Y V Reddy: Evolving role of the Reserve Bank of India - recent
developments
Speech by Dr Y V Reddy, Governor of the Reserve Bank of India, on the occasion of the
Foundation Day of the Institute of Development Studies, Jaipur, 30 June 2007.
Dr. Reddy is thankful to Mr. Kanagasabapathy, Adviser-in-Charge (Retd.), Reserve Bank of
India, for his valuable advice.
* * *
Respected Professor Vyas, distinguished participants, ladies and gentlemen,
I am indeed thankful to the Institute of Development Studies and Professor Vyas for
providing me this opportunity to share my thoughts with you today on the "Evolving role of
the Reserve Bank of India: Recent Developments".
My association with Professor Vyas has been long, but it became closer since November
2000, when he was appointed as a director on the Central Board of the Reserve Bank of
India. Professor Vyas was also the Chairman of the "Advisory Committee on Flow of Credit
to Agriculture and Related Activities from the Banking System", which was constituted by the
Reserve Bank of India (RBI) in December 2003. Many of the recommendations of the
Committee have since been implemented with good results. Professor Vyas is easily among
the most eminent agricultural economists of the world and had been associated with the
Food and Agriculture Organisation of the United Nations, where he made a significant
contribution. As a person, he is extremely soft spoken and very scholarly, but his scholarship
and erudition sit very lightly on his shoulders. Humility is a trait which comes very naturally to
him. It is my pleasure and honour to be here at his invitation.
The Institute of Development Studies, set up in 1981 at the initiative of a group of academic
scholars and the Government of Rajasthan, has had the benefit of Professor Vyas'
leadership. The Institute aims to contribute to the understanding of the development
processes broadly defined, besides providing a forum for better understanding of the issues
involved in resolving the problems unique to the State of Rajasthan. Given the track record of
the Institute, I am confident that it will continue to make a meaningful contribution to the
development process of the Indian economy in general and of Rajasthan in particular -
especially those of bypassed sections.
I. Evolving role of RBI
The Reserve Bank, established through the Reserve Bank of India Act, 1934 commenced its
operations in 1935. It draws its powers and responsibilities through other legislations also
such as the Banking Regulation Act, 1949. The RBI has over the years been responding to
changing economic circumstances and these organisational developments have been
documented in a recent Report on Currency and Finance for the year 2004-05, the theme of
which was "The Evolution of Central Banking in India". Today, I would like to highlight some
recent developments and discuss certain issues of contemporary relevance relating to the
evolving role of RBI.
First, compared with several countries which introduced rapid reforms in central banking law
and governance in the last about two decades, the Indian experience reflects an evolution or
adaptation of central banking to new economic realities. These changes were brought about
both through some legislative measures and changes in operating procedures.
Second, this evolution has inter alia contributed to imparting some autonomy to the central
de
bank, facto, particularly in the areas of monetary management and financial regulation.
Third, in sharp contrast to the situation before 1991, since then, apart from a transparent
communications policy and a broad based consultative approach to policy making,
Governors' speeches and appearances on the electronic media and the press have been
substantial, having significant influence on markets and opinions. In the process, the RBI has
gained reputational bonus and public credibility.
Fourth, thanks to related developments in the last 15 years, financial and external sectors in
India have also become relatively more efficient and resilient.
Fifth, while the effectiveness of monetary policy has improved significantly to meet the
evolving demands, some constraints are persisting, which impact the choice and
effectiveness of our policy framework.
In reviewing the evolving role of RBI, it is necessary to distinguish between an exclusive
monetary authority and a generic central bank, which performs not only monetary functions,
but also other functions, in particular, banking supervision. A recent survey by the Bank for
International Settlements (BIS) has shown that over sixty per cent of central banks across
developed and developing countries have banking supervisor's role exercised by a central
bank. India has adopted a middle path. Banking Supervision continues to be with RBI, but it
has been accorded a distinct semi-independent status. A Board for Financial Supervision
(BFS), a Committee of the Central Board of RBI, was set up in 1994 and meets at least once
a month to guide and oversee the RBI's supervisory functions. The BFS includes four
independent members drawn from the Central Board of Directors of RBI with relevant
professional background and experience.
While it is true that globally the general tendency recently has been to stress the
independence or autonomy of central banks in general and monetary management in
particular, this has been brought about by different countries in a variety of means:
constitutional changes, legal amendments, treaty, obligations, policy reorientation or by
changes in practices, procedures and overall environment of public policy. Evolution, thus,
does not exclude legislative changes to meet the challenges of globalisation and new
economic realities, though in India most changes have thus far been effected within the basic
structure of the original legislation in terms of mandate, governance procedures and
instruments. A notable legislative measure in the recent past (The Reserve Bank of India
Amendment Act, 2006) nevertheless relates to greater flexibility to RBI in regard to cash
reserve requirements, deployment of forex reserves, and clarity in regulation over money,
forex and government securities markets.
The independence of a central bank sometimes is rigidly associated with a single objective,
such as price stability. But, in practice, there are many instances of dual or multiple
objectives with equal or different weights and there are many cases of hierarchy of objectives
for a central bank. In the overall context of its policy and operations, the RBI in practice is
subject to the current legal framework and operates as a monetary authority with multiple
objectives and multiple functions assigned to it. Within such a mandate, efforts are made to
(a) articulate the hierarchy of objectives in a given context; (b) impart transparency through
enhanced communication, emphasise participative nature of decision making in its activities,
including monetary management, through advisory committees; and (c) move towards
greater autonomy in operations relating to monetary policy while ensuring harmony in macro
policies in coordination with the government.
II. RBI autonomy: de jure versus de facto
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 RBI is placed under the Entry 38 of List 1 of Schedule VII of the
Constitution of India, which is the Union List.
The Preamble to the RBI Act describes the basic objective 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,
there is no explicit mandate for price-stability or formal inflation targeting. 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. Consideration of macroeconomic and financial stability is
also subsumed in the articulation of policy.
The RBI is also entrusted with the management of foreign exchange reserves, which are
reflected in its balance sheet. While RBI is essentially a monetary authority, its founding
statute mandates it to be the manager of public debt of the Government of India and banker
to the Government. In terms of Section 20 of the RBI Act 1934, RBI has the obligation to
undertake the receipts and payments of the Central Government and to carry out the
exchange, remittance and other banking operations, including the management of the public
debt of the Union. In the recent past, a functional separation of monetary and debt
management was debated and the Union Budget for 2007-08 has announced a proposal to
setting up of an autonomous Debt Management Office to keep the debt management distinct
from monetary management. Further, as per Section 21 of the said Act, RBI has the right to
transact Government business of the Union in India.
While, as per statute, RBI is the monetary authority of the country, the RBI has also been
entrusted with the work relating to Banking and Supervision by an enactment in 1949. The
RBI exercised a tight regime of exchange control particularly under the Foreign Exchange
Regulation Act (FERA), 1973; but, a qualitative change was brought about in the legal
framework to enable liberalization by the enactment of the Foreign Exchange Management
Act (FEMA) in June 2000 replacing the earlier FERA. With this, 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.
It is significant to note that the RBI Act, Section 19 precludes RBI from performing certain
business which protects the integrity of the institution, such as trading or taking any direct
interest in commercial, industrial or other undertaking, purchasing shares or giving loans
against shares, and advancing money on security of immovable property, drawing or
accepting bills payable otherwise than on demand. Because of the last provision, the RBI
evolved the Market Stabilisation Scheme through an MoU with the Government, for
undertaking stabilisation operations.
On practical considerations, central bank independence may be viewed as related broadly to
three areas, viz., management including personnel matters; financial aspects; and conduct of
policy. Managerial independence refers to the procedures for appointment, term of office and
dismissal procedures of top central bank officials and the governing board. It also includes
the extent and nature of representation of the Government in the governing body of the
central bank and Government's powers to issue directions. Financial independence relates to
the freedom of the central bank to decide the extent to which Government expenditure is
via
either directly or indirectly financed central bank credits. Direct or automatic access of
Government to central bank credits would naturally imply that monetary policy is
subordinated to fiscal policy. Finally, policy independence is related to the flexibility given to
the central bank in the formulation and execution of monetary policy, under a given mandate.
While the Central Government may give such directions to the RBI after consulting the
Governor as it may consider necessary in the public interest, the overall management of the
Bank's affairs and business rests with the Central Board of Directors. The Governor is
appointed by the Central Government and may be removed from office without specifying
any reason. All Deputy Governors are also appointed by the Central Government and may
be similarly removed. All Directors of the Central Board are nominated by the Central
Government with one Government official as a participant in the Board deliberations. The
Directors hold office during the pleasure of the Central Government which can also
supersede the RBI's Central Board.
The staffing pattern is left to the RBI, but rules governing their service conditions and
compensation are not out of alignment with public sector in general and banking sector in
particular. There is legal protection to the Bank and also to its officers for actions taken in
good faith. There have been no noticeable changes in the recent past in the relationship
between the Government and RBI on managerial/personnel matters.
vis-à-vis
On financial aspects of RBI Government, however, there have been several positive
developments. Since the 1990s, as the case for according greater operational flexibility to the
RBI in the conduct of monetary policy and regulation of the financial system became
stronger, the practice of automatic monetisation of the Government's fiscal deficit through the
issue of ad hoc treasury bills came under severe criticism (Rangarajan, 1993). In subsequent
years, the phasing out of automatic monetisation of fiscal deficits by 1997 and the enactment
of FRBM legislation in 2003 are two important milestones in the direction of providing
safeguards to monetary policy from the consequences of expansionary fiscal policy and
ensuring a degree of de facto autonomy of the RBI.
It is interesting to note that the above autonomy in financial matters was obtained by the RBI
through exchange of letters and agreements whereby automatic monetisation through ad hoc
Treasury Bills was discontinued since April 1997. The Fiscal Responsibility and Budget
Management (FRBM) Act, 2003, further strengthened the position by prohibiting the RBI from
participating in primary issuances of all government securities.
The RBI has gradually withdrawn from the practice of providing concessional finance or
refinance for specified sectors such as agriculture, industry and export, though the legal
provisions continue to enable it. In the same view, as part of strengthening monetary
management, only notional provisions are made out of RBI profits for Agriculture, Industrial
and Housing Credit Funds. No doubt, there are persistent demands on RBI to reverse the
process, but the RBI advocates direct fiscal support to development activities so as to be
transparent, accountable and quantifiable rather than through monetary operations of RBI,
which would tantamount to quasi-fiscal operations.
Transfer of the balance of profits, after necessary provisions, to the Central Government has
been rationalised as part of the reform process in 1997. The present arrangement is
governed by the objective of reaching a stipulated level of reserves in RBI's balance sheet
over a period - though the timeframe to reach the level is extended by mutual consent to
accommodate immediate fiscal compulsions.
In technical parlance, accountability of an institution like RBI goes together with a specific
mandate and operational independence or autonomy to achieve the said mandate. In the
absence of these, in practice, the RBI is accountable indirectly to Parliament through the
Ministry of Finance, Government of India. At times, it is summoned by Parliamentary
Committees, and even in such cases, it generally plays only a supportive role to the
executive wing of the government.
In a recent IMF Working Paper published in April 2007, where the indices of central bank
autonomy have been calculated for 163 central banks as of end-2003, in a group of 32
emerging markets, India has scored 0.25 for political autonomy of the central bank as against
the average score of 0.56 for the group of emerging markets and scored 0.75 for economic
autonomy of the central bank which is the same as the average score for that group.
Dr. Bimal Jalan at the time of laying down office as Governor in 2003 remarked: "the
autonomy of a central bank is best set by convention rather than by statute, especially in
emerging countries. There should be harmony between the government and the central bank
with shared objectives, though the instrumentalities in achieving the objectives may be
different".
Harmonious relations between Government and RBI have no doubt generally contributed to
the successful policy outcomes thus far, but it would not be appropriate to conclude that
there are no differences in analysis, approaches, judgements and instrumentalities. In the
given legal and cultural context, while making every effort to give its views either informally or
formally, but as unambiguously as possible, the RBI generally respects the wishes and final
inclination of the government. The RBI, however, has to accept the responsibility for all its
decisions and actions, while being generally conscious of the impact of its articulation and
actions on the credibility for central banks operations. The Government, for its part,
recognises the dilemmas posed to RBI, and accord significant weight to central bank's
judgements.
In sum, de jure, RBI has not been accorded autonomy on par with recent trends in some of
de facto,
the industrialised as well as emerging economies; but, the experience reflects a
growing degree of autonomy. During the period of reform since 1991, there has been a
gradual and mutually agreed progress towards greater autonomy in matters relating
particularly to financial markets and, in the conduct of monetary policy.
III. Monetary policy framework
The preamble to the Reserve Bank of India Act, 1934 sets out in a way broadly the tone of
RBI's monetary policy objectives: "to regulate the issue of Bank notes and the 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". I can do no better than quote
one of my distinguished predecessor and current Chairman, Economic Advisory Council to
the Prime Minister, Dr. C. Rangarajan on this subject:
"In a broad sense, the objectives of monetary policy can be no different
from the overall objectives of economic policy. The broad objectives of
monetary policy in India have been: (a) to maintain a reasonable degree of
price stability; and (b) to help accelerate the rate of economic growth. The
emphasis as between the two objectives has changed from year to year,
depending upon the prevailing conditions." (1997)
Thus, although, unlike the current trend in many countries, there is no explicit mandate for
price stability, the twin objectives of monetary policy in India have evolved as those of
maintaining price stability and ensuring adequate flow of credit to the productive sectors of
the economy. Of late, considerations of macroeconomic and financial stability have assumed
an added importance in view of increasing openness of the Indian economy.
In India, the broad money (M3) emerged as the nominal anchor from the mid-1980s based
on the premise of a stable relationship between money, output and prices. In the late 1990s,
in view of the ongoing financial openness and increasing evidence of changes in the
underlying transmission mechanism with interest rates and exchange rates gaining in
importance vis-à-vis quantity variables, it was felt that monetary policy exclusively based on
the demand function for money could lack precision. The RBI, therefore, formally adopted a
multiple indicator approach in April 1998 whereby interest rates or rates of return in different
financial markets along with data on currency, credit, trade, capital flows, fiscal position,
inflation, exchange rate, etc., are juxtaposed with the output data for drawing policy
perspectives. Such a shift was gradual and a logical outcome of measures taken during the
reform period since the early 1990s. The switchover to a multiple indicator approach
provided necessary flexibility to respond more effectively to changes in domestic and
international economic environment and financial market conditions.
In the context of monetary policy making, let me highlight some recent developments:
First, the availability of instruments to manage, in the context of large capital flows and
sterilisation, has been strengthened with open market operations through Market
Stabilisation Scheme (MSS), which was introduced in April 2004. Under the MSS, the RBI
was allowed to issue government securities as part of liquidity sterilisation operations in the
wake of large capital inflows and surplus liquidity conditions. While these issuances do not
provide budgetary support, interest costs are borne by the fisc; as far as Government
securities market is concerned, these securities are also traded in the secondary market, on
par with the other government stock.
Second, another development in the recent period has been to fix a numeraire to inflation.
The RBI's self-imposed medium-term ceiling on inflation at 5.0 per cent has had salutary
effect on inflation expectations and the socially tolerable rate of inflation has come down. In
recognition of India's evolving integration with the global economy and societal preferences
in this regard, going forward, the resolve would be to condition policy and expectations for
inflation in the range of 4.0-4.5 per cent. This would help in maintaining self accelerating
growth, keeping in view the desirability of medium-term inflation at around 3 per cent to
ensure India's smooth global integration.
Third, while the preferred instruments are indirect, and varied, there is no hesitation in taking
recourse to direct instruments also, if circumstances so warrant. In fact, complex situations
do warrant the dynamics of different combination of direct and indirect instruments, in
multiple forms, to suit the conditions affecting transmission mechanism.
Fourth, there are occasions when the medium-term goals, say reduction in cash reserve ratio
for banks, conflict with short-term compulsions of monetary management requiring actions in
both directions. Such operations do warrant attention to appropriate articulation to ensure
policy credibility. Drawing a distinction between medium-term reform goals and flexibility in
short-term management is considered something critical in the current Indian policy
environment.
Fifth, while there is considerable merit in maintaining a broad distinction between monetary
and prudential policies of the central bank, the RBI did not hesitate, as a complement to
monetary tightening, to enhance the provisioning requirements and risk weights for select
categories of banking assets, namely real estate, housing and capital market exposures.
These measures were needed to specifically address the issues of rapidly escalating asset
prices and the possible impact on banks' balance sheets in a bank dominated financial
sector. This combination, and more important, readiness of the RBI to use all instruments,
has a credible impact, without undue restraint on growth impulses.
Sixth, some of the important factors that shaped the changes in monetary policy framework
and operating procedures in India during the 1990s were the delinking of budget deficit from
its automatic monetisation by the RBI, deregulation of interest rates, and development of the
financial markets with reduced segmentation through better linkages and development of
appropriate trading, payments and settlement systems along with technological
infrastructure. With the enactment of the FRBM Act in 2003, the RBI has withdrawn from
participating in the primary issues of Central Government securities with effect from April
2006. The recent legislative amendments enable a flexible use of the CRR for monetary
management, without being constrained by a statutory floor or ceiling on the level of the
CRR. The amendments also removed the statutory floor of 25 per cent on the Statutory
Liquidity Ratio (SLR) - which would further improve the scope for flexible liquidity
management by the RBI.
IV. Major issues in analytics of monetary policies
Let me now discuss some major issues in the analytics of monetary policy in India. It is
generally recognised that monetary policy framework, to be efficient and effective requires a
reasonable assessment of potential output, a measure of unemployment, and above all a
convincing measure of inflation. Monetary authorities are acutely aware of inherent and
growing difficulties in regard to all these three but in India, perhaps the problems are less
than fully appreciated.
First, the measurement of potential output, a key prerequisite for forward looking monetary
policy, is generally difficult and more so in an increasingly globalising economies like India.
Recent studies have shown that the measurement of potential output is extremely sensitive
to the choice of methodology. In respect of India, empirical exercises have projected
potential output in India in the range of 6 to 8 per cent, based on alternative approaches
et
(Ranjan al, 2007). Besides the wide range of estimates, which in itself is indicative of the
uncertainties surrounding potential output, it needs to be noted that these estimates do not
fully factor-in fast and significant structural changes of the more recent period which are
expected to have a positive impact on potential output. Similarly, reliable estimates of
inventories, unit labour costs, coefficient of capacity utilisation and the like, which can serve
as proximate determinants of potential output, are not readily available. Thus, what would
appear in standard analysis as an elegant formulation of the monetary policy operating rule is
extremely difficult to estimate and fashion, in terms of policy formulation, in India.
Second, lack of an economy-wide measure of the rate of unemployment makes the conduct
of monetary policy in India complex. While framing appropriate policy responses to trends in
output and inflation, policymakers would like to make some assessment as to whether the
economy is operating beyond or short of full employment. In the absence of comprehensive
data on employment, any measure of the natural rate of unemployment (NRU) would be
inadequate for policy formulation. Given that only a small part of the Indian labour force, say
about ten per cent, is employed in the organised sector and the greater majority is in the
unorganised sector, estimation of unemployment is rendered difficult. Moreover, even within
the organised sector, the process of gradual outsourcing of jobs compounds the problem of
measurement.
A third set of issues which represents a gap in monetary policy analysis and, therefore, a
constraint on operational autonomy, is the assessment of inflationary pressures in the
economy. In terms of commodity prices, the issue relates to the choice of price index and
RBI has to depend on those which are readily available. In India, there are two sets of
indices, viz., wholesale price index (WPI) and consumer price indices (CPIs). The latter is
based on occupational classification and category of residence (rural or urban). Four broad
measures of CPIs are available at the national level to capture prices of a defined basket of
goods and services consumed by a particular segment of the population : (i) CPI for
Agricultural Labourers (CPI-AL); (ii) CPI for Rural Labourers (CPI-RL); (iii) CPI for Industrial
Workers (CPI-IW); and (iv) CPI for Urban Non-Manual Employees (CPI-UNME). While these
various measures of CPI do move together in the long run, significant variations are
observed in the short-run. Moreover, food and fuel items together, having a weight of 52.6
per cent in CP-IW, are prone to supply shocks, both domestic and global, which contribute to
sudden spikes in the inflation rate. As a result, this renders the assessment of inflationary
pressures difficult which, in turn, complicates the process of monetary policy formulation. The
recommendation of the National Statistical Commission (NSC) regarding the importance of
developing an appropriate index is relevant in this regard and, when implemented, may
alleviate the situation. The NSC has recommended:
"As the current CPI series does not provide changes in the prices for the
entire rural and urban population since they are designed to measure the
changes in the prices of goods and services consumed by specific
segments of the population, there is a need to compile the CPI separately
for the entire rural and urban population. TAC on SPCL should give a
methodology for compilation of CPI of rural and urban areas separately
using quinquennial NSS Consumer Expenditure Survey Data for the
preparation of the weighting diagram. TAC should also give a procedure for
compiling a combined index based on these two indices. The existing
system of price data collection should be suitably streamlined and
augmented so as to provide price data for compilation of CPI for rural and
urban areas."
V. Instruments and transmission of monetary policy: dynamics
The instruments that the central bank uses in day-to-day implementation of monetary policy
can be broadly classified into direct and indirect instruments. Typically, direct instruments
include cash and/ or liquidity reserve ratios, directed credit and administered interest rates.
The indirect instruments generally operate through price channel which cover repurchase
(repos) and outright transactions in securities (open market operations), standing facilities
(refinance) and market-based discount window. The RBI currently uses multiple instruments
to ensure that appropriate liquidity is maintained in the system, consistent with the objective
of price stability, so that all legitimate requirements of credit are met. Towards this end, the
RBI pursues, inter alia, a policy of active management of liquidity through open market
operations including liquidity adjustment facility (LAF), market stabilisation scheme and cash
reserve ratio, and deploys the policy instruments at its disposal, flexibly, as warranted by the
situation. Changes in fixed reverse repo/repo rates set by the RBI from time to time for the
conduct of its LAF, under which the central bank conducts daily auctions for the banks, have
emerged as the main instruments for interest rate signalling in the Indian economy.
Institutional mechanisms have been evolved in parallel to improve transparency and
communication of monetary policy.
Traditionally, four key channels of monetary policy transmission are identified, viz., interest
rate, credit aggregates, asset prices and exchange rate channels. The interest rate channel
emerges as the dominant transmission mechanism of monetary policy. Nevertheless, it is fair
to regard the credit channel as running alongside the interest rate channel to produce
monetary effects on real activity. Changes in interest rates by the monetary authorities also
induce movements in asset prices, which generate wealth effects in terms of market
valuations of financial assets and liabilities. With the increasing integration of the Indian
economy with the global economy the significance of exchange rate channel has increased.
In the recent period, a fifth channel - expectations - has assumed prominence in the conduct
of forward-looking monetary policy in view of its influence on the traditional four channels.
In a market-oriented economy, policy signals are transmitted through an integrated and
efficient money, government securities and foreign exchange markets combined with a
robust payments and settlement system. The RBI has therefore, been engaged in
developing, widening and deepening of various markets and institutions. 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.
A wide range of regulatory and institutional reforms were introduced in a planned manner
over a period to improve the efficiency of financial markets. These included development of
market micro structure, removal of structural bottlenecks, introduction / diversification of new
players / instruments, free pricing of financial assets, relaxation of quantitative restrictions,
better regulatory systems, introduction of new technology, improvement in trading
infrastructure, clearing and settlement practices and greater transparency. Prudential norms
were introduced early in the reform phase, followed by interest rate deregulation and gradual
lowering of statutory pre-emptions. These policies were supplemented by strengthening of
institutions, encouraging good market practices, rationalised tax structures and enabling
legislative and accounting fram