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

Transformation of Reserve Bank's Balance Sheet Due to Accretion of Forex Reserves

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 also taken to mobilise deposits from non-residents through special schemes such as Resurgent India Bonds and India Millennium Deposits. Notwithstanding brief episodes of volatility, capital flows remained vastly in excess of current account deficits - which remained moderate in the face of low domestic absorption. As a result, the foreign exchange reserves increased, on an average, by nearly US $ 4.1 billion per year. During this phase, changes in reserve money were, therefore, largely dominated by the accretions to net foreign exchange assets of the Reserve Bank. As a result, the ratio of net foreign assets to reserve money increased from 38 per cent at end-March 1996 to 65 per cent by end-March 2001.

The fourth phase - 2001-02 onwards - posed new challenges for the conduct of monetary policy. This period has been marked by sustained surges in capital inflows coupled with surpluses in current account in the balance of payments. The turnaround in the current account balance was mainly due to a higher invisible surplus. On the capital account, there was unprecedented volume of net inflows. Even as debt creating flows ebbed in response to policy changes such as prepayment of high cost official debt and rationalisation of interest rates on NRI deposits, non-debt creating flows, par ticularly por tfolio investments surged ahead. With both current and capital accounts in surplus, foreign exchange markets were marked by persistent excess supply conditions. These excess supplies were absorbed by the Reserve Bank and, as a result, its foreign exchange reserves more than doubled during the 3-year period from US $ 42.3 billion at end-March 2001 to US $ 113.0 billion at end-March 2004 - an average increase of US $ 23.6 billion per annum. Concomitantly, the ratio of net foreign assets to reserve money increased from 65 per cent at end-March 2001 to more than 100 per cent by end-March 2004. The concomitant excess supply in the foreign exchange market - reflected in the overall balance of payments surpluses - was absorbed by the Reserve Bank in line with its exchange rate and foreign exchange reserves policies. The level of reserves held by any country is, of course, really a consequence of the exchange rate policy being pursued (RBI, 2004a). The overall approach to the management of India's foreign exchange reserves in recent years has reflected the changing composition of capital account of the balance of payments and the liquidity risks associated with different types of flows within the parameters of reserve adequacy. The policy for reserve management is built upon factors and contingencies such as the size of the current account deficit, the size of short term liabilities (including current repayment obligations on long term loans), the potential variability in portfolio investment and other types of capital flows and unanticipated external shocks. The policy objective is to ensure that excluding short-term variations in response to market movements, the quantum of reserves in the long run is in line with the growth in the economy and the size of risk adjusted capital flows. With the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition and the risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable. There is considerable merit in taking a national balance sheet approach to the external sector and to provide cushions through official reserves in response to increasing external liabilities on account of the private sector. Further, it is useful to recognise the comfort and the confidence provided to the investors by the level of reserves in the context of volatility in capital flows (RBI, 2004b).

A number of steps have been taken to offset the expansionary impact of external flows on domestic money supply. These include:-

• Increase in the minimum maturity of non-resident deposits to one year to attract stable flows as also to minimise the country's short-term external debt.

• LIBOR-linked interest rate ceilings on foreign currency denominated deposits since 1997.

• LIBOR-linked interest rate ceilings on non-resident rupee deposits effective July 2003 to provide consistency in the interest rates offered to nonresident Indians. The ceiling was initially fixed at 250 basis points above LIBOR. It was tightened and reduced to only 100 basis points above LIBOR effective September 15, 2003 and to 25 basis points above LIBOR effective October 18, 2003. The ceiling was tightened further to the LIBOR itself, effective April 17, 2004. More recently, the ceiling has been relaxed to 50 basis points above LIBOR, effective October 26, 2004. Available empirical evidence suggests that non-resident deposits are influenced by standard risk and return variables. In particular, these deposits respond favourably to changes in relative interest rates.

• Substantial expansion of the automatic route of FDI abroad by Indian residents.

• Greater flexibility to corporates on pre-payment of their external commercial borrowings.

• Liberalisation of surrender requirements for exporters enabling them to hold up to 100 per cent of their proceeds in foreign currency accounts.

• Extension of foreign currency account facilities to other residents.

• Allowing banks to liberally invest abroad in high quality instruments.

• Pre-payment of US $ 6.9 billion of debt owed to multilateral and bilateral agencies by the Government of India during 2002-03 and 2003-04. An increase of 50 basis points in the cash reserve ratio (CRR) from 4.5 per cent to 5.0 per cent, effective October 2004. Finally, appreciation of the nominal exchange rate of the rupee vis-a-vis the US dollar.

As noted earlier, effective October 2004, the CRR was raised from 4.5 per cent to 5.0 per cent, based on a review of current liquidity conditions. The medium-term policy objective of the Reserve Bank is to reduce CRR to its statutory minimum of 3.0 per cent while retaining the option to use CRR in both directions for liquidity management, as and when essential, in addition to other instruments.