Rakesh Mohan: Monetary policy and exchange rate frameworks - the Indian
experience
Presentation by Mr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the Second
High Level Seminar on Asian Financial Integration organised by the International Monetary Fund and
Monetary Authority of Singapore, Singapore, 25 May 2006.
The assistance of Michael Patra, Himanshu Joshi, Rajib Das and Partha Ray in preparation of the address is gratefully
acknowledged.
The references for this speech can be found on the Reserve Bank of India's website www.rbi.org.in.
* * *
I would like to congratulate the International Monetary Fund and Monetary Authority of Singapore for
holding this Second High Level Seminar on Asian Financial Integration. This forum provides a good
opportunity for all of us to exchange notes, ideas and views on the continuously evolving texture of the
international financial architecture, particular as it affects Asia and as Asian financial growth itself
impacts the rest of the world. The international financial landscape today is clearly much more
complex than it has been in previous decades. In each of our countries monetary policy making has
become a delicate balancing act between the imperatives of domestic economic, financial and
monetary concerns and the evolving international situation that we have to observe closely on a real
time basis and to take it as a given. The rapid changes that technological change, financial innovation
and globalisation have brought to financial markets are also forces at work that have to be taken
account of. We are all living through interesting times, but our job as central bankers is perhaps to
make the world less interesting through the implementation of policies that ensure monetary and
financial stability!
Indian economic reforms that have been in process now for a decade and a half seem to have
propelled us to a higher growth path of 8 per cent plus GDP growth. Our challenge in monetary policy
making now is to ensure that such a growth path can be preserved, or further accelerated, while we
provide a macro-economic environment that is characterised by monetary, price and financial stability.
As I will document further, among the changes that we have gone through in the last decade and a
half, a key transformation is the increasing openness of the Indian economy. Within that, our economic
relationships with the rest of Asia are also intensifying through sustained expansion in trade and
hence in financial relationships as well. Given the emerging economic demographics in the world, and
the shifting economic weight towards Asia, we are very conscious of the need for increasing
integration in Asia and how our own role will evolve in the coming years.
Each of the Asian countries has experienced significant changes in the operation of monetary policy in
an open economy framework in recent years. Whereas we do face many similar problems, particularly
through the impact of international developments such as the international crude oil price hikes,
domestic developments continue to carry greater weight in most of our economies in our monetary
and macro-economic management approaches. I, therefore, thought that the best thing that I can do
today to facilitate discussion is to provide a brief description and evaluation of India's experience as
we have implemented significant structural changes in the framework of monetary and exchange rate
management in an increasingly market oriented and open economy.
I. Changes in the monetary policy framework
In the aftermath of a balance of payments crisis in 1991, stabilization was undertaken simultaneously
with structural reforms over wide areas of the Indian economy. This dramatic change in context
fundamentally altered the manner in which monetary policy began to be formulated.
First, given the reality of multiple goals assigned to the monetary authority, the achievement of
macroeconomic and price stability received greater emphasis. Thus the overall objective has had to be
approached in a flexible and time variant manner with a continuous rebalancing of priority between
growth and price stability, depending on underlying macroeconomic and financial conditions. As we
observed the severe costs of financial instability elsewhere, financial stability has ascended the
hierarchy of monetary policy objectives since the second half of the 1990s. Strong synergies and
complementarities are observed between price stability and financial stability in India. Accordingly, we
believe that regulation, supervision and development of the financial system remain within the
legitimate ambit of monetary policy broadly interpreted.
Second, the operating framework of monetary policy underwent a transformation during the 1990s. A
variety of administered interventions in interest rates and bank credit flow characteristic of the 1970s
and 1980s gave way in the early 1990s to a brief period of broad monetary policy rules or 'monetary
targeting with feedback'. From the second half of the 1990s, the Reserve Bank of India (RBI) switched
to a multiple indicator approach in which high frequency and low frequency indicators are tracked and
the information used to draw policy perspectives.
Third, the growing market orientation of monetary policy has tilted the choice of instruments decisively
from direct to more indirect and market-based monetary policy measures. On the eve of reforms,
statutory pre-emptions in the form of cash reserve ratio (CRR) and statutory liquidity ratio (SLR)
requirements locked away nearly 70 per cent of bank deposits, severely eroding the profitability of the
financial system and effectiveness of monetary policy. The SLR was brought down from 38.5 per cent
of net demand and time liabilities (NDTL) in early 1992 to 25 per cent in mid -1994. The CRR has
been progressively reduced to 5 per cent from 15 per cent in 1991.
Fourth, interest rate deregulation was initiated across different segments. In September 1990, all
sector-specific and use specific interest rate prescriptions were abolished except for loans below
Rs.200,000 which were subject to a minimum rate prescription. In October 1994, the minimum rate
prescription was withdrawn and the lending rates of banks were made free subject to the setting of the
prime lending rate (PLR). In 2003, banks were advised to announce a benchmark PLR to
transparently reflect actual cost of funds. At present, banks enjoy the flexibility of pricing loans and
advances using market benchmarks and time varying spreads in an objective and transparent manner.
Interest rates on a number of loans and advances, including advances for acquiring residential
properties, purchase of consumer durables and the like are determined without reference to the
benchmark PLR. Although, savings bank deposit rates continue to be regulated, by 1995, rates on
term deposits with maturities of over two years were freed. In the following year, rates on deposits of
over one year maturity were freed. By October 1997, the ceiling on rates on deposits of thirty days to
one year maturity period was removed. Currently, deposit rates for all maturity are free and the
minimum maturity period for term deposits has been reduced to 7 days by 2004. Banks can offer
differential rates of interest on wholesale domestic term deposits different from those offered on the
retail domestic term deposits. Interest rate ceilings on export credit in foreign currency and
nonresident deposits are prescribed but they are transparently linked to international interest rates. The
Reserve Bank provides information on its website on the range of deposit rates and lending rates.
We, thus, made a carefully calibrated transition from an administered interest rate regime to one of
market determined interest rates over a period of time, while minimising disruption and preserving
financial stability. This approach also provided market participants adequate time to adjust to the new
regime.
Interest rate deregulation is essential to smoothen the transmission channels of monetary policy and
enhance the signaling effects of policy changes. However, some rigidities remain in certain segments
hindering the overall efficiency of interest rates in resource allocation. In this context, administered
interest rates fixed by the Government on a number of small saving schemes and provident funds is of
special relevance as they generally offer a rate higher than corresponding instruments available in the
market as well as tax incentives. As banks have to compete for funds with small saving schemes, the
rates offered on long-term deposits mobilized by banks set the floor for lending rates at a level higher
than would have obtained under competitive market conditions. In fact, this has been observed to be a
factor contributing to downward stickiness of lending rates, which has some implications for the
effectiveness of monetary policy. This is a reality that we have to appreciate and live with given the
absence of social security coverage and adequate safety nets in the country. These small savings
schemes administered by the government through the wide reach of post offices, and some through
commercial banks, provide small savers access tax savings instruments that are seen as safe and
stable. Whereas they do have some impact in terms of blunting monetary transmission mechanisms,
they can perhaps be seen as contributing to overall financial stability. Benchmarking these
administered interest rates to market determined rates has been proposed from time to time. Whereas
some rationalisation in schemes has indeed been done, more progress will depend on the emergence
of better social security and pension systems, and perhaps easier access to marketable sovereign
instruments.
Finally, all sector-specific refinance facilities have been phased out except export credit refinance. A
liquidity adjustment facility (LAF) consisting of repo / reverse repo in government securities has
emerged since June 2000 as the main operating instrument of monetary policy. The LAF serves two
objectives. First, it has provided greater flexibility in addressing day-to-day liquidity mismatches.
Second, it sets a corridor for overnight market interest rates, imparting stability in the market. The LAF
rates serve as tools for liquidity management as well as signalling of interest rates. The effectiveness
of LAF has has perceptibly improved the efficacy of monetary policy transmission.
The evolution of autonomous monetary policy in the 1990s also depended on the effective removal of
fiscal dominance that had existed earlier through the automatic monetisation of fiscal deficits. Over the
period 1994-97, this subvention was phased out by agreement between the government and the RBI,
marking a unique milestone in monetary-fiscal coordination. Another important institutional change
was the freeing of the RBI's balance sheet from the burden of exchange guarantees accumulated in
the pre-reform era.
Legislative amendments have been carried out, first in 2000 and now in 2006, to strengthen RBI's
regulatory jurisdiction over financial markets in terms of the operations of the forex, money and
government securities markets. These legislative changes are expected to empower the RBI in terms
of instrument independence and hence the effectiveness of monetary policy. In terms of process, we
are also proceeding towards greater transparency and consultation, while increasing the frequency of
policy reviews from semi-annual to quarterly. Alongside this enhancement in accountability we are
also attempting greater transparency in communicating monetary policy. Going forward, the key issue,
given the institutional empowerment, is the speed and quality of the transmission of monetary policy
impulses. This is the subject matter of the following section.
II. Monetary transmission
Consistent with these structural changes in the monetary policy framework, improvements in the
channels of transmission emerged early on as a concurrent objective in order to enhance policy
effectiveness. Accordingly, the RBI simultaneously undertook the development of the domestic
financial market spectrum, sequenced into the process of deregulation of interest rates, the withdrawal
of statutory pre-emptions, the qualitative improvement in monetary-fiscal coordination and the
progressive liberalisation of the exchange and payments regime, including the institution of a market
oriented exchange rate policy. The development of financial markets in India encompassed the
introduction of new market segments, new instruments and a sharper focus on regulatory oversight.
The Indian money market was fairly underdeveloped till the mid-1980s; dominated by the overnight
segment with a narrow base, limited number of participants and administered interest rates since
December 1973. In 1987, participation was widened on the lending side and institutions were set up
as market makers for the orderly development of the market. Select institutions were allowed to
borrow from the money market on a term basis and the ceiling on interest rates was withdrawn in
1989. New instruments like Certificates of Deposit (CDs) and Commercial Paper (CP) were introduced
in 1989 and 1990 and interest rates on money market instruments became progressively market
determined. In 1998, the RBI initiated a process of developing the overnight money market into a pure
interbank market. The phasing out of non-banks from the money market was sequenced over the
period 2000-05. Non-banks (except PDs who are allowed to operate in the overnight market) have
largely migrated to the new collateralised markets which were developed in consonance. Non-banks
can now take recourse to collateralised repos outside the RBI for purposes of borrowing and lending of
funds. An innovative money market instrument called the Collateralised Borrowing and Lending
Obligation (CBLO) was introduced in January 2003, which provides investors the benefit of
guaranteed settlement and an exit option before maturity. Trading volumes in the collateralised money
markets have increased substantially. Technological upgradation has accompanied the development
of the money market. Efforts are currently underway to introduce screen-based negotiated
quotedriven dealings in call/notice and term money markets. Information on overnight rates and volumes
would be disseminated by the RBI in order to enable market participants to assess the liquidity
conditions in an efficient and transparent manner.
The Indian foreign exchange market has been widened and deepened with the transition to a
marketdetermined exchange rate system in March 1993 and the subsequent liberalisation of restrictions on
various external transactions leading up to current account convertibility under Article VIII of the
Articles of Agreement of the International Monetary Fund in 1994. Since the mid-1990s, banks and
other authorised entities have been accorded significant freedom to operate in the market. Banks have
been allowed freedom to fix their trading limits and to borrow and invest funds in the overseas markets
up to specified limits. They have been allowed to use derivative products for hedging risks and
assetliability management purposes. Similarly, corporates have been given flexibility to book forward cover
based on past turnover and are allowed to use a variety of instruments like interest rates and currency
swaps, caps/collars and forward rate agreements. The swap market for hedging longer-term exposure
has developed substantially in recent years. A number of steps have also been taken to liberalise the
capital account covering foreign direct investment, portfolio investment, outward investment including
direct investment as well as depository receipt and convertible bonds, opening of Indian corporate
offices abroad and the like. In recent years, the Reserve Bank has delegated exchange control
procedures to banks and authorised dealers to such an extent that there is hardly any need to
approach the Reserve Bank for any approval. These reforms are being reflected in vibrancy in activity
in various segments of the foreign exchange market with the daily turnover over US $33 billion (as at
the end of April 2006).
The government securities market was moved to an auction-based system in 1992 to obtain better
price discovery and to impart greater transparency in operations. This was a major institutional change
which, along with the freeing of the money and foreign exchange market and the phasing out of
automatic monetisation of fiscal deficits, created a conducive environment for the progressive
deregulation that was to follow. The setting up of well capitalised Primary Dealers (PDs) for dealing in
Government securities followed in 1995, backed up by the introduction of Delivery versus Payment
(DvP) for Government securities, adoption of new techniques of floatation, introduction of new
instruments, particularly Treasury Bills of varying maturities and repos on all Central Government
dated securities and Treasury Bills of all maturities by April 1997.
It may be mentioned that since April 1992, the entire Central Government borrowing programme in
dated securities has been conducted through auctions. In 2005 the Reserve Bank has put in place an
anonymous order matching system to improve price discovery, and settlement procedures for
mitigating risks. To further activate trading and improve the depth of the securities market, the
introduction of a "when issued" market has also been announced recently. All these measures have
brought about significant changes and a new treasury culture is developing, contributing to the
formation of the term structure of interest rates. The demand for government securities is now driven
more by considerations of effective management of liquidity rather than by statutory liquidity
requirements. Efforts are being made to improve the retail holding of government securities since the
Government securities market still lacks in depth and is dominated by banks and financial institutions
often exhibiting uni-directional perceptions about liquidity. To attract retail participation in government
securities market, one of the foremost tasks ahead is to create an environment that provides a safe
and secure investment avenue for small investors with adequate returns and liquidity. In this context,
the RBI is emphasising the provision of demat holding facility for non-institutional retail/small investors
for risk mitigation in scrip losses or settlement of deals in the secondary market. Non-competitive
bidding has also been introduced since January 2002 for direct access to the primary issues for
nonsophisticated investors.
The corporate debt market in India has been in existence since independence in 1947. It was only
since the mid - 1980s, however, that state owned public enterprises (PSUs) began issuing bonds. In
the absence of a well functioning secondary market, such debt instruments have remained highly
illiquid and unpopular among the investing population at large. Corporates continue to prefer private
placements to public issues for raising resources. The dominance of private placement can be
attributed to several factors, viz., ease of procedures and operation of private placement, considerably
higher costs of public issues, and higher subscriptions for private placements. Financial institutions
have tended to dominate public issues in the primary corporate debt market. The secondary market for
corporate debt has suffered from lack of market making resulting in poor liquidity, and a tendency on
the part of institutional investors to hold securities to maturity and consequent reduction in market
supply of securities.
Several measures have been taken in the recent past to transform the corporate debt market in India.
Some of these measures include de-materialisation and electronic transfer of securities, rolling
settlement, introduction of sophisticated risk management, trading and settlement systems. Towards
the end of 2003, steps were also taken to reform the private placement market. All these measures
are expected to improve the functioning of the corporate debt market in India. It needs to be
recognised, however, that it has been difficult to develop the corporate bond market everywhere. Just
under half the world's corporate bond market is in the US, and another 15 per cent in Japan. Among
other countries, the UK has a long standing bond market, but the European one is still developing.
Among developing countries, it is perhaps only South Korea that has a reasonably well developed
bond market. The corporate debt market in India has a large potential to raise resources particularly
for infrastructure projects, housing and for corporate and municipal needs. Appropriate institutional
processes, development of various market segments including for mortgage - backed securities and
bond insurance institutions for credit enhancement, easing cost and abridgment of disclosure
requirements for listed companies, rating requirements for unlisted companies, a suitable framework
for market making, consolidation, centralized data base on primary issues for wider public information,
real time trade reporting system for dissemination of information, access to RTGS and state of the art
technology would provide a strong impetus for corporate bond markets to grow in India.
A key area of emphasis in the development of financial markets in India is the provision of the
appropriate technological infrastructure for trading, clearing, payment and settlement. Since the late
1990s, the establishment of a modern, robust payments and settlement system consistent with
international best practices has emerged as an important objective of the RBI. A three-pronged
strategy of consolidation, development and integration is pursued in this regard. Consolidation
revolves around strengthening the existing payment system by providing the latest levels of
technology. The developmental dimension includes real time gross settlement, centralised funds
management, securities settlement and structured financial messaging. Other key elements in the
technological content of market development are electronic clearing (introduced in 1994), electronic
finds transfer (1996), quick funds transfers with centralized settlement in Mumbai (2003), negotiated
dealing system (NDS), screen based order matching system (2002) for electronic reporting of trades
and online dissemination system and submission of bids for primary issuance of government securities
and a Clearing Corporation of India Ltd. (CCIL), promoted by banks, financial institutions and primary
dealers for clearing and settlement of trades in foreign exchange, government securities and other
debt instruments, commenced operations in April 2001. The CCIL acts as a central counterparty
(CCP) to all transactions and guarantees settlement of trades executed through its rules and
regulations eliminating counterparty risks in adherence to international best practices. Oversight over
the payments and settlement system is vested in a National Payments Council, and Board for
Payment and Settlement Systems established within the RBI.
As may be seen from this brief description of the various measures that had to be taken to develop the
market and institutional framework for efficient monetary policy transmission, development of markets
is an arduous and time consuming activity that requires conscious policy making and implementation.
Markets do not develop and function overnight: they have to be created, nurtured and monitored on a
continuous basis before they start functioning autonomously.
III. Exchange rate management
The regime shift in the conduct of exchange rate management in India that occurred in the early 1990s
had a significant impact on the monetary policy framework. Coincidentally, the 1990s were
characterised by bouts of currency turmoil and contagious financial crises in many parts of the world,
developing, transitional and developed alike. Monetary policy became increasingly complex. For the
majority of developing countries, including those in the Asian region, which continue to depend on
export performance, appropriate exchange rate determination is of great importance as volatility
imposes significant real effects in terms of fluctuations in employment and output and the distribution
of activity between tradeables and non-tradeables, fluctuations that are difficult to absorb in such
economies. In the fiercely competitive trading environment where countries seek to expand market
shares aggressively by fiercely compressing margins, volatility in the exchange rate can easily
translate ex ante profits into ex post losses along with the deleterious collateral impact on employment
and economic welfare. The determinants of exchange rate behaviour however, seem to have altered
dramatically. Earlier, factors related to changes in merchandise trade flows and the behaviour of
commodity price inflation were well understood and provided guidance for operating monetary policy.
In this environment, monetary policy principally targeting low inflation was consistent with exchange
rate changes under purchasing power parity. These traditional anchors of understanding have been
swept away by the vicissitudes of capital movements, with currencies often moving far out of
alignment of the traditional fundamentals. Moreover, it now appears that expectations and even
momentary reactions to the day's news are often more important in determining fluctuations in capital
flows and hence it serves to amplify exchange rates volatility.
Furthermore, the liquidity impact of capital flows has become an even more important problem for
monetary management than it was the case hitherto. The globalisation of financial markets, even if
imperfect, has now magnified the impact of monetary policy actions taken in one country on others.
The policy accommodation pursued until recently by the US had a global impact, affecting the rest of
the world with an abundance of liquidity. Low interest rates in the US have encouraged capital to flow
into emerging market economies. This has resulted in a large build-up of foreign exchange reserves
and excessive domestic liquidity in many countries in Asia, amplifying the Fed's policy stance.
Complicating the environment of monetary and exchange rate management further, there is now
increasing evidence that exchange rate pass-through to domestic inflation has tended to decline from
the 1990s across a number of countries. Inflation has turned out to be much less sensitive to
exchange rates but has tended to equilibrate around the globe (Mohan, 2005).
In India, the exchange rate regime up to 1990 is best described as an adjustable nominal peg to a
basket of currencies of major trading partners with a band. After the balance of payment crisis of 1991
a two-step downward adjustment in the exchange rate was undertaken in July 1991 and then followed
by a transitional 11-month period of dual exchange rates before a market-determined exchange rate
system was set in place in March, 1993. Since then, the exchange rate is largely determined by
demand and supply conditions in the market. The exchange rate policy in recent years has been
guided by the broad principles of careful monitoring and management of exchange rates with flexibility,
without a fixed target or a pre-announced target or a band, while allowing the underlying demand and
supply conditions to determine the exchange rate movements over a period in an orderly way. Subject
to this predominant objective, the exchange rate policy is guided by the need to reduce excess
volatility, prevent the emergence of destabilising speculative activities, help maintain adequate level of
reserves, and develop an orderly foreign exchange market. The Indian market, like other developing
countries markets, is not yet very deep and broad, and can sometimes be characterised by uneven
flow of demand and supply over different periods. In this situation, the Reserve Bank of India has been
prepared to make sales and purchases of foreign currency in order to even out lumpy demand and
supply in the relatively thin forex market and to smoothen jerky movements. However, such
intervention is not governed by a predetermined target or band around the exchange rate. As the
foreign exchange exposure of the Indian economy expands, the role of such uneven demands can be
seen to reduce. While it is not possible for any country to remain completely unaffected by
developments in the international exchange markets, fortunately we were able to keep the spillover
effects of the Asian crisis to a minimum through constant monitoring and timely action, including
recourse to strong monetary measures, when necessary, to prevent the emergence of self-fulfilling
speculative activities (Mohan, 2005).
The experience with capital flows has important lessons for the choice of the exchange rate regime.
The advocacy for corner solutions - a fixed peg without monetary policy independence or a freely
floating exchange rate retaining discretionary conduct of monetary policy - is distinctly on the decline.
The weight of experience seems to be tilting in favour of intermediate regimes with country-specific
features, without targets for the level of the exchange rate and exchange market interventions to fight
extreme market turbulence. In general, emerging market economies have accumulated massive
foreign exchange reserves as a circuit breaker for situations where unidirectional expectations become
self-fulfilling.
Recent information suggests that India's integration with the world economy is getting stronger, with
plus
implications for the conduct of exchange rate policies in the future. Trade in goods (i.e., exports
imports) as a proportion of GDP increased from 14.6 per cent in 1990-91 to 28.9 per cent in 2004-05;
while gross current account receipts and payments as percentage of GDP increased from 19.4 per
cent to 45.0 per cent over the same period, reflecting the growth in buoyant Indian trade in services.
plus
Correspondingly, in the capital account, gross flows (total inflows outflows) have doubled as a
proportion of GDP: from 12 per cent in 1990-91 to 24 per cent (US$ 167 billion) in 2004-05. Thus, the
Indian economy is substantially exposed to the international economy and hence increasingly subject
to the vicissitudes of international financial developments. There is also growing evidence pointing to a
distinct strengthening of India's balance of payments, benefiting from the equilibrating properties of a
more flexible exchange rate regime. Recent developments in the balance of payments seem to
indicate that the Indian economy is entering an expansionary phase of the business cycle. A
noteworthy feature is the re-emergence of a current account deficit (CAD) since 2004-05 after a hiatus
of three years of surpluses, preceded by a decade of CADs averaging 1 per cent of GDP. Oil imports,
which account for about a quarter of total imports, have recorded high growth rates and contributed 47
per cent to the change in the current account deficit in 2004-05 over the previous year. The elevated
levels of international crude prices that rule currently have affected countries across the globe and
India has been no exception. Apart from the impact of high crude oil price, the significant growth in
merchandise trade deficit in 2004-05 and 2005-06 was also caused by the sizeable growth in non-oil
goods imports, emanating from capital goods, export-related inputs and a range of intermediate goods
all of which have an intrinsic growth linked character. Besides, the large expansion in imports is also
spurring vigorous export growth. In this sense, the merchandise trade deficit has acquired a growth
leading dimension and is thus a positive feature of the Indian economy.
As the current account deficit widens, and we contribute to the unwinding of global imbalances at the
margin, we have to give consideration to the sustainable magnitude of the current account deficit. This
sustainability depends on the perceived stability of capital flows which, in turn, would be dependent on
the assessment of growth prospects of the economy by foreign lenders and investors. Whereas it is
understood that a more open economy that has access to international capital flows can run a higher
current account deficit than a less open one, our approach to this issue will remain informed by
appropriate caution in the interest of financial stability. The acceleration in overall growth and the
reemergence of current account deficit since 2004-05 has been accompanied by a greater degree of
openness. The