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

The overarching objective of monetary and financial sector reforms was to set free the process of price discovery with a view to enhancing the allocative efficiency of the financial markets, while at the same time, ensuring macroeconomic stability (RBI, 1993; Rangarajan, 1997). The operating procedure of monetary policy, in terms of targets and instruments, saw substantial changes in response to the challenges of financial liberalisation. The deregulation of interest rates, for instance, sharpened the Reserve Bank’s dilemma of funding both the Government and the commercial sector at a reasonable cost, without stoking inflationary pressures. Besides, following the opening up of the external sector, the need to maintain orderly conditions in the foreign exchange market, at times, required higher interest rates, while the pursuit of the growth objective required a softer interest rate regime. Finally, the shifts in the channels of transmission of monetary policy, as a result of freeing of financial prices, necessitated monetary operations in terms of both the price and quantum of liquidity.

The twin objectives of monetary policy remained the pursuit of price stability and ensuring the availability of sufficient credit for the productive sectors of the economy during the 1990s. However, the relative emphasis varied from year-to-year depending on the evolving price-output situation.

The intellectual edifice of the reigning monetary policy framework the world over was essentially developed in the backdrop of high inflation of the 1960s and 1970s. In view of the ensuing anti-inflationary stance, an inflation-targeting framework with price stability as the single objective of monetary policy, gained increasing currency worldwide during the 1990s (Box V.1). In the Indian context as well, the Advisory Group on Transparency in Monetary and Financial Policies (Chairman: M. Narasimham) (RBI, 2000c) recommended that it would be best to veer towards prescribing to the Reserve Bank a single medium-term inflation objective. There are, however, several constraints in pursuing a single price stability objective (RBI, 2000a; Jalan 2002b):

• The recurrence of supply shocks limits the role of monetary policy in the inflation outcome. Structural factors and supply shocks from within and abroad make inflation in India depend on monetary as well as non-monetary factors.

• The persistence of fiscal dominance implies that the debt management function gets inextricably linked with the monetary management function while steering liquidity conditions.

• The absence of fully integrated financial markets suggests that the interest rate transmission channel of policy is rather weak and yet to evolve fully. In particular, the lags in the pass-through from the policy rate to bank lending rates constrain the adoption of inflation targeting.

• The high frequency data requirements including those on a fully dependable inflation rate for targeting purposes are yet to be met.

The present co-existence of low inflation and low growth in large parts of the world economy presents a fresh challenge to the conduct of monetary policy. At one end of the spectrum lies the "continuity view" which essentially treats the present economic slowdown as an unusual supply shock within the context of the present anti-inflationary monetary stance. At the other end is the "new environment view" which enjoins central banks a much greater preemptive role in smoothening output fluctuations, especially as financial imbalances are increasingly able to create disturbances in the real economy without necessarily showing up in overt inflation rate at the initial stages (Borio, English and Filardo, 2003). Notwithstanding the lively academic debate over the policy rules regarding the inflation-growth trade-off, the more standard central banking practice often lies in the "middle ground" of constrained discretion (Bernanke, 2003). This is built on the parsimonious principle that within its strong commitment to price stability, monetary policy should strive to limit cyclical swings in effective demand. This broadly corresponds to the Reserve Bank’s current monetary policy stance of ensuring easy liquidity conditions to facilitate the revival of industrial growth while maintaining a constant vigil over the price level. Given properly designed monetary policy rules, the key socially important objectives of price stability and growth, thus, tend to be mutually reinforcing rather than competing goals.

The Reserve Bank broadly followed a monetary targeting rule with feedback from the mid-1980sonwards till around 1997-98. Broad money (M3) served as the intermediate target with the CRR as the operating instrument. The intellectual underpinnings of monetary targeting, laid by the Chakravarty Committee (RBI, 1985), were based on a stable relationship between money, output and prices. In the Indian case, money demand was generally found to be stable, providing reasonable predictions of average changes in prices over a medium-term horizon of 4-5 years, though not necessarily on a year-to-year basis (Rangarajan and Arif, 1990; Jadhav 1994). Financial innovations that were supposed to have imparted instability to money demand in some industrial economies were not considered relevant for the Indian economy at that stage (Arif 1996; Joshi and Saggar, 1995).1 Finally, the money stock target was believed to be relatively well-understood by the public at large. All these factors provided a rationale for monetary targeting in the Indian context (Rangarajan 1988; 1997).

The behaviour of the velocity of money provides a gauge of the underlying monetary dynamics of the economy. Theoretically, while the increased monetisation of the economy is expected to lower the velocity, financial innovations are expected to raise it (Bordo and Jonung, 1987). The M3 income velocity, for instance, declined from an average of 3.7 during the 1970s to 2.6 during the 1980s, reflecting the role of institutional factors, such as, financial deepening in the economy. The declining trend persisted throughout the 1990s, albeit at a slower pace. Although deregulation and diversification of the Indian financial system tended to arrest the decline in velocity of money, this was simultaneously counterbalanced by the fact that most of the ensuing transactions continue to be conducted through the banking channel and occasional flights to safety of bank deposits, especially in the late 1990s (Jadhav, 1994; RBI, 2000b, 2002d).

The growing complexities of monetary management, by the latter half of the 1990s, in the context of the ongoing liberalisation of financial markets and the opening up of the economy, required that the process of policy formulation should be based on a wider range of inputs rather than being predicated on a single M3 aggregate. The Working Group on Money Supply (RBI, 1998b) reported that real GDP and broad money balances continued to be co-integrated, reflective of a long-run equilibrium relationship. At the same time, unidirectional short-term deviations from the long-run equilibrium path suggested that monetary policy exclusively based on the demand function for money could lack precision. The Reserve Bank’s Monetary and Credit Policy for the first half of 1998-99 pointed out that, although most studies in India have shown that money demand functions have so far been fairly stable, "…the financial innovations that have recently emerged in the economy provide some evidence that the dominant effect on the demand for money in near future need not necessarily be real income, as in the past. Interest rates too seem to exercise some influence on the decisions to hold money" (RBI, 1998a).

The Reserve Bank, accordingly, formally switched to a multiple indicator approach effective 1998-99. A host of macroeconomic variables, including interest rates or rates of return in different markets (money, capital and government securities markets) along with such data as on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange available on high frequency, are now juxtaposed with output trends for drawing policy perspectives. In this framework, although use of M3 as an intermediate target has the exclusive been de-emphasised, it remains an important indicator of the monetary policy stance. The multiple indicator approach allows a correct assessment of potential inflationary pressures when alternative indicators of inflation emit differing signals as for instance in the second half of the 1990s (RBI, 1999a).

The increasing complexities of macroeconomic management are gradually leading a number of central banks, as in the Indian case, to abandon the traditional monetary strategy which was woven around individual nominal anchors - money, interest rates or exchange rates - closely related to the ultimate objectives of price stability and growth. The management information system of monetary policy formulation now spans a large set of macroeconomic variables rather than a single monetary or interest rate target in the case of most central banks

• The operating procedure of monetary policy changed dramatically in the 1990s driven by three inter-related factors:

• Need for a market-oriented policy mix of open market operations and interest rate signals consistent with the process of price discovery.

• Need to sterilise capital flows following the opening up of the economy.

• Need for swift policy reactions to maintain orderly conditions in the financial markets.

The Reserve Bank introduced open market (including repo) operations in an attempt to move from direct to indirect instruments of monetary control in 1992-93. Following the recommendations of the Report of the Committee on Banking Sector Reforms (Chairman: M. Narasimham) (Government of India, 1998), an Interim Liquidity Adjustment Facility (ILAF) was introduced initially in April 1999. This later transited into a full-fledged LAF, put in place on June 5, 2000. The Reserve Bank is now able to adjust market liquidity on a daily basis through repo/reverse repo auctions of varying frequencies under the LAF. While interest rates in the repo/reverse repo auctions usually emerge out of the bids, the Reserve Bank occasionally conducts fixed interest rate auctions to send signals to the markets. In the process, the interest rates emerging out of the repo and reverse repo auctions provide a corridor for the call money and other short-term interest rates. The LAF is gradually emerging as the principal operating instrument of monetary policy, replacing all other windows of liquidity support to the market

Another major step towards a market-based monetary policy was the reactivation of the Bank Rate in April 1997. The interest rate on the majority of the accommodation extended by the Reserve Bank was initially linked to the Bank Rate. As the price of primary money is now increasingly market-determined, essentially at rates emerging out of the LAF auctions, the Bank Rate is now used, more or less, as a signalling instrument of monetary policy in line with the evolving macroeconomic and liquidity conditions.

The Reserve Bank now manages liquidity through open market (including repo) operations, reinforced by direct interest rate signals through changes in the policy rates such as the Bank Rate/ repo rates, besides the traditional tools of changes in reserve requirements and standing facilities. While CRR continues to be used as a monetary policy instrument, the adverse impact of impounding lendable resources has been minimised by bringing it down to 4.75 per cent of NDTL, in line with the medium-term goal of reducing it to the statutory minimum of 3.0 per cent. Furthermore, the banks are now remunerated for CRR balances (above the statutory minimum) at the Bank Rate.

The liquidity management framework is in line with the cross-country experience which suggests that the operating procedures of monetary policy during the 1990s are gradually coalescing into a process of estimating market liquidity, before initiating policy action through a mix of open market operations and interest rate signals. This helps steer monetary conditions to a trajectory consistent with the macroeconomic objectives (Borio, 1997; Schaechter, 2002). The Reserve Bank Balance Sheet in the 1990s.

In view of the increasing market orientation of monetary policy, the Reserve Bank undertook several steps to impart greater transparency and resilience to its balance sheet. First, the foreign currency assets are valued every Friday in respect of exchange rate changes and gains/losses from valuation are not booked in the profit and loss account. The revaluation is parked in the capital account to meet fluctuations in foreign exchange markets. The Reserve Bank marks its investment portfolio, both domestic and foreign securities, to the market on a monthly basis and on the balance sheet date (i.e., June 30) in terms of the prudential policy of valuing investments at the lower of book or market value. Second, the Reserve Bank has set an indicative target of building up the Contingency Reserve to 12.0 per cent of assets by June 2005 (11.7 per cent as at end-June 2002) and the Asset Development Reserve to 1.0 per cent of assets (within the 12.0 per cent indicative target) to meet unforeseen contingencies in line with best international practices (Stella, 2002). Third, the ratio of net foreign assets to currency (123 per cent as on March 14, 2003), an indicator of external vulnerability, by far exceeds the 70 per cent benchmark set by the Committee on Capital Account Convertibility (Chairman: S.S.Tarapore). Finally, apart from releasing a weekly statement of its assets and liabilities and annual audited accounts in fulfilment of the statutory obligations, the Reserve Bank releases data on i) commercial banks’ cumulative balances with it and money market operations, on a daily basis, ii) foreign exchange reserves, on a weekly basis and iii) outstanding forward liabilities, on a monthly basis. The Advisory Group on Transparency in Monetary and Financial Policies (RBI, 2000c) opined that the Reserve Bank’s accounting disclosure norms are in consonance with the best international practices