Duvvuri Subbarao: The Reserve Bank of India making a difference in
your daily life
Convocation address by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
Sambalpur University, Sambalpur, 24 February 2011.
* * *
First of all, my thanks to the Governor and Chancellor, HE Shri M.C. Bhandare, Vice
Chancellor Professor Pujari, faculty and students of Sambalpur University for inviting me to
be the convocation speaker this year. This is an honour to which I attach a lot of value. It
feels wonderful to be in this beautiful state of Orissa and in the bustling Sambalpur area.
Changes around the world
All of you young graduates, passing out with degrees today, are a delightful sight. My mind
goes back to my own college days. Of course, my time took place roughly half way between
the discovery of fire and the invention of the ipad!!! The world was, maybe a little bit different
then! Our phones still had cords, our cameras still had films and our engineers did
calculations using a slide rule. The only way we knew of sending mail was by sticking stamps
on an envelope; and the only way we knew of making copies was by using a carbon paper.
And if we wanted to look for the web, we didn't click on a mouse; we dusted in the corner.
The world, and with it India, have changed in the last few decades.
Orissa then and now
And changed for the better in many ways. Look at Orissa for instance. In 1970, Orissa's
literacy rate was just 26 per cent, way behind the country. Today, the literacy rate is close to
the national average of 65 per cent with an impressive jump in the female literacy rate. Child
mortality rate more than halved between 1970 and 2010, but it is still behind the national
average of 53 per thousand live births. There is significant progress on economic parameters
too. Following the familiar development trend over the last 40 years, the share of agriculture
in the gross state domestic product declined and that of industry had gone up. The average
population for bank branch declined from 110,000 in 1970 to the national average level of
14,000 in 2010. With only 8 per cent of its population living in towns and cities, Orissa was
the least urban state in India in 1970. Urbanization almost doubled in the next 40 years,
although it is still below the national average.
Today Orissa is among the most rapidly industrializing states in the country, with a number of
large, medium and small-scale enterprises in steel, aluminium, chrome, power, textile,
handicraft and a host of other sectors. Orissa is also attracting a lot of foreign investment,
and if harnessed in an eco-friendly way, this investment can contribute to job creation,
poverty reduction and inclusive growth.
Sambalpur university
How Orissa changed, and how India changed over the last four decades, is impressive. I
know that many of the alumni of Sambalpur University contributed to this remarkable
transformation. Some of my colleagues in the IAS studied here, and there are several staff
members of the Reserve Bank who are products of this university. So, let me congratulate all
of you in the graduating class of 2011 as you begin building a future for yourselves.
Making a difference
These momentous changes in our country between my time and your time, that I indicated
above, have affected almost every facet of our lives. But even in such flux, some things have
not changed - for example, the value system that should guide our living and thinking.
Today marks a milestone in your lives. You will be leaving the shelter of your homes and
your college to enter the real world as responsible adults. Whatever you choose to do for a
career, I am sure that your education here in Sambalpur University has equipped you to take
advantage of the opportunities, to meet the challenges that come your way. Whatever career
you decide to pursue, remember that you can and should "make a difference" to the society.
As I look back over the last 35 years when I have been in the civil service, I realize that our
collective wellbeing as a nation has been the result of the efforts by numerous individuals
and institutions that made a difference. And the only way you can repay your obligation to
society is in turn to make a difference.
"Making a difference" is indeed the focus of my speech here today. In particular, I want to tell
you how the Reserve Bank of India (RBI), an institution I have had the privilege of leading
over the last two and a half years, makes a difference to everyday lives of Indians.
RBI - a mysterious institution?
As I was preparing for this talk, it struck me that most people, even educated people, do not
know very much about what the Reserve Bank does and why what it does is important. Many
people think of the Reserve Bank as a mysterious institution, a sort of monolith - doing
obscure things that have no real relevance for the everyday lives of people. Others think that
all that the Reserve Bank does is print currency, and wonder why, when short of resources,
we don't just print more of the stuff. Some people think that all that the Governor does every
day in office is sign currency notes, and that if there is shortage of currency, it is because he
is slow in signing.
The reality is quite different. We print and distribute currency, of course, but we do a lot of
other things besides. We are the monetary authority of the country. We are the gatekeepers
of the external sector. We regulate and supervise banks, non-bank finance companies and
segments of the financial markets to ensure that the money you keep in banks is safe and is
productively deployed towards generating economic activity. Our regulation extends also to
the payment and settlement systems with the aim of making financial transactions safe,
robust and efficient. The Reserve Bank is also the central bank - that is it is the bank of
banks and the bank of the Government of India as well as of state governments. On top of all
this, and importantly, the Reserve Bank has a key role in the economic development of the
country and drives an impressive social development agenda.
That in a nutshell is the range and diversity of responsibilities of RBI. And what we do affects
the everyday lives of people across the country from the prices they pay in the market, the
interest they earn on their deposits in the bank, the interest that is charged when they borrow
money and indeed how the government pays for new roads, schools and hospitals. In my
remarks today, I will try and demystify the world of the Reserve Bank; I will explain some of
its main responsibilities, share with you some of the policy challenges we face, and convey to
you above all, how we try to make a difference.
Production and distribution of currency
Let me start with currency management - a function that most people are familiar with. An
exclusive prerogative to issue currency has in fact become a defining characteristic of central
banks. You must have noticed that the currency that you use has on it a promise by the
Governor of the Reserve Bank that says that the note that you are carrying is worth what it
says. Tautological as it might sound, this promise is significant because it enjoins on the
Reserve Bank the responsibility of preserving the value of the rupee.
An important issue we need to decide on is how much currency to print. We need to print
enough currency to replace soiled and mutilated notes. On top of that we also need to print
additional currency to meet the needs of economic growth. The currency expansion required
to support growth depends on a number of variables including the growth rate, inflation rate,
the growth elasticity of money and the velocity of money. This is a complex formula, but the
important point to understand is that the amount of currency we need to print is determined
by the replacement requirement and the economic growth requirement.
As much as the amount of currency to be printed is formula driven in the first instance, the
Reserve Bank cannot just "issue" currency. The currency we issue is a liability of the
Reserve Bank. It has, therefore, to be backed by assets. Earlier on, the Reserve Bank too
was part of the theology of the gold standard - the belief that issue of currency should be
backed by the gold holdings of the central bank. In fact, the original Reserve Bank Act
prescribed a proportional reserve system whereby of the total note issue, at least 40 per cent
was to be backed by gold bullion and sterling. Like other central banks, we too have moved
away from the gold standard, and today the asset backing for note issue comprises both
domestic and foreign securities including gold held by the Reserve Bank.
We have four presses where currency is printed. Two presses - one at Nasik in Maharashtra
and the other at Dewas in Madhya Pradesh are under the control of the Government; the
remaining two presses - at Mysore in Karnataka and at Salboni in West Bengal are under
the control of the Reserve Bank. The currency printed at these four presses is distributed
across the country through 20 of the Reserve Bank's regional offices and over 4200 currency
chests located in commercial banks across the country.
We are self-sufficient in printing capacity but we still import the paper required for printing
currency. To remedy this, we are setting up a state of the art banknote paper mill in Mysore
with a capacity 12000 MT per year which should cut our import demand by more than half.
By far the most important facet of currency management is building in security features to
prevent counterfeiting. People should be aware of these security features so that they can
tell a forged note from a genuine one. This is the motivation for the awareness campaign that
the Reserve Bank has launched in the print and electronic media to educate people on the
security features.
A dilemma we face here is that when we launch an awareness drive, we are willy-nilly
providing information also to counterfeiters. We resolve this issue by making the replication
of the security features technically complex and prohibitively expensive, and also by
incorporating some additional security features that can be detected only by sophisticated
gadgets and equipment.
The Reserve Bank is also committed to a "clean note" policy. We exchange soiled notes for
clean ones, and mutilated notes for new ones subject to certain conditions. In pursuit of our
clean note policy and to check counterfeiting, we also prescribed that, by March 31, 2011, all
bank branches with cash receipts of over 50 lakhs per day be equipped with a note sorting
machine so that every high denomination currency note is checked for fitness and
genuineness before being put back in circulation. Furthermore, we have instructed banks to
ensure that the notes that they issue through their ATMs are also pre-checked for
genuineness and cleanliness.
Cost and longevity are important dimensions of currency management. We are a large cash
economy; in fact, we are the second largest producer and consumer of currency in the world,
next only to China. Producing such a large amount of currency is expensive. One option for
economizing is replacing paper currency with plastic currency as some countries such as
Singapore and Australia have already done. We are planning to try this out on a pilot basis
starting with a plastic note in the 10 denomination, which we will distribute out of five of our
regional offices in the country including our Bhubaneswar office. During the pilot phase, we
need to study not only the relative costs but also the carbon footprint associated with the
recycling and disposal of plastic notes vis-à-vis paper notes. If the pilot proves successful,
we will mainstream the use of plastic currency.
Monetary policy
A quintessentially central banking function is the management of monetary policy. In
formulating the monetary policy, the Reserve Bank is guided by three main objectives:
maintain price stability, support economic growth by ensuring adequate flow of credit to
productive sectors and preserve financial stability. Monetary policy is typically operated
mainly through two variables - the price of money (policy interest rates) and the volume of
money (liquidity).
The Reserve Bank's monetary stance is defined by how we determine the price and volume
of money. We decide on the price of money by prescribing the short term policy interest rates
which define the upper and lower bands of the liquidity adjustment facility (LAF) corridor. At
the upper end is the repo rate - the rate of interest we charge banks for overnight borrowing
from us, and at the lower end is the reverse repo rate - the interest rate we pay banks for
their overnight deposits with us. By calibrating the overnight repo and reverse repo rates, we
hope to influence the long term interest rates of the economy through a process called
monetary transmission.
The other variable - the volume of money - is controlled through mainly two instruments.
The first is the cash reserve ratio (CRR), the proportion of their net demand and time
liabilities (NDTL) that banks are required to keep locked up with the Reserve Bank. The
second is the OMO (open market operations) whereby the Reserve Bank buys and sells
government securities in the open market in order to inject or withdraw money from the
system.
Another way in which money supply expands or contracts is through the Reserve Bank's
intervention in the foreign exchange market. When the Reserve Bank buys (sells) foreign
exchange, it releases (absorbs) an equivalent amount of liquidity into (from) the system.
Having said that I must add that we do not intervene in the forex market for liquidity
management purposes; we intervene only to contain volatility in the forex market, and any
impact on liquidity is an incidental by product.
Of course, price stability and macroeconomic stability do not necessarily guarantee financial
stability. This is, in fact, one of the big lessons of the recent crisis. A post-crisis policy
dilemma for central banks, and one that is dominating both academic and policy debates at
the international level, is this: should financial stability be in the domain of monetary policy or
should it be pursued as an objective of regulatory policy? In India though, we have never
been doctrinaire about this. We have traditionally used regulatory tools such as risk weights
and provisioning norms governing bank loans to aid monetary policy objectives. Indeed, one
of the main reasons India came out of the crisis relatively unscathed is that the Reserve
Bank "leaned against the wind" and took preemptive action to restrict the flow of credit to
certain sectors such as real estate which showed signs of risk build-up.
The Reserve Bank reviews its monetary policy stance every quarter through a scheduled
policy review. This involves determining the relative prioritization between the three
objectives of monetary policy - growth, price stability and financial stability - and on that
basis, to determine whether and how our policy variables should be changed.
Notwithstanding scheduled quarterly and mid-quarterly reviews, we reserve the right to alter
our policy stance at any time to respond to the evolving macroeconomic situation.
In the aftermath of the crisis, our biggest challenge has been to manage the tension between
the demands of growth and of inflation. Even though we recovered from the crisis ahead of
most other countries, inflation too caught up with us sooner than elsewhere. The tension that
we need to manage is that economic growth requires that we maintain a low interest rate
regime whereas inflation management warrants that we raise interest rates. In managing this
tension, we are deeply conscious that inflation is a regressive tax that hurts the poor the
most as their earnings are not protected against rising prices. You will of course have noted
that as part of managing our growth-inflation dynamics in the post-crisis period, the Reserve
Bank has raised policy interest rates seven times since March 2010. At the same time, we
are sensitive to the need for supporting growth as economic growth is a necessary condition
for poverty reduction.
Monetary policy making is always a challenge. The challenge has become even more
complex in the globalizing world that we live in. How other countries, especially systemically
important advanced economies, manage their monetary policies has implications for us and
we need to take that into account in determining our own policy stance. Just to illustrate, the
liquidity infusion policy of the US Fed, popularly known as quantitative easing (QE), has
triggered larger capital flows to emerging market economies (EMEs). This has in turn put
upward pressure on EME exchange rates eroding their export competitiveness and pushing
up asset prices. EMEs had to adjust their macroeconomic policies to manage the
implications of these flows.
I hope you now have a better understanding of the implications of the Reserve Bank's
monetary policy for you at an individual and household level, and of the challenges that we
address in formulating the policy.
Regulation and supervision
The Reserve Bank is the regulator and supervisor of banks, non-bank financial companies
(NBFCs) and significant parts of the financial markets. In a market system, regulation is
important in order to protect the interests of all stakeholders and to preserve financial
stability. Let me explain both these objectives of regulation.
The logic of protecting the interests of stakeholders is quite self-evident. Banks are the main
conduits of financial intermediation in an economy - that is, banks take money from savers
and lend it to borrowers keeping a margin for themselves to cover expenses and profits. This
should ideally serve everyone's interest including that of the economy at large. However, the
apprehension is that banks will overstep the limits of prudence in lending thereby
jeopardizing the interests of the depositors. The task of regulation in this context is to ensure
that banks stay within prudent limits in their financial intermediation role.
Regulation is necessary also to ensure financial stability. Financial stability is notoriously
difficult to define but we can easily tell when stability is disrupted, as happened during the
recent crisis when financial markets went into a seizure. Financial stability gets disrupted
when the fundamental macro variables such as the interest rate and the exchange rate get
way out of alignment with economic fundamentals. We have all learnt from text books that
the fundamental fulcrum of capitalism is a competitive market. We have also learnt that
markets fail because the assumptions underlying competitive markets are very exacting and
cannot be fully met in the real world. Financial markets are even more vulnerable to failure
than markets for goods and services because of problems of information asymmetry, moral
hazard, adverse selection and what have you. When financial markets fail, financial stability
is impaired, and when that happens, it takes a devastating toll on economic growth and
welfare. The purpose of regulation is to build in safeguards against failure of financial
institutions and financial markets.
Financial firms such as banks are different from non-financial firms, and financial markets are
different from non-financial markets. The important difference is that financial firms are all
interconnected, and a disruption in any one part of the system spreads rapidly through the
entire system. Illustratively, a run on one bank could potentially trigger a run on other banks
spreading and deepening the contagion. In contrast, the failure of a non-financial firm such
as a manufacturing company hurts the company's equity holders and creditors but does not
hurt people beyond that.
We conduct bank regulation through a whole host of prescriptions. These prescriptions
govern illustratively licencing of banks and their expansion through branch network, their
corporate governance framework, the reserves they must maintain with the Reserve Bank,
the type and quantum of capital they must hold and the way they must manage risk.
Although, I have explained the concept with reference to banks, it applies equally to
regulation of NBFCs, and other financial institutions.
To ensure that banks comply with our regulations, we undertake periodic on-site inspections
which are supplemented with off-site surveillance on an ongoing basis. We also hold periodic
meetings with the top managements of banks to alert them to the bank's vulnerabilities and
to sensitize them to our supervisory concerns. If the banks do not comply with the regulatory
norms, the Reserve Bank has a range of supervisory powers in its armory: issuing cautionary
letters and letters of displeasure, issuing directives to restrict business and imposition of
financial penalties.
The Reserve Bank is not the only regulator in the financial sector. There are other regulators
too - such as, for example, SEBI which regulates the capital market, IRDA which regulates
the insurance sector and the PFRDA which regulates the pension sector.
A frequently asked question is whether the Reserve Bank regulates the rate of interest that
must be paid on deposits or the interest that should be charged to borrowers. We used to do
that but have almost entirely given it up as part of the reform process. Interest rates both to
savers and borrowers now work on the market principle of competition among banks. As of
now, only interest rates on NRI deposits and on savings bank accounts are administered.
There is a view that we should deregulate the interest rate on savings bank accounts too. We
are examining the pros and cons of doing that and will shortly put out a Discussion Paper for
eliciting feedback.
Regulation has both costs and benefits. Excessive or inappropriate regulation increases
intermediation costs, impedes efficiency and stifles innovation. It can also result in regulatory
arbitrage whereby financial operators evade stiff regulation by shifting operations to a lightly
regulated regime. On the other hand, light regulation can cause financial instability and loss
to some stakeholders at the expense of others.
Financial regulation is an intensely analytical and intellectually challenging task. It requires
sophisticated models and a good "sense" of the market since many of the risk indicators are
not "real time". Regulators need to be intellectually agile and fastfooted in their responses.
The challenge for the Reserve Bank, and indeed for all financial sector regulators, is to
intelligently balance the costs and benefits of regulation and to do so in a dynamic sense as
the market and macroeconomic circumstances are constantly evolving.
External sector management
The Reserve Bank shares the responsibility for the management of the external sector with
the Government. The power for this is derived from the Foreign Exchange Management Act
(FEMA), 1999 which is a successor to the earlier Foreign Exchange Regulation Act (FERA),
1973.
Of all the different sectors of the economy, possibly the most extensive reforms have taken
place in the external sector. Prior to 1991, India was one of the most closed economies in the
world, and controls on foreign exchange transactions were near total. Today the situation is
completely different. Now there are virtually no restrictions on current account transactions.
Foreign exchange can easily be obtained for business expenses, travel, tourism, studies
abroad, medical treatment, etc. In the pre-reform era, a licence had to be obtained for almost
every type of import, and the import duties were prohibitive. Today, there are no quantitative
restrictions and duties have been substantially slashed.
Our liberalization has extended to the capital sector too. India's policy on foreign direct
investment (FDI) is quite liberal and transparent. We allow foreign investment in almost all
sectors except for a small negative list. Today, every resident Indian is allowed to take out up
to $200,000 per financial year for any permitted current or capital account transaction under
the Liberalized Remittance Scheme. Corporates can invest abroad up to 400 per cent of their
net worth in Joint Ventures and Wholly Owned Subsidiaries.
India runs a current account deficit which means that we spend more foreign money on
import of goods and services than we earn on exporting them. The gap between our
spending and our earning has to be met by capital flows - that is by foreign savings.
Development Economics says that it is alright for a developing economy to run a current
account deficit provided the foreign savings - capital flows - that bridge the deficit are used
productively. Capital flows come in various forms, and can be classified as debt or equity
flows or short term or long term flows. In India, we have a preference for non-debt flows such
as foreign equity over debt flows, and we have a preference for long-term flows such as
foreign direct investment over short-term flows such as foreign institutional investment.
An important problem, indeed one that is very prominent on the current international agenda,
is the surge of capital flows into emerging market economies (EMEs). As I said earlier, EMEs
surely need capital flows for their investment needs. But if they get more of the flows than
they can absorb, it hurts the economy both in financial and economic terms. I will not go into
all the details here, but what you should know is that there are no easy ways to deal with
excess flows. Depending on how the excess flows are handled, it can lead to appreciation of
the currency making exports less competitive, build up asset price bubbles, fuel inflationary
pressures or drive up interest rates. What exacerbates the problem is that these flows are
prone to "sudden stops and reversals" which is to say that they can reverse direction and go
out of an economy suddenly, as happened during the crisis, and that can dent financial
stability.
Another big issue in the external sector is the exchange rate. Just as inflation determines the
purchasing power of the rupee in the domestic economy, the exchange rate determines the
purchasing power of the rupee in the external economy. It is possible to manage the
exchange rate by buying or selling foreign exchange, and countries do that either to improve
their trade advantage or for economic management purposes such as control inflation.
In India too, the exchange rate is an important macroeconomic variable as it determines how
much we earn from our exports and how much we need to spend on our imports. When the
exchange rate appreciates, exporters are hurt and they demand that RBI must intervene in
the market to bring the exchange rate down. But depreciating the exchange rate by
intervention is not a completely benign option. It hurts importers who need to spend more. It
hurts the government as it has to spend more on subsidizing imports such as oil and
fertilizers and also spend more on external debt servicing. Intervention can also fuel
inflationary pressures in which case it hurts everyone. We believe that it is in our collective
interest as global citizens if exchange rates are allowed to be determined by market
fundamentals.
You all probably heard of "currency wars" - a situation where countries indulge in competitive
devaluation of their currencies for trade advantage. That can lead to global imbalances of
several kinds. In the Reserve Bank, our policy is that we do not target a specific exchange
rate or a rate band. We intervene only to smooth exchange rate volatility and prevent
disruptions to macroeconomic stability. Indeed one of the important issues on the G-20
agenda is to reach an agreement to end currency wars - that is to reach a shared
understanding on what types of interventions may be appropriate to manage the external
sector and under what circumstances.
Foreign exchange reserve management
Managing our country's foreign currency assets and gold reserves is another responsibility of
the Reserve Bank. Today, our foreign exchange reserves stand at nearly US$ 300 billion, up
from just a few billion in 1991. An adequate level of foreign exchange reserves is important
for several reasons. In particular, it protects us against external shocks and inspires the
confidence of foreign investors.
In investing our foreign exchange reserves, we are guided by three principles: safety,
liquidity, and return. In our investment policy and practice, we exercise utmost care and
caution to maintain a high degree of quality of foreign currency assets.
In November 2009, we bought 200 metric tonnes of gold from the International Monetary
Fund. This triggered a lot of public and media interest on the rationale of the transaction. In
recent years, although there has been significant accretion to our reserves, our gold holdings
have remained stagnant. This purchase from the IMF helped in raising the proportion of gold
in our reserves. Secondly, you will recall how, at the height of the balance of payments crisis
in 1991, we had to pledge gold to raise resources. In view of the strategic importance of gold
as a reserve asset, we exploited the opportunity that came our way to buy a sizeable quantity
of gold from a reliable, multilateral financial institution at market prices in a single deal.
Financial inclusion
In recent years, financial inclusion has become one of the top priorities of the Reserve Bank.
We all know that economic opportunity is strongly intertwined with financial access. Such
access is especially powerful for the poor as it provides them opportunities to build savings,
make investments and avail credit. Importantly, access to financial services also helps the
poor insure themselves against income shocks and equips them to meet emergencies such
as illness, death in the family or loss of employment.
Financial inclusion is good for the poor. But it is also good for the economy as it channels the
savings of the poor for productive use. Let me just say this: till financial inclusion becomes a
reality, we have not conquered the final frontier of development.
Despite all the progress we have made in other spheres, our performance on the financial
inclusion front is disappointing. More than half the households in the country do not have a
bank account, and a larger number of those that do, do not use the banks account in any
meaningful sense. Of the 600,000 habitations in the country, only 30,000, or just 5% have
access to a bank branch. Redressing this woeful story is the challenge of financial inclusion.
What is the Reserve Bank's role here? On the commercial side, this means creating an
enabling environment, giving macro prudential direction, possibly even changing our
approaches and policies to make it easier for businesses in targeted industries to access the
funds they need to grow and expand. On the individual consumer side, this means adopting
new tools and technologies to bring every Indian household into the banking fold and helping
educate them to be financially literate.
Let me briefly list a few of the steps we have taken :
 We have advised banks to adopt policies in support of financial inclusion with new
financial product offerings such as zero or minimal balance no frills accounts.
 We are encouraging bank branch expansion in parts of the country which are
underbanked, especially in underserved geographies, through innovative modes of
financial service delivery.

We are facilitating the deployment of business correspondents (BCs) - you can
think of them as "barefoot bankers" - as agents to carry banking to uncovered
villages and areas.

We are tailoring our regulation to encourage innovation in financial inclusion through
hand held machines, mobile phones, ATM machines, etc.

Banks have been advised to ensure universal financial inclusion in all villages
having a population above 2000 by March 2012 through some form; either a brick
and mortar branch or through any of the various ICT-based models.

We have advised banks to draw up Board approved Financial Inclusion Plans (FIPs)
for a period of three years up to March 2013, which should be integrated with the
business plan of the bank. A uniform model has not been imposed so that each
bank can build its strategy in line with its business model and comparative
advantage.

We have encouraged banks to include performance on financial inclusion in the
performance evaluation of their field staff.

We are encouraging state governments to shift to "electronic benefit transfer" (EBT)
- that is that all benefits and wages that the government pays to people should be
remitted directly to the bank accounts of