Y V Reddy: Monetary and financial sector reforms in India: a practitioner's
perspective
Presentation by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the Indian Economy
Conference, Program on Comparative Economic Development (PCED) at Cornell University, Ithaca,
New York, on April 19-20, 2002. Footnotes and references have been omitted; please see the
Reserve Bank of India's website for these.
* * *
The objectives of this paper are to review the monetary and financial sector reforms in India, identify
the emerging issues and explore the prospects for further reform. The first part is devoted to a brief
background on the need for reforms taken up in 1991-92. The second part is devoted to the
institutional aspects of the reform. Issues relating to ownership, competition and regulation in the
financial sector as a whole, but primarily in the banking sector are analysed. The third part relating to
policy framework focuses on monetary policy and credit delivery. The fiscal policy insofar as it impacts
on the financial sector is also analysed. The fourth part focuses on managing process of reform in its
various dimensions and perspective is that of the Reserve Bank of India (RBI). The concluding part
identifies the critical elements that would possibly determine the progress of reform.
Need for reforms
The Indian financial system of the pre-reform period essentially catered to the needs of planned
development in a mixed-economy framework where the Government sector had a predominant role in
economic activity. As part of planned development, the macro-economic policy in India moved from
fiscal neutrality to fiscal activism (Reddy 2000). Such activism meant large developmental
expenditures, much of it to finance long-gestation projects requiring long-term finance. The sovereign
was also expected to raise funds at fine rates, and understandably at below the market rates for
private sector. In order to facilitate the large borrowing requirements of the Government, interest rates
on Government securities were artificially pegged at low levels, which were unrelated to market
conditions. The government securities market, as a result, lost its depth as the concessional rates of
interest and maturity period of securities essentially reflected the needs of the issuer (Government)
rather than the perception of the market. The provision of fiscal accommodation through ad hoc
treasury bills (issued on tap at 4.6 per cent) led to high levels of monetisation of fiscal deficit during the
major part of the eighties. In order to check the monetary effects of such large-scale monetisation, the
cash reserve ratio (CRR) was increased frequently to control liquidity.
The environment in the financial sector in these years was thus characterised by segmented and
underdeveloped financial markets coupled with paucity of instruments. The existence of a complex
structure of interest rates arising from economic and social concerns of providing concessional credit
to certain sectors resulted in "cross subsidisation" which implied that higher rates were charged from
non-concessional borrowers. The regulation of lending rates, led to regulation of deposit rates to keep
cost of funds to banks at reasonable levels, so that the spread between cost of funds and return on
funds is maintained. The system of administered interest rates was characterised by detailed
prescription on the lending and the deposit side leading to multiplicity and complexity of interest rates.
By the end of the eighties, the financial system was considerably stretched. The directed and
concessional availability of bank credit with respect to certain sectors resulted not only in distorting the
interest rate mechanism, but also adversely affected the viability and profitability of banks. The lack of
recognition of the importance of transparency, accountability and prudential norms in the operations of
the banking system led also to a rising burden of non-performing assets.
In sum, there was a de facto joint family balance sheet of Government, RBI and commercial banks,
with transactions between the three segments being governed by plan priorities rather than sound
principles of financing inter-institutional transactions (Reddy, November 2000). There was a
widespread feeling that this joint family approach, which sought to enhance efficiency through
co-ordinated approach, actually led to loss of transparency, of accountability and of incentive to
measure or seek efficiency.
The policies pursued did have many benefits, although the issue of the higher costs incurred to realize
the laudable objectives remains. Thus, the post-nationalisation phase witnessed significant branch
expansion to mobilise savings and there was a visible increase in the flow of bank credit to important
sectors like agriculture, small-scale industries, and exports. However, these achievements have to be
viewed against the macro-economic imbalances as well as gross inefficiencies at the micro level in the
financial sector compounded by non-transparent accounting of intra-public sector financial
transactions.
Institutional aspects of reforms
Institutions
At present, the institutional structure of the financial system is characterised by (a) banks, either
owned by the Government, RBI or private sector (domestic or foreign) and regulated by the RBI;
(b) development financial institutions and refinancing institutions, set up either by a separate statute or
under Companies Act, either owned by Government, RBI, private or other development financial
institutions and regulated by the RBI and (c) non-bank financial companies (NBFCs), owned privately
and regulated by the RBI.
Since the onset of reforms, there has been a change in the ownership pattern of banks. The legislative
framework governing public sector banks (PSBs) was amended in 1994 to enable them to raise capital
funds from the market by way of public issue of shares. Many public sector banks have accessed the
markets since then to meet the increasing capital requirements, and until 2001-02, Government made
capital injections out of the Budget to public sector banks, totalling about 2 per cent of GDP. The
Government has initiated legislative process to reduce the minimum Government ownership in
nationalized banks from 51 to 33 per cent, without altering their public sector character. The underlying
rationale of the proposal appears to be that the salutary features of public sector banking is not lost in
the transformation process.
Reforms have altered the organizational forms, ownership pattern and domain of operations of
financial institutions (FIs) on both the asset and liability fronts. Drying up of low cost funds has led to
an intensification of the competition for resources for both banks and FIs. At the same time, with banks
entering the domain of term lending and FIs making a foray into disbursing short-term loans, the
competition for supply of funds has also increased. Besides, FIs have also entered into various
fee-based services like stock-broking, merchant banking, advisory services and the like. Currently,
while Industrial Credit and Investment Corporation of India Ltd. (ICICI) is in the process of finalising its
merger with ICICI Bank, Industrial Development Bank of India (IDBI) is also expected to be
corporatised soon. At present, the RBI holds shares in a number of institutions. The further reform
agenda is to divest the RBI of all its ownership functions.
In the light of legal amendments in 1997, the regulatory focus of the NBFCs was redefined, both in
terms of thrust as well as the focus. While NBFCs accepting public deposits have been subject to the
entire gamut of regulations, those not accepting public deposits have been sought to be regulated in a
limited manner. In order to consolidate the law relating to the NBFCs, regulation is being framed to
cover detailed norms with regard to entry point and the regulatory and supervisory issues.
Competition
Steps have also been initiated to infuse competition into the financial system. The RBI issued
guidelines in 1993 is respect of establishment of new banks in the private sector. Likewise, foreign
banks have been given more liberal entry. Recently, the norms for entry of new private banks were
rationalised. Two new private sector banks have been given 'in-principle' approval under these revised
guidelines. The Union Budget 2002-03 has also provided a fillip to the foreign banking segment,
permitted these banks, depending on their size, strategies and objectives, to choose to operate either
as branches of their overseas parent, or, corporatize as domestic companies. This is expected to
impart greater flexibility in their operations and provide them with a level-playing field vis-à-vis their
domestic counterparts.
As a group, however, the performance of PSBs in terms of profitability, spreads, non-performing
assets and standard assets position seems to have been lower than that of the new private sector and
foreign banks. There have been significant divergences in performance among the public sector banks
- some have performed on par with private and foreign banks, whereas the performance of others has
been relatively unsatisfactory. Hence, although PSBs have been subject to Government intervention,
these do not appear to provide a complete explanation of bank performance. Bank specific factors
such as rapid expansion, higher operating costs and differential industry focus seem to have been
important considerations as well. Public sector banks operating in the same environment with the
same constraints have shown varied performance; ultimately this reflects the performance of
management.
Regulation and supervision
A second major element of financial sector reforms in India has been a set of prudential measures
aimed at imparting strength to the banking system as well as ensuring safety and soundness through
greater transparency, accountability and public credibility.
Capital adequacy norms for banks are in line with the Basel Committee standards and from the end of
March 2000, the prescribed ratio has been raised to 9 per cent. While the objective has been to meet
the international standards, in certain cases, fine-tuning has occurred keeping in view the unique
country-specific circumstances. For instance, risk weights have been prescribed for investment in
Central Government securities on considerations of interest rate risk. Also, while there is a degree of
gradualism, there is an intensification beyond the 'best practices' in several instances in recent period,
an example being exposure norms stipulated for the banking sector in respect of investment in equity.
Investments are valued and classified into appropriate categories, as per international best practices.
To take into account the vagaries of interest rate risks, a prescription for meeting a targeted
Investment Fluctuation Reserve out of the realised profits from sale of investments within a stipulated
time frame has also been prescribed recently.
The supervisory strategy of the Board for Financial Supervision (BFS) constituted as part of reform
consists of a four-pronged approach, including restructuring system of inspection, setting up of off-site
surveillance, enhancing the role of external auditors, and strengthening corporate governance, internal
controls and audit procedures. The BFS, in effect, integrates within the Reserve Bank the supervision
of banks, NBFCs and financial institutions.
Prudential regulations have had a significant impact on the banking system in terms of ensuring
system stability even in the face of both external and internal uncertainties, almost throughout during
the second half of the nineties. As at end-March 2001, 95 out of 100 scheduled commercial banks had
capital adequacy ration of 9 per cent or more. There was a distinct improvement in the profitability of
public sector banks measured in terms of operating profits as well as in terms of net profits to total
assets. Reflecting the efficiency of the intermediation process, there has been a decline in the spread
between the borrowing and lending rates as reflected by the decline in the ratio of net interest income
to total assets. The most significant improvement has been in terms of reduction in NPAs.
Policy environment
Changing monetary policy framework
Since the onset of the reforms process, monetary management in terms of framework and instruments
has undergone significant changes, reflecting broadly the transition of the economy from a regulated
to liberalized and deregulated regime. While 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 has varied over
the year depending on the circumstances. Reflecting the development of financial markets and the
opening up of the economy, the use of broad money as an intermediate target has been
de-emphasised, but the growth in broad money (M 3) continues to be used as an important indicator of
monetary policy. The composition of reserve money has also changed with net foreign exchange
assets currently accounting for nearly one-half. A multiple indicator approach was adopted 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 were 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.
The thrust of monetary policy in recent years has been to develop an array of instruments to transmit
liquidity and interest rate signals in the short-term in a more flexible and bi-directional manner. A
Liquidity Adjustment Facility (LAF) has been introduced since June 2000 to precisely modulate
short-term liquidity and signal short-term interest rates. The LAF, in essence, operates through repo
and reverse repo auctions thereby setting a corridor for the short-term interest rate consistent with
policy objectives. There is now greater reliance on indirect instruments of monetary policy. The RBI is
able to modulate the large market borrowing programme by combining strategic debt management
with active open market operations. Bank Rate has emerged as a reasonable signally rate while the
LAF rate has emerged as both a tool for liquidity management and signaling of interest rates in the
overnight market. The RBI has also been able to use open market operations effectively to manage
the impact of capital flows in view of the stock of marketable Government securities at its disposal and
development of financial markets brought about as part of reform.
The responsibility of the RBI in undertaking reform in the financial markets has been driven mainly by
the need to improve the effectiveness of the transmission channel of monetary policy. The
developments of financial markets have therefore, encompassed regulatory and legal changes,
building up of institutional infrastructure, constant fine-tuning in market microstructure and massive
upgradation of technological infrastructure.
Since the onset of reforms, a major focus of architectural policy efforts has been on the principal
components of the organised financial market spectrum: the money market, which is central to
monetary policy, the credit market, which is essential for flow of resources to the productive sectors of
the economy, the capital market, or the market for long- term capital funds, the Government securities
market which is significant from the point of view of developing a risk- free credible yield curve and the
foreign exchange market, which is integral to external sector management. Along with the steps taken
to improve the functioning of these markets, there has been a concomitant strengthening of the
regulatory framework.
The medium-term objective at present is to make the call and term money market purely inter-bank
market for banks, while non-bank participants, who are not subject to reserve requirements, can have
free access to other money market instruments and operate through repos in a variety of instruments.
The Clearing Corporation of India Ltd is expected to facilitate the development of a repo market in a
risk free environment for settlement. A phased programme for moving out of the call money market
has already been announced and the final phase-out will coincide with the implementation of the Real
Time Gross Settlement (RTGS) system. Further reform is being contemplated in terms of reduction of
CRR to the statutory minimum of 3 per cent, removal of established lines of refinance, limits on call
money borrowing lending and borrowing by banks and PDs and a move over to a full-fledged LAF.
With the switchover to borrowings by Government at market related interest rates through auction
system in 1992, and more recently, abolition of system of automatic monetisation, it was possible to
progress towards greater market orientation in Government securities. Further reforms in the
Government Securities market have resulted in the rationalization of T-Bills market, increase in
instruments and participants, elongated the maturity profile, created greater fungibility in the secondary
market, instituted a system of delivery versus payment, strengthened the institutional framework
through Primary Dealers and more recently Clearing Corporation, and enhanced the transparency in
market operations. Clarity in the regulatory framework has also been established with the amendment
to the Securities Contracts Regulation Act. A Negotiated Dealing System for trading in Government
Securities is in operation. Further developments in the Government Securities market hinges on
legislative changes consistent with modern technology and market practices; introduction of a RTGS
system, integrating the payments and settlement systems for Government securities and
standardisation of practices with regard to manner of quotes, conclusion of deals and code of best
practices for repo transactions.
The movement to a market-based exchange rate regime took place in 1993. Reforms in the foreign
exchange market have focused on market development with prudential safeguards without
destabilizing the market. Thus, authorized dealers have been given the freedom to initiate trading
position in the overseas markets; borrow or invest funds in the overseas markets (up to 15 per cent of
tier I capital, unless otherwise approved); determine the interest rates (subject to a ceiling) and
maturity period of Foreign Currency Non-Resident (FCNR) deposits (not exceeding three years); and
use derivative products for asset-liability management. These activities are subject to net overnight
position limit and gap limits, to be fixed by them. Other measures such as permitting forward cover for
some participants, and the development of the rupee-forex swap markets also have provided
additional instruments to hedge risks and help reduce exchange rate volatility. Alongside the
introduction of new instruments (cross-currency options, interest rates and currency swaps,
caps/collars and forward rate agreements), efforts were made to develop the forward market and
ensure orderly conditions. Foreign institutional investors were allowed entry into forward markets and
exporters have been permitted to retain a progressively increasing proportion of their earnings in
foreign currency accounts. The RBI conducts purchase and sale operations in the forex market to
even out excess volatility.
In respect of the financial markets, 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 in the markets has increased in all markets, the most impressive being
the Government Securities market. The institutional and technological infrastructures that have been
created by the RBI to enable transparency in operations and secured settlement systems. The
presence of foreign institutional investors has strengthened the integration between the domestic and
international capital markets.
Credit delivery
The reforms have accorded greater flexibility to banks to determine both the volume and terms of
lending. The RBI has moved away from microregulation of credit to macro management. External
constraints to the banking system in terms of the statutory premptions have been lowered. All this has
meant greater lendable resources at the disposal of banks. The movement towards competitive and
deregulated interest rate regime on the lending side has been completed with linking of all lending
rates to PLR of the concerned bank and the PLR itself has been transformed into a benchmark rate.
As a result of reforms, borrowers are able to the get credit at lower interest rates. The lending rate
between 1991-92 and 2001-02 has declined from about 19.0 per cent to current levels of 10.5-11.0
per cent. The actual lending rates for top rated borrowers could even be lower since banks are
permitted to lend at below Prime Lending Rate (PLR). Further, since banks invest in Commercial
Paper (CP), which is more directly related to money market rates, many top rated borrowers are able
to tap bank funds at rates below the prime lending rates. These developments have been possible to
banks because the overall flexibility now available in the interest rate structure has enabled them to
reduce their deposit rates and still improve their spreads.
In terms of priority sector credit also, the element of subsidisation has been removed although some
sort of directed lending to Agriculture, Small Scale Industry (SSI) and export sector have been
retained. The definition of priority sector has been gradually increased to help banks make loans on
commercially viable terms. However, the actual experience has been that the credit pick up is not up
to the mark and has been generally less than projected by the RBI in its monetary policies, in a
number of years. Also, while in general the rates of interest have come down, they are available more
to highly rated borrowers than to the small and medium enterprises. There is considerable concern
about the inadequate flow of resources to rural areas, and in particular agriculture, while interest rates
have not been reduced to the extent they were, for the corporate sector.
Fiscal policy and financial sector
There are several channels that link the fiscal and financial sectors and in the Indian context four of
them appear significant. These relate to (a) governments' borrowing programme; (b) guarantees
extended by governments; (c) mechanisms such as 'direct debits'; and (d) governments' investments
in financial sector.
The market borrowing programme of the central government continued to be relatively large, both in
gross and net terms. Since a large part of the borrowing programme has to be completed in the first
half of the fiscal year, in view of seasonality for demand for credit on private account, the monthly
average borrowing by centre is around three quarters of a percent of GDP in recent years. Further,
there has been an upward revision in the borrowing programme of central government during the
course of every year, usually, around three quarters of a percent of GDP. It has been possible for RBI
as debt manager to complete the borrowing programme while pursuing its interest rate objectives
without jeopardizing external balance, by recourse to several initiatives in terms of institution,
instruments, incentives and tactics. At the same time, it has been able for RBI to reduce statutory
preemptions in regard to banks to the prescribed minimum of 25% of their net liabilities. The banking
system, in which PSBs account for about three quarters of activity, holds majority of the outstanding
stock of government securities, and currently their holdings in excess of statutory prescriptions are far
in excess of the annual borrowing programme of the Central and State Governments. In any case, a
large part of outstanding government securities are held by Government owned financial institutions,
especially in banking and insurance sectors. RBI has so far been able to successfully reconcile the
interests of Government as its debt manager and of banks as regulator and supervisor. In this regard,
recognizing the importance of containing interest rate risks and widening the participant profile, RBI
has prescribed an Investment Fluctuation Reserve for banks and is pursuing retailing of government
securities. While technological, institutional and procedural bottlenecks for retailing are being
overcome by RBI, some of the constraints such as tax treatment and relatively high administered
interest rates do persist.
The conduct of borrowing programme of State Governments is, however, posing several problems.
While the market borrowing programme of states in aggregate is well below a quarter of centre's
market borrowings, in a liberalized environment, banks cannot be compelled to subscribe to the
programme. It was necessary to provide investors a premium for states' paper over the centre's paper
of a comparable maturity. Of late, the premium is widening and differing as between states, while in
the case of some states, there have been some difficulties in ensuring subscriptions. In recent years,
the increases in states' borrowing programme over the budgeted amounts have been large with the
attendant problems of garnering subscriptions. It has, however, been possible for RBI to conduct the
programme without serious disruption in the markets, since some states have also begun to take
initiatives to improve their fiscal profile and discharge their liabilities, especially to banks, in a timely
fashion. It is necessary to recognise that size of government borrowings is only one element in public
debt management, since there are other liabilities also, especially ballooning of pension liabilities.
In this regard, extra budgetary transactions are also emerging, which impinge on the balance sheets of
banks and other financial institutions which take an exposure on them. For example, "oil bonds" to
settle government's dues to public sector oil companies and "power bonds" to settle dues from State
Electricity Boards to national level power utilities fall in this category. Banks exposure to food credit,
which is in the nature of funding of buffer stock operations is also relatively large at over 2.0% of GDP.
RBI had been advocating that a law be passed imposing a ceiling on government borrowings as
enabled by the Constitution, but more recently, a Bill is under contemplation for fiscal responsibility at
the centre and several states.
Financial intermediaries, especially banks, take exposures with a great degree of comfort when there
is a sovereign guarantee. Such guarantees are often formally extended and notified as such to the
legislative bodies and financial markets. RBI has encouraged governments to pass a legislation
prescribing a ceiling on such guarantees and also charge a fee without exception to ensure credibility
to guarantees and comfort to subscribers. Several State Governments have passed such legislations,
though some are less stringent than others. In view of the magnitudes of such guarantees by many
States, banks have been advised to exercise due diligence in subscribing to them. Apart from explicit
guarantees, recourse is occasionally made by governments to letters of comfort which have a similar
effect, and RBI has been dissuading such relatively non-transparent practices.
There are, in addition, what may be termed as "implicit-guarantees" which have maximum linkage
between fiscal and financial sectors. A predominant point of financial intermediation through banks,
mutual funds, and insurance, in spite of significant reform is undertaken by publicly owned or
government backed financial institutions. Hence, public tend to repose confidence with a
corresponding implicit direct obligation on the part of government to protect the interests of depositors
or investors. Such a reasonable expectation is not only justified on the considerations of reputational
risk and the concept of "holding out' or backing, but also by the obligations discharged in the past by
the Government of India, in several cases; some of them at the instance of regulator concerned.
In some cases, banks and financial institutions seek and obtain instructions for direct debit of dues to
them from government accounts to ensure the timely recovery of dues to them and thus bring about
comfort through credit enhancement. Since large scale recourse to such mechanisms, especially
when State Governments are under fiscal strain has the potential of eroding both the integrity of
budget process and the de facto comfort to financial intermediaries, RBI has been vigorously
advocating avoidance of recourse to such direct debit mechanisms.
The governments have, in its asset portfolio, equity holding and some debts of financial intermediaries
that they own, and financial returns on these do impact the fiscal situation. More important, whenever
pockets of vulnerability arise in financial sector, the headroom available in the fiscal situation to
provide succour to financial entities needs to be assessed. Fortunately, on present reckoning, the
magnitudes of the few pockets of vulnerability appear to be manageable without undue fiscal strain.
In assessing fiscal financial linkage, the scope for money financing of budgets vis-à-vis bond financing
also needs to be considered. Since there are elements of open capital account, the maneuverability
for RBI in the short-term to monetize government's deficit is severely circumscribed by the direction
and magnitudes of such flows. Keeping these considerations in view, RBI and Government have
agreed upon freedom to RBI to determine the extent of monetization of government budget consistent
with macro-economic stability.
Managing the process of reform
Financial sector reform and changes in law
Any reform has both public and private dimensions, and ideally all participants should recognize the
emerging new realities, assess costs and benefits and make attempts to cope. Reform outcomes
should thus, be related not only to public action but also several other factors. In public action itself,
there can be legal, policy and procedural aspects including subordinate legislations and institutional
changes. There are possibilities of significant policy and procedural changes within a given legal
framework and these need to be explored since changes in law are often difficult to get through in any
democratic process.
RBI has been articulating the need for appropriate changes in Law, assisting the Government in the
process and has also been brining about changes in the financial sector without necessarily waiting for
changes in law. Thus, several legislative measures affecting ownership of banks, IDBI, debt recovery,
regulation of non banking financial companies, foreign exchange transactions and money market have
been completed. Those on the anvil include measures relating to fiscal and budget management,
public debt, deposit insurance, securitization and foreclosure, and prevention of money laundering.
The agenda for further legal reform, as identified by several Advisory Groups relate to RBI, Banking
Regulations, Companies, Chartered Accountant, Income-tax, Bankruptcy, Negotiable Instruments,
Contracts, Unit Trust of India, etc.
The legislative process is complex in a democratic set up and it will be inadvisable to rush into
legislation through a "big bang" approach. Furthermore, many elements of economic reform and
underlying legislative framework need to be harmonized. At the same time, it may not be necessary to
wait for legislative framework to change to bring about some of the reforms or initiate processes to
demonstrate usefulness of reform-orientation. In fact, there are several examples of managing reform
within constraints of law which need to be recalled. For example, there are some enabling but not
mandated provisions which may or may not be used. Thus, RBI had shed its direct developmental role
in the sense of money financing, by ceasing to operate on relevant provision and by and large,
confining money creation for Government of