Monetary Policy as it states is all about Money. Money plays an important role in the economic system we see the use of money at every step of life indeed it would be hard to imagine life without money! The main function of money in an economic system is to facilitate the exchange of goods and services.
The actions of a central bank, currency board or other regulatory committee, that determine the size and rate of growth of the money supply, which in turn affects interest rates.
In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy.
In India context central bank is referred to as RBI (Reserve bank of India)
A central bank can be said to have two main kinds of functions:
(1) macroeconomic when regulating inflation and price stability and
(2) microeconomic when functioning as a lender of last resort.
Macroeconomic Influences
As it is responsible for price stability, the central bank must regulate the level of inflation by controlling money supplies by means of monetary policy. The central bank performs open market transactions that either inject the market with liquidity or absorb extra funds, directly affecting the level of inflation. To increase the amount of money in circulation and decrease the interest rate (cost) for borrowing, the central bank can buy government bonds, bills, or other government-issued notes. This buying can, however, also lead to higher inflation. When it needs to absorb money to reduce inflation, the central bank will sell government bonds on the open market, which increases the interest rate and discourages borrowing. Open market operations are the key means by which a central bank controls inflation, money supply, and price stability.
Microeconomic Influences
The establishment of central banks as lender of last resort has pushed the need for their freedom from commercial banking. A commercial bank offers funds to clients on a first come, first serve basis. If the commercial bank does not have enough liquidity to meet its clients' demands (commercial banks typically do not hold reserves equal to the needs of the entire market), the commercial bank can turn to the central bank to borrow additional funds. This provides the system with stability in an objective way; central banks cannot favor any particular commercial bank. As such, many central banks will hold commercial-bank reserves that are based on a ratio of each commercial bank's deposits. Thus, a central bank may require all commercial banks to keep, for example, a 1:10 reserve/deposit ratio. Enforcing a policy of commercial bank reserves functions as another means to control money supply in the market.
The rate at which commercial banks and other lending facilities can borrow short-term funds from the central bank is called the discount rate (which is set by the central bank and provides a base rate for interest rates). It has been argued that, for open market transactions to become more efficient, the discount rate should keep the banks from perpetual borrowing, which would disrupt the market's money supply and the central bank's monetary policy. By borrowing too much, the commercial bank will be circulating more money in the system. Use of the discount rate can be restricted by making it unattractive when used repeatedly.
What are elements of Monetary Policy?
As said earlier, The Central Bank controls the money supply and credit in the best interests of the economy. The bank does this by taking recourse to various instruments.
1) Bank Rate Policy
The bank rate is the rate at which the central bank lends funds to banks, against approved securities or eligible bills of exchange. The effect of a change in the bank rate is to change the cost of securing funds from the central bank. An increase in the bank rate increases the costs of securing funds and of borrowing reserves from the central bank. This will reduce the ability of banks to create credit and thus to increase the money supply. A rise in the bank rate will then cause the banks to increase the rates at which they lend. This will then discourage businessmen and others from taking loans, thus reducing the volume of credit. A decrease in the bank rate will have the opposite effect.
2) Open Market Operations
OMO is the buying and selling of government securities by the Central Bank from/to the public and banks on its own account. It does not matter whether the securities are bought from or sold to the public or banks because ultimately the amounts will be deposited in or transferred from some bank. The sale of government securities to banks will have the effect of reducing their reserves. This directly reduces the bank’s ability to give credit and therefore decrease the money supply in the economy. When the Central Bank buys securities from the banks it gives the banks a cheque drawn on itself in payment for the securities. When the cheque clears, the Central Bank increases the reserves of the bankby the particular amount. This directly increases the bank’s ability to give credit and thus increase the money supply.
3) Varying Reserve Requirements
Banks are obliged to maintain reserves with the Central Bank on two accounts. One is the Cash Reserve Ratio (CRR) and the other is the Statutory Liquidity Ratio (SLR). Under CRR the banks are required to deposit with the Central Bank a percentage of their net demand and time liabilities. Varying the CRR is a tool of monetary and credit control. An increase in the CRR has the effect of reducing the banks excess reserves and thus curtails their ability to give credit. Reducing the CRR has the effect of increasing the bank’s excess reserves, which increases its power to give credit.
The SLR requires the banks to maintain a specified percentage of their net total demand and time liabilities in the form of designated liquid assets which may be (a) excess reserves (b) unencumbered (are not acting as security for loans from the Central Bank) government and other approved securities (securities whose repayment is guaranteed by the government) and (c) current account balances with other banks. Varying the SLR affects the freedom of banks to sell government securities or borrow against them from the Central Bank. This affects their freedom to increase the quantum of credit and therefore the money supply. Increasing the SLR reduces the ability of banks to give credit and vice versa.
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Wednesday, October 31, 2007
What is Monetary Policy? - India Story
Monday, October 1, 2007
Early signs of easing seen in subprime lending
Former Federal Reserve chairman Alan Greenspan defended the U.S. subprime mortgage market Monday, arguing that the securitization of home loans for people with poor credit not the loans themselves were to blame for the current global credit crisis.
Greenspan also said there were some early signs of an easing in the crisis, but warned that the longer term effects on the economy were still being determined.
"Subprime mortgages were and are risky, but they are worth it," Greenspan said, adding that is better to have a larger property owning class with a vested interest in the system.
"I'm terribly concerned that we would cut back on the availability of subprime that has enabled a very significant increase in mortgages among minorities in the United States," he added.
The current credit market turmoil began with rising defaults in the United States on subprime mortgages. Those problems have since spread as banks repackaged risky loans with the more reliable and sold them to a wide range of investors, including several European banks.
Credit dried up in early August, roiling financial markets, as banks became wary of exposure to the risky loans.
Greenspan acknowledged that a number of people should not have been taking out those mortgages, but that the current crisis was due "not the subprime problem itself, but to the securitization of subprime."
Greenspan said there are "some positive signs" that the crisis is calming.
"For example, the yields on what has been the poster child of this crisis, asset backed commercial paper, have jumped up sharply," he said. "It has since come down, but not all the way."
Similarly, the interbank lending rate, which jumped in recent weeks amid fears about insolvencies, have started to come down, but "not all the way," he said.
"We are not through with this yet," he added, suggesting there could still be what he termed an "Act II," in which falling house prices feed into slower consumer spending.
However, he reiterated earlier comments that he believed the probability of a recession in the United States was "less than 50/50."
Greenspan also implicitly criticized the role of ratings agencies in the crisis.
"The problem was that people took that as a triple-A because ratings agencies said so," he said. Yet when they tried to sell the products they ran into difficulties, which shook confidence.
"What we saw was a 180 degree swing from euphoria to fear and what we've learned over the generations is that fear is a very formidable challenge," Greenspan said.
Ratings agencies such as Standard & Poor's Corp., Moody's Investors Service Inc. and Fitch Ratings have come under fire for being slow to lower their ratings on securities based on mortgage loans to U.S. borrowers with poor credit records.
Friday, September 28, 2007
Recession chatter gets louder
The fear factor has spiked in recent weeks as a series of indicators signal that Wall Street's troubles are starting to spread to Main Street.
Housing price declines. Slowing job creation. Profit warnings from the country's biggest retailers. To an Econ 101 student, those are telltale signs of an imminent recession. Not surprisingly, the R-word has dominated talk among bankers for weeks.
"We're very close to stall speed in the economy," says Paul Kasriel, director of economic research at Northern Trust. And it's not just the usual Chicken Littles talking about it: Everyone from top auto executives to normally ebullient tech venture capitalists are making noises about the slowing economy. Former Treasury Secretary Larry Summers, now at hedge fund D. E. Shaw, is adamant that there's a greater than 50% chance of a recession.
So what's really happening? By most economists' terms, a recession is defined as two or more consecutive quarters of GDP decline -- something we haven't seen since 1991. By that narrow definition we're not even close. Of 50-plus economists surveyed by research firm Blue Chip Economic Indicators, not one is predicting a recession. They still expect GDP to grow 2.6% next year.
But the broader definition, one put out by the National Bureau of Economic Research, is simply a "significant decline in economic activity, spread across the economy, lasting more than a few months." By that measure, many say the sky is falling.
Until now, problems with the economy have remained within the financial sector, with most of the pain hitting mortgage companies and investment banks. But in recent weeks a few key signs show that Wall Street's problems are seeping into the rest of the economy.
Of course, the biggest driver has been the downturn in the real estate market. After 15 years of rising home prices, a cooldown was expected. But the sharp price drops this summer showed that the downturn is deeper and broader than previously thought. In July home prices fell 4.5% from a year earlier.
Housing is closely tied to overall consumer spending. With homeowners facing growing mortgage headaches, there's been a simmering fear that they will curtail discretionary spending. Many retailers had already warned that the second half of the year would fall short of expectations. Then, in a one-two punch in late September, Target (Charts, Fortune 500) and Lowe's (Charts, Fortune 500) issued profit warnings on the same day - news that sent retail stocks plummeting and created new fears of a broader slowdown.
Another key metric is employment. The unemployment rate, at 4.6%, is not a worry so far. But when August figures showed the number of Americans with jobs had fallen for the first time in four years, it raised fears that the weakness in the economy had spread -- and was probably the main factor behind the Fed's Sept. 18 rate cut.
In fact, that rate cut is one of the most telling differences between today's outlook and that of 1991. Typically recessions follow aggressive hikes in interest rates, a deliberate slamming on the brakes by the Federal Reserve designed to halt consumer price inflation. This time the Fed has raised rates gradually, from a very low level. But because of consumers' big debt binges in recent years, the slightest tightening of the money supply may simply have been too much.
To be sure, not everyone is saying a recession is coming. After all, the S&P 500, driven by tech stocks, is trading close to its all-time high. Dean Maki, chief economist for Barclays Capital, says a surprisingly large proportion of overall personal spending comes from the wealthy, who are not likely to dial back their conspicuous consumption.
So where is the economy really headed? Some cooler heads say the more likely effect is a pullback to slower GDP growth. "It's much harder to get into a recession than people understand," says Drew Matus, senior economist at Lehman Brothers.
Others say recessions are an inevitable outcome of prolonged periods of growth and a way to wring excesses out of the economy. As anyone who balked at paying $1 million for a two-bedroom condo in a hot market would agree, there's nothing wrong with the economy that a few months of stalled growth wouldn't fix.
Thursday, September 20, 2007
Indian rupee breaks through 40 per dollar level for 1st time since 1998
The Indian rupee rose to a nine-year high against the U.S. dollar Thursday amid strong demand from foreign funds investing in one of the world's fastest growing economies.
The rupee rose 0.7 percent to 39.88 per dollar, breaching the psychologically crucial 40-per-dollar mark for the first time since May 1998.
The rupee has appreciated more than 10 percent against the dollar so far this year as global investors have flocked to India, where the economy is growing about 9 percent annually and the stock market has been climbing to record highs.
Analysts expect the rupee to remain strong through this quarter, although that could hurt exporters, especially the country's hugely profitable outsourcing industry.
"It will stay around 40 for some time," said Agam Gupta, head of foreign exchange trading at Standard Chartered Bank in India.
The rupee's strength has come despite measures by the Reserve Bank of India to counter a surge in foreign money into the country that also has fueled inflation. Last month, the central bank installed several curbs on overseas borrowing by Indian companies and ordered banks to hold more cash in reserves.
But Gupta said the central bank can do little to stem the flow of money from other sources.
"A lot of inflows have been in the form of foreign direct investment and investments in stocks and bonds," he said. "Those inflows will continue."
Foreign institutional investors have bought US$10.1 billion in Indian stocks and bonds so far this year, according to the Securities and Exchange Board of India. That money is on top of a record US$16 billion India received as foreign direct investment in the last fiscal year that ended March 2007.
The rupee got a boost after the U.S. Federal Reserve made a bigger-than-expected cut its key interest rate Tuesday, stoking expectations that investors will bring in more dollars to take advantage of higher interest rates here and a bull run in the stock market. The rupee gained about 1 percent against the U.S. dollar in Wednesday's trading.
India's benchmark interest rate is now 7.75 percent, 3 percentage points higher that the Fed's key rate, and it's unlikely that the Indian central bank will cut rate soon.
Market players will likely revise their projections for the rupee-dollar rate following the Fed move, Gupta said. Most foreign exchange traders earlier expected the rupee-dollar rate to average around 41 during the October-December quarter.
That is bad news for exporters, whose overseas earnings are eroded by the strong rupee.
Indian Commerce and Industry Minister Kamal Nath said the rupee's strength was "a cause for concern" and the government may have to revise the export target of US$160 billion set for the current fiscal year.
Trade data released earlier this month showed exports growth have already begun to decelerate.
"It is a new situation and requires a new response," Nath said, adding the government would explore measures to help exporters tide over the impact of a stronger rupee.
Tuesday, September 18, 2007
Subprime Lending Crisis and It's impact on the Emerging Markets
What is Credit Report?
credit report is, in many countries, a record of an individual's or a company's past borrowing and repaying, including information about late payments and bankruptcy. The term "credit reputation" can either be used synonymous to credit history or to credit score.
When a customer fills out an application for credit from a bank, store or credit card company, his or her information is forwarded to a credit bureau, along with constant updates on the status of his or her credit accounts, address, or any other changes made since the last time he or she applied for any credit.
This information is used by lenders such as credit card companies to determine an individual's or entity's credit worthiness; that is, determining an individual's or entity's means and willingness to repay an indebtedness. This helps determine whether to extend credit, and on what terms. With the adoption of risk-based pricing on almost all lending in the financial services industry, this report has become even more important since it is usually the sole element used to choose the annual percentage rate (APR).
What is subprime lending?
Subprime lending, also called B-paper, near-prime, or second chance lending, is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. The term also refers to paper taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed individuals. Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the increased risk.
Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself.
Subprime lending is highly controversial. Opponents have alleged that the subprime lending companies engage in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans, thus leading to default, seizure of collateral, and foreclosure. Proponents of the subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.
About Current Subprime Lending Crisis
The institution giving out the home loans in the subprime market does not stop here. It does not wait for the principal and the interest on the subprime home loans to be repaid, so that it can repay the loan it has taken from the bank.
It goes ahead and securitises these loans. Securitisation essentially involves, converting these home loans into financial securities, which promise to pay a certain rate of interest. These financial securities are then sold to big institutional investors. The interest and the principal that is repaid by the subprime borrowers through equated monthly installments is passed onto these institutional investors who buy these financial securities.
The institution then takes the money that it gets from selling the financial securities and passes it on to the bank, it had taken the loan from, thereby repaying the loan. And everybody lives happily ever after. Well, not really.
This part we had already seen in the last article. The entire problem arose because institutions giving out subprime home loans could easily securitise it. Once an institution securitises a loan, it does not remain on the books of the institution. Hence that institution does not take the risk of the loan going bad. The risk is passed onto the investors who buy the financial securities issued for securitising the home loan.
Given the fact that institutions giving out the loan do not take the risk, their incentive is in just giving out the loan. Whether the individual taking the home loan has the capacity to repay the loan, isn't their problem. Hence chances are that proper due diligence to give out the home loan is not done and loans are given out to individuals who are more likely to default.
Other than this, greater the amount of loan the institution gives out, greater is the amount it can securitise and, hence, greater the amount of money it can earn.
After borrowers started defaulting, it has come to light that institutions giving out loans in the subprime market had been inflating the incomes of borrowers, so that they could give out greater amount of home loans. As explained above, by giving out greater amounts of home loan, they were able to securitise more, issue more financial securities and hence earn more money.
These loans were floating rate home loans, once interest rates started to go up the equated monthly installment (EMI) to repay these loans, went up as well. The borrowers who had bad credit ratings in the first place, could not service the higher EMIs and started defaulting.
Another advantage of securitisation, which has now become a disadvantage, is that money keeps coming in. Once an institution securitises the first lot of home loans and repays the bank it has borrowed from, it can borrow again to give out loans. The bank having been repaid and made its money, does not have any inhibitions in lending out money again.
And so the story continues. Till, that is, one fine day when borrowers stop repaying. Investors who bought the financial securities cannot be serviced. So to make up their losses in the subprime market in the United States, they go out and sell their investments in emerging markets like India. Since the amount of selling in the market far outweighs the amount of buying, emerging markets like India have been falling.
Dollar drops after Fed cuts more than expected
The dollar fell against its major counterparts Tuesday, hitting a new record low against the euro, after the U.S. Federal Reserve cut its benchmark federal funds rate more than many investors had expected, thereby lowering the return on dollar-denominated assets.
The central bank cut the fed funds rate for the first time in more than four years to 4.75% from 5.25%, and also cut its discount rate by half a point. Most economists and investors had expected the Fed to trim its benchmark federal funds rate at least 25 basis points, with some predicting the 50-basis point reduction.
The dollar index, which tracks the greenback against a basket of six major currencies, was at 79.375, down from 79.645 before the announcement.
The pound sterling was at $2.0122, compared to $1.9982 earlier.
The dollar was up at 115.65 yen, down from 115.80 yen earlier.
While lower interest rates are dollar-negative in the long term, rallying stock prices after the Fed's policy decision provided daily support for the U.S. currency Tuesday.
"Expect further dollar weakness in the days to come and expect further strength in the stock market and carry trades," said Kathy Lien, chief strategist at Forex Capital Markets. Carry traders refer to the practice of borrowing funds in lower-yielding currencies and investing them in higher-yielding ones.
Stocks were trading solidly higher Tuesday, and surged after the Fed's announcement. See Market Snapshot.
Crude-oil futures were higher after the Fed move, after earlier touching a new front-month contract high of $81.50 a barrel on hopes that the expected interest rate cut will boost energy demand. See Futures Movers.
