MONETARY POLICY FROM 1952 TO 1991

MONETARY POLICY FROM 1952 TO 1991 Indian monetary policy, as it was designed and implemented during the planning period of 1952 to 1991, with a heavy accent on government intervention, differed considerably from the normal concept of monetary policy in economic literature, which is identified with the regulation of quantity of money through indirect methods of changing the cost and availability of bank credit, rather than through direct methods of controlling its quantity. It was required to reconcile multiple objectives as embedded in India's first Five-Year Plan (1951–1956). The objectives were:

1. Price stability should be maintained.
2. Savings of the community should be mobilized, and its financial component (i.e., savings held in bank deposits, shares, etc.) should be steadily enlarged.
3. Savings so mobilized should be allocated to the sectors in accordance with national economic goals as set out in the country's Five-Year Plans.
4. The resource needs of the major sectors in the economy, that is, the public sector, should be met as a priority.

Little thought was, however, given to the mutual inconsistency of these objectives, desirable though they were. The goal of price stability often conflicted with meeting the resource needs of the public sector. In fact, channeling the resources to the public sector and the government undermined efforts to contain inflationary pressures. The mobilization of savings was admirably achieved, but savings so mobilized could not be allocated in an efficient manner to the sectors in accordance with plan priorities. In pursuing these goals, the Reserve Bank of India (RBI), a central bank, could not avoid a "mismatch between its responsibility to supervise and control the functioning of the monetary system on the one hand, and its authority to do so on the other" (RBI).

Monetary Policy Framework

Monetary policy under planning was formulated in rather a crude way by going through the following procedure. To begin with, a desirable level of supply of money was estimated on certain assumptions based partly on historical experience and partly on expectations about the movement of future economic events such as output growth and trends in prices; demand for money was assumed to grow in proportion to income growth. The magnitude of quantity of money so projected to match the demand for it was considered to be noninflationary. Working backward, using the balance sheet of the banking system, reserve money, that is, currency in circulation plus cash with banks and their deposits held with the RBI was calculated. It was the changes in the reserve money that the RBI targeted in order to ensure an appropriate level of bank credit both to the government and the private sector.

Monetary Policy Instruments

The RBI had recourse to the following instruments both for regulating the level of money and credit and for directing bank credit to the high-priority sectors of the Indian economy. These were: cash reserve ratio; open market operations; refinancing facilities from the RBI; administered interest rates; statutory liquidity ratio; and selective credit controls, known in economic literature as directed credit. The first three of these were used to regulate the reserve money changes, though the cash reserve ratio was more effective in the Indian conditions than the open market operations, or the refinancing facilities to neutralize the impact of reserve money changes on the credit operations of banks. This ratio was very high, at around 14 percent of deposits, entailing a heavy tax on the banking system, and for that reason it was difficult to make changes in it beyond a certain limit. Refinance facilities were not large enough to make a dent on reserve money variations. As regards the open market operations, they were employed more to "maintain a desired pattern of yields on government securities and generally to help the Government raise resources from the capital market" (RBI, 1985, pp. 262–263) than to bring about variation in the reserve money. Thus it became more a fiscal policy and less a monetary policy instrument.

India relied on the administered interest rate regime rather than on market mechanism to bring about the desired changes in interest rates. The RBI, through periodical issue of directives, fixed the minimum and maximum deposit and lending rates and maintained the return on government securities at a level consistent with that on banks' assets and liabilities. In addition, financial institutions of all types—provident funds, insurance companies, and so on—were guided by the government through the RBI as to how they should invest their funds. As a consequence, until the 1980s real interest rates, that is, money interest rates adjusted for changes in the wholesale price index, turned negative. There was, however, a welcome change after the mid-1980s, when the real interest rates turned positive, even when the administered interest rate regime system prevailed.

The statutory liquidity ratio, defined as the ratio of cash on hand of banks, net interbank balances, unencumbered government and government guaranteed securities, and gold to the total deposit liabilities was used to preempt bank resources for investment in government securities and away from the private sector. This ratio introduced a distortive element in the financial system inasmuch as the return on government securities was almost always lower, until 1990, than on bank loans. The height of this ratio at around 33 percent was also a serious disincentive to banks.

Selective credit controls were used to channelize credit flows to certain private sectors of the economy considered to be priority sectors. This instrument relied on setting margins, quantum of credit in terms of proportion of total credit and the interest rate subsidy. The proportion of such credit varied over the years, depending on the public policy objectives of the government, but generally accounted for around 40 percent of total bank credit. These credits turned out to be very costly as the default rate was very high. The accumulation of bad and doubtful debts, estimated to be roughly 25 to 30 percent of deposits, had virtually wiped out the entire capital base of several banks in 1989 and 1990.

Consequences

The monetary policy apparatus that evolved in the context of Indian planning made the RBI more a facilitator of fiscal policy with monetary intent rather than conventionally defined monetary authority. Given the institutional imperatives, as well as the exigencies of government finances, the RBI could only influence the operations of banks by stipulating and administering the cash reserves and statutory liquidity ratios, or adjusting floors and ceilings on interest rates charged by banks on their assets and liabilities, rather than by its perception of the monetary events and the practical precepts of central banking. Because of the obsessive preoccupation with government finances, the RBI had perforce to crowd out private sector investment, which should have been the main domain for the exercise of its monetary policy. It also became a helpless spectator for the growing public debt over time, which turned out to be one of the most destabilizing factors in the Indian economy since the mid-1980s. Only when the Indian economic policy changed radically after 1991 did the RBI come into its own to wield a monetary policy without fiscal apron strings.

Deena Khatkhate

See alsoMonetary Policy since 1991 ; Reserve Bank of India, Evolution of

BIBLIOGRAPHY

Government of India. Ministry of Finance. Economic Survey. New Delhi, 1988–1989, 1989–1990.

Khatkhate, Deena R. "National Economic Policies in India." In National Economic Policies: Handbook of Comparative Economic Policies, vol. 1, edited by Dominick Salvatore. New York: Greenwood Press, 1991.

——. "Indian Banking System: Restitution and Reform Sequencing." Report submitted to Government of India, New Delhi, 1993.

Reserve Bank of India. Report of the Committee to Review the Working of the Monetary System (RCRWM). Mumbai: Reserve Bank of India, 1985.

——. Reports on Currency and Finance. Mumbai: Reserve Bank of India, 1987–1988, 1988–1989.