V2C4: MONETARY MANAGEMENT AND FINANCIAL INTERMEDIATION

BASIC TERMS

Neutral Monetary policy: Neutral Monetary policy refers to the central bank  (read RBI) keeping such rate or range of rates, which are consistent with full  employment, trend growth, and stable prices. An economy in this state  doesn’t need to be stimulated or slowed by monetary policy.

Accommodative Monetary policy: An Accommodative monetary policy occurs  when a central bank attempts to expand the overall money supply to boost  the economy when growth is slowing (as measured by GDP).

Repo rate: Repo rate is the rate at which the central bank of a country lends  money to commercial banks in exchange of commercial banks selling their  securities to the central bank.

• RBI lends money to commercial banks in the event of any shortfall of funds.
• A lower repo rate will reduce the cost of borrowing for commercial banks.
• A low cost of borrowing will incentivise commercial banks to lend money to  investors/businesses at a lower interest rate.
• At a lower rate of interest, businesses will borrow more.
• More money will be injected into the system, and businesses will undertake  more investment activities.
• Higher investment will generate higher economic activity and higher  employment.
• This will increase the GDP of the economy.

Repo rate as a measure to control inflation: A reduced repo rate will  increase the money supply in the economy, increase demand, and if not matched  by adequate supply, it will increase inflation.

• Alternatively, in the event of inflation, central banks increase the repo  rate as this acts as a disincentive for banks to borrow from the central  bank. This ultimately reduces the money supply in the economy and thus  helps in arresting inflation.

Why did MPC cut repo rates?

Repo rates were cut four times, and an accommodative monetary policy was  followed by RBI, to strengthen domestic growth by spurring private  investment in the economy.

• RBI was able to reduce repo rates because there was already low  inflation in the economy, and the risk of inflation increasing because of  lowering repo rate was not there.

Why did MPC not cut repo rate the 5th time?

MPC decided to keep the repo rate unchanged at 5.15%, because by this time  the consumer price inflation had already started rising. MPC also wanted  to give time for the effects of earlier rate cuts to work out in the economy, i.e.,  waiting until effective monetary policy transmission happens.

An Accommodative Monetary policy during 2019-20: Monetary Policy  during 2019-20 was conducted under the revised statutory framework.

• As at the end of January 2020, the Monetary Policy Committee (MPC),  cut the repo rate by 110 basis points in four consecutive meetings.
• The decision to cut the policy repo rate reflects the changing stance of monetary policy from  neutral to accommodative.
• In its 5th meeting, MPC kept the repo rate unchanged.

Trends in monetary aggregates:

During 2018-19, the growth rates of monetary aggregates witnessed  reversion to their long-term trend after experiencing unusual behaviour in  2016-17 due to demonetization and again in 2017-18 due to the process of  remonetisation.

• Reserve Money (M0): Reserve Money dipped significantly during the  demonetisation period. It bounced back after remonetisation.  Expansion in M0 was due to increase in the following:
  • Currency in Circulation (CIC)
  • RBI’s Net Foreign Assets (NFA)
  • RBI credit to government (a component within Net Domestic Assets  (NDA))

• Broad Money (M3): Broad money growth has been on a declining  trend since 2009. Its marginal pickup in 2018-19 was driven by  growth in aggregate deposits (demand deposits and time deposits).
  • Bank’s credit to the government also contributed to M3 expansion.

• Money Multiplier (M3/M0): Between mid- 1990’s to 2016-17, the  money multiplier was mostly increasing.
  • However, it has been declining since 2017-18.

BACK TO BASICS

Narrow Money (M1) = Currency with the public + Demand Deposits of the  public in Banks

• Narrow money is the most liquid part of the money supply because demand  deposits can be withdrawn anytime during the banking hours.

M2 = M1 + Post Office Savings

Broad Money (M3) = Narrow money + Time deposits of the public in   Banks

M4 = M3 + Post Office Savings

Reserve Money (M0) = Currency in circulation + Bankers’ deposits with the RBI  + ‘Other’ deposits with the RBI + Cash reserves of banks with themselves

• Reserve Money is all the Cash in the economy.
• It’s also called High Powered Money.

M2 and M4 are relatively irrelevant indicators, due to less prominence of Post  Office Savings.

Factors affecting the Money supply:

• Monetary Base: Monetary Base depends on Reserve Money. Money  supply moves in the same direction as Reserve Money.
• Money Multiplier (m): Measured as a ratio of M3/M0.
• Money supply is the product of Money multiplier and Reserve money.

Liquidity condition in the economy:

Systemic liquidity in 2019-20 has been largely in surplus since June 2019.  Liquidity was injected into the economy through the following measures:

• Four Open Market Operations (OMOs)
• One US$ 5 billion buy/sell swap auction for three-year term
• RBI’s forex operations, augmenting domestic rupee liquidity
• Reducing the Statutory Liquidity Ratio (SLR)
• Moderation in currency demand after two years of high demand  following demonetization.

BACK TO BASICS

OMO is the sale and purchase of government securities (G-Sec) and treasury  bills by RBI. The purchase of G-Sec by RBI increases liquidity, as it releases  money in return.

• OMO raise G-Sec bond prices. As bond prices go up, the yields go down.
• RBI also conducted a ‘Special OMO’ where there was a simultaneous sale  (of short term securities) and purchase (of long term securities).
• This was done to reduce the difference between short and long term yields.

A foreign exchange Buy/Sell swap comes under RBI’s Liquidity Management  Framework (LMF).

• Banks sell dollars to the RBI at a dollar-rupee exchange rate fixed by the  central bank. In turn, the RBI will pay rupees to the participating banks at  the current spot rate (thereby increasing liquidity in the system).
• Three years later, the banks would buy back the dollars, in rupee terms, at  an exchange rate that includes the cut-off premium.
• A net forex purchase by the RBI results in the return of currency to the  banking system.

SLR is the portion of net demand and time liabilities (NDTL) which banks are  required to park in treasury bills and other instruments. By reducing the level  of SLR, RBI can increase funds available with commercial banks, resulting  in increased investment. This can fuel growth and demand.

Developments in the Banking sector:

Gross Non-Performing Advances (GNPA) ratio (i.e., GNPAs as a percentage  of Gross Advances) of Scheduled Commercial Banks (SCBs) remained flat at  9.3% at the end of September 2019, as was at end March 2019.

• Restructured Standard Advances (RSA) ratio of SCBs remained  unchanged at 0.4% during the same period.
• Stressed Advances (SA) ratio of SCBs also remained flat at 9.7%.
• GNPA ratio of Public Sector Banks (PSBs) was unchanged at 12.3%.
• SA ratios of PSBs increased from 12.7 to 12.9%.
• Capital to risk-weighted asset ratio (CRAR) of SCBs increased from  14.3 to 15.1%, largely due to improvement in CRAR of PSBs.
• Many PSBs have continued to record negative profitability ratios.

BACK TO BASICS

NPA: A loan whose interest and/or instalment of the principal have remained  overdue for a period of 90 days is considered as NPA.

Gross NPA consists of the following types:

• Substandard Assets– If a loan account remains NPA for a period less than  or equal to 12 months.
• Doubtful Assets– An asset is doubtful if it has remained in the sub- standard category for 12 months.
• Loss Asset– A loan account is declared as a loss asset when the bank’s  internal or external auditors declare it so or RBI inspection declares it as  one.
• Restructuring of a loan means changing its terms and conditions to  mitigate the difficulties encountered by the borrower due to genuine  reasons. Changes may include:
  • Extended repayment period
  • Reduced interest rate
  • Converting a part of loan into equity, etc.
• Stressed assets = NPAs + Restructured loans + Written off assets
• Capital to risk-weighted asset ratio: CRAR is also known as ‘Capital  Adequacy Ratio’, the ratio of a bank’s capital to its risk.
  • It is calculated to ensure that the bank can absorb a reasonable  amount of loss and complies with statutory Capital requirements.

Monetary Transmission, as mentioned earlier, has been weak in 2019 on all  three accounts:

• Rate Structure: The Weighted Average Lending Rate (WALR) of SCBs  has not declined at all in 2019 despite the reduction of repo rate by 135  bps since January 2019.
• The credit spread (the difference between repo rate and WALR) is at  the highest level in this decade.
• This suggests that there has been no transmission of the cut in repo  rate to lending rates of the banks in 2019.
• Term structure: RBI’s monetary easing and Liquidity Adjustment  Facility (LAF) has had some impact on short term interest rates.  However, the same has not been the case for longer-term maturities.

Credit growth: Despite a decrease in policy rates, credit growth in the  economy has been declining since the beginning of this year.

• Credit growth moderated across all major segments of non-food  credit, except personal loans, which continued to grow at a steady pace.
• Credit growth to the services sector decelerated sharply.
• Credit growth in the industry has also been very low in recent months.
• The main contributor to this slowdown has been a negative growth of  credit to Micro, Small and Medium Enterprises (MSME) and the Textile  sector.

Major Policy Changes related to Banking Regulations

• Permitting One-time Restructuring of Existing Loans to MSMEs,  classified as ‘Standard’, without a downgrade in the Asset Classification.
• Bank Lending to Infrastructure Investment Trusts (InvITs).
• New Prudential Framework for Resolution of Stressed Assets.
• External Benchmark Based Lending.
• Revised guidelines on the compensation of Whole Time  Directors/Chief Executive Officers/ Material Risk Takers and Control  Function Staff for all Private Sector Banks.

Non-Banking Financial Sector (NBFC):

After growing very fast in 2017-18 and in the first half of 2018-19, the sector  has decelerated sharply since then.

• The growth of loans from NBFCs declined from 27.6% in September  2018 to 9.9% at the end of September 2019.
• The cost of funds for NBFCs declined by March 2019.
• The third quarter of 2018-19 witnessed liquidity stress.
• There is an observable shift in the sources of funding of NBFCs, among  other signs of stress in the sector:
  • Bank borrowings increased.
  • Deployment of credit by mutual funds to NBFCs has been  contracting.
  • Market borrowings increased.
  • Among instruments of market borrowing, the share of Commercial  Papers decreased, while the share of Non-Convertible Debentures  (NCDs) increased.
  • CRAR of the NBFC sector stood at 19.5%at the end of September  2019, as against the regulatory requirement of 15%.
  • The gross NPAs ratio of the NBFC sector increased.
  • The net NPAs ratio also marginally increased.
  • The Return on Assets (RoA) of the sector decreased.
  • The Return on Equity (RoE) also moderated.

Major Policy Changes related to Non-banking Financial Regulation  /Supervision

• Amendment to the RBI Act, 1934 to strengthen the Regulation and  Supervision of the NBFC Sector, vesting additional powers with the  Reserve Bank.
• Reserve Bank allowed non-deposit taking systemically important NBFC- ICCs to obtain AD-Category II license.
• Liquidity Risk Framework for NBFCs.
• Increase of lending limits for NBFC-Micro Finance Institutions (NBFC- MFIs).
• Regulation of Housing Finance Companies (HFCs) transferred from  National Housing Bank (NHB) to the RBI.

Developments in Capital market:

• Primary Market Resource Mobilisation through public and rights issues  had declined as compared to 2017-18.
• Public issues (equity) decreased.
• Rights issues (equity) increased sharply.
• Public Issue (Debt securities) declined significantly.
• Primary Market Resource Mobilisation through Private Placements  was a preferred route to gear up the capital by Indian corporates.
• There was a net inflow into the mutual funds’ industry during April- December 2019.
• There was net inflow on account of Foreign Portfolio Investors  (FPIs) in the Indian capital market during April-December 2019, as  compared to net outflows in the previous corresponding period. It stood  at US$ 259.5 billion as on December 31, 2019.

BACK TO BASICS

Capital markets refer to the places where savings and investments are moved  between suppliers of capital and those who are in need of capital.

• It consists of the primary market, where new securities are issued and  sold, and the secondary market, where already-issued securities are  traded between investors.
• The most common capital markets are the stock market and bond  market.
• Equity represents shareholders’ stake in the company. The calculation of  equity is a company’s total assets minus its total liabilities
• Debt security refers to a debt instrument, such as a government bond,  corporate bond, certificate of deposit (CD), municipal bond, etc. that can be  bought or sold between two parties and has basic terms defined, such as  amount borrowed, interest rate, maturity and renewal date. It also  includes collateralized and mortgage-backed securities.
• Mutual fund is a type of financial vehicle made up of a pool of money  collected from many investors to invest in securities like stocks, bonds,  money market instruments, and other assets.
• Foreign Portfolio Investment is the entry of funds into a country where  foreigners deposit money in a country’s bank or make purchases in the  country’s stock and bond markets.
  • FPI does not provide the investor with direct ownership of a  company’s assets and is relatively liquid depending on the volatility of  the market.
  • Along with foreign direct investment (FDI), FPI is one of the common  ways to invest in an overseas economy.
• FDI provides ownership control in a business based in another country.

Issues made in the primary market can be classified as public, rights,  bonuses, and private placement.

• Public issue
  • Initial Public Offer (IPO)
  • Follow on Public Offer (FPO)
• Rights issue
• Bonus issue
• Private placement
  • Preferential issue
  • Qualified Institutional Placement (QIP)

Movement of Indian Benchmark Indices: India’s benchmark indices,  namely, Nifty50 and S&P BSE Sensex, reached record highs during 2019-20.

Developments in the Insurance sector: The level of development of the  insurance sector in a country is generally assessed on the basis of two  parameters viz insurance penetration and insurance density.

• Both, insurance penetration and insurance density have increased  in India, compared to the levels in 2001.
• Insurance density is more in case of Life insurance vis-à-vis Non-life  insurance.
• Insurance penetration for Life insurance has declined from 2011,  whereas for the Non-life insurance has increased.

National Pension System

The New Pension Scheme, now renamed as National Pension System (NPS)  was introduced in 2003 and it was made mandatory for Central Government  employees (except armed forces).

• The Scheme was extended to State Governments and as of now 28  State Governments have notified NPS for their employees.
• The Scheme was extended to all citizens of the country on a voluntary  basis from May 2009.
• Atal Pension Yojana falls under NPS and is a guaranteed pension  scheme for workers in the unorganised sector.
• Assets Under Management (AUM) includes returns on the corpus, under  NPS.
• During FY 2019-20, the following options were provided for Central  Government NPS subscribers:
  • Choice of Pension Fund
  • Choice of Investment pattern
  • NPS is administered by the Pension Fund Regulatory and  Development Authority (PFRDA).

Developments in the Insolvency and Bankruptcy Code (IBC): IBC has  been in operation for the past three years now. Insolvency and Bankruptcy  Board of India (IBBI) is the adjudicating authority for insolvency  proceedings.

• IBC recovered 42.5% of the total bad loans filed with the National  Company Law Tribunal (NCLAT).
• The proceedings under IBC take on average about 340 days, compared  to 4.3 years in the previous regime.
• 41.2 per cent of the cases admitted by NCLT for Corporate Insolvency  Resolution Processes (CIRP) is in the manufacturing sector followed by  19% in Real Estate, Renting and Business Activities sector.

Amendments under Insolvency and Bankruptcy Code (IBC)

Since its enactment in 2016, the Code has been amended three times.

• The first amendment introduced Section 29A, which deals with the  provision introduced to bar promoters from bidding for their own  companies. It prevented defaulters from regaining control of their  companies at a cheaper value.
  • While promoters of MSMEs are allowed to bid for their companies  as long as they are not wilful defaulters.
• The second amendment introduced Section 12A to provide creditors the  option to withdraw the insolvency application within 30 days of filing  the petition. Homebuyers shall be treated as financial creditors, to  discourage real estate developers from defaulting on commitments not  only to banks but also to their customers.
• The third amendment primarily focused upon
  • ensuring timely admission of insolvency cases and completion  within the newly set deadline of 330 days (it was 270 days earlier).
  • The resolution plan under the corporate insolvency resolution  process will also be binding on the Centre, State and local  authorities.

The govt is taking steps to increase capacity of National Company Law  Tribunal (NCLT) and increased its benches from 10 to 15. Also 26 new  members have been added taking total strength to 52, she added.