Introduction
Reserve Bank of India (RBI) produces once in every two months monetary policy through Monetary Policy Committee (MPC). The primary objective of monetary policy is to maintain the price stability (inflation) and growth (GDP).
This write-up consider inflation and GDP as a risk factor to the Government of India in managing the economy of the country. While the risk mitigating tools are repo rate, reverse repo rate etc. The article will look at the monetary policy through the lens of risk management.
There are five steps of risk management, they are
- Risk Identification
- Risk Measurement
- Risk Management
- Risk monitoring and
- Risk reporting.
Risk Identification
The first step of risk management is risk identification, without the identification of the risk, we cannot do risk management. So what is the risk with respect to the economy that monetary policy addresses? The risk is that the inflation will be out of the defined band and GDP will be lower than projected.
According to the RBI act that provide the inflation target to be set by the Government of India, in consultation with RBI once in every five year. For the period of August, 5 2016 to March 31, 2021, the target set is 4% CPI inflation with upper tolerance of 6% and lower tolerance of 2%.
The government will consider it as a failure if average inflation is more than upper tolerance (6%) for three successive quarters; similarly, failure to consider if the average inflation is less than lower tolerance (2%) for three successive quarters.
So the risk is if average inflation is more than 6% for three successive quarters or less that 2% for three successive quarters.Similarly, on GDP front, the risk is actual GDP is lower than planned.
So from monetary policy point of view, we have identified the risk. The next step is to measure the risk in quantitative terms.
Risk Measurement
The time to failure is three successive quarters, so this is our time line for measurement of risk. The projected inflation is calculated using the current inflation, projected prices, weather conditions and econometric models. The inflation is also simulated at 50%, 70% and 90% statistical confidence level to identify the range of future inflation for the defined period.
Apart from this, sensitivity testing are also performed on crude oil price by 10% for both up and down shock to identify resulting level of GDP and inflation. Such sensitivity helps in understanding the future outlook and be prepared now, if the actual scenario turns out to be like in sensitivity.
The measurement of the future outlook helps in taking the risk mitigation plan now.
Risk Management
Risk management is a third step in the risk management cycle. There are four tools under the risk management, they are
- Accept the risk
- Avoid the risk
- Transfer the risk
- Manage the risk
Being in the economy, the risks can hardly be avoided, so this option cannot be applied. Also, the government does not have option to transfer the risk, for such purpose, RBI have been established. Inflation and GDP are output of various economic activity, so there are no option except to accept the risk and manage it. So management of risk is the only option that can be taken out.
How RBI manages the risk of inflation out of the band and GDP below target. RBI uses following tools to manage the risks.
- Repo rate
- Reverse Repo rate
- Cash Reserve Ratio (CRR)
- Statutory Liquidity Ratio (SLR)
- Other
Repo Rate
A rate at which RBI lend money to commercial banks in the event of shortfall of funds. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa.
What happens when repo rate increases?Banks lend from RBI at a higher rates of interest which in turn lead to borrowing at a high rate of interest. Higher borrowing rate reduces borrowing activity which reduces money supply leading to lower inflation and lower GDP
What happens when repo rate decreases? Banks lend from RBI at a lower rates of interest which in turn lead to borrowing at a lower rate of interest. Lower borrowing rate increases borrowing activity which increases money supply leading to higher inflation and higher GDP
Reverse Repo rate
Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money is in safe hands with a good interest.
An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.
Reverse Repo rate effect on inflation
If RBI increases this Reverse Repo rate, it means RBI wants to contraction of credit. When RBI gets loan from banks at high rate of interest, more and more banks will supply to central bank because it is safe and earning is more. Effect of this will on financial market. Supply of money in financial market will decrease. Due to decrease in the supply of credit in the market, inflation rate will decrease.
Cash Reserve Ratio (CRR)
The Cash Reserve Ratio refers to a certain percentage of total deposits the commercial banks are required to maintain in the form of cash reserve with the central bank.The objective of the CRR is to ensure that the banks maintain a minimum level of liquidity against their liabilities so that they don’t run short of liquidity in case of excess demand for funds.
The CRR do not earn interest and kept with RBI as a reserve to be used in case of an emergency. Increase in CRR would mean that the RBI want to reduce the liquidity from the market as higher cash is now to be kept with the RBI. Higher CRR may be used to address the increasing inflation by reducing the money supply from the market. On the contrary, reduction in CRR help banks increase in liquidity that helps in growth but increases inflation.
The current CRR is 4% of the total deposits.
Statutory Liquidity Ratio (SLR)
Every bank is to maintain a certain amount of money in liquid assets with themselves in a form of cash or Gold. The ratio of liquid assets to total deposits is referred as Statutory Liquidity Ratio (SLR), the current SLR is 19.5%.
When RBI is to reduce the money supply from the market to control the inflation, they may increase the SLR, but this does not help in the growth of the economy. On the contrary, reduction in SLR helps in money supply that boosts the growth but increases inflation.
Risk mitigation tools, as seen above the RBI has tools that helps in managing the risk of inflation going out of the defined band and also help in the boosting the economic growth.
Considering the fall in the CPI inflation, the MPC has reduced the repo rate from 6.5% to 6.25% in the February monetary policy.
Risk Monitoring
The purpose of risk monitoring is to review the identified risks and its mitigation program. This helps in fine tuning both the risks identified as well as its mitigation plan. For example, the risks of inflation and GDP is to be regularly monitored so that it does escape out of the tolerance limits. If there is any improvement is needed in the risk management that may need to be provided through the MPC meeting.
The bi-monthly meeting helps in providing an oversight on to both risks and its mitigation plan in terms of repo rate or any other tools that RBI may have used
Risk Reporting
Risk reporting is part of risk management process where a committee review the results of the risk management previous steps. Here MPC is the committee that review the results on the bi-monthly basis and take the corrective action to manage the risks.
