Rakesh Mohan: Capital account liberalisation and conduct of monetary policy -
the Indian experience
Paper by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, presented at an
International Monetary Seminar on Globalisation, Inflation and Financial Markets, organised by the
Bank of France, Paris, 14 June 2007.
Assistance of Sanjay Hansda, Indranil Bhattacharyya, Partha Ray and M.D. Patra in preparing the paper is gratefully
acknowledged.
* * *
I. Overall approach
The distinguishing feature of our overall reform process initiated in the early 1990s has been the
accomplishment of high economic growth in an environment of macro economic and financial stability.
In fact, we have achieved acceleration in growth while maintaining price and financial stability.
During this period, apart from all the other reforms, we have achieved current account convertibility,
and also opened the capital account to a substantial extent. With this growing openness, we have not
been insulated from exogenous shocks. These shocks, global as well as domestic, included a series
of financial crises in Asia, Brazil, Russia and Mexico, in the 1990s and other events such as 9/11
terrorist attacks in the US, border tensions, sanctions imposed in the aftermath of nuclear tests,
political uncertainties, changes in the Government, and the current oil shock. Nonetheless, stability
could be maintained in financial markets. Indeed, inflation has been contained since the late-1990s to
an average of around five per cent, distinctly lower than that of around seven to eight per cent per
annum over the previous four decades. Simultaneously, the health of the financial sector has recorded
very significant improvement.
The story of Indian reforms is by now well-documented (e.g., Ahluwalia, 2002); nevertheless, what is
less appreciated is that India achieved this acceleration in growth while maintaining price and financial
stability. With increased deregulation of financial markets and increased integration of the global
economy, the 1990s were turbulent for global financial markets: 63 countries suffered from systemic
banking crises in that decade, much higher than 45 in the 1980s. Among countries that experienced
such crises, the direct cost of reconstructing the financial system was typically very high: for example,
recapitalisation of banks had cost 55 per cent of GDP in Argentina, 42 per cent in Thailand, 35 per
cent in Korea and 10 per cent in Turkey. There were high indirect costs of lost opportunities and slow
economic growth in addition (McKinsey & Co., 2005). It is therefore particularly noteworthy that India
could pursue its process of financial deregulation and opening of the economy without suffering
financial crises during this turbulent period in world financial markets. The cost of recapitalisation of
public sector banks at less than 1 per cent of GDP is therefore low in comparison. Whereas we can be
legitimately gratified with this record, we now need to focus on the new issues that need to be
addressed for the next phase of financial development, particularly in the context of fuller capital
account convertibility and increasing integration of financial markets.
That the current annual GDP growth of around 8.5 to 9 per cent can be achieved in India with a level
of gross domestic investment in the range of 30 to 33 per cent over the past 4 years suggests that the
economy is functioning quite efficiently. Thus our policy of gradual and sequenced reform cannot be
said to have been at the cost of growth or efficiency. We need to ensure that we maintain this level of
efficiency and attempt to improve on it further. As the Indian economy continues on such a growth
path and attempts to accelerate it, new demands are being placed on the financial system.
In examining the conduct of monetary policy in India in the presence of continuing and gradual capital
account liberalisation, a key lesson is that this process has to be viewed in the context of the overall
reform process. As an economy undergoes the transition from a closed to an open economy, first on
the current account and then on the capital account, the interest of financial stability is served by
simultaneous action on a number of different fronts. The framework of monetary policy itself has to
undergo a change from the previous direct methods of control of monetary aggregates to indirect
methods imparting signals through the market. For such a change to be effective the monetary policy
transmission process has to be strengthened through development of all financial markets, and the
building of market micro-infrastructure. On the external front, the transition from a fixed or pegged
exchange rate to a market determined one itself needs careful assessment of the efficiency of the
foreign exchange market, the capabilities of market players and evaluation of effects of exchange rate
volatility. The operation of financial markets and the degree of vulnerability that an economy becomes
exposed to with greater opening is itself influenced significantly by fiscal conditions. Hence the efficacy
of monetary policy, efficiency of financial markets, and external vulnerability are closely linked to the
practice of prudent fiscal policy. Finally, for efficient monetary policy transmission, and depth, liquidity
and efficiency of financial markets, financial intermediaries themselves have to be strengthened. It is in
view of all these inter-linkages that I have chosen to provide a brief overview of developments in each
of these areas as they have evolved over the past decade and a half in India.
II. Process of setting out monetary policy objectives
General objectives
Traditionally, central banks pursue the twin objectives of price stability and growth or employment. In
pursuing the basic objectives, central banks also need to keep in view considerations of orderly
financial markets and financial stability. Needless to say, the objectives of monetary policy are
interrelated and have trade-offs as well. The preamble to the Reserve Bank of India Act, 1934 sets out
the Bank's objectives as "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". Although there is no explicit mandate for price stability, as is the current
trend in many countries, the 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. In essence, monetary policy aims to maintain a judicious balance between price stability
and economic growth. The relative emphasis between price stability and economic growth is governed
by the prevailing circumstances at a particular time and is spelt out from time to time in the policy
announcements of the Reserve Bank.
Considerations of financial stability have assumed greater importance in recent years in view of the
increasing openness of the Indian economy, financial integration and the possibility of cross border
contagion. As we observed the severe costs of financial instability elsewhere, financial stability has
ascended the hierarchy of monetary policy objectives since the second half of the 1990s. Strong
synergies and complementarities are observed between price stability and financial stability in India.
Accordingly, we believe that regulation, supervision and development of the financial system remain
within the legitimate ambit of monetary policy broadly interpreted.
Framework
Till 1997-98, monetary policy in India used to be conducted with broad money (M3) as an intermediate
target. The aim was to regulate money supply consistent with the expected growth of the economy
and the projected level of inflation. The targeted monetary expansion used to be set on the basis of
estimates of these two crucial parameters. In practice, the monetary targeting framework was used in
a flexible manner with feedback from developments in the real sector.
In the wake of financial sector reforms and opening up of the economy in the 1990s, appropriateness
of the monetary targeting framework was questioned with the changing inter-relationship between
money, output and prices. Accordingly, the Reserve Bank switched over in 1998-99 to a multiple
indicator approach. With this approach, interest rates or rates of return in different markets (money,
capital and government securities markets), along with data on currency, credit extended by banks
and financial institutions, fiscal position, trade flows, capital flows, inflation rate, exchange rate,
refinancing and transactions in foreign exchange available on high-frequency basis, are all examined
along with output in framing monetary policy.
The specific features of the Indian economy, including its socio-economic characteristics predicate the
investing of the monetary authority with multiple objectives for some time to come. While it could be
desirable in the interest of clarity and transparency to stack up the objectives in a hierarchy, the jury is
still out on the merits of public announcement of the policy weights assigned to each objective.
Flexibility in the setting of monetary policy should override consideration of transparency so that public
indication of weighting patterns associated with objectives should not solidify into a binding rule.
Moreover, continuous monitoring of the underlying macro economic and financial conditions for
monetary policy purposes will necessitate a continuous re-balancing of weights assigned to various
objectives. In a pragmatic sense, therefore, it should suffice for the monetary authority to indicate the
main objectives and an ordinal ranking, at best, to reflect the reading of underlying developments.
A single objective for monetary policy, as is usually advocated, particularly in an inflation targeting
framework, is a luxury that India cannot afford, at least over the medium term. The cause of monetary
policy is not lost, however; analytically, it can be shown that even if one of the multiple objectives is
nominal among others that may be real, it can serve as the quintessential nominal anchor and enable
monetary policy to work. This view is supported by a pragmatic and influential strand in the literature
which questions the recent proliferation of inflation targeting as a monetary policy framework
(Friedman, 2000; McCallum, 1981). As regards inflation targeting, as the monetary policy regime
fulfilling the single mandate advocacy, the jury is still out. Even though there has been an increase in
the number of central banks adopting inflation targeting since the early 1990s, a number of central
banks, notably the Federal Reserve, retain multiple objectives. I am not a monetary scholar, but I do
feel that, given the current domestic and international complexities, we need to continue with a flexible
framework for monetary policy. The least we need in the current circumstances is a less simplistic
approach.
"In India, we have not favoured the adoption of inflation targeting, while keeping the attainment of low
inflation as a central objective of monetary policy, along with that of high and sustained growth that is
so important for a developing economy. Apart from the legitimate concern regarding growth as a key
objective, there are other factors that suggest that inflation targeting may not be appropriate for India.
First, unlike many other developing countries we have had a record of moderate inflation, with double
digit inflation being the exception, and largely socially unacceptable. Second, adoption of inflation
targeting requires the existence of an efficient monetary transmission mechanism through the
operation of efficient financial markets and absence of interest rate distortions. In India, although the
money market, government debt and forex market have indeed developed in recent years, they still
have some way to go, whereas the corporate debt market is still to develop. Though interest rate
deregulation has largely been accomplished, some administered interest rates still persist. Third,
inflationary pressures still often emanate from significant supply shocks related to the effect of the
monsoon on agriculture, where monetary policy action may have little role. Finally, in an economy as
large as that of India, with various regional differences, and continued existence of market
imperfections in factor and product markets between regions, the choice of a universally acceptable
measure of inflation is also difficult" (Mohan, 2006b).
It is important to recognise the reality of multiple objectives of monetary policy in India. Nonetheless, it
needs to be appreciated that relative to the past, we need to communicate better on the objective of
albeit
price stability and as firmly as possible, without necessarily a precise numerical objective.
Indeed, why should a monetary policy invested with multiple objectives choose to quantify only one -
the inflation rate? Indeed, setting such a precise numerical objective for inflation runs the risk of loss of
central bank credibility in the context of the dominance of supply side shocks emanating from sources
such as monsoon failure and administered pricing of various agricultural commodities and petroleum
products. Whereas the share of agriculture in GDP has been declining and is now less than 20 per
cent, the sector continues to be extremely important since the majority of the population remains
dependent on agriculture. Therefore, setting precise numerical targets for inflation is fraught with the
risk of loss of reputation across a large constituency.
Nevertheless, as the Indian economy becomes increasingly open with fuller capital account
convertibility, the objective of progressively bringing inflation down to near international levels and
maintaining price stability assumes greater importance. The experience of successfully bringing down
inflation from persistent higher levels since the late 1990s to around 5 per cent in recent years has
already brought down inflation expectations significantly.
As we place greater emphasis on low inflation and price stability, we also need to improve
communication with respect to the understanding of inflation. At present, headline inflation in India is
indicated by the weekly release of the All India Wholesale Price Index (WPI). Most countries use the
Consumer Price Index (CPI) instead. The CPI is difficult to use in India because of the existence of 4
indexes of CPI, each reflecting the consumption basket of different sets of consumers in urban and
rural areas.
An appropriate inflation indicator should (i) reflect price changes of constituent items accurately and (ii)
provide some understanding of headline inflation. Whereas it is feasible to construct an economy wide
consumer price index on the lines of the harmonized consumer price index (HICP) adopted in the UK
and the Euro Area, it is not clear how useful it would be as an indicator of the general price level, given
the widely differing consumption baskets as between rich and poor, between rural and urban areas
and even between regions in India. In fact, a measure of producer prices to which the wholesale price
index (WPI) is akin, is likely to be more representative and familiar across the country, since these
prices are more likely to be uniform across the country. Accordingly, the commodity/services based
price index should be seen as useful more as an indicator/information variable than as defining the
inflation objective. Moreover, the WPI is available on a weekly basis, with a two week lag, whereas the
CPI indices are only available on monthly basis, and with a 2 month lag.
Monetary policy should be more explicitly associated with managing inflation expectations rather than
current inflation. Accordingly, the guiding criterion for inclusion of a variable in the inflation indicators
panel should be the information content on future inflation. An important sub-set would be real sector
indicators of future inflation such as variability of output around trend/potential, capacity utilisation,
inventory, corporate performance, industrial/ investment expectations and other indicators of
aggregate demand. We have initiated greater quantitative technical work in these areas over the last
couple of years to better inform our monetary policy making with a forward looking approach.
The Reserve Bank has also initiated inflation expectation surveys so that we can have some direct
indicators of changing inflation expectations of the public. These quarterly surveys are still in the pilot
testing stage so their results are not yet in the public domain. But the initial results look promising.
The more complex is the mandate for the central bank, the more is the necessity of communication
(Mohan, 2005). The Reserve Bank of India clearly has complex objectives. Apart from pursuing
monetary policy, financial stability is one of the overriding concerns of the RBI. Within the objective of
monetary policy, both control of inflation and providing adequate credit to the productive sectors of the
economy so as to foster growth are equally important. This apart, the Reserve Bank acts as a banking
regulator, public debt manager, government debt market regulator and currency issuer. Faced with
such multiple tasks and complex mandate, there is an utmost necessity of clearer communication on
the part of the Reserve Bank.
A significant step towards transparency of monetary policy implementation is formation of various
Technical Advisory Committees (TACs) in the Reserve Bank with representatives from market
participants, other regulators and experts. In line with the international best practices and with a view
to further strengthening the consultative process in monetary policy, the Reserve Bank, in July 2005,
set up a Technical Advisory Committee on Monetary Policy (TACMP) with external experts in the
areas of monetary economics, central banking, financial markets and public finance. The Committee
meets at least once in a quarter, reviews macroeconomic and monetary developments and advises
the Reserve Bank on the stance of monetary policy. The Committee has contributed to enriching the
inputs and processes of monetary policy setting in India. Whether any further institutional changes are
necessary, however, remains an open question.
III. Development of monetary policy instruments and transmission process
Consistent with the structural changes in the monetary policy framework, improvements in the
channels of transmission emerged early on as a concurrent objective in order to enhance policy
effectiveness. Monetary policy clearly cannot work without adequate monetary transmission and the
appropriate monetary transmission cannot take place without efficient price discovery of interest rates
and exchange rates in the overall functioning of financial markets and their integration. Therefore, the
corresponding development of the money market, Government securities market and the foreign
exchange market became necessary. Accordingly, from the 1990s, the RBI simultaneously undertook
the development of the domestic financial market spectrum, sequenced into the process of
deregulation of interest rates, the withdrawal of statutory pre-emptions, the qualitative improvement in
monetary-fiscal coordination and the progressive liberalisation of the exchange and payments regime,
including the institution of a market oriented exchange rate policy. The development of financial
markets in India encompassed the introduction of new market segments, new instruments and a
sharper focus on regulatory oversight.
We have made a carefully calibrated transition from an administered interest rate regime to one of
market determined interest rates over a period of time, while minimising disruption and preserving
financial stability. This approach also provided market participants adequate time to adjust to the new
regime.
The growing market orientation of monetary policy has tilted the choice of instruments decisively from
direct to more indirect and market-based monetary policy measures. Until the early 1990s, statutory
pre-emptions in the form of cash reserve ratio (CRR) and statutory liquidity ratio (SLR) requirements
locked away nearly 65 per cent of bank deposits, severely eroding the profitability of the financial
system and effectiveness of monetary policy. The SLR was brought down from 38.5 per cent of net
demand and time liabilities (NDTL) in early 1992 to 25 per cent in October-1997. The CRR had been
reduced progressively from 15 per cent in 1991 to 4.5 per cent in 2003, before it had to be increased
again in steps to 6.5 per cent in the current monetary tightening phase. Monetary maneuverability has
now been strengthened further with removal of the erstwhile floor of 3 per cent and ceiling of 20 per
cent in CRR through a statutory amendment. The statutory minimum SLR of 25 per cent has also
been removed to provide for greater flexibility in the RBI's monetary policy operations.
The key policy development that has enabled a more independent monetary policy environment was
the discontinuation of automatic monetisation of the government's fiscal deficit since April 1997
through an agreement between the Government and the Reserve Bank of India in September 1994,
marking a unique milestone in monetary-fiscal coordination. Another important institutional change
was the freeing of the RBI's balance sheet from the burden of exchange guarantees accumulated in
the pre-reform era. Subsequently, enactment of the Fiscal Responsibility and Budget Management
Act, 2003 has strengthened the institutional mechanism further: from April 2006 onwards, the Reserve
Bank is no longer permitted to subscribe to government securities in the primary market. This step
completes the transition to a fully market based system for Government securities. Looking ahead,
consequent to the recommendations of the Twelfth Finance Commission, the Central Government has
now ceased to raise resources on behalf of State Governments, which now have to access the market
directly. Thus, State Governments' capability in raising resources will be market determined and based
on their own financial health. For ensuring a smooth transition, institutional processes are being
revamped towards greater integration in monetary operations.
Given the pivotal role of the money market in transmission, efforts initiated in the late 1980s were
intensified over the full spectrum. Following the withdrawal of the ceiling on inter-bank money market
rates in 1989, several financial innovations in terms of money market instruments such as certificate of
deposits, commercial paper and money market mutual funds were introduced in phases. Barriers to
entry were gradually eased by increasing the number of players and relaxing the issuance and
subscription norms in respect of money market instruments, thus fostering better price discovery. In
order to improve monetary transmission as also on prudential considerations, steps were initiated in
1999 to turn the call money market into a pure inter-bank market and, simultaneously, to develop a
repo market outside the official window for providing a stable collateralised funding alternative,
particularly to non-banks who were phased out of the call segment, and banks. The Collateralised
Borrowing and Lending Obligation (CBLO), a repo instrument developed by the Clearing Corporation
of India Limited (CCIL) for its members, with the CCIL acting as a central counter-party for borrowers
and lenders, was permitted as a money market instrument in 2002. With the development of market
repo and CBLO segments, the call money market has been transformed into a pure inter-bank market,
including primary dealers, from August 2005. A recent noteworthy development is the substantial
migration of money market activity from the uncollateralised call money segment to the collateralised
market repo and CBLO markets. Thus, uncollateralised overnight transactions are now limited to
banks and primary dealers in the interest of financial stability. Technological upgradation has
accompanied the development of the money market. Efforts are currently underway to introduce
screen-based negotiated quote-driven dealings in call/notice and term money markets. Information on
overnight rates and volumes would be disseminated by the RBI in order to enable market participants
to assess the liquidity conditions in an efficient and transparent manner.
The government securities market was moved to an auction-based system in 1992 to obtain better
price discovery and to impart greater transparency in operations. This was a major institutional
change, which, along with the freeing of the money and foreign exchange market and the phasing out
of automatic monetisation of fiscal deficits, created a conducive environment for the progressive
deregulation that was to follow. The setting up of well capitalised Primary Dealers (PDs) for dealing in
versus
Government securities followed in 1995, backed up by the introduction of Delivery Payment
(DvP) for Government securities, adoption of new techniques of floatation, introduction of new
instruments, particularly Treasury Bills of varying maturities and repos on all Central Government
dated securities and Treasury Bills of all maturities by April 1997.
Since April 1992, the entire Central Government borrowing programme in dated securities has been
conducted through auctions. In 2005, the Reserve Bank put in place an anonymous order matching
system to improve price discovery, and settlement procedures for mitigating risks. To further activate
trading and improve the depth of the securities market, the introduction of a "when issued" market has
also been announced recently. All these measures have brought about significant changes and a new
treasury culture is developing, contributing to the formation of the term structure of interest rates. The
demand for government securities is now driven more by considerations of effective management of
liquidity rather than by statutory liquidity requirements.
The Indian foreign exchange market has been widened and deepened with the transition to a
marketdetermined exchange rate system in March 1993 and the subsequent liberalisation of restrictions on
various external transactions leading up to current account convertibility under Article VIII of the
Articles of Agreement of the International Monetary Fund in 1994. Since the mid-1990s, banks and
other authorised entities have been accorded significant freedom to operate in the market. Banks have
been allowed freedom to fix their trading limits and to borrow and invest funds in the overseas markets
up to specified limits. They have been allowed to use derivative products for hedging risks and
assetliability management purposes. Similarly, corporates have been given flexibility to book forward cover
based on past turnover and are allowed to use a variety of instruments like interest rates and currency
swaps, caps/collars and forward rate agreements. The swap market for hedging longer-term exposure
has developed substantially in recent years. A number of steps have also been taken to liberalise the
capital account covering foreign direct investment, portfolio investment, outward investment including
direct investment as well as depository receipt and convertible bonds, opening of Indian corporate
offices abroad and the like. In recent years, the Reserve Bank has delegated exchange control
procedures to banks and authorised dealers to such an extent that there is hardly any need to
approach the Reserve Bank for any approval. These reforms are being reflected in vibrancy in activity
in various segments of the foreign exchange market with the daily turnover over US $ 28 billion (as at
the end of April 2007).
A key area of emphasis in the development of financial markets in India is the provision of the
appropriate technological infrastructure for trading, clearing, payment and settlement. Since the late
1990s, the establishment of a modern, robust payments and settlement system consistent with
international best practices has emerged as an important objective of the RBI. A three-pronged
strategy of consolidation, development and integration has been pursued in this regard. Consolidation
revolves around strengthening the existing payment system by providing the latest levels of
technology. The developmental dimension includes real time gross settlement, centralised funds
management, securities settlement and structured electronic financial messaging. Other key elements
in the technological content of market development are electronic clearing (introduced in 1994),
electronic finds transfer (1996), quick funds transfers with centralised settlement in Mumbai (2003),
negotiated dealing system (NDS), screen based order matching system (2002) for electronic reporting
of trades and online dissemination system and submission of bids for primary issuance of government
securities and a Clearing Corporation of India Ltd. (CCIL), promoted by banks, financial institutions
and primary dealers for clearing and settlement of trades in foreign exchange, government securities
and other debt instruments, commenced operations in April 2001. The CCIL acts as a central
counterparty (CCP) to all transactions and guarantees settlement of trades executed through its rules
and regulations eliminating counterparty risks in adherence to international best practices. Oversight
over the payments and settlement system is vested in a National Payments Council, and Board for
Payment and Settlement Systems established within the RBI.
As may be seen from this brief description of the various measures that had to be taken to develop the
market and institutional framework for efficient monetary policy transmission, development of markets
is an arduous and time consuming activity that requires conscious policy making and implementation.
Markets do not develop and function overnight: they have to be created, nurtured and monitored on a
continuous basis before they start functioning autonomously. Efficient transmission of monetary
impulses clearly needs integration of markets.
Issues
Interest rate deregulation is essential to smoothen the transmission channels of monetary policy and
to enhance the signaling effects of policy changes. Whereas considerable progress has been made in
this direction, full deregulation is constrained by the need for various policy interventions in the context
of a still developing economy. The Government had nationalised most of the banking system in 1969
in order to ensure the spread of banking throughout the country. Whereas new private sector banks
have now been introduced since the mid 1990s, public sector banks still account for 70 per cent of
banking assets. These banks need to continue to perform various public policy activities, particularly in
the area of agriculture, small and medium enterprises, and the cause of overall financial inclusion. This
can also include certain degree of credit allocation and interest rate directions. Hence, monetary
transmission can get muted at the margin.
The Government also fixes certain administered interest rates on a number of small saving schemes
and on provident funds, along with providing certain tax incentives, in the absence of well developed
social security systems. As banks have to compete for funds with small saving schemes, the rates
offered on long-term deposits mobilised by banks sometimes have to be set at levels higher than
would have obtained under competitive market conditions. In fact, this has been observed to be a
factor contributing to downward stickiness of lending rates, which has some implications for the
effectiveness of monetary policy. This is a reality that we have to appreciate and live with given the
absence of social security coverage and adequate safety nets in the country. These small savings
schemes administered by the government through the wide reach of post offices, and some through
commercial banks, provide small savers access to tax savings instruments that are seen as safe and
stable. Whereas they do have some impact in terms of blunting monetary transmission mechanisms,
they can perhaps be seen as contributing to overall financial stability. Benchmarking these
administered interest rates to market determined rates has been proposed from time to time. Whereas
some rationalisation in schemes has indeed been done, more progress will depend on the emergence
of better social security and pension systems, and perhaps easier access to marketable sovereign
instrume