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Banking > Policies>
Mid-Term Review of Monetary and Credit Policy 1999-2000 > Part II

Stance of Monetary Policy for the Second Half of 1999-2000

In view of the paramount need to support industrial recovery, the Monetary and Credit Policy Statement in April had stated that "the current stance of monetary policy will continue to be in the direction of facilitating adequate availability of liquidity along with stable medium and long-term interest rates, with policy preference for softening to the extent circumstances permit." This stance of monetary policy was already reflected in the measures announced by the Reserve Bank on March 1,1999, when the repo rate was reduced by 2 percentage points and the Bank Rate and the Cash Reserve Ratio were reduced by 1 percentage point and 0.50 percentage point, respectively. The Cash Reserve Ratio was further reduced by 0.50 percentage point in April 1999. Following the RBI's measures, banks and financial institutions also announced their decisions to lower prime lending rates.

In line with the above stance, during the first half of the current financial year, the Reserve Bank has been closely monitoring the overall liquidity conditions in the market as well as the behaviour of interest rates. So far as liquidity conditions are concerned, by and large, they have remained generally easy owing inter alia, to growth in bank deposits and the cuts in Cash Reserve Ratio announced in March and April 1999. Non-food bank credit has also recorded an increase during this period by Rs.14,802 crore in contrast with an increase of Rs.8,181 crore during the first half of 1998-99. The increase in investments by banks in commercial paper, bonds/shares/ debentures of PSUs and private corporate sector during this period, however, showed an increase of about Rs.6,314 crore during April-September 1999 against Rs.9,359 crore in the corresponding period of 1998-99.

There has been a reduction in yields and interest rates on Government securities and Certificates of Deposit in the first half of the current year. So far as the Government securities are concerned, the yields have fallen by 46 basis points for 10-year paper in October 1999 compared with the yields in March 1999. The discount rates on Certificates of Deposit have declined from 10.00 per cent to 8.50 per cent for three months maturity and from 12.50 per cent to 11.00 per cent for one year maturity, between April and early September, 1999. There was also a decline in prime lending rates of public sector banks from the range of 12.75 - 14.50 per cent at the end of February 1999 to 12.00 - 13.50 per cent in October 1999.

While liquidity conditions have generally been easy, overnight call money rates have tended to be firm during the first half of the year compared with the position in the corresponding period of last year. The fortnightly average rates were in the region of 7.7 to 9.9 per cent for the most part as compared with 6.1 to 9.8 per cent last year. Part of the reason for this may be attributed to the pick-up in demand for credit and greater opportunities for investments in medium and long-term paper. (In the first fortnight of October 1999, however, call money rates, shot up to a high of 20.0 per cent for a few days mainly because of miscalculation of CRR requirements by some banks and low level of lending by major lenders in the call market.)

The hardening of short-term interest rates was also reflected in an increase in the cut-off yields on Treasury Bills. The yields on 91-day and 364-day Treasury Bills showed an increase during the first half of the current financial year of about 46 basis points and 75 basis points respectively, over the corresponding period of last year. On the whole, while liquidity conditions have been comfortable and medium and long-term rates have tended to soften, there has been some pressure at the shorter end of the yield curve.

In order to cool down the pressures on call money market during the first half of October, the Reserve Bank opened a purchase window for Treasury bills as part of its open market operations. It is the intention of RBI to continue with this practice as and when considered necessary and, over time, to develop a two-way market operations in Treasury bills. In due course, with further development of Treasury bills market, such action should enable RBI to confine its activities to secondary market operations in Treasury bills, obviating the need for any devolvement in primary auctions.

In view of the decline in inflation rates in the past few months, and a relatively favourable outlook for the year as a whole, there is a case for a further downward movement in the structure of interest rates. The Reserve Bank has already indicated its policy preference for softening of interest rates to the extent circumstances permit. It, however, needs to be stressed once again that prime lending rates of banks for commercial credit are entirely within the purview of the banks and are no longer set by the Reserve Bank. The interest rates which are subject to regulation are only the rate of interest on savings accounts (which is 4.5 per cent), and rates of interest on export credit and credit for small and tiny sectors, including DRI schemes, up to an amount of Rs. 2 lakh. Decisions in regard to interest rates, therefore, have to be taken by banks themselves in the light of various factors, including their own cost of funds, their transaction costs, and interest rates ruling in the non-banking sector, etc.

While greater flexibility in interest rates is a most desirable objective, it has to be recognised that banks face several structural and other constraints. Among these are:

  • For the public sector banks, the average cost of funds is in the region of 8 per cent. The non-interest operating expenses work out to 2.5 to 3.0 per cent of total assets, putting pressure on the required spread over cost of funds leading to high lending rates. Relatively high overhang of NPAs together with interest tax pushes further the lending rates.
  • Banks do have the freedom to offer variable interest rates on longer term deposits. However, the preference of depositors for as well as the traditional practice with banks is to offer fixed interest rates on term deposits. The effect of this practice is to reduce the flexibility that banks have in lowering their lending rates since the rates on the existing stock of deposits cannot be lowered.
  • There is persistent and large volume of market borrowing requirements by the Government giving an upward bias to the entire interest rate structure.
  • Interest rates on contractual savings like Provident Fund, National Savings Scheme are substantially higher than long-term deposit rates of banks. Provident Fund rates are generally in the region of 12 per cent and National Savings Scheme rate on 4-year deposits is 11 per cent as compared with the bank deposit rate of 10-12 per cent for similar maturity. Similarly, private sector mutual funds offer a much higher rate of interest than those offered by banks on their term deposits. Compared to bank deposits, many of the other saving schemes and mutual funds carry larger tax benefits.
  • The level of CRR continues to be high in view of the need to control the overall expansion of liquidity in the system. A high level of CRR also raises the average cost of funds for banks.


From the short-term and long-term points of view, in the context of financial sector deregulation and industrial liberalisation, priority needs to be given to removing some of the above constraints so that the interest rate structure can be made more flexible during different phases of the business cycle. An important policy priority of the Reserve Bank, Government as well as banks must be to undertake concrete steps in this direction as early as possible.

As mentioned in the April Statement, the Bank Rate and short-term repo rate have been increasingly perceived by the markets as signals for movements in market rates of interest, particularly call money rates. The changes in CRR have served as one of the important instruments for regulating liquidity, and have been effective in meeting the short-term challenges in domestic money and forex markets. The Interim Liquidity Adjustment Facility has also helped in keeping the money market rates range bound. The medium/long-term objective of monetary policy will continue to be in reducing the average level of CRR, while in the short-term it could be varied in both directions depending on the behaviour of monetary indicators.

With the use of multiple indicator approach, the position in the financial markets will continue to be assessed by movements in money market interest rates, exchange rate, foreign exchange reserves, credit to Government and commercial sector and fiscal position of the Government besides real sector developments. Constant efforts are being made to explore the relationships among different sectors of the economy through a short-term operational model which will also be useful in understanding the transmission mechanism of monetary policy. In this respect, the estimates of the new monetary aggregates (based on the recommendations of the Working Group on `Money Supply: Analytics and Methodology of Compilation'), both from the component and sources side, compiled and released in the October issue of RBI Bulletin are likely to be helpful.

Apart from price stability, central banks all over the world also accord importance to financial stability as a policy objective. RBI has been making continuous efforts towards strengthening financial soundness by prescribing capital adequacy norms of banks and financial institutions, advising improvements in asset classification and accounting systems and establishing best practice norms for income recognition and provisioning against exposures faced by them. Following the recommendations of the Narasimham Committee II, the RBI had, in October 1998, announced , inter alia, a range of specific prudential norms for banks which have since been progressively implemented. The thrust in this direction was carried forward in the April 1999 Statement enabling banks not only to adopt prudent accounting standards but also to allow some measure of freedom in managing loan accounts, and operation of ALM guidelines for financial institutions. Moving further from the gains of ALM system, banks are encouraged to put in place comprehensive risk management systems to take care of credit risk, market risk and operational risk. After holding consultations with banks, RBI has recently provided detailed guidelines in this regard. RBI also places utmost importance on the quality and standards of supervision which have been progressively refined under the dispensation of the Board for Financial Supervision (BFS) ever since its establishment. Sustained reforms in this area during the last few years have significantly improved the outlook with respect to overall financial sector stability in India. RBI would continue to review the position with regard to the issues integral to the maintenance of financial stability in the future.

The Bank's overall stance of policy for 1999-2000 would continue to be : provision of reasonable liquidity; stable interest rates with preference for softening to the extent possible within the existing operational and structural constraints; orderly development of financial markets and ensuring financial stability.

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