Monetary policy is the policy of a central bank that deals with supply of money. This means that central bank can help injecting liquidity or can absorb the same looking into overall prospect of economy.
Banks are the main financial institutions in a country that help in mobilization of public money for investment. Thus the regulator, in case of India, RBI can use various measures, both qualitative and quantitative to change the potential of banks with regard to lending and borrowing. There has been continuous reform in the monetary policy framework from Ways and Means Advances era to global integration of monetary policy as well as change in inflation targeting criteria. These steps were encouraging and came as a rescue of the banks from the financial meltdown directly. However, various measures call for a reform in the broad term for the overall growth budding.
CRR (Cash Reserve Ratio) and SLR (Statutory liquidity Ratio) are the portion of net demand and time liabilities (NTDL) that it has to keep with RBI in form of cash and with itself in the form of public sector bonds; gold etc respectively. CRR are nothing but a tool to regulate direct money supply. It is just a type of non-performing asset that is kept with RBI. It does not earn interest and neither is used for any investment by RBI. It is a run-off on the bank and thus must be eliminated. The point of its use in short term liquidity changes can be counteracted by various qualitative measures like moral suasion and selective credit controls etc.
The RBI has recently decreased SLR by 0.5 percentage point in the consecutive monetary policy review and brought it to 22%. However, this has had little impact on the overall liquidity environment as banks have been investing in these securities over and above their SLR limits. These securities are considered risk free as well as also help in meeting their Basel Requirements. Thus there has been inertia on the part of the banks to change this structure. Amendments made to RBI Act 19354 and Banking Regulation Act, 1949 in 2007, have capped the SLR to 40% which needs to be abolished. The investment by banks needs to be reduced and shall be made at a maximum of 2% points above the minimum SLR. Thus banks will not be able to invest in these securities and gold above a particular limit. This will help in decreasing the over-dependence on Government securities as well as increases the credit worthiness in the country. Further, SLR shall be broad based to include some other instruments of financial market like corporate bonds having a tangible net worth above a particular limit and also a positive credit rating from various credit rating agencies.
More than just inflation targeting
In the recent times, monetary policy has become synonymous to price control or inflation. The hawkish stand of RBI has made it more complacent for maintaining a status quo on the liquidity adjustment measures. Urjit Patel committee recommended a change in the inflation targeting stand of RBI from WPI to CPI which is more inclusive and broad based as it contains the services as well. This has made it almost impossible for a rate cut. However, RBI has overlooked other features of the monetary policy that needs to be considered: financial stability and exchange rate.
It may be right that RBI has taken right steps with regard to exchange rate when there was a run-off of the rupee. However, it has been quite late in its stand and thus led to havoc in the economy. There is a need for proper integration of exchange rate in the overall monetary policy and pre-emptive steps shall be taken before eleventh hour. There must be more information exchange with various central banks. As the Federal Reserve is conceiving a change in its quantitative easing and thus bound to have ramification on the inflow of dollars, there is a need for more emphasis on these mechanisms. This will, in the long run, may have a sentimental impact on the investors, traders etc. While talking about financial stability, though it is not an exclusive domain of the central bank , but it has to be considered while chalking out any of the new strategy whether it is with regard to change in rates or overall policy environment.
The various paradigms changes in the monetary policy frameworks are in the right direction but RBI needs to be more pragmatic with the dynamic economic realities and thus needs a transformation in its structural parameters.