Deepak Mohanty: Implementation of monetary policy in India
Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the
Bankers Club, Bhubaneswar, 15 March 2010.
* * *
The assistance provided by Shri Bhupal Singh and Shri Binod B. Bhoi is acknowledged.
I thank the Bankers Club, Bhubaneswar for providing me this opportunity to speak to you this
evening. How does the Reserve Bank of India implement monetary policy? This is the
question I would like to address. But before doing that I will briefly touch upon the objectives
and framework of monetary policy, as they have evolved, to set the context for discussion on
operational aspects of monetary policy. I will conclude with a discussion on the process of
monetary policy formulation and communication.
Objectives and framework
In India, the objectives of monetary policy evolved as maintaining price stability and ensuring
adequate flow of credit to the productive sectors of the economy. With progressive
liberalisation and increasing globalisation of the economy, maintaining orderly conditions in
the financial markets emerged as an additional policy objective. Thus, monetary policy in
India endeavours to maintain a judicious balance between price stability, economic growth
and financial stability.
The monetary policy framework in India from the mid-1980s till 1997-98 can be
characterized as a monetary targeting framework on the lines recommended by Chakravarty
Committee (1985). Because of the reasonable stability of the money demand function, the
annual growth in broad money (M3) was used as an intermediate target of monetary policy to
achieve the final objectives. Monetary management involved working out M3 growth
consistent with projected GDP growth and a tolerable level of inflation. In practice, however,
the monetary targeting approach was used in a flexible manner with "feedback" from the
developments in the real sector. For example, if the real GDP growth was expected to be
higher, projection was revised upwards.
M3
In the 1990s, the increasing market orientation of the financial system and greater capital
inflows imparted instability to the money demand function. Consequently, there was a shift to
multiple indicators approach in the late 1990s. Under this approach, interest rates or rates of
return in different markets along with movements in currency, credit, fiscal position, trade,
capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange -
available on a high frequency basis - are juxtaposed with output data for drawing policy
perspectives. The multiple indicators approach continued to evolve and was augmented by
forward looking indicators and a panel of parsimonious time series models. The forward
looking indicators are drawn from the Reserve Bank's industrial outlook survey, capacity
utilization survey, professional forecasters' survey and inflation expectations survey. The
assessment from these indicators and models feed into the projection of growth and inflation.
Thus, the current framework of monetary policy can be termed as augmented multiple
indicators approach.1
Operating procedure
Operating procedure refer to the day to day management of monetary conditions consistent
with the overall stance of monetary policy. It is in essence the "nuts and bolts" of monetary
policy. It involves: first, the choice of the operational target; second, the nature, extent and
the frequency of different money market operations by the central bank; third, the use and
width of the corridor for very short-term market interest rates and; finally, the manner of
signalling policy intentions. The choice of the operating target is crucial as this variable is at
the beginning of the monetary transmission process. The operating target of a central bank
could be bank reserves, base money or a benchmark interest rate. While actions of a central
bank could influence all these variables, the final outcome is determined by the response of
financial markets and institutions to the central bank action. I will briefly survey the
international experience before turning to our own experience.
International experience
─ ─
Among the two operating targets bank reserves and interest rates the focus increasingly
shifted towards interest rates in the early 1990s reflecting greater significance of interest
rates in the monetary transmission mechanism as markets developed in a deregulated
environment. Consequently, the overnight rate emerged as the most commonly pursued
operating target in the conduct of monetary policy. For example, developed countries such
as the US, the UK, Japan, Canada and Australia focus on the overnight inter-bank rate as
the key operative target. The European Central Bank (ECB) follows a corridor approach for
short-term market interest rates with a floor provided by its deposit facility and the ceiling by
its marginal lending facility. The ECB provides liquidity through its main refinancing
operations to ensure that the demand-supply conditions in the inter-bank market support a
short-term inter-bank market interest rate consistent with its interest rate target. While many
emerging market economies (EMEs) target overnight interest rate, there is also a preference
for an interest rate corridor.
Literature on the central banks' own accounts in the industrial countries attribute five main
reasons for reforms in their operating procedures during the 1980s and the 1990s.2
- First, monetary policy instruments were changed to adapt to the new operational
frameworks of the respective monetary authorities.
- Second, with financial deepening occurring more or less entirely outside the central
banks' balance sheets, the share of the financial system over which monetary
authorities had direct control was reduced, warranting indirect, price-oriented as
opposed to quantity-oriented instruments, ways to control the non-monetary
components of liquidity in the financial system.
- Third, in the wake of expansion, diversification and integration of financial markets
and the narrowing of differentials between rates of return in different currencies,
there was a need for instruments that could impart flexibility to liquidity management
in terms of timing, magnitude and accuracy.
- Fourth, the growing importance of expectations in financial markets favoured the
adoption of instruments that were better suited for signalling the stance of monetary
policy.
- Fifth, there was a growing urge on the part of central banks to stimulate money
market activity and improve monetary policy transmission while emphasising the
separation of monetary and government debt management objectives.
Thus, during the 1990s there was continuous reduction in reserve requirements with
increasing emphasis on active liquidity management accompanied by a greater transparency
in the policy signals relating to desired interest rate levels. Most central banks prefer open
market operations (OMO) as a tool of monetary policy, which allow them to adjust market
liquidity and influence the term structure of interest rates.
Indian experience
Consistent with the objectives and policy framework, the operating procedure of monetary
policy in India has also witnessed significant changes. The choice of targets, instruments and
operating procedure was circumscribed to a large extent by the nature of the financial
markets and the institutional arrangements. During the monetary targeting period
(1985-1998), while M3 growth provided the nominal anchor, reserve money was used as the
operating target and cash reserve ratio (CRR) was used as the principal operating
instrument. Besides CRR, in the pre-reform period prior to 1991, given the command and
control nature of the economy, the Reserve Bank had to resort to direct instruments like
interest rate regulations and selective credit control. These instruments were used
intermittently to neutralize the expansionary impact of large fiscal deficits which were partly
monetised. The administered interest rate regime kept the yield rate of the government
securities artificially low. The demand for them was created through periodic hikes in the
Statutory Liquidity Ratio (SLR) for banks. The task before the Reserve Bank was, therefore,
to develop the financial markets to prepare the ground for indirect operations.
The year 1992-93 was a landmark in the sense that the market borrowing programme of the
government was put through the auction process. This was buttressed by a phased
deregulation of lending rates in the credit market. The Reserve Bank also brought down the
SLR to its statutory minimum of 25 per cent by October 1997, while CRR was brought down
from 15 per cent of net demand and time liabilities (NDTL) of banks to 9.5 per cent by
November 1997. The automatic monetization of deficits was also phased out in April 1997.
All these developments resulted in a decline in pre-emption of resources from the banking
system from a peak of 63 per cent in 1992 to 35 per cent by 1997.
The Narsimham Committee (1998), however, noted that the money market continued to
remain lopsided, thin and volatile and the Reserve Bank also had no effective presence in
the market. Therefore, it reiterated the need to transform the call money market into a pure
inter-bank market and recommended the Reserve Bank's operations to be market-based.
Following these recommendations, the Reserve Bank introduced the liquidity adjustment
facility (LAF) in June 2000 to manage market liquidity on a daily basis and also to transmit
interest rate signals to the market. Under the LAF, the Reserve Bank's policy reverse repo
and repo rates set the corridor for overnight market interest rates. Thus, OMO including LAF
emerged as the dominant instrument of monetary policy, though CRR continued to be used
as an additional instrument of policy.
The call money market was transformed into a pure inter-bank market by August 2005 in a
phased manner. Concomitantly, to enable a smooth exit of non-banks, new instruments such
as the collateralized borrowing and lending obligations (CBLO) were introduced in January
2003. With the introduction of prudential limits on borrowing and lending by banks in the call
money market, the collateralized money market segments developed rapidly. Maturities of
other money market instruments such as commercial papers (CPs) and certificates of
deposit (CD) were gradually shortened to seven days in order to align the maturity structure.
Managing large and persistent capital inflows in excess of the absorptive capacity of the
economy added another dimension to the liquidity management operations during the 2000s.
Although, initially the liquidity impact of large capital inflows were sterilised through OMOs and
LAF operations, given the finite stock of government securities in the Reserve Bank's portfolio
and the legal restrictions on issuance of its own paper, additional instruments were needed to
contain liquidity of a more enduring nature. This led to the introduction of the market
stabilisation scheme (MSS) in April 2004. Under this scheme, short-term government securities
were issued but the amount remained impounded in the Reserve Bank's balance sheet for
sterilisation purposes. Interestingly, in the face of reversal of capital flows during the recent
crisis, unwinding of such sterilised liquidity under the MSS helped to ease liquidity conditions.
In response to the measures taken to develop the money market, over the years the turnover
in various market segments increased significantly. All these reforms have also led to
improvement in liquidity management operations by the Reserve Bank as evident from the
stability in call money rates, which also helped improve integration of various money market
segments and thereby effective transmission of policy signals (Chart 1). The rule-based fiscal
policy pursued under the Fiscal Responsibility and Budget Management (FRBM) Act, by
easing fiscal dominance, contributed to overall improvement in monetary management.
Chart 1
Money Market Integration and Policy Rates
Notwithstanding such improvements at the short-end of the financial market spectrum, the
transmission of the policy signals to banks' lending rates has been rather slow given the
rigidities in the system, particularly the preference for fixed interest rate on term deposits.
Against the backdrop of ample liquidity in the system more recently, as banks have reduced
their deposit rates, the effective lending rates would have shown further moderation (Chart 2).
Chart 2
Transmission of Policy Rate to Lending Rate
Policy formulation processes
The process of monetary policy in India had traditionally been largely internal with only the
end product of actions being made public. The process has overtime become more
consultative, participative and articulate with external orientation. The internal work
processes have also been re-engineered to focus on technical analysis, coordination,
horizontal management and more market orientation. The process leading to monetary policy
actions entails a wide range of inputs involving the internal staff, market participants,
academics, financial market experts and the Bank's Board (Chart 3).
Chart 3
Processes of Monetary Policy Formulation
Several new institutional arrangements and work processes have been put in place to meet
the needs of policy making in a complex and fast changing economic environment. At the
apex of the policy process is the Governor, assisted closely by Deputy Governors and guided
by deliberations of the Board of Directors. A Committee of the Board meets every week to
review the monetary, economic and financial conditions and renders advice on policy. There
are several other standing and ad hoc committees or groups which play a critical role with
regard to policy advice. An interdepartmental Financial Markets Committee focuses on
day-to-day market operations and tactics while periodic monetary policy strategy meetings
analyse strategies on an ongoing basis.
Information dissemination and policy communication
It is generally believed that greater information dissemination and policy communication
could lead to better policy outcome. It is, however, not clear as to what extent the
communication would result in shaping and managing expectations. For example, the US
Federal Reserve, since 1994, appears to have been providing forward guidance, while the
ECB appears to be in the mould of keeping the markets informed rather than guiding it. In
India, a middle path is followed by sharing of both information and analysis.
The stance of monetary policy and the rationale are communicated to the public in a variety
of ways, the Governor's most important being the quarterly monetary policy statements.
Further, the policy measures are analysed in various statutory and non-statutory
publications, speeches and press releases. Information on areas relating to the economy,
banking and financial sector is released with stringent standards of quality and timeliness.
Dissemination of information takes place through several channels (Chart 4). The Reserve
Bank has also developed a real time database on the Indian economy, which is available to
the public through its website.
Chart 4
Information Dissemination and Policy Communication
Conclusions
With the changing framework of monetary policy in Indian from monetary targeting to an
augmented multiple indictors approach, the operating targets and processes have also
undergone a change. There has been a shift from quantitative intermediate targets to interest
rates, as the development of financial markets enabled transmission of policy signals through
the interest rate channel. At the same time, availability of multiple instruments such as CRR,
OMO including LAF and MSS has provided necessary flexibility to monetary operations.
While monetary policy formulation is a technical process, it has become more consultative
and participative with the involvement of market participant, academics and experts. The
internal process has also been re-engineered with more technical analysis and market
orientation. In order to enhance transparency in communication the focus has been on
dissemination of information and analysis to the public through the Governor's monetary
policy statements and also through regular sharing of policy research and macroeconomic
and financial information.