Central Bank

By. Prof Riaz Ahmed Mian

Principles of Banking, Currency

& Finance

CentralBank

By. Prof Riaz Ahmed Mian

Monetary Policy

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

1Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

Monetary Policy

Meanings:

Monetary Policy refers to all those steps that the central bank of the country takes to influence, manage and control the supply of credit and to regulate the volume of credit in the economy.


Monetary Policy – cont’d

Explanation:

The basic rule is that too much of a good thing is also bad. So credit, investment and expenditure are no doubt extremely essential for a healthy economy but they must be put under some limits. Excess of all these variable could produce harmful effects over the economy.


Objectives of Monetary Policy

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Objectives of Monetary Policy

Underdeveloped Countries:

Under develop countries or LDCs (Less Developed Countries) are those countries which are either extremely backward or which are in the process of development.

Meanings:


Underdeveloped Countries – cont’d

1. To Achieve Full Employment2. To Have High Efficiency3. To Have Large Scale Resource Mobilisation4. To Increase Exports5. To Have High Investments6. To Provide Price and Exchange Stability7. To Have Efficient Allocation and Utilisation of Resources8. To Accelerate Economic Growth

(cont’d..)

6

Underdeveloped Countries – cont’d

9. To Raise Living Standards

According to SBP Act, 1956,“The bank is required to regulate and

foster the growth of the monetary and credit system to ensure monetary stability and to secure full utilisation of country’s productive resources.”


Developed Countries

Developed countries include Japan, USA. Germany etc. The economy of these countries is characterise by high per capita income, high rate of growth, savings and capital formation, high living standards, sound infrastructure and institutions etc.

Meanings:


Developed Countries – cont’d

1. To Have High Aggregate Demand without Inflation

2. Eradicating Inflationary and Deflationary Gaps

3. High Research/Further Development4. Providing Assistance to Other Countries5. Gaining Monetary Control over Others

Prof. Riaz Ahmed Mian, HCBF, University of the Punjab 9

Tools of Monetary Policy


Tools of Monetary Policy

I. Quantitative ToolsII. Qualitative Tools

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Tools of Monetary Policy – cont’d

I. Quantitative Tools:

These tools are of such nature that they produce effects on whole of the economy without any distinction.


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I. Open Market Operations (OMO)

Meanings: Open Market Operations may be

defined as purchase and sale of government securities in the open market by the central bank. This is basically done with the objective of influencing the monetary assets of commercial bank.


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Open Market Operations (OMO) – cont’d

Functions:Buying Securities: State bank can buy securities either from the commercial bank or from public.

Selling Securities: Securities can be sold either to banks or to public.


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Open Market Operations (OMO) – cont’d

Result: When central bank buys securities from commercial banks, it pays them in money. This increases cash reserves of the commercial bank and hence their lending power increases. When it sells securities, it hands over securities to commercial banks. Commercial banks pay cash to central bank. This reduces the commercial banks cash reserves and their lending power is reduced.


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Effects on Interest Rate

When securities are purchased by the central bank then commercial banks end up with excessive cash reserves. In order to attract borrowers and investors they lower their interest rates.


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Effects on Interest Rate – cont’d

When securities are sold, this results in reduced cash reserves with commercial banks. If there is high demand for loans from borrowers and investors, the interest rate and hence cost of borrowing rises.


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Purpose of Open Market Operations 1. To administer and maintain the prices of

government securities.2. To create suitable climate for the floatation of new loans.3. To activate the money market.4. To manage gold inflows and outflows.5. To create climate in which other tools of

monetary policy i.e., bank rate could be used effectively.

6. To avoid sudden fluctuation in the money market.7. To support government credit.

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Limitations / Assumptions

1. Undeveloped Market:For effective Open Market Operations

the money and capital markets must be fully developed.


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Limitations / Assumptions – cont’d

2. Excessive Cash Reserves:The basic rational of open market

operations is to decrease cash balances of commercial banks so as to reduce their lending power.


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3. Availability of Securities:For Open Market Operations to be

effective, there must be ample and adequate securities. The central bank purchases securities at high prices in order to stimulate economy and to push it out of depression or slump. On the other hand, it sells securities in order to check inflation however for all this there must be adequate amount of securities i.e., the total amount of securities must form some considerable proportion of the total excessive cash reserves.


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4. Economic Climate :

The economic climate of the country also determines the effectiveness of Open Market Operations.


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5. Willingness of Borrowers :The investors and borrowers attitude

is an important factor that can disturb the central bank plans based on open market operations. If the borrowers are discouraged and disappointed and they have become pessimist about future then they will not like to borrow or to make investment.



6. Willingness of Bankers :The banker’s attitude also plays a role

in deciding the fate of open market operations.

7. Borrowings of Central Bank:The borrowings of the central bank

neutralise the effects of open market operations.


Open Market Operations with Reference to Pakistan

In Pakistan the money and capital markets are not fully developed. Open Market Operations are not widely used as a chief instrument of monetary policy. There have been sales and purchases of government securities by the central bank, but these were basically done to provide timely assistance to bank.


II. Bank Rate:

Bank rate is another quantitative tool of monetary policy. Bank rate is the rate at which central bank is willing to rediscount first class bills of exchange of commercial banks or is willing to advance loans against approved securities. This rate is also called discount rate.


Other Objectives:

1. To reduce consumption expenditure and to generate savings.2. To improve the country’s balance of payment position. This is done by encouraging the inflows of foreign funds and by restricting outflows.3. To reduce inflationary trends in the economy by reducing credit creating potential of commercial banks.


Assumptions & Limitations :

1. Development of Capital and Money Markets2. Availability of Bills3. Economic Climate

4. Borrower’s Attitude:If due to bright future prospects, the

borrowers and investors are determined to borrow, whatever the cost, then increase in bank rate is unlikely to contract the supply of credit.


Assumptions & Limitations – cont’d

5. Lender’s Attitude:The lender’s attitude can also help or

hinder central bank to produce desire results. If following their own priorities, commercial banks keep on advancing loans despite higher bank rate then such a credit control policy will be a failure.



6. Absence of Excessive Cash Reserves:In order that bank rate policy be

effective and fruitful, commercial banks must not be maintaining excessive cash reserves with themselves. In such a case, they will have to rediscount bill of exchange whenever they feel need of extra reserves. Then they will be directly affected by the changes in the bank rate.



7. Relationship between Rates:For bank rate policy to be affective,

there must be active relation between inter bank rates and open market rates. If changes in discount rates and other inter bank rates brings any affect on open market rates then bank rate policy can’t be used as an effective weapon to curtail credit creating powers of commercial banks.


III. Cash Reserve Requirements :

It is a well known fact that every commercial bank is required to hold certain amount of cash reserves with the central bank. This amount is expressed as a certain percentage of banks time and demand liabilities. This percentage is called cash reserve ratio.


IV. Liquidity Ratio : The cash reserve requirements which are discussed above, is a part of the overall liquidity ratio. The liquidity ratio is defined as follows: It means the percentage of total demand and time liabilities which commercial banks must keep in the form of cash, gold or approved securities.


V. Special Deposits:

Meanings: Besides reserve requirements, the central bank may call additional reserve from commercial banks. Such deposits are called special deposits and they are expressed as a percentage of bank’s liabilities. These deposits are other than operational deposits and some interest is paid on these deposits.


Qualitative Tools:Quantitative weapons which have

been just discussed are of such nature that they cause affects the whole of banking system. They affect the whole economy without any distinction. Apart from these controls, there are some other weapons which can be used in such a way that only certain required sectors of the economy are affected. Such weapons are called selective or qualitative credit control weapons.


Qualitative Tools – cont’d

I. Credit Rationing:Central bank does so by rediscounting bills or by providing loans and funds. Credit rationing can be used to control credit supply. In this method, the central bank specifies a maximum limit to which it is prepared to accommodate commercial banks in financial pressure. Under this method central bank can adopt following ways.1. It can restrict the amount of loan that a commercial bank can obtain from central bank.2. It may refuse to rediscount bills beyond certain amount.



II. Credit Ceiling:Credit ceiling is another qualitative

credit control weapon. Under this central bank specifies the maximum supply of credit to the economy during a particular period.



III. Moral Persuasion:A friendly and polite type of credit

control is called moral persuasion. Here instead of specifying a particular limit and imposing penalties, central bank requests the commercial banks to follow the general monetary policy and credit control guidance.



IV. Direct Action:When the commercial banks continue to

avoid the instruction of central bank, the central bank can take direct action against them.

Through direct actions the central bank restricts commercial banks from expanding credit. Direct action can be taken in any of the following ways: Central bank may refuse to rediscount bills of

exchange of the defaulting commercial banks. Or it may not provide direct financial assistance, advances and loans to such commercial banks which do not follow the general monetary policy. 38


V. Advertisement:From time to time for general as well

as for specific purposes, the central bank publicises the objectives and goals of monetary policy. This can also increase the efficiency of the whole banking and financial infrastructure.


Limitations of Monetary Policy

1. Absence of Developed Banking System:The monetary policy is effective only

when practised in a developed economy where money and capital markets are working efficiently.


Limitations of Monetary Policy – cont’d

2. Not Applicable for Foreign Banks:Another limitation is that central

bank can’t always exercise its extensive and special powers against all banks especially against foreign banks.



3. Conflicting Objectives:Sometimes the situation is such that

monetary policy is required to achieve two conflicting objectives. For instance if an underdeveloped country is experiencing high rate of inflation then economic development and price stability both are needed at the same moment.



4. Large-Scale Deficit Financing:Monetary policy is also affected by the

size of the Public Sectors, Borrowing Requirements (PSBR) or by Public Sector Debt Repayment (PSDR). Where the government is borrowing heavily and running a budget deficit, monetary policy will find it difficult to achieve the objective of controlling credit in the economy.



5. Position of Bank Reserve:If commercial banks are holding

excessive amount of reserves with themselves then monetary policy can’t effectively work.



6. Economic Situation:Economic situation also determines the

success of monetary policy. If monetary situation is stable and businessman is optimistic about the future, he will continue to borrow from banks despite the high cost of borrowing.


Establishment, Management & Functions of the State

Bank of Pakistan

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Establishment, Management & Functionsof the State Bank of Pakistan

1. The History: The Reserve Bank of India was directed to perform all functions of the Central Bank of Pakistan until Sep. 1948.

The Reserve Bank of India to be the sole currency note issuing authority for Pakistan until Sep. 1948.

(cont’d)47Prof. Riaz Ahmed Mian, HCBF, University of the Punjab

The History – cont’d

The Indian currency notes will be valid and they will remain legal tender in Pakistan until Sep. 30, 1948. The Pakistan government will issue its own currency from Oct. 1, 1948.

The Indian coins will be valid and they will remain legal tender in Pakistan for at least one year from the date of issuances of Pakistani coins. The Pakistan government will issue its own coins from Oct. 1, 1948.


The History – cont’d

The Reserve Bank of India will transfer the Pakistan’s share of 75 crore to Govt. of Pakistan till Sep. 30, 1948.


Establishment of the State Bank of Pakistan

On Dec. 30, 1948 the British Government's commission distributed the Bank of India's reserves between Pakistan and India as 30 percent for Pakistan and 70 percent for India. The share of Pakistan was Rs. 75 crore. Irrespective of the provisions of the Monetary system and Reserve Bank Order 1947.

(cont’d)


Establishment of the State Bank of Pakistan – cont’d

The Reserve Bank of India did not perform its function with diligence and good faith for Pakistan. Also this Bank refused to transfer Rs.550 million which Pakistan was entitled to receive as the proportionate share of assets of undivided India. Further the losses incurred in the transition to independence which were amounting to Rs. 23 crore were taken from Pakistan's share.

(cont’d)


Establishment of the State Bank of Pakistan – cont’d

Governor General of Pakistan Quaid-e-Azam Muhammad Ali Jinnah issued the order of the establishment of SBP on 12May, 1948.

This order is known as the “State Bank of Pakistan Order, 1948” and under this order the SBP started its operations on July 1, 1948.


Objectives (Under 1948 Order)

“Regulating the issue of bank currency notes and keeping the reserves with the view to securing monetary stability in Pakistan and generally to operate the currency and credit system of the country to its advantage.”

(cont’d)


Objectives (Under 1948 Order) – cont’d

“Regulate the monetary and credit system of Pakistan and to foster its growth in the best national interest with the view to securing monetary stability and the fuller utilisation of the countries productive resources.”

So the SBP has twofold objectives i.e., issuance of the currency notes and the advanced objective of leading the country towards development and prosperity.


The Laws Governing SBP

The powers, functions, operations and administration of the SBP are governed and directed by the SBP Act, 1956 and the Banking Companies Ordinance 1962.

(cont’d)


The Laws Governing SBP – cont’d

Functions / Role of the SBP

1. Issue of Currency NotesCurrency Note Issue Offices:The SBP has 3 offices of currency notes

issue situated at Karachi, Lahore and Peshawar. Apart from this currency chests are situated all over the country. The currency chests remain in the custody of the National Bank of Pakistan or the Treasury Officers.


Functions / Role of the SBP – cont’d

2. Banker to the Government

3. Banker’s Bank



4. SBP as Clearing House By acting as a clearing house the

SBP / NIFT introduces flexibility in the banking operations and also remains informed about the liquidity position of various banks.

SBP / NIFT helps commercial banks to settle inter-bank transactions with the minimum use of cash.


SBP as Clearing House – cont’d

By acting as a clearing house, SBP / NIFT also keeps a check on unwanted and harmful competition among commercial banks.

The clearing house function of the SBP also helps the commercial banks, in times of need and crisis. They can help one another by deferring early payments.



5. Advisor to Government6. Lender of Last Resort

7. SBP as Controller of Credit1. Open Market Operations2. Bank Rate Policy3. Changes in Reserves Ratio4. Changes in Margin Requirements5. Change in Liquidity Ratio6. Moral Persuasion7. PublicityAlso in 1972, a National Credit Consultative Council (NCCC) was setup for the purpose of monitoring and controlling credit. 60

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