Instruments of the Monetary Policy

The instruments at the disposal of the RBI for managing money supply, interest rates and exchange rates are:

Liquidity Management

• Cash Reserve Ratio
• Open Market Operations
• Managing Credit Expansion

Interest rate Management

• Repo Rate
• Bank rate
• Rates paid on government securities

Forex Management

• Tweaking the basket of currencies against which rupee rate is determined
• Market Intervention

Liquidity Management

• Cash Reserve Ratio:

  Banks reserve liquidity through their power to create credit. Presently in India, banks are required to maintain the following reserves:

  • Cash Reserve ratio: 8.25% of demand and time deposits (w.e.f. 24.05.2008)
  • Statutory Liquidity ratio: 25% of demand and time deposits

  Just as additional cash inflows enable the banking system to create credit, any increase in CRR will require the banking system to contract credit by a large amount.

  SLR (Statutory Liquidity ratio) is a requirement peculiar to India. In addition to ensuring that banks can fall back on the readily saleable government deposits in the event of a run on the bank, it was a prescription to divert bank deposits to meet government investment expenditure.

• Open Market Operations:

  Banks as well as other financial institutions, such as insurance companies, mutual funds and corporate with surplus cash are big investors in government securities. When RBI wishes to inject liquidity into the market, it has another option of buying government securities. When RBI offers to buy the securities at a rate that is better than the rate prevailing in the market, some of the investors can sell their holdings and the cash inflow would lead to credit creation of a large magnitude.

  Similarly, when RBI sells government securities at a higher rate than market rate, RBI absorbs funds and the banking system contracts credit by a large magnitude to reduce liquidity. This is known as open market operation.

• Managing Credit Expansion:

  CRR and OMO reduce liquidity in the system and reduce the ability of banks to create credit. RBI also controls sector specific expansion of credit by specifying maximum amounts that can be lent, minimum margins to be maintained and higher risk weights.

  When RBI feels that banks have overextended themselves to certain sectors, the flow of credit to certain sectors is leading to an imbalanced growth of the economy or it wants to control the price of certain commodities by preventing hoarding by wholesalers with borrowed funds, RBI makes sector specific or commodity specific interventions.

Interest Rate Management

• Repo rate:

  Repo rate or repurchase rate is a swap deal involving the immediate sale of securities and simultaneous purchase of those securities at a future date, at a designated price. It could also be an overnight deal with sale taking place on day one and repurchase on day two. The repurchase price is adjusted for the interest payable for the use of funds for the period of contract. Reverse repo involves the immediate purchase and future sale of those same securities. RBI uses repo and reverse repo to control liquidity on a day-to-day basis.

• Bank rate:

  RBI provides refinance to banks against funds deployed by banks in specified sectors such as export finance portfolio of the banks. In the past, the bank rate used to be the primary interest rate tool of RBI. But over a period of time the repo rate has presently emerged as the primary interest rate tool and bank rate has lost much of its relevance. Changes in the bank rate are a signal to the market regarding the direction in which the RBI would like interest rates to move.

• Rates paid on government securities:

  RBI, as a banker to the government, helps government to borrow from the market by selling their securities. RBI also determines the timing, size, and rate paid on the issues. Rates offered by RBI on government securities are both a reflection of the market and also an indicator to the market on the direction of interest rate movements.

Foreign Exchange Management

• Tweaking the basket of currencies:

  The exchange rate of rupee is calculated by RBI based on the exchange rates of basket of currencies of countries with which India has significant trade transactions. RBI maintains confidentiality about the weightage given to each currency in the basket and when RBI wishes to manage the extent of volatility in the exchange rate of rupee, RBI adjusts the weightages properly.

• Market intervention:

  Large balance of payment surpluses and build up of Forex reserves are bound to strengthen the rupee in the exchange market. This market force cannot be counted by RBI for long periods of time. However, by intervening in the market by offering to buy any amount of foreign currency at a particular rate, RBI can prevent the sudden strengthening of rupee. RBI seeks to smoothen the movement of rates in either direction so than importers and exporters have time to adjust to the changing exchange rate scenario and are not caught by surprise by violent rate movements, which could cripple them.