1. Introduction
IV.1 The efficacy of monetary policy actions lies
in the speed and magnitude with which they achieve
the final objectives. With the deepening of financial
systems and growing sophistication of financial
markets, most monetary authorities are increasingly
using indirect instruments (such as policy interest
rates and open market operations) rather than direct
measures (like credit allocation). Adjustments in the
policy interest rate, for instance, directly affect shortterm
money market rates which then transmit the
policy impulse to the fuller spectrum of interest rates
in the financial system, including deposit and lending
rates, that in turn affect consumption, saving and
investment decisions of economic agents and
eventually aggregate demand, output and inflation.
The interest rate channel of transmission has become
the cornerstone of monetary policy in most countries.
This channel may also operate through expectations
of future interest rates, and thereby influence the
behaviour of economic agents in an economy in a
forward looking manner.
IV.2 Underdeveloped and incompletely integrated
market segments inhibit the transmission of
monetary policy through the interest rate channel.
Accordingly, some central banks operate by directly
altering reserve requirements alone or in conjunction
with the policy interest rate to affect the availability
and price of credit.
IV.3 The transmission mechanism is characterised
by long, variable and uncertain time lags, making it difficult to predict the precise effect of monetary
policy actions on the economy. Apart from differential
lags, there are also asymmetries involved in the
quantitative responses of the policy impulse to the
goal variables in alternate phases of the business cycle
and liquidity conditions. It is generally accepted in
the literature that monetary policy has limited effects
on aggregate supply or productive capacity, though in
the presence of credit constraints, the ability of firms
to expand capacities is impacted, thus affecting
aggregate supply1.
2. International Experience
IV.4 Monetary transmission in advanced
economies occurs through several alternative
channels, and is generally found to be robust and
efficient in normal times. In contrast, in emerging
market economies (EMEs), it is the credit channel that
dominates transmission2.
2.1. Interest rate channel
IV.5 In the case of advanced economies (AEs), the
interest rate channel works by impacting the cost of
capital. It has been found to be strong and has
exhibited good information content about future
movement of real macroeconomic variables (Bernanke
and Blinder, 1992)3. In the case of EMEs, which do
not have well-functioning capital markets for debt
and equities, and in which real estate markets are
fragmented and illiquid, monetary transmission
through the interest rate has been found to be weak.
Furthermore, the interest rate channel is also dulled during surges in capital inflows. On an average across
Asian economies, the pass-through coefficients for
transmission from policy rates to lending rates
declined by about 30-40 basis points during episodes
of capital inflows, but were still about 0.3-0.6 (Jain-
Chandra and Unsal, 2012)4. Transmission from policy
rates to money market rates and retail lending rates
is found to be strong in transition economies of
Europe, but the transmission to longer maturity rates
is rather weak (Égert and MacDonald, 2009)5. However,
recent evidence suggests that the interest rate channel
is strengthening in many EMEs, including India6.
This is attributed, inter alia, to reduced fiscal
dominance, more flexible exchange rates and
development of market segments (Gumata et al.,
2013)7.
2.2. Credit Channel
IV.6 Empirical evidence supports the existence of
the credit channel of transmission. This operates by
affecting the external finance premium through both
the bank lending channel (by decreasing the supply
of bank loans in response to contractionary monetary
policy) and the balance sheet channel (contractionary
monetary policy decreases collateral valuation and
net worth of firms, raises agency costs and affects
firms’ activity levels through the financial accelerator).
Recent evidence from the euro area suggests that the
bank lending channel was more pronounced than the
balance sheet channel in the case of firms, while for
households, it was the other way round (Cicarrelli, et
al, 2010)8. The bank lending channel is also found to
have a larger impact on banks that are small, less capitalised and less liquid. Some evidence suggests
that firms substitute trade credit for bank loans at
times of monetary contraction, thus weakening the
credit channel. This is particularly the case for EMEs.
In the case of Sub-Saharan Africa, excluding South
Africa, the bank lending channel has been found to
work feebly, given that informal finance dominates
credit markets and the penetration of institutional
finance is limited, given the low competition from
the banking sector. However, in the case of many
EMEs, especially where bank-oriented financial
systems exist, the credit channel is strong. While
informal finance weakens monetary transmission,
experience suggests that transmission through the
credit channel is strong in the case of micro-finance
institutions (MFIs).
2.3. Exchange Rate Channel
IV.7 An important channel of monetary
transmission has been the exchange rate that is either
directly influenced by the central bank or gets
impacted by its actions. Typically, the exchange rate
channel works through expenditure switching
between domestic and foreign goods. For instance, an
appreciation of the domestic currency makes foreign
goods cheaper causing demand for domestic goods
and net exports to fall. However, this may also reduce
external debt in domestic currency terms. Both effects
transmit to aggregate demand and the price level.
Empirical evidence suggests that the exchange rate
channel is strong in economies with freely floating
exchange rates, but its impact is dampened with
central bank intervention. For instance, in the case of Latin American countries, lower exchange rate
flexibility relative to peers in Asia seems to have
resulted in weaker transmission of policy rates.
2.4. Asset Price Channel
IV.8 Apart from exchange rates, changes in other
asset prices such as equities and house prices also
impact inflation and growth. Equity prices are
dampened in response to contractionary monetary
policy and the resultant wealth effects and collateral
valuation changes feed through to consumption and
investment. The asset price channel is quite weak in
many EMEs where equity markets are small and
illiquid, but relatively strong in countries that have
open equity markets. Transmission is also found to
be limited in countries with weak property price
regimes and poorly developed and illiquid real estate
markets. In countries like the US and Australia, where
the mortgage market is well integrated with capital
markets, the asset price channel turns out to be quite
strong. In general, stock prices respond faster to
contractionary monetary policy, though the intensity
and lags of transmission are impacted by the liquidity
in the stock markets.
2.5. Transmission Lags
IV.9 Time lags in transmission are usually long,
variable and tend to differ from one country to
another owing to differences in economic and market
structures. They also vary over time due to dynamically changing macroeconomic and financial conditions.
For instance, these lags are found to vary from 1-14
quarters for transmission of policy rates to output
across a gamut of advanced and emerging economies
with varied monetary arrangements. While
transmission is weaker in case of EMEs, it is not clear
if the transmission lags are longer. In fact, some recent
evidence suggests longer lags for AEs relative to EMEs
– for instance, average lag of 33.5 months for all
countries; 42 months in the case of the US, 48 months
for the euro area, and in the range of 10-19 months
for transition economies that became new EU
members (Havránek and Rusnák, 2012)9. For Brazil,
the monetary policy transmission through the
aggregate demand channel takes between 6 and 9
months: the interest rate affects consumer durables
and investment in between 3 to 6 months and the
output gap takes an additional 3 months to have a
significant impact on inflation (Bogdanski et.al.,
2000)10,11.
3. Sensitivity of Inflation and Output to Monetary
Policy in India
IV.10 Empirical evidence indicates that monetary
transmission in India has been taking place through
several channels (RBI, 2005; Patra and Kapur, 2010;
Mohanty, 2012; Khundrakapam and Jain, 2012;
Khundrakapam, 2011; Kapur and Behera, 2012; Singh,
2011 and Keltzer, 2012)12. The broad consensus
emerging from these studies is that monetary policy in India impacts output with a lag of about 2-3 quarters
and WPI headline inflation with a lag of about 3-4
quarters and the impact persists for 8-12 quarters.
Among the channels of transmission, the interest rate
has been found to be the strongest. In view of the
Committee’s choice of inflation as the nominal anchor
for monetary policy in India, this section primarily
focuses on empirical evaluation of the transmission
of monetary policy signals to inflation.
3.1. Interest Rate Channel
IV.11 Monetary policy interest rate movements
have been found to share a co-integrating relationship
with rates across different segments of financial
markets. Results of block exogeneity tests show that
there exists bi-directional causality between call
money rates and interest rates in other segments such
as the government debt market, credit market or
returns on equity market and the forex market13.
Medium to long term rates such as bank deposit and
lending rates exhibit asymmetrical responses to policy
rate changes under varied market conditions,
responding faster with relatively larger responses in
liquidity deficit conditions than in surplus conditions.
Furthermore, lending rates for certain sectors such as
housing and automobiles respond relatively faster to
policy rate changes compared with other sectors.
3.2. Credit Channel
IV.12 India is a bank-dominated economy, even
though in recent years the role of equity and debt
markets as sources of financing of economic activities
has increased. The share of banks in domestic
corporate borrowing has remained high (Chart IV.1).
High-dependence on bank finance makes the bank
lending and the balance sheet channels particularly
important for monetary transmission, which is also
evidenced through Granger causality tests14. In terms
of balance sheet effects, credit growth is seen to have
an inverse relationship with movements in the policy
rate15.
3.3. Exchange Rate Channel
IV.13 The exchange rate channel is found to be
feeble in India with some evidence of weak
exogeneity16. While changes in policy interest rates
may influence movements in exchange rates, the level
of the exchange rate is not a policy goal, as the RBI
does not target any level or band of the exchange rate.
Exchange rate depreciation is a key source of risk to
inflation as the estimated pass-through coefficients
for India suggest (Table IV.1).
Table IV.1: Summary of Exchange Rate Pass-through Coefficient from Select Studies |
Study |
Time Period of Study |
Exchange rate pass-though coefficient |
WPI |
Khundrakpam (2007)17 |
1991M8 to 2005M3 |
10 per cent change in exchange rate increases final prices by 60 bps in short run and 90 bps in long run |
Kapur (2012)18 & Kapur and Behera (2012)19 |
1996 Q2 to 2011 Q1 |
10 per cent appreciation (depreciation) of rupee vis-à-vis the US dollar reduces (increases) inflation by 60 bps in the same quarter, while the long-run pass-through is 120 basis points. |
Patra and Kapur (2010)20 |
1996 Q2 to 2009 Q3 |
A 10 per cent appreciation (depreciation) of the Indian rupee (vis-a-vis the US dollar) would reduce (increase) inflation by 50 bps in the same quarter, by 150 percentage points after seven quarters. |
Patra et al. (2013)21 |
1996 Q2 to 2013 Q1 |
A 10 per cent change in the exchange rate resulted in 1.5 per cent change in prices prior to the global crisis and 1.0 per cent change including post crisis period. |
CPI |
Ghosh and Rajan (2007)22 |
1980Q1 to 2006Q4 |
Exchange rate pass-through elasticity of the rupee-USD to CPI to be between 45 and 50 percent and quite stable over the period under consideration |
Bhattacharya, et.al. (2008)23 |
1997M9 to 2007M10 |
One per cent increase in exchange rate causes rise in CPI level by 0.10-0.11per cent in the short run and 0.04-0.17per cent in the long-run |
3.4. Asset Price Channel
IV.14 Empirical evidence for India indicates that
asset prices, especially stock prices, react to interest rate changes, but the magnitude of the impact is small
(Singh and Pattanaik 2012)24. Moreover, the wealth
effect of increasing equity prices in the Indian case is
found to be limited (Singh, 2012)25. With the
increasing use of formal finance (from banks and
non-banks) for acquisition of real estate, the asset
price channel of transmission has improved. However,
during periods of high inflation, there is a tendency
for households to shift away from financial savings
to other forms of savings such as gold and real estate
that tend to provide a better hedge against inflation.
To the extent that these acquisitions are funded from
informal sources, they may respond less to
contractionary monetary policy, thus weakening the
asset price channel in India.
4. Identifying Impediments to Transmission
IV.15 In India, financial sector reforms and
progressive deregulation of the financial sector
created pre-conditions for conducting monetary policy
primarily through changes in the interest rate as the
main policy instrument. The effectiveness of
monetary policy, however, remains constrained by
several country-specific factors that affect transmission
of the policy impulses through the interest rate
channel. Some of the major factors are briefly
explained below.
4.1. Sustained Fiscal Dominance
IV.16 Despite phasing out of the Reserve Bank’s
participation in primary issuances of Government
securities (G-secs), fiscal dominance continues to
impinge on monetary policy efficacy as open market
operations are intermittently deployed to ‘manage
yields’ in the face of large government borrowings.
Data for the past decade show that whenever the net
market borrowing of the government has increased,
the ratio of incremental investment by banks in
government securities has gone up, leading to lower
share of non-food credit in bank finance, i.e., pointing
to crowding out of the private sector (Chart IV.2).
i. Statutory Pre-emption through SLR
IV.17 Large government market borrowing has been
supported by regulatory prescriptions under which
most financial institutions in India, including banks,
are statutorily required to invest a certain portion of
their specified liabilities in government securities
and/or maintain a statutory liquidity ratio (SLR)
(Table IV.2).
IV.18 The SLR prescription provides a captive
market for government securities and helps to artificially suppress the cost of borrowing for the
Government, dampening the transmission of interest
rate changes across the term structure. It is also
observed that the Government often borrows at a
negative real interest rate, especially in recent years
(Chart IV.3). While banks generally invest in
government securities above the statutory prescription
since excess SLR securities serve as the only collateral
for availing central bank resources under the LAF
(Table IV.3), a lower SLR prescription, ceteris paribus,
is likely to decrease banks’ investments in G-secs.
ii. Small Savings Schemes
IV.19 Besides market borrowings, the other main
source of funding government deficits in India is
small savings mobilised through, inter alia, post office
deposits, saving certificates and the public provident
fund, characterised by administered interest rates
and tax concessions. The interest rates on small
savings were earlier changed infrequently26.
Consequently, small savings in the past had acquired a competitive edge over bank deposits during the
easing phase of monetary policy, as was evident during 2009-10 (Chart IV.4). The resultant substitution
from bank deposits to small savings eroded the
effectiveness of the monetary transmission
mechanism, especially the bank lending channel. To
some degree, the annual reset for the small savings
rates continues to provide them a competitive edge.
Therefore, the option of a half-yearly or quarterly
reset should be implemented.
Table IV.2: Guidelines on Investment in Centre and State Government Securities (select institutions) |
Institution |
Instruments |
Minimum Allocation |
Remarks |
Gilt Funds |
Central Government Securities and State Development Loans (SDL). |
100 per cent of total corpus. |
This is the cap or maximum allocation.
In addition to this, there is a discretionary investment to the extent of 30 per cent which are also generally investment in SDLs. As a result, total investment in government paper (Centre+States) is around 70 per cent. |
Life Insurance Companies |
Government Securities and other approved securities. |
50 per cent of total corpus (of which 25 per cent in Government Securities). |
Non-life Insurance Companies (Pension and General Annuity Business) |
Government Securities, and other approved securities. |
40 per cent of total corpus (of which 20 per cent in Government Securities). |
Employees’ Provident Fund |
Central Government Securities, SDL and other approved securities. |
55 per cent of incremental accretions belonging to the Fund. |
PFs/Retirement Trusts/Gratuity Funds |
Central Government Securities; |
25 per cent of Assets Under Management (AUM); |
SDL and other approved securities. |
15 per cent of AUM. |
Scheduled Commercial Banks |
Central Government Securities, SDL and other approved securities. |
23 per cent of net demand and time liabilities (NDTL).* |
Urban Co-operative Banks |
Central Government Securities, SDL and other approved securities. |
25 per cent of NDTL. |
DICGC |
Central Government Securities. |
100 per cent of cash surplus. |
*: The statutory liquidity ratio is marginally met through holdings of gold and cash as well. |

Table IV.3: SLR Maintenance by Banks |
(Per cent of NDTL) |
Financial Year End |
SLR Maintained |
SLR prescribed |
2008-09 |
28.1 |
24 |
2009-10 |
28.8 |
25 |
2010-11 |
27.1 |
24 |
2011-12 |
27.4 |
24 |
2012-13 |
28.0 |
23 |
iii. Subventions
IV.20 The Government also influences the monetary
policy transmission channel through its directives to
banks. Keeping some economically and socially
important objectives in mind, both the Central and
State Governments offer interest rate subvention to
certain sectors, including agriculture (Table IV.4).
There have also been non-interest subventions, such
as the Agricultural Debt Waiver and Debt Relief
Scheme in 2008.
iv. Taxation
IV.21 The tax advantage for the fixed maturity plans
(FMPs) of the debt Mutual Funds of tenors of a year or more against fixed deposits of corresponding
maturities also weakens the credit channel of
monetary transmission. Similarly, to the extent the
financial products of non-banks are not subjected to
tax deduction at source, they have an advantage over
bank deposits and weaken the transmission on the
same grounds.
Recommendations
IV.22 In order to address specific impediments to
monetary policy transmission in India, the Committee
recommends the following:
(a) Consistent with the time path of fiscal
consolidation mentioned in Chapter II, SLR
should be reduced to a level in consonance with
the requirements of liquidity coverage ratio (LCR)
prescribed under the Basel III framework.
(b) Government should eschew suasion and
directives to banks on interest rates that run
counter to monetary policy actions.
(c) More frequent intra-year resets of interest rates
on small saving instruments, with built-in
automaticity linked to benchmark G-sec yields,
need to be brought in. Also, the benchmark
should be based on average of the previous six
months or even shorter intervals so as to better
capture changes in interest rate cycles within a
year.
Table IV.4: Subvention Schemes in Force in the Last Two Years |
1 |
Introduced in July 2007, there is an interest subvention on pre- and post-shipment rupee export credit for certain employment oriented export sectors. The subvention of two per cent for the financial year 2013-14 was increased to three per cent with effect from August 1, 2013. The interest charged is, however, subject to a floor rate of seven per cent. Applicable to all banks and EXIM Bank. |
2 |
In 2006-07, an interest subvention was introduced to ensure availability of short-term crop loans up to `3,00,000 to farmers at a reduced rate of seven per cent. This scheme continues with minor variations. In 2013-14, with three per cent additional subvention for timely repayment, the effective cost of short-term crop loan for farmers is four per cent. It was, until recently, applicable to public sector banks only, but now extended to private sector. |
3. |
In October 2009, a scheme of one per cent interest subvention for housing loans up to `1 million was introduced. With enhancements, in 2013-14, the one per cent subvention is available for housing loans up to `1.5 million for the cost of a house up to `2.5 million. |
4. |
In 2013-14, the Union Budget announced working capital and term loans at a concessional interest of six per cent to handloom weavers. This is supposed to benefit 150,000 individual weavers and 1,800 primary cooperative societies (mostly women and those belonging to the backward classes) in 2013-14. |
(d) All fixed income financial products should be
treated on par with bank deposits for the
purpose of taxation and TDS. Further, the tax
treatment of FMPs and bank deposits should also
be harmonised .
(e) With a sharp rise in the ratio of agricultural credit
to agricultural GDP, the need for subventions on
interest rate for lending to certain sectors would
need to be re-visited27.
4.2. Large Informal Sector and Still Significant
Presence of Informal Finance
IV.23 Despite the growing reach of the formal
banking and non-banking network, informal finance
still caters to the financing requirements of the major
part of India’s population28. The recourse to noninstitutional
sources is relatively high, both in rural
and urban areas, particularly by lower income groups.
Also, the cost of borrowing from informal/semi-formal
sources is significantly higher than that of borrowing
from banks (Table IV.5). High cost itself may be an
impediment to transmission, particularly when
incremental changes in the policy rate constitute only
a small fraction of the overall funding costs. Thus,
the significant presence of informal finance as well as its costs of intermediation can impede the impact
of monetary policy on aggregate demand.
Table IV.5: Cost of Credit from Various Agencies in India |
Lender Category |
Interest Rate (Per cent per annum)* |
Self Help Groups (SHGs) |
18-24 |
Microfinance Institutions (MFIs) |
20-24 |
Informal credit providers |
18-36 |
Banks (small borrowal accounts) |
6-20 |
*: Data pertains to 2006.
Source: Report on Currency and Finance, 2006-08, Reserve Bank of India. |
4.3. Financial and Credit Market Frictions, Bank
Behaviour and Monetary Policy
IV.24 There are certain facets of monetary policy
that interface with credit and financial markets. In
this context, market frictions and/or the endogenous
response of the RBI to liquidity demand weaken
monetary transmission.
IV.25 First, on the lending side, banks determine
their interest rates with reference to the base rate.
While banks are free to decide their base rates, they
are required to take into consideration factors like
cost of funds, adjustment for the negative carry in
respect of CRR and SLR, overhead cost and a profit
margin. The policy repo rate does not directly affect
the determination of base rate of banks, except at the
margin where wholesale funding is used. Even this
role has greatly diminished, since wholesale funding
(including borrowing from the Reserve Bank)
constitute barely 10 per cent of the total funds raised
by banks (Table IV.6).
IV.26 Secondly, with regard to deposits, while
interest rates are re-priced when policy rates increase,
this is only at the margin. A more complete
transmission is impeded by the maturity pattern
being largely concentrated in fixed tenor deposits
(Table IV.7). Moreover, the distribution of term
deposits is tilted in favour of longer duration (i.e., one
year and above) deposits (Table IV.8). These fixed rate
deposits, together with the pursuit of inflexible net
interest margins by public sector banks, imparts
rigidity to the entire interest rate structure. Going
forward, increase in competition as suggested by the Reserve Bank is necessary to impart greater dynamism
and flexibility to the banking structure and associated
outcomes (RBI, 2013)29.
IV.27 Thirdly, the transmission of monetary policy
to deposit and lending rates is sensitive to liquidity
conditions prevailing at the time of a policy rate
change and during the period thereafter. As shown
in Table IV.9, cumulative increase of 175 bps in the
repo rate in 2011-12 was transmitted to both deposit and lending rates, albeit less than proportionately. In
2012-13, however, the repo rate was cut by 100 bps,
but despite the cut in CRR by 75 bps, deposit and
lending rates did not soften much due to deficit and
occasionally tight liquidity conditions. In 2013-14 (so
far), the cumulative increase in repo rate has been 25
bps, but in the absence of any CRR cuts and because
of the policy induced tightness in liquidity conditions,
transmission to the modal deposit rate has been
higher than the change in the policy rate30. Empirical
research for India corroborates the role of liquidity
conditions in impacting the transmission – “monetary
policy transmission is more effective during the
liquidity deficit mode as compared to the surplus
mode” (Ray and Prabhu, 2013)31. Significant asymmetry
is observed in the transmission of policy rate changes between the surplus and deficit liquidity conditions,
suggesting that maintaining suitable liquidity
environment is critical to yielding improved passthrough
(Singh, 2011,op. cit.).
Table IV.6: Asymmetry in Transmission in Different Phases of Monetary Policy Cycles
(to Deposit and Lending Rates of Banks) |
Change (percentage points) |
|
Tightening Phase (October 26, 2005 to October 19, 2008) |
Easing Phase (October 20, 2008 to March 18, 2010) |
Tightening Phase (March 19, 2010 to April 16, 2012) |
Easing Phase (April 17, 2012 to July 15, 2013) |
Repo Rate |
3.00 |
-4.25 |
3.75 |
-1.25 |
Modal Deposit Rate |
2.38 |
-2.38 |
2.31 |
0.04 |
Modal Base Rate* |
3.00 |
-2.00 |
2.75 |
-0.50 |
WALR |
N.A. |
N.A. |
2.08 |
-0.49 |
*: Base rate system was introduced from July 1, 2010.
N.A.=Not Available |
Table IV.7: Distribution of Current, Savings and Term Deposits-March 2012 |
(Per cent) |
|
Current |
Savings |
Term |
Total |
SBI and Associates |
8.8 |
33.5 |
57.7 |
100.0 |
Nationalised Banks |
9.1 |
23.4 |
67.5 |
100.0 |
Foreign Banks |
29.2 |
15.4 |
55.3 |
100.0 |
Private Sector Banks |
14.3 |
24.8 |
60.9 |
100.0 |
Source: Basic Statistical Returns, 2011-12. |
Table IV.8: Distribution of Maturity Pattern of Term Deposits of SCBs March 2012 – Based on Contractual Maturity |
(Per cent) |
|
Up to 90 days |
91 days and above but less than 6 months |
6 months and above but less than 1 year |
1 year and above but less than 2 years |
2 years and above but less than 3 years |
3 years and above but less than 5 years |
5 years and above |
SBI and Associates |
4.1 |
4.8 |
5.4 |
38.9 |
15.7 |
11.6 |
19.5 |
Nationalised Banks |
6.6 |
6.5 |
11.8 |
49.9 |
6.7 |
10.9 |
7.6 |
Foreign Banks |
34.3 |
12.7 |
9.8 |
34.9 |
3.9 |
3.6 |
0.8 |
Private Sector Banks |
10.4 |
12.5 |
13.8 |
43.1 |
11.1 |
5.2 |
4.0 |
Source: Basic Statistical Returns, 2011-12. |
Table IV.9: Monetary Policy Transmission and Liquidity Conditions |
Period |
Change in Policy
Rates (bps) |
Average Liquidity Deficit*
(` billion) |
Modal Deposit Rate |
Modal Base Rate |
WALR |
Repo Rate |
CRR |
Q4 (2010-11) |
50 |
- |
-464 |
6.65 |
9.00 |
11.40 |
2011-12 |
|
|
|
|
|
|
Q1 |
75 |
- |
-378 |
7.08 |
9.50 |
11.45 |
Q2 |
75 |
- |
-453 |
7.44 |
10.25 |
11.71 |
Q3 |
25 |
- |
-916 |
7.46 |
10.50 |
12.24 |
Q4 |
- |
-125 |
-1341 |
7.42 |
10.50 |
12.58 |
Change during the year |
175 |
-125 |
-772 |
0.77 |
1.50 |
1.18 |
2012-13 |
|
|
|
|
|
|
Q1 |
-50 |
- |
-937 |
7.40 |
10.50 |
12.39 |
Q2 |
- |
-25 |
-543 |
7.29 |
10.45 |
12.30 |
Q3 |
- |
-25 |
-1046 |
7.33 |
10.25 |
12.18 |
Q4 |
-50 |
-25 |
-1101 |
7.31 |
10.20 |
12.18 |
Change during the year |
-100 |
-75 |
-907 |
-0.11 |
-0.30 |
-0.40 |
2013-14 |
|
|
|
|
|
|
Q1 |
-25 |
- |
-847 |
7.26 |
10.20 |
12.11 |
Q2 |
25 |
- |
-1007 |
7.46 |
10.25 |
12.21 |
Q3 |
25 |
- |
-856 |
7.65 |
10.25 |
12.15# |
Change up to Q3 |
25 |
- |
-903 |
0.34 |
0.05 |
-0.03 |
*: Include Repo, Reverse Repo, Term repo, MSF and ECR; #: Data relate to November; ‘-‘ : No change. |
Recommendations
IV.28 Unless the cost of banks’ liabilities moves in
line with the policy rates as do interest rates in money
market and debt market segments, it will be difficult
to persuade banks to price their loans in response to
policy rate changes. Hence, it is necessary to develop
a culture of establishing external benchmarks for
setting interest rates based on which financial
products can be priced. Ideally, these benchmarks
should emerge from market practices. However, the
Committee is of the view that the Reserve Bank could
explore whether it can play a more active supportive
role in its emergence.
IV.29 The RBI’s liquidity management operations
should strive to ensure consistency with the stance
of monetary policy. Accordingly, an increase in the
policy rate to convey an anti-inflation policy stance
should be accompanied by tightening of liquidity
conditions through liquidity management
operations, whereas an easing of the policy stance
should be associated with accommodative liquidity
conditions.
IV.30 The Committee is also of the view that there
should be close coordination between the settings of
monetary policy and macro-prudential policies, since
variations in macro-prudential instruments such as
capital buffers, provisions, loan-to-value ratios and
the like impacts the cost structures and lendable
resources of banks, thereby impacting monetary
transmission.
4.4. Other Aspects of Monetary Policy Transmission
i. High Inflation and Financial Disintermediation
IV.31 High inflation in itself impedes transmission
of monetary policy. This impact is exacerbated if
interest rates on financial products do not adjust to
inflation and yield negative returns. In India, gold and
real estate compete with deposits, thereby constraining
the degree of flexibility available to banks, particularly
in lowering the deposit rates (given the fear of loss
of deposits) in an easing phase of monetary policy.
For four consecutive years between 2009-10 and 2012-
13, average deposit rates remained below the CPI
inflation for those years, whereas the annual return
from gold and real estate exceeded CPI inflation most
of the times, and by a significant margin as well (Table
IV.10). With the annual average consumer price
inflation touching double digits or staying just
underneath for the last six years, bank deposits have
been yielding negative returns in real terms.
ii. Endogenous Liquidity Under the Monetary Policy
Framework
IV.32 Under the extant monetary policy framework,
financing of large fiscal deficits through market
borrowings has effectively resulted in the use of open market operations (OMO) primarily to smoothen
G-sec yields rather than being employed as a pure
monetary policy tool, contrary to cross-country
practices which have increasingly favoured the
separation of debt management operations from
liquidity management (Table IV.11). In India, on the
other hand, transmission has been impeded by: (a)
not enforcing enough liquidity management discipline
in the banking system; and (b) allowing excessive
indirect monetisation of the fiscal deficit which also
undermines the credibility of discretionary liquidity
management operations. The LAF framework allows
banks complete freedom to access liquidity from the
RBI at the repo rate, up to their excess SLR holdings.
The cost of holding excess SLR gets reflected in the
pricing of other assets.
Table IV.10: Nominal Return on Gold, Real Estate and Bank Deposits (Per cent, y-o-y) |
Year |
Return on domestic gold price |
Return on real estate (RBI's House Price Index) |
CPI-IW Inflation (Average) |
Weighted avg. term deposit rates of banks* |
2004-05 |
7.5 |
- |
3.8 |
6.18 |
2005-06 |
12.3 |
- |
4.4 |
6.51 |
2006-07 |
33.9 |
- |
6.7 |
8.22 |
2007-08 |
8.2 |
- |
6.2 |
8.71 |
2008-09 |
29.0 |
- |
9.1 |
8.84 |
2009-10 |
22.2 |
11.7 |
12.4 |
6.97 |
2010-11 |
22.0 |
19.1 |
10.4 |
8.29 |
2011-12 |
33.8 |
22.3 |
8.4 |
7.40 |
2012-13 |
17.6 |
22.7 |
10.4 |
7.27 |
Apr-Oct 2013 |
-5.4@ |
0.9 ** |
10.9$ |
7.74 |
*: End-March @: Apr-Aug, 2013 $: Apr-Nov, 2013 ** 2013-14 q1 |
IV.33 As government market borrowing crowds out
funds to the private sector, in turn placing pressure
on liquidity, the central bank is often forced to
accommodate the resultant liquidity shortages by
providing additional liquidity through open market
operations, especially via outright purchases of G-secs.
The net market borrowings of the central Government
have increased 10-fold in the eight years till 2012-13,
even without counting for additional funding of `1.16
trillion through 364-day treasury bills during the
terminal year. Even in 2010-11, when monetary policy
needed to be tightened aggressively and efforts were
being made in that direction, large OMO purchases
were effected. Reflecting these developments, OMO
transactions have largely become one-sided in recent
years and have turned into a dominant source of
reserve money creation rather than a tool for
managing liquidity mismatches (Chart IV.5). While
some expansion of reserve money consistent with
the growth in broad money and nominal GDP is
necessary (as set out under Pillar II in Chapter III),
excessive monetary expansion at times results from
indirect monetisation of the fiscal deficit through
OMOs.
Table IV.11: Debt Management Arrangements: Cross-Country
Practices in Some Emerging Market Economies |
Country |
Arrangements |
Country |
Arrangements |
Indonesia |
Government debt securities (T-bills and G-bonds) are issued by Ministry. Bank Indonesia (BI) as the implementing agency stipulates and administers the regulations regarding the issuance, sale and purchase of these instruments. |
Chile |
The International Finance Unit of the Ministry of Finance is in charge of proposing and implementing strategies regarding public debt through the Public Debt Office (PDO). The Central Bank of Chile carries out monthly bond auctions on dates published in a calendar in the amounts established by the Finance Ministry. |
Brazil |
The National Treasury Secretariat is an agency of the National Treasury in charge of management and administration of domestic and external public debt. Most of the domestic government debt is issued through auctions held by National Treasury, making public offerings to financial institutions. |
Mexico |
The Federal Government of Mexico, through the Ministry of Finance and Public Credit, is responsible for management and issuance of government securities. The Bank of Mexico operates as the financial agent for the Federal Government and undertakes primary auctions of government securities on a weekly basis. |
Poland |
The Republic of Poland, via the Ministry of Finance on behalf of State Treasury, issued T-bills of upto one year and bonds of upto 10 years to cover the budget deficit. The National Bank of Poland (NBP) can purchase T-bonds in the secondary market only exceptionally, in the case of a severe crisis, threatening domestic financial stability. |
Hungary |
The Hungarian Government issues government bonds and discount T-bills, which was shifted out of the central bank in the late 1990s. The majority of government securities – discount T-bills and G-bonds – are sold through public issues. |
Turkey |
The Under Secretariat of the Treasury, which is the issuer of G-bonds and T-bills, is responsible for the method and terms of issuance as well as debt management. On behalf of the Under Secretariat, the Central Bank of the Republic of Turkey issues bonds and bills in accordance with the financial services agreement with the Treasury. The CBRT is the central securities depository. |
South Africa |
The management of debt is vested with the National Treasury. The Treasury conducts weekly bond auctions according to a calendar published at the beginning of the fiscal year. |
IV.34 When the OMO cut-off yields in a given
auction are lower than the cut-off yield in the
immediately following primary auction of G-secs (Chart IV.6, Table IV.12), it creates opportunities for
the banking system to profit from the RBI’s liquidity
management operations. In 2012-13, in effect, 30 per cent of the net borrowing requirement of
the Government was supported through OMOs
(Table IV.13).


Table IV.12: Comparison of Yields (OMOs versus Primary Auctions) |
Auction Date |
Weighted Average Cut off Yield (Per cent) |
OMO Auction |
First primary auction subsequent to OMO |
May 11, 2012 |
8.51 |
8.66 |
May 18, 2012 |
8.54 |
8.60 |
May 25, 2012 |
8.51 |
8.62 |
June 12, 2012 |
8.25 |
8.36 |
June 22, 2012 |
8.36 |
8.36 |
December 4, 2012 |
8.24 |
8.22 |
December 11, 2012 |
8.23 |
8.22 |
December 21, 2012 |
8.19 |
8.19 |
December 28, 2012 |
8.17 |
8.19 |
February 15, 2013 |
7.93 |
7.92 |
May 7, 2013 |
7.82 |
7.60 |
June 7, 2013 |
7.47 |
7.40 |
July 18, 2013 |
8.45 |
8.34 |
August 23, 2013 |
8.67 |
8.90 |
August 30, 2013 |
9.09 |
9.15 |
October 7, 2013 |
8.61 |
8.74 |
November 18, 2013 |
8.67 |
8.99 |
Recommendations
IV.35 Accordingly, the Committee recommends that
OMOs have to be detached from fiscal operations and
instead linked solely to liquidity management. OMOs
should not be used for managing yields on government
securities.
IV.36 To sum up, there are several impediments
that need to be taken on board for effective monetary
transmission, some of which can be addressed
through steps taken by the Reserve Bank itself. First
and foremost, OMO purchases should be undertaken
only when the liquidity condition warrants them.
Second, the Reserve Bank should continue its efforts
to develop the term repo market by calibrating
liquidity at its overnight repo window as necessary.
Third, the Reserve Bank should avoid regulatory
forbearance, especially by changing norms for
portfolio classification when yields rise. Fourth, it
should facilitate a more competitive and dynamic
banking structure so that re-pricing of deposit and
lending rates, in due course, becomes faster in
response to RBI’s monetary policy actions.
Table IV.13: Indirect Monetisation Eases Crowding-out Pressures but affects
Transmission of Changes in Repo Rate |
Year |
Net Market Borrowing (NMB) (` bn) |
RBI Support through Direct Subscription and OMO* (` bn) |
RBI Support as per cent of NMB |
SCBs' Support to NMB (` bn) |
SCBs' Support as per cent of NMB |
Total Support from RBI and SCBs as per cent of NMB |
1 |
2 |
3 |
4 |
5 |
6 |
7=4+6 |
2000-01 |
734 |
103 |
14 |
616 |
84 |
98 |
2001-02 |
908 |
-16 |
-2 |
711 |
78 |
77 |
2002-03 |
1041 |
-179 |
-17 |
1122 |
108 |
91 |
2003-04 |
889 |
-205 |
-23 |
1313 |
148 |
125 |
2004-05 |
509 |
-35 |
-7 |
642 |
126 |
119 |
2005-06 |
1062 |
-39 |
-4 |
-182 |
-17 |
-21 |
2006-07 |
1148 |
-51 |
-4 |
753 |
66 |
61 |
2007-08 |
1306 |
59 |
5 |
1826 |
140 |
144 |
2008-09 |
2470 |
945 |
38 |
1971 |
80 |
118 |
2009-10 |
3944 |
755 |
19 |
2226 |
56 |
76 |
2010-11 |
3264 |
672 |
21 |
1188 |
36 |
57 |
2011-12 |
4841 |
1342 |
28 |
2379 |
49 |
77 |
2012-13 |
5075 |
1545 |
30 |
2686 |
53 |
83 |
*: Direct Subscription discontinued with effect from April 2006. |
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