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Date : Aug 29, 2005

III. Monetary and Credit Policy Operations

III MONETARY AND CREDIT POLICY OPERATIONS

III.1 Monetary management had to contend with testing challenges on several fronts during 2004-05. First, an increase in domestic prices in the first half of the year, driven largely by a sustained increase in international commodity prices including fuel, and an unsatisfactory and uneven South-West monsoon posed serious concerns about price stability. Second, the situation was complicated by a large overhang of domestic liquidity generated by capital inflows. Third, financial markets had to be sensitised to the expected upturn in the interest rate cycle. The Reserve Bank had to, therefore, strike a fine balance between reining in inflationary expectations, encouraging the impulses of growth and ensuring financial stability. This called for a calibrated strategy of liquidity management in conjunction with fiscal measures to cushion the impact of international commodity prices on domestic inflation. The Market Stabilisation Scheme (MSS) was introduced in April 2004 to provide the monetary authority an additional instrument of liquidity management and sterilisation. Several measures were also initiated to maintain asset quality of the banking system at a time of rapid credit growth. Initiatives to improve the credit delivery system, especially in respect of agriculture and small and medium enterprises, gathered further momentum during the year.

III.2 Based on an assessment of the macroeconomic prospects and financial conditions, and assuming no unexpected exogenous shocks or adverse inflationary developments, the overall stance of monetary policy for 2004-05 in the Annual Policy Statement (in May 2004) was stated to be:

• Provision of adequate liquidity to meet credit growth and support investment and export demand in the economy while keeping a very close watch on the movements in the price level.

• Consistent with the above, while continuing with the status quo, to pursue an interest rate environment that is conducive to maintaining the momentum of growth and, macroeconomic and price stability.

III.3 The policy stance was tested in the second quarter of 2004-05 when a surge in inflation imposed conflicting pulls. As inflation was essentially supply induced, monetary policy action could have turned out to be premature, especially as industry was coming out of a prolonged sluggish phase. On the other hand, a deterioration in inflation expectations in the absence of policy measures could have become self-perpetrating against the backdrop of a large liquidity overhang, strong credit growth and pass-through effect of the oil price shock, and would have ultimately endangered the growth process itself.

III.4 It is against this backdrop of uncertainties that the Reserve Bank undertook a number of steps in a measured and calibrated manner to maintain the momentum of growth while reining in inflation. These, inter alia, included an increase in the MSS ceiling, hike in the cash reserve ratio (CRR), de-linking of the remuneration on the eligible CRR balances from the Bank Rate and hikes in the reverse repo rate¹ by 25 basis points each in October 2004 and April 2005.

III.5 In view of the developments during the first half of the year, particularly the inflation experience, the overall stance of monetary policy for the second half of 2004-05 was altered in the Mid-term Review (in October 2004) of the Annual Policy Statement as:

• Provision of appropriate liquidity to meet credit growth and support investment and expor t demand in the economy while placing equal emphasis on price stability.

1 With effect from October 29, 2004, the nomenclature of repo and reverse repo has been interchanged as per international usage. Prior to that date, repo indicated absorption of liquidity while reverse repo meant injection of liquidity. The nomenclature in this Report is based on the new use of terms even for the period prior to October 29, 2004, i.e., reverse repo indicates absorption of liquidity while repo indicates injection of liquidity in exchange for Government securities on a repurchase basis .

• Consistent with the above, to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth.

• To consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations.

III.6 This Section presents the Reserve Bank's monetary and credit policy operations during 2004-05. A review of monetary operations highlights the response of the Reserve Bank to the various challenges faced during the year. This is followed by an assessment of interest rate policy which focuses on various initiatives undertaken to impart flexibility to the interest rate structure. The Section also profiles the policy measures initiated by the Reserve Bank during the year with a view to strengthening the credit delivery system.

MONETARY POLICY OPERATIONS

Monetary Measures
Bank Rate

III.7 The Bank Rate signals the medium-term stance of monetary policy. Given the short-term character of the supply-induced inflationary pressures during 2004-05, the Bank Rate was retained at the existing level of 6.0 per cent. It was reduced to its present level – the lowest level since May 1973 –effective April 29, 2003.

Repo Rates

III.8 The repo/reverse repo rates signal the Reserve Bank's monetary policy stance in the short term. The fixed reverse repo rate, the price at which the Reserve Bank absorbs liquidity under the LAF, was increased by 25 basis points to 4.75 per cent, effective October 27, 2004 and by a further 25 basis points to 5.00 per cent, effective April 29, 2005 (Table 3.1). The repo rate, the price at which the Reserve Bank injects liquidity under the LAF, remained unchanged at 6.0 per cent during the year. The spread between the repo rate and the reverse repo rate was thus reduced by 25 basis points each on two occasions (to 125 basis points with effect from October 27, 2004 and 100 basis points with effect from April 29, 2005).

Cash Reserve Ratio

III.9 The cash reserve ratio (CRR) was increased to 5.0 per cent in two stages of 25 basis points each with effect from September 18, 2004 and October 2, 2004, partly to absorb liquidity from the system but

Table 3.1: Movement in LAF Rates

Month	2005-06		2004-05		2003-04		2002-03

	Reverse Repo	Repo	Reverse Repo	Repo	Reverse Repo	Repo	Reverse Repo	Repo

1	2	3	4	5	6	7	8	9
April	5.00	6.00	4.50	6.00	5.00	7.00	6.00	–
	(April 29)
May	5.00	6.00	4.50	6.00	5.00	7.00	6.00	8.00
June	5.00	6.00	4.50	6.00	5.00	7.00	5.75	–
							(June 27)
July	5.00	6.00	4.50	6.00	5.00	7.00	5.75	–
August			4.50	6.00	4.50	6.50	5.75	–
					(August 25)	(August 25)
September			4.50	6.00	4.50	6.50	5.75	–
October			4.75	6.00	4.50	6.50	5.50	–
			(October 27)				(October 30)
November			4.75	6.00	4.50	6.50	5.50	7.50
December			4.75	6.00	4.50	6.50	5.50	–
January			4.75	6.00	4.50	6.50	5.50	7.50
February			4.75	6.00	4.50	6.50	5.50	7.50
March			4.75	6.00	4.50	6.00	5.00	7.00
						(March 29)	(March 3)

Note : With effect from October 29, 2004, the nomenclature of repo and reverse repo has been interchanged as per international usage. Prior to that date, repo indicated absorption of liquidity while reverse repo meant injection of liquidity. The nomenclature in this Report is based on the new use of terms even for the period prior to October 29, 2004, i.e., reverse repo indicates absorption of liquidity while repo indicates injection of liquidity.

Table 3.2: Cash Reserve Ratio

									(Rupees crore)

	Month	2005-06		2004-05		2003-04		2002-03

		CRR	Amount*	CRR	Amount*	CRR	Amount*	CRR	Amount*
		(Per cent)		(Per cent)		(Per cent)		(Per cent)

	1	2	3	4	5	6	7	8	9

April		5.0		4.5		4.75		5.5
May		5.0		4.5		4.75		5.5
June		5.0		4.5		4.5	3,500	5.0	6,500
July		5.0		4.5		4.5		5.0
August				4.5		4.5		5.0
September				4.75	-4,500	4.5		5.0
October				5.0	-4,500	4.5		5.0
November				5.0		4.5		4.75	3,500
December				5.0		4.5		4.75
January				5.0		4.5		4.75
February				5.0		4.5		4.75
March				5.0		4.5		4.75

* : Amount stands for first round release (+)/ impounding (-) of resources through changes in the cash reserve ratio.

more importantly, to curb inflationary expectations (Table 3.2). The Reserve Bank continues to pursue its medium-term objective of reducing the CRR to the statutory minimum level of 3.0 per cent. At the same time, it retains the option to use the CRR flexibly in both directions for liquidity management, in addition to other instruments.

III.10 A survey of the cross-country experience demonstrates that the level of the CRR in the Indian case is comparable with other emerging market economies (EMEs). Moreover, several EMEs do not pay interest on balances with the central bank/monetary authority (Table 3.3).

III.11 The Reser ve Bank of India Act, 1934 provides for payment of interest on the required reserves beyond the statutory minimum at a rate determined by the Reserve Bank from time to time. Payment of interest on eligible cash balances partially mitigates the impact of a high CRR on the cost of funds of banks. The degree of implicit taxation has, however, lessened in recent years with the substantial scaling down of the CRR, coupled with a marked decline in the overall interest rate structure in the economy. It is in this context that the Reserve Bank's Internal Group on Liquidity Adjustment Facility recommended that the remuneration of eligible cash balances at the Bank Rate (6.0 per cent per annum) was no longer justifiable. The interest rate paid on CRR balances was accordingly lowered to 3.5 per cent per annum with effect from the fortnight beginning September 18, 2004.

III.12 Section 42(1) of the Reserve Bank of India Act, 1934 empowers the Reserve Bank to levy a cash reserve ratio between 3-20 per cent of the total of the demand and time liabilities of banks to be maintained on an average daily basis. The Union

Table 3.3: Required Reserves in Emerging Market Economies

Country	Required Ratio		Interest Paid	Eligible Assets
		(per cent)	on Reserves	other than Cash
			(per cent)	Balances with
				Central Bank

1		2	3	4
China		6	1.9	Cash with banks
Czech Republic		2	Repo rate	None
India $		5	3.5	@
Indonesia		5	None
Korea		1-5	None	Vault Cash (up to
				35 per cent)
Malaysia		4	None
Mexico		Zero	None
Poland		4.5	None	Vault Cash
				(limited)
Russia		7-10	None	Vault Cash
South Africa		2.5	None	25 per cent of
				cash with banks
Thailand		6	None	Vault Cash
				(up to 2.5
				percentage points)

$:as on August 18, 2005. @:Paid on required reserves above the statutory minimum requirement of three per cent. Source : Hawkins, J. (2005): Globalisation and Monetary Operations in Emerging Economies. BIS Papers No. 23, Bank for International Settlements.

Box III.1

Monetary Policy Signalling

Signalling assumes key importance in conveying the stance of monetary policy. This is especially because the transmission of monetary policy impulses works through financial markets, which are characterised by asymmetric information. It is in this context that monetary authorities now emphasise the need to clearly communicate their policy intentions to the markets in order to bridge information asymmetries.

In the Indian context, indirect instruments for transmitting policy signals were activated beginning with the Bank Rate in April 1997. With the sharp decline in recourse to central bank refinance (at rates linked to the Bank Rate) under easy liquidity conditions, there has been a shift in emphasis on managing short-term liquidity. The Liquidity Adjustment Facility (LAF) has become the principal operating instrument of monetary policy. In this regard, the reverse repo/repo rates have become potent tools for signalling the stance of monetary policy and defining an informal corridor of short-term interest rates. Moreover, the scale of absorption/injection of liquidity through reverse repos/repos itself also has a bearing on short-term liquidity conditions. In addition, the CRR continues to be used for augmenting/absorbing liquidity and influencing interest rates. An empirical investigation carried out in the Indian context suggests that CRR, Bank Rate and reverse repo rate (Granger) cause changes in the call rate, Government securities yields and forward premia, but have a negligible impact on the BSE Sensex.

References

1. Bhattacharyya. I. and R. Sensarma (2005), 'Signalling Instruments of Monetary Policy: The Indian Experience', Journal of Quantitative Economics, July.
2. Reddy, Y.V. (2002): 'Parameters of Monetary Policy In India', Reserve Bank of India Bulletin, February.

Budget, 2005-06 proposes to introduce legislation to amend the Reserve Bank of India Act, 1934 to remove the limits of the CRR in order to facilitate a more flexible conduct of monetary policy.

Liquidity Management

III.13 The Reserve Bank continued to manage the liquidity in the system through a mix of open market operations (OMOs), the LAF, Central Government Treasury Bills and dated securities issued under the MSS, changes in the CRR and interest rate signals (Box III.1).

III.14 The instruments used for sterilisation operations in India underwent changes during 2004-05. It was recognised that the finite stock of Government paper with the Reserve Bank could potentially circumscribe the scope of outright OMOs for sterilising capital flows. Outright OMOs for sterilisation purpose were last carried out in January 2004 (Char t III.1). Accordingly, LAF, essentially an instrument of day-to-day liquidity management, had to be relied upon for sterilisation as well during 2004-05.

III.15 The sterilisation operations were also constrained by several other factors. First, under the Reserve Bank of India Act, 1934 the Reserve Bank is not allowed to borrow beyond its paid-up capital of Rs.5 crore without collateral. Second, in the past, the Reserve Bank had augmented its ability to carry out OMOs by converting non-marketable special securities funded from Treasury Bills into marketable paper. With the full conversion of the entire stock of such paper in September 2003, the Reserve Bank was unable to resor t to such operations. Third, the Reserve Bank cannot issue its own paper under the extant provisions of the Reserve Bank of India Act, 1934 and such an option has generally not been favoured in India. Central bank bills/bonds would impose the entire cost of sterilisation on the Reserve Bank's balance sheet. Besides, the existence of two sets of risk-free paper

Box III.2

Central Bank Reserves as an Instrument of Monetary Policy Credibility

The need to maintain sufficient net worth in the form of central bank reserves has acquired a renewed urgency with the increasing market orientation of monetary policy. There is now an emerging consensus that well-capitalised central banks are relatively more credible because they can bear larger quasi-fiscal costs of market stabilisation, especially in case of economies with large fiscal deficits. Most central banks prefer to build up reserves by transfer from annual profits rather than by raising capital. While monetary authorities have the first statutory charge on their income, the fisc typically appropriates the dominant share (often up to 90 per cent), although this is often counterbalanced by parallel restrictions on deficit financing.

The US Federal Reserve usually transfers its profits to the surplus fund after distributing 6 per cent of capital to member central banks with only occasional transfers to the Treasury. The Bank of England, on the other hand, passes the entire profits of the Issue department to the Treasury. The Bank of Japan transfers its surplus to the Government after transferring 5 per cent to its reserve fund and a maximum of 5 per cent to other shareholders. In the EMEs, some central banks transfer the bulk of their profits to the Government after retaining a share (illustratively, two per cent for the National Bank of Poland and 10 per cent for the South African Reserve Bank) towards their reserves. The Bank of Mexico transfers its surplus to the fisc after ensuring that its reserves are maintained at a real value in line with the gross domestic product. The median size of central bank capital, as a proportion to total assets, at 8.8 per cent in EMEs, lags that of advanced economies at 15.3 per cent at end-May 2003.

The Reserve Bank of India Act, 1934 requires the Government to maintain reserves of the equivalent of the paid-up capital of Rs.5 crore. Besides, the Reserve Bank created a number of reserves under the enabling provisions of Section 47. The Reserve Bank maintains a Contingency Reserve (CR) to enable it to absorb unexpected and unforeseen contingencies. In order to meet the internal capital expenditure and make investments in its subsidiaries and associate institutions, the Reserve Bank had created a separate Asset Development Reserve (ADR) in 1997-98, with the aim of reaching one per cent of the Reserve Bank’s total assets within the overall indicative target of 12 per cent set for CR. The size of the Reserve Bank’s CR and ADR together constituted 10.1 per cent of total assets of the Reserve Bank at end-June 2005. The balance in CR is sufficient to meet contingent liabilities.

References

1. Hawkins, John (2003): 'Central Bank Balance Sheets and Fiscal Operations', BIS Economic Papers. No. 20.

2. Jadhav, Narendra, Partha Ray, Dritidyuti Bose and Indranil Sen Gupta (2003): 'The Reserve Bank of India's Balance Sheet: Analytics and Dynamics of Evolution', RBI Occasional Papers, Vol. 24, No. 3, pp. 1 - 59.

3. Reddy, Y.V. (1997): 'Financial Sector Reforms and RBI's Balance Sheet Management', Reserve Bank of India Bulletin, December.

4. Stella, Peter (2002), 'Central Bank Financial Strength, Transparency, and Policy Credibility', IMF Working Paper, August.

– gilts and central bank securities – tends to fragment the market. Fourth, as the Government cannot statutorily receive interest on surplus balances with the Reserve Bank, its surpluses are 'invested' in its own securities held by the Reserve Bank to avoid costs for the Government in terms of idle funds. This arrangement, however, diminishes the availability of the stock of Government securities for sterilisation operations and overall liquidity management.

III.16 Strong capital inflows increasingly pose a challenge to monetary policy in a number of EMEs. The cross-country experience suggests that most EMEs are deploying a policy matrix of sterilisation, liberalisation of the capital account in respect of residents, some degree of controls on capital inflows and greater flexibility in the exchange rate to manage capital inflows. Given the difficulties in distinguishing the 'permanent' and 'transitory' components of capital flows, most EMEs have also sought to build up large foreign exchange reserves as an insurance against quick reversal of capital inflows. It is also important that the central bank has the sufficient wherewithal in terms of internal reserves to sustain the costs of its market operations in its balance sheet (Box III.2).

III.17 The constraints on sterilisation operations induced a four-fold change in the strategy of sterilisation during 2004-05. First, the MSS was introduced in April 2004 to provide the Reserve Bank with an additional instrument of liquidity management and to relieve the LAF from the burden of sterilisation operations (Box III.3). The total outstanding amount absorbed under the MSS at end-March 2005 amounted to Rs.64,211 crore (Table 3.4). The papers issued under the MSS comprised dated Government securities (Rs.25,000 crore), 91-day Treasury Bills (Rs.19,248 crore) and 364-day Treasury Bills (Rs.19,963 crore). Concomitantly, the balances

Box III.3

Liquidity Management and Market Stabilisation Scheme

Pursuant to the recommendations of the Working Group on Instruments on Sterilisation (Chairperson: Smt Usha Thorat), a Market Stabilisation Scheme (MSS) was introduced on April 1, 2004 following a Memorandum of Understanding signed between the Government and the Reserve Bank on March 25, 2004. The ceiling on the outstanding amount under the MSS, fixed by mutual consultation, was raised from the initial Rs.60,000 crore to Rs.80,000 crore on October 14, 2004.

The MSS is designed to absorb liquidity of an enduring nature by way of sterilisation. Used in conjunction with the LAF, it allows the absorption of surplus liquidity built up into various maturity buckets ranging from overnight (under the reverse repo window) to the short-term (91-day, 182-day and 364-day Treasury Bills under the MSS) and the medium-term (dated Government securities with residual maturity upto 2.5 years). Under the MSS, the Government issues Treasury Bills and dated Government securities (with the same features as existing paper) to mop up rupee liquidity and parks the proceeds in a separate identifiable cash account maintained and operated by the Reserve Bank. These funds can be appropriated only for the purpose of redemption and/or buyback of paper issued under the MSS. The resultant decline in net Reserve Bank credit to the Government nullifies the expansionary impact of an accretion to the Reserve Bank's net foreign assets resulting from capital flows. The impact on the revenue/ fiscal accounts of the Government is limited to the discount on Treasury Bills and coupons on dated securities (net of premium/discount and accrued interest) issued under the MSS. Interest payments under the MSS were placed at Rs.2,969 crore during 2004-05.

under LAF reverse repos fell over the course of the year. Second, the Reserve Bank hiked reserve requirements for the first time after consistently reducing them for three years. Third, the reverse repo rate was hiked after three years of reduction to signal the Reserve Bank's monetary policy stance. Finally, the Union Budget for 2005-06 has proposed to introduce legislation to amend the Reserve Bank of India Act, 1934 to enable the Reserve Bank to lend or borrow securities by way of repo, reverse repo or otherwise.

Table 3.4: Liquidity Absorbed through LAF and MSS

		(Rupees crore)

Outstanding at	LAF	MSS	Total
Month end			(2+3)

1	2	3	4

2004
April	73,075	22,851	95,926
May	72,845	30,701	1,03,546
June	61,365	37,812	99,177
July	53,280	46,206	99,486
August	40,640	51,635	92,275
September	19,245	52,255	71,500
October	7,455	55,087	62,542
November	5,825	51,872	57,697
December	2,420	53,481	55,901

2005
January	14,760	54,499	69,259
February	26,575	60,835	87,410
March	19,330	64,211	83,541
April	27,650	67,087	94,737
May	33,120	69,016	1,02,136
June	9,670	71,681	81,351
July	18,895	68,765	87,660

Course of Liquidity Management

III.18 The Reserve Bank's liquidity management operations during the year could be analytically divided into three phases, essentially reflecting the switches in capital flows: the first phase lasting till mid-May 2004; the second phase covering mid-May-October 2004; and the third phase spanning the remaining part of the year (Table 3.5).

III.19 In the first phase, the liquidity overhang of about Rs.81,000 crore was further augmented by a surge in capital inflows in April 2004, a draw down of the Centre's surplus balances with the Reserve Bank and a truncation of the Government's borrowing programme (Table 3.6). Securities issued under the MSS supplemented LAF reverse repo operations to mop up the surplus liquidity resulting from the accretion of about Rs.38,000 crore in the Reserve Bank's foreign currency assets (adjusted for revaluation). Reflecting easy liquidity conditions, the average daily call money borrowing rates softened to a little below reverse repo rate levels. The liquidity absorbed through LAF and MSS increased to over Rs.1,00,000 crore (five per cent of M3) by end-May 2004. In view of the finite stock of Government securities available with it, the Reserve Bank had to temporarily discontinue the practice of investing the Government's surplus balances in its own securities held by the Reserve Bank.

III.20 In the second phase (mid-May-October, 2004), capital outflows, rising import demand, escalation of international crude prices and a build-

Table 3.5: Phases of Liquidity Management Operations

						(Rupees crore)

			2005-06			2004-05
Item			July 23-	April 1-	October 30,	May 15-	March 27-
			August 12,	July 22,	2004-March 31,	October 29,	May 14,
			2005	2005	2005	2004	2004
1			2	3	4	5	6
A.	Drivers of Liquidity (1+2+3)		35,118	-4,890	43,734	-24,471	37,170
	1.	RBI’s Foreign Currency Assets (adjusted for revaluation)	19,348	6,412	83,662	-4,614	37,919
	2.	Currency with the Public	-1,307	-14,802	-25,896	6,639	-20,021
	3.	Others (residual)	17,077	3,500	-14,032	-26,496	19,272
		3.1 Surplus cash balances of the
		Centre with the Reserve Bank	5,972	6,053	-7,721	-18,481	15,355
B.	Management of Liquidity (4+5+6+7)		-24,633	-740	-31,852	37,960	-40,148
	4.	Liquidity impact of LAF Repos	-26,565	8,845	-11,875	66,040	-12095
	5.	Liquidity impact of OMO (net)	-66	-2,069	-1,853	-769	-277
	6.	Liquidity impact of MSS	1,998	-7,516	-9,124	-27,311	-27,776
	7.	First round liquidity impact due to CRR change	0	0	-9,000	0	0
C.	Bank Reserves (A+B)#		10,485	-5,630	11,882	13,489	-2,978

+: Indicates injection of liquidity into the banking system. -: Indicates absorption/ leakage of liquidity from the banking system. #: Includes vault cash with banks and adjusted for first round liquidity impact due to CRR change.

up of the Centre's surpluses with the Reserve Bank following primary auctions of Government securities drove down the surplus liquidity to about Rs.60,000 crore by end-October 2004. Recourse to the LAF window began to ease by June with seasonal currency demand, acceleration in the Government's borrowing programme and higher absorption of liquidity under the MSS. Temporary mismatches in the money markets arising from short covering by some banks, primary auctions and redemption

Table 3.6: Monthly Primary Liquidity Flows and Open Market Operations

Month		RBI’s Net		Net Reverse Repos				RBI’s Initial		Net OMO Sales			Market
	Foreign Currency			under the LAF				Subscription					Stabilisation
		Assets #											Scheme (MSS)

	2005-	2004-	2003-	2005-	2004-	2003-	2005-	2004-	2003-	2005-	2004-	2003-	2005-	2004-
	06	05	04	06	05	04	06	05	04	06	05	04	06	05

1	2	3	4	5	6	7	8	9	10	11	12	13	14	15

April	1,432	32,608	3,817	8,320	38,430	19,990	0	0	0	263	253	7	2,876	22,851
May	1,970	202	15,626	5,470	-230	-1,240	0	0	5,000	325	116	5,569	1,929	7,850
June	1,632	350	4,500	-23,450	-11,480	380	0	0	0	954	60	44	2,665	7,111
July	1,378	946	13,865	815	-3,290	19,025	0	0	0	526	218	57	-2,916	8,394
August		-5,360	11,550		-24,350	-4,840		217	0		78	11,526		3,235
September		1,001	6,417		-6565	-9,730		630	0		131	5,089		2,815
October		1,635	13,124		-19,705	-9,065		0	0		189	14,024		2,831
November		15,039	10,775		-1,630	-10,215		0	0		342	69		-3,215
December		13,184	13,661		-6265	2,430		0	0		339	132		737
January		1,537	11,723		15,795	-5515		0	9,500		703	5,178		945
February		14,392	14,610		10,610	-28,005		0	7,000		37	85		5,800
March		39,510	21,760		-6,635	-17,335		350	0		431	69		4,857

# : Adjusted for revaluation. Note : 1.Data pertain to the last day for March and last reporting Friday for all other months. 2.MSS was introduced effective April 2004.

pressure on mutual funds kept call rates firm until the first half of August 2004. In order to ease liquidity conditions, the Reserve Bank had to inject liquidity through repos of Rs.5,000 crore on August 12, 2004. Call rates firmed up again in the second half of September 2004 as the outflows on account of advance tax payments coincided with the first hike in CRR of 25 basis point effective September 18, 2004. Pressures from higher credit offtake and the second phase of the CRR hike again pushed the call rates above the reverse repo rate in the second half of October 2004. A 25 basis point hike in the reverse repo rate effective October 27, 2004 also raised the lower bound of the money market.

III.21 The scenario began to change in the third phase as capital flows resumed by end-October 2004. Festival cash demand and scheduled Government securities auctions initially drove up call rates beyond the reverse repo rate to a peak of 6.30 per cent on November 18, 2004. The Reserve Bank injected liquidity, averaging over Rs.10,000 crore on a daily basis, during November 5-22, 2004. The Reserve Bank also modulated MSS operations by cancelling some scheduled auctions of Treasury Bills and/or accepting partial amounts against the amounts notified for the auctions. Call rates softened to reverse repo rate levels by early December 2004 as the liquidity situation improved with the ebbing of festival cash demand and revival of interest of Foreign Institutional Investors (FII) in the Indian market. The Reserve Bank's foreign currency assets registered an increase of Rs.21,000 crore (net of revaluation) between mid-November and mid-December 2004. Call rates firmed up again in the second half of December 2004 as a result of pressures from advance tax payments and strong credit off-take (Chart III.2). Liquidity conditions eased in January 2005 with the return of the advance tax flows into the system, pulling the call rates back to the reverse repo rate levels. Average reverse repo balances under the LAF correspondingly increased by Rs.16,000 crore in this phase.

III.22 Liquidity conditions eased further in February 2005 with the resumption of FII inflows following a rally in the stock markets, a positive investment outlook and improved third quarter corporate results. Coupon and other inflows in the banking system continued to exceed outflows due to auctions of Central Government securities and tap issuances of State Government securities. Consequently, reverse repo operations had to be supplemented by issuances under the MSS. Notwithstanding the seasonal credit off-take, liquidity conditions eased further in March

2005 as FII inflows continued. The Reserve Bank's operations to balance the foreign exchange market resulted in an accretion of nearly Rs.40,000 crore (net of revaluation) to its net foreign assets. In order to maintain orderly conditions, the Reserve Bank continued its LAF operations, reinforced by MSS issuances. As at end-March 2005, the liquidity absorbed through the MSS and the LAF was about Rs.83,000 crore (about 3.7 per cent of M3). III.23 During 2005-06 so far (up to August 19, 2005), liquidity conditions have been comfortable. Large expansion in merchandise trade deficit coupled with stable capital flows eased liquidity pressures emanating from accretions to the foreign currency assets and sterilisation operations, mainly through MSS, were of a lower magnitude. However, from the end of July 2005 capital flows staged a strong revival and the consequent mopping up of liquidity was reflected in an increase in balances under LAF reverse repos.

Liquidity Adjustment Facility

III.24 The LAF is the Reserve Bank's primary instrument for modulating liquidity at the margin and transmitting interest rate signals to the market. All bids under the LAF were accepted during the year (Table 3.7).

III.25 The Reserve Bank introduced a revised LAF scheme on March 29, 2004 based on the recommendations of the Internal Group on the Liquidity Adjustment Facility. Effective April 5, 2004,

Table 3.7: Reverse Repo/Repo Bids under LAF


									(Number of days)

	Month		Reverse Repo					Repo

		Bids	All bids	Full	Partial	Bids	All bids		Full	Partial
		received	rejected	acceptance	acceptance	received	rejected	acceptance		acceptance
				of bids	of bids			of bids		of bids

1		2	3	4	5	6	7		8	9

2004-05
April		19	0	19	0	0	0		0	0
May		20	0	20	0	0	0		0	0
June		21	0	21	0	0	0		0	0
July		23	0	23	0	0	0		0	0
August		21	0	21	0	1	0		1	0
September		22	0	22	0	0	0		0	0
October		19	0	19	0	0	0		0	0
November		14	0	14	0	12	0		12	0
December		23	0	23	0	10	0		10	0
January		19	0	19	0	0	0		0	0
February		20	0	20	0	0	0		0	0
March		21	0	21	0	0	0		0	0

2005-06
April		18	0	18	0	0	0		0	0
May		21	0	21	0	0	0		0	0
June		22	0	22	0	2	0		2	0
July		18	0	18	0	0	0		0	0

Note : See note to Table 3.1.

daily repo/reverse repo variable rate auctions were replaced by 7-day fixed rate reverse repo auctions and daily fixed rate repo auctions, with a spread of 150 basis points. In order to restore flexibility in liquidity management so as to stabilise inflation expectations, the Reserve Bank replaced 7-day fixed rate and 14-day variable rate reverse repo auctions with overnight fixed rate reverse repo auctions, effective November 1, 2004. The Reserve Bank, however, retains the discretion to conduct overnight/ longer term repo/ reverse repo auctions at fixed rate or variable rates depending on market conditions and other relevant factors.

Open Market Operations

III.26 Outright sales under OMOs were not conducted during 2004-05 in view of the finite stock of Government securities with the Reserve Bank (Table 3.8). Consequently, the Reserve Bank's OMO sales were limited only to the transactions relating to the sale of securities to State Governments for investments in the Consolidated Sinking Funds (CSFs) and Guarantee Redemption Funds (GRFs) aggregating Rs.2,899 crore during 2004-05. With continuing liquidity surpluses in the system, the need for outright OMO purchases did not arise.

Interest Rate Policy
Interest Rate on Non-resident Deposits

III.27 The ceiling on interest rates on Non-Resident (External) Rupee (NRE) deposits was raised to LIBOR/SWAP rates of US dollar of corresponding maturities plus 50 basis points effective November

1, 2004 from the level of US dollar LIBOR/SWAP rates. Based on the suggestions received from banks and with a view to bringing in consistency in the procedure of fixing interest rates, effective November

1, 2004 banks were allowed to fix the ceiling on interest rates on FCNR(B) deposits on a monthly basis for the following month based on rates prevailing as on the last working day of the preceding month. Interest rates for FCNR(B) deposits hitherto used to be fixed on a weekly basis, unlike NRE deposits in respect of which interest rates are fixed on a monthly basis. The ceiling interest rates on FCNR(B) deposits, however, continue to be capped at LIBOR/SWAP minus 25 basis points.

Interest Rate on Rupee Export Credit

III.28 The validity of the reduction in the interest rate ceiling to 250 basis points below the benchmark prime lending rate (BPLR) on pre-shipment rupee export

Table 3.8: Reserve Bank’s Holdings of Central Government Dated Securities

								(Rupees crore)
Year	Devolvement	Private	OMO	Conversion	Total addition	OMO	Net Addition	Outstanding	Memo:
	On Reserve	Placement	Purchases	of Special	to Stock of	Sales by	to Stock	Holding by	Net Reverse
	Bank	taken by	by Reserve	Securities	Reserve	Reserve	(6-7)	Reserve	Repos
		Reserve	Bank	into dated	Bank ‘s	Bank		Bank	Outstanding
		Bank		securities	investments			(end
					(2+3+4+5)			period)*

1	2	3	4	5	6	7	8	9	10

1996-97	3,698	–	623	–	4,321	11,206	-6,885	6,666	2,300
1997-98	7,028	6,000	467	20,000	33,495	8,081	25,414	31,977	4,202
1998-99	8,205	30,000	–	–	38,205	26,348	11,857	42,212	400
1999-00	–	27,000	1,244	–	28,244	36,614	-8,370	35,190	–
2000-01	13,151	18,000	4,471	–	35,622	23,795	11,827	41,732	1,355
2001-02	679	28,213	5,084	–	33,976	35,419	-1,443	40,927	4,355
2002-03	5,175	31,000	–	40,000	76,175	53,780	22,395	55,438	2,415
2003-04	–	21,500	–	61,818	83,318	41,849	41,469	77,397	34,645
2004-05	847	350	–	–	1,197	2,899	-1,702	80,770	19,330

* : Inclusive of securities sold under the LAF.

credit up to 180 days and post-shipment credit up to 90 days announced on September 24, 2001 was extended up to April 30, 2005. This was later extended further to October 31, 2005.

Reduction of Tenor of Domestic Term Deposits

III.29 Banks were allowed at their discretion to reduce the minimum tenor of retail domestic term deposits (under Rs.15 lakh) from 15 days to 7 days with effect from November 1, 2004. This was done to provide uniformity of tenor between wholesale domestic term deposits (Rs.15 lakh and above) and retail domestic term deposits. Banks continue to have the freedom to offer differential rates of interest on wholesale domestic term deposits of Rs.15 lakh and above.

MONETARY POLICY STANCE FOR 2005-06

III.30 The Reserve Bank's stance of monetary policy in 2005-06 was set out as conditional upon macroeconomic prospects, global developments and the balance of risks. First, the outlook for growth which should be noticeably better than the previous year, may get moderated by developments in the international oil markets which remain tight. Second, while supply factors would continue to dominate the price situation, demand management would invite close attention. Third, adequate credit growth would need to be ensured for productive sectors while closely assessing the implications for demand management and price stability. In these circumstances, liquidity management would become critical. The interest rate outlook would have to take into account these domestic challenges but the increasing integration also warrants some attention to global factors. Four th, the smooth completion of the significantly higher borrowing programme of the Centre, particularly in a year of strong credit demand, needs to be factored in. Finally, while the external sector is expected to continue to exhibit strength and resilience in 2005-06, globally transmitted unanticipated shocks cannot be ruled out.

III.31 It was assumed that with a normal monsoon, the growth in agriculture could be around three per cent. Further, it was expected that industry and services would maintain their current growth momentum while absorbing the impact of oil prices. The real GDP growth during 2005-06, on the basis of these assumptions, was placed around 7.0 per cent for the purpose of monetary policy formulation.

III.32 It was recognised that several factors blurred a precise assessment of the potential inflationary pressures - the liquidity overhang, renewed volatility in international oil prices, postponed adjustment of domestic prices to international oil prices and the limited scope for fiscal manoeuvrability. On the other hand, credit growth continues to remain buoyant. Finally, increasing productivity in several sectors in the economy could moderate pressures on prices and the level of food stocks and foreign exchange reserves could provide a cushion against some price increases. In view of these considerations, the inflation rate for 2005-06, on a point-to-point basis, was placed in a range of 5.0-5.5 per cent, subject to the growing uncertainties on the oil front both with regard to global prices and their domestic absorption.

III.33 Consistent with the real growth of GDP and inflation, the projected expansion of money supply

(M 3) for 2005-06 was placed at 14.5 per cent. In tune with this order of growth in M3, the increase in

aggregate deposits of scheduled commercial banks was set at Rs.2,60,000 crore which is higher by 15.0 per cent over its level in the previous year. Non-food bank credit including non-SLR investments of banks was projected to increase by around 19.0 per cent, which was expected to adequately meet the credit needs of all the productive sectors of the economy.

III.34 Barring the emergence of any adverse and unexpected developments in various sectors of the economy and keeping in view the inflationary situation, the overall stance of monetary policy for the year 2005-06 would continue to be as set out in the Mid-term Review of October 2004, i.e.,

• Provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability.

• Consistent with the above, to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth.

• To consider measures in a calibrated manner, in response to evolving circumstances with a view to stabilising inflationary expectations.

III.35 The Reserve Bank would continue to pursue the integration of the various segments of the financial market, improve credit delivery, nurture credit culture and enhance the quality of financial services.

Quarterly Review of Monetary Policy

III.36 The Reserve Bank decided to introduce a First Quarter Review of Part I of the Annual Policy Statement in July and a Third Quarter Review in January. The Mid-term Review in October would cover, as in the past, both Part I and Part II (Annual Statement on Developmental and Regulatory Policies). While the Annual Policy Statement and the Mid-term Review will continue to be presented in the meeting with bankers, the quarterly reviews will be released to the Press. Tentatively, for 2005-06, the dates planned for the First Quarter Review, the Mid-term Review and the Third Quarter Review were set as July 26, 2005, October 25, 2005 and January 24, 2006, respectively.

III.37 With a view to further strengthening the consultative process in monetary policy, the Reserve Bank, in July 2005, set up a Technical Advisory Committee on Monetary Policy (TACMP) with external experts in the areas of monetary economics, central banking, financial markets and public finance. The Committee would meet at least once in a quarter and review macroeconomic and monetary developments, and advise the Reserve Bank on the stance of monetary policy. The setting up of the TACMP is in line with international best practices (Box III.4).

III.38 In its First Quarter Review (July 26, 2005), the Reserve Bank noted that the stance of monetary policy would depend on the macroeconomic developments including the global developments and the overall balance of risks. Factors such as increased global uncertainties, high and volatile international prices of oil, incomplete pass-through of oil prices domestically, upward trajectory of the policy rate in the US, overhang of liquidity, high credit growth, sustained industrial growth and possible capacity pressures, enlargement of trade deficit, infrastructural constraints and delayed monsoon could prompt a change in the stance of policy. On the other hand, it needs to be recognised that the oil price hike has been managed well with a combination of monetary and fiscal measures, overhang of liquidity has reduced with the increase in the absorptive capacity of the economy, excess liquidity remains sterilised, visible liquidity under LAF has reduced, money supply growth is within the projected trajectory, credit flow is getting broad-based, industrial growth has revived after a long period of sluggishness, pick up in investment demand is evident, investment climate remains favourable, corporate earnings and profits have been sustained, current level of inflation remains moderate both at the wholesale level and retail level, globally monetary policy continues to be somewhat accommodative and global inflation during 2005 is projected to be moderate despite high oil prices. It is apparent that there are several global uncertainties but there are domestic factors, which indicate a confidently growing economy in a stable environment. While global factors are getting to be increasingly significant for India, the domestic factors still dominate and the latter point to favouring stability to maintain growth momentum at this juncture while being ready to respond to evolving circumstances. Accordingly, the overall stance of monetary policy

Box III.4

Monetary Policy: Decision Making and Communication

Given the forward-looking nature of financial markets and the critical role played by them in the monetar y transmission process, it is increasingly felt that the effectiveness of monetary policy depends as much on expectations about future policy as on actual actions that transpire. Accordingly, central banking is increasingly concerned with the management of expectations. Monetary authorities are today much more transparent and articulate in their communication of policy objectives and the rationale behind the decision making process than before.

As regards the decision-making process, greater reliance is being placed on a consultative process involving a collective body - typically called ';monetary policy committee'; (MPC) - rather than an individual. The preference for the committee system is due to the belief that (a) collective bodies tend to make better decisions than individuals, (b) it is more democratic and enjoys wider public suppor t and (c) it reinforces central bank independence. A survey by the Bank of England found that 79 of the 88 central banks surveyed for the purpose had such a policy making body. In some central banks, an advisory body discusses policy options although the final decision rests with the Governor.

Cross-country experience on MPCs in various central banks shows:

• MPCs are broadly of two types, viz., 'collegial' and 'individualistic'. 'Collegial' MPCs, such as the Governing Council of the European Central Bank (ECB), strive for consensus and decisions are based on the collective wisdom of the members. In contrast, members of 'individualistic' MPCs - for instance, the Bank of England and the Riksbank (Swedish Central Bank) - develop and advocate their own positions, vote accordingly and even defend their action in public. As a result, decision making in these bodies is based on the majority voting principle.

• In some cases, MPCs are solely responsible for monetary policy while others are involved in the broader management of the central bank.

• In most cases, the constitution of the MPC is backed by law.

• The size of the MPC varies greatly, ranging from three members (Swiss National Bank) to 18 (European Central Bank).

• The frequency of the meetings of the MPC ranges from once every two weeks (Bank of Mexico) to every quarter (Swiss National Bank).

• Most MPCs have external members to get the benefit of outside perspectives.

A key issue of debate relates to the publication of the minutes of the committee meetings, especially the relative merits and demerits of publishing the dissension among members of the MPC. On the one hand, differences of opinion on purely technical matters could be misinterpreted by the public, which could erode the credibility of the central bank. This may be quite relevant for emerging economies, which function under various constraints including, in some cases, on credibility. On the other hand, some central banks, especially in more mature economies, tend to prefer public disclosure of their views in the belief that greater transparency enhances policy credibility as well as individual accountability and assists the markets in correctly interpreting signals.

References:

1. Blinder A. and J. Morgan (2000): 'Are Two Heads Better than One? An Experimental Analysis of Group vs Individual Decision Making', NBER Working Paper No. 7909.

2. Mahadeva L. and G.Sterne (2000): Monetary Policy Frameworks in a Global Context, Routledge, London.

for the remaining part of the year 2005-06 will continue to be as set out in the Annual Policy Statement of April 2005, but the Reserve Bank would respond, promptly and effectively, to the evolving situation depending on the unfolding of risks.

CREDIT DELIVERY

III.39 Credit delivery to small borrowers, particularly to the agriculture and small-scale industries (SSI) sector, is critical to the growth of the economy. The Reserve Bank has been proactively promoting a conducive credit culture by removing bottlenecks in credit delivery and providing adequate and timely finance at reasonable rates without procedural hassles to different sections of the economy. The policies relating to rural credit have been designed to bring about economic and social change in the rural areas, especially for the benefit of poorer sections of the society.

Priority Sector Lending

III.40 The Reser ve Bank under took several measures to improve credit delivery to the priority sector during 2004-05. More categories of advances were brought under the ambit of the priority sector lending: (i) bank loans to storage units, including cold storage units, designed to store agricultural produce/ products, irrespective of their location are to be treated as indirect agricultural finance under priority sector; (ii) investments by banks in securitised assets representing direct (indirect) lending to agriculture are to be treated as their direct (indirect) lending to agriculture under the priority sector, provided the securitised loans are originated by banks and financial institutions; (iii) investments made by banks in mortgage backed securities (MBS) are to be treated as direct lending to housing within the priority sector lending subject to cer tain conditions; and (iv) investments made by banks in securitised assets representing direct lending to the SSI sector are to be treated as their direct lending to the SSI sector under the priority sector, subject to certain conditions. Banks can advance loans to the distressed urban poor to prepay their debt to non-institutional lenders against appropriate collateral or group security and classify the same under weaker sections within the priority sector. In order to encourage direct lending to priority sector, investments made by banks on or after April 1, 2005 in special bonds issued by cer tain specified institutions have been made ineligible for classification under priority sector lending. Such investments which have already been made by banks up to March 31, 2005 would cease to be eligible for classification under priority sector lending in a phased manner. Investments made by banks on or after July 1, 2005 in venture capital have been made ineligible for classification under priority sector lending. Such investments which have already been made up to June 30, 2005 would cease to be eligible for classification under priority sector lending with effect from April 1, 2006.

III.41 The limit on advances for dealers in agricultural machinery for being categorised under the priority sector was increased from Rs.20 lakh to Rs.30 lakh and for distribution of inputs for allied activities from Rs.25 lakh to Rs.40 lakh. Besides, banks with the approval of their boards were allowed to extend direct finance to the housing sector up to Rs.15 lakh, irrespective of location, as part of their priority sector lending. Furthermore, the limit on advances granted by banks to farmers through the produce marketing schemes under priority sector lending, against pledge/hypothecation of agricultural produce (including warehouse receipts) for a period not exceeding 12 months was increased from Rs.5 lakh to Rs.10 lakh. The composite loan limit for SSI entrepreneurs was enhanced from Rs.50 lakh to Rs.1 crore.

III.42 The investment limit in plant and machinery for seven items belonging to sports goods, which figure in the list of items reserved for manufacture in the small-scale industries (SSI) sector, was enhanced from Rs.1 crore to Rs.5 crore for the purpose of classification under priority sector advances.

III.43 Since 1994-95, public sector banks have been preparing Special Agricultural Credit Plans (SACPs) on an annual basis in line with the Reserve Bank's instructions. Banks were advised to make efforts to increase their disbursements to small and marginal farmers to 40 per cent of their direct advances under SACPs by March 2007. In view of the Union Finance Minister's announcement in June 2004 for doubling the flow of credit to agriculture in the next three years, private sector banks were advised to fix the SACP target for the year 2005-06 showing a growth rate of 30 per cent over the disbursements during 2004-05, Finally, banks were allowed to waive margin/security requirements for agricultural loans up to Rs.50,000 and in the case of agri-business and agri-clinics for loans up to Rs.5 lakh.

III.44 All bank groups were able to achieve the overall target for priority sector lending as on the last reporting Friday of March 2005 (Table 3.9). However, two out of 27 public sector banks and 12 out of 30 private sector banks fell short of the target of 40 per cent.

Table 3.9: Priority Sector Advances


		(Rupees crore)

As on Last Reporting	Public Sector	Private Sector	Foreign
Friday of March	Banks	Banks	Banks

1	2	3	4

2000	1,27,478	18,368	9,934
	(40.3)	(38.0)	(35.2)

2001	1,49,116	21,567	11,572
	(43.7)	(36.7)	(33.5)

2002	1,71,484	24,184	9,936
	(43.5)	(38.4)	(34.6)
2003	1,99,786	36,648	14,555
	(41.2)	(44.1)	(33.1)
2004*	2,45,672	52,861	18,276
	(44.0)	(47.3)	(34.8)
2005*	3,10,093	69,384	24,254
	(43.2)	(43.3)	(35.6)

: Data are provisional. Note :*1.Figures in brackets are percentages to the net bank credit. 2.The target for aggregate advances to the priority sector is 40 per cent of the net bank credit for domestic banks and 32 per cent of net bank credit for foreign banks.

Credit to Agricultural Sector

III.45 The share of agricultural advances, as a percentage of net bank credit, increased in respect of public sector banks but decreased in respect of private sector banks during 2004-05 (Table 3.10).

III.46 Disbursements to agriculture under the SACPs increased to Rs.65,218 crore during 2004-05 from Rs.42,211 crore during the preceding year. The recovery of direct agricultural advances of public sector banks improved further during 2004-05 (Table 3.11).

Micro Finance

III.47 The Self-Help Group (SHG)-Bank Linkage Programme implemented by commercial banks, RRBs and cooperative banks has emerged as the major microfinance programme in the country. As on March 31, 2005, 1.6 million SHGs have been linked to banks and total flow of credit to these SHGs worked out to over Rs.6,800 crore. The NABARD and banks have set a target of linking additional 0.6 million SHGs by end-March 2007. The Reserve Bank has allowed non-governmental organisations (NGOs) engaged in microfinance activities to access external commercial borrowings (ECBs) up to US$ 5 million during a financial year under the automatic route, subject to certain conditions, as an additional channel for resource mobilisation.

III.48 As announced in the Union Budget, 2005-06 the Micro Finance Development Fund (MFDF), set up in the NABARD, has been re-designated as 'Microfinance Development and Equity Fund'. Its corpus has also been doubled from Rs.100 crore to Rs.200 crore. The fund is to be managed by a board consisting of representatives of NABARD, commercial banks and professionals with domain knowledge.

III.49 An in-house Group (Chairman: Shri H. R. Khan) has been set up within the Reserve Bank in order to examine the issues relating to allowing banks to adopt agency models by using infrastructure of civil society organisations, appointment of 'banking correspondents' to function as intermediaries between the lending banks and the beneficiaries and identification of steps to promote micro-finance institutions (MFIs). The Group submitted its final report on July 19, 2005 after incorporating the comments/ suggestions received from the public.

Table 3.10: Outstanding Agricultural Advances


			(Rupees crore)

As at	Public Sector Banks		Private Sector	Banks
End-March	Amount	Percentage	Amount	Percentage
	Out-	of Net	Out-	of Net
	standing	Bank	standing	Bank
		Credit		Credit

1	2	3	4	5
2000	45,296	14.3	4,023	8.3
2001	53,571	15.7	5,634	9.6
2002	58,142	14.8	6,581	8.5
2003	70,501	14.5	9,924	10.9
2004*	86,187	15.4	17,652	12.3
2005*	1,12,475	15.7	21,473	12.1
* : Data are provisional. Note:The target for advances to agriculture is 18 per cent of net bank credit.

Relief Measures for Persons Affected by the Tsunami

III.50 In view of the loss of life and property caused by the tsunami in the States of Andhra Pradesh, Tamil Nadu and Kerala, and the Union Territories (UTs) of Pondicherry and Andaman and Nicobar Islands, the convenor banks of the State Level Bankers' Committees (SLBCs) in these States/UTs were advised to take immediate measures to provide appropriate relief to the affected people in terms of the standing guidelines issued by the Reserve Bank. A Task Force (Chairman: Shri V. Leeladhar) was also set up on December 27, 2004 to monitor the progress of relief and rehabilitation measures through banks and to constantly review the situation. Special meetings of the SLBCs were convened in the three States and two UTs and measures were initiated by banks to provide financial assistance to persons, particularly those engaged in fisheries, in the affected areas. Based on the suggestion received from a few SLBCs, the consumption loan limit was enhanced from Rs.1,000 to Rs.3,000 in the case of persons affected by the tsunami.

Table 3.11: Public Sector Banks – Recovery of Direct Agricultural Advances

				(Rupees crore)

Year ended	Demand	Recovery	Overdues	Percentage
June				of Recovery
				to demand

1	2	3	4	5
2001	22,429	15,540	6,889	69.3
2002	24,561	17,758	6,803	72.3
2003	28,940	21,011	7,930	72.6
2004	33,544	25,002	8,542	74.5

III.51 Instructions were issued to all scheduled commercial banks to receive donations to the Prime Minister's Relief Fund at all branches and to nominate a nodal branch at New Delhi for the purpose of collection. Furthermore, the Government of India exempted, up to March 31, 2005 all associations (other than political parties) having a definite cultural, economic, educational, religious or social programme from the provisions of the Foreign Contributions (Regulation) Act, 1976 enabling them to accept foreign contributions in cash and kind for providing relief to the tsunami victims, without obtaining formal approval from the Central Government.

III.52 In addition, the following measures were suggested for immediate implementation by banks:

• To take the help of good NGOs working in the areas to identify borrowers.

• To increase the limit of consumption loan to be provided to the affected persons to Rs.5,000 without any collateral. The limit could be enhanced to Rs.10,000 at the discretion of the branch manager, depending on the repaying capacity of the borrower.

• To allow opening of savings bank accounts with nominal balance (say, Rs.10) without insisting on minimum balance so that victims can receive relief cheques in their accounts. In the case of loss of passbooks/ cheque books, fresh ones should be immediately issued.

• To provide education loans to the affected persons to enable them to purchase books, clothes, etc. for children studying in educational institutions.

• To formulate a scheme for financing of defaulting fishermen and other types of borrowers on the lines of the scheme for financing 'farmers in arrears' as announced by the Finance Minister on June 18, 2004 and communicated to banks by the Indian Banks' Association (IBA).

• To identify the victims, on the basis of their experience and in consultation with other agencies operating in the area, who are in need of assistance and to provide them necessary relief without waiting for any list of victims to be formally made available by the Government.

III.53 The Government of India announced a Rajiv Gandhi Rehabilitation Package for the tsunami-affected areas under which subsidy would be provided by it for loans advanced to the victims for purchase of boats and for repairs to the boats. The IBA advised its member banks that while the ceilings on loans indicated under the Package are for the limited purpose of extending subsidy, they should provide loans to the extent of full unit costs, after taking into account the eligible subsidy.

Relief Measures in Areas Affected by Rains and Floods in Maharashtra

III.54 Consequent to the unprecedented rains and floods resulting in heavy damage to life and property in the State of Maharashtra, the convenor bank of the State Level Bankers’ Committee (SLBC) was advised to assess the situation and take immediate measures to provide appropriate relief to the affected people in terms of the Reserve Bank’s standing guidelines on relief measures by banks in areas affected by natural calamities. In particular, attention of banks was drawn to providing financial assistance to artisans, self-employed, traders, tiny and small-scale industrial units affected by the unprecedented calamity. In view of the situation prevailing in the State, banks were also advised to consider increasing the limit of consumption loan to be provided to the affected persons in the State up to Rs. 5,000 without any collateral. This limit may be enhanced to Rs. 10,000 at the discretion of the branch manager, depending on the repaying capacity of the borrower. Banks were also advised to consider provision of financial assistance for the purpose of repairs/ reconstruction of dwelling units and also to small road transport operators including taxis, auto rickshaw operators affected by the calamity, keeping in view the viability of the proposals. Banks were requested to take necessary action to expeditiously restore banking services in the affected areas.

Kisan Credit Cards

III.55 The Kisan Credit Card (KCC) Scheme was introduced in 1998-99 to enable the farmers to purchase agricultural inputs and draw cash for their production needs. Public sector banks issued 4.4 million KCCs during 2004-05, taking the total cards issued since inception of the scheme to 17.6 million.

III.56 A National Impact Assessment Survey (NIAS) of the KCC Scheme was commissioned through the National Council of Applied Economic Research (NCAER), New Delhi. On the basis of the salient findings of the survey, guidelines have been issued to banks by the IBA and the NABARD.

III.57 Since allied and non-farm activities were outside the ambit of the KCC Scheme, farmers had to approach the banks separately for their additional requirements every time, entailing additional time and cost. The NABARD has, therefore, revised the Model KCC Scheme providing for adequate and timely credit for the comprehensive credit requirements of farmers under a single window, with flexible and simplified procedures. The Scheme would cover term credit, working capital for agriculture and allied activities and a reasonable component for consumption needs.

Advisory Committee on Flow of Credit to Agriculture and Related Activities from the Banking System

III.58 The Advisory Committee on Flow of Credit to Agriculture and Other Related Activities from the Banking System (Chairman: Prof. V.S. Vyas) submitted its final report to the Reserve Bank in June 2004. Out of 99 recommendations made by the Committee, 32 have been accepted and implemented by the Reserve Bank. These include waiver of margin/security requirements on agricultural loans up to Rs.50,000, and in case of agri-business and agri-clinics for loans up to Rs.5 lakh, revision of non-performing asset (NPA) norms for agricultural finance and dispensing with the Service Area Approach except for Government sponsored schemes. In respect of 32 recommendations, either no action is necessary at this stage or action has already been initiated by the NABARD. Recommendations already implemented by the NABARD include providing skills, technical support and market linkage to SHGs; providing financial and technical support to cooperatives and associating cooperative banks in SHG-bank linkage; and review of refinance products in line with the market expectations. Out of the remaining 35 recommendations, 31 are under examination by the Government of India.

III.59 In order to examine the role of banks in providing loans against warehouse receipts and evolve a framework for participation of banks in the commodity futures market, a Working Group on Warehouse Receipts and Commodity Futures was constituted. The Group submitted its Report in April 2005 (Box III.5).

III.60 During the ten-year period spanning from 1993-94 to 2002-03, the ratio of gross capital formation in agriculture to real GDP originating in agriculture increased by only one percentage point

Box III.5

Report of the Working Group on Warehouse Receipts and Commodity Futures

• Banks may be permitted to deal in agricultural commodities including derivatives.

• Warehouse Receipts should become freely transferable between holders to reduce transaction costs and increase usage.

• Creation of an umbrella structure which may act as a Closed User Group (CUG) for everyone engaged in the agricultural commodities business.

• Proprietary positions in agricultural commodity derivatives could be used by banks to mitigate their risk in lending to farmers with suitable amendment to the Forward Contracts (Regulation) Act, (FCRA) 1952. Forward Markets Commission may evolve a suitable framework for option trading in India.

• Banks may be permitted to have independent proprietary position in commodity futures linked in a macro way to their credit portfolio with suitable risk control measures.

• As purely cash settled contracts are not available in India, banks trading or dealing in commodity contracts would have to be prepared to make or accept delivery of physical goods. Banks may, however, be persuaded to preferably close their positions and cash settle the contracts.

• Banks may offer non-standard contracts to farmers to

suit their needs including commodity derivative based products.

• Transferable specific delivery (TSD) contracts, where one of the parties to the contract is a bank authorised by the Reserve Bank, may be exempted from the operation of FCRA, 1952 to encourage OTC contracts.

• Banks may be allowed to become professional clearing members of commodity exchanges, provided they do not assume any exposure risk on account of offering clearing services to their trading clients.

• Banks may reduce/divest their equity holding in commodity exchanges to a maximum permitted level of 5 per cent over a period of time so as to avoid any conflict of interests and attendant regulatory concerns.

• Guidelines on capital adequacy and market risk issued by the UK Financial Services Authority and Australian Prudential Regulation Authority could be suitably modified consistent with the existing guidelines issued by the Reserve Bank.

• A limit may be placed on a bank's total exposure or gross positions, regardless of maturity, in all the commodities in relation to net loans and advances and/or capital or net worth of the bank. Initially, the limit could be put at 5 per cent of the net worth of the bank, which could be increased later in the light of experience gained.

Box III.6

Expert Group on Investment Credit to Agriculture

The Expert Group submitted its Report to the Reserve Bank on June 6, 2005. Some of the major recommendations of the Group are as follows:

• State Gover nments to make legal provisions/ computerisation of land records, provide legal support for recovery, introduce reforms in agricultural marketing, improve credit absorption capacity by supporting infrastructure, strengthen infrastructure and extension network and develop marketing links.

• NABARD to design appropriate products for financing rural infrastructure.

• Banks to make efforts to reach the 'unreached' areas, integrate short term with term credit, promote supplementary credit delivery channels, outsource monitoring services, provide loan suppor t for diversified agriculture, review HR policies, share the pool of technical expertise and make use of the model bankable projects prepared by NABARD.

• The Reserve Bank and banks may adopt agency models for credit delivery.

• Government of India/State Governments and organisations engaged in agricultural research and development (R&D) to reorient R&D activities.

• NABARD to promote R&D in agriculture.

• To mitigate the risk in financing of agriculture, the Group recommended: development of suitable financial products; commodity exchanges; allowing banks to operate on behalf of far mers and participate in commodity futures; establishment of a risk fund for fragile agriculture; designing of special risk mitigation packages for low asset based borrowers; use of warehousing receipts with price hedging instr uments; use of technology for dissemination of market intelligence; sharing of borrower information; and financing value chain by banks through RIDF.

from 6.1 per cent to 7.1 per cent. With a view to evolving a conscious strategy for increasing investment in the agricultural sector and to suggest a road map for banks for increasing investment credit in agriculture, an Expert Group on Investment Credit to Agriculture (Chairman: Shri Y.S.P. Thorat) was set up by the Reserve Bank (Box III.6).

Rural Infrastructure Development Fund

III.61 All domestic scheduled commercial banks are required to deposit in the Rural Infrastructure Development Fund (RIDF) established with the NABARD such amount as may be allocated to them by the Reserve Bank on the basis of their shortfall in respect of priority sector/agricultural lending target. The Fund has completed its tenth year of operation. Pursuant to the announcement made in the Union Budget for 2005-06, RIDF XI has been set up with the NABARD with a corpus of Rs.8,000 crore. The total allocation under the RIDF (I to X) was of the order of Rs.42,000 crore. Cumulative sanctions and disbursements under various tranches of RIDF (I to X) aggregated Rs.42,949 crore and Rs.25,380 crore, respectively, till March 31, 2005. On the basis of representations made by various State Governments and on the recommendations of the NABARD, the lending and deposit rates in respect of the amounts disbursed on or before October 31, 2003 out of RIDF IV to VII have been restructured with effect from April 16, 2005 (Table 3.12).

Table 3.12: Rates of Interest Payable under the RIDF

					(Per cent per annum)

		RIDF	Deposit rates payable		Lending rates payable
			to banks		by State Governments

			Existing	Revised	Existing	Revised
	1		2	3	4	5
	IV		11.5	8.0	12.0	8.5
	V		11.5	8.0	12.0	8.5
	VI		11.0	8.0	11.5	8.5
	VII		7.0-10.0*	7.5	10.5	8.0

*: Linked to shortfall in agricultural lending.

Credit to Women

III.62 Public sector banks (PSBs) were advised to lend at least 5 per cent of their net bank credit to women. The credit extended to women by all PSBs stood at 5.4 per cent of overall net bank credit at end-March 2005.

Credit to Small Scale Industries

III.63 The total credit provided by the PSBs to SSI worked out to Rs.67,634 crore at end-March 2005, constituting 9.4 per cent of net bank credit and 21.8 per cent of the total priority sector advances. Out of these, advances to cottage industries, artisans and tiny industries amounted to Rs.20,390 crore, constituting 30.2 per cent of the advances to the SSI sector. PSBs were advised to operationalise at least one specialised SSI branch in every district and centre having cluster of SSI units. At end-March 2005, 536 specialised SSI bank branches were operational.

III.64 Credit extended by scheduled commercial banks to 1,38,811 sick SSI units stood at Rs.5,285 crore at end-March 2004. Of these 2,385 units were found to be viable with an outstanding bank credit at Rs.421 crore (8.0 per cent). Banks placed 783 units involving outstanding credit of Rs.385 crore (7.3 per cent) under nursing programmes.

Working Group on Flow of Credit to Small Scale Industries

III.65 The Working Group on Flow of Credit to the SSI sector (Chairman: Dr. A. S. Ganguly) submitted its repor t on April 30, 2004. Out of the 31 recommendations made by the Group, the Reserve Bank has so far accepted eight recommendations. These include identification of new clusters and adoption of a cluster-based approach for financing small and medium enterprises (SME) sector, sponsoring specific projects as well as widely publicising the successful working models of NGOs, sanctioning higher working capital limits to SSI in the North-East region for maintaining higher levels of inventory and exploring new instruments for promoting rural industry. As recommended by the Working Group, interest rates on deposits placed by foreign banks with the Small Industries Development Bank of India (SIDBI) in lieu of shortfall in priority sector lending obligations were restructured. The tenor of deposits was also increased from one year to three years with effect from 2005-06. There are 17 recommendations pertaining to other agencies, viz., the Ministries of Finance and SSI, Government of India, SIDBI, Credit Guarantee Fund Trust for Small Industries (CGTSI), the Credit Information Bureau of India Ltd. (CIBIL) and the IBA. Out of these recommendations, seven have been accepted while three have been partially accepted.

CIBIL - System of Proper Credit Records

III.66 As announced in the Annual Policy Statement for the year 2004-05, the CIBIL was requested to work out a mechanism in consultation with the Reser ve Bank, SIDBI and IBA for development of a system of proper credit records to enable the banks to determine appropriate pricing of loans to SMEs. The CIBIL is currently in the process of exploring solutions in association with its technology partner Dun and Bradstreet Information Services India (P) Ltd. either by modifying the existing system of CIBIL to segregate SME data or by creating a separate system for drawing information from both CIBIL's and Dun and Bradstreet's databases. This proposed SME solution will be in a position to provide consolidated report comprising SME loan-related data, SME vendor payment related data and a consolidated SME score. CIBIL expects to operationalise the projects within 18-24 months.

Internal Group to Review Guidelines on Credit Flow to SME Sector

III.67 An Internal Group (Chairman: Shri C. S. Murthy) was constituted in the Reserve Bank to review all circulars and guidelines regarding financing of SSIs, suggest appropriate terms for restructuring of the borrowal accounts of SSI/ medium enterprises and also examine the guidelines issued for nursing sick SSIs and suggest suitable norms thereof. It recommended the constitution of empowered committees at the regional level to periodically review the progress in financing the SSI and medium enterprises (ME) and to co-ordinate with other banks/financial institutions and the State Governments in removing bottlenecks, if any, to ensure smooth flow of credit to the sector. It also recommended that banks may open specialised SME branches in identified clusters/centres with a preponderance of SSI and ME units to enable entrepreneurs to have easy access to bank credit and to equip bank personnel to develop the requisite expertise. Considering the numerous problems and challenges being faced by the SME sector and predominance of a large number of sick but potentially viable SME units, the Internal Group proposed to empower the boards of banks to formulate policies relating to restructuring of accounts of SME units, subject to certain guidelines. Restructuring of accounts of corporate SSI/ME borrowers having credit limits aggregating Rs.10 crore or more under multiple banking arrangements will be covered under the revised CDR mechanism. While recommending continuation of the extant guidelines on definition of a sick SSI unit, the Group has recommended that all other instructions prescribed by the Reserve Bank relating to viability and parameters for relief and concessions to be provided to sick SSI units be withdrawn and banks be given freedom to lay down their own guidelines with the approval of their boards of directors.

Small Enterprises Financial Centres (SEFCs)

III.68 Consequent upon the announcement made in the Annual Policy Statement for the year 2005-06 regarding formulation of a scheme of strategic alliance between branches of banks and branches of SIDBI located in the clusters, a scheme ';Small Enterprises Financial Centres (SEFCs)'; has been worked out and circulated to all scheduled commercial banks for implementation.

Government Sponsored Schemes

III.69 A total of 1,084,749 Swarozgaris received bank credit amounting to Rs.958 crore (and Government subsidy amounting to Rs.381 crore) under the Swarnjayanti Gram Swarozgar Yojana

(SGSY) during 2004-05. Of the Swarozgaris assisted, 285,395 (26.3 per cent) belonged to the scheduled castes (SCs) and scheduled tribes (STs), while 338,391 (31.2 per cent) were women and 10,126 (0.9 per cent) were physically handicapped. Under the

Swarna Jayanti Shahari Rozgar Yojana (SJSRY), disbursements amounting to Rs.151 crore were made in 48,798 cases (out of 61,890 applications sanctioned) during the year 2004-05. Beneficiaries included 13,675 SCs/STs (Rs.40 crore disbursed), 10,921 women (Rs.31 crore disbursed) and 686 disabled persons (Rs.2.8 crore disbursed). Under the Scheme for Liberation and Rehabilitation of Scavengers (SLRS), Rs.21.3 crore was sanctioned and Rs.15.7 crore was disbursed to 8,209 beneficiaries (out of the total 13,654 applications received). Disbursals benefited 7,021 SCs/STs (Rs.14 crore), 691 OBCs (Rs.0.8 crore) and 1,889 women (Rs.3.8 crore) during 2004-05.

III.70 SHGs are considered eligible for financing under the Prime Minister's Rozgar Yojana (PMRY) effective December 8, 2003 (modified on July 30, 2004) provided all members individually satisfy the eligibility criteria laid down and total membership does not exceed twenty. There is also a ceiling on the loan amount. Assistance under the scheme during 2004-05 amounted to Rs.468 crore for 79,198 beneficiaries. Of these, 26,107 (33.6 per cent of total) belonged to the SC/ST category, 19,983 (23.9 per cent) were women and 901 (1.2 per cent) were physically handicapped.

Differential Rate of Interest Scheme

III.71 Outstanding advances of PSBs under the Differential Rate of Interest (DRI) Scheme at end-March 2005 amounted to Rs.385 crore in respect of 0.3 million borrowal accounts. At 0.1 per cent of the total advances outstanding as at the end of the previous year, this is substantially less than the target of 1.0 per cent.

General Line of Credit to NABARD

III.72 The Reserve Bank has been providing General Lines of Credit (GLC) to NABARD under Section 17(4E) of the Reserve Bank of India Act 1934, to enable it to meet the short-term requirements of scheduled commercial banks, state cooperative banks and Regional Rural Banks (RRBs). During 2004-05 (July-June), the Reserve Bank sanctioned an aggregate credit limit of Rs.5,200 crore comprising Rs.5,000 crore under GLC-I and Rs.200 crore under GLC-II at rates of interest of 6.00 per cent and 6.25 per cent, respectively.

Service Area Approach

III.73 The objective of the Service Area Approach (SAA) to rural lending, introduced in April 1989, was to focus on the credit activities of the bank branches in designated areas so that they could contribute to the development of specific areas assigned to them. All rural and semi-urban branches of scheduled commercial banks (including RRBs) were allocated specific villages, generally in geographically contiguous areas to take care of credit needs. The basic principle was demarcation of service area and preparation of credit plans for systematic administration of credit in the assigned area. In view of cer tain drawbacks, the Vyas Committee recommended that the restrictive provisions of SAA may be dispensed with. Consequent upon the announcement made in the Mid-term Review of the Annual Policy Statement for 2004-05, the restrictive provisions of the SAA have been dispensed with, except for lending under the Government sponsored programmes. Operational guidelines have been issued to all banks in consultation with the Government and NABARD. As the Vyas Committee had suggested strengthening of the Service Area Monitoring and Information System (SAMIS) under SAA, the NABARD has constituted a Working Group to initiate necessary modifications/changes.

Group of Experts on Credit Deposit Ratio

III.74 As a par t of the Common Minimum Programme (CMP), the Government of India had appointed a Group of Experts (Chairman: Shri Y. S. P. Thorat) to examine various aspects of the credit-deposit ratio on all-India basis. The report of the Committee, submitted to the Gover nment on February 24, 2005 is under consideration.

III.75 In brief, monetary management during 2004-05 had to contend with a spurt in inflation during the first half of the year. The Reserve Bank continued with its policy of active management of liquidity through OMOs including LAF, MSS and CRR. Various monetary measures supported by fiscal measures were successful in stabilising inflationary expectations. The Reser ve Bank continued with efforts to improve credit delivery to small borrowers, particularly to the agriculture and small scale industries. The overall stance of monetar y policy for 2005-06 is provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability; to pursue an interest rate environment that is conducive to macroeconomic and price stability and maintaining the momentum of growth; and to consider measures in a calibrated manner in response to evolving circumstances with a view to stabilising inflationary expectations.

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