Working of Reserve Bank of India and Monetary Policy

Introduction to Reserve Bank of India

The Reserve Bank of India (RBI) is the central bank providing financial and banking services for Government and commercial banking system in India. It is the highest monetary institution which manages, controls, and builds up the financial and monetary systems of the country.

The Reserve Bank was established as a private shareholders bank (under the Reserve Bank of India Act 1934) on April 1, 1935, with a fully paid-up capital of Rs. 5 crores. Later, the Reserve bank was nationalized on January 1, 1949. The head office of the Bank is located in Mumbai.

The Bank was constituted for the following needs:

• To regulate / control the issuance of bank notes

• To maintain cash reserves with a view to have monetary stability

• To operate the country’s credit and currency system

Reserve Bank of India is managed by a group of central board of directors, comprising 20 members. Governor is the executive head of the Reserve Bank, who will be helped by four Deputy Governors. Further, there will be one government official from the Finance Ministry, as well as 10 directors from various fields. Urijit Patel is the current governor of Reserve bank, who is appointed by the Indian Government in September 2016.

RBI has four local boards established in Chennai, Delhi, Kolkata, and Mumbai, constituting four regional areas of the country, i.e., south, north, east, and western areas of the country. Government of India elects one member each to the Central Board of Directors, from these local boards.

The primary functions of the Reserve Bank of India include:

• The issuance of bank notes, except one rupee notes. The one rupee notes are issued by the Ministry of Finance.

• Manages the banking needs of the Indian government, as well as maintains and operates the government’s deposit accounts.

• Collects funds’ receipts and makes payments on government behalf.

• Represents as the member of the IMF and the World Bank, on behalf of Government of India.

• Acts as the custodian of cash reserves for all commercial banks operating in the country.

• Manages exchange control of country’s foreign currency reserves. It acts as a custodian for the country’s reserves of international currency, thereby enabling it to deal with crisis.

• Acts as supervisor and regulator of the financial system. It authorizes banking operation parameters so that the country's banking and financial system will function.

• Monitors economic indicators and controls the monetary supply in the country.

Introduction to Monetary Policy

Monetary policy is an administrative policy through which the monetary authority of a nation controls the supply of cash, bank credit availability and the rate of Interest. It is viewed as an imperative tool of economic management in India through which RBI controls the supply of cash and bank credit.

The primary objectives of monetary policy in India are:

• Growth with Price Stability: RBI has introduced the policy of Growth with Price Stability, which means there will be adequate credit for developing needs of various parts of the economy. Inflation can also be put under control in a specific time period.

• Regulation, Supervision and Development of Financial Stability: Financial stability, which can arise from internal and external environment, will destabilize the financial system of the country. So, the monetary policy will be prepared in such a way that the country’s economy will have the ability to assimilate shocks and maintain trust in financial system.

• Promote principle sectors, such as export, agriculture, and small scale enterprises and weaker section of populace. RBI provides credit to the low income groups and weaker sections, with the help of local banks at affordable price. It is also focusing on microfinance through promoting Self Help groups and other institutions.

• Employment Generation: Monetary policy assists in the generation of employment by affecting the rate of investment and allocating investments among different economic activities.

• External Stability: India's linkages with worldwide economy are getting more stronger, with the development of imports and exports. RBI controlled foreign exchange market by deciding conversion rate in the past. But, currently, RBI has just indirect control over external stability, where it impacts exchange rate in the open market by purchasing and selling foreign currencies.

• Encourages Savings and Investments: RBI encourages savings, by offering attractive interest rates. High savings generally promotes investment. Hence, the monetary management can impact saving mobilization in the country.

• Regulation of Non-Banking Financial Institutions (NBFIs): NBFIs assume a crucial role in deploying credit and mobilizing savings. UTI, IFCI, and IDBI are some of the NBFIs operating in India, and RBI does not have any immediate control on their functioning. However, it can indirectly influence the functions of these institutions, through its financial policy.

RBI uses the below tools to manage monetary policy.

• REPO AND REVERSE REPO RATE - Repo rate is a rate where RBI sells certain securities and will be repurchased later at a fixed price. This price is persuaded in light to an interest rate called the repo rate. The central bank repurchases the securities, when the national banks require funds from the RBI. The higher the repo rate, more exorbitant are the funds for banks and henceforth, higher will be the rate that banks pass on to clients. A higher rate means that is too costly for banks to access to money, and lesser credit will stream into the market. Reverse repo rate is the rate used by the banks to stop overabundance cash with RBI. Currently, Repo rate is cut by 0.25% to 6.50% and the Reverse repo rate is increased by 0.25% to 6%.

• CASH RESERVE RATIO (CRR) - This is the rate of a bank's aggregate deposit that should be kept as cash security with the RBI. A high CRR curbs liquidity. If CRR is high, banks will have less reserve to lend to customers; while CRR is low, banks will surplus funds to lend to customers. As per the situations, RBI has the right to decrease or increase the CRR, so as to ease or tighten the liquidity position. The present CRR stays unaltered at 4%.

• Open Market Operations - This alludes to buying and selling government securities by RBI to control transient money supply. On the off chance that RBI needs to incite liquidity or more funds into the framework, it will purchase government securities and infuse fund. In the event that it needs to control the amount of cash, RBI will sell these securities to banks, thereby decreasing the amount of money that banks have. The standing facility rate is sliced by 0.75% to lower banks' borrowing costs.

• Statutory Liquidity Ratio (SLR) - This is the rate of banks’ total deposits that are required to be invested in government endorsed securities. The lesser the SLR ratio, the more the banks need to lend outside. The minimum daily cash maintenance by banks with RBI is cut by 5%.

The current RBI Governor, Urjit Patel, has decided to reduce the repo rate from 6.5% to 6.25%, in October 2016, owing to global economic slowdown, which is primarily attributable to uncertainty in European Banks and Brexit in Q2 2016. Furthermore, crude oil prices have reached higher levels in Q2 2016, after an interruption in the supply. All these are in favor of reduction in repo rate boost economic activity and also control food inflation.

The latest seventh pay commission will place cash in the hands of 10 million individuals which will increase the unrestricted spending of the general population and increase the prices of consumer goods. Therefore, this rate cut will help in supervising the inflation prices in the nation by guaranteeing huge borrowing and spending in the economy. The manufacturing and agricultural sectors will get a help with this progression. Additionally, good rainfall will guarantee the growth in the economy this year. The new RBI Governor is not as hawkish as his prominent forerunner, Raghuram Rajan. The new Governor has an inspirational viewpoint towards the economy and is finding a way to pass on the advantage of controlled inflation to the country's population. The RBI's monetary policy committee has taken the right choice in decreasing the repo rate and this will positively affect the economy. This will also stimulate growth and the government needs to ensure a fiscal deficit of 3.5% of GDP. The committee is aiming to keep up 5% inflation for next 10 years and 4.5% after that. The rate cut will help the government in accomplishing its long haul objectives.