Uncategorized

Central bank and inflation targeting

To maintain a good economic health in any country, it is necessary for both the Central bank and the government to work in tandem. However, in India, this has not been the case. There is a growing distrust between RBI and the Finance Ministry.

Few recent developments indicate this:

  • The denial of extension by the government to previous RBI governor despite his willingness to continue. This is only the second instance after economic reforms when an incumbent governor has not got a term of five years.
  • The creation of the monetary policy committee (MPC) also implies a change in the way the policy is designed in the country.

 

Challenges before the new governor:

  • New governor Urjit Patel is expected to deal with the changed policy environment. The popular notion of the central bank and monetary policy as being the primary instrument of inflation targeting is no more relevant in the changing domestic and global environment. This is going to get further exacerbated with the changing financial architecture and the changing nature of inflation and price transmission.
  • Changing economic structure domestically as well as globally also suggests a need for focusing on stabilizing the financial market.
  • The existence of crony capitalism and the corporate-bank nexus will require more than a cleaning up of the balance sheets of banks. But a bigger challenge will be to integrate the rural and informal economies with the financial economy.
  • Also, he has to deal with the issue of bridging the trust deficit between the government and RBI.

 

Background:

It is now widely believed that monetary policy had very little to do with the decline in inflation since 2014. There are few factors which helped keep inflation low in the last two years. These include:

  • Sharp drop in petroleum prices and the accompanying decline in primary commodity prices after August 2014. Metal and mineral prices declined sharply in the last two years and various agricultural commodities also witnessed a sharp fall in prices.
  • The distress in rural areas that had started building up since November 2013 has continued until now. The drying up of demand in the last three years was seen in the decline in real wages in rural areas.
  • There was also a decline in farm business income and a drop in construction and other non-farm activities which had maintained wage rate growth even during periods of drought.
  • The cutback in rural spending, partly a result of the Fourteenth Finance Commission award and partly as a result of the government’s decision to cut back spending on rural programmes, also resulted in low rural demand.
  • Back-to-back droughts in the last two years have added to the misery of the rural population.
  • The continued recession in major markets outside India meant that exports fell throughout the last two years. The net result of weak domestic demand coupled with falling exports was a build-up of inventory and excess capacity in the manufacturing sector.

 

Role of Monetary Policy in Inflation control:

According to experts, while all those factors mentioned above contributed to low inflation that persisted in the last two years, none of these was affected by the RBI’s monetary policy. Nor was monetary policy successful in keeping retail inflation low.

  • While retail inflation has come down as a result of the factors mentioned above, the real problem with inflation in India has been persistently high food inflation. While these have moderated a bit due to distress in the economy, they continue to be beyond acceptable limits.
  • Most of the inflation in food commodities has been due to structural problems of marketing, excessive speculation and flip-flop in government policy, with no role of monetary policy. This continues even today.
  • Hence, it can be said that neither was the high inflation a result of poor monetary policy nor is the decline in inflation a result of monetary policy.

 

What is inflation targeting?

Inflation targeting is a monetary policy in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public. It will have price stability as the main goal of monetary policy.

Many central banks adopted inflation targeting as a pragmatic response to the failure of other monetary policy regimes, such as those that targeted the money supply or the value of the currency in relation to another, presumably stable, currency.

 

Why it is good?

  • It will lead to increased transparency and accountability.
  • Policy will be linked to medium/long term goals, but with some short term flexibility.
  • With inflation targeting in place, people will tend to have low inflation expectations. If there was no inflation target, people could have higher inflation expectations, encouraging workers to demand higher wages and firms to put up prices.
  • It also helps in avoiding boom and bust cycles.
  • If inflation creeps up, then it can cause various economic costs such as uncertainty leading to lower investment, loss of international competitiveness and reduced value of savings. This can also be avoided with targeting.

 

Challenges to inflation targeting:

  • It puts too much weight on inflation relative to other goals. Central Banks Start to Ignore More Pressing Problems.
  • Inflation target reduces “flexibility”. It has the potential to constrain policy in some circumstances in which it would not be desirable to do so.
  • Cost-push inflation may cause a temporary blip in inflation.

 

Way ahead:

Inflation targeting has been successfully practiced in a growing number of countries over the past 20 years, and many more countries are moving toward this framework. Over time, inflation targeting has proven to be a flexible framework that has been resilient in changing circumstances, including during the recent global financial crisis. Individual countries, however, must assess their economies to determine whether inflation targeting is appropriate for them or if it can be tailored to suit their needs. This should not be seen as a panacea for all the problems.

 

Conclusion:

Inflation targets can have various benefits, especially during ‘normal’ economic circumstances. However, the prolonged recession since the credit crunch of 2008 has severely tested the usefulness of inflation targets. There is a danger that Central Banks give too much weighting to low inflation, when there is a much more serious economic and social problem of unemployment. One solution would be to give an equal weighting to an inflation target and output gap target.

GS-1, Social Empowerment, Uncategorized

Provide loans to women SHGs at 7 per cent: RBI to banks

The Reserve Bank has asked banks to provide loans to women self-help groups (SHGs) at 7% per annum, as per the government’s revised guidelines for 2016-17. All women SHGs are eligible for interest subvention on credit up to Rs 3 lakh at 7% per annum under Deendayal Antyodaya Yojana-National Rural Livelihoods Mission.

Details:

  • As per the RBI notification, the banks will lend to all the women SHGs in rural areas at 7% in 250 districts.
  • However, SHGs availing capital subsidy under SGSY in their existing credit outstanding will not be eligible for benefit under this scheme.
  • All banks will be subvented to the extent of difference between the weighted average interest charged and 7%, subject to the maximum limit of 5.5% for 2016-17.
  • This subvention will be available to all the banks on the condition that they make SHG credit available at 7% annually in the 250 districts.
  • Further, the SHGs will be provided with an additional 3% subvention on the prompt repayment of loans.

Deen Dayal Antyodaya Yojana – NRLM:

Aajeevika – National Rural Livelihoods Mission (NRLM) was launched by the Ministry of Rural Development (MoRD) in June 2011. Aided in part through investment support by the World Bank, the Mission aims at creating efficient and effective institutional platforms of the rural poor, enabling them to increase household income through sustainable livelihood enhancements and improved access to financial services.

  • Under the scheme, the poor would be facilitated to achieve increased access to rights, entitlements and public services, diversified risk and better social indicators of empowerment.
  • In November 2015, the program was renamed Deen Dayal Antayodaya Yojana (DAY-NRLM).
Editorials, GS-3, Indian Economy, Uncategorized

The currency question

Livemint

The recent agreement between the Government of India and the Reserve Bank of India to make inflation targeting the central bank’s prime focus has long way to go. This move represents an important structural shift in one of the two pillars of conventional macroeconomic policy (the other, of course, being fiscal policy).

Background:

Since the 1970s inflation targeting has become widely adopted by developed economies. Inflation targets were introduced to help reduce inflation expectations and help avoid high inflation which can destablise an economy. However, since the recession of 2008 and consequent prolonged unemployment, people have begun to question the importance attached to inflation target and are worried that a ‘religious’ commitment to low inflation is conflicting with other more important macro economic objectives.

What is inflation targeting?

Inflation targeting is a monetary policy in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public. It will have price stability as the main goal of monetary policy.

Why inflation targeting?

Many central banks adopted inflation targeting as a pragmatic response to the failure of other monetary policy regimes, such as those that targeted the money supply or the value of the currency in relation to another, presumably stable, currency. In general, a monetary policy framework provides a nominal anchor to the economy. A nominal anchor is a variable policymakers can use to tie down the price level. One nominal anchor central banks used in the past was a currency peg—which linked the value of the domestic currency to the value of the currency of a low-inflation country. But this approach meant that the country’s monetary policy was essentially that of the country to which it pegged, and it constrained the central bank’s ability to respond to such shocks as changes in the terms of trade or changes in the real interest rate. As a result, many countries began to adopt flexible exchange rates, which forced them to find a new anchor.

Many central banks then began targeting the growth of money supply to control inflation. This approach works if the central bank can control the money supply reasonably well and if money growth is stably related to inflation over time. Ultimately, monetary targeting had limited success because the demand for money became unstable—often because of innovations in the financial markets. As a result, many countries with flexible exchange rates began to target inflation more directly, based on their understanding of the links or “transmission mechanism” from the central bank’s policy instruments (such as interest rates) to inflation.

Why it is good?

  • It will lead to increased transparency and accountability.
  • Policy will be linked to medium/long term goals, but with some short term flexibility.
  • With inflation targeting in place, people will tend to have low inflation expectations. If there was no inflation target, people could have higher inflation expectations, encouraging workers to demand higher wages and firms to put up prices.
  • It also helps in avoiding boom and bust cycles.
  • If inflation creeps up, then it can cause various economic costs such as uncertainty leading to lower investment, loss of international competitiveness and reduced value of savings. This can also be avoided with targeting.

Challenges to inflation targeting:

  • It puts too much weight on inflation relative to other goals. Central Banks Start to Ignore More Pressing Problems.
  • Inflation target reduces “flexibility”. It has the potential to constrain policy in some circumstances in which it would not be desirable to do so.
  • Cost-push inflation may cause a temporary blip in inflation.

Way ahead:

Inflation targeting has been successfully practiced in a growing number of countries over the past 20 years, and many more countries are moving toward this framework. Over time, inflation targeting has proven to be a flexible framework that has been resilient in changing circumstances, including during the recent global financial crisis. Individual countries, however, must assess their economies to determine whether inflation targeting is appropriate for them or if it can be tailored to suit their needs. This should not be seen as a panacea for all the problems.

Conclusion:

Inflation targets can have various benefits, especially during ‘normal’ economic circumstances. However, the prolonged recession since the credit crunch of 2008 has severely tested the usefulness of inflation targets. There is a danger that Central Banks give too much weighting to low inflation, when there is a much more serious economic and social problem of unemployment. One solution would be to give an equal weighting to an inflation target and output gap target.

Editorials, GS-3, Uncategorized

P2P lending: towards easy funding

Livemint

Issue

  • Analysis of the guidelines issued by the Reserve Bank of India (RBI) on peer-to-peer (P2P) lending.

What is P2P lending?

  • To bridge the gap of unavailability of proper formal credit, an aggressive breed of loan providers has emerged in India, called peer-to-peer (P2P) lending.
  • The concept is not new—it is basically an individual, who is not a financial institution, lending money to another individual.
  • P2P lending is similar to a friend lending to you, but in this case, you have to pay an interest on the loan and the lender is a stranger.
  • Online P2P lending companies work as marketplaces that bring individual borrowers and lenders together for loan transactions without the intervention of traditional financial institutions such as banks and NBFCs.
  • Through partnerships with leading banks, P2P lending is now moving towards offline channels.

RBI guidelines

RBI has proposed following key areas to frame the regulatory guidelines around P2P lending.

(1) permitted activity; (2) reporting, (3) prudential and governance requirements; (4) business continuity planning and (5) customer interface.

Analysis by the author

Scope of permitted activites:-

  • The scope of permitted activities needs to be defined clearly, especially in view of the aggressive expansion plans of P2P players.
  • For instance, what kind of advertisements can be displayed on the websites of these portals.

Regulation of Guarantees

  • The aggressive lending plans of P2P players may lead to questionable practices such as credit enhancement or other financial incentives offered by the P2P platform.
  • If these platforms are allowed to give guarantees, then some prudential norms need to be put in place.
  • Alternatively, P2P lenders could also take the benefit of availing specific products, such as credit risk protection from a registered Indian insurance company.
  • There is a possibility that many lenders could get duped into investing because of the guarantee, which may be difficult to meet at a later date.
  • Perhaps, their performance should be observed before the RBI allows them to continue with their guarantees and if approved, then provide them with an insurance against it.

Differentiation is required

  • There needs to be clarity on the maximum ticket size of transaction that can be serviced by a P2P lender to clearly differentiate them from other lenders, such as microfinance institutions and banks.

Periodic assessment of the lending pool

  • There should be a periodic assessment of the lending pool by an independent credit rating agency.

“Brick-and-Mortar” presence in India.

  • The compulsion for P2P lenders to set up an office will enable personal scrutiny of records, but could result in operational inefficiencies.
  • Instead, RBI could take a cue from the ‘online only’ foreign banks. Mandating disclosure requirements on their websites can increase efficiency and improve transparency of the model.

Protect the stakeholders

  • The interests of stakeholders, especially lenders, in case the platform goes bankrupt, should be protected.
  • There needs to be clarity on whether all contracts will continue to stay enforceable and how will investors be serviced.

Conclusion

  • The guidelines should strike a balance between overregulation and leaving too many loopholes. If guidelines are too strict and harsh, it will bring down the P2P market.
  • If P2P isn’t well regulated and things get ugly, the government will come back with heavy restrictions.
  • But, in any case, the guidelines will bring awareness about the sector and more individual lenders will come on board.
  • To conclude, P2P lending has the potential to be disruptive. Hence, its platform guidelines should not promise extraordinary returns to lenders
Editorials, GS-3, Indian Economy, Uncategorized

On-tap bank licences: 5 questions that linger

The Hindu

Issue

Questions being asked related to ‘on-tap’ bank licenses.

Q.1) External committee needed?

  • The RBI had said it would form a standing external advisory committee (SEAC) that will vet the applications after the initial screening is done by central bank staffers.
  • The committee is to have a three-year term and will comprise eminent personalities from the banking, financial and other relevant sectors.
  • The RBI grants licences to primary dealers, non-banking finance companies and even to foreign banks to operate in India, without any external help. So why do they need a committee only for domestic bank licences?
  • Now that on-tap licensing has been proposed, the RBI should set up a separate department to look into only licensing issues

Q.2) No timeframe?

  • The central bank has tried to make the process on-tap licensing process transparent.
  • For example, for the first time, it has allowed unsuccessful candidates to appeal to the central board of the RBI.
  • Unsuccessful candidates can also apply again, after three years from the date of rejection.
  • While the RBI has said it will communicate its decision to the unsuccessful candidates as well, it has not specified any timeframe by which a licence will be awarded or declined.

Q.3) Reasons for rejection?

  • Applicants from past rounds feel that the central bank, known to be a conservative regulator, seldom communicates the cause for rejection.
  • There is a demand from bank aspirants, in order to ensure transparency, that the central bank should make public reasons for rejecting bank licence applications.

Q.4) Not to all eligible?

  • In the draft norms, the RBI had said entities or individual promoters would be found be fit and proper if they had 10 years of banking experience or running their respective businesses, sound credentials and integrity, sound financials, and diversified shareholding pattern among promoting entities.
  • Prospective applicants said if the objective is to allow financial services to reach the remotest part of the country, adding only a few banks will not solve the problem.

Q.5) Why not business houses?

  • It is clear from the guidelines that the central bank wants entities that are predominantly in financial services.
  • The big change in guidelines comes in the form of excluding large industrial houses from being promoters, and cap their shareholding to 10 per cent
GS-3, Indian Economy, Uncategorized

RBI for easier bank permits

As part of its plan to put universal bank licences ‘on tap’, the Reserve Bank of India has unveiled draft guidelines that could encourage big non-banking financial players to throw their hats in the banking ring.

What is ‘on tap mechanism?

The central bank has been opening the bank licence window only periodically. Under the ‘on tap’ mechanism, however, an application can be made at any time subject to certain conditions.

Who is eligible?

According to the draft RBI guidelines, non-banking finance companies and resident individuals or professionals with 10 years of experience in banking and finance will be eligible to apply.

  • Also eligible are private sector entities and groups owned and controlled by residents, provided they have total assets worth at least 5,000 crore, with the non-financial group business not accounting for more than 40% of the total assets or the gross income.
  • Individuals and companies directly or indirectly connected with large industrial houses may also take equity in a new private bank but only up to 10%. Such shareholders will not get any representation on the board.

Capital requirements:

  • The initial minimum paid-up voting equity capital for a bank has been left unchanged at 500 crore. But the bank has to have a minimum net worth of Rs. 500 crore at all times.
  • The promoters need to hold a minimum 40% of the paid-up voting equity capital, which will be locked-in for five years from the date of commencement of business. The RBI has allowed banks to get their shares listed within six years (three years earlier) of commencement of business.
  • In the case of an NBFC applying for a licence, if the entity has diluted the promoter shareholding to below 40% but above 26%, the RBI may not insist on the promoters’ minimum initial contribution. However, the lock-in period of five years will apply to the 26% promoter shareholding.
GS-3, Indian Economy, Uncategorized

With 10 branches, first small finance bank kicks off operations

Jalandhar-based Capital Small Finance Bank Ltd, India’s first small finance bank, has commenced operations. The bank kicked off operations with ten branches.
Capital Small Finance Bank has been set up by converting the erstwhile Capital Local Area Bank Ltd. It was one of the 10 applicants to be given in-principle approval for setting up SFBs as announced by the Reserve Bank in its press release dated September 16, 2015.

Ten selected applicants include
Au Financiers (Jaipur),
Capital Local Area Bank (Jalandhar),
Disha Microfin (Ahmedabad),
Equitas Holdings (Chennai),
ESAF Microfinance and Investments (Chennai),
Janalakshmi Financial Services (Bengaluru),
RGVN (Northeast) Microfinance (Guwahati),
Suryoday Micro Finance (Navi Mumbai),
Ujjivan Financial Services (Bengaluru) and
Utkarsh Micro Finance (Varanasi).

The small finance bank will primarily undertake basic banking activities of acceptance of deposits and lending to unserved and underserved sections including small business units, small and marginal farmers, micro and small industries and unorganised sector entities. There won’t be any restrictions in the area of operations of small finance banks.

The minimum paid-up equity capital for small finance banks shall be Rs 100 crore. The promoter’s minimum initial contribution to the paid-up equity capital of such a small finance bank should at least be 40 per cent and gradually brought down to 26 per cent within 12 years from the date of commencement of business of the bank.