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Home > Business > Business Headline > Report

Monetary policy: What it means to you

October 25, 2004 11:24 IST

It is Monetary Policy time. But what does that mean for retail investors? Or instead, are monetary policies important from retail investors' perspective? To an extent, we think they are.

In this article, we try to explain what role monetary policy plays and how it impacts the retail investor?

To start of with, a deep understanding of economics is required to interpret the monetary policy. Therefore, in order to simplify the same from a layman perspective, we have broad-based our approach and to that extent, some aspects of the policy may not be dealt with in detail.

What is it all about?

Monetary Policy, as the name itself suggest, deals with money. There are two aspects here i.e. quantum of money supply in the economy and the cost of the money (read interest rates).

The monetary policy plays the important role of bringing in price stability and facilitating growth of the economy. Apart from the aforesaid function, the monetary policy also plays a very vital role in strengthening the financial system of the country over the long-term. Before going any further, let us look at the demand and the supply side of money.

The demand side

Demand for money arises because of various reasons,

  • Corporates demand money for their working capital requirements, capacity expansion and upgradation.

  • Individuals require money for their day-to-day requirements and also for acquiring assets including property and durable.

  • Not surprisingly the government too requires money – to fund expenditure in excess of its income (the country's fiscal deficit).

The supply side…

The supply of the money (also called as liquidity) is impacted by various factors,

  • Every bank has a requirement to maintain a percentage of deposits with the RBI (as per the cash reserve ratio, or CRR) and also remain invested in liquid assets like government bonds (as part of the statutory liquidity ratio, or SLR, requirements).

    If the RBI lowers these rates for the banking system, banks have to allocate lesser quantum of money for SLR and CRR, so, supply of money rises. The situation is reversed when the RBI raises these rates.

  • The RBI, to enhance liquidity, could announce a purchase of bonds from the market. When the central bank buys some bonds from the market, it pays for the same.

    This injects liquidity in the system. On the other hand, when supply of money increases, the RBI resorts to auctions of its bonds (offers bonds for purchase), thus sucking out excess liquidity.

  • If foreigners (including non-resident individuals, corporates, investors) find investment opportunities in India attractive, money flows into the country. When corporates borrow more from the international markets, money supply increases.

The basic role of the RBI is to take the demand side and supply side into consideration and arrive at a policy stance that is consistent with its long-term objective of maintaining inflation at a low level. The RBI takes decisions on both these aspects, depending on the economic scenario.

Let's take a couple of examples to understand this better.

  • When the economy is growing slowly, demand for money tends to be lower as corporates are generally hesitant to invest. Retail demand for goods also tends to be lower as incomes are not rising. So, in order to boost consumption, the RBI reduces the cost of money i.e. interest rates by increasing liquidity.

    If the corporates find the cost of money attractive enough to justify investments, economic activity will rise (this will also result in higher incomes for individuals). If the consumers get loans at attractive rates to fund housing, cars and durables, demand from this section will also grow.

    Since demand has a multiplier effect, the economic growth is kick started over a period of time (the 'virtuous' circle). While this is an ideal scenario, sometimes it may take years before the impact of monetary adjustments are reflected in actual economic performance.

  • On the other hand, the RBI could take a different stance when the economy is growing faster and demand for goods increase. As economics suggests, given constant supply, when demand is higher, prices tend to increase.

    If the RBI feels that the economy is growing much faster than it should and prices are growing or are expected to rise by more than what is 'acceptable', it would opt for a higher interest rate regime to cool off the economy.

Though these may sound simple, from a retail investor perspective, it takes a lot to predict where interest rates are heading. However, in every monetary policy, there is a mention about interest rate and the 'stance' of the central bank towards the same.

In the late 1990s, the RBI's stance towards interest rate was that of a preference towards a 'softer interest rate' regime. Depending upon economic scenario (global and local), the RBI could review its stance. So, a retail investor could get a perspective about interest rates, if one takes the effort to the read the monetary policy.

We are emphasising on interest rates because it directly affects retail investors in two ways i.e. return on savings or investment and cost of borrowings (loans). Asset allocation of an investor is likely to be different when interest rates are likely to firm up, remain stable or go down.

Without getting into the complexities of trying to find whether a movement in interest rate is short-term or medium-term or long-term, from a broader perspective,

  • If interest rates move up: Among various asset classes the allocation is likely to be more skewed towards property (borrowing a loan and locking it at a lower rate), equities and short term fixed deposits. The allocation towards long-term debt mutual funds should be lowered.

    Though a rising interest rate scenario is not completely favorable for equities, the decision to invest in equities or other instrument is purely a matter or risk profile and the relative attractiveness. Gold is also a good option in an inflationary environment.

  • If interest rates remain stable: Though property is a must for all investors, the allocation towards equities, debt mutual funds and fixed deposits is likely to be more balanced in such a scenario as opposed to the former one.

  • If interest rates go down: In this scenario, investments in debt mutual funds is likely to be rewarding. If interest rates are expected to decline, fixed deposits are likely to lose charm and corporates will benefit as borrowing cost could decline. So, equities, on a relative basis, are likely to gain attractiveness.

The objective of an investor is to generate adequate returns from various asset classes to meet one's long-term objectives.

To attain this objective, an investor has to be aware of developments that are taking place around him. Monetary Policy is one such policy announcement that would enable investors to be abreast of macro-issues and not necessarily enable them to time their investment decisions.

Equitymaster.com is one of India's premier finance portals. The web site offers a user-friendly portfolio tracker, a weekly buy/sell recommendation service and research reports on India's top companies.



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