Personal Website of R.Kannan
Students Corner - A Decade of Economic
Reforms in India - A Review

Besides the pursuit of price stability, the Reserve Bank attempts to ensure that sufficient credit is available at a reasonable cost to the productive sectors of the economy to fund growth. At the heart of the reforms of the monetary fiscal interface lay the objective of enhancing lendable funds with the banking system by limiting the Government’s draft of resources by fiat . Following the deregulation of interest rates, the price of credit also emerged as a focus of monetary policy attention. With the slowdown in economic activity in the second half of the 1990s, the Reserve Bank attempted to put in place a softer interest rate regime with a view to facilitating the revival of credit demand.

The 1990s witnessed a weakening of the simultaneity of the processes of money and credit creation underscoring the need for focusing greater attention on credit aggregates.5 The share of foreign assets of the banking sector in M3 increased substantially, concomitantly reducing the share of domestic credit to 89.6 per cent during 2001-02 from 115.7 per cent during 1989-90. The proportion of the net bank credit to Government in domestic credit, however, increased to 45 per cent during the 1990s as compared with 43 per cent during the 1980s and the 1970s reflecting the persistence of the fiscal constraint. The proportion of incremental net bank credit to the Government in the Centre’s gross fiscal deficit increased from 51.7 per cent during the first half of the 1990s to 59.5 per cent during the latter half of the 1990s.

The composition of net bank credit to the Government changed substantially as the declining net Reserve Bank support to the Centre was mirrored by the increasing investment by the banking system in government securities. Scheduled commercial banks’ investments in government securities, as a result, increased from 25.3 per cent of deposits as at end-March 1990 to 37.3 per cent by end-March 2002 even as the SLR was brought down to 25 per cent.

The banks’ continued preference for government securities, almost 12 percentage points above the statutory requirements, can be attributed to a variety of factors:

• Increased resources emanating from strong capital flows on the supply side.

• Weak credit off-take on the demand side in line with the industrial slowdown as well as due to a downward rigidity in the bank lending rates. Reported shortening of the working capital cycle of manufacturing companies may be yet another reason for weak credit demand (Business Standard, 2003).

• Heightened risk aversion on the part of the banks on account of prudential guidelines requiring risk-weight for credit to the commercial sector vis-à-vis the credit risk-free government paper.

• Growing gross market borrowings of the Government in view of the large fiscal gap.

This near exclusive recourse to gilts to park investible surpluses even by strong commercial banks reflects dissipation of banking knowledge capital with regard to credit appraisals and runs a danger of the link between liquidity, credit, money and economic activity being severed in the long-run (Mohan, 2002).

A critical concern regarding the changes in the monetary-fiscal co-ordination is the impact on the cost of public debt. Although the interest rates on market borrowings hardened with the switch to market-determined rates in the initial years of the reform process, they declined sharply from 1997-98 onwards and are now at their lowest in the last two decades. The weighted average interest rate on government borrowings followed an inverted U-curve, initially increasing from around 11.5 per cent in the late 1980s to 13.75 per cent by 1995-96 and thereafter declining to 9.44 per cent during 2001-02. The reduction in the yields continued during 2002-03, with the yield on the 10-year paper declining from 7.36 per cent at end-March 2002 to around 6.5 per cent by mid-March 2003.

An important issue in the context of the monetary-fiscal interface, drawing upon the unpleasant monetarist arithmetic (UMA) proposition, is the non-inflationary central bank financing of the gross fiscal deficit of the Centre and an optimal degree of monetisation. The decline in the ratio of net Reserve Bank credit to the Centre to GDP to 0.7 per cent during the 1990s led to a view that the degree of monetisation has been on the lower side (Rakshit, 2000; Venkitaraman 1995). On the other hand, it has been argued that while bond financing may increase real interest rates vis-a-vis money financing, it is still beneficial as it reduces inflation and, hence, enhances long-run welfare (Moorthy et al, 2000). There exists an optimal degree of monetisation for a given level of government deficit (Prasad and Khundrakpam, 2000). For the Union Budget, 2001-02, the optimal degree was about 40 per cent of the budgeted fiscal deficit (Rao, 2000). The optimal degree of monetisation has been falling in the second half of the 1990s, and the decline in monetisation may be reflecting structural changes and policy efforts to widen the financial markets to enable the absorption of government debt (RBI, 2002a). The degree of monetisation of fiscal deficits is also constrained by the fluctuations in capital flows (RBI, 2002d).

It was possible to ease the fiscal constraint on monetary management in recent years on account of a strong demand for government paper essentially emanating from a mix of strong capital flows and relatively poor credit offtake. This also implies that the burden of direct financing of the fiscal deficit could easily revert to the Reserve Bank in case of a reversal in the liquidity conditions, especially as banks’ investments in Government securities are already far in excess of their statutory SLR requirements. The overall task of monetary management, therefore, becomes more and more difficult when a large and growing borrowing programme puts pressure on the absorptive capacity of the market (RBI, 2001b).

Scheduled commercial banks’ credit to the commercial sector increased by 15.9 per cent during the 1990s as compared with 16.8 per cent during the 1980s. The conventional bank credit-deposit ratio declined from 60.4 per cent as at end-March 1991 to 53.4 per cent as at end-March 2002, in line with the long-term trends. Unlike in the 1970s and 1980s, when commercial credit was squeezed by statutory stipulations, the decline in the 1990s partly reflected the growing securitisation of bank portfolios, following the easing of investment norms. It is, therefore, important to expand the concept of bank credit to include other investments in money and equity markets (RBI, 1998b). Once the data on such non-SLR sources are taken into account, the share of credit as a proportion of bank deposits increased from 58.7 per cent as at end-March 1997 to 60.8 per cent as at end-March 2002, substantially higher than that of 53.4 per cent in terms of the conventional definition.

Bank credit plays a critical role in the Indian economy as the principal source of external financing for the corporate sector. Although directed credit programmes have been phased out, the Reserve Bank continues to monitor credit as a driver of growth. With the growing market orientation of the Indian economy, business cycle analysis is emerging as an important input for the formulation of a forward-looking monetary policy. In this context, recent research to find robust leading indicators of activity has identified non-food credit as a potential lead indicator, notwithstanding episodic aberrations from this underlying relationship.

Industrial production and non-food credit are cointegrated with Granger causality tests indicating a bi-directional causation.6 A component-wise analysis of industrial output shows that the bi-directional causation is relatively weaker between non-food credit and intermediate goods (RBI, 2001b). While the bidirectional causation reduces the usefulness of the leading indicator property of non-food credit, the leading property finds support from a comparative analysis of the impulse responses which indicate that the impact of a shock to IIP on non-food credit is smaller vis-à-vis that of a shock to non-food credit on IIP. This dynamic and complex relationship between non-food credit and industrial activity, therefore, needs to be further investigated before ascribing leading, coincident or lagging information content to non-food credit in relation to real activity (Mall, 1999; Mohanty, Singh and Jain, 2000; RBI, 2001b, 2002a, 2002b).

In brief, non-food credit and industrial production show co-movement. Cointegration analysis suggests that a 10 per cent increase in industrial production leads to an almost 15 per cent increase in real non-food credit.7 In view of this, the recent preference of banks to invest in government securities could be attributed, partly to the weak industrial demand. Reflecting the role of credit in the economy and its sensitivity to interest rate signals, the provision of adequate liquidity to meet credit growth and support investment demand in the economy continues to be a core policy objective of the Reserve Bank. Given the information content, credit is one of the variables in the present multiple indicator approach to monetary policy in India.

The Reserve Bank had to operate simultaneously in the money and foreign exchange markets to counterbalance domestic and external sources of monetisation following the opening up of the economy in the 1990s. Besides, the gradual evolution of inter-linked financial markets, while necessary for economic efficiency, posed challenges of rapid contagion to monetary management. With the growing market orientation, the role of the Reserve Bank moved away from exercising control and discretion towards becoming an active player in the market itself through proactive, timely and effective interventions to modulate liquidity conditions and signal the policy stance in regard to interest rates (Kanagasabapathy, 2001). The empirical evidence suggests that the Reserve Bank was able to stabilise liquidity conditions in the market for bank reserves by systematically reacting to changes in bank liquidity, autonomous of policy action, with discretionary operations (RBI, 2001b; Sen Gupta et al, 2000).

An episodic analysis brings out the increasing effectiveness of liquidity management. During the initial episodes of financial market volatility, the monetary policy responses induced a very sharp reaction in the bank reserves as the Reserve Bank did not possess commensurate instruments to fine-tune market liquidity on a day-to-day basis. The Reserve Bank had to first create a sufficiently large gap through a concerted hike in CRR and a cut in refinance limits, which was later funded by higher cost reverse repos and refinance drawals. For instance, monetary tightening in the wake of excess demand conditions in the foreign exchange market in end-October 1995 drove DFHI’s call lending rates to a peak of 85 per cent as on November 3, 1995, which was stabilised by liquidity injection via reverse repos. Similarly, DFHI’s call rates zoomed to a peak of 110 per cent on January 24, 1998 following the monetary measures of January 16, 1998, in the wake of the South-Asian crisis and came down thereafter as banks began to draw on the refinance window to fund their liquidity gap.

With the operationalisation of the LAF by June 2000, the Reserve Bank was able to supplement the standard monetary measures by active liquidity management through a mix of primary support to Government and changes in both the price and quantum of primary liquidity on a daily basis. Reflective of the greater degree of manoeuvrability in discretionary operations, call rates remained, by and large, range-bound around the LAF 1-day repo rate during the episode of financial market volatility in August-September 2000. As a result, the volatility in the short-term money market rates was lower in the recent period .