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
Tasks before RBI (Contd)

Reduction in CRR

Among the unrealized medium-term objectives of reforms in monetary policy, the most important is reduction in the prescribed CRR for banks to its statutory minimum of 3.0 per cent. The movement to 3.0 per cent can be designed in three possible ways, viz., the traditional way of pre-announcing a time-table for reduction in the CRR; reducing CRR as and when opportunities arise as is being done in recent years; and as a one-time reduction from the existing level to 3.0 per cent under a package of measures.

In the initial years, the first approach was effective but had to be abandoned when the timetable had to be disrupted to meet the eruption of global financial uncertainties and pressures on forex market. Hence, the second approach of lowering CRR when opportunities arise has been adopted, and now it has been brought down to 5.5 percent. However, if it is felt that this approach takes a longer time and a compressed time-frame is desirable to expedite development of financial markets, it is possible to contemplate a package of measures in this regard. The package could mean the reduction of CRR to the statutory minimum level of 3.0 per cent accompanied by several changes such as in the present way of maintenance of cash balances by banks with RBI. With the lagged reserve maintenance system now put in place, banks can exactly know their reserve requirements. With the information technology available with banks and with the operationalisation of Clearing Corporation of India Ltd. (CCIL) shortly and with the development of repo market, it would be appropriate if CRR is maintained on a daily basis. However, till banks adjust to such changes in the maintenance of CRR, a minimum balance of 95 per cent of the required reserves on a daily basis may have to be maintained when CRR is reduced to 3.0 per cent. The other elements of package have to be worked out carefully. (Presently as at end 2004 CRR is 5%

An important related component of ongoing reform relates to restricting the call money market to banks and Primary Dealers (PDs). Several measures have been initiated in this regard but in view of the growing importance attached to stability in the financial system and the growing alternatives to access liquidity management through activation of repos facilitated by CCIL, there is a strong case to impose some limits on access to non-collateralised borrowing through call money even under the dispensation of restricted participation only to banks and PDs. The call money window should be used to iron out temporary mismatches in liquidity and banks should not use this on a sustained basis as a source of funding their normal requirements. A beginning has been made by prescribing for access to call money a ceiling of 2.0 per cent of aggregate deposits in respect of urban co-operative banks (UCBs). Such a stipulation can be extended to all commercial banks and with some modifications such as, an alternative of 25.0 to 50.0 per cent of their net owned funds. If any bank has any temporary need to go beyond the ceilings prescribed for access to call money, RBI could consider such requests to alleviate possible shocks to individual banks. Similarly, once the repo market develops, PDs should reduce and in fact consider eliminating their access to the call money market. There is an opinion that such restrictions of access to call money in Indian conditions would add to stability in financial markets and help develop term money market. A final decision would no doubt be taken after discussions in Technical Advisory Committee on financial markets of RBI, and further consultations with market participants.

RBI influences liquidity on a day-to-day basis through LAF and is using this facility as an effective flexible instrument for smoothening interest rates. The operations of non-bank participants including FIs, mutual funds and insurance companies that were participating in the call/notice money market are in the process of being gradually reduced according to pre-set norms. Such an ultimate goal of making a pure inter-bank call money market is linked to the operationalisation of CCIL and attracting nonbanks also into an active repo market. The effectiveness of LAF thus will be strengthened with a pure inter-bank call/notice money market in place coupled with growth of repo market for non-bank participants. The LAF operations combined with judicious use of OMOs are expected to evolve into a principal operating procedure of monetary policy of RBI. To this end, RBI may have to reduce substantially the liquidity through refinance to banks and PDs. For example, if RBI intends to tighten the money market conditions through LAF, the automatic access of refinance facility from the RBI to banks and PDs may reduce the effectiveness of such an action and thereby cause transmission losses of monetary policy. It may be appropriate to note that in most of the developed financial markets, the standing facilities operate at the margin.

At present RBI provides standing facilities comprising the support available to banks under Collateralized Lending Facility (CLF) and export credit facility to banks, and liquidity support to PDs. One way of reducing the standing facility will be to eliminate CLF from the standing facilities and reducing the present ratio of normal and back-stop facilities. The existing methodology of calculating eligible export credit refinance continues till March 2002 and RBI has expressed its intention of moving away from sector specific refinance. As CRR gets lowered and repo market develops, the refinance facilities should also be lowered giving more effectiveness to the conduct of monetary policy.

As part of the ongoing process of reforms, it is necessary to improve our standards, codes and practices in matters relating to financial system and bring them on par with international ones. One of the Advisory Groups with Shri M. Narasimham as Chairman and Shri S.S. Tarapore as a member, assessed the extent of India's compliance with international standards and codes in the area of 'Transparency in Monetary and Financial Policies'. Noting that RBI's policies and operations largely conform to the IMF Code, the Group offered a set of recommendations for making India fully compliant with the Codes.

First, the Group recommended that the objective of monetary policy should be set out by the Government, as part of its overall economic policy package, and the Government should be obliged to seek parliamentary debate on these objectives as also any changes in these objectives thereafter. The Group further suggested that the Government should also consider prescribing to the RBI single objective such as a medium-term inflation while the Government would have for itself a clearly set out hierarchy of objectives for which it could use its other instruments of policy. However, RBI is of the view that at the current stage of institutional development and fiscal stance, coordination and harmony are of paramount importance though there is need for clearer demarcation of responsibilities and accountability between RBI and the Government with appropriate degrees of transparency. Moving in this direction, RBI is divesting all ownership functions as also term lending functions, subject to approvals by the Government.

Second, the Group recommended amendments to relevant legislation to accord greater operational flexibility to the RBI for the conduct of monetary policy and regulation of financial system. In the light of the Finance Minister's budget statement, RBI has transmitted proposals for legislative changes in the Reserve Bank of India Act, which is under the consideration of the Government. These proposals if endorsed by the Parliament would accord greater operational flexibility to the RBI for conduct of monetary policy.

Third, it was suggested that the Government should set up its own independent debt management office to take over the present functions discharged by the RBI, and thus avoid conflict of interest in conduct of monetary policy. RBI in its annual monetary policy of 2001, has announced progress made in this regard and its intention to divest itself of the debt management function. An enabling proposal to delink the function of debt management of the Government from the Reserve Bank has been made in the RBI (Amendment) Bill 2001. The Government has also decided, in principle, to delink these functions.

Fourth, the Group recommended that RBI should set up Monetary Policy Committee (MPC) as a committee of the Board, by regulation, requiring no specific changes in the law. However, at present, no view has been taken in the matter of either setting up such a Committee or disclosing the deliberations leading to monetary policy actions. In this context, it needs to be noted that the transparency and consultative processes in RBI have been deepened and widened significantly in the recent years. RBI's approach in this regard is to evolve the processes of monetary policy making that are appropriate to the changing conditions in Indian monetary and financial system recognizing the need to be in broad harmony with best practices.

Finally, the Group proposed that the RBI should continue to be in the avant garde on disclosures of forward liabilities and should reveal, on a regular basis, separately its direct and indirect intervention operations. RBI has continued to enhance its disclosures both through its publications and through Special Data Dissemination Standards (SDDS) of the IMF.

It is useful to identify a research agenda where both the academic community and policy makers could engage productively. For example, some academic work has been done on inflation targetting in India. Considering that inflation targetting is in no case a panacea but a sensible possible option, many central banks have adopted this strategy and in India also, this issue of inflation targeting is being debated. Before taking a view on this, some related issues like measurement of inflation, core inflation, choice of price variables (to include asset prices or not) may have to be addressed. Similarly, with RBI pursuing the twin objectives of monetary policy and operating on short-term interest rates, it is essential to properly study the transmission mechanism of monetary policy. Related issues include measurement of potential output,. assessment of the lag structure of different variables with respect to monetary policy decisions. Some light on these crucial areas will help the policy makers. At the present juncture of segmented money market lacking in depth and width, development of yield curve and term structure of interest rates may not appear to be critical, but as we move along with development of financial markets, these important areas have to be explored. Moreover, the relationship between bank credit and output may also require indepth analysis. Finally, the last chapter of the Report on Currency and Finance 2000-01 attempts to present the estimated characteristics of sectoral behaviour, inter-linkages and the underlying dynamics of the overall economy in the form of a structural macroeconomic model. This model is the result of the on-going research work among the professionals of RBI. This provides a basis for further research work in the academic community also. These are some illustrative items of significance for further research in the realm of monetary policy.

The narative as above focuses on the conduct of monetary policy and highlights some of the immediate tasks. For a detailed overview of theory and analytics, especially in the context of role of monetary policy in revitalizing growth in India, you are advised to refer to the Report on Currency and Finance 2000-01. The challenges ahead are aptly summarized in the concluding paragraph of the chapter on Growth, Inflation and the Conduct of Monetary Policy of the Report, which states "The conduct of monetary policy in India would continue to involve the constant rebalancing of objectives in terms of the relative importance assigned, the selection of instruments and operating frameworks, and a search for an improved understanding of the working of the economy and the channels through which monetary policy operates".

Next Module: Monetary Policy Operating Procedures in Emerging Market Economies (BIS Papers) - Development of Monetary Policy Initiatives by RBI over the years