Development of Monetary Policy Initiatives by RBI over the years - Part: 2
[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]

(ii) Post-reform period

The financial sector reforms initiated following the recommendations of the Narasimham Committee (1991), in conjunction with the recommendations of the Chakravarty Committee and the Vaghul Working Group, produced far-reaching changes in the financial sector which had an important bearing on the conduct of monetary policy.

The Chakravarty Committee had advocated regulation of the money supply in line with the evolving price/output situation. As regards the means of achieving the desired monetary expansion, the Committee had recommended control of the monetary base (reserve money). However, as the practice of automatic monetisation of the Government's fiscal deficit impinged on the effective control of the monetary base, there was an imperative need for a change in the institutional arrangement. A momentous step in this direction was the historic agreement of 1994-95 between the Government of India and the Reserve Bank, eventually culminating in the elimination of the issuance of ad hoc Treasury bills with effect from 1st April 1997²

With the initiation of financial sector reforms, the emphasis was placed on the development and deepening of money, government securities and forex markets, and an effort was made to move away from the use of direct instruments of monetary control to indirect measures such as open market operations and market-related interest rates. In order to improve short-term liquidity and encourage its efficient management, interbank participation certificates, certificates of deposit (CDs) and commercial paper (CP) were introduced. The Discount and Finance House of India (DFHI) was set up to promote a secondary market in a range of money market instruments. Treasury bills of varying maturities (14-, 91- and 364-day) were introduced. More importantly, interest rates on money market instruments were left to be determined by the market.

The process was well supported by reforms in the government securities market. Concomitant with sharp fiscal adjustment by the Central government, the interest rates on government paper were made market-related and the maturity periods reduced substantially to a maximum of ten years³. Other fundamental reforms in the government securities market include setting up a system of primary dealers (PDs) for dealing in government securities, introducing a delivery-versus-payment (DVP) system in respect of government securities settlement, adopting new techniques for flotation, introducing new instruments such as zero coupon bonds, partly paid stock and capital-indexed bonds, conducting auctions to impart greater transparency in operations, allowing repos in government dated securities and Treasury bills of all maturities and issuing guidelines for setting up satellite dealers (SDs). All these measures have brought about significant changes in that a new treasury culture has been developed amongst banks and institutions so that the demand for government paper is no longer governed solely by statutory liquidity ratio (SLR) requirements but by considerations concerning the effective management of liquidity.

In consonance with the medium-term objectives of financial sector reform, the SLR was brought down from its peak level of 38.5% in April 1992 to 250/0 of net demand and time liabilities (NDTL) in October 1997. Moreover, there were sharp cuts in the cash reserve ratio (CRR), progressively to 100/0 in January 1997 from 150/0 in 1991⁴. The Reserve Bank's refinance facility was also rationalised while lowering the CRR - the sector-specific refinance facilities were de-emphasised and simultaneously a general refinance window was opened in April 1997.

Open market operations (OMOs) have gained considerable momentum as the Reserve Bank now responds more flexibly to market yields when drawing up its price list. It also conducts repo and reverse repo transactions in order to ensure a reasonable corridor for money market rates of interest.

The interest rate structure was rationalised. Banks are now free to determine their domestic term deposit rates and prime lending rates (PLRs), except for certain categories of export credit and small loans below Rs 0.2 million. In addition, all money market rates are also free. The most significant development in this area has, however, been the reactivation of the bank rate by linking it to all other rates including the Reserve Bank's refinance rate.

India switched over to a market-determined exchange rate system in March 1993 and current account convertibility was instituted in August 1994. Since then, a number of steps have been taken to integrate the Indian forex market with the global financial system by allowing authorised dealers (ADs) more freedom to manage their foreign currency assets and liberalising inward capital flows. Furthermore, with a view to moving progressively towards capital account convertibility a committee was set up and its recommendations are under consideration by the Government of India and the Reserve Bank.

In view of the fairly stable demand function for money, broad money (M3) has been treated as an intermediate target in the conduct of monetary policy. The Reserve Bank sets indicative broad money expansion targets in line with the expected rate of growth of GDP and a tolerable level of inflation. On the basis of the targeted level of broad money expansion, the desired level of reserve money expansion is ascertained. The order of the reserve money expansion, however, has to be consistent with the likely fiscal and external payments position. With the recent change in the institutional arrangement resulting in the phasing-out of the automatic financing of the Government's deficit, the Reserve Bank has some manoeuvrability with regard to the expansion of reserve money. The targeted M3 expansion is publicly announced through the Governor's statement on monetary and credit policy. However, a number of other indicators such as movement in interest rates, exchange rate and availability of credit to productive sectors of the economy are also considered when formulating monetary policy.

The reform of the monetary and financial sector has enabled the Reserve Bank to expand the array of instruments at its command. The operational target of monetary policy continues to be banks' reserves, which are controlled by changes in reserve requirements effected mainly through the cash reserve ratio (CRR). However, the Reserve Bank is attempting to reduce the emphasis on the use of the CRR as an instrument of monetary control. The CRR has been progressively brought down and the liquidity management in the system is carried out through open market operations in the form of (i) outright purchases/sales of government securities and (ii) repo and reverse repo operations.

In the face of unidirectional movements in the CRR⁵, except on occasions of exchange rate volatility or necessitated by the need to sterilise capital inflows, the excess liquidity in the system was mopped up by outright sales of government securities by the Reserve Bank. Although the net demand and time liabilities (liabilities subject to reserve requirements) of the commercial banks expanded from Rs 3,602 billion in August 1994 to Rs 5,201 billion in January 1997, their deposit balances with the Reserve Bank declined from Rs 504 billion to Rs 446 billion during the same period. This would imply, that between August 1994 and January 1997, the incremental liabilities of the commercial banks were not only free from reserves but there was a release of reserves to the tune of Rs 58 billion. The liquidity pressure thus generated was to be contained by resorting to open market operations. The cumulative net outright sales of government securities during the four-year period between 1993/94 and 1996/97 amounted to Rs 216 billion. The market demand for government securities was so strong, partly aided by cuts in the CRR, that the Reserve Bank was able to offload most of its stock of marketable securities accumulated in the past. However, the reduction of marketable securities in the Reserve Bank's portfolio did not hinder the subsequent conduct of open market operations as non-marketable special securities worth Rs 200 billion were converted into marketable lots during 1997/98. Over the reform period, the market absorption of government securities was rendered possible by reforms in the government securities markets, which ensured market-related rates of interest and thus helped the development of a secondary market.