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

Operating Procedures of Monetary Policy

With the shift away from the monetary targeting framework towards a multiple indicator approach, the operating procedures of monetary policy in India have undergone a significant shift. In particular, short-term interest rates have emerged as instruments to signal the stance of monetary policy. In order to stabilise short-term interest rates, the Reserve Bank now modulates market liquidity to steer monetary conditions to the desired trajectory. This is achieved by a mix of policy instruments including changes in reserve requirements and standing facilities and open market (including repo) operations which affect the quantum of marginal liquidity and changes in policy rates, such as the Bank Rate and reverse repo/repo rates, which impact the price of liquidity.

The Reserve Bank had originally conducted its monetary policy through a standard mix of open market operations and changes in the Bank Rate. The fiscal dominance during the 1970s and the 1980s changed the contours of the operating framework of monetary policy. A natural corollary was that the Reserve Bank's traditional instruments, the Bank Rate and open market operations, began to loose their efficacy. As a consequence, the Reserve Bank began to turn to changes in reserve requirements in order to modulate monetary conditions.

India, like most emerging market economies, saw a structural shift in the financing paradigm in the 1990s. The Ninth Five Year Plan recognised that the role of the financial system would have to be upgraded from mere channelisation to allocation of resources in order to reap the benefits of higher growth. In order to infuse a degree of efficiency in the allocation of resources by the financial system, the Reserve Bank initiated a multi-pronged strategy of institutional reforms to rekindle the process of price discovery in the financial markets.

First, the Reserve Bank began to deregulate interest rates, beginning with the removal of restrictions on the inter-bank market as early as 1989. This was supported by the process of putting the market borrowing programme of the Government through the auction process in 1992-93. This was buttressed by a phased deregulation of lending rates in the credit markets. At present, banks are free to fix their lending rates on all classes of loans except small loans below Rs.2 lakh and export credit. The deregulation of deposit rates began later, especially as an incipient attempt in the late 1980s ended in a price war between banks. Banks are now free to offer interest rates on all classes of domestic deposits (except savings deposits), not only in terms of tenor but also in terms of size. Interest rates on non-resident deposits are linked to international interest rates and these are modulated from time to time, depending on the macroeconomic - including the balance of payments - scenario.

Second, the process of interest rate deregulation had to be supported by the development of market architecture, especially to address the problem of missing markets at the short end. Two key reasons explain as to why short-term instruments were not actively traded. First, the system of cash credit shifted the onus of cash management from the borrowers to the banks. Second, the availability of fixed rate 4.6 per cent Treasury Bills, with a discounting facility from the Reserve Bank, on tap, in turn, allowed banks to pass the fluctuations in liquidity onto the Reserve Bank balance sheet. To overcome these shortcomings, the Reserve Bank began to introduce a number of money market instruments, such as commercial paper, short-term Treasury Bills and certificates of deposits following the recommendations of the Working Group on the Money Market (Chairman: Shri N. N. Vaghul). The process of replacing cash credit with term loans, phasing out of fixed rate tap Treasury Bills and the development of a repo market outside the Reserve Bank is gradually generating a vibrant set of markets at the short end of the interest rate spectrum.

Third, the introduction of new instruments was buttressed by the parallel process of market development, beginning with the institution of the Discount and Finance House of India as a market maker with two-way quotes in the money markets. Although the call money market was initially widened by introducing non-bank participants, they are now being phased out in tandem with the parallel development of a repo market outside the Reserve Bank. The emergence of a vibrant Government securities market, in particular, has played a key role.

Fourth, with a view to deepening inter-linkages, the development of markets was supported by withdrawal of balance sheet restrictions which had tied financial intermediaries to their primary segments of the financial markets. Banks now operate across all the segments of the financial markets, including equity and foreign exchange markets, albeit with prudential limits on their exposures.

In brief, the liberalisation of the Indian economy required a comprehensive recast of the operating procedures of monetary policy. The Reserve Bank had to shift from direct to indirect instruments of monetary policy in consonance with the increasing market orientation of the economy. This required development of an array of monetary policy instruments, which could effectively modulate monetary conditions in alignment with the rejuvenated process of price discovery. Besides, shifts in monetary policy transmission channels necessitated policy impulses which would travel through both quantum and rate channels. Finally, the episodes of volatility in the foreign exchange markets emphasised the need for swift policy reactions balancing the domestic and external sources of monetisation in order to maintain orderly conditions in the financial markets. Even within the set of indirect instruments, the preference is for relatively more market-based instruments such as open market operations. Accordingly, the cash reserve ratio (CRR) has been gradually lowered from 15 per cent in the early 1990s to five per cent by 2004, notwithstanding minor upward adjustments to deal with the evolving liquidity situation in the economy. As the Reserve Bank's Internal Working Group on Instruments for Sterilisation noted, the use of CRR as an instrument of sterilisation, under extreme conditions of excess liquidity and when other options are exhausted, should not be ruled out altogether by a prudent monetary authority ready to meet all eventualities (RBI, 2004a).