147. Methods of credit control and combating inflation written by MS Navya Sixth Article

Methods of credit control and combating inflation written by MS Navya  Sixth Article

Variation of Cash Reserve Ratio vs. Open Market Operations

Variation of cash reserves is superior to open market operations in the following respects:

(a) The success of open market operations depends upon the existence of a broad and developed capital market and a large supply of Government securities with the Central Bank to conduct such operations on an extensive scale.

In countries where open market operations cannot be carried out on an extensive scale due to the absence of these conditions, the variation of cash reserves has an increasing influence on the Central Bank.

(b) The large scale sale of securities by the Central Bank as a part of open market operations policy will depress the value of securities and bring loss to the Cen­tral Bank. If the values of securities fall, commercial banks also incur loss as their portfolio consists of a large volume of government securities.

The variation of cash reserves secures the same results as open market operations but without the loss that may arise in dealing in securities. When commercial banks are asked by the Central Bank to increase the percentage of reserves, they may of course sell securities for maintaining increased case reserve.

In order that the sale of Gov­ernment securities by commercial banks does not depress its price realization, the central bank may simultaneously buy such securities. It may however be stated that this method may help commercial banks to avoid incurring losses in the sale of securities, it may not serve the objective of the central bank,

(c) Another limitation of open market operations is that the cash reserves of com­mercial banks may be so excessive that Central Bank may not be able to reduce them by selling securities available with it but a change in reserve requirements achieve the result easily with a mere change in the reserve rate,

(d) Whenever the Central Bank conducts open market purchase of securities, the volume of earning assets held by the banks in their portfolio is reduced. Vari­able reserve ratios do not affect the earning assets of banks unless banks sell securities to increase their reserves.

(e) The new method of credit control can be adopted to strengthen the Central Bank­ing control under highly liquid monetary conditions or conversely under condi­tions of severe credit stringency.

It has been suggested that open market operations and variation of cash ratios should be followed as complementary to each other. A judicious combination of both will remedy the defects of each technique when used individually, and produce good results.

Repo’ Transactions

‘Repo’ stands for repurchase. ‘Repo’ or Repurchase transactions are undertaken by the central bank to influence money market conditions. Under ‘Repo’ transaction or agreement one party lends money to another for a fixed period against the collateral of securities approved for this purpose.

At the end of the fixed period, the borrower will repurchase the securities at the predetermined price. The difference between the repurchase price and the original sale price will be the cost for the borrower.

In other words, instead of a pure or simple borrowing of funds, the borrower parts with securities to the lender with an agree­ment to repurchase at the end of the fixed period. This parting with the securities will make the cost of borrowing, known as ‘Repo Rate’ little cheaper than pure borrowing.

‘Repo’ transactions are conducted in Money market to manipulate short-term interest rate and to manage liquidity levels. ‘Repos’ are conducted by central banks to absorb or drain liquidity from the system. In case they desire to inject fresh funds in the cash market, they will conduct ‘Reverse Repo’ transactions.

In the reverse repo ‘the securities are re­ceived first against money paid and returned after receipt of money, at the end of the agreed period. In India, ‘Repos’ are normally conducted for a period of 3 days.

The eligible secu­rities for the purpose are decided by RBI. These securities are usually Government prom­issory notes, Treasury bills and some public sector bonds.

Qualitative Methods of Credit Control

The qualitative credit control is also called as selective credit control. It is used as an adjunct to general credit control. In certain situations quantitative credit control may not be helpful. At times it may harm certain sectors of the economy.

Because, the quantitative methods control the volume of credit in total, it does not discriminate the credit flow into productive and unproductive purposes. Thus, it affects the genuine productive purposes also. But, the selective credit control provides for such discrimination.

Under these meth­ods the credit is made available for the productive and priority sectors and restricted to others. This is very much helpful to the developing and underdeveloped economies.

Selective Credit Control

The selective credit control methods control certain types of credit and not all credit. They directly affect the demand for bank credit as also the capacity of the banks to lend. They can be used more effectively without any changes in the prevailing rates of interest.

Objectives of Selective Credit Control

a) The following are the main objectives of selective credit control measures:

b) To distinguish between essential and non-essential uses of bank credit.

c) To ensure adequate credit to the desired sectors and curtail the flow of credit to less essential economic activities.

d) To control the consumer credit used for purchase of durable consumer goods.

e) To control a particular sector of the economy without affecting the economy as a whole.

f) To correct the un favourable balance of payments of the country.

g) To control the inflationary pressures in the particular and important sector of the economy.

h) To control the credit created by other institutions.

As of SEPTEMBER

Indicator

Current rate

Inflation 10.3%
Bank rate 9%
CRR 4.50%
SLR 23%
Repo rate 8%
Reverse repo rate 7%

Methods of Selective Credit Control

The Central Bank uses the following qualitative methods to control the credit in the economy:

1. Fixation of margin requirements:

The Central Bank prescribes the margin which banks and other lenders must maintain for the loans granted by them against commodities, stocks and shares. To restrict the speculative dealing in stock exchanges, the Central Bank pre­scribes the margin requirements for securities dealt with.

When the Central Bank prescribes higher margin the borrowers can obtain less amount of credit on his stock. If the margin prescribed is low, the speculators can borrow from bankers buy the commodity, storage and sell only after price rise. To contract credit, the Central Bank raises margins and lowers the margins to expand the credit available.

Objectives of Margin Requirements

The Central Bank may prescribe margin requirements to achieve the following objec­tives:

(i) To divert investible funds from speculative to productive lines.

(ii) To reduce the volume of credit created by commercial banks.

(iii) To reduce the prospect of making speculative profits in stock exchanges.

(iv) To reduce the risks and uncertainties of joint stock companies by maintaining the stability of stock prices.

2. Rationing of credit:

The Central Bank controls the credit created by the banks through the rationing of credit. Under this method, the Central Bank fixes a maximum limit for loans that a commercial bank can provide to a particular sector or for all purposes. This can be achieved through the following two methods:

(i) Variable portfolio ceiling:

Under this method, the Central Bank fixes a ceiling on the aggregate portfolios of commercial banks above which loans and advances should not be increased. It may even fix a ceiling for specific categories of credit. It may also fix a maximum limit for the loans that the commercial banks can borrow from the Central Bank.

(ii) Variable capital assets ratio:

Under this method, the Central Bank can fix the minimum ratios which the capital and surplus of banks must bear to the volume of assets or specific categories thereof of the commercial banks. The Central Banks can change such minimum ratio from time to time. Rationing of credit can play a great role in planned economies.

It secures diversion of commercial resources into the channels fixed by the public authority in achieving the objectives of plan­ning.

3. Regulation of consumer credit:

The Central Bank to regulate the consumer credit, fixes the down payments and the period over which the instalments are spread. In devel­oped countries, large portion of national income is spent on consumer durable goods such as cars, refrigerators, costly furniture, etc.

The instalment credit for consumer durable goods plays an important part in certain economies. Expansion of such credit affects the devel­oped economies adversely. Many countries have adopted this weapon to control credit allowed to the consumers.

It is essential to regulate consumer expenditure on such durable goods to control infla­tions. The method of control involves the following steps.

Steps involved in Controlling Consumer Credit

1. The scope of regulation with respect to particular consumer durable goods will have to be defined.

2. Fix the minimum down payment.

3. The length of the period over which instalment payments may be spread will have to be fixed.

4. The maximum cost of instalment pur­chases exemptions have to be prescribed.

Effect of Control

To control inflation a large number of durable goods will be listed for control, the minimum down payments will be raised, the period over which instalment payment can be spread will be reduced and finally the maximum exemption costs will be lowered.

4. Control through Directives:

The Central Bank issues directives to control the credit created by commercial banks. The directives may be in the form of written orders, warn­ings or appeals, etc. Through such directives the Central Bank aims to achieve the follow­ing objectives:

(i) To control the lending policies of the commercial banks.

(ii) To prevent the flow of bank credit into non-essential lines.

(iii) To divert the credit to productive and essential purposes.

(iv) To fix maximum credit limits for certain purposes.

The Central Bank issues directives from time to time and the commercial banks abide

5. Moral Suasion:

Under this method, the Central Bank merely uses its moral influence on the commercial banks. It includes the advice, suggestion request and persuasion with the commercial banks to co-operate with the Central Bank.

If the commercial banks do not follow the advice extended by the Central Bank, no penal action is taken against them. The success of this method depends upon the co-operation between the Central Bank and Com­mercial Banks and the respect the Central Bank commands from other banks.

6. Publicity:

The Central Banks generally use the method of publicity to control the credit creation of commercial banks. Under this method, the Central Bank gives wide pub­licity to its credit policy through its bulletins.

By this, the Central Bank educates the general public regarding the monetary policy and its objectives. Through such publicity, the com­mercial banks are guided and change their lending policies accordingly.

7. Direct Action:

The method of direct action is the most effective weapon of Central Bank to control credit creation. The Central Bank uses this method to enforce both quantita­tive and selective credit controls. It is used as a supplement to other methods of credit control.

The Central Bank can take action against the banks which contravene its instruc­tions. But this method may lead to conflict between the central bank and commercial banks.

However, these days no commercial bank can afford to go against the wishes of the central bank with regard to policy matters, as the central bank has wide powers even to stop banks’ operations.

 

 

 

2 thoughts on “147. Methods of credit control and combating inflation written by MS Navya Sixth Article

  1. Dear Madam,

    Can you please answer the following question.

    1. What are government bond and securities? Can you please elaborate with examples?

    2. What is the relation between the value of a security and the profit or loss incurred by the banks?

    3. How does sale of security decreases the money liquidity in the market or vice versa?

    4. How is interest rate and currency value related? (This is not with respect to this blog).Can you please explain in detail

    Thanks,
    Sathvik

  2. Ma’am,

    Can you please explain what types of bonds / securities are used by the banks for obtaining loans from RBI under repo? Are these bonds / securities purchased by the banks from the Government? Who will be ultimately responsible for payment when these bonds / securities are surrendered?

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