Y V Reddy: Glimpses of the Indian economy and its financial sector
Speech by Dr Y V Reddy, Governor of the Reserve Bank of India, at the Central Bank of the Russian
Federation, Moscow, 2 July 2007.
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Chairman Sergey M. Ignatiev and distinguished central bankers of the Bank of Russia,
I am grateful to Chairman Ignatiev for inviting me to visit your bank and interact with you for mutual
benefit.
I have the pleasure of meeting my friend Chairman Ignatiev, almost once a month, in meetings of BIS
or G20 or IMF or other international seminars. His address in Buenos Aires in early June on the
current state of Russian economy was highly appreciated because he gave a glimpse of not only the
achievements of Russian economy in recent years but also a hint of admirable future for the Russian
economy.
We, in India, always had a very special bond with Russia, in technology, trade, culture and diplomacy.
These are being further strengthened in recent years in terms of cooperation both bilaterally and
multilaterally.
At my persistent request, Chairman Ignatiev came to India in January and he delivered an address in
the Reserve Bank of India. We had a scintillating discussion session where Chairman Ignatiev gave a
frank and a highly professional response to the searching questions. We hope to get permission of
Chairman to publish the script of the speech in English in India.
In my address today, I intend giving brief introduction to Reserve Bank of India, followed by glimpses
of the Indian economy. I will give a more detailed account of reforms in India's financial sector, in
particular, the banking sector, and financial markets.
Introduction to the RBI
The RBI was established under the Reserve Bank of India Act, 1934 on April 1, 1935 as a private
shareholders' bank but since its nationalisation in 1949, is fully owned by the Government of India.
The Preamble of the Reserve Bank describes the basic functions as "to regulate the issue of Bank
notes and keeping of reserves with a view to securing monetary stability in India and generally, to
operate the currency and credit system of the country to its advantage". Thus, unlike the current trend
in many countries, there is no explicit mandate for price-stability or formal inflation targeting, but the
mandate appears to be similar to that of the Federal Reserve of the USA. The twin objectives of
monetary policy in India have evolved over the years as those of maintaining price stability and
ensuring adequate flow of credit to facilitate the growth process. The relative emphasis between the
twin objectives is modulated as per the prevailing circumstances and is articulated in the policy
statements by the Reserve Bank from time to time. Consideration of macro-economic and financial
stability is also subsumed in the mandate. The Reserve Bank is also entrusted with the management
of foreign exchange reserves (which include gold holding also), which are reflected in its balance
sheet.
While the Reserve Bank is essentially a monetary authority, its founding statute mandates it to be the
manager of market borrowing of the Government of India and banker to the Government.
The function of regulating and supervising of banks has been assigned to the Reserve Bank by a
separate legislation enacted in 1949, while the regulation of Non-Banking Finance Companies
(NBFCs) has been entrusted to it through an amendment to the RBI Act recently. The powers for
regulation of money markets, government securities market, forex market and gold are derived from
the RBI Act and the regulation explicitly entrusted through government notifications under the
Securities Contracts (Regulation) Act.
The regulation of current and capital account transactions of the external sector was assigned to the
Reserve Bank under another statute in 1999, replacing an earlier one in 1973.
In addition to the issuance of currency, the Reserve Bank is also entrusted with the responsibilities
relating to distribution of coins.
The Reserve Bank has been assigned some responsibilities in several statutory bodies such as public
sector banks, development finance institutions governing Agriculture, Housing and Deposit Insurance,
etc.
The Reserve Bank's affairs are governed by a Central Board of Directors, consisting of fourteen
nonexecutive, independent directors nominated by the Government, in addition to the Governor and up to
four Deputy Governors. Besides, one Government official is also nominated on the Board who
participates in the Board meetings but cannot vote.
The Reserve Bank has 19 regional offices and 4 sub-offices, mostly in state capitals. The Reserve
Bank is the debt-manager and banker to State governments (i.e., the provinces constituting the Indian
federation).
The Reserve Bank renders advice to the Central and the State Governments, particularly in regard to
financial sector reforms.
In brief, the Reserve Bank has been assigned several functions, in addition to monetary management.
In performing each of the functions, the statute as well as the functional content, requires that the
Reserve Bank exercise varying degrees of autonomy and coordination vis-à-vis the government. The
three over-arching features governing the relations with the Government are autonomy in operations;
harmony in policies; and coordination in structural transformations.
Performance of the Indian economy: self accelerating growth with stability
Sometimes India is described as a re-emerging economy. Since in the 18th century, this geographical
area had accounted for about a quarter of world output - but that is part of history. The annual growth
rate of GDP in the geographical area of India in the first half of 20th century is estimated to be around
an average of 0.9 per cent per annum and per capita income at an average rate of 0.1 per cent per
annum. The economy of independent India which is of contemporary interest had to be built upon the
overhang issues of second World War, the trauma of partition, the integration of princely states
numbering over 500 and a low level of GDP. From an annual average growth rate of 3.5 per cent
during 1950 to 1980, the growth rate of the Indian economy accelerated to around 6.0 per cent in the
1980s and 1990s. In the last four years (2003-04 to 2006-07), the Indian economy grew by 8.6 per
cent. In 2005-06 and 2006-07, it had grown at a higher rate of 9.0 and 9.4 per cent, respectively.
There is, thus, tangible evidence of self-accelerating growth.
An important characteristic of the high growth phase of over a quarter of century is resilience to shocks
and considerable amount of stability. We have witnessed one serious balance of payments crisis
triggered largely by the Gulf war in the early 1990s. Credible macroeconomic structural and
stabilization programme was undertaken in the wake of the crisis. The Indian economy in later years,
could successfully avoid any adverse contagion impact of shocks from the East Asian crisis, sanction
like situation in post-Pokhran scenario, and border conflict during May-June 1999. Seen in this
context, this robust macroeconomic performance, in the face of recent oil as well as food shocks,
demonstrates the vibrance and resilience of the Indian economy.
The average saving rate in India was 10 per cent in the 1950s, which rose to 17.5 per cent in the
1970s and further to 23.4 per cent in the 1990s. The saving rate was 32.4 per cent in 2005-06. The
strengthening of economic activity in the recent years has been supported by persistent increase in
gross domestic investment rates from 22.9 per cent of GDP in 2001-02 to 33.8 per cent in 2005-06. It
may also be noted that over 95 per cent of investment in the country during this period was financed
by the domestic savings.
On the price stability front, India's performance has been fairly good. Since independence, the inflation
rate, in terms of the wholesale price index (WPI), on an average basis, was above 15 per cent in only
five out of fifty years. In thirty-six out of fifty years, inflation was in single digit and on most occasions
high inflation was due to shocks - food or oil. The tolerance level to inflation has been low, relative to
many developing countries, especially on account of the democratic pressures in the country.
The inflation rate accelerated steadily from an annual average of 1.7 per cent during the 1950s to 6.4
percent during the 1960s and further to 9.0 per cent in the 1970s before easing marginally to 8.0 per
cent in the 1980s. However, the inflation rate declined from an average of 11.0 per cent during
199095 to 5.3 per cent during the second half of the 1990s (1995-2000) and further to 4.9 per cent during
2003-07.
More recently during 2006-07, WPI based inflation rate increased from 4.1 per cent at the end of
March 2006 to an intra-year peak of 6.7 per cent at end-January 2007 and remained firm in the range
of 6.1-6.6 per cent in the succeeding weeks before moderating to 5.9 per cent by the end of the
financial year (i.e., as on March 31, 2007). Since then, the inflation has further moderated and as on
June 16, 2007, the WPI inflation rate was 4.0 per cent.
In recent period, there has been considerable improvement in the fiscal position. The average gross
fiscal deficit of the central government as per cent to GDP during the decade of 1980s was 6.8 per
cent as against 3.8 per cent in the 1970s. The Government of India is pursuing the path of rule-based
fiscal consolidation from the year 2004-05 under the Fiscal Responsibility and Budget Management
Act, 2003 whereunder time-specific targets have been mandated. The underlying purpose of the
targets is to reduce the ratio of gross fiscal deficit (GFD) to gross domestic product (GDP) to three per
cent by 2008-09. Furthermore, the revenue deficit (RD) to GDP ratio has been targeted to touch 0.0
per cent by 2008-09 so that borrowed resources can be used to meet only capital expenditures. The
progress of targeted fiscal consolidation has been satisfactory so far and GFD/GDP and RD/GDP
ratios are budgeted to reduce to 3.3 per cent and 1.5 per cent, respectively, in 2007-08. The objective
is to meet the targets under the Fiscal Responsibility Act by 2008-09.
The average current account deficit since 1950-51 has been around one per cent of the GDP. During
this period, except for 11 years when there was marginal surplus in the current account, we had
modest deficit during the rest of the years. In the aftermath of the balance of payment crisis in the
early 1990s, several stabilisation and structural reform measures were undertaken.
External sector indicators show considerable level of sustainability attained in the last decade.
Sustained growth in export of services and remittances has continued to provide buoyancy to the
surplus in the invisible account, which has enabled financing a large part of trade deficit. The capital
flows have been buoyant leading to sustained rise in foreign exchange reserves. The merchandise
trade deficit is currently close to 7.0 per cent of GDP; however, the current account deficit is under 1.5
per cent of GDP, mainly due to receipts from services and the steady support from remittances from
Indians working abroad
Prospects for the Indian economy
In terms of immediate prospects, overall, we expect the real GDP growth in 2007-08 to be around 8.5
per cent, assuming no further escalation in international crude prices and barring domestic or external
shocks. For the year 2007-08, the Reserve Bank's policy endeavour would be to contain inflation close
to 5.0 per cent. In the medium term, in recognition of India's evolving integration with the global
economy and societal preferences, the resolve, going forward, is to condition policy and expectations
for inflation in the range of 4.0-4.5 per cent.
The acceleration of growth in the real sector has been reflected in the upward shift in the growth
trajectory of credit extended by commercial banks, which in the past three years has been
unprecedented in the history of the Indian economy. There has been some sign of deceleration in the
recent period.
In consonance with the rising capital flows, the reserve money growth has been higher in the recent
period averaging 17.8 per cent during 2003-07. The rate of growth of reserve money was 23.0 per
cent as on June 22, 2007 on year on year basis (18.2 per cent a year ago).
Similarly, the high credit growth in the recent period has led the money supply growth to remain high
averaging 16.8 per cent during 2003-07. During 2006-07, the money supply grew by 21.3 per cent. As
on June 8, 2007, the growth in money supply on year on year basis was 21.0 per cent (18.5 per cent a
year ago).
Taking into account the high expansion of money supply worldwide, and given the monetary overhang
of 2005-07, it is important to contain monetary expansion in 2007-08 at around 17.0-17.5 per cent, in
consonance with the outlook on growth and inflation. The Annual Policy Statement for the year
200708 also placed aggregate deposits growth in 2007-08 at around Rs.4,900 billion and a graduated
deceleration of non-food credit to 24.0-25.0 per cent in 2007-08.
For the medium term, the Approach Paper for the Eleventh Five Year Plan (2007-08 to 2011-12)
targets an average annual growth of 9 per cent relative to 8 per cent targeted by the Tenth Plan
(2002-03 to 2006-07). This aspiration for growth would require significant acceleration in investment
from 27.8 per cent in the Tenth Five Year Plan to 35.1 per cent in the Eleventh Five Year Plan.
Realising that the growth benefits need to trickle down further, the Eleventh Five-Year Plan is likely to
provide an opportunity to restructure policies to achieve a new vision based on faster, more
broadbased and inclusive growth. Doubling of agricultural GDP growth to around 4 per cent is particularly
important in this context. The Approach Paper suggests that this must be combined with policies to
promote rapid growth in non-agricultural employment so as to create 70 million job opportunities in the
11th Plan.
Very recently on May 29, 2007, our Honourable Prime Minister announced a major scheme to double
the growth rate of agriculture to 4.0 per cent over the 11th Plan period. The Government would provide
rupees 250 billion for new farm initiatives launched by States. A time-bound Food Security Mission
was also announced to counter rising prices of food products and to ensure visible changes in their
availability over three years.
If these objectives are achieved, the percentage of people in poverty could be reduced by 10
percentage points by the end of the Plan period. The policy reforms and monitorable targets as
indicated in the Approach Paper, particularly on education, health, women and children, infrastructure,
when attained, are expected to benefit a larger chunk of population immensely. This will help in
making the Indian growth process more inclusive and durable.
Financial sector
The Indian financial system of the pre-reform period, before 1991, essentially catered to the needs of
planned development in a mixed-economy framework, where the Government sector had a
predominant role in economic activity. Interest rates on Government securities were artificially pegged
at low levels, which were unrelated to the market conditions. The system of administered interest rates
was characterised by detailed prescriptions on the lending and the deposit side, leading to multiplicity
and complexity of interest rates. As would be expected, the environment in the financial sector in those
years was characterised by segmented and underdeveloped financial markets coupled with paucity of
financial instruments. Consequently, by the end of the eighties, directed and concessional availability
of bank credit to certain sectors adversely affected the viability and profitability of banks. Thus, the
transactions between the de facto joint balance sheet of the Government, the Reserve Bank and the
commercial banks were governed by fiscal priorities rather than sound principles of financial
management and commercial viability. It was then recognised that this approach, which, conceptually,
sought to enhance efficiency through a co-ordinated approach, actually led to loss of transparency,
accountability and incentive to seek efficiency.
Banking
The banking system in India has undergone significant changes during last 16 years. There have been
new banks, new instruments, new windows, new opportunities and, along with all this, new challenges.
While deregulation has opened up new vistas for banks to augment incomes, it has also entailed
greater competition and consequently greater risks. India adopted prudential measures aimed at
imparting strength to the banking system and ensuring its safety and soundness, through greater
transparency, accountability and public credibility. The capital adequacy ratio has increased to 12.4
per cent for scheduled commercial banks as at end March 2006, which is much above the
international norm. Commercial banks' net profits remained at 0.9 per cent of total assets during
2004-05 and 2005-06, up from 0.16 per cent in 1995-96. The ratio of NPLs to total loans of scheduled
commercial banks, which was as high as 15.7 per cent at end-March 1997, declined steadily to 3.3 per
cent by end-March 2006. The net non-performing assets declined to 1.2 per cent of net advances
during 2005-06 from 2.0 per cent in 2004-05. According to the preliminary financial results available for
most of the banks for the year 2006-07, the financial soundness has improved further.
Our banking sector reform has been unique in the world in that it combines a comprehensive
reorientation of competition, regulation and ownership in a non-disruptive and cost-effective manner.
Indeed our banking reform is a good illustration of the dynamism of the public sector in managing the
overhang problems and the pragmatism of public policy in enabling the domestic and foreign private
sectors to compete and expand. There has been no banking crisis in India.
The Government took steps to reduce its ownership in nationalised banks and inducted private
ownership but without altering their public sector character. The underlying rationale of this approach
is to assure that the salutary features of public sector banking were not lost in the transformation
process. On account of healthy market value of the banks' shares, the capital infusion into the banks
by the Government has turned out to be profitable for the Government.
An independent Banking Codes and Standards Board of India was set up on the model of the UK in
order to ensure that comprehensive code of conduct for fair treatment of customers is evolved and
adhered to. With a view to achieving greater financial inclusion, since November 2005, all banks need
to make available a basic banking 'no frills' account either with 'nil' or very low minimum balances as
well as charges that would make such accounts accessible to vast sections of population. Banks were
urged to review their existing practices to align them with the objective of 'financial inclusion'.
There is a scheme of Ombudsman, located in fifteen cities to provide redressal to grievances of the
bank customers. Customer-service is accorded high priority in the supervisory evaluation and
according regulatory comfort to the Reserve Bank.
With a view to strengthening the supervisory framework within the Reserve Bank, a Board for
Financial Supervision (BFS) was constituted in 1994, comprising select members of the Reserve
Bank's Central Board with a variety of professional expertise to exercise 'undivided attention to
supervision' and ensure an integrated approach to supervision of commercial banks and financial
institutions. The Reserve Bank has also instituted Off-site Monitoring and Surveillance System
(OSMOS) for banks in 1995, which provides for Early Warning System as also a trigger for on-site
inspections of vulnerable institutions.
Capital adequacy: three-track approach
In India, we have 84 commercial banks, which account for about 81 per cent (total assets) of the
financial sector at end-March 2006; over 3000 cooperative banks, which account for 11 per cent; and
133 Regional Rural Banks, which account for 3 per cent. Taking into account the size, complexity of
operations, relevance to the financial sector, need to ensure greater financial inclusion and the need
for having an efficient delivery mechanism, the capital adequacy norms applicable to these entities
have been maintained at varying levels of stringency. One might say that we are adopting a
threetrack approach with regard to capital adequacy rules. Given the differential risk appetite across banks
and their business philosophies, it is likely that banks would 'self select' their own approach, which in
turn, is likely to engender a stabilising influence on the system as a whole.
On the first track, the commercial banks are required to maintain capital for both credit and market
risks as per Basel I framework; the cooperative banks, on the second track, are required to maintain
capital for credit risk as per Basel I framework and through surrogates for market risk; the Regional
Rural Banks, on the third track, have a minimum capital requirement which is, however, not on par
with the Basel I framework. Consequently, we have a major segment of systemic importance on a full
Basel I framework, a portion of the minor segment partly on Basel I framework, and a smaller segment
on a non-Basel framework.
The guidelines for Basel II implementation have been issued. According to the schedule, foreign
banks operating in India and Indian banks having presence outside India are to migrate to the
standardised approach for credit risk and the basic indicator approach for operational risk under Basel
II with effect from March 31, 2008. All other scheduled commercial banks are encouraged to migrate to
these approaches under Basel II in alignment with them but in any case not later than March 31, 2009.
Development of financial markets
Financial markets in India in the period before the early 1990s as I mentioned earlier were marked by
administered interest rates, quantitative ceilings, statutory pre-emptions, captive market for
government securities, excessive reliance on central bank financing, pegged exchange rate, and
current and capital account restrictions. As a result of various reforms, the financial markets have now
transited to a regime characterised by market-determined interest and exchange rates, price-based
instruments of monetary policy, current account convertibility, phased capital account liberalisation and
auction-based system in the government securities market. A noteworthy feature is that the
government securities and corporate debt markets are essentially domestically driven since Foreign
Institutional Investor and non-resident participation in these markets are limited and subjected to
prudential ceilings.
The Reserve Bank has taken a proactive role in the development of financial markets. Development of
these markets has been done in a calibrated, sequenced and careful manner such that these
developments are in step with those in other markets in the real sector. The sequencing has also been
informed by the need to develop market infrastructure, technology and capabilities of market
participants and financial institutions in a consistent manner.
The Reserve Bank has accorded priority to the development of the money market as it is the key link
in the transmission mechanism of monetary policy to financial markets and finally, to the real
economy. The Reserve Bank has special interest in the development of government securities market
as it also plays a key role in the effective transmission of monetary policy impulses in a deregulated
environment.
A qualitative change was brought about in the legal framework by the enactment of the Foreign
Exchange Management Act (FEMA) in June 2000 by which the objectives of regulation have been
redefined as facilitating trade and payments as well as orderly development and functioning of foreign
exchange market in India. The legal framework envisages both the developmental dimension and
orderliness or stability. The legislation provides power to the government to re-impose controls if public
interest warrants it. The Reserve Bank has undertaken various measures towards development of
spot as well as forward segments of foreign exchange market. Market participants have also been
provided with greater flexibility to undertake foreign exchange operations and manage their risks.
Linkage between the money, government securities and forex markets has been established and is
growing. The price discovery in the primary market is more credible than before and secondary
markets have acquired greater depth and liquidity. The number of instruments and participants has
increased in all the markets, the most impressive being the government securities market. The
institutional and technological infrastructure has been created by the Reserve Bank to enable
transparency in operations and to provide secured payment and settlement systems.
Current challenges
In assessing short-term prospects, say for 2007-08, it is essential to recognise that the impressive
growth in GDP at 9.4 per cent during the preceding year, reflects the contribution of both - the
structural and the cyclical factors though their relative contribution is somewhat non-quantifiable. The
critical task before the public policy, in general, and Reserve Bank of India, in particular, is to
strengthen the structural factors in the economy but determinedly moderate the cyclical and
excessively volatile elements of the economy.
There are reasonable grounds for optimism in regard to the prospects for Indian economy, and this
has been globally recognised. However, it is necessary to remain guarded in matters relating to
economic growth and stability of an emerging market economy in the current global environment of
high output-growth, notable inflation pressures, persisting global imbalances, incipient signs of
repricing of risks, and perceived volatility of capital flows.
We do recognise that relative to most large emerging market economies, we have several significant
economic strengths but we also have twin deficits - current and fiscal; have a higher component of
more volatile portfolio flows on capital account, and severe policy challenges in managing capital
flows.
In view of the proven success of our overall approach to reform over the last fifteen years, there is
considerable merit in pursuing the gradualist, participative and harmonious approach towards further
reforms in financial and external sectors. Since it is generally accepted that financial and external
sectors in India are reasonably strong and resilient, high priority is being accorded for further reforms
in fiscal sector, agriculture, physical infrastructure, especially in power and urban areas, and delivery
of public services such as water, health and education. Progress in these sectors will help, over the
medium term, enhance competitiveness and accelerated reforms in financial and external sectors, in a
harmonious and non-disruptive manner, thus, reinforcing self-accelerating growth with assured
stability.
Let me conclude by thanking Chairman Ignatiev of Bank of Russia for his kind invitation and warm
hospitality. We hope to further strengthen our bilateral co-operation in matters relating to central
banking, since we realise that we have much more in common than we were aware of.