Mr Reddy discusses monetary policy in India  (Central Bank Articles and Speeches, 26 May 1999)
Central bank: rbi | Type: speech | Date: 1999-05-26

## Mr Reddy discusses monetary policy in IndiaSpeech

by Y.V.

Reddy, Deputy Governor of the Reserve Bank of India, at the Fourth Secu Industry Summit, in Mumbai, India on 26 May 1999.

## Chairman and friends,I thank the organisers for inviting me to deliver the inaugural address at the Fourth Annua Industry Summit.

Although the discussions in this Summit will specifically veer around the market, monetary policy strongly influences the working of the financial markets.

As a centr I will, therefore, speak on monetary policy making, which I trust will provide some perspect deliberations at the Summit.

## ObjectivesIn India, monetary policy has always emphasised the objectives of price stability and gro this,

in effect, has meant in practical policy setting is, formulating a balance betw objectives depending on the evolving situation but within the broad context of keeping th rate within a reasonable bound.Apart from these two important goals, there has been a conscious attempt on the part of th Bank in recent years to maintain orderly conditions in the foreign exchange market, and destabilising and self-fulfilling speculative activities.

This has assumed strategic impor sustainability of the external sector in the face of growing cross border capital flo economy.

With the increasing order of domestic and international financial integration, exc expectations do impact on the domestic stance of monetary policy and hence the signific inflation.

In the transitional phase, however, given the exchange market imperfections, th rate objective may occasionally predominate due to emphasis on avoidance of undue volati fact, sometimes, as was the case recently, it could be the most dominant reason for s monetary policy adjustments.In a broader framework, the objectives of monetary policy in India continue to be price st growth.

These are pursued inter alia through ensuring credit availability, with stability i value of the rupee as well as overall financial stability, all being reflective of pursui objectives.

The relative emphasis among the objectives is governed by the prevailing circums

## TargetsThe conduct of monetary policy in India has traditionally proceeded with the help of an in target, which the central bank could influence directly and which bears a reasonably close r with

the ultimate objectives.

The particular mode of central bank intervention is the instrument.

Macro-economic variables, which post useful information about the objecti monetary policy, although they may not in themselves be amenable to central bank targeti 'indicators' or 'information' variables.The Reserve Bank of India (RBI) sets indicative broad money (M3) expansion targets in line expected rate of growth of GDP and a tolerable level of inflation.

Consistent with the targ broad money expansion, is a desired level of reserve money expansion.

The order of the money expansion, however, has to be consistent with the likely fiscal and external payments since the main sources of reserve money expansion are net RBI credit to government and net exchange assets.

The targeted M3 expansion is publicly announced through the Governor's sta on monetary and credit policy.

The broad money target is also supported by a number ofindicators such as movement in interest rates, exchange rate and availability of credit to pro sectors of the economy.Monetary target is premised on a stable demand function for money.

In the Indian context, a num of earlier studies on the demand for money have demonstrated that it is stable.

Dr.Rangara demonstrated that money demand equations provide reasonable predictions of average changes in prices over a medium-term horizon of 4-5 years, though not necessarily on a year-to-year basis essence, the concern was with the long-run stability of the money demand function in terms of most proximate determinant, i.e. real GDP, rather than its short-term behaviour.

Most recent stud RBI examined the stability of the money demand equation using a number of alternative procedure While these tests showed parameter shifts, they did not point to parameter instability.

In the the monetary targets were set either as point targets or in a narrow range implying scope for m point targets, but it has to be recognised that a wider range would question the credibility, di very objective of targeting.The pressures on monetary expansion in the earlier part of targeting exercise emanated fr monetisation of fiscal deficit and later on from capital inflows.

During the period 1985-92, n credit to Central Government accounted for over 96 per cent of the monetary base, which was reduc to about 65 per cent in the subsequent period during 1993-98, with corresponding increase in foreign exchange assets of the RBI.Although the practice of automatic monetisation of the budgetary deficit was done away wit effective from April 1997, it can significantly reduce the pressure on monetisation only if the the Central Government's market borrowing programme is kept within reasonable limits.

However, there is a qualitative difference, since the RBI has some flexibility now in respect of the ext support to Government borrowing programme.With increasing market orientation of the financial structure and international capital flows, m policy responds to developments on an ongoing basis.

In an administered interest rate and excha rate regime, the quantity variables dominated and transmitted monetary policy impulses.

Howeve external and financial sector reforms have since enhanced the sensitiveness of quantity variab their market determined price, i.e. interest rate and exchange rate.It must be recognised that in recent times, the emphasis has also been on closely monitoring dif indicators apart from relying on the intermediate target.

For aiming at the intermediate targe broad money) the underlying operating target is reserve money, particularly the banks' reserves, the supplementary operating target is the short-term interest rate proxied generally by the ov call money rates.

## Operating Procedures and InstrumentsThe

reforms in the monetary and financial sectors have enabled the RBI to expand the array instruments at its command.

As already mentioned, the operational target of monetary poli continues to be banks' reserves which is controlled by changes in reserve requirements effe mainly through the instruments of cash reserve ratio (CRR).

However, the use of CRR as an instrument of monetary control is sought to be de-emphasised and the liquidity management in t system is increasingly undertaken through open market operations (OMO), both outright and repos.In view of the overall downward movement in CRR, except on occasions of exchange rate volatilit the excess liquidity in the system is mopped up by outright sales of government securities by Over the reform period, the market absorption of government securities was facilitated by reform the government securities market, which ensured market related rates of interest and thus some o basic conditions were provided for developing a secondary market.The short-term liquidity management is also aided by conduct of repos on a regular basis.

Us RBI conducts repos for a maturity of up to 14 days, which is the cycle for reserve req Recently, the RBI has been conducting 3-4 day fixed rate repos to absorb very short-term liq to even out money market rates, especially overnight call money rates.

The repo rates and th tendered in the repo auctions, apart from reflecting liquidity conditions, provide a f overnight call money rates.

In the event of tight liquidity conditions, the RBI' s liquid primary dealers (PDs) enables it to directly intervene in the market, thereby moderating p the overnight call money rates.The RBI also reactivated the Bank Rate in April 1997 as a reference rate and as a signallin reflect the stance of monetary policy.

The interest rates on different type accommodation RBI including refinance are linked to the Bank Rate.

The activation of the Bank Rate endo RBI with an additional instrument.

It must be noted that the announcement impact of Ban changes has been pronounced on the prime lending rates of commercial banks.The refinance window of the RBI provides an additional instrument for influencing reserve recently, the RBI provided two types of refinance facilities to banks - export credit re general refinance.

While the former facility is formula based and is extended to banks ag outstanding export credit eligible for refinance, the latter facility was provided to enabl over their temporary liquidity shortages.The general refinance window has since been replaced by a Collateralised Lending Facilit within the overall framework of an Interim Liquidity Adjustment Facility (ILAF).Currently, the liquidity management at the short end is in the form of ILAF.

Liquidity is the RBI through CLF to banks, export credit refinance to banks, and liquidity support to these facilities are available subject to quantitative limits [formula-based] for specified the Bank Rate.

Additional limits could be availed by banks under Additional Collateralised Facility (ACLF) and by PDs at two percentage points above the Bank Rate.

Absorption of li will continue to be through fixed rate repo i.e., at repo rate announced on a day to day bas supplemented by OMO in Government dated securities and Treasury Bills by the RBI.

OMO invol decisions by the RBI on a daily basis or even intra-day basis in regard to the quantities a yields at which the dated securities and Treasury Bills are operated upon.

It may be noted operations are in the given framework of the CRR that directly affects liquidity and the Often, the periodic Treasury bill auctions by RBI, themselves provide opportunities for t signal its overall stance on the appropriateness of interest rate and liquidity.Thus, the ILAF provides a mechanism by which liquidity would be injected at various intere and absorbed when necessary at the fixed repo rate, so that the volatility in the money minimised and the market operates within a reasonable range.At present, there is no formal corridor for market interest rates, but the Bank Rate often an upper bound and the fixed repo rate provided the lower bound.

In a sense, an informal exists for short-term interest rates and the introduction of ILAF has facilitated the evo corridor.The experience with the movements in the interest rates and exchange rate in the last two increasingly reflected the integration among various market segments.

The interest rates market instruments [91-day and 364-day Treasury Bills, Commercial Paper and Certifica Deposit] in recent period show some correlation with reasonable speed of adjustment, which well for some element of targeting of interest rates in the conduct of monetary policy.

## DilemmasMonetary management poses dilemmas not only at the analytical level but also at the operatio level.

In fact, some of these dilemmas have been articulated in the recent policy statemen Governor Bimal Jalan.First, the basic dilemma arises out of the trade off between growth and inflation.

Althou consensus has emerged on the basis of empirical evidence that in the long run there is no tra between employment and inflation, it is the inconclusive evidence in the short-run that pos challenge for monetary management.

Given the deleterious effects of inflation on distributio income, there is an imperative need in developing countries to keep the inflation rate as l possible.

In the last year's Economic Survey, it was stated that 'As world inflation rates are c of the order of 0 to 3 percent, 4 to 6 percent inflation rate could be regarded as an acceptable India at present.' This order of inflation has been, it may be noted, built into the monetary o framework of the RBI.Secondly, even a moderate inflation rate poses a dilemma in an open economy.

If the domesti inflation rate of an economy, however low it may be, is higher than the average inflation rate trading partners, it puts pressure on the exchange rate.

In this context, the question of simu balance of the internal and external sectors becomes a major issue.Thirdly, in a dynamic setting, when the financial markets are continually evolving, and paym systems and technology are changing, one may not find a clear cut evidence of stability in the m demand, which is taken as a basis for intermediate targeting; and in such circumstances, one nee look also at other relevant indicators.

It is not that such dilemmas are specific to us and by countries follow a menu approach or a 'check list' to track a number of relevant variables.Fourthly, the dilemma that the central bank faces as a manager of public debt and the monet authority is well known.

While the former may require keeping its cost low, the latter may deman reduction in the extent of government debt that it holds, considering the impact it has on agg expenditures and thus on demand.

The market-borrowing programme of the government is determined by the fiscal parameters, but the size of the government debt impacts on the interest rates economy and it should be clearly recognised that there is a limit to the extent of market bor that the central bank can support.

These dilemmas can be resolved through proper fiscal monetary ordination.Fifthly, the conflict between roles of the regulator/supervisor and as a conductor of the mo policy has often been discussed.

This is illustrated by the case of a central bank, as a m authority, which may require to reduce the liquidity in the system by raising the rate of inter such a rise in the rate of interest could be detrimental to the interests of the weak banks. while tightening prudential norms, the central bank has to take into account its impact on ba systems' capacity to intermediate credit.Finally, in an open economy, the potential conflict between the interest rate and exchange objectives could arise when short-term and volatile capital flows occur.

For example, the bou volatility in exchange rate experienced by us recently necessitated that market conditions are re less liquid even if it meant that the interest rates are kept high.

This policy has implica promoting domestic output growth in that the interest rates may for this purpose, be required kept at moderate levels.

But the larger objectives of evading the likely potential disrupt domestic activities arising out of an exchange rate crisis should also be kept in view.

## ConclusionAs part of financial sector reforms, a number of steps have been taken to enhance the effectiven monetary

policy, and these include, improvement in the payments and settlement systems, development of secondary market in government securities with a diversification of investor breduction in non-performing assets, introduction of ALM guidelines, and reduction in the transactions costs.

In particular, the recent initiatives of RBI to develop money marke markets should contribute to improving the transmission mechanisms of monetary policy.All the reforms in the monetary and financial sectors may not have the desired result credible fiscal adjustment.

Notwithstanding the discontinuation of automatic monetisation deficit, the responsibility for management of a large government borrowing programme circumscribe the manoeuvrability of monetary policy.