Monetary Policy of India

 Dayna McKnight

January 12, 2003

Executive Summary

          Monetary policy helps to promote national economic goals, by influencing the availability and cost of money and credit. 

          In the United States, the Federal Reserve Bank indirectly influences demand, by raising and lowering short-term interest rates.  It watches various economic indicators to determine which the direction the economy is going.  By forecasting increases in inflation or slow times in the economy, the Federal Reserve knows whether to raise or lower interest rates or increase the supply of money, in an effort to influence the economy.

          In India, the Reserve Bank of India is India’s central banking institution. The Reserve Bank lays downs restrictions on bank lending and other activities with large companies.  It is the sole authority for issuing bank notes and supervises all banking operations in India.   

          It is important for Staples to consider the monetary policy of India and how it will affect the operation and success of Staples.

Introduction

          Monetary policy is a “central bank's actions to influence the availability and cost of money and credit, as a means of helping to promote national economic goals” (Federal Reserve Bank of Minneapolis, 2003).  Monetary policy affects people everywhere making economic and financial decisions.  It influences the performance of economies, as reflected in factors such as inflation, employment or unemployment, and economic output.  It affects demand across the economy, influencing how a person chooses to spend money on goods and services.

As Staples decides whether or not to operate in India, it must consider how effective India’s central bank is in controlling domestic inflation and maintaining a stable currency value.  This will affect how likely the citizens of India will be willing to spend disposable income on Staple’s products. 

Monetary Policy in United States

The Federal Reserve System (commonly referred to as the Fed) is the country's central bank. It was established by an Act of Congress in 1913 and consists of the seven members of the Board of Governors in Washington, D.C., and twelve Federal Reserve District Banks.  The Federal Reserve was structured to be insulated from day-to-day political pressures, independent of the government.  The premise is that the people who control the United States money supply should be independent of the people who frame the government's spending decisions. However, the Federal Reserve is ultimately accountable to Congress and comes until government review and audit.

The Federal Reserve affects interest rates mainly through open market operations and the discount rate, and both of these methods work through the market for bank reserves, known as the federal funds market (Federal Reserve Bank of San Francisco, 2003).  The Federal Reserve has the ability to use a monetary tool called the discount rate to affect the money supply and influence economic expansion or contraction.

Banks are legally required to hold a certain amount (usually 3-10%) of the funds they have in interest-bearing and non-interest bearing checking accounts in reserves.  These funds are used to meet unexpected outflows.  The amount of reserves a bank has can change on a daily basis, depending on deposits and other transactions.  When a bank needs additional reserves on a short-term basis, it can borrow from other banks.  These loans take place in what is known as the federal funds market. 

Another tool the Federal Reserve uses to affect the supply of reserves in the banking system is open market operations, the buying and selling of government securities on the open market.  If the Fed wants fund rates to fall, it buys government securities from a bank.  It then pays for the securities by increasing bank reserves.  The bank now has more reserves than it is required to have so it can lend these funds to another bank in the federal funds market, increasing supply and allowing federal fund rates to fall.

The discount rate is the interest rate that member banks have to pay for short-term loans.  Lowering the discount rate makes it easier for banks to increase their reserve funds and write more loans.  The lowering of rates tends to counteract a recessionary trend, having a positive impact on financial markets.  Raising the discount rate tends to counteract inflation, making it more difficult for member banks to increase revenues, negatively impacting financial markets (Calvert Online, 2003).

This combination of tools and lowering and raising short-term interest rates, allows the Federal Reserve to maintain prices; thus controlling inflation and ensuring maximum employment and production output.

Monetary Policy in India

          The Reserve Bank of India (RBI) is India’s central bank.  It was established in 1935 and was nationalized in 1949. From this point on, the RBI has operated as a state-owned and state-managed central bank of India.  The RBI’s preamble states its objective as being “to regulate the issue of bank notes and keeping of reserves with a view of securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage” (RBI, 2002).  It acts a banker to central and state governments, commercial banks, state cooperative banks, and other financial institutions.  The RBI’s functions include: formulating, implementing, and monitoring monetary policy; regulating the issue of bank notes, managing India’s foreign and exchange reserves; facilitates external trade; and develop India’s financial structure in line with national policies and objectives.  The RBI appears to be involved in just about everything: from managing overall growth targets to setting interest rates to meet these growth targets, managing exchange rates and managing money supply in order to keep a check on inflation and maintaining price stability.

India’s banking system has three tiers. These are the scheduled commercial banks; the regional rural banks which operate in rural areas not covered by the scheduled banks; and the cooperative and special purpose rural banks.

India’s banking system is one of the largest in the world. India’s banking system has a close association with the country’s development efforts.   The diversification and development of the economy, and the acceleration of the growth process, are due in part to the role banks have played in financing economic activities in different sectors throughout the economy. 

The Risks of Investing in India

          India’s local currency is currently under threat due to the country’s bloated fiscal deficit. India has set a fiscal deficit target of 5.3 per cent of gross domestic product for the financial year ending March 2003, down from 5.7 per cent last year (Rediff.com, 2002).  In September, Standards & Poors “lowered its rating on India's local currency denominated debt to 'junk', citing the South Asian giant's swelling debt burden and the country's vulnerable public sector finances. The local currency downgrade reflects the government's growing Indian rupee debt burden and its inability to staunch the financial weakening of the public sector” (Rediff.com, 2002).

 However, an article in the Economist magazine indicates that India may be getting out of its rut.  “‘Buoyant’ and ‘encouraging’ are the words used to describe three consecutive quarters of current-account surplus--the first in a quarter-century. Add to that swelling foreign-exchange reserves and a stronger rupee, and some are arguing that it is time for drastic liberalization of India's foreign-exchange regime” (The Economist, 2002).  The rupee has appreciated in real terms over the past year.  In the past, the nominal value had declined by approximately five percent against the dollar. 

Rising inflation has also been a concern in India.  Third-quarter consumer prices were up 3.2% from last year.  Tensions with Pakistan over the Kashmir region may boil over if the U.S. becomes preoccupied with its own attack on Iraq (Cooper, 2002). The threat of war in Iraq can also play a role in which direction Staples chooses to go.

An important risk to investing in India is its poor liquidity, given the extreme poor volumes and the impact costs it implies. There are also macroeconomic risks of government deficits financed through borrowing and the impact on GDP growth, interest rates and potential inflation and rupee foreign exchange rates (Parikh, 2002).

Summary

          Even with the recent changes in the rupee, India is still relatively unstable economically.  It is unclear (due to conflicting reports) exactly what direction the currency is going, nevertheless, it is fluctuating. The key to a currency’s success as an international payments instrument is its ability to hold value over time versus other currencies (Sullivan, 2002). 

There is no doubt that India has numerous opportunities to offer. It has a highly skilled technology workforce, ready to work but not enough jobs to go around. The rising inflation, deficit, and threat of war in Iraq all send up red flags in terms of investment opportunities.  The decision of whether or not Staples should invest in India at this time in terms of monetary policy may need to wait until the country is on more stable grounds.

References

Cooper, James. (December 7, 2002).  A Dire Combo: Drought and Political Conflicts.  Business Week, Issue 3807, pg. 32.

Calvert Online. (2003). Financial Learning Center.  Retrieved online January 10, 2003 from http://www.calvertgroup.com/finlearn.html.

The Economist.  (December 7, 2002). Currency Teaser. Vol. 365, Issue 8302, pg 73.

Federal Reserve Bank of Minneapolis. (2003). Retrieved online on January 8, 2003 from http://minneapolisfed.org/info/policy/.

Federal Reserve Bank of San Francisco. (2003).  Retrieved online on January 8, 2003 from http://www.frbsf.org/publications/federalreserve/monetary/tools.html.

Reserve Bank of India (2003). Retrieved online on January 10, 2003 from http://www.rbi.org.in.

Parikh, Cheata. (October 2002). How risky is India?  Retrieved online on January 8, 2003 from http://www.capitalideasonline.com/chetan/risky_india.htm.

Rediff.com. (2002).  India’s local currency market under threat.  Retrieved online on January 10, 2003 from http://www.rediff.com/money/2002/dec/02fitch.htm.

Sullivan, J. J. (2001). Exploring international business environments. Boston, MA: Pearson Custom Publishing. Chapters 5, 6; Scan Chapter 16