The Annual Report on the Working of the Reserve Bank of India

Part Two : The Working and Operations of
The Reserve Bank of India

III MONETARY AND CREDIT POLICY
OPERATIONS

III.1 The key issues that had to be addressed by monetary management during 2005-06 were the risks arising from rising domestic demand, high and volatile international crude oil prices and upturn in the global interest rate cycle. Monetary management also faced some challenges in maintaining stable liquidity conditions, which particularly arose in the last quarter of 2005-06, partly due to transient factors such as the redemption of India Millennium Deposits (IMDs) and partly cyclical factors associated with the upturn in credit demand. Nonetheless, calibrated and pre-emptive monetary measures during the year helped to keep inflation and inflationary expectations well-contained while supporting investment demand in the economy. The Reserve Bank continued with its policy of active demand management of liquidity through the flexible use of policy instruments at its disposal designed to ensure stability in financial markets. With inflation contained and inflationary expectations seen to be consistent with the policy stance, real growth picked up in an environment of price and financial stability, raising expectations of a structural shift in the medium-term growth path of the economy. Monetary policy was particularly effective in ensuring that the cost-push impulses from oil prices did not feed through into aggregate demand conditions. Monetary management during 2005-06 was, thus, conducted broadly in conformity with the stance of the policy set out in the policy statements during the year.

III.2 During 2005-06, the Reserve Bank initiated the system of reviewing the Annual Policy Statement on a quarterly basis as against the prevailing system of a half-yearly review. With a view to fur ther strengthening the consultative process in monetary policy formulation, the Reserve Bank, in July 2005, set up a Technical Advisory Committee on Monetary Policy (TACMP) with external experts in the areas of monetary economics, central banking, financial markets and public finance. The Committee meets at least once in a quarter and reviews macroeconomic and monetary developments, and advises the Reserve Bank on the stance of monetary policy. The Committee has met five times since its inception and has contributed to enriching the inputs and processes of policy setting.

III.3 This Chapter presents monetary and credit policy operations of the Reserve Bank during 2005-06. Various monetary measures by the Reserve Bank along with liquidity management operations are covered in this Chapter. Policy initiatives to improve the credit delivery mechanism are also included in this Chapter.

MONETARY POLICY OPERATIONS

III.4 The Annual Policy Statement for 2005-06 (April 2005) indicated that the stance of monetary policy would depend on several factors, including macroeconomic prospects, global developments and the balance of risks. Assuming a normal monsoon, and with expectations that industry and services sectors would maintain their growth momentum while absorbing the impact of oil prices, real GDP growth during 2005-06 was placed around 7.0 per cent for the purpose of monetary policy formulation. The inflation rate in 2005-06, on a point-to-point basis, was projected in a range of 5.0-5.5 per cent subject to the growing uncertainties on the oil front both in regard to global prices and their domestic absorption. The Statement stressed that the system has to recognise interest rate cycles and strengthen risk management processes to cope with eventualities so that financial stability could be maintained and interest rate movements could be transited in a non-disruptive manner. The Statement also stressed that it would be instructive to observe global trends as the Indian economy is progressively getting linked to the world economy. It was noted that while there was an overhang of domestic liquidity, partly mirroring abundant global liquidity, the trends in global interest rates, inflationary expectations and investment demand would also have some relevance in the evolution of the domestic interest rates. It would, therefore, be desirable to contain inflationary pressures to stabilise domestic financing conditions both for the Governments and the private sector. Against this backdrop, barring the emergence of any adverse and unexpected developments in various sectors of the economy and keeping in view the inflationary situation, the overall stance of monetary policy for the year 2005-06 was stated as follows:

•     Provision of appropriate liquidity to meet credit growth and support investment and export demand in the economy while placing equal emphasis on price stability.

•     Consistent with the above, to pursue an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the momentum of growth.

•     To consider measures in a calibrated manner in response to evolving circumstances with a view to stabilising inflationary expectations.

III.5 At the time of presentation of the Annual Policy Statement, the Reserve Bank faced two major challenges: (i) reining in inflationary expectations in the face of several uncertainties so as to ensure stability in the financial markets and maintaining financing conditions at levels appropriate to lend support to the ongoing growth momentum; and (ii) liquidity management in the context of budgeted Government borrowings and indications of strong credit growth. The Reserve Bank, therefore, sought to moderate inflationary expectations by demonstrable commitment to price stability by increasing the LAF reverse repo rate by 25 basis points to 5.0 per cent while retaining the repo rate at 6.0 per cent, thereby narrowing the LAF rate corridor from 125 basis points to 100 basis points with effect from April 29, 2005.

III.6 In its First Quarter Review of the Annual Statement on Monetary Policy  (July 2005), the Reserve Bank indicated that while the outlook for global growth and inflation was broadly unchanged from the presentation in the Annual Policy Statement in April 2005, the risks had increased since then. On balance, the Review noted that, during the first quarter, the underlying inflationary pressures appeared to have been contained and inflationary expectations maintained, as anticipated. While global factors were getting to be increasingly significant for India, the domestic factors were still the dominant factors and the latter pointed to favouring stability to maintain growth momentum. Accordingly, the Reserve Bank indicated that the overall stance of monetary policy for the remaining part of 2005-06 would continue to be as set out in the Annual Policy Statement of April 2005, but it would respond, promptly and effectively, to the evolving situation depending on the unfolding of the risks.

III.7 While leaving the repo rate and the reverse repo rate unchanged during the July 2005 Review, the Reserve Bank, however, enhanced risk weights on exposures to certain sectors around the same time in view of rapid credit growth to these sectors. Accordingly, the Reserve Bank raised risk weights on exposures of banks to commercial real estate as well as for credit risk on capital market exposures from 100 per cent to 125 per cent in July 2005 (Box III.1).

III.8 In its Mid-term Review of the Annual Policy Statement (October 2005), while noting that, on balance, macroeconomic and financial conditions have evolved as anticipated, the Reserve Bank pointed to the emergence of several factors posing risks to the outlook on growth and inflation. These included: need to ensure credit quality in light of the high expansion of non-food credit; continued infrastructure bottlenecks; substantial increase in asset prices, especially housing prices; high and volatile global crude oil prices, with an overwhelming part of the increase being increasingly regarded as permanent; emergence of increased current account deficits even if manageable; and upturn in the international interest rates cycle. Taking into account real sector developments of the first half, the Review revised upwards real GDP growth projections for 2005-06 to a range of 7.0-7.5 per cent from around 7.0 per cent as projected earlier. As regards outlook for inflation, taking into account oil prices having reached record highs, the Review noted that it may be difficult to contain the inflation in the range of 5.0-5.5 per cent projected earlier without an appropriate policy response. The Review reiterated that it is necessary, both for policy makers and market participants, to recognise interest rate cycles and strengthen risk management processes to cope with eventualities so that financial stability could be maintained and interest rate movements could be transited in a non-disruptive manner.

III.9 Against the backdrop of these developments, the Mid-term Review reaffirmed the stance of monetary policy set out in the Annual Policy Statement while rebalancing the priorities assigned to policy objectives in the context of the assessment of the economy and, particularly, the outlook on inflation. In response to the risks that had emerged, greater emphasis was placed on price stability. The fixed reverse repo rate under the LAF was increased by 25 basis points to 5.25 per cent to stabilize inflationary expectations while retaining the spread between reverse repo and repo rates at 100 basis points. The overall stance of monetary policy for the remaining part of the year was stated as:

•     Consistent with emphasis on price stability, provision of appropriate liquidity to meet genuine credit needs and support export and investment demand in the economy.

•     Ensuring an interest rate environment that is conducive to macroeconomic and price stability, and maintaining the growth momentum.

•     To consider measures in a calibrated and prompt manner, in response to evolving circumstances with a view to stabilising inflationary expectations.

Box III.1
Bank Credit and Financial Stability

Bank credit plays a critical role in economic growth, particularly in case of bank-based financial systems like India. At the same time, sustained episodes of high credit growth have often been found to be followed by banking and financial crisis.  Credit booms, especially in the current environment of relatively less regulated global order, therefore, need careful watch by policy authorities. With many central banks moving away from quantitative targets to use of interest rates as the key instrument of monetary policy, neglect of credit and monetary aggregates can be risky. Periods of credit boom are often associated with easing of lending standards, which sow possible seeds of future financial instability. It is widely believed that the Asian financial crisis of the late 1990s was, inter alia,  caused by the existence of an inefficient banking system that failed to perform the role of effective financial intermediation, as money and credit expanded without adequate risk management. Credit in many pre-crisis Asian economies was directed to speculative and ultimately unprofitable investments, such as real estate ventures or loss-making projects.

Empirical evidence suggests that credit booms – defined as a situation where credit/GDP ratio is four percentage points above its trend – turn out to be the best predictor of future financial imbalances and dominate other possible predictors such as money, asset prices and output gaps. Over a 3-5 year horizon, credit booms predict 80 per cent of banking crises, much higher than the predictive power of 47 per cent in case of asset price misalignments. Asset price misalignments taken in conjunction with sharp movements in credit aggregates turn out to be the best predictors of future instability.

With more and more EMEs progressively moving away from micromanagement of credit towards permitting interest rates a greater role in credit allocation, the potential threat of speculative movement of bank credit is stronger than ever before unless an efficient prudential and regulatory framework is put in place for the banking and financial system. Thus, it is necessary on the part of central banks today to pay particular attention to developments and movements in the credit market. Financial instability that might result from credit booms can, in fact, threaten the objective of price stability. Therefore, adequate stress by central banks on the quantum and quality of credit would be helpful in maintaining monetary and financial stability. Accordingly, the use of monetary and credit data can be a basis for resisting financial excesses.

In this context, following the multiple indicator approach adopted by the Reserve Bank, monetary policy in India has consistently emphasised the need to be watchful about indications of rising aggregate demand embedded in consumer and business confidence, asset prices, corporate performance, the sizeable growth of reserve money and money supply, the rising trade and current account deficits and, in particular, the quality of credit growth. This risk sensitive approach has served the Reserve Bank well in reining in aggregate demand pressures and second round effects of oil price increases to an extent while ensuring that constant vigil is maintained on threats to financial stability.

Since growth in credit during the recent period was relatively higher in a few sectors such as retail credit and real estate, monetary policy faced a dilemma in terms of instruments. An increase in policy rate across the board could adversely affect even the productive sectors of the economy such as industry and agriculture. While policy rates have indeed been raised, they have been mainly aimed at reining in inflation expectations in view of continuing pressures from high and volatile crude oil prices. Therefore, while ensuring that credit demand for the productive sectors of the economy is met, the Reserve Bank has resorted to prudential measures in order to engineer a ‘calibrated’ deceleration in the overall growth of credit to the commercial sector. Accordingly, the Reserve Bank raised risk weights on loans to these sectors during July 2005 and April 2006. It also more than doubled provisioning requirements on standard loans for the specific sectors from 0.4 per cent to 1.0 per cent in April 2006. Thus, the basic objective has been to ensure that the growth process is facilitated while ensuring price and financial stability in the economy.

Reference

1. Bank for International Settlements (2005), 75th Annual Report.

2. Borio. C. and P. Lowe (2004), “Securing Sustainable Price Stability: Should Credit Come Back from the Wilderness?”, Working Paper No.157, Bank for International Settlements.

3. Mohan, Rakesh (2006), “Financial Sector Reforms and Monetary Policy: The Indian Experience”, Reserve Bank of India Bulletin, July.

4. White, W. (2006), “Is Price Stability Enough?”, Working Paper No.205, Bank for International Settlements.

5. Reser ve Bank of India (2006), Annual Policy Statement for 2006-07.

III.10 In its Third Quarter Review of the Annual Statement on Monetary Policy (January 2006), the Reserve Bank observed that macroeconomic and financial developments were in support of the monetary policy stance. Real GDP growth in 2005-06, for the purpose of monetary management, was further revised upwards in the range of 7.5-8.0 per cent based on the assessment of a pick up in agricultural output and in the momentum in industrial and services sectors. Inflation was placed in the range of 5.0-5.5 per cent as projected earlier. While recognising that the current configuration of macroeconomic and financial factors favoured growth with stability in India, the need to extend these gains by continuing the greater emphasis on price stability was stressed. The risks to inflation from both domestic and global developments were perceived to remain high, persisting well into 2006-07, in view of the remaining pass-through of international crude prices into domestic prices. Emphasising the need to shore up the gains of recent high growth, the monetary policy stance was articulated in favour of a greater emphasis on price stability through measured but timely and even pre-emptive policy action to anchor inflation expectations. Accordingly, the fixed reverse repo rate and the repo rate under the LAF were increased by 25 basis points each to 5.50 per cent and 6.50 per cent, respectively. The overall stance of monetary policy was stated as:

•     To maintain the emphasis on price stability with a view to anchoring inflationary expectations.

•     To continue to support export and investment demand in the economy for maintaining the growth momentum by ensuring a conducive interest rate environment for macroeconomic, price and financial stability.

•     To provide appropriate liquidity to meet genuine credit needs of the economy with due emphasis on quality.

•     To consider responses as appropriate to evolving circumstances.

III.11 The fixed reverse repo rate, the price at which the Reserve Bank absorbs liquidity under the LAF was, thus, increased by 75 basis points during 2005-06 – 25 basis points each on three occasions (April 2005, July 2005 and January 2006) – to 5.50 per cent by end-March 2006 (Table 3.1). The repo rate, the price at which the Reserve Bank injects liquidity under the LAF, was hiked twice – 25 basis points each during October 2005 and January 2006 – to 6.5 per cent by end-March 2006. The spread between the repo rate and the reverse repo rate has, thus, been progressively reduced to 100 basis points by end-April 2005 from 200 basis points at end-March 2003.

Bank Rate

III.12 The Bank Rate signals the medium-term stance of monetary policy. Keeping in view the assessment of the economy including the outlook for inflation, the Bank Rate was retained at the existing level of 6.0 per cent, unchanged since April 2003 (Chart III.1).

Cash Reserve Ratio

III.13 The cash reserve ratio (CRR), which was increased by 50 basis points during September-October 2004, was left unchanged at 5.0 per cent of the net demand and time liabilities (NDTL) during 2005-06. All scheduled commercial banks (excluding RRBs) complied with CRR requirements during 2005-06. In line with the stipulation, banks generally maintained minimum daily level of 70 per cent of fortnightly CRR requirement on all the days.

III.14 Consequent upon amendment to sub-Section 42(1) of the Reserve Bank of India Act, 1934 in June 2006, the Reserve Bank, having regard to the needs of securing the monetary stability in the country, can prescribe CRR for scheduled banks without any floor rate or ceiling rate. Before the enactment of this amendment, in terms of Section 42(1) of the Act, the Reserve Bank could prescribe CRR for scheduled banks between 3 per cent and 20 per cent of their NDTL. The amendments will provide the Reserve Bank with greater flexibility in the conduct of monetary policy. In the light of the enactment of the Reserve Bank of India (Amendment) Bill, 2006 the Reserve Bank has decided to continue with the status quo on the existing provisions of CRR maintenance, including the CRR rate and extant exemptions. Accordingly, scheduled banks shall continue to maintain CRR of 5.0 per cent of their NDTL.

III.15 The Reserve Bank, prior to the amendment of the Act, had been paying interest on scheduled banks’ CRR balances above the statutory minimum of 3.0 per cent and up to the prescribed level of 5.0 per cent – known as eligible cash balances – at an interest rate determined by the Reserve Bank, which has been set at 3.5 per cent with effect from September 18, 2004. No interest was payable on any amount upto the statutory minimum CRR balances of 3.0 per cent or any amount actually maintained in excess of the balance required to be maintained. Consequent upon the amendment of sub-Section 42 (1A) of the Act, the statutory minimum CRR of 3.0 per cent no longer exists. Furthermore, with the removal of the sub-Section 42 (1B) of the Act, the Reserve Bank can not pay interest on any portion of CRR balances of banks. Accordingly, no interest is payable on CRR balances with effect from the fortnight beginning June 24, 2006.

III.16 The CRR for non-scheduled banks and non-scheduled cooperative banks continues to be governed by the provisions of Section 18 and Section 56, respectively, of the Banking Regulation Act, 1949 which remain unchanged. Accordingly, non-scheduled banks, including non-scheduled cooperative banks, shall continue to maintain CRR equivalent to 3.0 per cent of their NDTL as on the last Friday of the second preceding fortnight.

Statutory Liquidity Ratio

III.17 Statutory liquidity ratio (SLR) for scheduled commercial banks, at present, is at the statutory minimum of 25 per cent of their NDTL. Any further reduction in SLR would require amendment to the Banking Regulation Act. The legislative process of amendment of the Act in this regard has been initiated in order to provide greater flexibility to the Reserve Bank to specify SLR without any floor subject to the ceiling of 40 per cent. As discussed in Chapter I, reflecting strong demand for credit from the commercial sector, banks liquidated their holdings of Government securities during 2005-06. As a result, scheduled commercial banks’ holding of SLR securities fell from around 38 per cent of NDTL at end-March 2005 to 31.3 per cent at end-March 2006, but still above the statutory requirements (Chart III.2). The excess holdings of SLR securities at end-March 2006 at about Rs.1,45,297 crore exceeded the budgeted combined net market borrowings programme of the Central and State Governments for 2006-07.

Liquidity Management

III.18 Monetary management faced some challenges in maintaining stable liquidity conditions particularly in the last quarter of 2005-06. The recourse of market participants to primary liquidity support from the Reserve Bank during the last quarter of 2005-06 suggested an overlap between frictional and structural liquidity. First, some market participants had not prepared for the liquidity implications of the movements in the interest rate cycle as also the one-off impact of IMDs redemption and, as a consequence, found themselves facing a shortage of liquidity as well as securities eligible for accessing the Reserve Bank’s liquidity facilities or even the collateralised money markets. Second, the banking system as a whole was significantly overdrawn in order to sustain the credit disbursements and the persistent mismatches between the sources and uses of funds forced them to seek recourse to borrowing and rolling over on an overnight basis, thereby putting pressure on interest rates and liquidity conditions.

III.19 Against this backdrop, the Reserve Bank continued to manage liquidity using a combination of instruments consisting of repo and reverse repo operations under the LAF, open market operations (OMOs), operations under the MSS and interest rate signals through the reverse repo/repo rates (Box III.2 and Table 3.2).

Course of Liquidity Management

III.20 The market operations of the Reserve Bank responded to the change in liquidity conditions during 2005-06. The year 2005-06 was characterised by strong and sustained credit demand, a relatively lower order of accretion of the foreign exchange reserves to the Reserve Bank and redemption of IMDs along with a build-up of the Centre’s surplus with the Reserve Bank in the second half of the year.  Against this backdrop, the Reserve Bank’s liquidity management operations led to injection of liquidity through LAF operations and unwinding of the balances under the MSS in contrast to liquidity absorption through issuances under the MSS during the preceding year. Liquidity management operations during 2005-06 could be analysed in terms of five phases (Table 3.3). In the first phase, between end-March 2005 and up to July 22, 2005, absorption through continued issuances under the MSS was accompanied by reduction in absorption through reverse repos under LAF. In the face of widening of the trade deficit, outflows by the FIIs during April-May 2005 and strong currency demand, banks unwound their investments in Government securities in order to finance the buoyant credit demand. Reduction in the Centre’s surplus with the Reserve Bank also kept liquidity conditions comfortable. Liquidity in the system increased during the second phase (July 23 - August 12, 2005), mainly due to the spurt in foreign exchange inflows (following the revaluation of the Chinese currency) and a further reduction in the Centre’s surplus investment balances with the Reserve Bank. Excess liquidity in the system was absorbed by the Reserve Bank through LAF reverse repos which rose from Rs.10,485 crore as on July 22 to a peak of Rs.50,610 crore as on August 3, 2005.

III.21 During the third phase (August 13 – October 28, 2005), the Reserve Bank’s purchase of foreign exchange assets moderated while Government’s cash balances with the Reserve Bank started to build up. In view of the resultant tightness in liquidity, there was decline in bids received under LAF reverse repos. On the whole, liquidity conditions were broadly stable and comfortable with call money rates generally staying within the reverse repo and the repo rate corridor. Till the third phase, the Reserve Bank injected liquidity through LAF repos only on four occasions; on a net basis, the Reserve Bank absorbed liquidity even on those four days.

Box III.2
Liquidity Management by the Reserve Bank

Following the initiation of reforms in India in the early 1990s, the monetary policy framework also witnessed a significant transformation. While the conduct of monetary policy continues to be guided by the twin objectives of maintaining price stability and to provide appropriate liquidity to meet genuine credit needs of the economy, maintenance of financial stability has also emerged as a key consideration in the conduct of monetary policy. Concomitantly, with the growing market-orientation of the economy, there has been a shift from direct instruments of monetary management to an increasing reliance on indirect instruments. In the context of this shift towards indirect instruments and in line with international trends, the Reserve Bank has put in place a liquidity management framework. Liquidity management is carried out through open market operations (OMO) in the form of outright purchases/sales of Government securities and reverse repo/repo operations, supplemented by the Market Stabilisation Scheme (MSS).

The Liquidity Adjustment Facility (LAF), introduced in June 2000, enables the Reserve Bank to manage day-to-day liquidity or short-term mismatches under varied financial market conditions in order to ensure stable conditions in the overnight money market. The LAF operates through reverse repo and repo auctions, thereby setting a corridor for the short-term interest rate consistent with the policy objectives. The introduction of LAF had several advantages. First, it helped the transition from direct instruments of monetary control to indirect instruments. Second, it enabled the Reserve Bank to modulate the supply of funds on a daily basis to meet day-to-day liquidity mismatches. Third, it enabled the Reserve Bank to affect demand for funds through policy rate changes. Finally, it helped stabilise short-term money market rates.

Open market operations (OMOs) through outright sale and purchase of securities are also an important array of tools of the Reserve Bank’s monetary management. Apart from being directed at influencing enduring liquidity, OMOs can also be undertaken as ‘switch’ operations through purchase of gilts of a particular maturity against the sale of another to provide liquidity.  In view of the large stock of Government securities in its portfolio, the OMOs were used effectively by the Reserve Bank from the second half of the 1990s to 2003-04 to manage the impact of capital flows. However, in the context of sustained large capital flows, large-scale OMOs led to a decline in the Reserve Bank’s holdings of Government securities. The finite stock of Government securities held by the Reserve Bank as well as the legal restrictions on the Reserve Bank on issuing its own paper were seen as placing constraints on future sterilisation operations. Accordingly, an innovative scheme in the form of MSS was introduced in April 2004 wherein Government of India dated securities/Treasury Bills are being issued to absorb enduring surplus liquidity. These dated securities/ Treasury Bills are the same as those issued for normal market borrowings and this avoids segmentation of the market. With the introduction of MSS, the pressure of sterilisation on LAF has declined considerably and the LAF operations have been able to fine-tune liquidity on a day-to-day basis more effectively. The MSS has provided the flexibility to the Reserve Bank to not only absorb liquidity but also to inject liquidity in case of need.

The efficacy of various liquidity management tools was reflected clearly in the Reserve Bank’s market operations during 2005-06. Liquidity surpluses declined during October-November 2005 due to sustained demand for bank credit and currency demand during the festival season. Ahead of the redemption of the IMDs in December 2005, the Reserve Bank, making a forward looking assessment, began to unwind sterilised liquidity in a calibrated manner from September 2005. As part of this unwinding, fresh issuances under the MSS were suspended between November 2005 and April 2006. Redemptions of securities/ Treasury Bills issued earlier along with active management of liquidity through repo/reverse repo operations under LAF during January-March 2006 provided liquidity to the market. Some private placement during March 2006 and purchases of foreign exchange from the market also injected liquidity. The various tools of liquidity management, thus, provided the flexibility to Reserve Bank to maintain liquidity conditions and conduct monetary policy in accordance with the stated objectives.

References

1. Reserve Bank of India (2005), Report of the Internal Technical Group on Central Government Securities Market.
2. Mohan, Rakesh (2006), “Coping With Liquidity Management in India: A Practitioner’s View”, Reserve Bank of India Bulletin, April.
3. Reddy, Y.V. (2005), “Globalisation of Monetary Policy and Indian Experience”, Reserve Bank of India Bulletin, July.

III.22 In the fourth phase (October 29 – December 30, 2005), some tightness in the liquidity position started emanating from a host of factors such as festival season currency demand, scheduled auctions, advance tax outflows and redemption of IMDs amidst continuing strong demand for commercial credit. To ensure smooth redemption of IMDs, the Reserve Bank sold foreign exchange of US $ 7.1 billion out of its foreign exchange reserves to the State Bank of India during December 27-29, 2005 against equivalent rupees (Rs.31,959 crore). In response to the emergence of tight liquidity conditions, balances under LAF transited from absorption to injection mode, characterised by a swing of Rs.48,595 crore. The Reserve Bank provided liquidity on a net basis to the market through repo operations during November 10-18, 2005 (daily average net injection of Rs.1,565 crore). Furthermore, in view of the tightness in liquidity conditions, auctions of Treasury Bills (TBs) under the MSS were discontinued effective November 16, 2005. This also led to a substantial injection of liquidity (Rs.23,640 crore) during this phase from the redemption of maturing issuances under MSS.

III.23 In the fifth phase (end-December 2005 to end-March 2006), liquidity conditions generally remained tight following the IMDs redemption and a further build-up of Centre’s cash balances amidst sustained growth in demand for bank credit. On a review of the prevalent macroeconomic, monetary and liquidity

farmers and ensure that a certain proportion of the total credit is extended to them.

III.48 Outstanding agricultural advances of public as well as private sector banks increased by 40.9 per cent and 67.2 per cent, respectively, during 2005-06. While the share of agricultural advances in bank credit for public sector banks decreased marginally during the year, that of private sector banks increased (Table 3.9).

III.49 The recovery of direct agricultural advances of public sector banks continued to show improvement during the year ended June 2005 (Table 3.10).

Guidelines for Relief to Farmers

III.50 The Union Budget 2006-07 envisaged grant of interest relief of two percentage points in the interest rate on the principal amount up to Rs. one lakh on crop loans availed by the farmers for Kharif and Rabi 2005-06. The amount of the relief was

required to be credited to the borrower’s account before March 31, 2006. Commercial banks were advised that all crop loans for Kharif and Rabi disbursed to farmers during the financial year 2005-06 would be eligible for the interest relief.  In cases, where each crop loan exceeds Rs. one lakh, the interest relief would be applicable on the principal amount up to Rs. one lakh only. Banks were also advised that interest relief may be calculated at two percentage points on the amount of the crop loan disbursed from the date of disbursement/drawal up to the date of payment or up to the date beyond which the outstanding loan becomes overdue (i.e., March 31, 2006 for Kharif and June 30, 2006 for Rabi, respectively), whichever was earlier.

III.51 Furthermore, to provide farmers loans at a reasonable rate, the Government has decided to ensure that the farmers receive short-term credit at 7 per cent on loans up to Rs.3,00,000 on the principal amount with effect from Kharif 2006-07. The public sector banks and regional rural banks have been advised that Government will provide interest rate subvention of 2 per cent per annum to them in respect of short-term production credit up to Rs.3,00,000 provided to farmers. This amount of subvention will be calculated on the amount of crop loan disbursed from the date of disbursement/drawal up to the date of payment or up to the date beyond which the outstanding loan becomes overdue i.e. March 31, 2007 for Kharif and June 30, 2007 for Rabi, respectively, whichever is earlier.

III.52 Following the announcement in the Annual Policy Statement for 2006-07, a Working Group has been constituted under the chairmanship of Prof. S.S. Johl to suggest measures for assisting distressed farmers, including provision of financial counselling services and introduction of a specific Credit Guarantee Scheme under the DICGC Act for such farmers. The Group is expected to submit its report by September 30, 2006.

Micro Finance

III.53 Among the different models for purvey of micro finance, the Self Help Group (SHG)-bank linkage programme has emerged as the major micro finance programme in the country, which is being implemented by commercial banks, RRBs and cooperative banks. During the year 2005-06, 6.2 lakh new SHGs were provided with bank loans amounting to Rs.2330 crore and 3.45 lakh existing SHGs were extended further financial assistance. The total bank loan disbursed during the year 2005-06 amounted to Rs.4499 crore. As at March 31, 2006, the cumulative number of SHGs linked to banks stood at 2.2 million with total bank credit to these SHGs at Rs.11,398 crore. The Union Budget for the year 2006-07 envisages the banking industry to credit link another 3,85,000 SHGs in the year 2006-07.

III.54 In the context of the recent developments in the micro finance sector in certain districts of the country, the Reserve Bank, responding to requests from the various stakeholders, provided a forum to promote better understanding of the issues involved and enhance transparency in the operations of the MFIs. All Regional Directors of the Reserve Bank were advised that whenever issues relating to the sector are brought to their notice, they may offer to constitute a coordination forum comprising representatives of SLBC convenor bank, NABARD, SIDBI, State Government officials and representatives of MFIs (including NBFCs) and NGOs/SHGs to facilitate discussion and enable resolution of issues affecting the operations of the micro finance sector.

III.55 In order to examine the issues relating to (i) allowing banks to adopt agency model by using infrastructure of civil society organisations, (ii) appointment of ‘banking correspondents’ to function as intermediaries between the lending banks and the beneficiaries and (iii) identification of steps to promote MFIs, an in-house Group was set up in the Reserve Bank under the Chairmanship of Shri H. R. Khan, Principal, College of Agricultural Banking, Pune. Based on the recommendations of the Group and with the objective of ensuring greater financial inclusion and increasing the outreach of the banking sector, banks have been permitted to use the services of specified intermediaries as also post offices as business facilitator and correspondents.

Technical Group for Review of Legislation on Money Lending

III.56 The All-India Debt and Investment Survey (NSS 59th Round) has revealed that the share of money lenders in total dues of rural households has increased from 17.5 per cent in 1991 to 29.6 per cent in 2002. Considering that high indebtedness to money lenders can be an important reason for distress of farmers, a Technical Group (Chairman: Shri S.C. Gupta) has been set up to review the efficacy of the existing legislative framework governing money lending and its enforcement machinery in different States and to make recommendations to the State Governments for improving the legal and enforcement framework in the interest of rural households. The Committee is expected to submit its report by September 30, 2006.

Relief Measures for Natural Calamities

III.57 Standing guidelines have been issued by Reserve Bank to banks in August 1984 and June 1998 to be followed by them for providing relief in areas affected by natural calamities. These guidelines, inter alia, permit banks to convert/ reschedule loans for periods ranging from 3 to 9 years depending upon the successive crop failure/ intensity of damage to crops, grant fresh crop loans to affected farmers, convert principal as well as interest due on the existing loans, relax the security and margin norms, and provide consumption loans to the affected persons.

III.58 Consequent upon the loss of life and property caused by the Tsunami in the states of Andhra Pradesh, Tamil Nadu and Kerala, and the Union Territories (UTs) of Pondicherry, and Andaman and Nicobar Islands, the convenor banks of the State Level Bankers’ Committees (SLBCs) in these states/UTs were advised to take measures to provide appropriate relief to the affected people in terms of the standing guidelines. A Task Force (Chairman: Shri V. Leeladhar) was formed on December 27, 2004 to monitor the progress of relief and rehabilitation measures through banks and to constantly review the situation. An Empowered Task Force to accelerate the resolution of relief measures to the Tsunami affected borrowers, adopting a bank specific approach, in the Union Territory of Andaman and Nicobar Islands was constituted in February 2006 under the chairmanship of the Regional Director, Reserve Bank of India, Kolkata. Taking note of the revival package announced by the Government of India for small traders and businessmen in Andaman and Nicobar Islands, the Task Force made the following additional recommendations:

•     Given the fact that the extent of damage and destruction of life and property in the Southern Group of Islands comprising Little Andaman (in Andaman district) and entire Nicobar district was much more severe, compared to the damage in the Northern Group of Islands (caused more due to earthquake), there should be separate relief packages for the two groups of islands. Therefore, the Task Force recommended that there should be complete waiver of all loans irrespective of outstanding amounts in the Southern Group of Islands.

•     Housing loans, in the personal segment, not covered by insurance claim payment may be considered for relief, as applicable to respective outstanding amounts envisaged in the revival package of the Government of India.

•     Borrowers with outstanding loans above Rs.5 lakh in the Northern Group of Islands, except those under personal segment and covered by financial securities, should be given interest remission on the balance outstanding as on December 26, 2004 for one year up to December 31, 2005, subject to minimum benefit of Rs.1.80 lakh. Housing loans may also be included to the extent they were not covered by insurance claim payments.

•     The entire additional burden arising out of implementation of the above recommendations may be considered by the banks/ other financial institutions at their option.

III.59 The convenor bank of the Union Territory Level Bankers’ Committee (UTLBC) for the Union Territory of Andaman and Nicobar Islands has been advised that the recommendations of the Task Force may be brought to the notice of the banks in these areas for early implementation. Progress made in this regard may be invariably monitored in the UTLBC meetings.

III.60 There have been a spate of natural calamities during 2005-06 viz., floods in Maharashtra (July 2005), earthquake in Jammu & Kashmir (October 2005) and unprecedented rainfall in Tamil Nadu (November/ December 2005) claiming many lives and destroying wealth. In all the cases, the Reserve Bank advised the convenor bank of the SLBCs to assess the situation and take immediate measures to provide appropriate relief to the affected people in terms of standing guidelines on relief measures by banks in areas affected by natural calamities. The measures included rescheduling/ restructuring of existing loans; treatment of such loans as current dues; non-compounding of interest; financial assistance to artisans, self-employed, traders, tiny and small scale industrial units affected by the unprecedented calamity; increasing the limit of consumption loans; and financial assistance for the purpose of repairs/ reconstruction of dwelling units, etc.

Guidelines for Relief Measures by Banks to Poultry Industry

III.61 There have been instances of outbreak of Avian Influenza (commonly known as Bird Flu) in some areas of the country. Keeping in view the loss of income that had occurred due to culling of birds as well as steep fall in the demand for poultry products and their prices, banks were advised, inter alia, to consider (i) converting principal and interest due on working capital loans as also instalments and interest on term loans which have fallen due for payment on/after the onset of bird flu (February 1, 2006) and remaining unpaid into term loans and recovering such loans in instalments over a period up to three years with an initial moratorium of up to one year; (ii) rescheduling remaining portion of term loan with a moratorium period up to one year depending upon the cash flow generating capacity of the unit; and (iii) treating the rescheduled/converted loans as current dues. Banks were also advised that the borrower will be eligible for fresh need based finance and the relief measures may be extended to all accounts of poultry industry, which were classified as standard accounts as on March 31, 2006.

Kisan Credit Cards

III.62 The Kisan Credit Card (KCC) scheme was introduced in the year 1998-99 to enable the farmers to purchase agricultural inputs and draw cash for their production needs. During 2005-06, public sector banks issued 4.2 million KCCs. Since inception of the scheme, public sector banks have issued 21.8 million KCCs.

III.63 In order to safeguard the interest of the KCC holders by providing personal accident insurance coverage on an ongoing basis at competitive rates/ terms, banks have been given the discretion to approach either any general insurance company which is a member of GIPSA (General Insurer’s [Public sector] Association of India) or any private sector general insurance company, to take advantage of the competitive offers. However, the banks have been advised that they may, while negotiating with the insurers, keep in mind the guiding principles of Personal Accident Insurance Scheme (PAIS), especially the aspects such as premium sharing formula and coverage. This “add on” benefit is expected to bring in an increasing number of farmers under the KCC fold, thereby leading to complete coverage.

Advisory Committee on Flow of Credit to Agriculture and Related Activities from the Banking System

III.64 The Advisory Committee on Flow of Credit to Agriculture and Related Activities from the Banking System (Chairman: Prof. V.S. Vyas), set up by the Reserve Bank, examined the problems relating to agricultural credit and made recommendations to address the issues. Out of 99 recommendations of the Committee, 32 recommendations were accepted and implemented by the Reserve Bank. The recommendation relating to an alternative to the present system of declaration of Annewari for providing relief measures by banks through rescheduling of loans in the case of natural calamities has been accepted and advised to banks for implementation. Accordingly, the District Collector, on occurrence of the natural calamity such as drought and flood may ask the Lead Bank Officer to convene a meeting of the District Consultative Committee (DCC), and submit a report to the DCC on the extent of crop loss in the area affected by the natural calamity. If the DCC is satisfied that there has been extensive crop loss on account of the natural calamity, the relief including conversion/restructuring facilities of agricultural loans as per the standing guidelines may be extended to the farmers affected by the natural calamity, without declaring Annewari. In respect of another 32 recommendations, either no action is necessary at this stage or action has already been initiated by NABARD.

Rural Infrastructure Development Fund (RIDF)

III.65 Domestic scheduled commercial banks, both in the public and private sector, having shortfall in lending to priority sector and/or agricultural lending target are required to deposit the shortfall in Rural Infrastructure Development Fund (RIDF) established with the NABARD at specified interest rates. The Fund has completed its eleventh year of operation. Out of the total corpus of RIDF (RIDF I to RIDF XI) of Rs.50,000 crore, cumulative sanctions and disbursements under various tranches of RIDF (RIDF I to XI) were Rs.51,283 crore and Rs.31,337 crore, respectively, as on March 31, 2006. In terms of the announcement made by the Union Finance Minister in his budget speech for the year 2006-07, RIDF XII has been set up with NABARD with a corpus of Rs.10,000 crore during the year 2006-07. Furthermore, a separate window will be opened under RIDF XII for financing of rural roads under Bharat Nirman with a corpus of Rs.4,000 crore during 2006-07. Specified projects under the Public Private Partnership (PPP) model will also be allowed to access RIDF funds.

Credit to Women

III.66 Public sector banks were advised to lend at least five per cent of their net bank credit to women. The credit extended to women by all public sector banks stood at 5.37 per cent of their overall net bank credit as at the end of March 2006. Twenty two public sector banks have achieved the above target as on March 31, 2006. Ten public sector banks have opened 17 specialised women branches.

Credit to Small Scale Industries

III.67 The total credit provided by public sector banks to Small Scale Industries (SSI) at end-March 2006 was Rs.82,492 crore, forming 8.1 per cent of their total bank credit and 20.1 per cent of their total priority sector advances. Of these, advances to cottage industries, artisans and tiny industries amounted to Rs.33,314 crore, constituting 40.4 per cent of the advances to the SSI sector. Credit extended by scheduled commercial banks to 1,38,039 sick SSI units stood at Rs.5,380 crore as at end-March 2005. Of these, 3922 units were found to be viable, with their outstanding bank credit at Rs.435 crore (8.1 per cent). Banks placed 2080 units involving outstanding credit of Rs.260 crore (4.8 per cent) under nursing programmes. Public sector banks were advised to operationalise at least one specialised SSI branch in every district and centre having cluster of SSI units. At end-March 2006, 629 specialised SSI bank branches had been operationalised by the banks.

III.68 With effect from October 26, 2004, the composite loan limits for SSI entrepreneurs have been raised from Rs.50 lakh to Rs.1 crore and investment by banks in securitised assets representing direct lending to the SSI sector is treated as their direct lending to SSI sector under priority sector. With effect from January 12, 2005, SSI investment limit in plant and machinery in respect of sports goods has been enhanced from Rs.1 crore to Rs.5 crore.

III.69 The tenure and interest rate on deposits placed by foreign banks with SIDBI on account of their shortfall towards priority sector lending have been revised. With effect from 2005-06, the amount of shortfall in priority sector obligation is being placed with SIDBI by foreign banks for a tenor of three years (as against the tenor of one year earlier) at a graded interest rate structure linked to the Bank Rate (Table 3.11).

III.70 As announced by the Reserve Bank in the Annual Policy Statement for 2005-06, a scheme for Small Enterprises Financial Centres (SEFCs) has been worked out and circulated to all scheduled commercial banks for implementation. Under the scheme, banks are encouraged to establish mechanisms for better coordination between their branches and of SIDBI, which are located in the clusters identified by the Ministry of SSI, Government of India for co-financing of SME sector (including tiny and services sector) on mutually agreeable operational modalities to be worked out by SIDBI and the strategic partner banks. 388 SSI clusters have been identified by United Nations Industrial Development Organisation (UNIDO) spread over 21 states in the country.

Debt Restructuring Mechanism for Small and Medium Enterprises

III.71 As part of the announcement made by the Union Finance Minister for improving flow of credit to small and medium enterprises (SMEs), a debt restructuring mechanism for units in SME sector was formulated for implementation by all scheduled commercial banks. Accordingly, detailed guidelines were issued to all scheduled commercial banks to ensure restructuring of debt of all eligible small and medium enterprises at terms which are, at least, as favourable as the Corporate Debt Restructuring mechanism in the banking sector. Banks may decide on the acceptable viability benchmark, consistent with the unit becoming viable in 7 years and the

repayment period for restructured debt not exceeding 10 years. Banks are required to work out the restructuring package and implement the same within a maximum period of 60 days from date of receipt of requests.

Government Sponsored Schemes

III.72 Under the Swarna Jayanti Gram Swarozgar Yojana (SGSY), during 2005-06 (up to end-December 2005), a total number of 7,55,969 Swarozgaris received bank credit amounting to Rs.644 crore (and Government subsidy amounting to Rs.238 crore). Of the Swarozgaris assisted, 2,88,131 (38.1 per cent) were Scheduled Castes and Scheduled Tribes (SCs/STs), 4,72,972 (62.6 per cent) were women and 12,687 (1.7 per cent) were physically handicapped. Under the Swarna Jayanti Shahari Rozgar Yojana (SJSRY), disbursements amounting to Rs.93 crore were made in 30,420 cases (out of 77,408 applications received) during 2005- 06 (up to December 2005). Of the above, Rs.23.7 crore was disbursed to 7,113 SCs/STs, Rs.21.7 crore to 6,785 women and Rs.1.7 crore to 442 disabled persons. Under the Scheme for Liberation and Rehabilitation of Scavengers (SLRS), out of the total 10,363 applications received, Rs.15.5 crore was sanctioned and Rs.10.9 crore was disbursed to 5,437 beneficiaries. Of the above, Rs.9.8 crore was disbursed to 4,702 SCs/STs and Rs.0.4 crore was disbursed to 517 OBCs during 2005-06 (up to December 2005). During the period, Rs.2.1 crore was disbursed to 1,148 women.

III.73 Assistance under the Prime Minister’s Rozgar Yojana (PMRY) as at end-March 2006 amounted to Rs.761 crore for 1,31,290 beneficiaries. In the State of Himachal Pradesh, the condition that banks having less than 5 branches shall not be allocated targets under PMRY has been relaxed with effect from August 2005.

Differential Rate of Interest (DRI) Scheme

III.74 The outstanding advances of public sector banks under the DRI scheme as on the last reporting Friday of March 2006 amounted to Rs.490 crore under 3.89 lakh borrowal accounts, forming 0.07 per cent of the total advances outstanding as at the end of the previous year, as against the target of 1.0 per cent.

General Line of Credit (GLC) to NABARD

III.75 The Reserve Bank has been providing two General Lines of Credit (GLC) to NABARD under Section 17(4E) of the Reserve Bank of India Act 1934 to enable the latter to meet the shor t-term requirements of SCBs, state cooperative banks and RRBs. For the year 2005-06 (July-June), a GLC of Rs.3,000 crore was sanctioned at an interest rate of 6 per cent per annum for providing refinance to state cooperative banks and RRBs for seasonal agricultural operations. NABARD has been permitted to operate the GLC limit sanctioned for 2005-06 up to December 31, 2006. As the limit would not be available after this date, NABARD has been advised to start accessing the markets on a regular basis for sufficient amounts so that the time frame indicated for withdrawal of GLC is adhered to.

Package of Assistance for Sugar Industry

III.76 The Union Finance Minister in the Budget speech for the year 2005-06 had, on the basis of Tuteja Committee Report,  announced that NABARD, in consultation with the State Governments, the Reserve Bank, banks and financial institutions will work out a scheme for providing a financial package for sugar industry. Accordingly, a Committee was set up in NABARD to work out a scheme/package of assistance for the sugar industry. The Committee had submitted its report to the Government on July 23, 2005. Under the package approved by the Government, cooperative sugar mills in the country which have term loans outstanding as on March 31, 2005, and which are commercially viable and have adequate operational surplus to repay the said term loans will be classified into two categories ‘A’ and ‘B’. Category A will comprise the mills which can repay the term loan within a period of 5 years including a moratorium of two years for payment of interest and principal. Category Bwill comprise the mills which can repay the term loan within a period of 15 years including a moratorium of two years for payment of interest and principal. Accordingly, the term loans will be restructured/ rescheduled to enable repayment within five years (for Category A) or within 15 years (for Category B). The rate of interest on the restructured loans will be reduced to 10 per cent per annum with effect from April 1, 2005, irrespective of the original contractual rate. The Government of India will provide interest subvention on the restructured loan. The amount of interest subvention is estimated at Rs.525 crore.

Committee on Procedures and Performance Audit on Public Services (CPPAPS) – Study/Satisfaction Survey

III.77 The Committee on Procedures and Performance Audit on Public Services (CPPAPS) (Chairman: S.S. Tarapore), in its Special Report No.8, had set out its comments/recommendations on the Reserve Bank report on the study of services to depositors and small borrowers in rural and semi-urban areas. In paragraphs 3.1 and 3.2 of the Report, it was observed that the kind of survey undertaken by the Reserve Bank should have twin objectives, viz. regional comparison of services and inter-bank comparison of services rendered by various banks on all-India basis. The Committee had suggested that the Reserve Bank may consider conducting a study over an appropriately enlarged size of sample to accomplish the objectives. The Committee had further recommended that the Reserve Bank should commission a full-fledged study over a larger sample on the basis of a revised questionnaire and the results should be analyzed to throw up regional and inter-bank comparison of services rendered by bank branches in rural and semi-urban centres. Accordingly, the National Council of Applied Economic Research (NCAER) has been requested to undertake a detailed study on services offered by commercial banks in the rural and semi urban areas of the country.

Expert Committee on Credit Deposit Ratio

III.78 The Government of India had appointed a Group of Experts (Chairman: Shri Y.S.P. Thorat) to go into the nature and magnitude of the problem of low credit deposit (CD) ratio across States/regions and to suggest steps to overcome the problem. The Expert Group examined the problems and causes of low CD  ratio and submitted its report to the Government of India. The recommendations of the Group have since been examined and accepted by the Government of India with certain modifications. Accordingly, all scheduled commercial banks were advised in November 2005 that the CD ratio of banks should be monitored at different levels on the basis of the specified parameters (Table 3.12). On the basis of the recommendations, the banks have also been advised to set up Special Sub-Committees (SSCs) of the District Level Consultative Committee (DLCC) in districts having CD ratio of less than 40 per cent in order to monitor the CD ratio and to draw up Monitorable Action Plans to increase the CD ratio. 181 districts have been identified by the Reserve Bank as having CD ratio of less than 40 per cent as on March 31, 2006. So far, SSCs have been formed in 152 districts and steps have been initiated to constitute similar committees in the remaining 29 districts.