Monetary Policy in a Developing Economy — The Indian Experience

I have chosen to speak to you today on the Indian experience with respect to monetary policy as an instrument of economic management. Developments in monetary policy closely mirror the changes in overall economic policy. The decade of 1990s has seen far reaching changes in India’s economic policy. The content and approach to economic policy underwent a sea change. The country has become a more open economy. The roles of state and market are getting redefined. There is a common thread running through the various measures introduced since 1991 and that is to improve the productivity and efficiency of the system. This is sought to be achieved by imparting a greater element of competition in the system. It is in this context that monetary policy in India acquired a new role. Financial sector reforms which were an integral part of the economic reforms programme created a new institutional environment in which monetary policy had to operate.

In industrially advanced countries, after decades of eclipse, monetary policy re-emerged as a potent instrument of economic policy, in the fight against inflation in the 1980s. Issues relating to the conduct of monetary policy came to the forefront of policy debates in the 1980s. The relative importance of growth and price stability as the objective of monetary policy as well as the appropriate intermediate target of monetary policy became the focus of attention. Over the years, a consensus has emerged among the industrially advanced countries that the dominant objective of monetary policy should be price stability. Differences, however, exist among central banks even in these countries as regards the appropriate intermediate target. While some central banks consider monetary aggregates and, therefore, monetary targeting as operationally meaningful, some others focus on the interest rate. There is also the more recent practice to ignore intermediate targets and focus on the final goal such as inflation targeting.

A similar trend regarding monetary policy is discernible in developing economies as well. Much of the early literature on development economics focused on real factors such as savings, investment and technology as mainsprings of growth. Very little attention was paid to the financial system as a contributory factor to economic growth even though attention was paid to develop financial institutions which provide short term and long term credit. In fact, many writers felt that inflation was endemic in the process of economic growth and it was accordingly treated more as a consequence of structural imbalance than as a monetary phenomenon. However, with the accumulated evidence, it became clear that any process of economic growth in which monetary expansion was disregarded led to inflationary pressures with a consequent impact on economic growth. Accordingly, the importance of price stability and, therefore, the need to use monetary policy for that purpose also assumed importance in developing economies. Nonetheless, the debate on the extent to which price stability should be deemed to be the overriding objective of monetary policy in such economies continues.

The Reserve Bank of India was set up in 1935. Like all central banks in developing countries, the Reserve Bank has been playing a developmental and a regulatory role. In its developmental role, the Reserve Bank focused attention on deepening and widening the financial system. It played a major part in building up appropriate financial institutions to promote savings and investment. In the realm of agricultural credit, term finance to industries and credit to export, the apex institutions that are now operating were essentially spun off from the Reserve Bank. Strengthening and establishing new institutions to meet the country’s requirements is a continuing process. The promotional role had taken the Reserve Bank into the area of credit allocation as well. Pre-emption of credit for certain sectors and that too at concessional rates of interest became part of the overall policy. Commercial banks over time had been required to provide a certain percentage of their total credit to certain sectors which were regarded as ‘priority sector’.

An active role by the Reserve Bank of India in terms of regulating the growth in money and credit became evident only after 1950s. During the 1950s the average annual increase in the wholesale price was only 1.8 per cent. However, during the 1960s, the average annual increase was 6.2 per cent and in the 1970s, it was around 10.3 per cent. In the early years of planning, there was considerable discussion on the role of deficit financing in fostering economic growth. The First Plan said: ‘Judicious credit creation somewhat in anticipation of the increase in production and availability of genuine savings has also a part to play’. Thus, deficit financing, which in the Indian context meant Reserve Bank credit to the Government, was assigned a place in the financing of the plan, though its quantum was to be limited to the extent it was non-inflationary. Monetary growth, particularly in the 1950s, was extremely moderate. However, as each successive plan came under a resource crunch, there was an increasing dependence on market borrowing and deficit financing. These became pronounced in the 1970s and thereafter. The single most important factor influencing the conduct of monetary policy after 1970 had been the phenomenal increase in reserve money contributed primarily by the Reserve Bank credit to the Government.

To summarise, the system as it existed at the end of 1970s was characterised by the following features. The Reserve Bank of India as the central monetary authority prescribed all the interest rates on deposits and lending. The commercial banks were required to allocate a certain percentage of credit to what were designated as ‘priority sector’. Credit to parties above a stipulated amount required prior authorisation from the central bank. After the nationalisation of major commercial banks in 1969, nearly 85 per cent of the total bank assets came under public sector. Apart from small private banks, foreign banks were allowed to operate with limited branches.

The increase in the scale of borrowing by the Government resulted in (a) the steady rise in statutory liquidity ratio requiring banks to invest higher and higher proportion of their deposits in Government securities which carried less than ‘market rates’ and (b) the Reserve Bank of India becoming a residual subscriber to securities and Treasury Bills leading to monetisation of the deficit. The Reserve Bank had, therefore, to address itself to the difficult task of neutralising to the extent possible the expansionary impact of deficits. The increasing liquidity of the banking sector resulting from rising levels of reserve money had to be continually mopped up. The instrument of open market operations was not available for this task since the interest rates on Government securities were well below ‘market rates’. The task of absorbing excess liquidity in the system had to be undertaken mainly through increasing the cash reserve ratio. In fact, in mid 1991, the cash reserve requirement was 25 per cent on incremental deposits. In addition, the statutory liquidity ratio was 38.5 per cent. Thus, nearly 63.5 per cent of incremental deposits was pre-empted in one form or another.

In 1983, the Reserve Bank of India appointed a Committee under the Chairmanship of the distinguished economist Prof. Sukhamoy Chakravarty to review the working of the Indian Monetary System. I was a member of the Committee. The Committee’s Report covered a wide range. One of its major recommendations was to regulate money supply consistent with the expected growth rate in real income and a tolerable level of inflation. Recognising the fact that Government borrowing from the Reserve Bank had been a major factor contributing to the increase in reserve money and therefore, money supply, the Committee wanted an agreement between the Central Government and the Reserve Bank on the level of monetary expansion and the extent of monetisation of the fiscal deficit. Without such a coordination, the Committee felt that Reserve Bank’s efforts to contain monetary expansion within the limits set by expected increase in output could become impossible. While this recommendation of the Committee was accepted in principle, it could take a concrete shape only in the Nineties.

In the wake of the economic crisis in 1991 triggered by a difficult balance of payments situation, the Government introduced far reaching changes in India’s economic policy. Monetary policy was used effectively to overcome the balance of payments crisis and promptly restore stability. An extremely tight monetary policy was put in place to reap the full benefits of the devaluation of the rupee that was announced. However, it did not stop with that. Financial sector reforms became an integral part of the new reform programme. Reform of the banking sector and capital market was intended to help and accelerate the growth of the real sector. Banking sector reforms covered a wide gamut. The most important of the reforms was the prescription of prudential norms including capital-adequacy ratio. In addition, certain key changes were made with respect to monetary policy environment which gave to commercial banks greater autonomy in relation to the management of their liabilities and assets. First and foremost, the administered structure of interest rates was dismantled step by step. Banks in India today enjoy the complete freedom to prescribe the deposit rates and interest rates on loans except in the case of very small loans and export credit. Second, the Government began borrowing at market rates of interest. The auction system was introduced both in relation to Treasury Bills and dated securities. Third, with the economic reforms emphasising a reduction in fiscal deficit, pre-emptions in the form of cash reserve ratio and statutory liquidity ratio were steadily brought down. Fourth, while the allocation of credit for the priority sector credit continued, the extent of cross subsidisation in terms of interest rates was considerably brought down because of the reform of the interest rate structure.

Monetary policy in the 1990s in India had to deal with several issues, some of which traditional but some totally new in the context of the increasingly open economy in which the country had to operate. In the first few years, monetary policy had to contend with the consequences of devaluation and the need to quickly restore price stability to obtain the full benefits of devaluation. While the fiscal deficit was being brought down, the question of monetisation of the deficit continued to remain an issue and a solution had to be found. This eventually led to a new agreement between Government and RBI on financing deficit. The system of ad-hoc Treasury Bills under which Government of India could replenish its cash balances by issuing Treasury Bills in favour of the Reserve Bank and which had the effect of monetising deficit was phased out. It was replaced by a system of Ways and Means advances which had a fixed ceiling. The Reserve Bank of India continued to subscribe to the dated securities at its discretion. During 1993 and 1994, for the first time monetary policy had to deal with the monetary impact of capital inflows with the foreign exchange reserves increasing sharply from $9.2 billion in March 1992 to $25.1 billion in March 1995. In 1995–96, the change in perception with reference to exchange rate after a prolonged period of nominal exchange rate stability vis-a-vis the US dollar brought into play the use of monetary policy to stabilise the rupee — an entirely new experience for the central bank. Similar situations arose later on also at the time of the East Asian crisis. Monetary policy had begun to operate within a changed institutional framework brought about by the financial sector reforms. It is this change in the institutional framework that gave a new dimension to monetary policy. New transmission channels opened up. Indirect monetary controls gradually assumed importance. With the progressive dismantling of the administered interest rate structure and the evolution of a regime of market determined interest rate on Government securities, open market operations including ‘repo’ and ‘reverse repo’ operations emerged for the first time as an instrument of monetary control. Bank Rate acquired a new role in the changed context. The Nineties paved the way for the emergence of monetary policy as an independent instrument of economic policy.

Monetary policy in the 1990s had also to be conducted in the context of the financial sector reforms. The need to reduce non-performing assets and to conform to the new prudential norms put the banking industry under great strain. While introducing banking sector reforms, care had to be taken to ensure that there was no compromise with the basic objectives of monetary policy.

In the post reform period, the Indian economy has done well. Since 1992–93 the average annual growth rate of the economy in real terms has been 6.3 per cent. The average inflation rate, as measured by the wholesale price index in the 1990s has been 7.2 per cent. However, the significant fact to note is that the average inflation rate since 1996–97 has been less than five per cent. Broad money grew at an average annual rate of 17 per cent per annum. The exchange rate of the rupee in terms of US dollar has declined by 24 per cent since July, 1997. This decline is smaller than what other countries in this region have experienced. The current account deficit has averaged since 1992–93 at one per cent of the GDP. The foreign exchange reserves in the country have risen from about $5 billion to $43 billion as of a recent date. These broad macro economic indicators show a substantial improvement in the Indian economy, even though several concerns such as slow reduction in poverty ratio and slow growth rate in agriculture persist.