What is the Repo Rate and Why Does Everyone Care So Much About It?

What is a Repo? A ‘repo’ is nothing but a ‘repurchase agreement’. Even normal individuals can enter in a repo agreement. I give you a signed piece of paper in exchange for Rs. 10k. The paper states that “I will repurchase the signed piece of paper from you at a given date in the future for Rs. 11k.” The Rs. 1k or 10% is the ‘Repo Rate’. In the case of repo agreements between a central bank and commercial banks, the piece of paper is called the ‘Repo Rate Agreement’.

Why does the central bank do this? Because a central bank needs to control the ‘cash in the system’, so to say. That’s in their job description. In order to do that, they usually put up a handful of rules, the primary being the reserve requirements for banks and the ‘repo’ rates.

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What are the reserve requirements? In India, the RBI has told the banks that they need to have a CRR (Cash Reserve Ratio) of 4% and a SLR (Statutory Liquidity Ratio) of 21%. This simply means that for every Rs. 100 that a bank has in its hands, it needs to give for safe-keeping Rs. 4 in hot cash and Rs. 21 as mostly investment in government bonds to the RBI. This Rs. 25 acts as a guarantee of sorts in case the bank collapses.

Where does Repo figure in this? Let’s suppose that a bank has only received Rs. 100 worth of deposits. The bank gives the RBI Rs. 25 by way of maintaining the CRR and SLR. Slowly, the bank lends out the remaining Rs. 75 to its customers. Now, the banks figures out that there is still some demand for loans. It’s out of money though. So the bank tells the RBI “Hey, lend me Rs. 50. I’ll give you back Rs. 12.5 by way of CRR and SLR. Let me utilize the remaining Rs. 37.50 for my business.” Remember, the RBI prints money. The RBI can never run out of money to lend, unlike the banks. The RBI replies “Fine, take this Rs. 50. But for your SLR requirements, you will have to purchase government bonds from me. So, at a given date in the future, you will repurchase your agreement from me at Rs. 50 plus 6.50% interest per annum and I will repurchase my government bonds from you at 6.00% per annum.” The first part of the agreement, where the bank repurchases its agreement from the RBI is called the Repo Agreement. The second part of the agreement, where the RBI repurchases its government bonds from the bank is called the Reverse Repo Agreement. You might have noticed that the Reverse Repo Rate is always lesser than the Repo Rate. That’s one of the perks of being the controller of the banking system of the country.

The central bank and the commercial banks engage in these repo transactions (Called ‘Repo Rate Auctions’) very often. The repo is basically how money flows from the central bank to the banks and into the system.

Why does the Repo Rate matter so much? So, we’ve seen how a repo works, both generally and in the banking system. But why does the 6.50% matter so much? Every two months, the RBI does a policy review. The most important part of it is the modification of ‘key rates’ (Repo, CRR, SLR, MSF), if any.

Indian banks are currently ‘borrowing’ from the RBI at 6.50%. Imagine that the RBI announces a 50 Basis Points ‘rate cut’. The 6.50% drops to 6.00%. The banks can now borrow more and pay lesser interest to the RBI. Higher cash in the hands of the bank will mean higher lending from the banks to the public. Higher cash in the hands of the public means more spending on goods and services. More spending and demand leads to inflation – or rise in prices of goods and services. The public starts suffering from inflation.

The RBI now intervenes and increases the Repo Rate, to say 7.25%. Now, the banks can borrow only lesser and pay a higher interest rate on it as well. You can probably fill in the gaps of what will happen next based on what we saw above. This gradually leads to a recession. The RBI again intervenes and ‘cuts’ the rate, again. It’s a vicious cycle and a cycle which needs to be monitored closely. Ineffective monetary policy will lead to depression, hyper-inflation and all sorts of economic anomalies. Although the Repo Rate is not the only weapon at the disposal of a central bank, it’s the quickest and deadliest.

Alice Rivlin, the former Vice-Chair of the U.S. Federal Reserve puts it in a nutshell: “The job of the Central Bank is to worry.

P. S. Incidentally, ‘Bps’ or ‘Basis Points’ refers to decimal places. 10 Basis Points is equal to 0.10%, 25 Basis Points is equal to 0.25% and so on.

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)

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Should the RBI be Independent?

The debate arises because of the new Monetary Policy Committee. It points us towards two important aspects of any central bank – Independence and accountability. So how do we resolve all these two objectives and make sure that the Central Bank is capable of tackling the issues that it faces meeting the objectives that it is supposed to meet while at the same time remaining accountable to the people.

 

urijit-patel

 

What are the major functions of RBI?

 

  • Regulating the economy or regulating other players in the economic system.
  • RBI acts as a monetary authority in India.

 

This in turn means that RBI is a complete authority as far as Monetary Policy is concerned. It not only makes the rules, not only implements them but also monitors them. Whereas if we think in terms of the political structure of India ,formulation is done by legislature, implementation is done by the executive and monitoring is done by the judiciary, whereas here RBI is doing all three functions.

 

What is the objective of Monetary Policy itself?

 

  • Maintaining price stability
  • Ensuring adequate flow of money
  • Credit to required areas.
  • It acts as a regulator and supervisor of financial system

 

This is what RBI tries to achieve through its Monetary Policy. Maintaining the overall stable level primarily through controlling the interest rates and all this is done so as to maintain public confidence in the system. So, RBI puts some rules to the banks to follow so that banks maintain the trust of the public. It manages the FEMA, Foreign Exchange Management Act, so as to facilitate foreign trade to develop Indian trade as well as to maintain rupee stability in the foreign exchange market as well. RBI is also the issuer of currency because it is controlling the money supply in the country, so it issues currency and also destroys currency. Specific to a developing country RBI also has a development role in which it tries to promote what the Government is trying to do with the development agenda. It also has some major banking functions such as being a banker to the Government, being a banker to other banks and even being a lender of last resort in the economy.

 

What are the goals of the RBI?

 

RBI governor also consults with important bodies like FICCI CRISIL etc. so as to get a good understanding of the sentiments in the business sector of the country. In addition to all this RBI also publishes the annual report on the official website for public discussion and for transparency. So a good amount of transparency is being maintained in the current system itself. Now this structure of the RBI makes it one of the most independent agencies of the Government. It is comparable to Supreme Court in terms of independence that it commands. However RBI governor is appointed by the Government of India so that is one notch below in terms of independence. It is also one of the most independent Central banks in the entire world.

Now there are two different viewpoints about the RBI. One is that RBI has too much power and should be controlled more by democratically elected Government. So one viewpoint is we have to control RBI’s power so that democratically elected Government has power over RBI, or power over the Monetary Policy making. Another viewpoint is RBI should remain independence or else politicians including the Parliament and the Prime Minister’s office could order the RBI to boost money supply, increase credit etc. just before an election.  Government could misuse Monetary Policy for its own purposes because of that RBI has to remain as a separate institution. That is another viewpoint.

So what is the case for Central Bank independence? The first is that RBI avoids inflationary spending by the government. The government might spend more to meet its own political agenda, such as, spending more before an election so that people have a perception that the country is improving etc. So government can sell this by forcing the banks to buy bonds so that the government can spend more. This is banned because this can lead to inflation very fast. So one reason an independent organization is good is that this kind of problems can be avoided. And we can avoid the use of Monetary Policy for political goals.

So we cannot lower interest rates before an election so as to win an election. We can only lower the interest rates when we feel that the inflation is low enough to allow that. Otherwise, the election will in turn cause inflation. The election cycle used to be matching with the inflation cycle but independent RBI can control this kind of mismatches. If the government is given power over Monetary Policy, governments have a tendency, automatic tendency to misuse that power.

 

What is the case against central bank independence? 

 

The biggest reason is that central bank is not directly accountable to the voters. What the voters want and what the bank does might be slightly at odds. So RBI might sometimes be implementing monetary policy against the wishes of the electorate. For example, there could be a stack inflation situation in which economy is not growing. At the same time unemployment is high as well and RBI cannot reduce interest rates. Instead it has to hike interest rate because inflation is high. Now the electorate might not appreciate that. People might start feeling why should the RBI have this power, why can’t we decide, why can’t our government decide? So those kind of questions can come. Also government might sometime blame RBI for not allowing India to develop etc. So in these situations this accountability issue becomes a problem.

 

This article was written by Paulami Paul (PGDM, Batch 22, XIME-B)

I Want the Earth, Plus 5%

 

Disclaimer: The original article is I Want the Earth, Plus 5% © Larry Hannigan 1971, Australia. Only for reproduction purposes. No copyright infringement intended.

 

This is a heartwarming story of how a printed piece of contract paper came to rule over every aspect of human life.

 

Fabian was excited as he once more rehearsed his speech for the crowd certain to turn up tomorrow. He had always wanted prestige and power and now his dreams were going to come true. He was a craftsman working with silver and gold, making jewelry and ornaments, but he became dissatisfied with working for a living. He needed excitement, a challenge, and now his plan was ready to begin. For generations the people used the barter system. A man supported his own family by providing all their needs or else he specialized in a particular trade. Whatever surpluses he might have from his own production, he exchanged or swapped for the surplus of others.

Market day was always noise and dusty, yet people looked forward to the shouting and waving, and especially the companionship. It used to be a happy place, but now there were too many people, too much arguing. There was no time for chatting – a better system was needed.

Generally, the people had been happy, and enjoyed the fruits of their work.

In each community a simple Government had been formed to make sure that each person’s freedoms and rights were protected and that no man was forced to do anything against his will by any other man, or any group of men.

This was the Government’s one and only purpose and each Governor was voluntarily supported by the local community who elected him.

However, market day was the one problem they could not solve. Was a knife worth one or two baskets of corn? Was a cow worth more than a wagon … and so on. No one could think of a better system.

Fabian had advertised, “I have the solution to our bartering problems, and I invite everyone to a public meeting tomorrow.”

The next day there was a great assembly in the town square and Fabian explained all about the new system which he called “money”. It sounded good. “How are we to start?” the people asked.

“The gold which I fashion into ornaments and jewelry is an excellent metal. It does not tarnish or rust, and will last a long time. I will make some gold into coins and we shall call each coin a dollar.”

He explained how values would work, and that “money” would be really a medium for exchange – a much better system than bartering.

One of the Governors questioned, “Some people can dig gold and make coins for themselves”, he said.

“This would be most unfair”, Fabian was ready with the answer. “Only those coins approved by the Government can be used, and these will have special marking stamped on them.” This seemed reasonable and it was proposed that each man be given an equal number. “But I deserve the most,” said the candle-maker. “Everyone uses my candles.” “No”, said the farmer, “without food there is no life, surely we should get the most.” And so the bickering continued.

Fabian let them argue for a while and finally he said, “Since none of you can agree, I suggest you obtain the number you require from me. There will be no limit, except for your ability to repay. The more you obtain, the more you must repay in one year’s time. “And what will you receive?” the people asked.

“Since I am providing a service, that is, the money supply, I am entitled to payment for my work. Let us say that for every 100 pieces you obtain, you repay me 105 for every year that you owe the debt. The 5 will be my charge, and I shall call this charge interest.”

There seemed to be no other way, and besides, 5% seemed little enough charge. “Come back next Friday and we will begin.”

Fabian wasted no time. He made coins day and night, and at the end of the week he was ready. The people were queued up at his shop, and after the coins were inspected and approved by the Governors the system commenced. Some borrowed only a few and they went off to try the new system.

They found money to be marvelous, and they soon valued everything in gold coins or dollars. The value they placed on everything was called a “price”, and the price mainly depended on the amount of work required to produce it. If it took a lot of work the price was high, but if it was produced with little effort it was quite inexpensive.

In one town lived Alan, who was the only watchmaker. His prices were high because the customers were willing to pay just to own one of his watches.

Then another man began making watches and offered them at a lower price in order to get sales. Alan was forced to lower his prices, and in no time at all prices came down, so that both men were striving to give the best quality at the lowest price. This was genuine free competition.

It was the same with builders, transport operators, accountants, farmers, in fact, in every endeavor. The customers always chose what they felt was the best deal – they had freedom of choice. There was no artificial protection such as licences or tariffs to prevent other people from going into business. The standard of living rose, and before long the people wondered how they had ever done without money.

At the end of the year, Fabian left his shop and visited all the people who owed him money. Some had more than they borrowed, but this meant that others had less, since there were only a certain number of coins issued in the first place. Those who had more than they borrowed paid back each 100 plus the extra 5, but still had to borrow again to carry on.

The others discovered for the first time that they had a debt. Before he would lend them more money, Fabian took a mortgage over some of their assets, and everyone went away once more to try and get those extra 5 coins which always seemed so hard to find.

No one realized that as a whole, the country could never get out of debt until all the coins were repaid, but even then, there were those extra 5 on each 100 which had never been lent out at all. No one but Fabian could see that it was impossible to pay the interest – the extra money had never been issued, therefore someone had to miss out.

It was true that Fabian spent some coins, but he couldn’t possibly spend anything like 5% of the total economy on himself. There were thousands of people and Fabian was only one. Besides, he was still a goldsmith making a comfortable living.

At the back of his shop Fabian had a strongroom and people found it convenient to leave some of their coins with him for safekeeping. He charged a small fee depending on the amount of money, and the time it was left with him. He would give the owner receipts for the deposit.

When a person went shopping, he did not normally carry a lot of gold coins. He would give the shopkeeper one of the receipts to the value of the goods he wanted to buy.

Shopkeepers recognized the receipt as being genuine and accepted it with the idea of taking it to Fabian and collecting the appropriate amount in coins. The receipts passed from hand to hand instead of the gold itself being transferred. The people had great faith in the receipts – they accepted them as being as good as coins.

Before long, Fabian noticed that it was quite unusual for anyone to actually call for their gold coins.

He thought to himself, “Here I am in possession of all this gold and I am still a hard working craftsman. It doesn’t make sense. Why there are dozens of people who would be glad to pay me interest for the use of this gold which is lying here and rarely called for.

It is true, the gold is not mine – but it is in my possession, which is all that matters. I hardly need to make any coins at all, I can use some of the coins stored in the vault.”

At first he was very cautious, only loaning a few at a time, and then only on tremendous security. But gradually he became bolder, and larger amounts were loaned.

One day, a large loan was requested. Fabian suggested, “Instead of carrying all these coins we can make a deposit in your name, and then I shall give you several receipts to the value of the coins.” The borrower agreed, and off he went with a bunch of receipts. He had obtained a loan, yet the gold remained in the strong-room. After the client left, Fabian smiled. He could have his cake and eat it too. He could “lend” gold and still keep it in his possession.

Friends, strangers and even enemies needed funds to carry out their businesses – and so long as they could produce security, they could borrow as much as they needed. By simply writing out receipts Fabian was able to “lend” money to several times the value of gold in his strong-room, and he was not even the owner of it. Everything was safe so long as the real owners didn’t call for their gold and the confidence of the people was maintained.

He kept a book showing the debits and credits for each person. The lending business was proving to be very lucrative indeed.

His social standing in the community was increasing almost as fast as his wealth. He was becoming a man of importance, he commanded respect. In matters of finance, his very word was like a sacred pronouncement.

Goldsmiths from other towns became curious about his activities and one day they called to see him. He told them what he was doing, but was very careful to emphasize the need for secrecy.

If their plan was exposed, the scheme would fail, so they agreed to form their own secret alliance.

Each returned to his own town and began to operate as Fabian had taught.

People now accepted the receipts as being as good as gold itself, and many receipts were deposited for safe keeping in the same way as coins. When a merchant wished to pay another for goods, he simply wrote a short note instructing Fabian to transfer money from his account to that of the second merchant. It took Fabian only a few minutes to adjust the figures.

This new system became very popular, and the instruction notes were called “checks”.

Late one night, the goldsmiths had another secret meeting and Fabian revealed a new plan. The next day they called a meeting with all the Governors, and Fabian began. “The receipts we issue have become very popular. No doubt, most of you Governors are using them and you find them very convenient.” They nodded in agreement and wondered what the problem was. “Well”, he continued, “some receipts are being copied by counterfeiters. This practice must be stopped.”

The Governors became alarmed. “What can we do?” they asked. Fabian replied, “My suggestion is this – first of all, let it be the Government’s job to print new notes on a special paper with very intricate designs, and then each note to be signed by the chief Governor. We goldsmiths will be happy to pay the printing costs, as it will save us a lot of time writing out receipts”. The Governors reasoned, “Well, it is our job to protect the people against counterfeiters and the advice certainly seems like a good idea.” So they agreed to print the notes.

“Secondly,” Fabian said, “some people have gone prospecting and are making their own gold coins. I suggest that you pass a law so that any person who finds gold nuggets must hand them in. Of course, they will be reimbursed with notes and coins.”

The idea sounded good and without too much thought about it, they printed a large number of crisp new notes. Each note had a value printed on it – $1, $2, $5, $10 etc. The small printing costs were paid by the goldsmiths.

The notes were much easier to carry and they soon became accepted by the people. Despite their popularity however, these new notes and coins were used for only 10% of transactions. The records showed that the check system accounted for 90% of all business.

The next part of his plan commenced. Until now, people were paying Fabian to guard their money. In order to attract more money into the vault Fabian offered to pay depositors 3% interest on their money.

Most people believed that he was re-lending their money out to borrowers at 5%, and his profit was the 2% difference. Besides, the people didn’t question him as getting 3% was far better than paying to have the money guarded.

The volume of savings grew and with the additional money in the vaults, Fabian was able to lend $200, $300, $400 sometimes up to $900 for every $100 in notes and coins that he held in deposit. He had to be careful not to exceed this nine to one ratio, because one person in ten did require the notes and coins for use.

If there was not enough money available when required, people would become suspicious, especially as their deposit books showed how much they had deposited. Nevertheless, on the $900 in book figures that Fabian loaned out by writing checks himself, he was able to demand up to $45 in interest, i.e. 5% on $900. When the loan plus interest was repaid, i.e. $945, the $900 was cancelled out in the debit column and Fabian kept the $45 interest. He was therefore quite happy to pay $3 interest on the original $100 deposited which had never left the vaults at all. This meant that for every $100 he held in deposits, it was possible to make 42% profit, most people believing he was only making 2%. The other goldsmiths were doing the same thing. They created money out of nothing at the stroke of a pen, and then charged interest on top of it.

True, they didn’t coin money, the Government actually printed the notes and coins and gave it to the goldsmiths to distribute. Fabian’s only expense was the small printing fee. Still, they were creating credit money out of nothing and charging interest on top of it. Most people believed that the money supply was a Government operation. They also believed that Fabian was lending them the money that someone else had deposited, but it was very strange that no one’s deposits ever decreased when a loan was advanced. If everyone had tried to withdraw their deposits at once, the fraud would have been exposed.

When a loan was requested in notes or coins, it presented no problem. Fabian merely explained to the Government that the increase in population and production required more notes, and these he obtained for the small printing fee.

One day a thoughtful man went to see Fabian. “This interest charge is wrong”, he said. “For every $100 you issue, you are asking $105 in return. The extra $5 can never be paid since it doesn’t exist.

Farmers produce food, industry manufacturers goods, and so on, but only you produce money. Suppose there are only two businessmen in the whole country and we employ everyone else. We borrow $100 each, we pay $90 out in wages and expenses and allow $10 profit (our wage). That means the total purchasing power is $90 + $10 twice, i.e. $200. Yet to pay you we must sell all our produce for $210. If one of us succeeds and sells all his produce for $105, the other man can only hope to get $95. Also, part of his goods cannot be sold, as there is no money left to buy them.

He will still owe you $10 and can only repay this by borrowing more. The system is impossible.”

The man continued, “Surely you should issue 105, i.e. 100 to me and 5 to you to spend. This way there would be 105 in circulation, and the debt can be repaid.”

Fabian listened quietly and finally said, “Financial economics is a deep subject, my boy, it takes years of study. Let me worry about these matters, and you look after yours. You must become more efficient, increase your production, cut down on your expenses and become a better businessman. I am always willing to help in these matters.”

The man went away still unconvinced. There was something wrong with Fabian’s operations and he felt that his questions had been avoided.

Yet, most people respected Fabian’s word – “He is the expert, the others must be wrong. Look how the country has developed, how our production has increased – we must be better off.”

To cover the interest on the money they had borrowed, merchants were forced to raise their prices. Wage earners complained that wages were too low. Employers refused to pay higher wages, claiming that they would be ruined. Farmers could not get a fair price for their produce. Housewives complained that food was getting too dear.

And finally some people went on strike, a thing previously unheard of. Others had become poverty stricken and their friends and relatives could not afford to help them. Most had forgotten the real wealth all around – the fertile soils, the great forests, the minerals and cattle. They could think only of the money which always seemed so scarce. But they never questioned the system. They believed the Government was running it.

A few had pooled their excess money and formed “lending” or “finance” companies. They could get 6% or more this way, which was better than the 3% Fabian paid, but they could only lend out money they owned – they did not have this strange power of being able to create money out of nothing by merely writing figures in books.

These finance companies worried Fabian and his friends somewhat, so they quickly set up a few companies of their own. Mostly, they bought the others out before they got going. In no time, all the finance companies were owned by them, or under their control.

The economic situation got worse. The wage earners were convinced that the bosses were making too much profit. The bosses said that their workers were too lazy and weren’t doing an honest day’s work, and everyone was blaming everyone else.The Governors could not come up with an answer and besides, the immediate problem seemed to be to help the poverty stricken.

They started up welfare schemes and made laws forcing people to contribute to them. This made many people angry – they believed in the old-fashioned idea of helping one’s neighbor by voluntary effort.

“These laws are nothing more than legalised robbery. To take something off a person against his will, regardless of the purpose for which it is to be used, is no different from stealing.”

But each man felt helpless and was afraid of the jail sentence which was threatened for failing to pay. These welfare schemes gave some relief, but before long the problem was back and more money was needed to cope. The cost of these schemes rose higher and higher and the size of the Government grew.

Most of the Governors were sincere men trying to do their best. They didn’t like asking for more money from their people and finally, they had no choice but to borrow money from Fabian and his friends. They had no idea how they were going to repay. Parents could no longer afford to pay teachers for their children. They couldn’t pay doctors. And transport operators were going out of business.

One by one the government was forced to take these operations over. Teachers, doctors and many others became public servants.

Few obtained satisfaction in their work. They were given a reasonable wage, but they lost their identity. They became small cogs in a giant machine.

There was no room for personal initiative, little recognition for effort, their income was fixed and advancement came only when a superior retired or died.

In desperation, the governors decided to seek Fabian’s advice. They considered him very wise and he seemed to know how to solve money matters. He listened to them explain all their problems, and finally he answered, “Many people cannot solve their own problems – they need someone to do it for them. Surely you agree that most people have the right to be happy and to be provided with the essentials of life. One of our great sayings is “all men are equal” – is it not?”

Well, the only way to balance things up is to take the excess wealth from the rich and give it to the poor. Introduce a system of taxation. The more a man has, the more he must pay. Collect taxes from each person according to his ability, and give to each according to his need. Schools and hospitals should be free for those who cannot afford them …”

He gave them a long talk on high sounding ideals and finished up with, “Oh, by the way, don’t forget you owe me money. You’ve been borrowing now for quite some time. The least I can do to help, is for you to just to pay me the interest. We’ll leave the capital debt owing, just pay me the interest.”

They went away, and without giving Fabian’s philosophies any real thought, they introduced the graduated income tax – the more you earn, the higher your tax rate. No one liked this, but they either paid the taxes or went to jail.

Merchants were forced once again to raise their prices. Wage earners demanded higher wages forcing many employers out of business, or to replace men with machinery. This caused additional unemployment and forced the Government to introduce further welfare and handout schemes.

Tariffs and other protection devices were introduced to keep some industries going just to provide employment. A few people wondered if the purpose of the production was to produce goods or merely to provide employment.

As things got worse, they tried wage control, price control, and all sorts of controls. The Government tried to get more money through sales tax, payroll tax and all sorts of taxes. Someone noted that from the wheat farmer right through to the housewife, there were over 50 taxes on a loaf of bread.

“Experts” arose and some were elected to Government, but after each yearly meeting they came back with almost nothing achieved, except for the news that taxes were to be “restructured”, but overall the total tax always increased.

Fabian began to demand his interest payments, and a larger and larger portion of the tax money was being needed to pay him.

Then came party politics – the people started arguing about which group of Governors could best solve the problems. They argued about personalities, idealism, party labels, everything except the real problem. The councils were getting into trouble.

In one town the interest on the debt exceeded the amount of rates which were collected in a year. Throughout the land the unpaid interest kept increasing – interest was charged on unpaid interest.

Gradually much of the real wealth of the country came to be owned or controlled by Fabian and his friends and with it came greater control over people. However, the control was not yet complete. They knew that the situation would not be secure until every person was controlled.

Most people opposing the systems could be silenced by financial pressure, or suffer public ridicule. To do this Fabian and his friends purchased most of the newspapers, T.V. and radio stations and he carefully selected people to operate them. Many of these people had a sincere desire to improve the world, but they never realised how they were being used. Their solutions always dealt with the effects of the problem, never the cause.

There were several different newspapers – one for the right wing, one for the left wing, one for the workers, one for the bosses, and so on. It didn’t matter much which one you believed in, so long as you didn’t think about the real problem.

Fabian’s plan was almost at its completion – the whole country was in debt to him. Through education and the media, he had control of people’s minds. They were able to think and believe only what he wanted them to.

After a man has far more money than he can possibly spend for pleasure, what is left to excite him? For those with a ruling class mentality, the answer is power – raw power over other human beings. The idealists were used in the media and in Government, but the real controllers that Fabian sought were those of the ruling class mentality.

Most of the goldsmiths had become this way. They knew the feeling of great wealth, but it no longer satisfied them. They needed challenge and excitement, and power over the masses was the ultimate game.

They believed they were superior to all others. “It is our right and duty to rule. The masses don’t know what is good for them. They need to be rallied and organised. To rule is our birthright.”

Throughout the land Fabian and his friends owned many lending offices. True, they were privately and separately owned. In theory they were in competition with each other, but in reality they were working very closely together. After persuading some of the Governors, they set up an institution which they called the Money Reserve Centre. They didn’t even use their own money to do this – they created credit against part of the money out of the people’s deposits.

This Institution gave the outward appearance of regulating the money supply and being a Government operation, but strangely enough, no Governor or public servant was ever allowed to be on the Board of Directors.

The Government no longer borrowed directly from Fabian, but began to use a system of I.O.U.’s to the Money Reserve Centre. The security offered was the estimated revenue from next year’s taxes. This was in line with Fabian’s plan – removing suspicion from himself to an apparent Government operation. Yet, behind the scenes, he was still in control.

Indirectly, Fabian had such control over the Government that they were forced to do his bidding. He boasted, “Let me control the nation’s money and I care not who makes its laws.” It didn’t matter much which group of Governors were elected. Fabian was in control of the money, the life blood of the nation.

The Government obtained the money, but interest was always charged on every loan. More and more was going out in welfare and handout schemes, and it was not long before the Government found it difficult to even repay the interest, let alone the capital.

And yet there were people who still asked the question, “Money is a man-made system. Surely it can be adjusted to serve, not to rule?” But these people became fewer and their voices were lost in the mad scrabble for the non-existent interest.

The adminstrations changed, the party labels changed, but the major policies continued. Regardless of which Government was in “power”, Fabian’s ultimate goal was brought closer each year. The people’s policies meant nothing. They were being taxed to the limit, they could pay no more. Now the time was ripe for Fabian’s final move.

10% of the money supply was still in the form of notes and coins. This had to be abolished in such a way as not to arouse suspicion. While the people used cash, they were free to buy and sell as they chose – they still had some control over their own lives.

But it was not always safe to carry notes and coins. Checks were not accepted outside one’s local community, and therefore a more convenient system was looked forward to. Once again Fabian had the answer. His organisation issued everyone with a little plastic card showing the person’s name, photograph and an identification number.

When this card was presented anywhere, the storekeeper phoned the central computer to check the credit rating. If it was clear, the person could buy what he wanted up to a certain amount.

At first people were allowed to spend a small amount on credit, and if this was repaid within a month, no interest was charged. This was fine for the wage earner, but what businessman could even begin? He had to set up machinery, manufacture the goods, pay wages etc. and sell all his goods and repay the money. If he exceeded one month, he was charged a 1.5% for every month the debt was owed. This amounted to over 18% per year.

Businessmen had no option but to add the 18% onto the selling price. Yet this extra money or credit (the 18%) had not been loaned out to anyone. Throughout the country, businessmen were given the impossible task of repaying $118 for every $100 they borrowed – but the extra $18 had never been created at all.

Yet Fabian and his friends increased their standing in society. They were regarded as pillars of respectability. Their pronouncements on finance and economics were accepted with almost religious conviction.

Under the burden of ever increasing taxes, many small businesses collapsed. Special licenses were needed for various operations, so that the remaining ones found it very difficult to operate. Fabian owned and controlled all of the big companies which had hundreds of subsidiaries. These appeared to be in competition with each other, yet he controlled them all. Eventually all competitors were forced out of business. Plumbers, panel beaters, electricians and most other small industries suffered the same fate – they were swallowed up by Fabian’s giant companies which all had Government protection.

Fabian wanted the plastic cards to eliminate notes and coins. His plan was that when all notes were withdrawn, only businesses using the computer card system would be able to operate.

He planned that eventually some people would misplace their cards and be unable to buy or sell anything until a proof of identify was made. He wanted a law to be passed which would give him ultimate control – a law forcing everyone to have their identification number tattooed onto their hand. The number would be visible only under a special light, linked to a computer. Every computer would be linked to a giant central computer so that Fabian could know everything about everyone.

Islamic Banking: The Implications of an Interest-less Banking System

Quite a few heads were turned when the Reserve Bank of India (RBI) recently set up a three-member panel to review the feasibility of the Islamic Banking System in India, including Rajesh Verma, a deputy general manager, department of banking operations, Archana Mangalagiri, general manager, non-banking supervision and Bindu Vasu, joint legal adviser. This move was a surprise, considering how an earlier committee appointed in 2007 rejected the idea of implementing such a system in India.

 

dubai-islamic-bank-3_tcm87-21629
(Source: ILMABAD)

 

What is Islamic Banking?

 

Islamic Banking is a Banking System being followed in several parts of the world, mostly in Islamic nations like the Middle East. It follows the Islamic rulings or Shari’ah. Among other things, Islamic Banking prohibits ‘Riba’, roughly translated to ‘Money earned by money’, or in the modern parlance, Interest. The justification given is that money is not seen as an asset in Shari’ah, rather only a medium of exchange. This also means that there is no ‘creditor’ or ‘debtor’ in the system.

 

How do Islamic Banks function?

 

First and foremost, since Interest payments are prohibited, Islamic Banks do not accept deposits. They only ‘lend’ money. In return, instead of interest, the banks take a share of equity in the company. Whatever profit the company makes will then directly translates into better share value for the bank. Of course, if the company does not do well, the bank loses out as well. It is a kind of ‘brotherhood’ under which Islamic Banking operates. In addition to the prohibition of interest, Islamic Banking also prohibits all activities deemed evil by Shari’ah, such as investing in businesses that are related to pork, involving in activities that are highly risky and gambling. The functioning of an Islamic Banking system can be explained somewhat through the below diagram:

 

islamic-banking-cycle

 

Why Islamic Banking in India?

 

The reasoning behind considering the implementation of Islamic Banking in India is that a lot of Muslims in the country shy away from conventional Banking because Shari’ah prohibits it as ‘haram’. The Reserve Bank of India in tandem with the Modi government wants to explore this reform solely for the purpose of furthering financial inclusion, an agenda that is dear to both the central bank and the central government.

 

What are the implications of Islamic Banking?

 

Islamic Banking is very similar to traditional banking, except that traditional banking exchanges its funds for a liability (Debt), whereas Islamic Banking exchanges its funds for equity. In both the cases, the banks earn a ‘fee’ for parting with their funds, over several periods. In case of a default, the traditional bank loses out on interest payment and potentially the principal amount. In Islamic Banking, when the businesses in the bank’s portfolio do badly, the equity value held by the Islamic Bank will erode and the bank will eventually run out of liquidity. But at least, in traditional banking, there is a scope for recovery via Strategic Debt Restructuring and the central bank can control the supply of money via interest rates. In these frontiers, the Islamic Banking system offers little to no solution. There is also a major concern that Islamic Banking is convenient for illegal funds to flow through easily.

But Islamic Banking has become an inevitable part of modern banking and will also be implemented in India. It is only a question of whether or not the entire traditional banking system in India should be overthrown and replaced by Islamic Banking or should both the systems co-exist, that needs answering the most (Islamic Banking system is already allowed in very few banks across India). Hopefully, the latest committee set up by the Reserve Bank of India will find an answer. If not for anything else, there is a good chance that Islamic Banking will be introduced as an add-on service to traditional banking in order to encourage the marginalized sections of the Muslim population to take part in Banking activities.

 

This article was written by Dinesh Sairam (PGDM, XIME-B, Batch 21)

The Rajan Effect

Raghuram Rajan Takes Charge As Governor of The Reserve Bank of India
(Source: JapanTimes)

 

It’s time to bid a bittersweet adieu to Rajan. On the 4th of September, Raghuram Rajan, the current RBI Governor, will have completed three years in office. In these years, Rajan has garnered immense popularity as a central banker, especially for his determination and strict policies of fighting inflation. He gained nicknames such as ‘R3’ and ‘Rockstar’ as a part of his massive fan-following. The media made a highlighted his every public move, even comparing him with the likes of James Bond, for his famous words “My name is Rajan. I do what I do.” All in all, Rajan was a new kind of Central Banker to India that his predecessors never were – the famous kind.

A IIT-D and an IIM-A Gold Medalist, Rajan is also a distinguished University of Chicago scholar. Before his stint at the RBI, he served as the Chief Economist of the International Monetary Fund. Rajan is best known for anticipating the 2008 subprime lending crisis in his paper, “Has Financial Development Made The Word Riskier?” He also reiterated his views in the post-crisis short film “Inside Job“.

 

 

His record at the Reserve Bank of India speaks for itself. Raghuram Rajan walked into Mint Street in September 2013 while a currency crisis was unfolding. The rupee was nose diving and had almost hit Rs. 69 to a dollar while currency reserves had hit a three-year low. Inflation was galloping as well and at that time looked far beyond anyone’s control. While Consumer Price Inflation had hit 9.84 per cent in September 2013, inflation in primary food articles had crossed the 18 per cent mark.

On day one as central bank chief, Rajan vowed to preserve the value of the currency. He waged a war against inflation and straightened the rupee in weeks. To calm the vulnerable rupee, Rajan launched the FCNR (B) (Foreign Currency Non Resident (Bank) account is an account that can be opened with an Indian bank by a Non Resident Indian or a Person of Indian Origin in foreign currency) scheme under which it offered discounted currency swaps to banks to spur inflow.

 Banks raised $25 billion through FCNR deposits and another $9 billion through foreign currency borrowings. Surprising many, Rajan hiked Repo Rate not once but twice in October 2013 and January 2014 to break the spiral of rising inflation. The Indian economy has seen significant changes over the three years that Raghuram Rajan has been the Governor of the Reserve Bank of India.

In September 2013, when Rajan took over, the economy was part of the infamous ‘Fragile Five’ grouping. Today, it is celebrated as the fastest growing major economy in the world.While fortuitous factors like a drop in commodity prices have helped steady the fundamentals of the Indian economy, so have sound macroeconomic policies like a focus on bringing down inflation, building foreign exchange reserves and allowing a steady increase in foreign participation in the Indian debt markets.

 

Here is a summary of how economic indicators have evolved during Raghuram Rajan’s tenure as the Reserve Bank of India Governor:

 

  • Rupee: To say that the rupee was in bad shape will be an understatement. Two months before Rajan took office, the domestic currency had depreciated by a staggering 10.4 per cent as India faced its worst currency crisis in recent memory. Ever since Rajan took over, the rupee has gained 1.12 per cent with implied volatility hitting an eight-year low last week

 

  • Lending rate: Lending rate, or the rate of interest banks charge from borrowers, stood at 10.3 in September of 2013. As of August 2016, it’s down by 90 bps at 9.3 per cent. High lending rate has been one of the key concerns in the second half of Rajan’s tenure, as repeated cuts in repo rate by the central bank didn’t get transmitted fully.

 

  • Inflation: Rajan is known for his primary focus on curbing inflation. His biggest achievement is that he successfully brought down retail inflation to 3.78% in July 2015 from 9.8% in September 2013 – the lowest since the 1990s. Wholesale inflation was down to a historic low of -4.05% in July 2015 from 6.1% in September 2013. Under Rajan, the RBI adopted consumer price index (CPI) as the key indicator of inflation, which is the global norm, despite the government recommending otherwise.

 

  • Equity: In his first speech as RBI governor, Rajan promised banking reforms and eased curbs on foreign banking, following which Sensex rose by 333 points or 1.83%. After his first day at office, the rupee rose 2.1% against the dollar. The equity market, although not directly under Rajan’s influence, has nonetheless had a blast during Rajan’s tenure. The BSE Sensex rose 51 per cent even since Rajan took office through August 8, 2016. The NSE Nifty50 has gained 60 per cent in the same period.

 

  • Gross NPAs:The biggest achievement of Rajan’s tenure may not look like an achievement at all. Gross non-performing assets at India’s scheduled commercial banks jumped three-fold from Rs 2,52,275 crore in December 2013 to Rs 5,94,929 crore by March, 2016, thanks to a clean-up of the banking system that has brought forth the ugly side of the banking sector. With a former RBI governor accepting the responsibility for not doing much about the issue, the burden fell on Rajan and his team.

 

  • Foreign Exchange : Perhaps, a hands-down winner during Rajan’s tenure, foreign exchange reserves of RBI have swelled to record high. From $275 billion in September of 2013, it now stands at a record $365 billion and will provide the arsenal to the central bank to brace for the FCNR bond redemptions coming up in September, which is likely to create some ripples in the currency market. India’s forex reserve is now stronger by about 30% than it was two years back.

 

  • Banking: Under Rajan, two universal banks have been licensed and eleven payment banks have been given the nod. This is expected to extend banking services to the nearly two-thirds of the population who are still deprived of banking facilities.

 

  • Interest rates:After initially raising nominal interest rates by 50 basis points, or 0.50 per cent, to quell inflation, RBI embarked on a journey of rate cutting which is now in its 18th month. When Rajan took office, repo rate stood at 7.5 per cent, which then rose to 8 per cent in January 2014. Post-January 2015, repo rate has been slashed by 1.5 per cent to 6.5 per cent, which is the lowest level in four-and-a-half years.

 

  • Current account deficit:The current account deficit, though essentially a finance ministry domain, has seen a marked improvement over the past three years, climbing down from a record high level of 4.10 per cent to 0.1 per cent in June 2016.

 

cj
(Source: ETMarkets)

 

 Rajan’s early focus and battle with inflation earned him nicknames ranging from ‘Inflation warrior’ to ‘Inflation Hawk‘. There are a number of points to consider here when viewing the criticisms against Rajan’s stance on inflation and interest rates. He has more aggressively expanded on his predecessor’s attempt at using interest rates to curb inflation. The arguments in favour of Rajan having erred, when it comes to interest rates and inflation, are three-fold.

First, the central idea that the high inflation in the Indian economy was due to excess domestic demand is flawed. This inflation can be more attributed to global excess demand and thus raising interest rates was flawed. If this is true, Rajan’s restrictive monetary policy has been completely off the mark.

Second, even if Rajan’s initial stance of keeping inflation as the RBI’s number one goal was correct, he may have been too late in recognizing when this goal was achieved and therefore late in eventually cutting interest rates. Rajan at the time was still hesitant to cut interest rates even though retail inflation had fallen to 3.8%.

The problem of different perspectives here – whether India was undergoing disinflation or deflation – stemmed from the RBI’s decision to look at retail inflation (CPI) while deciding its monetary policy. So while the wholesale price index sat at negative 4% at that point of time, CPI was still at 3.8%.

The last argument for Rajan having tripped up was that even after he started his rate cut cycle, he didn’t do enough to help the money markets that were gasping for liquidity; a crucial side-effect of this was that a free transmission of rate cuts did not happen. It was only in his last year, and more specifically in the last five months, that the RBI governor set out to make more cash available in the banking system.

Out of these three arguments, there is greater evidence and support for the last two. In some ways it’s a pity that criticism levied against Rajan comes from parties that had a vested interest in his policies: politicians, India Inc. lobby groups, debt-laden promoters and wilful defaulters.

In his farewell letter, Rajan expresses a tinge of disappointment that he will not be able to see through two important developments: The formation of a monetary policy committee that may eventually reduce the role of the RBI governor, The asset quality review of public-sector banks.

Apart from these two issues, however, what has received less media attention was Rajan’s aim of overhauling the RBI’s administrative structure, including hiring talented external employees as well as improving the quality of institutional research.

One big mistake Rajan did was he failed to fathom the tolerance level of ruling political dispensation to criticism, especially on political matters. In a country, where all government bureaucrats are supposed to toe the line of their employer, no government servant, even if he is the RBI Governor, is supposed to speak his mind on sensitive political issues. That’s a taboo. The moment Rajan stepped out of his mandate and started commenting on political issues, the discord between him and the government started.

Rajan’s work is nothing short of exceptional. However, newer Central Bankers will most likely match his performance and maybe even exceed it. But whether India will have such an honest, outspoken and fearless Central Banker is a huge question mark. Rajan himself has assured that he remains loyal to India and will be happy to serve the people whenever he is called upon again. At this moment, we can only be thankful for his contributions and restate the message of the RBI Staff in their tribute rangoli to their outgoing boss: “Alvida na kehna” (“Never Say Goodbye“).

 

This article was written by Varnita Deep (PGDM, Batch 22,  XIME-B)