Important Comprehension Set – 54

D.1 – 8 ): Read the following passage carefully and answer the questions given below it.

The mid-term Monetary and Credit Policy for 2003-04 has maintained status quo over the objectives and instruments of monetary policy. The overall stance continues to focus on ensuring adequate credit growth and supporting investment demand while keeping a vigil on movements in the price level. A soft and flexible interest rate environment through appropriate liquidity management within the framework of macroeconomic stability is expected to fulfil the prescribed objectives. The policy seems to rely mostly on indirect instruments such as Bank Rate and open market operation, that includes repo/reverse repo operation, to ensure a soft interest rate regime. However, the two crucial policy parameters — Bank Rate and Cash Reserve Ratio (CRR) — are left untouched to rule at their current levels of 6 and 4.5 per cent respectively while the repo rate too is not disturbed. The Reserve Bank of India, in its recent Report on Trends and Progress of Banking in India, has hinted at raising the CRR in the coming months. First, this policy framework begs the central question of how to provide a soft rate regime by manipulating indirect policy instruments when the stock of government securities — the weapon — has already depleted substantially and is expected to decline further with continuous sterilisation of capital inflows. Moreover, the RBI Governor has hinted that the central bank has no plans to issue securities on its own account for its open market operations at this moment. If the present interest rate structure continues, then capital inflows will tend to continue due to falling rates in the international markets. If the RBI does not buy the foreign exchange, then there will be further pressure on the rupee to appreciate and this will place the country’s external competitiveness at stake. Continuous sterilisation, on the other hand, will render the RBI weaponless and this will take the country to a “currency board arrangement”. Second, even if interest rates are brought down through successful liquidity management it is doubtful whether this will get translated into lower lending rates which can help investment demand to pick up. A few leading private sector banks have already expressed their unwillingness to reduce lending rates even if the official rates are reduced. Further, reduction in lending rate may not ensure larger credit offtake as demand for credit now is influenced by factors beyond interest rates. And, the return on investment must not only exceed the cost of borrowing but also sustain for a longer period. In an uncertain environment, reduction in interest rate alone is inadequate to boost credit offtake. The issue calls for a thorough study so that the present policy can help achieve the objectives. One can observe multiple rates in the Indian market, reflecting the existence of a number of financial instruments with a continuum of maturity and risk profiles. Broadly, the structure of interest rates can be classified as the floor rate, the rates which prevail in the government securities market (sovereign rate) and the commercial lending rates. The floor rate or the Bank Rate is fixed by the monetary authority to drive the policy towards achieving a few desirable goals. Any change in the Bank Rate, therefore, is expected to produce a wave of changes through the market rates to affect the goals. Such “interest rate pass through effect” can be effective provided interest rates are properly aligned and integrated. In recent times, there has been a steady decline in the yield on government securities due to a comfortable liquidity position in the market. Indeed, the yield and short term rates in the government security market are less than the Bank Rate. The flat yield curve indicates that the real rates could be lower than that prevailing in the U.S.; hence, there is an argument that the current level of sovereign rate may be unsustainable. The irony is that the soft rate policy failed to bring down the prime lending rates (PLR) of commercial banks. The median lending rates on demand and term loans charged by public sector banks remained unchanged in a range of 11.5-14 per cent between March and June 2003. The prime lending rates of these banks ranged between 9 and 12.25 per cent during the same period. This provides a wider gap of around 450 to 550 basis points between the PLR and the Bank Rate. It will not be proper to argue that the difference reflects the risk attached to commercial lending as the PLR is the rate at which the best corporate borrow. Therefore, the only valid conclusion is that the interest rates are misaligned. The fiscal deficits during the past few years have stayed beyond the target levels. Concurrently, there has been a significant change in the mode of financing of the fiscal deficit. In recent years, it has been made mandatory that the Government must not issue fresh securities to the RBI. Further, the continuous sterilisation of capital inflows has resulted in a steady depletion of government securities from the RBI’s portfolio, contributing to demonetisation of the fiscal deficit. Also, declining reliance on external borrowing to finance the deficit has flooded the financial market with government securities.

1) What are the parameters that were left untouched in the current policy?

a) Bank rate.

b) Cash Reserve Rate.

c) Repo rate.

d) Both a and b.

e) All a b and c.

2) Why does the policy framework seek the question of how to provide a soft rate regime?

a) The manipulation of indirect money market instruments cannot provide soft rate regime

b) Since, the depletion in stock of government securities is expected to continue.

c) The securities will not be issued by the central bank as of now.

d) Both a and b.

e) Both b and c.

3) Why does the author say that there should be thorough study of the current policy ?

a) Demand for credit is only influenced by change in interest rates.

b) Reduction in lending rates can ensure larger credit offtakes.

c) Reduction in interest rate alone is not sufficient to boost credit offtake.

I. Both a and b

II. a alone

III. b and c

IV. C alone

V. All a b and c

4) How does the author come to a conclusion that the interest rates are misaligned?

a) Since the median lending rates on demand and term loans remains unchanged.

b) Because the prime lending rates ranged between 9 and 12.25 per cent.

c) Since there is wider gap between the PLR and the Bank rate.

d) Both a and b.

e) All the above.

5) According to the author what is(are) to be focused to fulfil the objectives of framing policy?

a) Should ensure adequate credit growth.

b) Should support investment demand .

c) Soft and flexible interest rates through appropriate liquidity management.

d) All the above.

e) Only a and b.

6) What can be inferred from the passage on the mid term monetary and credit policy for 2003-2004?

a) Soft rate regime can be provided by manipulating indirect policy instruments such as Bank rate and open market operations.

b) Cash Reserve Ratio should also be considered to ensure soft interest regime.

c) The current levels of bank rate, Cash reserve rate and repo rate should be altered to align the interest rates.

d) The current levels of bank rate, Cash reserve rate and repo rate should be unaltered to align the interest rates.

e) The soft rate policy brought down the prime lending rates (PLR) of commercials banks.

7) What does the author mean by “interest rate pass through effect”?

a) Change in Bank rate will affect the goal in an effective manner.

b) The interest rates can be properly aligned by changing the bank rate.

c) b accompanied by a.

d) Only a.

e) Either a alone or b alone.

8) Which of the following is true about the fiscal deficit according to the given passage?

a) The mode of financing the fiscal deficit has remained unchanged.

b) Government securities have been increased in the RBI’s portfolio due to continuous sterilisation of capital inflows.

c) Government securities have been increased in the financial market since it depends less on external borrowings.

d) It is not compulsory to issue fresh Government securities to the RBI.

e) None of the above