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

Module: 7 Monetary Transmission Mechanism

Financial Stability: The Indian Approach

The Indian economy has witnessed a gradual opening up since the 1990s. Significant and far-reaching reforms were effected in the various sectors of the Indian economy. Consequent to these reforms, the financial system has been transformed from a planned and administered regime to a market-oriented financial system. The external sector has been progressively opened up. Reflecting the policy framework with stress upon attracting non-debt creating stable flows, capital flows to India have been largely stable. At the same time, episodes of volatility have been witnessed with attendant consequences for exchange rate movements. Moreover, the financial sector liberalisation and deregulation has led to emergence of financial conglomerates in the Indian economy with implications for contagion and systemic risks. Finally, in the context of the shift to a system whereby monetary impulses are transmitted through modulations in short-term interest rates, it is important that policy signals are quickly passed onto the market rates of interest such as lending interest rates. The efficacy of this transmission channel depends upon the strength of the balance sheet of financial sector. Consequently, for all these reasons, the issue of financial stability has become much more important than in the erstwhile administered regime.

Before the onset of reforms in the early 1990s, the Indian financial sector was a Government-dominated system with limited efficiency and too much stability through rigidity. This would suggest that financial stability in India has to be viewed contextually, more so when the sector is graduating towards a market-oriented one, with focus on efficiency and avoiding instabilities. Accordingly, financial stability in India would mean

1. ensuring uninterrupted financial transactions,

2. maintenance of a level of confidence in the financial system amongst all the participants and stakeholders and

3. absence of excess volatility that unduly and adversely affects real economic activity. Such financial stability has to be particularly ensured when the financial system is undergoing structural changes to promote efficiency.

Thus, at present, the Reserve Bank simultaneously pursues the objectives of price stability and provision of adequate credit for growth. In addition, financial stability has gradually emerged as a key consideration in the conduct of monetary policy. The Reserve Bank has followed a three-pronged strategy to maintain financial stability:

• Maintaining the overall macroeconomic balance, especially through the twin objectives of price stability and growth;

• Enhancing the macro-prudential functioning of institutions and markets; and,

• Strengthening micro-prudential institutional soundness through regulation and supervision.

Against this brief overview, this Section dwells upon the various initiatives by the Reserve Bank to ensure financial stability in India. The Section starts with the role of monetary policy per se in contributing to financial stability in India - contribution to price stability and ensuring orderly conditions in financial markets. This is followed by a discussion of various regulatory and supervisory initiatives to achieve financial stability. In order to place these regulatory and supervisory initiatives in a proper context, a brief overview of the Indian financial sector is followed by the policy framework to promote stability of the financial system. Finally, an evaluation of the performance of various segments of the financial sector is undertaken, especially of the banking sector.

As discussed in Section I, monetary stability and financial stability complement each other in the long-run. Monetary stability is an important precondition for financial stability and, therefore, the most significant contribution that monetary policy can make to financial stability is through maintaining low and stable inflation. Looking at the Indian experience, this pre-condition seems to be in place. In India, price stability has been an abiding objective of monetary policy since Independence. Compared to many other developing economies, the inflation record of India can be considered quite satisfactory although, as discussed in Modules 2 and 4, the degree of success has varied over time, in line with the evolving monetary-fiscal interface. More recently, since the second half of the 1990s, inflation has been brought down to an average of five per cent per annum compared to an average of around 8-9 per cent per annum in the preceding two and a half decades. The reduction in inflation since the early 1990s has also enabled to stabilise inflation expectations. There is virtually a national consensus that high inflation is not good and that it should be brought down. Low and stable inflation expectations increase confidence in the domestic financial system and, thereby contribute in an important way to stability of the domestic financial system. By achieving a reasonable degree of monetary stability, the Reserve Bank has created the necessary enabling environment for financial stability. Inflation expectations, inter alia, depend upon fiscal prudence. The recently enacted Fiscal Responsibility and Budget Management Act with its envisaged reduction in key deficit indicators is expected to reduce the fiscal dominance over time and, in turn, provide the Reserve Bank further flexibility so as to maintain low and stable inflation. Adherence to these fiscal rules will stabilise inflation expectations and thus contribute to efforts of price stability.

Second, with the ongoing financial liberalisation, a number of measures have been taken to widen, deepen and integrate various segments of the financial markets. These measures have imparted efficiency to the financial system and are an important pre-requisite for transmission of monetary policy signals to the real sector. At the same time, financial markets are often characterised by herd behaviour and contagion which can be destabilising and lead to overshooting. Indian policy makers have been conscious of the fact that international financial markets act in a strongly pro-cyclical manner in the case of EMEs. The capacity of economic agents in developing economies to manage volatility in all prices, goods or foreign exchange is highly constrained and there is a legitimate role for non-volatility as a public good. Maintaining orderly conditions in various financial markets is, therefore, important for financial stability. Accordingly, ensuring orderly conditions in the financial markets is an important aspect of the Reserve Bank's approach towards maintaining financial stability. Operating procedures and instruments of monetary policy have evolved over time to meet these objectives. As regards money markets, the liquidity adjustment facility (LAF) has emerged as the main instrument to modulate liquidity in the system. In the context of large capital flows, LAF operations coupled with open market sales played a key role in absorbing liquidity in order to ensure macroeconomic and financial stability. With persistent capital flows, a new facility in the form of Market Stabilisation Bills/Bonds (MSBs) was put in place effective April 2004 (see Module 3). The MSS has provided the Reserve Bank greater flexibility in its market operations. A key message of the Indian experience is that a central bank constantly needs to innovate in terms of instruments in order to meet its policy objectives. 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. Monetary measures supported with market operations in the foreign exchange markets and administrative measures have been employed to maintain stable conditions in the forex markets. 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. Of course, prudent external sector management with a cautious approach to capital account liberalisation has been an important component of macroeconomic policies to ensure financial stability. Safeguards developed over a period of time to limit the contagion include: low current account deficit; comfortable foreign exchange reserves; low level of short-term debt; and absence of asset price inflation or credit boom. These positive features were the result of prudent policies pursued over the years notably, cap on external commercial borrowings with restrictions on end-use, low exposure of banks to real estate and stock market, insulation from large intermediation of overseas capital by the banking sector, close monitoring of off-balance sheet items and tight legislative, regulatory and prudential control over non-bank entities (RBI, 2004).

Overall, the Reserve Bank's approach is to minimise volatility in the financial markets and, in public policy, minimise knee-jerk reactions, while focusing on price stability and the underlying inflation. The objective has been to ensure that there are no avoidable uncertainties in policy, while mitigating undue pressures on the functioning of markets without undermining market efficiency. These issues have come to the forefront during 2004 with the upturn in the interest rate cycle. As interest rates fell consistently in recent years, market participants were not fully prepared for the inevitable turn in the interest rate cycle. With the gradual increase in market yields since early 2004, market participants have now begun to get a feel of this interest rate cycle for the first time, even as the Reserve Bank had been continuously highlighting this possibility in its policy pronouncements. Against these developments, the Reserve Bank's endeavour has been to facilitate adaptation to the new environment by working together with the banking system to ensure that the appropriate systems to withstand interest rate cycles are built more consciously.

The stability of the Indian financial system has been tested on certain occasions, the most recent being in May 2004. A brief discussion of the policy response would be apposite. On May 17, 2004, the stock market witnessed turbulent conditions, caused mainly by political uncertainty after the general elections. External factors such as rising oil prices and apprehensions of rise in international interest rates also contributed to the sudden reversal of market sentiment. In response to these market developments, the Reserve Bank initially intervened in the forex market and once it was realised that there were no spillovers into other markets, maintaining the integrity of the payment and settlement system assumed prominence. Accordingly, the Reserve Bank operated at three different levels. First, settlement banks were informed that in case of liquidity problems, they could access the 'backstop facility' under LAF from the Reserve Bank. Second, a statement was made informing market participants that there was no shortage of liquidity in the system, either in domestic or foreign currency. Finally, this was followed by a statement that carried credibility for the system at large. A Task Force was also constituted for providing clarifications and liquidity assistance. Certain prudential relaxations were provided for a temporary period to market players in the light of market conditions and the same was subsequently restored to normal levels once markets returned to normal functioning. The idea inherent in the Reserve Bank's strategy during this period was to ensure no transmission of panic from equity markets to other markets. Thus, stability in the financial markets was maintained even as the Reserve Bank did not take any view on the equity markets.

To sum up, by maintaining relatively low inflation and stabilising inflation expectations, in particular, monetary policy in India has created a conducive environment for financial stability. Second, given the limited capacity of economic agents to manage volatility in developing economies like India, a central bank has a key role to play in maintaining stability in financial markets. In the Indian context, the Reserve Bank has been able to maintain stability in the financial markets through a judicious use of instruments - both existing as well as by developing innovative instruments. The central bank acts as a shock absorber to ensure stability as it manages volatility in the system.