MONETARY POLICY SINCE 1991

MONETARY POLICY SINCE 1991 Monetary policy operations since 1991 reflect the responses of the Reserve Bank of India (RBI) to the challenges posed by the Indian economy's transformation from financial repression to a liberalized market orientation. Recent efforts to develop and integrate financial markets established a closer linkage of monetary management operations with internal debt management, exchange rate, and reserves management operations. The basic objective of monetary policy to maintain price stability and support growth by ensuring adequate flow of credit continued to be paramount, while its scope was broadened to encompass aspects of financial stability by maintaining orderly conditions in financial markets and achieving greater interest rate flexibility. Greater transparency has also been imparted through institutional mechanisms for internal coordination within the central bank and for external consultations.

With procedures increasingly shifting to market-based interventions, monetary policy operations have become primarily a process of managing liquidity on a day-to-day basis. These operations are, however, consistent with the overall policy announced in April and reviewed in October for every fiscal year. These announcements are considered useful as a framework for relevant measures, for capturing events affecting macroeconomic assessments including fiscal management and seasonal factors, and as a means of greater transparency, better communication, and an effective consultation process.

The period up to 1996–1997 reflected the challenges of macrostabilization and adjustment against the background of a high inflation rate, a difficult balance of payments situation, and massive draw down of foreign exchange reserves. The focus was on reining in inflationary pressures, and therefore a tight and cautious policy stance was taken. This period also saw far-reaching financial reforms, such as rationalization and liberalization of interest rates, greater autonomy for the central bank with elimination of automatic monetization of fiscal deficits, financial markets development and integration, and considerable easing of operational constraints on the financial system. The latter half of the 1990s and the early years of the new millennium represented a gradual phase of easing liquidity, softening interest rates reflecting the lowering of inflationary expectations, and further deepening of financial markets. This period also witnessed, however, a comparative slowdown in industrial and economic activity until 2003–2004, contributed by a variety of domestic and external shocks. Consequently, the focus was upon containing volatility in markets, particularly the foreign exchange market, strengthening reserves, and efficiently coordinating internal debt management with monetary operations.

A comparison of projections with actuals in respect to major monetary policy parameters, namely the growth rate, inflation rate, and M3 (broad money) reveals some interesting features (see Table 1).

During the period 1992–1993 to 1996–1997, since there was acceleration in economic activity due to easing of constraints, the growth projections were consistently underestimated; and actual inflation rates and M3 growth rates were mostly higher than the projections. During 1994–1995 and 1995–1996, the actual growth rates turned out to be higher than projections by about 2 percent. A very cautious and tight monetary policy stance was adopted in 1995–1996 to contain inflationary pressures. This was viewed by the market as a period of credit crunch, and the central bank had to defend its position very strongly by arguing that the credit growth was high enough. The inflation rate, which exceeded the projection in 1994–1995 by more than 3 percentage points at a double-digit level, was brought down by nearly 6 percentage points, to less than 5 percent in 1995–1996. The M3 growth was the lowest, at below 14 percent that year, and the ten-year gilt yield rate peaked to around 14 percent. There was practically no backtracking on the inflation front since then, and the inflation rate since 1995–1996 remained moderate throughout the period. The inflation projection has been brought down to less than 5 percent in the last two years. But, the economy consistently underperformed since 1997–1998, compared to projections. The softening of interest rates did not produce the 7 percent growth rate, the upper range of projections until 2000–2001. The success story of this period lies in the containment of inflation and inflationary expectations, substantial easing of interest rates, considerable strengthening of the external sector, reflected in a buildup of substantial foreign exchange reserves, deepening of financial markets, and the sharpening of debt and monetary management tools.

Since 1997 the bank rate, repo rate, and cash reserve ratio have been used more frequently to meet short-term monetary policy objectives in the light of the emerging domestic and external situations. Markets also perceive these changes as signals for movements in market rates of interest. Deposit and lending rates of banks also respond to these changes, though in varying degrees.

Open market operations, including repos operations under a Liquidity Adjustment Facility, combined with participation in primary issues of government securities serve the central bank to steer interest rates across the maturity spectrum, besides modulating volatility in government securities yields. This greatly helped effective monetary management, smooth debt management, and completion of the large borrowing program by the government. The daily repos operations lend considerable flexibility and leverage to the central bank in managing liquidity and the repo rate has gained prominence as a signaling instrument since 2001.

Institutional arrangements for monetary policy formulation had also undergone changes since 1997. An interdepartmental Financial Markets Committee now monitors developments in financial markets, reviews market developments with regard to both volume and rates in money, foreign exchange and government securities, and makes quick daily assessments of liquidity conditions for market interventions. The central bank also conducts resources management discussions with selected banks to get feedback on market perceptions for possible policy action. A Technical Advisory Committee on Money and Government Securities Markets has also been appointed, with representation from financial, banking, and academic communities to advise the central bank on new policy procedures.

Impact of Monetary Policy Operations: Some Key Indicators

From a macroeconomic perspective, there are key indicators that capture the impact of monetary policy operations since 1991. The interest rates in respect to call money and deposits in general have softened significantly after their peak in 1995–1996, though the bank lending rates showed some inflexibility, despite showing some decline (see Figure 1). As a result, alongside lower inflation rates, the real interest rate is perceived to be high. The effect of monetary policy, particularly on lending rates, is observed to be asymmetric, showing some downward stickiness.

TABLE 1

In contrast to domestic assets, the net foreign exchange assets have emerged as a significant contributing source of reserve money (see Figure 2).

The growth rates in both reserve money and broad money have been contained since 1998, and correspondingly, the price level remained stable and showed some decline (see Figure 3).

The money multiplier showed a secular increase, whereas the income velocity showed a similar decline (see Figure 4).

Some Key Issues in Perspective

While there is a growing consensus that central banks should have operational independence and concentrate on a single target, such as inflation, there is some sense of discomfort in India as to whether this will survive the test of time. This is particularly true as a result of a conflict between the goal of preventing future inflation, and avoiding a sharp downturn in industry. Under such circumstances, the reliance on mechanistic, simpler, and narrower rules restricting discretion or judgment does not appear feasible. The RBI is likely to pursue its multiple indicator approach for some time to come.

In the area of exchange rate management, a basic question is how much flexibility should be allowed. Based on the experience of many other countries, India has managed "floating" with no fixed rate targets. The rate is primarily determined by market forces, but India's foreign exchange market being thin, the RBI intervenes in foreign exchange market to contain volatility and to maintain orderly market conditions.

Yet another issue dominating recent discussions of central bank autonomy is the separation of debt management and monetary management functions. The fundamental question is whether monetary policy can operate on an exclusive basis, outside fiscal constraints, before a sustainable level of fiscal deficit is attained. Integration of India's financial markets is yet to attain adequate depth before the central bank can completely withdraw from direct debt management. A Fiscal Responsibility and Budget Management Act was passed in 2003.

In the context of large capital inflows since the turn of the twenty-first century, questions about the adequacy of foreign exchange reserves and the sustainability of sterilizing such inflows have been raised. Limitations on instruments available for sterilization have recently been addressed by a Working Group. Its recommendations should enable the RBI to adequately shore up its capacity to sterilize large capital flows.

K. Sabapathy

See alsoBalance of Payments ; Debt Markets ; Money and Foreign Exchange Markets

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