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

Module: 2 - Monetary Policy Framework In India

Monetary-Fiscal Interface in India

A key message from the above discussion is that the surge in inflation during the 1970s and 1980s was a consequence of expansionary monetary policy. This, in turn, was the outcome of expansionary fiscal policies. Concomitantly, the 1990s received a renewed focus on improving monetary-fiscal interface in order to provide the monetary policy necessary flexibility in monetary management. This Section briefly touches upon the monetary-fiscal interface over the past decades and the recent efforts to strengthen the same through fiscal rules.

With the progressive widening of fiscal deficits from the 1960s onwards, the burden of financing was borne by the Reserve Bank and the banking system. The support of the banking system to the Government's borrowing programme took the form of a progressive increase in statutory liquidity ratio (SLR). Although interest rates - initially kept artificially low to contain the interest cost of public debt - on Government securities were steadily raised to enhance their attractiveness to the market, it got increasingly difficult to get voluntary subscriptions even at higher rates of return. The SLR, therefore, was raised to 38.5 per cent by the early 1990s¹. The increase in the SLR was, however, unable to fully meet the fiscal requirements and the burden of financing the Government had also to be borne by the Reserve Bank. As Reserve Bank financing is inflationary beyond a limit, the increase in the Reserve Bank support to the Central Government was accompanied by an increase in cash reserve requirements (CRR). The CRR was increased from three per cent in the early 1970s to reach 15 per cent (in fact, 25 per cent if incremental reserve requirements are also taken into account) by the early 1990s. However, even this order of increase in the CRR to impound liquidity was insufficient and broad money growth continued to remain high during the 1970s and 1980s and spill over to inflation.

As discussed earlier there are limits to the effectiveness of monetary policy in containing inflation in the face of an expansionary fiscal policy. Accordingly, monetary-fiscal coordination is often emphasised in order to achieve price stability. In India too, following the balance of payments crisis of the early 1990s, structural reforms addressed the issue of imparting monetary policy greater flexibility. This was done through, inter alia, raising market borrowings at market-related yields and the phasing out of the automatic monetisation through ad hocs. These measures were able to reduce the reliance on the Reserve Bank significantly from mid-1990s onwards² . It is now clear that the Reserve Bank is able to control the timing and form of its accommodation to the Government. The more critical issue is whether the Reserve Bank would be able to contain the volume of its support to the Government, once liquidity conditions change - either because domestic credit demand picks up or capital flows dry up. Not only is the Centre's fiscal deficit still substantial, but the share of net bank credit to the Government in financing the fiscal deficit remains high. Monetary management, however adroit, and monetary-fiscal co-ordination, however seamless, cannot thus be a substitute for fiscal discipline (Box III.6). It is for these reasons that, as discussed in Section I, several countries have put in place fiscal responsibility legislation which, inter alia, place limits on fiscal deficits to guard against fiscal profligacy.

As in other economies, the fiscal-monetary coordination in India has been strengthened through the enactment of the FRBM Act, 2003. The FRBM Act, while placing limits on deficits, prohibits borrowings from the Reserve Bank from the fiscal year 2006-07 except by way of WMA or under exceptional circumstances. The Reserve Bank would, however, still be able to buy or sell Government securities in the secondary market consistent with the conduct of monetary policy. In exercise of the powers of the Act, the Central Government has framed the FRBM Rules, 2004. In the Fiscal Strategy Statement, the Government proposes to assist the Reserve Bank in restraining the growth in money supply without damaging the medium/long-term prospects of savings in the economy and without hurting the interests of the poor, senior citizens and other fixed-income earners.

To conclude, price stability has been an abiding objective of monetary policy in India although its achievement was circumscribed by the fiscal dominance of monetary policy till the mid-1990s. In the subsequent years, the reforms in the monetary-fiscal interface have been successful in providing the Reserve Bank greater flexibility in monetary management. A key development in this regard was the accord between the Government and the Reserve Bank in 1994 that eliminated the automatic monetisation of the Central Government's fiscal deficit by gradually phasing out ad hocs by 1997. The most noteworthy endeavour in this direction is the enactment of the FRBM Act. Adherence to FRBM targets is critical for the objective of maintaining price stability, and more importantly, to stabilise inflation expectations in the economy.

¹The increase in SLR coupled with the increase in the cash reserve requirements (CRR) had the effect of crowding out the private sector from the credit markets (see Module 4).

²Other factors such as strong capital flows, weak credit demand and risk aversion by banks also lowered the recourse to monetisation. This, in turn, implies that commercial banks hold a large proportion of long-term Government paper although their deposit liabilities are usually short, creating an inherent maturity mismatch in commercial bank balance sheets. As their demand for longer-term assets is already met by investments in government paper, the ability of commercial banks to fund infrastructure financing is also thus limited (see Module: 2).

³The need for central bank independence was, in fact, prophetically stressed by the Government while piloting the Reserve Bank of India Act, 1934: ".It has generally been agreed in all the constitutional discussions, and the experience of all other countries bears this out, that when the direction of public finance is in the hands of a ministry responsible to a popularly elected Legislature, a ministry which would for that reason be liable to frequent change with the changing political situation, it is desirable that the control of currency and credit in the country should be in the hands of an independent authority which can act with continuity. Further, the experience of all countries is again united in leading to the conclusion that the best and indeed the only practical device for securing this independence and continuity is to set up a Central Bank, independent of political influence.(In) modern life, and modern economic organisations, there are two important functions: they are the functions of those who have to raise and use money and there are the functions of those who are responsible for producing the actual tokens of money, the money in circulation. The basis of the whole proposal for setting up an independent Central Bank is to keep these functions separate. The largest user of money in the country is the Government, and the whole principle of the proposal is that the Government, when it wants money to spend, should have to raise that money by fair and honest means in just the same way as every private individual has to raise money which he requires to spend for his own maintenance. If the Government is in control of the authority which is responsible for exercising the other function, then all sorts of abuses can intervene".