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

Module: 3 External Sector Openness And Conduct Of Monetary Policy : The Indian Experience

Reforms in the External Sector

Structural reforms initiated in the Indian economy during the 1990s virtually encompassed all areas of the economy. At the same time, reforms were marked by a sense of gradualism. In regard to financial markets, 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 expected to increase the efficacy of monetary policy signals to the real sector. At the same time, financial markets are often characterised by herd behaviour and contagion from abroad can be destabilising and lead to overshooting. Since the capacity of economic agents in developing economies to manage volatility is highly constrained, ensuring orderly conditions in various segments of the markets - money, debt, forex and credit markets - has been a key objective of monetary policy in India.

As a part of the reform process, widespread and extensive reforms in the external sector have transformed India from a relatively closed economy to a fairly open economy. In the external sector, as in other areas, India has followed a cautious approach to capital account convertibility, exchange rate management, and trade liberalisation. Careful monitoring of capital account transactions has been advocated to ensure an orderly process of liberalisation and macroeconomic stability, with a view to maintaining sustainability of the balance of payments and overall macroeconomic stability. In particular, the Indian approach to exchange rate management has focussed on managing volatility.

External demand conditions, capital flows and exchange rates affect the Indian economy much more now than during the 1980s. Empirical evidence confirms that global business cycles have a relatively larger influence on the Indian economy than was the case during the 1980s and exports and industrial production have started exhibiting co-movement with global business cycles. Remittances and trade in services have further augmented the linkages between India and the rest of the world. As regards capital flows, although the period since 1993-94 has been largely marked by persistent surpluses in the balance of payments, the period also witnessed a number of shocks such as the Asian financial crisis, sanctions resulting from the nuclear explosions, credit rating downgrades and the bursting of the information technology bubble in the US. These episodes have had repercussions on capital flows and exchange rates. As discussed in Section I, swings in capital flows, exchange rates and external demand conditions affect not only output and inflation, but also impact upon banking and financial stability. More recently, the unprecedented volume of capital flows during 2003-04 threw new challenges for the conduct of monetary policy. Excessive capital flows can be inflationary as well as can lead to a surge in credit booms. In this milieu, while price stability remains a key objective, ensuring financial stability has also emerged as a key consideration in the conduct of monetary policy in India.

With the growing openness of the Indian economy, the conduct of monetary policy has undergone significant shifts in operating procedures, instruments and timing. In this regard, the year 1991-92 marks a threshold in the conduct of monetary policy. Sweeping changes in the environment in which it operates were brought on by the unprecedented balance of payments crisis of 1990-92. From being operated almost exclusively in a closed economy context, monetary policy had to contend with the pressures of the open economy dynamics. Three overarching features marked the transition:

1. the exchange rate, which was hither to administered, became market determined and ensuring orderly conditions in the foreign exchange market became an objective of exchange rate management;

2. the vicissitudes in capital flows came to influence the conduct of monetary policy; and,

3. lessons of the balance of payments crisis highlighted the need to maintain adequate level of foreign exchange reserves and this in turn both enabled and constrained the conduct of monetary policy.

Initial conditions for the transformation were, in a sense, brought together by the response to the crisis in 1991-92 to achieve macro-economic stabilisation and structural adjustment. A two-step downward adjustment in the exchange rate of the rupee was effected in July 1991. This was accompanied by simultaneous tightening of monetary policy with increases in the Bank Rate, deposit and lending rates and refinance rates. Along with the exchange rate adjustment, significant structural reforms were effected in trade policy so as to liberalise the system from administrative controls and licences. On the trade front, tariffs were reduced sharply and quotas have been phased out. The peak rate of customs duty has declined from 150 per cent in 1991-92 to 20 per cent in 2004-05. The openness of the economy -merchandise exports and imports as a proportion of GDP - has increased significantly from 15 per cent in 1990-91 to 24 per cent by 2003-04. A more striking feature has been the opening up of the economy to financial flows - direct as well as portfolio investment flows and debt flows.

Since 1991, there has been a continuous move towards integration of the Indian economy with the world economy. During this continuum of reforms, four distinct phases are clearly discernible in terms of the underlying balance of payments conditions, shifts in monetary conditions and the policy responses. These are briefly discussed in the following paragraphs.

The first phase - the period 1993-95 - was characterised by strong capital inflows accompanied with stability in the exchange rate. During this period, foreign investment inflows - in particular, portfolio investment inflows in the form of foreign institutional investors' (FII) inflows and global depository receipts (GDRs) - increased sharply. Net portfolio inflows increased from negligible levels to more than US $ 3 billion in each of the two years. Coupled with curtailment of the current account deficit, there were large overall surpluses in the balance of payments and this led to a significant increase in foreign exchange reserves from their extremely low levels of the crisis period. During this period, the rupee witnessed a remarkable stability vis-a-vis the US dollar. The Reserve Bank's passive intervention was motivated by the need to protect export competitiveness by preventing an appreciation of the rupee which would in any case have been against fundamentals (RBI,1994).

Large accretions to the foreign exchange reserves led to a transformation in the composition of the Reserve Bank's balance sheet and, hence the dynamics of the money supply process. In contrast to the trend of the 1980s, net foreign exchange assets emerged as a key driver of reserve money. As capital flows continued, a number of steps were undertaken to sterilise the monetary impact of capital flows. In the second half of 1993-94, indirect instruments of monetary policy were activated and the Reserve Bank undertook large open market sales of Government securities from its portfolio. Nonetheless, increase in monetary aggregates was higher than that anticipated and excess liquidity led to inflationary pressures in the economy. With average inflation rate at 10.9 per cent during 1994-95, a package of measures was undertaken to sterilise the impact of external flows. These included an increase in the cash reserve ratio and a reduction in export refinance limits. The deceleration in capital inflows in the latter half of 1994-95 reduced the strain on sterilisation of capital inflows and consequently open market operations remained subdued in 1994-95.

The second phase - the year 1995-96 - was characterised by a deceleration in capital inflows and a widening of the current account deficit. There was a turnaround in the foreign exchange market and the prolonged stability in the exchange rate of the rupee witnessed from March 1993 came under stress in the second half of 1995-96. In response to the upheavals, the Reserve Bank intervened in the market to signal that the fundamentals are in place and to ensure that market correction of the overvalued exchange rate was orderly and calibrated. Exchange market intervention by the Reserve Bank in the spot market was initially supported by a withdrawal of liquidity from the money market to prevent speculative attacks on the exchange rate. These measures were successful in ensuring an orderly correction in the overvaluation of the rupee.

The third phase - 1996-2001- witnessed return of capital inflows. Although each of the year in this period was characterised by an overall surplus in the balance of payments, the phase was also marked with a few episodes, albeit brief, of heightened volatility in capital flows. The volatility was on account of both international and domestic factors - the Asian financial crisis, the spread of contagion to other markets such as Russia and Brazil, border tensions and sanctions imposed after the nuclear tests. This necessitated policy initiatives to manage the volatility in capital inflows, including monetary measures (such as increases in the Bank Rate, the repo rate and the cash reserve ratio), sales of foreign currency in the market to meet temporary demand-supply mismatches and administrative measures (Annex IV.2). Monetary measures were temporary, often reversed within a period of 2-3 months, consistent with the policy objective of ensuring orderly conditions. Recourse was four distinct phases are clearly discernible in terms of the underlying balance of payments conditions, shifts in monetary conditions and the policy responses. These are briefly discussed in the next article