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

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.

Fiscal dominance continues to be the critical issue. Capital inflows coupled with weak credit demand enabled the Reserve Bank to trade surpluses of the banking system with the deficits on the Government account and thereby ease the fiscal constraint on monetary policy. In the process, net domestic assets of the Reserve Bank have been shrinking and this could impose limits on the scope for sterilisation in the future. At the same time, in view of the burgeoning fiscal deficit, the situation could change very quickly in case there is a pick-up in industrial activity or if capital flows dry up, especially as banks continue to hold a large portfolio of government securities well beyond the statutory prescriptions. It is in this context that the need is sometimes felt to separate the internal debt and monetary management functions. At the same time, even if the Reserve Bank does not directly subscribe to market borrowings, the fiscal impact on bank liquidity would still constrain monetary policy. There is thus a limit to which a central bank can ease the fiscal constraint through liquidity management operations. The proposals advocated by the proposed FRBM legislation for reducing the role of the Reserve Bank in primary subscriptions and limiting the fiscal deficit, thus, assume particular significance.

The deregulation of interest rates and the evolution of inter-linked financial markets facilitated the gradual emergence of an interest rate channel of monetary policy transmission. There is increasing evidence that the Reserve Bank is now able to effectively influence movements in short-term interest rates in the money markets and by extension, prices in the government securities markets. The pass through to the credit markets is, however, still very weak. The deposit and lending rates of scheduled commercial banks continue to be relatively sticky, largely reflecting structural constraints in the form of a large order of NPAs and the continuation of Government administered interest rates in small saving instruments. This had led to downward rigidity in real interest rates blunting the effectiveness of monetary policy. It may be mentioned here that this rigidity in the small savings rate has been partially addressed as the Union Budget, 2002-03 announced that the interest rate on small savings would be linked to the average annual yield on government securities in the secondary market. Corresponding adjustments in these rates have been announced in the Union Budget, 2003-04. To promote flexibility in interest rates, issues such as asset quality of banks, adoption of floating deposit rates and strengthening of asset-liability and risk management by banks, and rigidities in the interest rates of competing assets need to be addressed.

Unlike in the past when bank balances with the Reserve Bank were largely governed by reserve requirements, the demand for bank reserves in the future, in the context of a declining cash reserve ratio (CRR), are likely to depend on banks’ requirements in respect of settlement balances. Day-to-day monetary management would thus require a closer assessment of market liquidity. It is in this connection that the Reserve Bank has initiated a process of liquidity forecasting. While the gradual institution of a real time gross settlement (RTGS) system would control domino risks of default, this is also likely to exert pressure on liquidity management.

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 poses a fresh challenge to the conduct of monetary policy.