Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 1 - Structure & Framework of Monetary Policy in India - An Overview

Monetary Policy in India: An Assessment

Price Stability

Looking at the inflation record in India, it has been much better than many developing economies. In the period since mid-1990s, inflation has seen a noticeable reduction from its average of around 8-9 per cent per annum during 1970-97 to less than five per cent in the subsequent period (1997-2004). Structural reforms since the early 1990s coupled with improved monetary-fiscal interface and reforms in the Government securities market enabled better monetary management from the second half of the 1990s onwards. The phasing out of ad hocs by March 1997 eliminated automatic monetisation of the fiscal deficit. Introduction of an auction system for Government borrowings at market rates of interest increased the appetite for the Government securities from the commercial banking system and this also reduced the pressure on the Reserve Bank to finance the Government.

In this context, it is noteworthy that inflation could be reduced even as the country received unprecedented level of capital flows. A multi-pronged approach has been followed to manage the persistent external flows in order to ensure macroeconomic and financial stability. The key features of the package of measures include: liberalisation of policies in regard to capital account outflows; encouraging pre-payment of external borrowings; alignment of interest rates on non-resident deposits; and greater flexibility in exchange rate. These measures have been supplemented with sterilisation operations to minimise the inflationary impact of capital flows and to ensure domestic financial stability. The expansionary effect emanating from massive capital flows to India was effectively sterilised through a variety of instruments including open market sales of Government bonds and operations under the Liquidity Adjustment Facility (LAF). Operations involving sterilisation are undertaken in the context of a policy response which has to be viewed as a package encompassing the Government's borrowing programme, exchange rate policy, level of reserves, interest rate policy along with considerations related to domestic liquidity, financial market conditions as a whole, and degree of openness of the economy. Notwithstanding the large scale of sterilisation operations, interest rates in India have softened across the spectrum.

Judicious use of innovations such as Market Stabilisation Scheme was resorted to manage liquidity conditions consistent with the objective of price stability. Thus, notwithstanding the unprecedented order of external capital flows, monetary management was effective in ensuring a reduction in inflation and keeping it broadly stable. Adequate foreign exchange reserves and stocks of foodgrains have provided increased comfort in meeting supply shocks and thereby stabilising inflation expectations. The degree of credibility that the Reserve Bank has earned over time is in itself likely to be an effective instrument of monetary policy in meeting the challenges of the future. The success with achieving and maintaining low inflation in India since mid-1990s has led to a number of positive developments. First, there is virtually a national consensus that high inflation is not good and that it should be brought down. Second, inflation expectations have come down and, consequently, inflation tolerance has also come down.

In the context of monetary management in an open economy, the Indian experience with exchange rates has highlighted the need for developing countries to allow greater flexibility in exchange rates but the authorities should also have the capacity to intervene in foreign exchange markets in view of herd behaviour in capital flows. With progressive opening of the emerging markets to financial flows, capital flows are playing an increased role in exchange rate determination and often reflected in higher exchange rate volatility. Against this background, India's exchange rate policy of focusing on managing volatility with no fixed rate target while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way has stood the test of time. A key lesson of the Indian approach is that flexibility and pragmatism are required in the management of exchange rate in developing countries, rather than adherence to strict theoretical rules.

For the majority of developing countries which continue to depend on export performance as a key to the health of the balance of payments, exchange rate volatility has had significant real effects in terms of fluctuations in employment and output and the distribution of activity between tradables and non-tradables. In the final analysis, the heightened exchange rate volatility of the era of capital flows has had adverse implications for all countries except the reserve currency economies. The latter have been experiencing exchange rate movements which are not in alignment with their macro imbalances and the danger of persisting currency misalignments looms large over all non-reserve currency economies. Of late, even for major reserve currency economies, the recent sharp swings in exchange rates have been considered "unwelcome" .

Availability of credit for the productive sectors of the economy, as noted before, remains a key objective of monetary policy in India. Efforts by the Reserve Bank in this direction over the recent years to improve credit delivery mechanism have had a positive effect on credit flow to various sectors of the economy. Credit flow to the agricultural sector has recovered sharply in the last 3-4 years and outstanding credit to agriculture in relation to its sectoral GDP has also indicated an upward trend. Micro-finance has emerged as an important source of channelling credit to the weakest sections of the society. Credit flow to industrial sector by banks has also been maintained. The increase in disbursement of housing finance is hear tening as housing construction has strong backward and forward linkages.

Along with efforts to improve the quantum of credit, the Reserve Bank has taken initiatives to impart a greater degree of flexibility and transparency to the interest rate structure in the economy. Although rigidities in the financial system have blunted the pass-through from short-term policy rates to the lending rates of the banks, there is some evidence of an improvement in the pass-through in recent years. A series of initiatives such as encouraging banks to offer flexible interest rates on deposits and the introduction of Benchmark Prime Lending Rates have imparted greater transparency to the interest structure and has also led to a reduction in their lending rates. Initiatives in the past few years to improve recovery of loans have led to a significant reduction in non-performing loans (NPLs) of banks. Lower NPLs have also been one factor that enabled banks to reduce their lending rates. Concomitantly, this has enabled a moderation in real lending rates for borrowers over time. This is expected to have a positive effect on investment demand in the economy.

The flow of credit to the various sectors of the economy could be improved further if banks can contain their operating costs and further improve the loan recovery. Operating costs of banks in India remain higher than major economies. Indian banks have done a remarkable job in containment of NPLs considering the overhang issues and overall difficult environment. It is noteworthy that NPLs have come down, despite a shift to 90-days norm. These efforts need to be pursued further. This will help banks to reduce their lending rates which will provide a further impetus to investment demand in the economy.

A number of issues would need to be addressed in order to further improve credit flow to the various sectors so as to finance productive activities.

1. A key challenge is to design a market-oriented framework of affirmative action in channelling credit to the relatively disadvantaged sections of the society. With regard to the agricultural sector, there is a need for legal and institutional changes relating to governance, regulation and functioning of rural cooperative structure and Regional Rural Banks (RRBs). The changes warranted in cooperatives as well as RRBs involve deep commitment of State Governments and have significant bearing on political economy.

2. Second, in view of overhang problems of non-performing loans and erosion of deposits in both cooperatives and RRBs, restructuring and recapitalisation by the Government becomes important. The current acceleration in credit-delivery can be sustained in the medium term, if such fiscal support from States and Centre is firmly put in place soon to revive or reorganise rural cooperative structure and RRBs.

3. Third, there is a need to foster an appropriate credit culture to make enhanced rural credit a lasting phenomenon. Fourth, a comprehensive public policy on risk-management in agriculture is required as not only a means of relief for distressed farmers but as an ingredient for more efficient commercialised agriculture.

Turning to financing of the industrial sector, the ability of commercial banks to meet the long-term fund requirements is hampered on two grounds: first, the relatively shorter maturity of their deposits and second, banks already hold large volumes of Government paper, usually of long tenors, which may not be very liquid. The envisaged reduction of fiscal deficits under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 is expected to provide banks greater manoeuvrability in extending additional long-term credit to the industry. An active corporate bond market in the country will also meet the long-term financing requirements. Although several pre-conditions for the evolution of a successful corporate debt market are now in place, other requirements such as an enhanced public disclosure and effective bankruptcy laws are still awaited. Funding from equity markets hinges upon the continued expansion of the mutual fund industry and channelling of a part of contractual savings to equity markets.

As regards flow of credit to small-scale industry, banking institutions need to improve their credit assessment capabilities so that they can distinguish adequately between good and bad credit. Small-scale must not be equated with high risk. Recent initiatives such as developing a system of proper credit records would reduce information and transaction costs. Empirical evidence shows that wider availability of credit histories greatly expands the flow of credit as potential borrowers are no longer tied to their local lenders. With mechanisms such as credit histories in place, financiers can also move away from lending only against collateral or on the basis of prior contacts. This permits a greater degree of financing without collaterals.

Finally, structural reforms during the 1990s, inter alia, attempted to enhance the credit flow to the private sector through reductions in statutory preemptions. However, despite this reduction, banks continued to prefer to invest in Government securities for a variety of reasons like weak demand, excess capital flows and risk aversion. The large holdings of Government securities by banks in the face of comfortable liquidity yielded certain benefits. First, the large trading profits emanating from the rally in Government securities enabled them to boost their profits and make higher provisions. Second, excessive lending in a lacklustre industrial climate might have engendered 'adverse selection' of borrowers. A heartening development in this respect is the significant increase in non-food credit by banks during the current fiscal year. Nonetheless, scheduled commercial banks' investments in SLR securities remain well-above the stipulated 25 per cent.

Furthermore, with the upturn of the interest rate cycle, there could be an adverse impact on banks' profitability. There is, therefore, a need by banks to undertake appropriate risk assessments and tradeoffs while allocating resources between credit to the commercial sector and investments in Government securities.

A noteworthy achievement has been the maintenance of financial stability in the country, even as the economy has been progressively liberalised from the early 1990s. This can be attributed to success achieved in ensuring reasonable price stability in the economy on the one hand and prudent policies in regard to financial and external sector management on the other hand. Prudential norms have been gradually brought on par with international standards and best practices, including graduating towards Basel II, with suitable country specific adaptations. India's approach to financial sector reforms has served the country well, in terms of aiding growth, avoiding crises, enhancing efficiency and imparting resilience to the system. The development of financial markets has been, by and large, healthy. The basic features of the Indian approach are gradualism; coordination with other economic policies; pragmatism rather than ideology; giving due weight to contextual relevance; consultative processes; dynamism and good sequencing so as to be able to meet the emerging domestic and international challenges. In the banking system, diversified ownership of public sector banks has been promoted over the years and the performance of their listed stocks in the face of intense competition indicates improvements in the system. Since the initiation of reforms, financial health as well as efficiency of the banking sector has improved. From the vantage point of 2004, one of the successes of the Indian financial sector reform has been the maintenance of financial stability and avoidance of any major financial crisis during the reform period - a period that has been turbulent for the financial sector in most emerging market countries.

At the same time, several challenges such as encouraging ratings of issuers, assessing the level of additional capital requirement by banks, capital requirement for operational risk and addressing the systemic risk posed by large conglomerates would all need to be satisfactorily addressed before the transition to Basel II can occur. There also remains scope for improvements in the operational efficiency of the banking sector. Moreover, despite the decline in the stock of NPLs in the banking system, these remain high compared to international standards. The improved institutional and legal arrangements accompanied by concomitant strengthening of risk management practices by banks are likely to keep incremental NPLs low. Enforcement of creditors rights will need continuous strengthening. The legal provisions and practice in bankruptcy of the real sector are still inadequate and need further reform.

The cost of funds of the banking sector would be a key determinant of its sustained profitability in the years ahead. Diversification into fee-based activities coupled with prudent asset liability management holds the key to future profitability. Governance issues in private banks have lately received considerable attention, more so in view of the recent draft guidelines issued in this regard by the Reserve Bank. The issues of size and governance are extremely important from the viewpoint of financial stability. The draft policy is in consonance of treating banks as special with the objective of setting upfront a roadmap in a transparent manner for existing investors to align their policies and potential investors to make informed decisions. The intention of the draft policy is to ensure adequate capital and consolidation in the banking industry with the regulator being aware of the intention of existing and potential shareholders.

Although the housing sector provides a relatively safe destination for bank credit on account of relatively low default rates, banks need to be on alert against an unbridled growth of housing finance and should take due precaution in the matter of interest rates, margin, reset period and documentation. Moreover, during periods of sharp increases in housing and other retail credit, risk containment measures are desirable. Illustratively, as a temporary countercyclical measure, the Reserve Bank, in October 2004, increased the risk weight from 50 per cent to 75 per cent in the case of housing loans and from 100 per cent to 125 per cent in the case of consumer credit.

Risk management of banks has gained credence in recent times. It is important for banks to look ahead at the expansion of the credit portfolio in a healthy way, particularly in the background of higher industrial growth, new plans of corporate expansion and higher levels of infrastructure financing. In this context, adopting an integrated risk management approach based on risk models suited to their risk appetite, business philosophy and expansion strategy is a sine qua non for the banking sector.

As the financial sector matures and becomes more complex, the process of deregulation would need to continue, but in such a manner that all types of financial institutions are strengthened and financial stability of the overall system is safeguarded. As deregulation gathers force, the emphasis on regulatory practice has to shift from micro-management to macro-regulation. In order to achieve these regulatory objectives, corporate governance within financial institutions would need to be strengthened, and internal systems would need to be developed to ensure this shift in regulatory practice.