate: Another objective of

credit control is to achieve the stability of foreign exchange rate. If the
foreign exchange rate is stabilized, it indicates the stable economic
conditions of the country.

METHOD OF CREDIT CONTROL

There are two method of credit control:-

 QUANTITATIVE METHOD

1. Bank Rate Policy

2. Open Market Operations
3. Change in Reserve Ratios
4. Credit Rationing

 QUALITATIVE METHOD

31
1. Direct Action
2. Moral persuasion
3. Legislation
4. Publicity

QUANTITATIVE METHOD

1. Bank Rate Policy: Bank rate is the rate of interest which is charged by the
central bank on rediscounting the first class bills of exchange and advancing
loans against approved securities. This facility is provided to other banks. It is
also known as Discount Rate Policy.

2. Open Market Operations: The term “Open Market Operations” in the wider
sense means purchase or sale by a central bank of any kind of paper in which it
deals, like government securities or any other public securities or trade bills etc.
in practice, however the term is applied to purchase or sale of government
securities, short-term as well as long-term, at the initiative of the central bank, as
a deliberate credit policy.

3. Change in Reserve Ratios: Every commercial bank is required to deposit with

the central bank a certain part of its total deposits. When the central bank wants
to expand credit it decreases the reserve ratio as required for the commercial
banks. And when the central bank wants to contract credit the reserve ratio
requirement is increased.

4. Credit Rationing: Credit rationing means restrictions placed by the central

bank on demands for accommodation made upon it during times of monetary
stringency and declining gold reserves. This method of controlling credit can be
justified only as a measure to meet exceptional emergencies because it is open
to serious abuse.

5. CRR (Cash Reserve Ratio): Cash reserve Ratio (CRR) is the amount of Cash
(liquid cash like gold) that the banks have to keep with RBI. This Ratio is basically

32
to secure solvency of the bank and to drain out the excessive money from the
banks. If RBI decides to increase the percent of this, the available amount with
the banks comes down and if RBI reduces the CRR then available amount with
Banks increased and they are able to lend more.RBI has reduced this ratio three
times and reduced it to 6%.

6. SLR((Statutory Liquidity Ratio) is the amount a commercial bank needs to

maintain in the form of cash, or gold or govt. approved securities (Bonds) before
providing credit to its customers. SLR rate is determined and maintained by the
RBI (Reserve Bank of India) in order to control the expansion of bank credit.
Generally this mandatory ration is complied by investing in Govt bonds. Present
rate of SLR is 25%.

7. Repo Rate: Repo rate is the rate at which our banks borrow rupees from RBI.
This facility is for short term measure and to fill gaps between demand and supply
of money in a bank .when a bank is short of funds they borrow from bank at repo
rate and if bank has a surplus fund then the deposit the funds with RBI and earn
at Reverse repo rate .So reverse Repo rate is the rate which is paid by RBI to
banks on Deposit of funds with RBI.A reduction in the repo rate will help banks to
get money at a cheaper rate. When the repo rate increases borrowing from RBI
becomes more expensive.

QUALITATIVE METHOD

1. Direct Action: The central bank may take direct action against commercial
banks that violate the rules, orders or advice of the central bank. This punishment
is very severe of a commercial bank.

2. Moral persuasion: It is another method by which central bank may get

Credit supply expanded or contracted. By moral pressure it may prohibit or
dissuade commercial banks to deal in speculative business.

3. Legislation: The central bank may also adopt necessary legislation for
expanding or contracting credit money in the market.

33
4. Publicity: The central bank may resort to massive advertising campaign in the
news papers, magazines and journals depicting the poor economic conditions of
the country suggesting commercial banks and other financial institutions to
control credit either by expansion or by contraction.

MONETARY POLICY

34
Monetary Policy is a tool used by RBI to control money supply and liquidity in an
economy.
Monetary policy is the process by which the central bank or monetary authority of
a country controls the supply of money and the rate of interest. Monetary policy is
usually used to attain a set of objectives oriented towards the growth and stability
of the economy. These goals usually include stable prices and low unemployment

Monetary policy is referred to as either being an expansionary policy, or

a contractionary policy, where an expansionary policy increases the total supply
of money in the economy, and a contractionary policy decreases the total money
supply. Expansionary policy is traditionally used to combat unemployment in
a recession by lowering interest rates, while contractionary policy involves raising
interest rates to combat inflation. Monetary policy is contrasted with fiscal policy,
which refers to government borrowing, spending and taxation

Monetary policy is the management of money supply and interest rates by central
banks to influence prices and employment. Monetary policy works through
expansion or contraction of investment and consumption expenditure.

Importance of Monetary Policy

 Gross National Product (GNP) = C + I + G + X

 Where: C = Private Consumption expenditure
 I = Private Investment Expenditure
 G = Government Expenditure
 X = Net Exports
 C, I, X can be influenced by the monetary policy which can
also influence the private consumption and investment
spending and exports and imports.
 The Government and the Central Bank (i.e., RBI) make use of
various fiscal and monetary weapons respectively to achieve
stability and growth by influencing and regulating the behavior
of the various classes of spenders as savers, consumers and
investors.

35
  These policies can influence the aggregate supply and demand and the
associated level of employment, wages, interest, rent, price and profit.

When is the Monetary Policy announced?

Historically, the Monetary Policy is announced twice a year - a slack season

policy (April-September) and a busy season policy (October-March) in
accordance with agricultural cycles. These cycles also coincide with the halves of
the financial year. Initially, the Reserve Bank of India announced all its monetary
measures twice a year in the Monetary and Credit Policy. The Monetary Policy
has become dynamic in nature as RBI reserves its right to alter it from time to
time depending on the state of the economy.

Difference between Monetary Policy and the Fiscal Policy:

Two important tools of macroeconomic policy are:

 Monetary Policy and
 Fiscal Policy.

The Monetary Policy regulates the supply of money and the cost and availability
of credit in the economy. It deals with both the lending and borrowing rates of
interest for commercial banks.
The Monetary Policy aims to maintain price stability, full employment and
economic growth.
The Reserve Bank of India is responsible for formulating and implementing
Monetary Policy. It can increase or decrease the supply of currency as well as
interest rate, carry out open market operations, control credit and vary the
reserve requirements.
The Monetary Policy is different from Fiscal Policy as the former brings about a
change in the economy by changing money supply and interest rate, whereas
fiscal policy is a broader tool with the government.

36
 The Fiscal Policy can be used to overcome recession and control inflation. It may
be defined as a deliberate change in government revenue and expenditure to
influence the level of national output and prices.
For instance, at the time of recession the government can increase expenditures
or cut taxes in order to generate demand.
On the other hand, the government can reduce its expenditures or raise taxes
during inflationary times. Fiscal policy aims at changing aggregate demand by
suitable changes in government spending and taxes.
The annual Union Budget showcases the government's Fiscal Policy. The annual
Union Budget showcases the government's Fiscal Policy

There are four main 'channels' which the RBI looks at:

 Quantum channel: money supply and credit (affects real output and price level
through changes in reserves money, money supply and credit aggregates).
 Interest rate channel.
 Exchange rate channel (linked to the currency).
 Asset price.

Monetary Policy and Money Supply

The capacity of banks to provide credit depends on their cash reserves

(comprising cash in hand and balances with the Reserve Bank), a substantial
portion of the reserves being generally held in the form of balances with the
Reserve Bank.

Cash Reserves increase through a rise in the deposit resources of banks, or by

their borrowing from the Reserve Bank, or by sale of their investments.

If Bank desires to bring about an expansion in credit, it adopts measures to

increase the banks reserves. If credit is to be restricted, it attempts to shorten
the reserves.

SLR and Cash reserve ratio is maintained for bank solvency and higher ratio of
SLR and CRR makes bank relatively safe as higher ratio means they have more
of their funds deposited in liquid securities and can fulfill the demand on
redemption of deposit from the Bank. Let’s take an example: suppose a Bank has

37
taken a deposit of 100 from public and CRR is 9 and SLR is 25 then available
funds to lend from deposits with the bank will be 100-9-25=66 so there is direct
relation between CRR, SLR and Funds available with bank to lend to public out of
deposit received from public

Impact on Interest rates of this ratios:

Now take point what will be the impact on Interest rates of this ratios: Interest rate
are fixed on the Demand supply situation of the amount available with person
who want to lend and person who want to borrow and interest rate is fixed on
demand supply of the funds if demand is more and supply is less then interest
rate rises up and if demand is less and supply is excessive then interest rate
comes down .this relation is based on many assumption as said above.

So RBI is controlling the supply side of the Funds and by changes in  CRR
and SLR, Bank control the supply side of the money. so when RBI increase these
ratio then available funds with the banks will go down and as demand remain the
same then people will have to pay more as interest and interest rate will go up.
On the reverse if RBI reduces these rates, then amount available with bank for
lending will be increased and they have to reduce rates to lend more. In these
situation banks also reduce the rate of short term deposit from public as they
have surplus money already to lend. So these rates have double impact the first
direct effect is ,bank reduce rate of lending so more money is available with
people and second is interest on Deposit will be reduced so more money will be
available with the people.

But other side of interest rate i.e. demand/off take of loan is also important to set
the interest rate .This may be some time region wise and seasonal or other factor
also effect the decision of Interest rate

38
Impact on Inflation

As from the above para we have understood that how these ratio reduce or
increase the money supply in the system and we know if more person is
demanding few goods then price of goods tends to increase and it’s called
inflation so when RBI reduce these ratios then money supply in market increases
and inflation is rises further but in present case this is not the correct and right
relation. The Increase in CRR will squeeze 36000 crore from market, so less
money will chase few things means less demand so it will reduce Inflation.

At the time of depression the reduction of these ratios is to maintain liquidity

without disturbing inflation much. While marked is falling and each and every
commodity rate going downwards. In these situations after increasing of money
supply inflation rate does not goes up as the demand is slow and reduction in
commodity prices will nullify the impact of increase in money supply and have
less inflationary effects.

39
CONTRACTIONARY MONETARY POLICY

Problem: Inflation
Measures: (1) Central bank sells securities
through open market operation
(2) It raises cash reserve ratio
and statutory liquidity
(3) It raises bank rate

Money supply decreases

Interest rate raises

 
Aggregate demand declines
 
Price level falls

Fig 3.1

40
EXPANSIONARY MONETARY POLICY

Problem Recession
Measures: (1) Central bank buys securities
through open market operation
(2) It reduces cash reserves ratio
(3) It lowers the bank rate
 
Money supply increases
 
Investment increases
 
Aggregate demand increases
 
Aggregate output increases by a
multiple of the increase in investment

Fig 3.2

41
 CHAPTER 4
ANALYSIS

DURING PERIOD OF GLOBAL SLOWDOWN

The subprime crises triggered by a dramatic rise in mortgage delinquencies and

foreclosures in the United States ,lead to major adverse consequences for banks
and financial markets around the globe. Administered interest rates are one of the
major measures for controlling the money supply in an economy. Bank rate, repo
rate and reverse repo rate are administered by The Reserve Bank of India. The
records show high fluctuation in the interest rates in the past in India. The reserve
bank of India made drastic cuts in interest rates during the recession period to
make sure that the banks and individuals get the benefit of higher credit
availability. The Government of India had the stimulus package for the India Inc.,
where as the Banking sector has been successfully managed by RBI measures.
A picture of Indian economy before and during the recessionary period. The
inferences below show the changes made by RBI in the bank rate from 2006-09
and their impact on Indian economy.

INTEREST RATES/POLICY RATES

Interest rates can be defined from different perspectives, for an Individual an

interest rate is the price a borrower pays for the use of money, they do not own.
For an Organization, Interest is a fee paid on borrowed funds/assets. It is the
price paid for the use of borrowed money or, money earned by deposited funds.
For General Banking, An interest rate is the amount received in relation to an
amount loaned. An interest rate is the amount received in relation to an amount
loaned, generally expressed as a ratio of rupees received per hundred rupees
lent. Interest rates can be classified as specific interest rates and interest rates in
general. Specific interest rates area interest rates on a particular financial
instrument market, these rates are driven by market forces (i.e. Demand and

42
supply). General interest rates, such as bank rate are administered interest rates
are set by RBI.

BANK RATE, REPO AND REVERSE REPO RATE

Every central bank functions as a controller of credit in an economy. One of the

measures to control credit is by the way of monitoring the bank rate, repo rate
and reverse repo rate. Bank rate is the rate at which the central bank (RESERVE
BANK OF INDIA in INDIA) lends to commercial banks [and acts an important
benchmark in determination of interest rates charged by banks from the ultimate
borrowers. In brief, raising bank rates by raising bank rate, central bank raises the
cost of borrowing. This forces the commercial banks to raise in turn the rate of
interest from the public and vice versa. Changes in bank rate are generally
referred in terms of basis points. A basis point (often denoted as bp) is a unit
relating to interest rates that is equal to 1/100th of a percentage point per annum.
It is frequently but not exclusively used to express differences in interest rates of
less than 1% pa. It avoids the ambiguity between relative and absolute
discussions about rates. Whenever the banks have any shortage of funds they
can borrow it either from Reserve Bank of
India (RBI) or from other banks. The repo rate is the rate at which the banks
borrow these excess funds. The borrowing bank mortgages its government
securities to carry out this loan transaction. A reduction in the repo rate will help
banks to get money at a cheaper rate. When the repo rate increases borrowing
from RBI becomes more expensive. Reverse Repo rate is the rate at which
Reserve Bank of India (RBI) borrows money from the various commercial banks.
An increase in Reverse repo rate can cause the banks to transfer more funds to
RBI due to attractive interest rates. It can cause the money to be drawn out of the
banking system.

43
INDIAN ECONOMY

2006-07

Economy grew by 9.4% during 2006-07. The six core infrastructure industries
grew at a high of 8.6%.Telephone connections in the country crossed the 200
million mark and an addition of about 67 million phones was made during the
year 2006-07. Indian exports growing at 20.9% as against the high growth of 24%
in 2005-06 in US dollar terms. Stock market had touched the score of 14267
points.

2008-09 (JULY)

GDP growth for 2008-09 was estimated at 6.7%.Investments in government and

approved securities stepped up by 6% in the month of April 2009 from
4%.Foreign direct investment flows were observed to increase every month\ and
in April of 2009 it totaled USD 2.3 billion. The Indian stock market plunged below
( BSE –Sensex) 10 K points in December 2008 from a high 20K in January 2008
and it took more than a quarter to get the index back to above 10K level.

THE SUBPRIME MORTGAGE CRISIS – THE GLOBAL

RECESSION

The subprime mortgage crisis is an ongoing real estate and financial crisis
triggered by dramatic consequences for banks and financial markets around the
globe. The crisis, which has its roots in the closing years of the 20th century,
became apparent in 2007 and has exposed pervasive weaknesses in financial
industry regulation and the global financial system.

44
 1. BANK RATE 2006

Fig 4.1

The year 2006 witnessed a fluctuating bank rate, with three changes ranging
between 5.25- 6 %.

45
 2. BANK RATE 2007

Fig 4.2

The year 2007 had a constant bank rate at 6% throughout the year.

3. BANK RATE 2008

46
 Fig 4.3

The year 2008 was witnessed a similar bank rate as in 2007. But there was a hint
that the economy will be heading towards a downturn. The global economy was
hinting a downturn.

4. BANK RATE 2009

47
Fig 4.4

5. OVERALL GRAPH
Fig 4.5

48
REPO RATE

Fig 4.6

49
 RBI ACTIONS
Fig 4.7

Since September 2008, RBI has taken multiple actions in order to ensure that the
economy does not suffer a massive downturn. The RBI has cut the repo rate by
400 basis points from 9% to 5%, reverse repo rate by 250 basis points from 6%
to 3.5% and the CRR by 400 basis points from a high of 9% to the 5%.

To reverse the tight liquidity situation in the domestic markets brought on by the
global financial turmoil, the Reserve Bank of India reduced the cash reserve ratio
(CRR)—the amount of reserves banks keep with RBI--by 50 basis points, the first
time in five years. It also made it clear that liquidity concerns, not inflation, will get
priority now.

The new CRR of 8.5% in place of 9% will come into effect from October 11. Since
September 16, when the global crisis broke, the daily borrowing by banks through
the repo window has jumped from an average of Rs 15,000 crore to above Rs
50,000 crore. October 3, RBI data shows banks had borrowed Rs 90,725 crore
from the central bank .In the very first auction, the banks have borrowed Rs
49,460 crore at an interest rate of 9%. The bank said the CRR reduction will
release Rs 20,000 crore into the system.

50
The central bank had raised CRR by 400 basis points since December 2006 to
check inflation, with the last revision occurring in July with a 25-basis point hike.
Explaining its stance, RBI governor D Subbarao said, “In view of the evolving
environment of heightened uncertainty, volatility in global markets and the
dangers of potential spillovers to domestic equity and currency markets, liquidity
management will continue to receive priority in the hierarchy of policy objectives
over the period ahead.” The central bank has already raised interest rates on NRI
deposit by 50 basis points in September.

Accordingly, on a review of the evolving liquidity situation in the context of global

and domestic developments it has been decided to reduce CRR by 150 basis
points to 7.50 per cent with effect from the fortnight beginning October 11, 2008
instead of 50 basis points reduction announced on October 6, 2008,CRR cut of
1.5 per cent which released about Rs 60,000 crore in the banking system that
could results in softening of interest rates, Both lending and deposit rates saw
some downward trends as the cost of fund declined,

To ease the tight liquidity conditions due to the turmoil in the global financial
marketsRBI has been continuously monitoring the liquidity and monetary
conditions in the recent period. A host of measures had been taken over the last
one month to ensure that there is adequate liquidity in the system.

.Further the cash reserve ratio (CRR) was cut by 1 per cent and the repo rate by
0.5 per cent on November 1, 2008 to infuse more liquidity into the market.The
one percentage point cut in the CRR, which is the amount banks have to keep
with the apex bank, had been brought down to 5.5 per cent to infuse additional
liquidity of Rs 40,000 crore into the system.

The CRR cut was in two tranches and the first one of 0.5 per cent was from
October 25, and the second was from November 8.

The RBI also cut the repo rate - with effect from November 3, 2008.

The central bank had also reduced the statutory liquidity ratio (SLR) - the amount
which banks are to put into government securities - by 100 basis points to 24 per
cent.

51
It will released much needed liquidity into the system and signal reduction in
interest rates."

The 350 basis points cut across October and November 2008 bought in Rs

140000 crore into the banking system

January 02, 2009, reserve repo rates and cash reserve ratio (CRR ) were
cut by 100 and 50 bps respectively.

The repo rates now stood at 5.5 percent and reverse repo rate at 4 percent while
the CRR at 5 percent and infused Rs 20,000 crore in the system. 
. The repo rate had been cut aggressively since mid-October last year as the
central bank tried to minimize the knock-on effects of the global financial crisis. 

IMPACT

Lowering of the interest rates has an impact on the deposit rates offered by
banks as they bring down their cost of funds and then pass on the benefits to the
borrowers by lowering lending rates. The impact of lower deposit rates make
fixed income instruments less attractive in the short to medium term. The cut in
both reverse repo and repo is expected to induce banks to reduce their lending
rates as seen with the immediate cut in lending rates by certain private banks of
50 bps. This reduction in turn added more spending power of the borrowers as
existing loans get cheaper resulting in increased discretionary income which will
start to draw the consumer to spend again and help in boosting demand. The
new loans generation will also be done at a lower rate which will in turn increase
the borrowers’ affordability. As developers procure additional loans at a lower rate
they would be able to pass this benefit on to the end user with lower capital
values. The lower lending rates will also result in lower EMI payment resulting in
higher affordability, as the interest rates continue to soften in the short to medium
term. On the commercial real estate front, developers who were facing a liquidity
crunch will be able to abate the stringent cash flows as there is already sufficient
52
liquidity in the banking system and as the lending rate reduces, the cost of funds
for the developers would decrease leading to improved cash flows.

RBI’S ROLE IN COMBATING WITH INFLATION

CRR hiked by 75 bps, benchmark rates unchanged; focus on curbing

inflation
The RBI has hiked the Cash Reserve Ratio (CRR) to 5.75% in January 2010
(removing excess liquidity of about Rs. 360 billion from the system), the first
change in the CRR since January 2009. This increase in cash Reserve Ratio
(CRR) of scheduled commercial banks by 75 basis points from 5.0 percent to
5.75 percent of their net demand and time liabilities (NDTL) would be effected in
two stages; the first stage of increase of 50 basis points will be effective from the
fortnight beginning February 13, 2010, followed by the next stage of increase of
25 basis points effective from the fortnight beginning February 27, 2010.
During the economic slowdown prevailing in FY08-09, CRR was reduced by
400 bps within a period of 6 months leading to a liquidity infusion of over Rs.
1600 billion. With abundant liquidity in the system post a slew of liquidity injecting
measures including steep reduction in CRR and special refinance facilities over
the past few quarters, excess liquidity prevails in the system. An increase in CRR
is more of a signal from the RBI that excess liquidity prevails in the system that
needs to be reduced to curb inflation, which has spiralled up on supply side
constraints. Concurrently, with the credit growth continuing to be muted in
Q3FY10 as well, similar to the trend in H1FY2010, RBI has restricted itself to
sucking out part of the excess liquidity from the system and has abstained from
increasing the Repo or the Reverse Repo rate, which would have led to a rise in
borrowing costs and could have adversely impacted the business sentiments in
the short term. With an increase that is higher than the broad market
expectations, we feel that RBI is unlikely to have another policy measure before
the April 2010 credit policy. We think that there could be another round of CRR
hike around the next policy announcement, before the RBI considers interest rate

53
hikes should inflation rise unabated and signs emerge of a sustained credit
revival in the system. Overall the broad stance of the RBI over the remainder of
2009-10 would be curbing inflation, actively managing liquidity to ensure that
credit demands of productive sectors are adequately met consistent with price
stability and maintaining an interest rate environment consistent with price
stability and financial stability, and in support of the growth process

Repo Rate:

Repo Rate is the rate of interest at which the RBI lends money to banks. This
also means that Repo Rate is the RBI's lending rate to other banks. When RBI
reduces the Repo Rate, the banks can borrow more at a lower cost. This
contributes to lowering of the rates.

In the Annual Monetary Policy 2010-11 the RBI has hiked the Repo rate by 25
basis points to 5.25 percent. This means that RBI has increased its lending rate
to other banks by .25%. For banks the borrowing from RBI becomes costlier.

Reverse Repo Rate:

Reverse repo rate is the rate at which RBI borrows funds from banks. This is
opposite of repo rate. Reverse repo rate is also known as RBI's borrowing rate.

In the Annual Monetary Policy 2010-11, the RBI has increased the Reverse Repo
Rate by 25 basis points to 3.75 percent. This means that now RBI will provide
0.25% etc. interest on the money which it borrows from the banks. An increase in
reverse repo rate means that banks earn higher returns by lending to RBI. This
indicates a hike in the deposit rates.

54
Thus we can see that change in Policy rates has a direct impact the lending and
borrowing rates of the banks. The consumers get affected accordingly.

Prime lending rate is going to be replaced with Base Rate System from July 2010
and the impact will be seen on Base Rates after the Base rate system comes into
effect.

Statutory Liquidity Ratio (SLR): 

Statutory Liquidity Ratio is the fraction of liquid assets which a bank has to keep
an assured amount of funds. The funds may be in the form of cash, gold,
government bonds, etc. In October 2009 Credit Policy the RBI had RBI had hiked
the SLR by 100 basis points - from 24 to 25 per cent.

This measure controls bank's credit expansion and can lead to higher interest
rates. In the October 2009 Credit Policy, RBI had hiked the SLR by 100 basis
points - from 24 to 25 per cent. It has not been touched by RBI in the
Annual Monetary Policy 2010-11.

OPEN MARKET OPERATIONS (OMO)

RBI sells government securities in secondary market it sucks out the liquidity
(stock of money) in the economy. So overall it reduces the money supply
available with banks in effect the capital available with banks for lending purpose
becomes scarce hence interest rates move in upward direction. Exactly opposite
happens when RBI buys securities from open market. The transaction increases
the money supply available with banks so the cost of money (interest rate) moves
in downward direction and business activities like new investments, capacity
expansion gets boost.

55
OMO is also used in curbing the artificial liquidity created to avoid strengthening
of rupee against dollar in order to remain competitive in exports

Government of India announce the sale of three dated securities for Rs. 12,000
crore on April 23, 2010

56
RBI’S ANNUAL POLICY STATEMENT FOR FY10-11 – APRIL 2010

 CRR hiked by 25 bps; to absorb Rs. 125 billion from the system.
 Benchmark Repo and Reverse Repo rates hiked by 25 bps each to 5.25%
and 3.75% respectively
 SLR and Bank Rate kept unchanged at 25% and 6%, respectively
 Bank credit growth expectations increased to 20% in fiscal 2011,
compared to 17% in fiscal 2010
 Bank deposit growth expectations increased to 18%, marginally higher
than 17% reported in fiscal 2010
 GDP forecast hiked to 8.0% with a positive bias for fiscal 2010-11 as
compared with expected 7.2-7.5% in fiscal 2010
 Inflation estimated to moderate to 5.5% by March 2011
 Policy stance is to support „non-disruptive‟ growth in demand for credit
while anchoring inflation expectations; to maintain an interest rate regime
consistent with price, output and financial stability
 Banks‟ investments in Non-SLR Bonds of infrastructure companies with
residual maturity of more than 7 years allowed to be classified under HTM
category
 Provisioning requirement for sub-standard unsecured infrastructure
exposures reduced to 15% from 20%
 Scheduled Commercial Banks and Non Bank Finance Companies with net
worth more than Rs. 10 billion to migrate to IFRS converged Accounting
Standards by April 2013
 Discussion paper on mode of presence of foreign banks by September
2010
 Discussion paper on guidelines for new bank to be placed
 Differential regulatory treatment for Core Investment Companies with asset
size of over Rs. 1 billion

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 MONETARY POLICY 2010-2011

 RBI continues with monetary tightening: CRR, Repo and Reverse Repo
hiked by 25 bps each

The RBI has hiked the Cash Reserve Ratio (CRR) by 25 bps to 6.00% with effect
from April 24, 2010 and thereby removing excess liquidity of about Rs. 125 billion
from the system. Earlier in January 2010, the RBI had hiked CRR by 75 bps (50
basis points effective fortnight beginning February 13, 2010, and another 25 basis
points effective fortnight beginning February 27, 2010) and sucked out excess
liquidity of Rs. 360 billion. In addition the RBI has also raised the Repo and
Reverse Repo rates by 25 basis points each to 5.25% and 3.75% respectively
with immediate effect. The RBI had raised the Repo and Reverse Repo rates by
25 bps each in March 2010 as well.

Fig4.8

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RBI MOVES TO TIGHTEN LIQUIDITY WITHIN THE SYSTEM

The RBI absorbed about Rs.1,00,000 crores on a daily average basis under the
liquidity adjustment facility (LAF) through reverse repo during the current financial
year upto February 12, 2010, i.e., before the first increase in the CRR (which was
announced in the January end monetary policy review) came into effect. At the
end of January 2010, the RBI raised the CRR by 75 basis points, sucking out
about Rs. 36,000 crores from the system.

During February 27- March 31, 2010, the average daily absorption of surplus
liquidity declined to around Rs. 38,200 crores reflecting the increase in the CRR,
year-end advance tax outflows and higher credit demand from the private sector.
The recent 25 basis points hike in CRR by the RBI (effective from 24 April 2010)
is expected to draw out another Rs. 12,500 crores from the banking system.
Thus, liquidity has been gradually reducing within the banking system, but is still
quite high considering RBI’s aggressive stance on combating inflation. Non-food
credit growth has also recently picked up to 16.9% in March 2010, above RBI’s
projection of 16.0% for the fiscal and recovering from its intra-year low of 10.3%
in October 2009.

We expect credit growth to continue increasing with the strong pickup in

economic and industrial activity and the proposed capex plans of India Inc.
Money supply (M3) growth decelerated from over 20.0% at the beginning of the
financial year to 16.4% in February 2010, before increasing to 16.8% by March
2010, slightly above the RBI’s projection of 16.5%

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LIQUIDITY MODERATES WHILE CREDIT GROWTH PICKS UP

The central bank will also have to manage a large borrowing programme in FY11,
although it is lower than what the markets had expected earlier. The total
budgeted gross borrowing for the first half of FY11 (April – September 2010) is
Rs. 2.87 lakh crores, which accounts for 63% of the borrowing for the entire fiscal
(Rs. 4.57 lakh crores). This is lower than the borrowing in the first half of the
previous fiscal year and also below market estimates of around 3 lakh crores.
However, a front loaded (majority of borrowing in first half) borrowing programme
will keep yields buoyant during the first half of this fiscal. On a net basis (after
accounting for redemptions) the borrowing programme for FY11 is actually lower
than that of the previous fiscal. However, the fresh issuance of government paper
in FY11 will be 36% higher than the previous fiscal year. 

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 Government’s borrowing programme is front-loaded in FY11, but lower
than estimates

Government Borrowing Calendar 

(Amount In Crores)
First Half Second Half
 
(April - Sept) (Oct - March)
2010-11 287000 170000
2009-10 323000 128000
2008-09 106000 155000
2007-08 97000 59000
2006-07 89000 57000
Source: RBI, Bloomberg, iFAST
Compilations

Fig 4.9 

 GDP GROWTH TARGET FORECAST AT 8%

RBI revised its growth forecast upwards for 2010-11 at 8% with an upward bias
compared to 2009-10 figures of 7.5%.  It said “Indian economy is firmly on the
recovery path.” RBI’s business outlook survey shows corporates are optimistic
over the business environment.  Growth in industrial sector and services has
picked up in second half of 2009-10 and is expected to continue. The exports
and import sector has also registered a strong growth. It is important to note
that RBI has placed the growth under the assumption of a normal monsoon.
India could have achieved a near 8% growth in 2009-10 itself, if monsoons

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 were better. Table below looks at growth forecasts of Indian economy for 2010-
11 by various agencies.

:Projections of GDP Growth by various agencies for 2010-11 (in %, YoY)

  2009-10 2010-11
RBI 7.5 with an upward 8 with an upward bias
bias
PM’s Economic Advisory Council 7.2 8.2

Ministry of Finance 7.2 8.5 (+/- 0.25)

IMF 6.7 8
Asian Development Bank 7.2 8.2
OECD 6.1 7.3
RBI’s Survey of Professional 7.2 8.5
Forecasters

 BASELINE INFLATION FORECAST AT 5.5% BY MARCH 2011

Against the backdrop of the reassuring prospects of Indian economic growth, the
sharp rise in the wholesale price index (WPI) inflation since September 2009,
exceeding the target of 8.5% for March 2010 set by the RBI, and the
generalisation of persistently high food inflation into core inflation in recent
months has emerged as the key concern for the RBI. The RBI expects that a
return of pricing power as well as the re-emergence of capacity constraints with a
strengthening of demand in the near term would exert further pressure on
inflation.
Accordingly, the RBI has indicated its policy stance towards anchoring inflationary
expectations, while “being prepared to respond appropriately, swiftly and

62
effectively to further build-up of inflationary pressures”. Overall, the RBI
anticipates a softening of inflation by mid-2010, from the 9.9% WPI inflation seen
in March 2010 and has indicated a baseline projection of 5.5% inflation for March
2011, basing its forecasts on a favourable monsoon in 2010. The RBI maintained
its stance to “condition and contain perception of inflation” around 4.0-4.5% while
maintain a medium-term objective of 3.0% inflation.

Fig 4.10

Fig 4.11

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While RBI‟s policy changes are likely to have a limited impact on food and fuel
inflation, which would be determined by the RBI harvest as well as the south-west
monsoons in 2010, and international prices and changes in the domestic pricing
regime respectively, the main focus of the policy is to clamp down on inflationary
expectations. Additionally, if inflation does not moderate as anticipated in coming
months, it is likely that the RBI would undertake further monetary tightening to
combat the buildup of inflationary expectations.

CONCLUSION

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RBI has been following a balancing act to manage inflation and at the same time
not hurt economic growth too much. With the strong economic recovery and
demand pressures building up on inflation, it is expected that the central bank will
continue to hike rates and engage in further monetary tightening in a calibrated
manner. The statements of RBI of being concerned about inflation as well as
wanting growth to continue with proper credit availability is a positive one. It has
raised key interest rates and CRR by 25 basis points each and said further rises
were likely, as it moves to return the monetary policy towards pre-crisis settings
and battles near double-digit inflation. Policy rate moves in India can take as long
as a year to result in bank rate changes, while increases in CRR immediately
sucks out liquidity from the system.

RBI has ruled out using the statutory liquidity ratio (SLR) as a monetary policy
tool, as it thinks any increase in this measure is retrogressive because of it being
a safety pool of money and not a policy instrument. SLR is the proportion of
deposits banks need to hold in government securities, and currently stands at 25
per cent

Open Market Operations is a part of RBI’s management of liquidity of the

system. Last year, RBI had resorted to OMOs frequently to ensure availability of
resources in the system to support the government borrowing programme

RECOMMENDATIONS

65
The Reserve Bank of India (RBI) will have to continue to tighten its monetary
policy stance to arrest the runaway inflation numbers, which is expected to
harden further . The pace of tightening, however, should not be aggressive as it
may hamper the economic recovery.

The RBI, which started exiting its easy money stance since last October, "will
have to continue to tighten its policy to control the high inflation" to avert the
pressure it may exert on the domestic economy

RBI would have to closely watch monsoon this year, which might play a key role
in tackling inflation and influencing future RBI policy actions. RBI projects
wholesale price index at 5 per cent by next March.

CURRENT SCENARIO

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The latest assessment of liquidity conditions suggests that there could be
temporary liquidity pressures in the market largely due to changes in government
balances on account of advance tax payments and 3G auctions. It is a high-wire
balancing act for RBI: it cannot afford to ease its monetary stance and flood the
financial system with liquidity at a time when industrial output is rising rapidly and
core inflation is accelerating. Liquidity-starved banks have been raising an
average of over Rs50,000 crore from RBI everyday.

The fiercely competitive auction of 3G spectrum, which ended on 19 th May ,

offered Rs 67,719 crore to the exchequer, almost double of the Rs 35,000-crore
projected in the Budget. Indian corporations pay income every quarter on their
projected profits. This time around, the amount of tax payment is around
Rs35,000 crore.

This means the money market will see a shortfall of at least Rs lakh crore
nobody knows how long the crunch will continue. To aggravate the tight
situation, RBI is auctioning two government bonds to raise Rs11,000 crore
Between June and end-July, another Rs68,000 crore worth of government
bonds will be auctioned. With about a another one lakh crore -rupee shortfall.

At present, the Reserve Bank offers only one window-- the Liquidity Adjustment
Facility (LAF) - to banks between 9.30 am and 10.30 am everyday to lend or
borrow from it against government securities. RBI manages daily money supply in
the system through LAF.

Starting from May 28, the apex bank will allow banks to avail of the second such
measure for half an hour between 4 pm and 4.30 pm.
The facility will allow banks to borrow more from the central bank to the tune of
0.5 per cent of their deposits.

In the first LAF of the morning hours, banks can borrow or lend as much as their
requirements. However, RBI sees money supply in the system before accepting
or rejecting their demands.

67
The second window may inject up to Rs 25,000 crore--0.5 per cent of the total
bank deposits of Rs 50 lakh crore at present.

Banks towards the close of the day would know exactly how much is their actual
demand for cash after taking money from each other in the call money market.
The central bank also allowed banks to seek waiver of the penal interest if they
have less government securities when they borrow more from the RBI.
At present, banks are required to have 25 per cent of their deposits in
government securities, cash and gold (statutory liquidity ratio or SLR).

For any shortfall in maintenance of SLR arising out of availment of this facility,
banks may seek waiver of penal interest," the RBI said.

This measure is however temporary, RBI said the facility would be available till
July two this year. Earlier, RBI had announced second LAF after funds dried up
due to deepening global financial crises.

The liquidity thus generated, around Rs22,500 crore, can be used to meet credit
demand. Since the crunch will continue beyond 2 July, RBI may extend this by a
few weeks till liquidity returns to the system, but this concession will not make a
significant difference as it will not create liquidity, but will merely allow commercial
banks to borrow extra money from the central bank.

One way to ease pressure is by cutting the cash reserve ratio (CRR), or the
portion of deposits that commercial banks need to keep with RBI. Currently it is
6%. A one percentage point cut in CRR will infuse about Rs45,000 crore liquidity
in the system, but RBI cannot do this as a cut in CRR will signal a reversal of its
policy stance.

What it can possibly do is buy back bonds from the market under its so-called
open market operations. On 2 July, a government bond worth Rs15,515 crore is
due for redemption. Another redemption, worth Rs34,000 crore, is slated for 28
July. RBI can offer to buy back these bonds from the banks. Essentially, this will

68
mean a slightly premature redemption of the bonds and an infusion of Rs39,515
crore into the system.

RBI is expected to opt for a quarter percentage point rate hike. This will be in
conformity with its gradual approach to a tight money policy as otherwise a
sudden spike will dampen economic growth.. RBI will announce its quarterly
review of monetary policy in July.

BIBLIOGRAPHY

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www.rbi.org.in
www.moneycontrol.com
www.icra.in
www.wikipedia.org
www.livemint.com
www.investopedia.com
www.kotak.com

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