Dr. Rajans Last Policy

Written by- Ronak Pol
Published on 14th August 2016

With the term of our Rock Star Governor nearing its end and no official reappointment confirmed there is one more thing that will change along with him – The way our monetary policy is sculpted.

Traditionally the Governor had complete autonomy over the rates, theoretically giving him infinite power to influence markets but now that is about to change and a new Monetary Policy Committee (MPC) will be set in place. But before we indulge into the discussion of MPC it is only fair to take a look at Dr.Rajan’s final policy statement which came out this week(9th August 2016) and to look at projections for future.

Policy Overview and Introduction.

As we all know there were no changes made to any major policy rates this time around, Repo Rates and Liquidity adjustment facility stands at 6.5% and CRR stands at 4.0% of NDTL. But a no change does not necessarily mean that we should completely ignore what Dr.Rajan had to say about the state of economy and his projections for Future.

When it comes to Monetary Policy – No change is still a change. As markets work on discounted expectations we observed no unusual fluctuations in the market, making clear that this policy stance was nearly fully expected and hence reflected in stock prices leading up to the policy statement.

Consumer Price Inflation(CPI) in India stands at 5.77 % (July 2016) pushing retail inflation to a 22 week high and well above the government target of 5% which it aims to achieve by the end of March 2017 but Dr.Rajan did not take any explicit steps to contract the economy this time around. He was also clearly upset because of the resistance shown by commercial banks to resist transmitting policy rate cuts, and also addressed their concerns about FCNR(B) redemptions. He also showed relative confidence in the ability of banks to clear the balance sheets off their NPA’s and hopes that slowly banks will be able to transmit more the rate cuts to consumers.

When it comes to Monetary Policy – No change is still a change

Policy Tool of RBI.

We have all heard RBI officials complain about the lack of rate transmission shown by commercial banks, but very few of us actually understand what that means. Understanding policy tools that RBI has can help us understand how monetary policy works and what the transmission issue is.

When it comes to policy rates there are three main rates one needs to look at

  1. Bank Rate (7.00%)
  2. Repo-Rate (6.50%)
  3. Reverse Repo Rate (6.00%)

There is also the Marginal Standing Facility Rate(MSFR – stands at 7.00%) which is used when the RBI gives overnight short term loans to commercial banks, but that rate does not directly affect our transmission mechanism.

Another set of ratios that affect transmission are

  1. CRR or Cash Reserve Ratio (4.00%)
  2. SLR or Statutory Liquidity Ratio (21.00%)

Clear understanding of these three rates and two ratios is very important before we understand the transmission mechanism.

Bank Rate is the rate at which RBI gives loan to commercial banks without keeping any collateral people confuse it with repo rate which is also commonly refered to the rate at which commercial banks take loan from RBI. But the important distinguishing factor is that REPO stands for Repurchase Obligation meaning that commercial banks actually sells securities to the central bank which the commercial bank promises to repurchase at a predetermined date(less than 14 days) and a predetermined rate (6.50% currently).
Reverse Repo rate is exactly the opposite of Repo rate and in this case RBI sell securities and absorbs liquidity from the market.

Now that we know these basic rates we can move on to the two reserve ratios banks need to maintain.

CRR is related to amount of minimum liquidity that banks need to hold, in India it is calculated as a proportion of NDTL (Net Demand and Time liabilities) of the commercial banks and currently stands at 4.00%.
SLR or Statutory Liquidity Ratio is maintained as a proportion of total demand and time liabilities and currently stands at 21.00%.

If you have clearly understood these rates and ratios then its easy to understand how monetary policy works.
For example if RBI senses that inflation in the economy has gone up due to increased liquidity (ie people spending a higher proportion of their income) then RBI can increase SLR meaning now banks will have to keep a higher proportion of money as reserve and in turn the banks ability to lend goes down making loans more difficult to get or RBI can increase Repo rate and again reducing banks ability to lend as banks have to pay a higher amount on the loans that they take from RBI. (This is also called as monetary contraction)

Understanding the transmission mechanism.

Now that we understand ways through which RBI can influence banks and affect money flow in the economy, we can understand why RBI is unhappy with lack of transmission and did not cut policy rates this time around.

Back in April when RBI further cut Repo rates by 25 basis points bringing it down to 6.50% as it stands now, it was looking to stimulate the economy through monetary easing.

When RBI cuts rates it is expected of banks to cut lending rates as RBI is essentially giving headroom in form of higher liquidity which should be ideally transmitted to public, if that does not happen then banks are essentially holding higher liquidity.This is precisely the transmittion problem that people refer to.

Banks have been reluctant to cut rates stating concerns about FCNR(B) redemptions – which RBI assures it has hedged against through forward contract. But FCNR(B) redemptions is a discussion for another day.

PS: If some of you don’t understand parts of this jargon don’t worry and just move on, slowly in future articles I will clear all of it through timely examples.

Why no rate cut?.

One can easily observe from the tools that I have explained above that a rate cut is used to stimulate the economy, so expecting one when the economy is facing uncertainty and turbulence both overseas and at home would be premature.

Rather with CPI pushing 5.77% and expected to rise post GST reforms there is a need to control inflation than to stimulate spending, then one can rightfully question – “Why did RBI not carry out any contractionary measure by increasing rates or changing the reserve requirements?”

Well there is a two-part answer, First RBI is already taking concrete steps to absorb liquidity through Open Market Operations(OMO) in the Bond market and is also more actively using Reverse Repos to manage increased liquidity in the market.

Second part is that monsoon this year has been helpful and RBI expects this to slowly reduce food Inflation, also assuming that Oil price reduction is not turbulent and lasts over the financial year one can expect inflationary pressure coming down slowly. But the prospects for inflation excluding food and fuel are more uncertain.

Now a question might arise of – “Why RBI is upset for lack of transmission if it is looking at monetary contraction?” then the simple answer would be that easier credit does not only affect consumer spending but also alters investment spending, easy accessibility to funds helps stimulate investment; grounds for which government is already creating through GST. All of this combined can help give a sustainable boost to the economy.


A simple conclusion can be that not always are rate cuts more desirable and policy rates should always be in line with the economic outlook for both short-term and long-term and understanding policy instruments is key to having a more fruitful discussion of ways in which RBI policy should operate.

Also even if there is no direct policy intervention does not mean RBI is not fighting inflation under the radar an example of which are the steps taken in the Bond market. I wish Dr.Rajan good luck for future endeavours and hope that in the next policy meeting we will have decisions that are taken by the MPC.

Note: I can understand that this article can be a bit technical for some readers of my blog, but I have tried my best to explain the jargon and would be more than happy to help you understand more of these policy tools. You can also email me or comment below about any further doubts.


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