Dr Y V Reddy: Developments in monetary policy and financial markets in India
Address by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, to the Madras Chamber of
Commerce and Industry, Chennai, 24 April 2001.
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I am thankful to the organisers for their perseverance in getting me to Chennai. I am using this
opportunity to share with you some explanations on the Monetary and Credit Policy for 2001-02
announced last week. This is the fifth Annual Policy of Reserve Bank of India (RBI) that I have been
associated with, and soon after every one of the fine statements, I had publicly articulated some
explanations. The purpose has generally been to highlight elements of continuity, change and
contextual relevance in each policy. However, on this occasion, a slightly different approach is
adopted. To start with, there will be an assessment of the projections made in the policy statements
since 1997-98 with reference to outcomes, giving some sort of monetary marksmanship, akin though
not similar to fiscal marksmanship. This will be followed by a brief review of the progress in reforms in
monetary policy and financial markets during the last five years. The features of the latest Monetary
and Credit Policy would then be mentioned to lead to the tasks ahead. The tasks ahead, following
from the recent policy statement are presented in four sections, viz., for Reserve Bank of India; for
Government of India, for market participants and for technical work on some relevant areas of
significance.
Projections and outcomes : an assessment
The monetary projections and underlying assumptions in regard to the macro-economy are contained
in the annual statements, and revised, if considered necessary, in mid-year review in October. An
analysis of projections and actual out turn since 1997-98 would help appreciate the realism in the
analysis as well as the overall macro management.
Broadly speaking, the following inferences can be drawn from such an analysis.
First, the outturn in regard to growth in Gross Domestic Product has been close to the projections
indicated in the Policy Statement and/or mid-year review except in 1997-98, when it touched the
lowest level at 5.0 per cent.
Second, anticipated inflation has been out of alignment (i.e. beyond one hundred basis points from the
projection) only in respect of 1999-2000, when it peaked at 6.8 per cent.
Third, the growth in money supply has been consistently above the projected rate except in
19992000, when it was at 14.6 per cent, below the projected level of 15.5-16.0 per cent.
Fourth, the deposit growth has been higher than projected in all the years except in 1999-2000 when
the growth was a mere 13.9 per cent compared to the projected level of 16.5 per cent.
Fifth, the growth of non-food credit {including investments in PSU bonds, corporate debentures,
Commercial Paper (CP) etc.} has generally been less than projected in all the years.
Sixth, in regard to interest rates, the general preference has been to bring down or soften interest
rates while focussing on stability, though no specific rates were indicated. There has been a reduction
every year, the range measured by Prime Lending Rates of public sector banks, having come down
from 14.0 to 14.5 per cent in 1997-98 to 10.0 to 13.0 per cent in 2000-01.
Seventh, the market borrowing programme of the union government exceeded the projections (as per
budget estimates) in all the years except in 2000-01, and there has been a significant borrowing in the
fortnight following the end of the fiscal year. In fact, the slippage in 1998-99 and 1999-2000 had been
very large, being about Rs. 15,000 crore, accounting for about 0.75 per cent of GDP. The borrowing
programme of State Governments has been consistently higher than originally indicated to RBI except
during 1997-98.
Eighth, as regards external sector, the current account deficit has been consistently less than 2.0 per
cent of GDP, strictly in consonance with the broad policy indications. In fact, it has been significantly
lower and at 1.5 per cent or less in all the years.
Ninth, the policy objective of augmenting reserves has also been achieved in every one of the years
and the total addition to foreign currency reserves during the period at U.S.$ 17 billion far exceeded
the total addition to external debt (including amounts raised under Resurgent India Bonds and India
Millennium Deposits) of U.S.$ 4.5 billion.
Finally, the conditions in forex markets appear to have been reasonably stable, though there have
been several occasions when there were pressures warranting prompt actions by RBI.
There is no doubt that the actual outcomes depend upon several uncertainties and unanticipated
events that characterise any policy making during any given medium- term frame. The period under
consideration had to contend with several domestic and international events that were unexpected,
viz., domestic political uncertainties due to Parliamentary elections, Asian crisis, sanctions against
India by the USA, border conflict at Kargil and oil shock or large increase in price of petroleum. Surely,
there are lessons to be learnt and elements of good luck that might have visited on occasions but the
period also exhibited exercise of sound judgements and enhancement of skills in management at all
levels within RBI. What is of greater significance is the fact that the monetary policy was conducted
while bringing about significant structural improvements in the financial sector and developing financial
markets, especially the money market and the government securities market. Monetary management
was greatly facilitated by the solid foundations laid and sound policy framework created by the RBI
during the early nineties preceding the period analysed.
Review of progress (1996-2001)
The main objectives of the policy measures during 1996-2001 have been to increase operational
effectiveness of monetary policy by broadening and deepening various segments of the financial
market, to redefine the regulatory role of the Reserve Bank, to strengthen prudential and supervisory
norms, to improve the credit delivery system, and to develop the technological and institutional
infrastructure for an efficient financial sector. These measures usually announced as part of Policy
Statements help the market agents to appreciate the policy changes in offing and to prepare
themselves to meet possible challenges. In evolving these measures, market participants are closely
associated and consulted.
The recent experience shows that monetary management in terms of objectives, framework and
instruments has undergone significant changes, reflecting broadly the transition of Indian economy
from a regulated to liberalised and deregulated regime. In that context, it would be worth the while to
address some of the major highlights of these changes and the related issues which have received
added and focused attention in recent years.
First, during this period the twin objectives of monetary policy of maintaining price stability and
ensuring availability of adequate credit to productive sectors of the economy to support growth have
remained unchanged; the relative emphasis on either of these objectives also continues to depend on
the circumstances. However, the gradual liberalization of financial markets has increased the potential
risks and vulnerability of institutions and has, therefore, implications for financial stability. The linkages
between financial stability and price stability have become pronounced in recent times. In this context,
the recent policy measures laid emphasis inter alia upon maintaining orderly conditions and containing
volatility in financial markets. While the market determined exchange rate system has implications for
monetary policy, the international transmission of price changes also need to be recognized in
understanding the inflationary process. The structure of the economy and the role of services sector
have also been changing which have implications for transmission of monetary policy.
Second, though inflation is not targeted, policy statements including those in the reference period,
have been identifying a tolerable level of inflation taking into account the global trends and domestic
compulsions. The measurement issues have also come to the fore and the notions of core-inflation
and underlying inflation as against headline have been subjects of discussion. There has also been
some sensitivity in the market, to the issues relating to measurement of prices in the growing services
sector as also asset prices. A national consensus on the need to emphasize price stability in macro
policy seems to be emerging.
Third, in a deregulated environment, besides the provision of adequate credit, availability of adequate
resources at appropriate costs, i.e., interest rates becomes more important. Stable and preferably a
low interest rate regime is conditional upon enabling stable inflationary expectations, which in turn
depends on price stability. During the period, the fiscal and other constraints inhibiting the downward
flexibility in interest rates had been debated and the need to impart flexibility to interest rates has
emerged as a focal point for policy action. Consequently, there is widespread appreciation of the
efforts to ensure reduction in existing high levels of revenue deficit and fiscal deficit, besides
rationalising administered interest rates on contractual savings to impart efficiency and operational
flexibility to the financial sector.
During this period, most interest rates have been deregulated. The few prescriptions that exist, viz.,
export credit, small loans, foreign currency deposits are in the nature of ceilings related to market
interest rates such as the relevant Prime Lending Rate (PLR) of the concerned bank or the LIBOR of
the concerned currency. Currently, the only administered interest rate is on saving deposits. While
directed credit continues, the conditions attached to such credit dispensation have been made
considerably flexible.
Fourth, the monetary policy framework in India from mid-1980s till 1997-98, can, by and large, be
characterised as a monetary targeting framework on the lines recommended by Chakravarty
Committee (1985). Because of reasonable stability of the money demand function, the annual growth
in broad money (M3) was used as an intermediate target of monetary policy to achieve monetary
objectives. In practice, unlike many other countries, which followed such an approach, the monetary
targeting approach was used in a flexible manner with a 'feedback'. This was necessary partly
because of high level of government borrowings and the fiscal dominance, administered interest rates
and the large size of unorganized sector. Deregulation and liberalization of the financial markets
combined with increasing openness of the economy during this period necessitated some changes in
this framework. Consequently, a multiple indicator approach was announced in 1998-99, wherein
interest rates or rates of return in different markets (money, capital and government securities
markets) along with such data as on currency, credit extended by banks and financial institutions,
fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign
exchange available on high frequency basis are juxtaposed with output data for drawing policy
perspectives. Such a shift was gradual and a logical outcome of measures taken over the reform
period since early nineties.
Thus the 'exclusive' use of broad money as an intermediate target was de-emphasised, but the growth
in broad money (M3) continues to be used as an important indicator of monetary policy. In a
deregulated financial environment with reasonably open capital account, monetary policy has to
respond to unexpected changes on short-term basis. The switchover to a multiple indicator approach
provided necessary flexibility to the Reserve Bank to respond to changes in domestic and international
economic and financial market conditions more effectively. In a medium to long-term perspective, the
impact of money supply on inflation, however, cannot be ignored and for purposes of policy, the
Reserve Bank still continues to announce projections of money supply compatible with the outlook on
growth of GDP and expected inflation.
Fifth, the institutional context in which monetary policy was conducted was vastly different till very
recently. Since 1997, a major change has taken place with the discontinuation of the process of
automatic monetisation of government deficit. Although the mutually agreed Ways and Means
Advances (WMA) sought to put a limit on direct short-term access of funds from the Reserve Bank to
the Government, the continued high fiscal deficit made it difficult for the Government to reduce its
requirement of borrowings from the banking sector. In the process, the Reserve Bank had to manage
liquidity in the system in such a way that the impact of the high fiscal deficit on monetisation as also on
interest rates is minimized. In effect, while the fiscal impact on monetisation has been reduced
significantly, the interplay between fiscal and monetary operations continued to be significant in the
post-1997 scenario.
The overall monetary management becomes difficult with a large and growing borrowing programme
of the government, year after year, which puts pressure on the absorptive capacity of the market. The
banking system at end-March 2001 held government securities of around 35.0 per cent of its net
demand and time liabilities as against the minimum statutory requirement of 25.0 per cent. In terms of
volume, such holdings above the statutory liquidity ratio (SLR) amounted to as much as Rs.1,00,000
crore, which is substantially higher than the net annual borrowings of the government.
Sixth, in addition to the changes in the monetary policy framework, targets and indicators, and the
institutional context in which monetary policy is being conducted over the past five years, a major
transformation has also taken place in the operating procedure of monetary policy. The reform of
monetary and financial sectors has enabled the Reserve Bank to expand the array of instruments at
its command.
The reliance on reserve requirements, particularly the cash reserve ratio (CRR), has been reduced as
an instrument of monetary control. The CRR has been brought down, notwithstanding intra-year
variations, from a peak of 15.0 per cent in 1994-95 to 8.0 percent in 2000-01. The objective of policy is
to reduce CRR to its statutory minimum of 3.0 per cent over a period of time. The Statutory Liquidity
Ratio has already been brought down to its statutory minimum of 25.0 per cent.
The liquidity management in the system is carried out through open market operations (OMO) in the
form of outright purchases/sales of government securities and repo and reverse repo operations. The
OMO are supplemented by access to the Reserve Bank's standing facilities and direct interest rate
signals through changes in the Bank Rate/repo rates.
For transmitting signals of monetary policy, the Bank Rate was initially operationalised as a signaling
and reference rate for influencing the interest rates in the economy. Interest rates on advances from
the Reserve Bank were linked to the Bank Rate. Refinance/liquidity support at the Bank Rate and repo
rates were intended to serve as a ceiling and a floor, respectively, setting an informal corridor for
money market particularly the call money market to operate. In the context of the continued large
market borrowing programme of the government, the Reserve Bank on occasions adopted a policy of
strategically accepting private placement of government securities and then releasing those to the
market at an appropriate time without putting undue pressure on interest rates.
In terms of further progress in the use of market-based instruments, a liquidity adjustment facility (LAF)
was introduced in June 2000. The LAF enables the Reserve Bank to modulate short-term liquidity
under varied financial market conditions in order to ensure stable conditions in the overnight (call)
money market. The LAF operates through repo and reverse repo auctions thereby setting a corridor
for the short-term interest rate consistent with policy objectives. The LAF operations combined with
strategic open market operations consistent with market liquidity conditions has evolved as the
principal operating procedure of monetary policy of the Reserve Bank. The next stage of development
in this direction aims to move towards a full-fledged LAF by gradually removing/minimizing standing
facilities, thus providing appropriate conditions for the Reserve Bank to exercise greater degree of
freedom in providing a direction on interest rates to the market.
Seventh, the emerging linkages among money, government securities and foreign exchange markets
require the Reserve Bank at times to use short-term monetary measures alongside intervention to
arrest excessive volatilities in foreign exchange market. While there is no settled conclusion about the
appropriateness of an exchange rate regime within the broad range of corner solutions of 'free float'
and a 'currency board', in the present market determined exchange rate regime, the primary objective
of the Reserve Bank continues to be the maintenance of orderly conditions in the foreign exchange
market, meeting temporary supply-demand gaps which may arise due to uncertainties or other
reasons, and curbing destabilizing and self-fulfilling speculative activities. To this end, the Reserve
Bank monitors closely the developments in the financial markets at home and abroad and takes such
measures, as it considers necessary from time to time.
The recent experience has highlighted the importance of building up foreign exchange reserves to
take care of unforeseen contingencies, volatile capital flows and other developments, which can affect
expectations adversely. The emerging economies have to rely largely on their own resources during
external exigencies (or contagion) as there is no international "lender of last resort" to provide
additional liquidity at short notice on acceptable terms. Thus, the need for adequate reserves is
unlikely to be eliminated or reduced even if exchange rates are allowed to float freely. The overall
approach to the management of India's foreign exchange reserves in recent years has reflected the
changing composition of balance of payments, and has endeavoured to reflect the "liquidity risks"
associated with different types of flows and other contingencies.
Finally, the gradual switchover to indirect market-based instruments in the conduct of monetary policy
was made possible because of simultaneous efforts at developing various segments of the financial
market, particularly money, foreign exchange and government securities market.
The increasing responsibility of the Reserve Bank of India in undertaking reform in the financial
markets has to be seen essentially in the context of improving the effectiveness of the transmission
channel of monetary policy. Development of financial markets has, therefore, encompassed regulatory
and legal changes, building up of institutional infrastructure, constant fine-tuning in market
microstructure and massive upgradation of technological infrastructure. An important achievement in
this area was the amendment to the Securities Contracts Regulation Act, which clarified the regulatory
jurisdiction of RBI over the money, government securities and forex segments of the financial market.
The money market is critical in facilitating the conduct of monetary policy and in improving the
transmission mechanism. This requires the RBI to have greater control over the liquidity in the system,
create an efficient mechanism to impart interest rate signals and undertake continuous refinements to
money market instruments. The market for repo is being scientifically developed over a period through
widening of participants and instruments, and by bringing uniformity in trading and accounting
practices with the help of Fixed Income Money Market and Derivatives Association of India (FIMMDA).
A Clearing Corporation has been proposed, so that repo operations could become efficient with
adequate safeguards. Similarly, RBI has been closely nurturing the Treasury Bill market. It has
increased the range of T-Bills over the years, modified the notified amounts and incorporated changes
in the auction formats to suit the needs of the market. The efficacy of Commercial Paper and
Certificates of Deposit has also been improved over the years with measures such as reduction in the
minimum period and amount of issue, lock-in period, preferring dematerialised form, etc. The most
important reform in the money market relates to the initiation of Liquidity Adjustment Facility (LAF).
With the announcement of the second phase of LAF, the RBI has moved gradually from a system of
segmented refinance to a more fungible system of liquidity adjustment at market related rates. Reform
in the call money market has also been announced to make it purely interbank market, over a phased
period.
In the Government Securities market, the borrowing programme of the Government has been
systematised and rationalised with the establishment of cash and Debt Management Group consisting
of officials from RBI and the Government and could be completed without destabilizing the financial
markets. Changes have been incorporated in the formats of auction by combining both price-based
and yield-based auctions, thereby improving the fungibility and liquidity and paving the way for the
development of a market for STRIPS, elongating the maturity for debt, facilitating the emergence of
benchmarks, etc. The institutional infrastructure has been strengthened by increasing the number of
Primary Dealers and making them functionally stronger through imposition of capital adequacy norms
and other prudential norms. PDs have been made more vibrant through careful modulation of
responsibilities and facilities. Changes in valuation norms for banks' investment portfolio have been
introduced and RBI has moved away from announcing the yield curve for government securities,
which is now the responsibility of FIMMDA. Further development of the government securities market
hinges on legal reforms proposed by RBI and completion of the technological upgradation process
that has already commenced.
Measures initiated to integrate the Indian forex market with global financial system include permitting
banks to fix their own position limits and aggregate gap limits, to borrow from and invest abroad up to
15 per cent of Tier I capital, and to arrange to hedge risks for corporate clients through derivative
instruments. Given the lack of depth and liquidity in the forex market, the aim is to remove these
imperfections.
A hallmark of the reform process in the financial markets is the consensus building, which is
operationalised through inter-departmental working groups, inter-agency committees and Technical
Advisory Committees at the formulation stages and Financial Markets Committee at the monitoring
stage. The aim is to involve all the stakeholders in the formulation and implementation stages. Greater
deregulation underscores the importance of closer monitoring of market developments by the
regulator. This is institutionalised in the form of Financial Markets Committee (FMC) in the RBI, which
meets daily before the opening of the markets and at times on more than one occasion, when situation
warrants. The FMC reviews the liquidity and interest rate situation in financial markets and advises the
top management on the course of action that would be required by RBI during the day. This
institutionalized framework helps the RBI to take an integrated view on all important decisions having
an impact on financial markets.
The presentation has not covered important areas relating to prudential regulation, supervision and
credit delivery, though they do constitute very critical aspects of financial sector reform.
Features of the Policy
The Policy has to take into account the macro-economic and monetary developments of the previous
year. Since last year, a separate detailed document is prepared on the subject, which is a highly
recommended reading for serious analysts. This document was issued on April 19, 2001 along with
the Statement of the Policy for 2001-02.
The statement itself explains in detail the developments in 2000-01 as well as the projections and
outcomes for 2001-02. What is noteworthy is the nuance in the stance of monetary policy, which gives
greater emphasis than in the past to (a) credit growth and revival of investment demand; and (b) the
interest rate flexibility. This may be described as the contextual response at macro-policy level. At
micro level, there are contextual measures such as those relating to urban cooperative banks, and
exposure norms of banks to stock market
The second set of measures would emphasise the continuation of some reform aspects of policy.
Changes are sought in the liquidity adjustment facility, call money market, repo market and export
refinance. The set of measures when fully implemented in the next two to three years would mean
completion of the transition towards indirect instruments of monetary policy, and imparting greater
effectiveness of monetary policy transmission. To illustrate, at present, banks get liquidity from
nonbanks and also from RBI. In fact, RBI is currently obliged to provide eligible amount of liquidity at
predetermined rate which gives greater freedom to banks but correspondingly constrains the
operations of RBI. Further, now intra-day liquidity cannot be handled by the RBI. The package of
measures announced now would take care of these issues and carry the operating environment of
monetary policy to international standards.
Similarly, in the area of institutional and technological infrastructure for financial markets, the full
implementation of computerisation of Public Debt Office and operationalisation of Clearing Corporation
during the course of the year represents culmination of medium term efforts to instill international
standards. Incidentally, the modern forex clearing operations proposed in India are pioneering, outside
of America and Europe, with Hong Kong becoming operational last year. There will be enormous
savings in time and cost of intra bank forex transactions in India. Corporates, mutual funds etc. can
operate in the repo market, i.e., access or provide collateralised liquidity for the very short term, with
all safeguards. Money market operations need no longer be confined to Mumbai. This should certainly
be cheered by Chennai!
The prescription that banks, Financial Institutions, Primary Dealers etc. should invest in CPs and other
instruments only in demat form is a significant new measure which will virtually make all these markets
into demat mode, thus ensuring safety for all including individual investors.
The movement towards competitive and deregulated interest rate regime has also been completed
with linking of all lending rates to PLR of the concerned bank while PLR itself has been transformed
into a benchmark rate. With this, the erstwhile non-transparent practices of circumventing PLR when it
was a floor, as applied to creditworthy borrowers may end. Also, this gives greater scope for banks to
meet emerging business cycles.
In the area of prudential standards, markets carry on impression that the level of Non Performing
Assets is understated on account of 180-Day instead of 90-Day norm. This will be clarified once the
position is crystalised as per international norm. However, to ensure smooth transition, sufficient time
up to 2004 is given for banks to make appropriate provisions. This is a forward looking measure, and a
change to meet global standards. Similarly, changes have been proposed in the measurement of
capital for exposure purposes and in the level of exposure limit itself. These changes will also be
applicable from a future date.
In the recent past, policy statements emphasised change in the role of RBI from being a micro
regulator to concentrate on macro aspects. While that process of changing the role is almost
complete, the current statement emphasises changing the functions of RBI. It sets the agenda for
divesting itself of the functions as debt manager, as owner, and in some ways as regulator say of
NBFCs or urban cooperatives and concentrate on monetary management.
There are several areas where progress is reported and further measures indicated, such as in the
areas of technology, regulatory review, credit bureau, international financial standards and codes,
legal reforms, debt recovery etc. Perhaps there is no need to elaborate these to this gathering.
Tasks ahead for Government
The current monetary policy has signalled important reforms which require changes in existing
legislation or introduction of new laws. These include amendments to the Public Debt Act and
introduction of Government Securities Bill (to provide flexibility in undertaking transactions in
Government securities and facilitate retailing) amendments to the Reserve Bank of India Act (to bring
about among other things greater flexibility in monetary policy operations by reducing the statutory
minimum for CRR/SLR, enable separation of debt management functions etc.); passage of Fiscal
Responsibility Bill (to bring reasonable control over fiscal management), amendments to the State
Bank of India (SBI) and other Acts governing public sector banks, National Housing Bank (NHB),
National Bank for Agriculture and Rural Development (NABARD), and Industrial Development Finance
Corporation (IDFC) Acts (to transfer ownership of these institutions from the RBI to the Government);
a new Deposit Insurance and Credit Guarantee Corporation (DICGC) Act (to make it consistent with
financial sector liberalisation); a separate Act for Non-Banking Financial Companies (NBFCs) (to
provide enhanced protection to depositors of NBFCs); amendment to Banking Regulation Act (to
encompass areas of security laws and regulatory framework of banking), amendment to Negotiable
Instruments Act (to bring it in conformity with the Information Technology Act, 2000 to bring electronic
cheque, securitised certificate and other evolving products within its ambit); enactment of Bill on asset
securitisation (to create an enabling environment for market for asset securitisation).
Apart from legislative changes, an important aspect relating to the supervisory framework for Urban
Cooperative Banks has been proposed. This would need to be pursued in consultation with the
Central and State Governments.
Tasks ahead for the Reserve Bank of India
First, RBI has already forwarded the draft amendments to the various acts, which is under
consideration of the Government. However, some further work may be needed from RBI also.
Second, the changes proposed in the financial sector will need follow-up actions by RBI. For instance,
the move over to the second and third stages of LAF would need RBI to have a greater fix on the
liquidity in its system. RBI is already formalising a short-term liquidity model, which should provide
important inputs to its decision making. This would be all the more critical in the next stage.
Third, on the operational side, RBI would need to be prepared to advance the timing of the auction
process under LAF as also be prepared with its systems to conduct discriminatory price auctions
under LAF and uniform price auctions with regard to dated securities.
Fourth, further progress in reform in the financial markets depends on the commencement of
operations by the Clearing Corporation and maintaining the time schedule for the Negotiated Dealing
System, Real Time Gross Settlement system and computerisation of Public Debt Office. RBI would
need to closely monitor to ensure timely implementation.
Fifth, although the Regulations Review Authority has ceased its operations, RBI has decided to make
the review exercise an integral part of the system by putting in place an alternate mechanism. RBI
should ensure that the new arrangements are in place quickly to continue with the work of the
erstwhile RRA both in letter and same spirit.
Sixth, apart from this, the progress by the various Committees in RBI relating to the move towards risk
based supervision, macro-prudential indicators etc. will have to be hastened.
Seventh, follow-up actions on the work by the Advisory Groups on international standards and codes
may be designed in close consultations with the Chairmen concerned.
Finally, keeping abreast with international de