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Students Corner - A Decade of Economic
Reforms in India - A Review

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Index of Articles in
Module No: 3

A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]

Module: 3 -Money, Credit And Prices

An Overview of Monetary Reforms

The conduct of monetary policy during the 1990s was geared to supporting the overall economic reforms with a view to creating a competitive environment as a means of improving productivity and efficiency and ensuring macroeconomic stability. While the twin objectives of monetary policy remained the pursuit of price stability and ensuring credit availability for growth, the operating procedure of monetary policy underwent significant changes in response to the challenges of financial liberalisation. This also entailed reforms in the monetary and fiscal interface in order to ease the fiscal constraint. This process was well supported by structural measures, through the dismantling of administered interest rates and the deregulation of credit markets. Given the changes in the monetary landscape, the process of adjustment has been reasonably smooth. The Reserve Bank was successful in achieving the objective of a phased scaling down of statutory pre-emptions. An important macroeconomic development was the sharp decline in the inflation rate during the second half of the 1990s attributable to better monetary management as well as generally favourable supply side factors. An empirical assessment of the monetary policy transmission mechanism suggests that the output and inflation variations, particularly in the second half of the 1990s largely emanated from non-monetary factors and the contribution of the monetary policy shocks has further declined during the 1990s as compared with the 1980s.

Monetary management increasingly assumed a market orientation. Switch over to indirect instruments of monetary control was consistent with the objective of rekindling the process of price discovery in the financial markets for the purpose of efficient resource allocation. Besides, the opening up of the economy required the Reserve Bank to counterbalance the domestic and the external sources of monetisation in order to maintain stable monetary conditions. The Reserve Bank gradually put in place a liquidity management framework in which monetary conditions are harnessed to the final objectives through a range of instruments, such as open market (including repo) operations and changes in reserve requirements, reinforced by interest rate signals through the Bank Rate and the repo rates. In the process, the liquidity adjustment facility (LAF) has emerged as the principal operating instrument of monetary policy. Besides, the growing macroeconomic complexities required a shift from the earlier monetary targeting framework to a multiple indicator approach in which a host of macroeconomic variables are now monitored for the purpose of monetary policy formulation

In addition, the Reserve Bank, like many other central banks in emerging market economies, has had to increasingly contend with maintaining financial stability. Besides, the Reserve Bank’s role as manager of public debt also implies that the internal debt management function gets inextricably mixed with the monetary management function. In view of the limited number of instruments, the Reserve Bank has to prioritise its objectives given the circumstances. This constrains the degree of flexibility available to monetary policy in a complex macroeconomic environment.

The monetary policy framework has been shifting course throughout the 1990s. The breakdown of a stable relationship between money, output and prices as a result of financial innovations coupled with high inflation rates led to the adoption of an inflation targeting framework in many economies. While the pursuit of price stability could be a sound proposition in itself, there continue to be many constraints in the Indian economy, as in many other emerging market economies, which prevent the switch to an inflation-targeting framework. At the same time, it must be recognised that the current anti-inflationary stance was largely built in the backdrop of the high inflation of the 1980s. Since inflationary pressures have been subdued in the recent past, the coexistence of low inflation and low growth in the past two years (2001-02 & 2002-0) poses a fresh challenge to the conduct of monetary policy.

In India, the monetary policy framework underwent a significant transformation during the 1990s. Monetary policy emerged as the chief instrument of macroeconomic stabilisation as well as a vehicle for the subsequent structural reforms in the financial system. The objective was to create a competitive environment in the financial sector while ensuring price stability and growth. The growing integration of various markets and increasing globalisation called for reforms in the monetary policy operating framework in terms of instruments, procedure and institutional architecture.

The efforts towards better fiscal-monetary coordination through the replacement of ad hoc Treasury Bills by a system of ways and means advances provided monetary policy the necessary flexibility. While the twin objectives of the conduct of monetary policy remained the pursuit of price stability and credit availability, the operating procedure shifted from administered and direct instruments of monetary control towards indirect instruments in order to improve the efficiency of resource allocation. Moreover, monetary management had to contend with vicissitudes in capital flows while maintaining orderly conditions in the financial markets during the 1990s. The shifts in the channels of policy transmission as a result of financial liberalisation necessitated a move from the existing monetary targeting framework to a multiple indicator approach. This called for a carefully crafted strategy in which an array of monetary levers – quantum and rate - had to be honed up to harness liquidity conditions to macroeconomic objectives.

This Module undertakes an assessment of the changes in the monetary policy framework in the 1990s. Section I places the imperatives of the reform process in perspective. The second, & third articles analyse the changes in the monetary policy framework, in terms of a shift from direct to indirect instruments of monetary control and the enabling structural reforms, including issues in monetary-fiscal co-ordination. The fourth, fifth & sixth articles evaluate the monetary policy reforms in terms of the inflation outcome and credit availability as well as the maintenance of orderly conditions in the financial markets. It also focuses on key issues like the management of capital flows, the interest rate pass-through and the real interest rate. The seventh article examines the impact of reforms on the monetary policy transmission channels. The last article concludes with a few emerging issues.

Module 3 covers money, credit and prices. Reforms during the 1990s were supported by a shift in the monetary policy framework in which monetary policy has been conducted. The Reserve Bank had moved in the 1980s from direct quantitative controls through credit budgeting to a formal monetary targeting framework. Monetary targeting was conducted in an environment where interest rates were substantially regulated. The system, however, was not efficient in resource allocation. It supported a large draft on household savings by the Government. The reforms that began in 1991 were supported by a change in operating procedures for the conduct of monetary policy. From a pure monetary targeting framework, a change to a multiple indicator approach was effected with a greater reliance on interest rates. The module assesses this shift in the context of monetary transmission channels. Among other changes, market borrowings of the Government began to be conducted at market determined interest rates. This was aimed at introducing a sense of fiscal discipline and freeing larger resources for private investment. It also enabled the conduct of open market operations, enabling monetary authorities to move to full-fledged use of indirect instruments of monetary policy. Focus has since shifted to operating on the short-end of the money market through Liquidity Adjustment Facility operations in addition to using the conventional tools like the Bank Rate and the CRR. In the milieu of the changed framework, the module analyses the inflation record during the reform period and explains the monetary and non-monetary factors that have helped lower inflation rate since the end of 1995. Empirical evidence on transmission of the impact of monetary policy actions to output and inflation is also presented in some detail

Imperatives of Monetary Reforms

India, like most developing economies, followed the path of planned development after Independence, based on the assumption that public savings would fund higher levels of investment. Monetary and credit policy was, therefore, geared to fund the requirements of the fisc, channelising public saving to "socially purposive" investment. The public sector, however, instead of being a source of savings for the community’s good became, over time, a consumer of community’s savings (Jalan, 2002a). As a result, the Government had to take increasing recourse to a draft of resources from the Reserve Bank and the banking system by fiat.

Fiscal dominance affected the conduct of monetary policy and resource allocation in a number of ways. First, although interest rates on government borrowings were raised during the 1980s – with the weighted yield on government borrowing climbing to 11.41 per cent during 1990-91 from 7.03 per cent during 1980-81 - they were still not high enough to attract voluntary subscriptions (RBI, 1991). As a result, the statutory liquidity ratio (SLR), originally a prudential norm mandating banks to earmark a portion of their liabilities in risk-free instruments, was increased steadily to provide a captive market for government borrowings, constricting portfolio choice. The SLR was hiked to a peak of 38.5 per cent of net demand and time liabilities (NDTL) in September 1990 from 25.0 per cent in September 1964.

Second, as the higher SLR was still not sufficient to fund the fiscal deficit, the gap was filled by an almost monotonic increase in the monetisation of the fiscal deficit, with the ratio of monetisation to GDP almost doubling from 1.1 per cent during the 1970s to 2.1 per cent during the 1980s.

Third, by the end of the 1980s, there was increasing empirical evidence that the excessive monetary expansion, emanating from the monetisation of the fiscal deficit, was beginning to spill over into inflation (Rangarajan and Arif, 1990). Given a higher elasticity of government expenditure with respect to prices relative to receipts, the higher inflation further widened the fiscal deficit. The consequent necessity of higher monetisation thus brought the inflation-fiscal-monetary nexus into sharp focus (Rangarajan, Basu and Jadhav, 1989; RBI, 2002a).

Fourth, from the viewpoint of monetary management, the Reserve Bank had to hike the cash reserve ratio (CRR) to contain the inflationary impact of the monetisation of the fiscal deficit, thereby imposing an indirect tax on the banking system. The CRR was raised from the statutory minimum of three per cent of NDTL in September 1962 to 15 per cent in July 1989. By March 1991, commercial banks had to, therefore, set aside over 60 per cent of their incremental resources for meeting statutory pre-emptions (after factoring in a 10 per cent incremental CRR

Finally, the need to contain the interest burden of public debt necessitated a regime of administered interest rates, both on the lending and the deposit side, resulting in a degree of financial repression. This blunted the interest rate channel of monetary policy transmission by the 1960s. The Bank Rate, in particular, as an instrument of monetary policy fell into disuse by the mid-1970s.

The imbalances emerging from deficit financing began to be recognised from the 1960s onwards. It was realised that "…a sizable deficit financed by recourse to the Reserve Bank credit creates difficulties for the Bank in maintaining monetary stability…" (Iengar, 1960). It was also recognised that deficit financing "…should be substantially cut down if not perhaps altogether eliminated for some years ahead, as the capacity of the economy to bear deficit financing has been weakened by continuous recourse to this form of finance…" (Bhattacharya, 1966). The Report of the Committee to Review the Working of the Monetary System (Chairman: S. Chakravarty) (RBI, 1985) emphasised the need to rein in deficit financing "within safe limits" through a mix of improved management of public finances and an increase in productivity of public enterprises.

Another integral feature of the monetary and credit policy before the 1990s was the regulation of credit with the stated objectives of curbing inflationary pressures, promoting its effective use, preventing the large borrowers from pre-empting the use of scarce credit and enlarging the spectrum of borrowers covered by banks in the overall context of national policies (RBI, 1985). Public sector banks (and subsequently private sector banks) were advised in 1974 to attain a priority sector lending target of not less than one-third of the outstanding credit by 1979 (40 per cent by March 1985). Although "social control" enabled deepening of bank finance, the directed credit and investment requirements along with the administered interest rate regime, inter alia, led to a decline in the productivity and efficiency of the banking system (RBI, 1991).

- - - : ( Changes in The Monetary Policy Framework ) : - - -

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