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Emerging Market Economies - Development of Monetary
Policy Initiatives by RBI over the years

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Module: 5
Development of Monetary Policy Initiatives by RBI over the years - Part: 1
[An Overview of the Discussion Papers Submitted by the Basel Policy Group - Dr.Y.V.Reddy, Dy Governor, RBI,
Representing India - The Original Article may be referred at - URL http://www.bis.org/publ/plcy05.htm]

Module: 5 - Development of Monetary Policy Initiatives by RBI over the years
Table of Contents

1. Monetary Policy Objectives
2. Development of Monetary Policy - Part: 2

3. Development of Monetary Policy - Part: 3




Foreword - Overview by BIS of Papers submitted by all Participants at the Policy Discussion Forum

This work provides an overview of monetary policy operating procedures in emerging market economies. Most of the discussion reflects the situation in mid-1998. The emphasis is on general principles although in practice country-specific factors condition actual procedures. Yet there has been a certain convergence in monetary policy instruments and procedures in recent years, not only in industrial countries but also in most emerging market economies. Major forces for change have been the rapid development and deepening of a variety of financial markets and instruments, the diversification of financial institutions and the globalisation of intermediation.

As long as the financial sector was relatively closed and dominated by commercial banks, monetary control was exercised by the setting of only two parameters: reserve requirements against demand deposits at commercial banks and the discount rate on bank borrowing from the central bank. This is what is defined in the South African paper as the classical cash reserve system. Adjustments in either parameter would induce banks to change the terms of their loans and deposits, leading to changes in the economy-wide stock of money and in turn aggregate spending. Even more rudimentary techniques based on quantity controls rather than on price signals proved effective as long as financial markets remained underdeveloped and insulated from foreign influences.

Once new financial markets developed and market integration progressed, bank intermediation became less dominant. Households placed part of their savings outside the banking sector, enterprises started tapping non-bank sources of funding and banks, too, had to gain a foothold in the new markets, on both the supply and the demand side. In this new environment, the setting of bank interest rates came to depend on conditions in financial markets. Moreover, aggregate spending became sensitive to more than just bank-determined interest rates. In order to control the new channels of financial transmission new procedures had to be developed, focused on influencing the behaviour of all market participants and price formation in a variety of short-term money and interbank markets. As paraphrased in the Bank of Israel's paper, "It is not enough to clear the landscape, one also has to construct new modes of travelling through it".

Although the experiences and the choices made in individual countries vary widely, a number of common trends in the modernisation of operating procedures can be detected. First, the deepening of financial markets and the growth of non-bank intermediation have induced, if not forced, central banks to increase the market orientation of their instruments. In most cases (but with a few notable exceptions identified below), a higher proportion of reserves is now supplied through operations in open markets, with the use of standing facilities limited to providing marginal accommodation or serving as emergency finance. This, however, does not imply an erosion of the power of standing facilities in affecting liquidity conditions; indeed, it is often the marginal changes in bank liquidity which have the greatest impact on interest rates. Secondly, the increased importance and flexibility of the price mechanism in the new market environment have induced many central banks to focus more on interest rates rather than bank reserves in trying to influence liquidity. A third trend is that, reduced market segmentation, and thus the greater ease and speed with which interest rate changes are transmitted across the entire spectrum of yields, has enabled central banks to concentrate on the very short end of the yield curve where, given payment and settlement arrangements, their actions tend to have the greatest impact. The move to real time gross settlement systems in several countries may increase the short-term focus of policy implementation even further. Fourthly, the greater market orientation of the central banks' instruments has been associated with a preference for flexible instruments. In the highly volatile financial environment marking several of the emerging market economies, flexibility in the design of the policy instruments may be particularly important. Much of this greater flexibility has come from the growing use of repurchase operations. Finally, awareness of the important role of market psychology and expectations has increased markedly. This has implications for the degree of transparency which central banks need to influence interest rates, their reliance on market information in formulating policies and their own tactics in signalling policy changes to the market.

Monetary Policy Objectives

The preamble to the Reserve Bank of India Act sets out the objectives of the Bank as "to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage". Although there has not been any explicit legislation for price stability, as has been the current trend in many countries, the objectives of monetary policy in India have evolved as those of maintaining price stability and ensuring an adequate flow of credit to the productive sectors of the economy. These twin objectives are clearly spelt out from time to time in monetary and credit policy announcements by the Reserve Bank. The objective of price stability has, however, gained further importance following the opening-up of the economy and the deregulation of financial markets in India in recent times.1

The growing recognition that price stability ought to be the core objective of monetary policy is reflected in the Reserve Bank's Annual Report for 1996/97: "in the case of India, both output expansion and price stability are important objectives but depending on the specific circumstances of the year, emphasis is placed on either of the two. Increasingly, it is being recognised that central banks would have to target price stability since real growth itself would be in jeopardy if inflation rates go beyond the margin of tolerance".

Institutional Background

As regards the conduct of monetary policy, the choice of targets, instruments and operating procedures was circumscribed to a large extent by the nature of the financial markets and the institutional arrangements. In this context, the period prior to 1992 can be termed as the pre-reform period, with the post-reform period emerging thereafter. Although the reform of the financial sector was initiated in the mid-1980s, the process was hastened following the economic crisis in the summer of 1991. The foundation for the reform of the monetary and financial system was laid by the Committee to Review the Working of the Monetary System (Chakravarty Committee, 1985) and the Working Group on the Money Market (Vaghul Group, 1987).

i Pre-Reform Period

In the pre-reform era, the financial market in India was highly segmented and regulated. The money market lacked depth, with only the overnight interbank market in place. The interest rates in the government securities market and the credit market were tightly regulated. The dispensation of credit to the Government took place via a statutory liquidity ratio (SLR) process whereby the commercial banks were made to set aside substantial portions of their liabilities for investment in government securities at below market interest rates. Furthermore, credit to the commercial sector was regulated, with prescriptions of multiple lending rates and a prevalence of directed credit at highly subsidised interest rates. However, the institutional arrangement for financing the government deficit is of particular significance for an understanding of the conduct of monetary policy. The provision for extending short-term credit (not exceeding three months) to the Central government slipped into a practice of rolling over this facility, resulting in automatic monetisation of the Government's deficit. The situation was aggravated further during the 1980s as the Government's fiscal balance rapidly deteriorated. The process of creating 91-day ad hoc Treasury bills and subsequently funding them into non-marketable special securities at a very low interest rate emerged as the principal source of monetary expansion. In addition, the Reserve Bank had to subscribe to the government dated securities which were not taken up by the market. As a result, net Reserve Bank credit to the Central government, which constituted about three-quarters of the monetary base (reserve money) during the 1970s, rose to over 920/0 during the 1980s. It was only in the 1990s that the trend was reversed following economic reforms.

In such an environment, monetary policy had to address itself to the task of neutralising the inflationary impact of the growing deficit. The Reserve Bank had to resort to direct instruments of monetary control, in particular the cash reserve ratio. This ratio was used to neutralise the financial impact of the Government's budgetary operations rather than as an independent monetary instrument.

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1It may be noted in this context that a number of measures have been taken in recent years to remove various restrictions on international current account transactions and ease capital account transactions, culminating in India accepting Article VIII status under the Articles of Agreement of the International Monetary Fund (IMF) in August 1994.

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