INTRODUCTION

History of RBI

The Reserve Bank of India is the central bank of the country. Central banks are a relatively
recent innovation and most central banks, as we know them today, were established around the
early twentieth century.

The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young
Commission. The Reserve Bank of India Act, 1934 (II of 1934) provides the statutory basis of
the functioning of the Bank, which commenced operations on April 1, 1935. The Reserve Bank
of India was nationalized with effect from 1st January, 1949 on the basis of the Reserve Bank of
India

The Bank was constituted to

• Regulate the issue of banknotes

• Maintain reserves with a view to securing monetary stability and
• To operate the credit and currency system of the country to its advantage.

The Bank began its operations by taking over from the Government the functions so far being
performed by the Controller of Currency and from the Imperial Bank of India, the management
of Government accounts and public debt. The existing currency offices at Calcutta, Bombay,
Madras, Rangoon, Karachi, Lahore and Cawnpore (Kanpur) became branches of the Issue
Department. Offices of the Banking Department were established in Calcutta, Bombay,
Madras, Delhi and Rangoon.

Burma (Myanmar) seceded from the Indian Union in 1937 but the Reserve Bank continued to
act as the Central Bank for Burma till Japanese Occupation of Burma and later upto April,
1947. After the partition of India, the Reserve Bank served as the central bank of Pakistan upto
June 1948 when the State Bank of Pakistan commenced operations. The Bank, which was
originally set up as a shareholder's bank, was nationalized in 1949.

An interesting feature of the Reserve Bank of India was that at its very inception, the Bank was
seen as playing a special role in the context of development, especially Agriculture. When
India commenced its plan endeavours, the development role of the Bank came into focus,
especially in the sixties when the Reserve Bank, in many ways, pioneered the concept and
practise of using finance to catalyse development. The Bank was also instrumental in
institutional development and helped set up insitutions like the Deposit Insurance and Credit
Guarantee Corporation of India, the Unit Trust of India, the Industrial Development Bank of
India, the National Bank of Agriculture and Rural Development, the Discount and Finance
House of India etc. to build the financial infrastructure of the country.
With liberalisation, the Bank's focus has shifted back to core central banking functions like
Monetary Policy, Bank Supervision and Regulation, and Overseeing the Payments System
and onto developing the financial markets.

MONETORY POLICY

Monetary policy in India underwent significant changes in the 1990s as the Indian Economy
became increasing open and financial sector reforms were put in place. in the 1980s,monetary
policy was geared towards controlling the quantum, cost and directions of credit flow in the
economy. the quantity variables dominated as the transmission Channel of monetary
policy. Reforms during the 1990s enhanced the sensitivity of price Signals of price signals from
the central bank, making interest rates the increasingly Dominant transmission channel of
monetary policy in India. The openness of the economy, as measured by the ratio of
merchandise trade(exports Plus imports) to GDP, rose from about 18% in 1993-94 to
about26%by 2003-04. Including services trade plus invisibles, external transactions as a
proportion of GDP Rose from 25% to 40% during the same period. Alongwith the increase in
trade as a Percentage of GDP, capital inflows have increased even more sharply, foreign
currency Assets of the reserve bank of India(RBI) rose from USD 15.1 billion in the march
1994
To over USD 140 billion by march 15,2005.these changes have affected liquidity and Monetary
management. Monetary policy has responded continuously to changes in Domestics and
international macro economic conditions. In this process, the current monetary operating
framework has relied more on outright open market operations and daily repo and reserve
repo operations than on the use of direct instruments. Oversight Rate are now gradually
emerging as the principal operating target.
The Monetary and Credit Policy is the policy statement, traditionally announced twice
a year, through which the Reserve Bank of India seeks to ensure price stability forth
economy. These factors include - money supply, interest rates and the inflation

Definition of monitory policy

Monetary policy is the management of a nation's money supply to achieve economic goals by
a central bank or currency board. Monetary policy objectives can include control of inflation,
control of exchange rates, or even simply economic stability. Monetary policy is contrasted with
fiscal policy, which aims to achieve economic goals through taxation and government
expenditure. The Reserve Bank of India (RBI), handles monetary policy in India. The RBI
controls the money supply through open market operations, and also sets interest rates
between banks and reserve requirements. Tight monetary policy, also called contractionary
monetary policy, tends to curb inflation by contracting the money supply. Easy monetary
policy, also called expansionary monetary policy, tends to encourage growth by expanding the
money supply

The key issue here is whether the attainment of price stability should be the dominant objective
of monetary policy. The case of price stability as the prime objective of monetary policy rests
on the assumption that volatility in prices creates uncertainty in economic decision making.
Rising prices affect savings adversely while they make speculative investments more
attractive. The most important contribution of the financial system to an economy is its ability to
augment savings and allocate resources more efficiently. A regime of rising prices, thus,
clearly vitiates the atmosphere for promotion of savings and allocation of investment.
Furthermore, the domestic inflation rate also has a bearing on the exchange rate of the
currency. Besides, there is a social dimension, particularly in developing economies. Indeed,
inflation affects adversely the poorer sections of the society who have no hedges against
inflation. Thus, a critical question that arises in this context is at what level of inflation the
adverse consequences begin to set in.

The empirical evidence on the relationship between inflation and growth in cross-country
framework is somewhat inconclusive. In many cases, the sample includes countries with
inflation rates as low as only one to two per cent as well as countries with inflation rates going
beyond 200 and 300 per cent. It is, however, clear that growth rates tend to fall with high
inflation.14 The appropriate inflation threshold beyond which costs tend to exceed benefits,
thus, needs to be estimated for each country separately.15 Nevertheless, even moderate
inflation levels are often perceived to be worrisome by the policy makers because, inflationary
pressures, if not held in check, can lead to higher inflation and eventually affect growth.

While there is a growing consensus among the central bankers regarding the virtues of price
stability, the case against price stability is not without its protagonists. Notably, Prof. Paul
Krugman has recently argued that.

"……..the belief that absolute price stability is a huge blessing, that it brings large benefits with
few if any costs, rests not on evidence but on faith. The evidence actually points the other way:
the benefits of price stability are elusive, the costs of getting there are large, and zero inflation
may not be a good thing even in the long run."

Prof. Krugman's arguments do not seem relevant for developing economies because his
criticism is aimed against those countries which seek 'absolute' price stability and (unlike most
developing countries), attempt to bring down inflation rate from about 2 per cent to almost
zero. This is evident from what he himself advocates: "….adopt as a long run target fairly low
but not zero inflation, say 3-4 per cent. This is high enough to accommodate most of the real
wage cuts that markets impose, while the costs of the inflation itself will still be very small."

The anti-inflationary stance of monetary policy during the 1990s was essentially framed
against the backdrop of high inflation of the 1960s, fuelled by large-scale monetisation of fiscal
deficits. In a sharp contrast, the recent co-existence of low and stable inflation - even deflation
- with low growth, has naturally fostered a degree of revisionism. In many cases, financial
crises, often sparked off by irregularities in the banking system and "irrational exhuberance" in
capital markets, which could not be picked up by inflation indicators, had adverse output
effects. This set off a process of deflation, which in turn, fed back into the system by eroding
collateral values. Combating the spiral of falling prices and output in a conventional monetary
policy framework is especially difficult given the zero bound on nominal interest rates. This has
fostered a lively debate between the proponents of the so-called "continuity view", who
interpret the present situation as an aberration and those advocating the so-called "new view",
who urge a broader degree of central bank activism, especially in response to financial market
developments, which have potential output effects.16 Notwithstanding the extreme theoretical
positions, most central banks tend to operate on the golden mean of constrained discretion
which takes the pragmatic view that within the mandate of price stability, monetary policy has
to stabilise swings in effective demand as well (Bernanke17, 2003). This is reinforced by the
recent report of the IMF's Interdepartmental Task Force on Deflation.18 The Report suggests
that central banks need to pay attention to a wide menu of macroeconomic indicators,
including developments in aggregate prices, output gaps and asset, credit and financial
markets (which are aggregated to construct an index of deflation vulnerability) so as to ward off
the potential deflationary tendencies.

Despite a generalised recognition of price stability as the primary goal of monetary policy, in
the face of a benign inflationary environment in the last few years, the objective of output
stabilisation has, thus, been prominently pursued by central banks all over the world, both in
terms of preventing economic overheating and providing stimulus to faster recovery from
recessions. Several developing countries have also used monetary measures to defend the
exchange rate. In this context, the debate on "rules versus discretion" has engaged the
attention of policy makers, and give the scope for time-inconsistent behaviour and the
associated inflation bias of central bankers, there has been a growing emphasis on policy
rules, particularly the Taylor-type rules.19 Constrained discretion seems to be the preferred rule
for most central banks today.

A number of central banks, beginning with New Zealand (1989), adopted price stability as the
sole goal of monetary policy during the 1990s. Presently, there are 18 inflation targeters.20 This
also implies there are many others, including the US Federal Reserve, no less, outside the
fold. Interestingly, a 1999 Bank of England21survey of monetary policy frameworks reveals the
continuing diversity of central bank objectives. While price stability emerged as the main/ other
important policy objective in 50 out of the 77 central banks, as many as 54 central banks
reported exchange rate management to be the main/other important policy objective. There is
no doubt that inflation targeters have been able to achieve a reasonable degree of price
stability. At the same time, there is little evidence to suggest that inflation targeting on average
improves performance as measured by the behavior of inflation, output, or interest rates.22

In the Indian context, the broad objectives of monetary policy have been:

· to maintain a reasonable degree of price stability; and

· to help accelerate the rate of economic growth.

The emphasis as between the two objectives has changed from year to year depending upon
the prevailing conditions.

The crucial question that is being debated in India as elsewhere is whether the pursuit of the
objective of price stability by monetary authorities undermines the ability of the economy to
attain and sustain high growth. A considerable part of the relevant research effort has been
devoted to the trade-off between economic growth and price stability.

In India, the Chakravarty Committee (1985) had presumed precisely the same target of four
per cent as "the acceptable rise in prices' purported to reflect 'changes in relative prices
necessary to attract resources to growth sectors". Subsequent research places estimates of
threshold inflation in India in the range of 4-7 per cent, depending on the period and
methodology.

A macro-econometric model of the Indian economy shows that a 10 per cent sustained hike in
real public investment in the non-agriculture sector, financed by primary money leads to an
annual inflation rate of about 2.3 per cent and additional GDP growth of one per cent, on an
average, during the first two years. In a span of 10 to 15 years, inflation rate rises to about 17
per cent per annum while additional output growth slows down considerably to an average of
2.7 per cent over this period. This implies that in the long run a sustained improvement in
growth through monetisation of the fiscal deficit could involve a severe trade-off in terms of
inflation as every one per cent additional output growth would entail nearly 6 to 6.5 per cent
increase in the inflation rate in the long-run.23

It may be noted, however, that there is a need to have an appropriate fix on the acceptable
level of the inflation rate in India. In the 1970s, the average annual inflation rate, as measured
by the Wholesale Price Index (WPI), was 9 per cent. In the 1980s, it was 8 per cent. However,
in the period between 1990 and 1995, the average inflation shot up to around 11.0 per cent
before decelerating to about 5.3 per cent during 1995-2002. The objective of the policy has
been to keep the inflation rate around 4 to 5 per cent. This itself is much higher than what the
industrial countries are aiming at and therefore, does have some implications for the exchange
rate of the rupee. Monetary growth can be so moderated that meeting the objective of growth
does not push inflation rate beyond this tolerable level on an average.

No one in India is advocating absolute price stability or even the order of price stability that is
being sought as an objective in the industrially advanced countries. The Advisory Group on
Monetary and Financial Policies (Chairman: Shri M. Narasimham), however, recommended
that the Reserve Bank should be mandated a sole price stability objective. There are several
operational constraints, as noted by Governor Jalan in the Monetary and Credit Policy
Statement of April 2000:

"Based on the experience of some industrialised countries, there is a view that, in India also,
monetary policy, to be transparent and credible, should have an explicit narrowly defined
objective like an inflation mandate or target. While technically this appears to be a sound
proposition, there are several constraints in the Indian context in pursuing a single objective.
First, there is still fiscal dominance and the debt management function gets inextricably linked
with the monetary management function while steering the interest rates…Secondly, in the
absence of fully integrated financial markets, which remain still imperfect and segmented, the
transmission channel of policy is rather weak and yet to evolve fully. Thirdly, the high
frequency data requirements including those on a fully dependable inflation rate for targeting
purposes are yet to be met " (December 2000).

A question that is sometimes raised in this context is whether monetary policy by itself could
be able to contain inflationary pressures particularly in developing economies like ours. It is
true that developing economies like India are subject to greater supply shocks than developed
economies. Fluctuations in agricultural output have an important bearing on prices.
Nevertheless, a continuous increase in prices, which is what inflation is all about, cannot occur
unless it is sustained by a continuing increase in money supply. The control of money supply
has thus an important role to play in any scheme aimed at controlling inflation.

The mix of monetary and non-monetary factors behind Indian inflation is reflected in Governor
Y. V. Reddy's Mid-Term Review of Monetary and Credit Policy of November 2003:

"…The probability of emergence of any undue pressure on prices during this year appears to
be low on current indications. First, the good monsoon and expected recovery of agricultural
production would have a favourable impact on prices of agricultural commodities. Second, the
comfortable stocks of foodgrains and foreign exchange reserves would facilitate better supply
management in the unlikely event of price pressures in agricultural commodities. Third, the
prices of 'fuel, power, light and lubricants' so far have remained moderate in the absence of
any renewed pressure on international oil prices, particularly in the wake of reduction in
geopolitical tensions in the Middle-East. Fourth, both M3 and reserve money growth have
remained subdued…".

Besides, the issue of the merit of price stability as a central banking objective, there is also the
question of measuring inflation. There are several issues involved here:

· The vast range of the consumption basket often makes it difficult to create a comprehensive
price index. The measurement of services inflation, for example, is an important issue in the
Indian context, which was recognised by the Working Group on the Index Numbers of
Wholesale Price in India (1999).

· There is also the choice between wholesale and consumer prices. The Wholesale Price Index
(WPI) and the Consumer Price Index (CPI) occasionally diverge because of the problems of
coverage and the weighting of commodities comprising the indices. As pointed out in the
Reserve Bank's April 2001 Monetary and Credit Policy Statement, this divergence between
retail and consumer prices is a reason why central banks need to monitor several indicators.

· The rapidity of product innovations makes inter-temporal comparisons increasingly difficult.

Illustratively, while a baseline personal computer could cost the same in 1997 and 2003, its
power could have been upgraded from 266 MHz to 1000 MHz.
· Individual consumption baskets have been rapidly expanding, especially in emerging market
economies. Thus, individuals could, ceteris paribus, be worse-off because the list of items of
consumption they perceive as a 'standard need' has expanded although their prices have not
changed.

· Another issue is the integration of asset prices in the standard price indices, which typically
comprise commodities.24 It is not clear, first of all, whether asset price changes should be
viewed as a cause or a component of inflation as we understand it today. Besides, the
methodology of factoring in asset prices in the standard price indices is still not very firm.

· There is a need to distinguish between the pull- and push- factors behind inflation. The recent
literature has attempted to construct measures of "core" inflation, which is the part of inflation
that emanates from demand side pressures.25 There are several methodologies available - the
most popular one being to exclude commodities whose prices are subject to supply shocks,
such as oil. Since the monetary authority is essentially concerned with the management of
demand, several central banks, such as Australia, Canada, New Zealand and the UK monitor
some variants of core inflation. In case of emerging market economies such as India, the
difficulty is often that a measure of 'core' inflation could lose public credibility since a large part
of the inflation is driven by a wide-range of regular supply shocks.

It is important to appreciate that, on balance, the monetary policy decisions of the Reserve
Bank, like those of most central banks, are essentially environment- specific. Thus, just as
price stability is of prime importance, growth is equally a matter of policy concern. Although the
two objectives are mutually reinforcing in the long run, short-run trade-offs are often live and
real, especially in case of structurally constrained economies. It is in this context, Governor
Jalan has summed up the prevalent thinking:

"…There is a growing consensus now - in theory as well as in practice - that Central Bank
should have instrumental independence, and concentrate on a single target of inflation control
with the use of a single instrument. The position, no doubt, is theoretically sound, but as I look
at the history of economic thought and changing fashions in economic policy making, I must
confess to a sense of discomfort on whether the current dominant view on "one target, one
instrument" will survive the test of time…In developing countries this whole question of trade-
off - particularly at the margin -and during periods of external or domestic uncertainties,
becomes even more relevant because of a large non-monetised and agricultural economy. It
seems to me that a certain amount of target flexibility and balancing of conflicting objectives
are unavoidable…" (December 2000).

Instruments of monetary policy in India

1. Net loans to central government (i.e. open market operations)

2. Net purchase of foreign currency assets
3. Change in cash reserve ratio
4. Changes in repo rate and reverse repo rate
5. Bank rate
 1. Open Market Operations:

Banks as well as other financial institutions, such as insurance companies, mutual funds and
corporate with surplus cash are big investors in government securities. When RBI wishes to
inject liquidity into the market, it has another option of buying government securities. When RBI
offers to buy the securities at a rate that is better than the rate prevailing in the market, some
of the investors can sell their holdings and the cash inflow would lead to credit creation of a
large magnitude.

Similarly, when RBI sells government securities at a higher rate than market rate, RBI absorbs
funds and the banking system contracts credit by a large magnitude to reduce liquidity. This is
known as open market operation.

2. Foreign Exchange Management

Tweaking the basket of currencies:

The exchange rate of rupee is calculated by RBI based on the exchange rates of basket
of currencies of countries with which India has significant trade transactions. RBI
maintains confidentiality about the weightage given to each currency in the basket and
when RBI wishes to manage the extent of volatility in the exchange rate of rupee, RBI
adjusts the weightages properly.

Market intervention:

Large balance of payment surpluses and build up of Forex reserves are bound to
strengthen the rupee in the exchange market. This market force cannot be counted by
RBI for long periods of time. However, by intervening in the market by offering to buy
any amount of foreign currency at a particular rate, RBI can prevent the sudden
strengthening of rupee. RBI seeks to smoothen the movement of rates in either
direction so than importers and exporters have time to adjust to the changing exchange
rate scenario and are not caught by surprise by violent rate movements, which could
cripple them.

3. Cash Reserve Ratio:

Banks reserve liquidity through their power to create credit. Presently in India, banks are
required to maintain the following reserves:

• Cash Reserve ratio: 8.25% of demand and time deposits (w.e.f. 24.05.2008)
• Statutory Liquidity ratio: 25% of demand and time deposits

Just as additional cash inflows enable the banking system to create credit, any increase in
CRR will require the banking system to contract credit by a large amount.
SLR (Statutory Liquidity ratio) is a requirement peculiar to India. In addition to ensuring that
banks can fall back on the readily saleable government deposits in the event of a run on the
bank, it was a prescription to divert bank deposits to meet government investment expenditure.

4. Repo rate and Reverse Repo rate:

Repo rate or repurchase rate is a swap deal involving the immediate sale of securities and
simultaneous purchase of those securities at a future date, at a designated price. It could also
be an overnight deal with sale taking place on day one and repurchase on day two. The
repurchase price is adjusted for the interest payable for the use of funds for the period of
contract. Reverse repo involves the immediate purchase and future sale of those same
securities. RBI uses repo and reverse repo to control liquidity on a day-to-day basis.

5. Bank rate:

RBI provides refinance to banks against funds deployed by banks in specified sectors such as
export finance portfolio of the banks. In the past, the bank rate used to be the primary interest
rate tool of RBI. But over a period of time the repo rate has presently emerged as the primary
interest rate tool and bank rate has lost much of its relevance. Changes in the bank rate are a
signal to the market regarding the direction in which the RBI would like interest rates to move.

RBI’s MONETORY POLICY:

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 mid-term 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
Reserve Bank’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 advise 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 Adhoc Groups, in addition to mechanisms such as resource management
discussions with banks. Within the Reserve Bank, 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.

Objectives

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.

Transmission Mechanism

The monetary policy framework in India from the mid-1980s till 1997-98 can, by and
large, be characterised 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
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.

Strategies and Tactics

There has been a shift in strategic objective, necessitated by deregulation and

liberalisation 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, the Reserve Bank 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.

Operating Procedures

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 neutralise 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 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 Reserve Bank helped create an array of other market related financial products. At
the next stage, the interest rate structure was simultaneously rationalised and banks were
given the freedom to determine their major rates. As a result of these developments, the
Reserve Bank 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 the
Reserve Bank 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.

Gains from Reform

It has been possible to reduce the statutory preemption on the banking system. The Cash
Reserve Ratio, 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 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 short-term 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, 1999-00 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 sterilised through OMO. This has helped in reducing the government’s
reliance on credit from the Reserve Bank. Consequently, there has been secular decline in
monetised deficit, and in the process net foreign exchange assets of the Reserve Bank have
become the principal contributor to reserve money expansion in the recent period.
Tasks before the Reserve Bank
These are impressive gains from reforms 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 liberalisation 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 recognise 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 the Reserve Bank are presented to provoke debate and
promote research.
Modeling Exercises

In addressing a gathering of elite econometricians assembled here, a mention should be

made about developments in monetary modeling. It is well recognised 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 recognising 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 makers 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 recognise 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, the Reserve Bank 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 Reserve Bank 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 the Reserve Bank. Accordingly, it was felt
that a short-term liquidity model may be developed in the Reserve Bank 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 the Reserve Bank 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 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 the Reserve Bank 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. The Reserve Bank would seek the active participation of the interested
econometricians in the debate on the draft model and give benefit of advice to the Reserve
Bank for finalising and adoption.

Concluding Remarks

The challenges ahead are aptly summarised 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”.
MONETORY POLICIES OF RBI

VIPIN PAYYAPAT

T.Y.BAF – B 119