Parameters of Monetary Policy in India
[Lecture by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the 88th Annual Conference of
The Indian Econometric Society at Madras School of Economics, Chennai, 15 January 2002.]

Monetary Policy in India
Policy Making Process

Traditionally, the process of monetary policy in India had been largely internal with only the end product of actions being made public. A process of openness was initiated by Governor Rangarajan and has been widened, deepened and intensified by Governor Jalan. The process has become relatively more articulate, consultative and participative with external orientation, while the internal work processes have also been re-engineered to focus on technical analysis, coordination, horizontal management, rapid responses and being market savvy.

The stance of monetary policy and the rationale are communicated to the public in a variety of ways, the most important being the annual monetary policy statement of Governor Jalan in April and the midterm review in October. The statements have become over time more analytical, at times introspective and a lot more elaborate. Further, the statements include not only monetary policy stance or measures but also institutional and structural aspects. The monetary measures are undertaken as and when the circumstances warrant, but the rationale for such measures is given in the Press Release and also statements made by Governor and Deputy Governors unless a deliberate decision is taken not to do so on a contemporaneous basis. The sources for appreciating the policy stance encompass several statutory and non-statutory publications, speeches and press releases. Of late, the RBI website has become a very effective medium of communication and it is rated by experts as one of the best among central bank websites in content, presentation and timeliness. The RBI's communications strategy and provision of information have facilitated conduct of policy in an increasingly market-oriented environment.

Several new institutional arrangements and work processes have been put in place to meet the needs of policy making in a complex and fast changing world. At the apex of policy process is Governor, assisted closely by Deputy Governors and guided by deliberations of a Board of Directors. A Committee of the Board meets every week to review the monetary, economic, financial conditions and advice or decide appropriately. Much of the data used by the Committee is available to the public with about a week's lag. There are several other standing and adhoc committees or groups of the Board and Board for Financial Supervision plays a critical role in regard to institutional developments.

Periodic consultations with academics, market participants and financial intermediaries take place through Standing Committees and Ad Hoc Groups, in addition to mechanisms such as resource management discussions with banks. Within the RBI, the supervisory data, market information, economic and statistical analysis are reoriented to suit the changing needs. A Financial Markets Committee focuses on a day-to-day market operations and tactics while a Monetary Policy Strategy Group analyses strategies on an ongoing basis. Periodic consultations with the Government, mainly with Ministry of Finance do ensure coordination. In brief, there are significant technical, analytical, institutional and dynamic inputs that go into the process of making monetary policy.

Although there has not been any explicit legislation for price stability, the major objectives of monetary policy in India have been those of maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy. The relative emphasis between the objectives depends on the underlying economic conditions and is spelt out from time to time. Compared to many other developing economies, India has been able to maintain a moderate level of inflation. Historically, inflation rates in India rarely touched double digit and when they did, in most cases, they were the result of supply shocks either in the form of increase in agricultural commodity prices or in the form of increase in international prices of crude oil.

The monetary policy framework in India from the mid-1980s till 1997-98 can, by and large, be characterized as a monetary targeting framework on the lines recommended by Chakravarty Committee (1985). Because of the reasonable stability of the money demand function, the annual growth in broad money (M3) was used as an intermediate target of monetary policy to achieve monetary objectives. Monetary management involved working out a broad money growth through the money demand function that would be consistent with projected GDP growth and a tolerable level of inflation. In practice, however, the monetary targeting approach was used in a flexible manner with a 'feedback' from the developments in the real sector.

While the monetary system in India is still evolving and the various inter-sectoral linkages in the economy are undergoing changes, the emerging evidences on transmission channel suggest that the rate channels are gradually gaining importance over the quantum channel. The econometric evidence produced by the Third Working Group on Money Supply (1998) indicated that output response to policy operating through the interest rate was gaining strength. Similarly, the impact of an expansionary monetary policy on inflation was found to be stronger through interest rates than the exchange rate, given the relatively limited openness of the economy.

There has been a shift in strategic objective, necessitated by deregulation and liberalization of the financial markets combined with increasing openness of the economy. The estimated income elasticity of demand for money which had exhibited a clearly decreasing trend in the earlier part of the reform period showed a sharp turning point in 1996-97 resulting in an increasing trend thereafter. The changing nature of the relationship highlights that while money is still an important indicator, information pertaining to other monetary and financial indicators should also be taken into account seriously while formulating monetary policy, especially in view of the sweeping changes in the financial sector in India in recent years. From the year 1998-99, RBI announced that henceforth it would follow a multiple indicator approach. In this approach, interest rates or rates of return in different markets along with movements in currency, credit, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange - available on high frequency basis - are juxtaposed with output data for drawing policy perspectives. In a way, such a shift was a logical outcome of measures taken over the reform period since the early 1990s.

In the pre reform period prior to 1991, given the command and control nature of the economy, the Reserve Bank had to resort to direct instruments like interest rate regulations, selective credit control and the cash reserve ratio (CRR) as major monetary instruments. These instruments were used intermittently to neutralize the monetary impact of the Government's budgetary operations. The administered interest rate regime during the earlier period kept the yield rate of the government securities artificially low. The demand for them was created through intermittent hikes in the Statutory Liquidity Ratio (SLR). The task before the Reserve Bank of India was, therefore, to develop the markets to prepare the ground for indirect operations.

As a first step, yields on government securities were made market related. At the same time, the RBI helped create an array of other market related financial products. At the next stage, the interest rate structure was simultaneously rationalized and banks were given the freedom to determine their major rates. As a result of these developments, RBI could use OMO as an effective instrument for liquidity management including to curb short-term volatilities in the foreign exchange market.

Another important and significant change introduced during the period is the reactivation of the Bank Rate by initially linking it to all other rates including the Reserve Bank's refinance rates (April 1997). The subsequent introduction of fixed rate repo (December 1997) helped in creating an informal corridor in the money market, with the repo rate as floor and the Bank Rate as the ceiling. The use of these two instruments in conjunction with OMO enabled RBI to keep the call rate within this informal corridor for most of the time. Subsequently, the introduction of Liquidity Adjustment Facility (LAF) from June 2000 enabled the modulation of liquidity conditions on a daily basis and also short term interest rates through the LAF window, while signaling the stance of policy through changes in the Bank Rate.

It has been possible to reduce the statutory preemption on the banking system. The Cash reserve Ratio (CRR), which was the primary instrument of monetary policy, has been brought down from 15.0 per cent in March 1991 to 5.5 per cent by December 2001. The medium-term objective is to bring down the CRR to its statutory minimum level of 3.0 per cent within a short period of time. Similarly, Statutory Liquidity Ratio (SLR) has been brought down from 38.5 per cent to its statutory minimum of 25.0 per cent by October 1997.

It has also been possible to deregulate and rationalise the interest rate structure. Except savings deposit, all other interest rate restrictions have been done away with and banks have been given full operational flexibility in determining their deposit and lending rates barring some restrictions on export credit and small borrowings. The commercial lending rates for prime borrowers of banks has fallen from a high of about 16.5 per cent in March 1991 to around 10.0 per cent by December 2001. In terms of monetary policy signals, while the Bank Rate was dormant and seldom used in 1991, it has been made operationally effective from 1997 and continues to remain the principal signaling instrument. The Bank Rate has been brought down from 12.0 per cent in April 1997 to 6.5 per cent by December 2001. It is envisaged that the LAF rate would operate around the Bank Rate, with a flexible corridor, as more active operative instrument for day-to-day liquidity management and steering shortterm interest rates.

A contrasting feature in the positions between 1991 and 2001 is India's foreign exchange reserves. The monetary and credit policy for 1991-92 was formulated against the background of a difficult foreign exchange situation. Over the period, external debt has been contained and short-term debt severely restricted, while reserves have been built in an atmosphere of liberalisation of both current account and to some extent capital account.

The foreign currency assets of the Reserve Bank have increased from US $ 5.8 billion in March 1991 to US $ 48.0 billion in December 2001. In view of comfortable foreign exchange reserves, periodic oil price increases (for example in 1996-97, 1999-2000 and 2000-01) did not translate into Balance of Payment (BoP) crises as in the earlier occasions. Such enlargement of the foreign currency assets, on the other hand, completely altered the balance sheet of the Reserve Bank

Large capital inflows have been accommodated by the Reserve Bank while its monetary impact has been sterilized through OMO. This has helped in reducing the government's reliance on credit from RBI. Consequently, there has been secular decline in monetised deficit, and in the process net foreign exchange assets of RBI have become the principal contributor to reserve money expansion in the recent period.

These are impressive gains from reform but there are emerging challenges to the conduct of monetary policy in our country. Thus, while the twin objectives of monetary policy of maintaining price stability and ensuring availability of adequate credit to the productive sectors of the economy have remained unchanged, capital flows and liberalization of financial markets have increased the potential risks of institutions, thus bringing the issue of financial stability to the fore. Credit flow to agriculture and small- and medium-industry appears to be constrained causing concerns. There are significant structural and procedural bottlenecks in the existing institutional set up for credit delivery. The pace of reforms in real sector, particularly in property rights and agriculture also impinge on the flow of credit in a deregulated environment. The persistence of fiscal deficit, with the combined deficit of the Central and State Governments continuing to be high, draws attention to the delicate internal and external balance. It is necessary to recognize the existence of the large informal sector, the limited reach of financial markets relative to the growing sectors, especially services, and the overhang of institutional structure that tend to constrain the effectiveness of monetary policy in India. The road ahead would be demanding and the Reserve Bank would have to strive to meet the challenge of steering the structurally transforming economy from a transitional phase to a mature and vibrant system and increasingly deal with alternative phases of the business cycle. Some of the immediate tasks before RBI are presented to provoke debate and promote research.

In addressing a gathering of elite econometricians assembled here, a mention should be made about developments in monetary modeling. It is well recognized that monetary policy decisions must be based on some idea of how decisions will affect the real world and this implies conduct of policy within the framework of a model. As Dr. William White of Bank for International Settlements (BIS) mentioned in an address recently in RBI, "the model may be as simple as one unspecified equation kept in the head of the central bank Governor, but one must begin somewhere. Economics may not be a science, but it should at least be conducted according to scientific principles recognizing cause and effect". While reliance on explicit modeling was rather heavy in some central banks, particularly in the 1960 and 1970s, there has been increasing awareness among the policy markers of the limitations of such models for several reasons. It is difficult to arrive at a proper model for any economy with the degree of certainty that policy makers want especially in view of observed alterations in the private sector behaviour in response to official behaviour. Further, data to monitor the economy are sometimes inadequate, or delayed, and often revised. It is said that in regard to modern economies, not only the future but even the past is uncertain, due to significant revisions in data. The process of deregulation coupled with technological progress has led to increasing role for market prices and consequently more complexities for establishing relationships in an environment where everything happens very fast, and in a globally interrelated financial world. In brief, there is need to recognize the complexities in model building for monetary policies and approach it with great humility and a dose of skepticism but ample justification for such modeling work certainly persists.

It is felt that this is an appropriate time to explore more formally the relationship among different segments of the markets and sectors of the economy, which will help in understanding the transmission mechanism of the monetary policy in India. With this objective in mind, RBI had already announced its intention to build an operational model, which will help the policy decision process. An Advisory Group with eminent academicians like Professors Mihir Rakshit, Dilip Nachane, Manohar Rao, Vikas Chitre and Indira Rajaraman as external experts and a team from within the RBI were set up for developing such a model.

The model was initially conceived to focus on the short term objective of different sources and components of the reserve money based on the recommendations of an internal technical group on Liquidity Analysis and Forecasting. Though, multi-sector macro econometric models are available, such models are based on yearly data and hence these may not be very useful for guiding the short term monetary policy actions of RBI. Accordingly, it was felt that a short- term liquidity model may be developed in the RBI focusing on the inter-linkages in the markets and then operationalise these linkages to other sectors of the economy. The Advisory Group met twice and after deliberations felt that a daily/ weekly/ fortnightly model would give an idea about short- to medium-term movements but models using annual data will also be useful to assess the implications of the monetary policy measures on the real economy. On the basis of the advice of eminent experts in the Advisory Group, it has been decided to modify the approach.

The current thinking in RBI is broadly on the following lines: the short term liquidity model making use of high frequency data will be explored. Accordingly, the interaction of the financial markets with monetary policy have been examined with weekly data focusing mainly on policy measures and different rates in the financial markets. Observations in the operational framework of the model is limited as the LAF has been operationalised only a year ago. A crucial aspect in an exercise is the forecast of currency in circulation

The intention of RBI is to expedite the technical work in this regard and seek the advice of individual members of Advisory Group on an ongoing basis both at formal and informal levels. It is expected that the draft of the proposed model would be put in public domain shortly. RBI would seek the active participation of the interested econometricians in the debate on the draft model and give benefit of advice to RBI for finalizing and adoption.