Mr Reddy discusses monetary policy in India
Speech by Y.V. Reddy, Deputy Governor of the Reserve Bank of India, at the Fourth Securities
Industry Summit, in Mumbai, India on 26 May 1999.
Chairman and friends,
I thank the organisers for inviting me to deliver the inaugural address at the Fourth Annual Securities
Industry Summit. Although the discussions in this Summit will specifically veer around the securities
market, monetary policy strongly influences the working of the financial markets. As a central banker,
I will, therefore, speak on monetary policy making, which I trust will provide some perspectives to the
deliberations at the Summit.
Objectives
In India, monetary policy has always emphasised the objectives of price stability and growth. What
this, in effect, has meant in practical policy setting is, formulating a balance between the two
objectives depending on the evolving situation but within the broad context of keeping the inflation
rate within a reasonable bound.
Apart from these two important goals, there has been a conscious attempt on the part of the Reserve
Bank in recent years to maintain orderly conditions in the foreign exchange market, and to curb
destabilising and self-fulfilling speculative activities. This has assumed strategic importance for the
sustainability of the external sector in the face of growing cross border capital flows into the
economy. With the increasing order of domestic and international financial integration, exchange rate
expectations do impact on the domestic stance of monetary policy and hence the significance of
inflation. In the transitional phase, however, given the exchange market imperfections, the exchange
rate objective may occasionally predominate due to emphasis on avoidance of undue volatility. In
fact, sometimes, as was the case recently, it could be the most dominant reason for short-term
monetary policy adjustments.
In a broader framework, the objectives of monetary policy in India continue to be price stability and
growth. These are pursued inter alia through ensuring credit availability, with stability in the external
value of the rupee as well as overall financial stability, all being reflective of pursuit of the overall
objectives. The relative emphasis among the objectives is governed by the prevailing circumstances.
Targets
The conduct of monetary policy in India has traditionally proceeded with the help of an intermediate
target, which the central bank could influence directly and which bears a reasonably close relationship
with the ultimate objectives. The particular mode of central bank intervention is the operating
instrument. Macro-economic variables, which post useful information about the objectives of
monetary policy, although they may not in themselves be amenable to central bank targeting, are
'indicators' or 'information' variables.
The Reserve Bank of India (RBI) sets indicative broad money (M3) expansion targets in line with the
expected rate of growth of GDP and a tolerable level of inflation. Consistent with the targeted level of
broad money expansion, is a desired level of reserve money expansion. The order of the reserve
money expansion, however, has to be consistent with the likely fiscal and external payments position,
since the main sources of reserve money expansion are net RBI credit to government and net foreign
exchange assets. The targeted M3 expansion is publicly announced through the Governor's statement
on monetary and credit policy. The broad money target is also supported by a number of other
indicators such as movement in interest rates, exchange rate and availability of credit to productive
sectors of the economy.
Monetary target is premised on a stable demand function for money. In the Indian context, a number
of earlier studies on the demand for money have demonstrated that it is stable. Dr.Rangarajan
demonstrated that money demand equations provide reasonable predictions of average changes in
prices over a medium-term horizon of 4-5 years, though not necessarily on a year-to-year basis. In
essence, the concern was with the long-run stability of the money demand function in terms of its
most proximate determinant, i.e. real GDP, rather than its short-term behaviour. Most recent studies in
RBI examined the stability of the money demand equation using a number of alternative procedures.
While these tests showed parameter shifts, they did not point to parameter instability. In the 1990s,
the monetary targets were set either as point targets or in a narrow range implying scope for missing
point targets, but it has to be recognised that a wider range would question the credibility, diluting the
very objective of targeting.
The pressures on monetary expansion in the earlier part of targeting exercise emanated from
monetisation of fiscal deficit and later on from capital inflows. During the period 1985-92, net RBI
credit to Central Government accounted for over 96 per cent of the monetary base, which was reduced
to about 65 per cent in the subsequent period during 1993-98, with corresponding increase in net
foreign exchange assets of the RBI.
Although the practice of automatic monetisation of the budgetary deficit was done away with,
effective from April 1997, it can significantly reduce the pressure on monetisation only if the size of
the Central Government's market borrowing programme is kept within reasonable limits. However,
there is a qualitative difference, since the RBI has some flexibility now in respect of the extent of its
support to Government borrowing programme.
With increasing market orientation of the financial structure and international capital flows, monetary
policy responds to developments on an ongoing basis. In an administered interest rate and exchange
rate regime, the quantity variables dominated and transmitted monetary policy impulses. However,
external and financial sector reforms have since enhanced the sensitiveness of quantity variables to
their market determined price, i.e. interest rate and exchange rate.
It must be recognised that in recent times, the emphasis has also been on closely monitoring different
indicators apart from relying on the intermediate target. For aiming at the intermediate target (viz.,
broad money) the underlying operating target is reserve money, particularly the banks' reserves, while
the supplementary operating target is the short-term interest rate proxied generally by the overnight
call money rates.
Operating Procedures and Instruments
The reforms in the monetary and financial sectors have enabled the RBI to expand the array of
instruments at its command. As already mentioned, the operational target of monetary policy
continues to be banks' reserves which is controlled by changes in reserve requirements effected
mainly through the instruments of cash reserve ratio (CRR). However, the use of CRR as an
instrument of monetary control is sought to be de-emphasised and the liquidity management in the
system is increasingly undertaken through open market operations (OMO), both outright and repos.
In view of the overall downward movement in CRR, except on occasions of exchange rate volatility,
the excess liquidity in the system is mopped up by outright sales of government securities by RBI.
Over the reform period, the market absorption of government securities was facilitated by reforms in
the government securities market, which ensured market related rates of interest and thus some of the
basic conditions were provided for developing a secondary market.
The short-term liquidity management is also aided by conduct of repos on a regular basis. Usually, the
RBI conducts repos for a maturity of up to 14 days, which is the cycle for reserve requirements.
Recently, the RBI has been conducting 3-4 day fixed rate repos to absorb very short-term liquidity and
to even out money market rates, especially overnight call money rates. The repo rates and the amounts
tendered in the repo auctions, apart from reflecting liquidity conditions, provide a floor for the
overnight call money rates. In the event of tight liquidity conditions, the RBI' s liquidity support to
primary dealers (PDs) enables it to directly intervene in the market, thereby moderating pressures on
the overnight call money rates.
The RBI also reactivated the Bank Rate in April 1997 as a reference rate and as a signalling device to
reflect the stance of monetary policy. The interest rates on different type accommodation from the
RBI including refinance are linked to the Bank Rate. The activation of the Bank Rate endowed the
RBI with an additional instrument. It must be noted that the announcement impact of Bank Rate
changes has been pronounced on the prime lending rates of commercial banks.
The refinance window of the RBI provides an additional instrument for influencing reserves. Until
recently, the RBI provided two types of refinance facilities to banks - export credit refinance and
general refinance. While the former facility is formula based and is extended to banks against their
outstanding export credit eligible for refinance, the latter facility was provided to enable banks to tide
over their temporary liquidity shortages.
The general refinance window has since been replaced by a Collateralised Lending Facility (CLF)
within the overall framework of an Interim Liquidity Adjustment Facility (ILAF).
Currently, the liquidity management at the short end is in the form of ILAF. Liquidity is injected by
the RBI through CLF to banks, export credit refinance to banks, and liquidity support to PDs. All
these facilities are available subject to quantitative limits [formula-based] for specified duration and at
the Bank Rate. Additional limits could be availed by banks under Additional Collateralised Lending
Facility (ACLF) and by PDs at two percentage points above the Bank Rate. Absorption of liquidity
will continue to be through fixed rate repo i.e., at repo rate announced on a day to day basis. These are
supplemented by OMO in Government dated securities and Treasury Bills by the RBI. OMO involve
decisions by the RBI on a daily basis or even intra-day basis in regard to the quantities and the cut-off
yields at which the dated securities and Treasury Bills are operated upon. It may be noted that these
operations are in the given framework of the CRR that directly affects liquidity and the Bank Rate.
Often, the periodic Treasury bill auctions by RBI, themselves provide opportunities for the RBI to
signal its overall stance on the appropriateness of interest rate and liquidity.
Thus, the ILAF provides a mechanism by which liquidity would be injected at various interest rates,
and absorbed when necessary at the fixed repo rate, so that the volatility in the money market is
minimised and the market operates within a reasonable range.
At present, there is no formal corridor for market interest rates, but the Bank Rate often has provided
an upper bound and the fixed repo rate provided the lower bound. In a sense, an informal corridor
exists for short-term interest rates and the introduction of ILAF has facilitated the evolution of this
corridor.
The experience with the movements in the interest rates and exchange rate in the last two years has
increasingly reflected the integration among various market segments. The interest rates of major
market instruments [91-day and 364-day Treasury Bills, Commercial Paper and Certificate of
Deposit] in recent period show some correlation with reasonable speed of adjustment, which augers
well for some element of targeting of interest rates in the conduct of monetary policy.
Dilemmas
Monetary management poses dilemmas not only at the analytical level but also at the operational
level. In fact, some of these dilemmas have been articulated in the recent policy statements of
Governor Bimal Jalan.
First, the basic dilemma arises out of the trade off between growth and inflation. Although a
consensus has emerged on the basis of empirical evidence that in the long run there is no trade off
between employment and inflation, it is the inconclusive evidence in the short-run that poses a
challenge for monetary management. Given the deleterious effects of inflation on distribution of
income, there is an imperative need in developing countries to keep the inflation rate as low as
possible. In the last year's Economic Survey, it was stated that "As world inflation rates are currently
of the order of 0 to 3 percent, 4 to 6 percent inflation rate could be regarded as an acceptable level for
India at present." This order of inflation has been, it may be noted, built into the monetary operating
framework of the RBI.
Secondly, even a moderate inflation rate poses a dilemma in an open economy. If the domestic
inflation rate of an economy, however low it may be, is higher than the average inflation rate of its
trading partners, it puts pressure on the exchange rate. In this context, the question of simultaneous
balance of the internal and external sectors becomes a major issue.
Thirdly, in a dynamic setting, when the financial markets are continually evolving, and payment
systems and technology are changing, one may not find a clear cut evidence of stability in the money
demand, which is taken as a basis for intermediate targeting; and in such circumstances, one needs to
look also at other relevant indicators. It is not that such dilemmas are specific to us and by and large,
countries follow a menu approach or a 'check list' to track a number of relevant variables.
Fourthly, the dilemma that the central bank faces as a manager of public debt and the monetary
authority is well known. While the former may require keeping its cost low, the latter may demand a
reduction in the extent of government debt that it holds, considering the impact it has on aggregate
expenditures and thus on demand. The market-borrowing programme of the government is determined
by the fiscal parameters, but the size of the government debt impacts on the interest rates in the
economy and it should be clearly recognised that there is a limit to the extent of market borrowing
that the central bank can support. These dilemmas can be resolved through proper fiscal monetary
coordination.
Fifthly, the conflict between roles of the regulator/supervisor and as a conductor of the monetary
policy has often been discussed. This is illustrated by the case of a central bank, as a monetary
authority, which may require to reduce the liquidity in the system by raising the rate of interest. But,
such a rise in the rate of interest could be detrimental to the interests of the weak banks. Similarly,
while tightening prudential norms, the central bank has to take into account its impact on banking
systems' capacity to intermediate credit.
Finally, in an open economy, the potential conflict between the interest rate and exchange rate
objectives could arise when short-term and volatile capital flows occur. For example, the bouts of
volatility in exchange rate experienced by us recently necessitated that market conditions are rendered
less liquid even if it meant that the interest rates are kept high. This policy has implications for
promoting domestic output growth in that the interest rates may for this purpose, be required to be
kept at moderate levels. But the larger objectives of evading the likely potential disruption of
domestic activities arising out of an exchange rate crisis should also be kept in view.
Conclusion
As part of financial sector reforms, a number of steps have been taken to enhance the effectiveness of
monetary policy, and these include, improvement in the payments and settlement systems,
development of secondary market in government securities with a diversification of investor base,
reduction in non-performing assets, introduction of ALM guidelines, and reduction in the overall
transactions costs. In particular, the recent initiatives of RBI to develop money market and debt
markets should contribute to improving the transmission mechanisms of monetary policy.
All the reforms in the monetary and financial sectors may not have the desired results without
credible fiscal adjustment. Notwithstanding the discontinuation of automatic monetisation of fiscal
deficit, the responsibility for management of a large government borrowing programme does
circumscribe the manoeuvrability of monetary policy.