HYDERABAD: The Reserve Bank of India (RBI) is widely known as the lord of interest rates. But besides rate decisions, what’s less known is that the central bank wields unmatched influence on various aspects of finance and economy in general. This, in turn, puts a premium on the Governor’s job, which has remained unparalleled since RBI’s inception in 1935.
Till date, RBI has had 25 governors overseeing banking regulation and monetary policy, and on December 11, former revenue secretary Sanjay Malhotra took over as its 26th Governor.
In his first media interaction, Malhotra vowed price and growth stability, but his brief, like his predecessors, goes much beyond chief concerns like inflation and a weakening economy.
While formulating, implementing and monitoring monetary policy or anchoring headline inflation to the 4% target gets the spotlight, the central bank undertakes some other crucial functions such as regulating and supervising financial entities. As forex manager, it facilitates external trade and payments, besides sustaining confidence in the value of rupee and preserving the purchasing power of the currency. As the custodian of currency, it issues, exchanges, and destroys currency notes as well as puts coins in circulation. As the public debt manager, it issues and manages borrowings of state and central governments. To avoid bank runs, central banks assume the role of lender of last resort, lending freely, against quality collateral and at a penal rate of interest.
Clearly, RBI is not any ordinary institution and is unique both in its functions and objectives. If the 2007-08 global financial crisis increased its relevance, it grew multi-fold following the Covid-19 pandemic.
The art of setting interest rates
Maintaining macroeconomic stability and financial stability is the holy grail of any central bank. Macroeconomic stability ensures stable prices and sustainable growth, while financial stability keeps the financial system (which includes banks, non-banking financial entities and others) resilient, avoiding financial crises.
The pursuit of sustainable growth and low and stable inflation have been fundamental to central banking activities since the early 19th century, though financial stability got equal prominence, thanks to black swan events like the Great Depression of 1930s and the 2007-08 global financial crisis when the global economy faced large bank failures and deep recession.
To maintain macroeconomic stability, RBI has several tools at its disposal, chief among them being monetary policy. Price stability, which is nothing but anchoring headline inflation rate to the 4% annual target, is the dominant objective of our monetary policy. To achieve this, while ensuring adequate flow of credit to productive sectors, RBI has several direct and indirect monetary instruments at its disposal. These include repo rate, reverse repo rate, marginal standing facility rate, bank rate, cash reserve ratio, open market operations, market stabilisation scheme and so on.
By tweaking short-term rates, i.e., either raising or lowering of the overnight repo rate, RBI controls the supply of demand for money in the economy and thereby economic activity and inflation. For example, if the economy is growing too fast and inflation is high, it raises the repo rate, or the interest rate it charges banks to lend money. Higher rates will then permeate into other rates like housing loans and as the cost of borrowing increases, it discourages consumption and investment, thereby reducing growth and taming inflation.
On the other hand, if the economy is growing too slow or if the inflation is too low, the central bank lowers the repo rate, which feeds into other rates, encouraging spending and investment thereby spurring growth and inflation.
The art of setting interest rates is to be ahead of the game, which is to raise rates before inflationary pressures seep in and to cut them before the economy weakens by too much, but it isn’t as simple as it sounds. For, at any given point, multiple other variables will be at play making RBI’s job a major challenge. There are several instances of central banks falling behind or ahead of the curve.
In the past, there wasn’t any set target for retail inflation, but in 2016, after much deliberations, India adopted a committee-based approach, ensuring transparency to monetary policy decisions. The central government, in consultation with the RBI, determines the annual inflation target once every five years and it also constitutes a Monetary Policy Committee (MPC) consisting of three external members, RBI Governor, RBI’s Deputy Governor in charge of monetary policy, and one officer of RBI.
The MPC meets once every two months to determine the policy rate required to achieve the inflation target and even if they time the rate decisions right, monetary transmission poses another challenge. Transmission or RBI rate hikes or rate cuts to bank lending and deposit rates continue to be a concern as they are impeded by a variety of factors and thus the impact of policy change on economic activity and inflation remains less than desired.
Monetary transmission is an important step, through which policy rate changes are transmitted to the entire spectrum of interest rates such as money market rates, bond yields, bank deposit and lending rates and asset prices like stock prices and house prices. Various economic agents like households, firms, and the government respond to these rate changes by adjusting their spending behaviour. This alters aggregate demand of households and firms and by aligning it with aggregate supply conditions, the broader macroeconomic policy objectives like price stability and growth are achieved. The whole process takes several quarters.
According to RBI, empirical evidence for India suggests that monetary policy actions are felt with a lag of at least 2-3 quarters on growth and with a lag of 3-4 quarters on inflation, and the impact persists for 8-12 quarters.
But apart from repo rate, which is RBI’s benchmark policy rate, the central bank has several other tools in its arsenal to tame inflation, control liquidity and support growth. Besides, RBI also undertakes unconventional monetary policy measures from time to time. For instance, starting February 2020, it conducted several operation twists, under which RBI simultaneously sold short-term securities and bought long-term securities through open market transactions to reduce the long-term benchmark yield rate. It also introduced measures aimed at durable liquidity injections to the banking system through long-term repo operations with the tenor of one year and three year at reasonable cost, i.e. repo rate.
Forex and exchange rate
Exchange rate volatility pertains to the movement in exchange rate over time. Volatile exchange rates make international trade and investment decisions difficult. While there have been several episodes of exchange rate volatility, the 1991 balance of payment and foreign exchange crisis was a watershed event that forced RBI and the government to undertake market and regulatory reforms, including liberalisation and privatisation.
Given the bitter experience, containing foreign exchange rate volatility is one of the central bank’s primary responsibilities.
Traditionally, exchange rate movements are determined by market demand and supply and RBI’s job of exchange rate management is to simply ensure that the economic fundamentals get reflected in the external value of the rupee. According to RBI, its exchange rate policy is guided by three core objectives: first, to reduce excess volatility in exchange rates, while ensuring that the market functions in an orderly fashion; second, to help maintain an adequate level of forex reserves, and third, to facilitate the development of a healthy forex market.
Due to India’s reliance on capital flows, high oil imports and others, the forex market is often prone to bouts of volatility. Complicating matters, geopolitical events like trade war fears, tensions in West Asia and severe exogenous shocks like volatility in markets caused by Covid-19 of late, have caused disruptions in the global and domestic forex markets. The policy response includes forex market interventions that have the immediate impact on the demand and supply of foreign currency. To curb exchange rate volatility, RBI conducts sales or purchases of foreign currency in the forex market, to contain the excessive volatility and/or to smoothen out lumpy outflows and inflows.
To deal with increased volatility during episodes of huge capital outflows with depreciating pressure on rupee, RBI sells dollars in the market, which causes the supply of dollars to go up, thereby stemming the depreciation of rupee against the dollar, and buys dollars to reduce the dollar supply when needed. Purchase of dollars by RBI through forex market intervention increases forex reserves, whereas the sale of dollars decreases forex reserves.
That leads us to the question about the adequacy of forex reserves, which is assessed based on several parameters like the import cover, quantum, composition and risk profile of various types of capital inflows, as well as the external shocks to which the economy is vulnerable.
Another important aspect of RBI’s intervention in the forex market is its impact on rupee liquidity conditions. If RBI sells foreign currency, it receives rupee from market participants and thus the banking system liquidity reduces to that extent. Similarly, when RBI purchases foreign currency in the forex market, rupee liquidity goes up in the banking system. To mitigate this impact of forex intervention on the rupee liquidity, RBI undertakes offsetting transactions via its liquidity management tools, which is otherwise known as ‘sterlisation’.
In fact, RBI has a dedicated liquidity management framework with tools for Liquidity Adjustment Facility (LAF) like Marginal Standing Facility (MSF) to manage transient liquidity ie., liquidity surplus or deficit of temporary nature. While LAF includes repos and reverse repos of various tenors, MSF is an additional facility, where banks borrow rupee funds from RBI at a higher rate against eligible collateral, dipping even below the prescribed statutory liquidity ratio up to a specified limit.
As for managing liquidity surplus or deficit in the banking system, it hauls instruments like long-term repo, reverse repo operations, open market operations by outright purchase or sale of government securities, changes in CRR and others. Interestingly, CRR, which the central bank cut by 50 bps just a week ago, is a direct instrument which immediately impacts liquidity. A higher CRR forces banks to maintain higher balances in their current account with RBI, thereby creating liquidity deficit, while a lower CRR has the immediate impact of creating liquidity surplus in the banking system.
Interestingly, monetary policy and liquidity management are inter-connected. For, the operating target of monetary policy is nothing but the weighted average call rate (WACR), and RBI ensures that the operating target, or WACR, is aligned to policy rate on a daily basis. To ensure that the WACR is anchored to the repo rate, RBI uses fine tuning operations, i.e., the discretionary variable-rate repo and reverse repo auctions, which is nothing but lending to banks and borrowing from banks.
RBI also continuously monitors the money market rates during the market hours and conducts fine-tuning operations, as and when needed, to achieve the objective of keeping the WACR close to the policy rate.
If the WACR is close to the reverse-repo rate, it indicates surplus liquidity, and RBI may intervene with variable rate reverse repo auctions to align WACR closer to the policy rate. If WACR is trending towards the MSF rate, it indicates liquidity deficit in the system and RBI may intervene with repo rate auctions to infuse liquidity.
Lender of last resort
The Indian financial system comprises banks, NBFCs, insurance companies, mutual funds, financial markets, and others. RBI regulates commercial banks, cooperative banks, and certain NBFCs registered with it. The central bank monitors systemic risk on an ongoing basis via tools like stress tests at micro and macro level, analysis of interconnectedness among various financial market entities and sectors, use of indicators like banking stability indicator, systemic liquidity indicator, credit-GDP growth trends, and others.
As a banking regulator, RBI prescribes broad parameters of banking operations within which the banking and financial system functions, besides maintaining public confidence, and protecting depositors’ interest.
Historically, banks are highly leveraged institutions as they mobilise huge quantum of deposits and borrowings against a relatively low quantum of their own equity. Since banks build-up huge leverage using depositors’ funds, protection of depositors’ interests becomes one of the central reasons for bank regulation. As a lender of last resort, RBI can come to the rescue of a bank that is solvent but faces temporary liquidity problems, to protect the interest of the depositors and prevent possible failure of the bank, which in turn may also affect other banks and institutions.
While depositor protection, systemic stability and fostering of competition, are goals of regulation, there are several aspects that banking regulation is not intended to accomplish. For instance, preventing the failure of individual banks is not the primary focus of banking regulation, subject to the condition that depositors are protected, financial stability is not affected, and adequate banking services are maintained. But in the case of private lender Yes Bank, RBI’s timely intervention avoided a systemic failure, besides protecting depositors.
Custodian of Currency
Another key role of RBI is currency management. It determines the volume and value of banknotes to be printed in a year in consultation with the Union government. RBI estimates the quantum using statistical models and considering factors such as growth in GDP, inflation, interest rates, growth of digital payments and others. Currency is printed at four currency presses, two of which are owned by the Government of India and two by RBI itself. As for distribution, RBI has authorised select scheduled banks to set up currency chests, which are storehouses of banknotes and coins. As of March 2024, there are 2,794 currency chests spread across the country.
The central bank, under central government’s orders, has complete command over introducing new currency and withdrawing existing currency. A case in point is the withdrawal of Rs 2,000 notes, preceded by demonetisation in 2016 that saw withdrawal of both Rs 500 and Rs 1,000 notes from circulation.
The highest denomination note ever printed by RBI was the Rs 10,000 note in 1938, which was demonetised in January 1946 along with other denominations including Rs 500 and Rs 1,000. Subsequently, the higher denomination banknotes in Rs 1,000, Rs 5,000, and Rs 10,000 were reintroduced in 1954, but were again demonetised in January 1978.
While designing banknotes, the RBI introduces security features to make counterfeiting difficult. It conducts training camps from time to time to enable users to identify fake notes based on the security features in a genuine Indian currency note. These features are easily identifiable by seeing, touching, and tilting the note. While mere possession of a forged note does not attract punishment, intending to use the same despite knowing it’s not genuine, is punishable under Section 489C of Indian Penal Code.
Lastly, as a debt manager to the central and state governments, RBI undertakes market borrowing on their behalf by issuing marketable securities like fixed rate bonds, floating rate bonds, treasury bills, cash management bills, and others. The objective is to mobilise borrowings at low cost, medium to long-term, with prudent levels of risk and a stable debt structure while working towards developing a liquid and well-functioning domestic debt market.
The long and short of it
If Benegal Rama Rau was the Governor with the longest tenure, at least four Governors served for the shortest periods. While B N Adarkar was RBI Governor for barely 40 days from May 4, 1970 to June 15, 1970, N C Sen Gupta had a three-month tenure from May 19, 1975 to August 19, 1975. M Narasimhan from May 2, 1977 to November 30, 1977. A Ghosh’s 15-day stint was the shortest in RBI’s history from January 15, 1985 to February 4, 1985. While two Governors Benegal Rama Rau and Dr Urjit Patel resigned due to differences with the government, at least three more Governors, namely Y V Reddy, Dr D Subbarao and Dr Raghuram Rajan completed their tenures notwithstanding the differences with the North Block