MONETARY POLICY & COMMON MAN

THE Reserve Bank of India (RBI), India's central bank, meets every quarter (in what is termed as the Monetary and Credit Policy meeting) to decide on the level of interest rates suitable to maintain a particular level of growth in the economy; to regulate the supply of money and credit in the system; and to effect structural and technical changes in the banking system.

Any monetary and credit policy measure introduced by altering the cost of money (interest rates) and/or by regulating the money flow in the system impacts everyone in the country as it affects the aggregate demand and supply situation in the economy. There are a lot of expectations that gets built up in anticipation of a policy change and market prices start aligning themselves to this eventuality. Market participants and the media, especially the pink press, are agog with discussions on the nature of the policy measure and the extent to which it would be used.

In its most recent monetary policy, announced on January 31, 2007, the RBI raised the repo rate by 0.25% to 7.5% to contain inflation within the stated target of 5-5.5%. It also increased the risk weights and provisioning norms on lending to commercial real estate, personal loans, capital market loans and credit card loans. These measures would lead to an increase in interest rates, affecting both the corporate and the individual borrower.

Corporates tend to be more aware of the macro environment and implement suitable mechanisms to insulate themselves from probable monetary policy actions. But the common man on the street, who is equally affected by the central bank's actions, might not have the awareness or even an access to suitable products to safeguard himself.

Through this article, we outline the reasons for the central banks' actions, the key macro indicators and trends to follow and an attempt to address whether a common man can pre-empt the monetary policy action and structure his investments and/or borrowings accordingly.

To start off with, one would need to know the various monetary and credit policy tools available with the RBI. Broadly, the central bank uses the following tools to achieve its stated objectives: To signal the level of interest rates Repo rate:It is the rate at which banks borrow from the RBI. An increase in the rate would signal a higher cost of funds for banks and thus for all borrowers.

Reverse repo rate: It is the rate at which the banks lend to the central bank. This rate acts as a floor for interest rates as the RBI itself is ready to borrow at this rate. So, the higher the rate, the higher would be the general level of interest rates.

Bank rate: The bank rate was used earlier as an interest rate signalling tool. The bank's prime lending rate (PLR) was derived out of the bank rate. It lost its significance after the introduction of the repo rates. To control money supply in the economy Cash reserve ratio (CRR): It is the amount of money the banks need to maintain as a reserve with the central bank. If the RBI intends to reduce the amount of money in the banking system it would increase the CRR and vice versa.

Open market operations (OMO):

As banks are the biggest owners of bonds issued by the government (government securities or G-Secs), the RBI would buy Gsecs (OMO purchases) from banks to increase the liquidity in the system or sell its stock of G-secs (OMO sales) to suck out excess liquidity from the banking system. To regulate the credit flow to corporates and individual borrowers Risk weights and provisioning norms: The RBI can increase or decrease the risk weights (it determines the amount of capital to be set aside before lending) applicable to different kinds of loans. This alters the pricing and the viability of these loan products.

Selective credit control: The RBI can also explicitly check the total credit flow to a sector. This is a drastic step impinging the growth in the sector but would be used as the last resort to achieve its objective.

A central bank's primary objective is to contain inflation and maintain the money supply at a level consistent with a required level of growth rate. On any deviation from the desired objectives of low inflation, appropriate money supply and potential growth rate, the central bank would use the above mentioned tools actively.

The RBI has used most of the above mentioned measures over the past two years to achieve its intended objective. The table describes the key monetary policy measure and its rationale.

The cumulative effect of these measures has been a steep rise in interest rates across products and markets. The 10-year government bond yield is up by 200 bps and corporate borrowing costs have gone up by 250-450 bps. Housing loan rates (fixed rate, 20 years) have increased from 7.5% to 11.5%, a 400 bps increase, with EMI payments being 30% higher. The increase in rates has been higher for personal loans and for loans to buy shares in an IPO. At the same time, retail bank deposit rates for a one year tenor pay 8.5-9.0% as against 6.0-6.5% a year back.

On hindsight, it would have been ideal to borrow at a fixed rate two years ago and invest in floating rate assets or in shorter maturity assets and reinvest at higher rates. But, can a layman try and pre-empt these policy moves of an astute central bank? We highlight certain key indicators the central bank targets to achieve its objective of 'growth with stability'. The central bank would forgo higher growth rates and even risk unemployment in the shorter term in order to maintain stability in the economy.

GDP growth rate:The RBI spells out a GDP growth target and reviews it periodically, according to the situation at hand. It raised its real GDP (nominal GDP minus inflation) growth target for FY07 to 8.59.0% from 8.0%. The targeted level of inflation and required level of money supply would be derived out of the expected GDP growth level. India's GDP growth rate has been on an uptrend over the last three years - A higher number in itself does not warrant a restrictive monetary policy action to cool down growth. What the central bank would be concerned about (and so should you) is the nature of the growth trend. If the current growth rate is above the potential rate of growth, ie, the economy is working at full capacity utilisation with low levels of unemployment, it could tend to be inflationary as the higher aggregate demand for goods and labour in a tight supply scenario would increase prices. So, when the industries are working at high capacity utilisation levels, it is likely that the RBI would be cautious about inflation and introduce a tighter monetary policy measure.

Inflation: Inflation is a general increase in the price level in the economy and it reduces the purchasing power of the currency. An inflation rate of 5% means that you would need to pay Rs 105 today for something you could have bought for Rs 100 last year. Central banks worldwide strive to keep demand led inflation under check by raising interest rates and contracting the supply of money. Normally, the government would ease supply side pressures by creating fresh capacities or by reducing taxes on specific commodities.

The RBI explicitly targets inflation in a range (currently 5-5.5%) and any deviation should invite tightening measures. Inflation in India recently exceeded the 6.0% mark and the RBI raised interest rates to lower the inflationary expectations. Even the government responded by cutting import duties on several products. As apparent from the earlier tightening measures, both the central bank and the government have low tolerance towards high inflation.

Money supply:Excess levels of money supply in the system would lower interest rates and induce conspicuous consumption, leading to inflationary pressures. The RBI's target for broad money supply (M3) growth is 15.0% (which is suitable to sustain an 8.0% GDP growth and 4.5-5.0% inflation), but the current M3 growth is at 20.0%. The RBI responded by increasing the CRR by 50 bps which led to Rs 13,500 crore being drawn out of the banking system. The RBI has also increased the cost of money which could further rein in the M3 growth.

Credit growth: India is currently experiencing its longest and fastest growing credit cycle. Growth is above 30.0% for two consecutive years. Though India is largely under-banked and the credit penetration to rural areas remains low, such growth frenzy portends trouble ahead. The RBI's target for credit growth is 20.0%. This is currently seen to be growing at 30.0%. The central bank has been increasing interest rates and raising risk weights and provisions for certain kinds of loans to sensitive sectors that have displayed unusually high increases. During an economic downturn, these loans are susceptible to default and carry the risk of jeopardising the stability of the entire financial system. As such, the central bank would rather prefer to play it safe.

A reasonable understanding and awareness of these indicators and their warranted levels would help the common man to pre-empt policy moves and help him to structure his personal balance sheet accordingly.

Framing the monetary policy is a science but it is not Rocket Science! These measures, their current levels and RBI's targeted levels are easily accessible at the RBI's website - www.rbi.org.in. The author is associate fund manager debt, Quantum Asset Management Company