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

The monetary policy reforms during the 1990s hinged on easing the fiscal constraint. The first important step was introduction of an auction system for the Central Government’s market borrowings in June 1992. This enabled an increasing proportion of the fiscal deficit to be financed by borrowings at market-related rates of interest. This, in turn, enabled the Reserve Bank to scale down the SLR to the targeted statutory minimum level of 25.0 per cent by October 1997.

The second major step was the historic accord between the Government and the Reserve Bank in September 1994, eliminating the automatic monetisation of the Centre’s fiscal deficit by gradually phasing out ad hocs by April 1997. A system of ways and means advances (WMA) to the Central Government, subject to mutually agreed limits at market-related rates, was put in place instead to meet mismatches in cash flows. Since the Reserve Bank reserves the right to trigger floatation of fresh government loans as and when the actual utilisation crosses 75 per cent of the limit, the WMA does not acquire the cumulative character of ad hocs. This enables the Reserve Bank to accommodate the Government at its discretion and helps impose a market discipline on fiscal activism

Finally, the Reserve Bank instituted a conscious strategy of providing primary support to the Government through private placements and devolvements in government securities auctions when liquidity is tight. Such acquisitions are later offloaded through secondary market operations [such as open market (including repo) operations] depending upon capital flows, credit growth and requirements of monetary management. This allows the Reserve Bank to contain volatility in the market and facilitate the smooth progression of market borrowings. The net effect on the Government budget and the balance sheet of the Reserve Bank remains unchanged because of the increased transfer of profits from the Reserve Bank to the Government and consequently the beneficial effects are being realised with virtually no extra costs to the Government (Reddy, 2000).

The deregulation of interest rates was central to the new market-oriented monetary strategy in terms of rejuvenating the price discovery process, on the one hand and in terms of developing an interest rate channel of monetary transmission on the other. The process of interest rate liberalisation began in the mid-1980s. The initial initiative to introduce a degree of flexibility by allowing banks to set interest rates for maturities between 15 days and up to one year subject to a ceiling of 8.0 per cent, effective April 1985, however, had to be withdrawn in the face of an ensuing price war by end-May 1985.

The dismantling of the administered interest rate structure gathered momentum during the 1990s. The first step in this direction was taken in September 1991 with the discontinuation of sector-specific and programme-specific prescriptions excepting for a few areas like agriculture and small industries, the Differential Rate of Interest (DRI) scheme and export credit. Loans above Rs.2 lakh were freed from various prescriptions, subject to the minimum lending rate prescribed by the Reserve Bank. By linking the concessionality in interest rates to the size of the loan, the new structure ensured that the basic societal concerns were taken care of while significantly reducing the multiplicity and complexity of the rate structure.

The process of deregulation was carried forward with the withdrawal of the minimum lending rate in October 1994, thereby providing banks full freedom to determine lending rates for loans above Rs.2 lakh. Banks were only required to announce their prime lending rates (PLR); subsequently, in October 1996, in view of the high spreads over the PLR and to impart a degree of transparency, banks were advised to announce the maximum spread over the PLR. Banks were later permitted to operate different PLRs for different maturities and lend at sub-PLR to creditworthy borrowers.

Deposit rate deregulation was more gradual as it was considered prudent to free deposit interest rates at the end of the process of deregulation and at a time when inflation was under control. The process began in April 1992 by replacing the existing maturity-wise prescription by a single ceiling rate, which was subsequently varied in line with the modifications in the minimum lending rate and the evolving macro-economic developments followed by complete deregulation in October 1997 (Table 5.4). At present, the only domestic deposit rate that continues to be prescribed is the savings deposit rate (fixed at 3.5 per cent, effective March 2003). The deposit rates in respect of non-resident rupee deposits were also deregulated on broadly similar lines while that on foreign currency deposits are subject to a ceiling rate linked to LIBOR.

While bank term deposit rates stand deregulated, small savings continue to be administered, thereby imparting a degree of rigidity to the interest rate structure. The Expert Committee to Review the System of Administered Interest Rates and Other Related Issues (Chairman: Y.V. Reddy) (RBI, 2001c) recommended that interest rates on small savings and other administered instruments of various maturities needed to be benchmarked to the secondary market yields of government securities of corresponding maturities. In pursuance of these recommendations, the Union Budget 2002-03 announced that interest rates on small savings would be henceforth linked to the average annual yield of government securities in the secondary market for the corresponding maturities, with an annual adjustment on an automatic and non-discretionary basis. This measure is expected to enhance the flexibility of the interest rate structure in the economy. Interest rates on small savings instruments were cut by 50 basis points in the Union Budget, 2002-03 and by another 100 basis points in the Union Budget, 2003-04.

The reforms in credit regulation, which began in the mid-1980s, intensified in the 1990s with a shift in focus from micro-regulation towards macro-management of credit. These included a scaling down of pre-emptions in the form of statutory stipulations to expand the pool of lendable resources, rationalisation of priority sector requirements, phasing out of directed credit programmes and relaxation of balance sheet restrictions to improve the credit delivery system.

The cash credit system in the Indian banking system, by allowing the borrowers to utilise credit limits at their discretion, passed the onus of cash management to banks. In order to introduce an element of credit discipline for borrowers under the cash credit system and better control over the credit flow, the Reserve Bank gradually introduced a "loan system" effective April 1995 in which fund management reverted to the borrower. This, along with the phasing out of on-tap Treasury Bills, provided a fillip to the development of a market for short-term funds

The liberalisation of investment norms in the 1990s, following initial relaxations in the mid-1980s, gradually transformed banks into active players in the emerging financial markets. This took two forms. First, the ambit of eligible investments was enlarged to cover commercial paper, units of mutual funds and the secondary equity market. Second, the limit on investments in the capital market was gradually raised to five per cent of the previous year’s deposit mobilisation in October 1993. The sub-ceiling in respect of corporate equity was withdrawn in May 1994. Effective May 2001, the total exposure of a bank to stock markets with sub-ceilings for total advances to all stock brokers and market makers as well as individual stock broking entities and their associate/ interconnected companies was limited to 5.0 per cent of the total advances (including CPs) as on March 31 of the previous year. At the same time, the scope of the ceiling was enlarged by gradually excluding several categories of investments.

The Reserve Bank, like many central banks in emerging market economies, initiated payment reforms to enhance the operational efficiency of the financial system. This essentially involves a three-pronged strategy of -

1. developing an institutional framework to oversee the payments systems,

2. operationalising information technology applications and

3. instituting satellite- and terrestrial-based communications infrastructure.

The Reserve Bank is also introducing a full-fledged real time gross settlement system, in line with international best practices, which would minimise risks arising out of domino effects of individual defaults.