IV CENTRAL BANKING IN INDIA - Reserve Bank of India · of the Bank. After the separation of Burma,...

CENTRAL BANKING IN INDIAIV

4.1 Recent growth literature focuses on theprimacy of institutions as a determinant of economicdevelopment in that they influence the decisionsregarding work, saving, investment, innovation,production and exchange. The new focus oninstitutions has led to an ambitious agenda ofgovernance reforms aimed at reducing corruption,improving regulatory apparatus, making monetary andfiscal inst i tut ions independent, strengtheningcorporate governance, etc. – christened as the secondgeneration of reforms. It is argued that the policychanges are ineffective, unless they are groundedstrongly in institutional reforms. The empiricalanalysis, however, suffers from the difficulty thatinstitutional quality is endogenous to income levelsand that “there is much to be learned still about whatimproving institutional quality means on the ground”(Rodrik et al., 2004). It is in this context that the studyof the evolution of institutions in country-specificsituations is crucial.

4.2 Central banks occupy a pivotal position in theinstitutional fabric of an economy. As discussed inchapter III, the functions of a modern central bankare vastly different from what was expected from theear ly central banks founded in Europe in theseventeenth century. The evolution of central bankingin the Indian context has its own specificity. TheReserve Bank of India (RBI), while discharging itsstatutory responsibilities, has played a crucial role inthe nation building process, par ticularly in thedevelopment of the financial sector. In fact, institutionbuilding constitutes a distinguishing feature of centralbanking in India.

4.3 This chapter describes the evolution of centralbanking in India over the period of seventy years sincethe inception of the Reserve Bank in 1935. Foranalytical convenience, the entire period 1935-2005is sub-divided into three broad phases: foundationphase (1935-1950), development phase (1951-1990)and reform phase (1991 onwards). The turning points– onset of economic planning in 1951 and initiationof structural reforms in the Indian economy in 1991 –had profound implications for the working of theReserve Bank. The Reserve Bank operated indistinctly different regimes in each of these eras.During most of the formation phase it was a private

bank, though formed under a statute and overseenby the then colonial government. The functions ofthe Bank during this phase were confined essentiallyto traditional central banking, i.e., note issue authorityand banker to the Government. During the war andpost war years, its major preoccupation was facilitationof war finance, repatriation of sterling debt andplanning and administration of exchange control.Upon the nationalisation of the Bank in 1949 in termsof the Reserve Bank of India (Transfer to PublicOwnership) Act, 1948 and the enactment of theBanking Regulation Act, 1949, regulation andsupervision of banks received the focus. On theinitiative of the Reserve Bank, the Governmentappointed the Rural Banking Enquiry Committee in1949 to consider important policy issues relating tothe extension of banking facilities in the country. Withthe launching of five-year plans, the Bank’s functionsbecame more diversified in terms of Plan financingand establishment of specialised institutions topromote savings and investment in the Indianeconomy and meet the credit requirements of thepriority sectors. Two important events during the1960s – the devaluation of the rupee in June 1966and nationalisation of 14 private commercial banksin July 1969 – greatly influenced the functions of theReserve Bank in the subsequent years. Externally,the uncertainties in the global economy following thebreakdown of the Bretton Woods system of stableexchange rates and the emergence of the floatingregimes exacerbated by the oil shock of 1973-74presented serious challenges for exchange ratemanagement and gave rise to balance of paymentsdifficulties in India as in many other developingcountries. The Government re-focused on the ForeignExchange Regulat ion Act (FERA), 1947 forconserving foreign exchange rather than regulatingthe entry of foreign capital. The FERA, 1973 wasdrafted incorporating the changes necessary foreffective implementation of the Government policyand removing the difficulties in the working of theexisting legislation. The major responsibil it iesdevolving on the Reserve Bank during the 1970srelated to regulation and management of the country’sscarce foreign exchange reserves and expansion inthe volume and scope of its refinance facilities foragriculture and rural development. During the 1980s,

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REPORT ON CURRENCY AND FINANCE

monetary policy assumed a new focus. On the whole,the development phase was characterised by aplethora of controls and regulations in the Indianeconomy. In the period since 1991, which witnesseda regime shift in the Indian economy, there has beena distinct re-orientation in the functions of the ReserveBank in the l ight of the domestic and globaldevelopments. The reform measures in the financialsector and the initiatives taken by the Reserve Bankfor developing financial markets to ensure efficienttransmission of monetary policy impulses, constitutedthe hallmark of this phase.

4.4 The rest of the chapter is organised as follows.Sections I, II and III provide a synoptic overview onthe transformation of central banking functions in Indiaover the three phases. Section IV addresses thecontemporary issues relevant to central banking inIndia, par t icular ly concerning the monetaryframework, while Section V sets out the concludingobservations.

I. FOUNDATION PHASE (1935-1950)

4.5 The Reserve Bank was formed as ashareholders’ institution in April 1935. The genesisof a central banking institution in India, however, canbe traced to the eighteenth century (Box IV.1). The

formation of the Reserve Bank was similar to theestablishment of early central banks in Europe. Thecrucial difference, however, was that Reserve Bankoperated under the colonial rule, whereas the centralbanks in the European countries were then mostlyowned by national governments.

4.6 The objective of establishing the ReserveBank, as stated in the preamble to the RBI Act 1934,was to “regulate the issue of bank notes and thekeeping of the reserves with a view to securingmonetary stability in India and generally to operatethe currency and credit system of the country to itsadvantage”. The Bank’s functions as laid down inthe statutes were: (a) issue of currency (b) banker toGovernment; and (c) banker to other banks. Exceptin the sphere of agriculture, the Bank was notentrusted with any great promotional role and thattoo on a limited scale (RBI, 1970).

4.7 The foundation phase was marked by severalwar and post war developments including theseparation of Burma (modern Myanmar) in 1937,partition of the country in 1947 and nationalisation ofthe Reserve Bank, which altered the area of operationsof the Bank. After the separation of Burma, the Bankacted as currency authority of that country till 1942 andas banker to the Burmese government till March 1947.

The efforts to establish a banking institution with centralbank character dates back to 1773. The Governor ofBengal under Br i t ish India recommended theestablishment of a General Bank in Bengal and Bihar. TheBank was set up in 1773 but it was only short-lived. In1914, the Chamberlain Commission had included in theirreport a comprehensive memorandum by John MaynardKeynes (one of their members), proposing theamalgamation of the three Presidency Banks into onecentral bank to be called the Imperial Bank of India. In thelatter stages of the First World War, the necessity of acentral banking institution became more apparent and theImperial Bank Act was passed in 1920. The amalgamationwas finally effected in 1921 leading to the formation of theImperial Bank of India. Essentially a commercial bank,the Imperial Bank performed certain central bankingfunctions such as banker to the Government and bankers’bank, while the core central banking function of the issue ofcurrency notes and management of foreign exchangecontinued to be the responsibility of the Central Government.

Meanwhile, central banking theory developed on the linesthat it was unsuitable for an institution with commercialbanking functions to also be the central bank in a country.

Box IV.1 The Genesis of Central Banking in India

In 1926, the Royal Commission on Indian Currency andFinance (Hilton Young Commission) recommended that thedichotomy of functions and division of responsibilities forcontrol of currency and credit should be ended. TheCommission suggested the establishment of a central bankto be called the Reserve Bank of India, whose separateexistence was considered necessary for augmentingbanking facilities throughout the country.

The Bill to establish the Reserve Bank of India wasintroduced in January 1927 in the Legislative Assembly,but it was dropped due to differences in views regardingownership, constitution and composition of its Board ofDirectors. The White Paper on Indian ConstitutionalReforms (1933) proposed the setting up of the ReserveBank of India free from political influences. The IndianCentral Banking Enquiry Committee (1931) had alsostrongly recommended the establishment of a ReserveBank. These events led to the introduction of a fresh Billin 1933. The Bill was passed in 1934 and the RBI Act cameinto force on January 1, 1935. The Reserve Bank wasinaugurated on April 1, 1935.

Source: RBI (1970).

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Upon the partition of the country in 1947, the Bankrendered central banking services to the Dominion ofPakistan until June 1948. In terms of the PakistanMonetary System and Reserve Bank (Amendment)Order, 1948, the Bank ceased to function as the centralbank for Pakistan from July 1, 1948. The Reserve Bankwas nationalised on January 1, 1949 in terms of theReserve Bank of India (Transfer to Public Ownership)Act 1948.

4.8 Each of these events had its bearing on theworking of the Reserve Bank, even though it confinedmainly to the traditional functions. The most activepart of the Bank’s operation during this period relatedto currency management and banker to thegovernment. In the sphere of monetary policy, exceptfor maintaining exchange rate stabi l i ty, themanagement of money supply or inflation was notwarranted due to the low levels of economic activitiesespecially during the colonial era.

Currency Management

4.9 In India, paper money, in the modern sense,traces its origin to the late eighteenth century in theform of note issues of the private banks as well assemi-government banks (the Bank of Bengal, theBank of Bombay and the Bank of Madras - thePresidency Banks). The Paper Currency Act of 1861conferred upon the Government of India themonopoly of note issue, bringing to an end the noteissues of pr ivate and Presidency banks. Thestatutory provisions governing the issue of coins arelaid down in the Indian Coinage Act 1906. Up toMarch 31, 1935, the task of currency managementwas under taken depar tmentally by the CentralGovernment through the Controller of Currency.Upon its establishment, the Reserve Bank took overthis function under Section 3 of the RBI Act, 1934.The transition of currency management from thecolonial to independent India was a reasonablysmooth affair. Until its own notes were ready, theBank issued currency notes of the Government ofIndia. The first issue of notes in the denominationof Rs.5 and Rs.10 was made by the Reserve Bankin January 1938, while notes in higher denominations(Rs.100, Rs.1,000 and Rs.10,000) were issued laterduring the year.

4.10 In terms of the RBI Act, the affairs of the Bankrelating to note issue and general banking businessare conducted through two separate Departments,viz., Issue and Banking. The Issue Department isresponsible for the aggregate value of the currencynotes of the Reserve Bank in circulation from time to

time and maintains the eligible assets for equivalentvalue. The mechanism of putting currency intocirculation and its withdrawal from circulation(expansion and contraction of currency) is undertakenthrough the Banking Department.

4.11 The assets of the Issue Department, againstwhich currency notes are issued under Section 33of the RBI Act, consist of gold coin and bullion,foreign securities, rupee coin, Government of Indiarupee secur i t ies of any maturi ty and bi l ls ofexchange and promissory notes payable in Indiawhich are eligible for purchase by the Bank. Theoriginal Act prescribed a proportional reserve of goldand sterling (later foreign) securities against noteissue, whereby, not less than 40 per cent of the totalassets was to consist of gold coin and bullion andsterling (later foreign) securities, stipulating furtherthat gold coin and gold bullion were not, at any time,to be less than Rs.40 crore. The proportional reservesystem was substituted by a minimum reservesystem in 1956 through the Reserve Bank of India(Amendment) Act, 1956. The minimum reservesystem stipulated the foreign exchange reserves inabsolute terms at Rs.400 crore and gold coins atRs.115 crore, making the total minimum assetbacking of Rs.515 crore.

4.12 The support for the currency in assets in 1935was much higher in terms of gold coin and bullionand sterling securities. The rupee securities of theGovernment of India constituted 27 per cent of thetotal assets of the Issue Department. The small orderof currency in circulation in 1935 not only indicatesthe smaller volume of money then required for tradebut also reflects the relatively small base on whichthe economy rested. To some extent, it also reflectedthe lack of monetisation in the economy. Afterindependence, the responsibilities of the Bankconfined to a single national currency and Indiancurrency has no link abroad.

4.13 Issue of bank notes in British India was in factthe most important function of the Reserve Bank inthe beginning. Accounting of currency chest moneyconstituted a major part of the daily routine businessof the Reserve Bank, employing about a third of theBank’s personnel. The issue of currency notes -consisting of one-rupee notes and small (subsidiary)coins issued by the Government and the notes issuedby the Reserve Bank - was undertaken from thebranches of the Issue Department. The Bank alsomaintained currency chests at the branches of theImperial Bank of India engaged in Governmenttreasury business and at Government treasuries and

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sub-treasuries. The Bank provided a measure ofelasticity to the currency system through its loan andopen market operations, although there was not muchscope for innovation or technical improvement incurrency management.

Bankers’ Bank

4.14 Prior to the formation of the Reserve Bank,the Imperial Bank (established in 1921) functionedto some extent as a bankers’ bank. Most other banksmaintained balances with it and could receiveaccommodation. It also operated clearing-housesand provided remittance facilities across its branches,other banks and the public. The predominant bankfinancing was for foreign trade, while the share ofinternal trade was not significant.

4.15 The Reserve Bank’s responsibility as bankers’bank was essentially two-fold. First, it acted as asource of reserves to the banking system, especiallyfor meeting the seasonal requirements apart fromserving as the lender of the last resort in times ofemergency. The second responsibility was to ensurethat banks were established and run on sound lines,the emphasis in those years being mainly on theprotection of depositors’ interest rather than on creditregulations. Regulation and supervision of thebanking sector was entrusted to the BankingDepartment in 1945. However, the Bank did not havemuch power until the enactment of the BankingCompanies Act in 1949 (renamed as BankingRegulation Act from March 1966). Furthermore, theBank could not immediately begin to exercise thepowers entrusted to it by the 1949 legislation due tothe post-war banking crisis. Indigenous bankers ona limited scale and moneylenders had a wide scopeand choice for their operations (RBI, 1985).

Banker to the Government

4.16 Before the formation of the Reserve Bank, theImperial Bank performed many of the functions asbanker to the Government. With the establishment ofthe Reserve Bank, the Imperial Bank ceased to bethe banker to the Government, but entered into anagreement with the Reserve Bank for providing itsservices as the sole agent of the Reserve Bank inplaces where it had a branch and there was no branchof the Banking Department of the Reserve Bank. Asthe banker to the Central Government and to the stateGovernments by virtue of agreements entered intowith them, the Reserve Bank provides a range ofbanking services for these Governments such asacceptance of money on government account

payment/withdrawals of funds and collection andtransfer of funds through different means. Sections20, 21 and 21A of the RBI Act provide the statutorybasis for these functions. The terms and conditionson which the Reserve Bank acts as banker to theCentral and State Governments are set out inseparate agreements, which the Bank entered intowith these Governments. The first of such agreementswas entered into in April 1935 with the Secretary ofState for India, which required the Reserve Bank totransact the general banking business of the CentralGovernment. The agreement was supplemented byexchanges of letters from time to time to cover matterssuch as minimum balances, provisions of temporaryfinancial accommodation in the form of ways andmeans advances and modification of some of theoriginal terms. The Reserve Bank provided temporaryadvances to the Government under Section 17(5) ofthe RBI Act to bridge mismatches in receipts andexpenditures.

4.17 The Central Government obtained ways andmeans advances from the Imperial Bank till 1935 andfrom the Reserve Bank thereafter. Since 1943-44,for about a decade, the Central Government did notresort to ways and means advances in view of thelarge cash balances accumulated during the waryears. The aftermath of economic depression and theabsence of the need for higher advances alsowarranted a low order of credit support from theReserve Bank to the Government. The most activepart of the Bank’s operation during those years asbanker to Government, however, related to loanfloatation of the central and provincial governmentsincluding the issue of their treasury bills. During theperiod 1935 to 1939, the Government of India floatedone sterling loan in London and four new rupee loans,mainly to provide for the repayment of maturingobligations. The vast acquisition of the sterling bythe country during the Second World War providedan opportunity for repatriation of its sterling debt andmuch of the initiative in this matter came from theReserve Bank, which also implemented therepatriation. While repatriation of sterling debt beganeven before the war on a modest scale, it wasundertaken on a large-scale during the war years –initially on a voluntary basis and since 1941, throughschemes of compulsory repatriation. Other modesof repatriation included funding of Railway Annuities,requisitioning of Railways Debenture Stocks andLiquidation of Chatfield debt. Over the period 1937-38 through 1945-46, sterling debt to the tune of £323million had been repatriated – the bulk of which (£289million) was undertaken during 1940-43 (RBI, 1970).

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Monetary Policy

4.18 Like other central banks, the core function ofthe Reserve Bank is to formulate and administermonetary policy to maintain the stability of the rupee.During the formative years there was, however, noformal monetary policy formulation other than that ofadministering the supply and demand for credit in theeconomy. The Bank Rate (the standard rate at whichthe Reserve Bank is prepared to buy or discount thebills of exchange or other commercial paper eligiblefor purchase under Section 49 of the RBI Act), reserverequirements and open market operations (buyingand selling securities particularly to the scheduledcommercial banks as part of the policy to maintainorderly coordination in the Securities Market) werethe mechanisms for regulating the credit availability.The Bank Rate, as an instrument of control, was notused at all in this period, except once in November1935 when the rate was reduced from 3.5 per cent to3.0 per cent. The rate remained unchanged thereaftertill November 1951. The Reserve Bank, however,employed the instruments of open market operations(OMOs) in a fairly substantial way. Although the Bankwas vested with adequate powers to resort to thequalitative instruments, viz., selective credit control,no need was felt during the initial stages of the Bank’sfunctioning due to the existence of price stability.

4.19 During the Second World War period, theReserve Bank preferred a policy of stable interestrates as against the prevailing wisdom of “cheapmoney” policy. The Bank’s stance in this regard wasclearly spelt out by the Governor, Sir James Taylor,in a public speech in February 1940. Excerpts fromthe speech:

People are too prone to oversimplify problems.To many monetary control means cheapmoney, and it is often argued both in thiscountry and elsewhere that the better thecontrol the cheaper it should be make money.This of course is essentially fallacious. Thebusiness of the controlling authority … is todo as far as possible what freely operatingmarkets would have done for themselves ifthey were not being subjected to abnormalstresses beyond their control or their abilityto foresee. In the absence of control thesewould be reflected in violent fluctuationsupwards and downwards… It is obviouslyadvantageous to have machinery to controland iron out these fluctuations, … if one goesfurther and tries to use such machinery tocarry out theoretical policies and do what the

market i f lef t to i tself in normalcircumstances… Too great a reduction in theeffective rate of interest must lead to dryingup the investing habit in which case the onlyalternative is inflation … the controllingauthority has to take these factors intoconsideration. It has to keep money on aneven keel … After all, no high degree oftechnique is required if the whole of monetarytheory simply boils down to turning on theprinting press (RBI, 1970).

4.20 The policy of stable interest rates was alsoreflected in the fixation of the terms of Governmentborrowing. The strategy of Government bond saleswas varied from time to time depending on the choicebetween issue of a new security and re-issue of anexisting loan, maturity, issue price, timing and thedecision whether the loan should be kept open for afixed period or be on tap. Broadly, the war wasfinanced with a coupon rate of 3 per cent – the issueprice in the case of longer term loans being graduallyraised, taking it closer to an effective yield basis of 3per cent.

4.21 Interestingly, Governor Taylor (op cit), whileconsidering the loan programme for 1942-43,suggested re-issue of the 3 per cent 1951-54 at parand a longer term loan of 3 per cent 1967-69 ataround Rs.95, giving an effective yield of over 31/

3

per cent at a time when the Government was desirousof lowering the yield basis to below 3 per cent – theywere thinking in terms of a 12-year 21/

2 per cent loan

at Rs.98 and a 25-year 3 per cent loan at Rs.98, givingeffect ive yields of roughly 23/

4 per cent and

31/8 per cent, respectively. The Governor, “precariously

concerned about the inflationary impact of such areduction”, preferred to go very slow in the matter(RBI, 1970).

4.22 In 1943, in view of the growing inflation,suggestions were made in various quarters to raisethe interest rates to st imulate investment inGovernment bonds; but the Reserve Bank opposedthis. The views of the Bank were communicated tothe Government in a letter in April 1943: “The resultsof attempting any enhancement of interest rates atthis stage are likely to be embarrassing for those whohave so far subscribed to Government loans, … Apartfrom the fact that high interest rates increase theburden on succeeding generations, there is alwaysthe possibility of any such increase failing in itsimmediate effect and defeating its own purpose”.Reflecting the Bank’s stance that did not favour cheapmoney either, the letter mentioned: “The cogency of

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the argument for a rise in the rate of interest may,however, be recognised to this extent that in presentconditions it does not seem possible to proceedfurther in the direction of cheapening money and thatGovernment may content themselves with aiming atthe maintenance of the present level of long terminterest rates” (RBI, 1970).

II. DEVELOPMENT PHASE (1951-1990)

4.23 With the launching of five-year plans in thecountry, the Reserve Bank took over a number ofcrucial developmental and promotional roles. TheFirst Five Year Plan emphasised the role of monetaryand credit policy as an important instrument formaintaining price stability and for regulation ofinvestment and business activity. Accordingly, theReserve Bank was expected to play its role inpromoting economic development by aligning thebanking system to the needs of a planned economy.The fundamental task before the Bank was to put inplace an appropriate institutional framework formobil isat ion of potential savings through thepromotion of financial intermediaries and creation ofa broad spectrum of financial assets and effectiveinvestment of these resources through the adaptationof a credit structure that would subserve thedevelopmental needs.

4.24 By this time, the Reserve Bank had acquiredenough experience and expertise in discharging thetraditional central banking functions. It had obtainedfairly adequate control over the money market (RBI,1985). Thus, organisationally, the Reserve Bank waswell equipped to play its due role to promote thecountry’s economic growth.

4.25 The planning era witnessed significant growthin the responsibilities of the Reserve Bank in thedirection of new developmental and promotionalactivities that are normally outside the purview of aCentral bank. The most critical tasks before the Bankwere plan financing and institution building to promotesavings and their deployment to various sections inaccordance with the Plan prior i t ies, besidesmaintaining a stable financial environment to developa healthy financial infrastructure. The adoption of theIndian Constitution in 1950 and the enactment of theStates Reorganisation Act in 1956, which facilitatedthe integration of currency and banking operations,tended to expand the ambit of the Reserve Bank’srole as banker to the Government. The importantevents that changed the course of action of the Bankduring the developmental phase included socialcontrol and the nationalisation of private commercial

banks. This per iod was also marked by theintroduction of a formal monetary policy frameworkemerging out of the necessity for striking a balancebetween the developmental functions and financialstability.

Banker to Government

4.26 A crucial developmental goal for the ReserveBank during the plan era was to fill the resource gapof the Government in the plan process - anenlargement of the role as banker to the Government.The RBI Act was amended in 1951 by inserting a newSection 21(a), which authorised the Bank to function,by an agreement, as banker to Governments in Part‘B’ states (formally princely states) and manage theirpublic debt and loan floatation. The final integrationculminated in the discontinuation of classifications ofstates as Part ‘A’ (former British India provinces) andPar t ‘B’ following the enactment of the StatesReorganization Act on November 1, 1956 (RBI, 1985).

4.27 The Reserve Bank’s role in Plan financingevolved in the form of deficit financing. In January1955, through the exchange of letters with the CentralGovernment, the Bank agreed to replenish the latter’sbalances whenever they fell short of Rs.50 crore atthe end of any week. This agreement in effect gave ago-ahead to an enabling provision in the RBI Act –Section 17(5), which authorised the Bank to provideto the Central and State Governments advancesrepayable not later than three months. Theseadvances were matched by the issue of ad hoctreasury bills issued by the Central Government tothe Reserve Bank, which were held in the IssueDepartment. While it was customary for a central bankto extend temporary short-term advances to theGovernment to cover mismatches between the latter’sreceipts and expenditure, the practice made routinesince 1955 gave the Central Government an unlimitedright to borrow from the Reserve Bank (Balachandran,1998). Over time, the practice of replenishing theGovernment’s balances by creation of ad hoc TreasuryBi l ls attained a permanent character and analternat ive source of f inancing governmentexpenditure. Similarly, the State Governments alsobegan drawing unauthorised overdraft from the Bank.As such, the Reserve Bank became a source of cheapcredit not only for the Central Government, but alsoindirectly for the State Governments. Plan financingalso necessitated heavy drawals in foreign exchangereserves held by the Reserve Bank, which in turncalled for appropriate legal measures to arm the Bankto facilitate as well as counter the ill effects thereof.

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The substitution of the proportional reserve systemby a minimum of foreign exchange reserve systemunder the Reserve Bank of India (Amendment) Act,1956 provided a more elastic method of note issue tomeet the growing currency requirements.Simultaneously, the Reserve Bank acquired additionalpowers to vary the reserve requirements so as toregulate the impact of large public expectations onthe ability of the banking system to sanction credit totrade and industry. The availability of refinance forthese sections was further liberalised in January andMarch 1963. The period since 1960 also markedthe beginning of the regulation of interest rates(lending as well as deposits) of commercial banksby the Reserve Bank.

4.28 The enactment of the Banking Companies Act,1949 gave special authority to the Reserve Bank tosupervise the operations of commercial banks so asto ensure their establishment and working on soundlines. By 1951, it had become a well-establishedpractice for the commercial banks and cooperativebanks to turn to the Reserve Bank for accommodation.As such, the Reserve Bank was in a position to pursuea credit policy that was both expansionary andregulatory, broadly in accordance with the investmentpriorities indicated in the Plans. In 1956, the ReserveBank was vested with power to vary, within broadlimits, the statutory reserve, which the commercialbanks would maintain with it. The Bank also madeefforts for credit planning, guiding the commercialbanks with regard to the aggregate quantum of creditcreation, season-wise and its sector-wise distributionand employing device of incentives and penalties inthe rate structure. Furthermore, the Reserve Bankalso instituted the mechanism for providing temporaryaccommodation to the banks for meeting theirseasonal demand requirements of reserves throughthe seasonal fluctuations in credit expansion andnarrowing. For this purpose, the Bank had institutedthe Bill Market Scheme as early as in January 1952,enabling the banks to borrow from the Reserve Bankagainst the security of their advances converted intousuance bills.

Institution Building

4.29 A major task thrust upon the Bank was to putin place the necessary institutional mechanism tocomplement the planning efforts. This was crucialespecially in the context of the weak financial systemwith an underdeveloped and evolving commercialbanking set-up. Organised credit institutions had anegligible presence in rural India. In this backdrop,

building up a sound and adequate institutionalstructure for rural banking and credit was paramount.

4.30 To supplement the institutional build-up, theReserve Bank also assumed special responsibilitiesfor augmenting the flow of rural credit. The formulationof agricultural credit policy beginning 1951 was a majorlandmark in the Bank’s responsibilities for agriculturalcredit. The Bank organised a comprehensive All-IndiaRural Credit Survey under the direction of a Committee(Chairman: A. D. Gorwala) appointed in 1951. Therecommendations of the Committee of Direction,which submitted its report in 1954, set the pace anddirections for the subsequent years not only for theBank’s agricultural credit policy but also for the relatedpolices of Central and State Governments. TheCommittee’s recommendations led to thenationalisation of the Imperial Bank of India and thebanks associated with the former princely states,restructuring of the short-term co-operative creditstructure and reorganisation of the institutionsspecialising in longer-term lending for agriculturaldevelopment (RBI, 1955 and Balachandran, 1998).The Agricultural Credit Department was establishedmainly with the objective of coordinating the Bank’soperation with those of other institutions engaged inagricultural lending. The RBI Act was amended in 1955to enable the Bank to create two funds - NationalAgricultural Credit (Long-Term-Operations) Fund andthe National Agricultural Credit (Stabilisation) Fund.The Reserve Bank set up the Agricultural RefinanceCorporation in 1963 for extending medium and long-term finance to agriculture. With the establishment ofthe National Bank for Agr iculture and RuralDevelopment (NABARD) on July 12, 1982, the focusof the Reserve Bank in regard to rural credit has beenmore on co-ordination. This role of the Reserve Bankin this regard expanded after 1982 with the formationof the Rural Planning and Credit Department.

4.31 In the absence of a well-developed capitalmarket, the Reserve Bank played a proactive role insett ing up a number of special ised f inancialinstitutions at the national and regional level to widenthe facilities for term finance to industry and forinstitutionalisation of savings - a novel departure fora central bank. The examples are: the IndustrialDevelopment Bank of India (IDBI) in 1964 and theUnit Trust of India (UTI) in 1964. The UTI came intoexistence as an offshoot of the Bank to help mobilisesmall savings for industr ial investment anddemocratise industrial share-ownership.

4.32 Apart from the initiatives to build-up aninstitutional base, the Reserve Bank made the

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provision of annual allocation from profit a fund calledthe National Industrial Credit (Long-Term Operations)Fund for use for development banking. The ReserveBank also administered, as the agent of the CentralGovernment, various credit guarantee schemes forthe small-scale industries (SSI) sector, which weredesigned to provide protection to banks and otherinstitutions lending to such small scale units. TheExport Import Bank of India (EXIM Bank) wasestablished in January 1982, to which the exportfinance functions of the IDBI were transferred. TheEXIM Bank was also made eligible to loans andadvances from the National Industrial Credit (Long-Term Operations) Fund operated by the Reserve Bank.

4.33 The Deposit Insurance Corporation (DIC), awholly owned subsidiary of the Reserve Bank,commenced operations in 1962. In that year, 287banks were registered with it as insured banks. Bythe end of 1967, the number of insured banks haddeclined to 100, largely due to the Reserve Bank’spolicy of reconstruction and amalgamation of smalland financially weak banks so as to make the bankingsector more viable. Up to 1967, the liabilities of theCorporation were invoked in the case of eleven banks[Bank of China, Calcutta (1963); Bank of AlagapuriLtd, Alagapuri (1963); Unity Bank Ltd, Madras (1963);Metropolitan Bank Ltd, Calcutta (1964); UnnaoCommercial Bank Ltd, Unnao (1964); Cochin NayarBank Ltd, Trichur (1964); Latin Christian Bank Ltd,Ernakulam (1964); Southern Bank Ltd, Calcutta(1964); Shree Jadeya Shankarling Bank Ltd, Bijapur(1965); National Bank of Pakistan, Calcutta (1966);Habib Bank Ltd, Bombay (1966)]. The licenses ofthree of these banks (viz., Habib Bank, National Bankof Pakistan and Bank of China) were cancelled forreasons other than financial viability. As at the endof 1966, the amounts paid or provided for in respectof these eleven banks amounted to Rs 56.83 lakh, ofwhich Rs 39.85 lakh was recovered by the DIC andthe overall risk experience of the Corporation was‘favourable’.

4.34 A number of impor tant developmentsconcerning deposit insurance took place during 1967-81. The DIC Act was amended in 1968 to extend theinsurance scheme to deposits with cooperative banks.This phase witnessed strong growth and consolidationof the deposit insurance fund consequent upon theexpansion of bank deposits and progressive increasein the coverage of insured deposits. The Reserve Bankpromoted a public limited company named CreditGuarantee Corporation in 1971. The main thrust ofthe credit guarantee schemes introduced by the Credit

Guarantee Corporation was to encourage thecommercial banks to meet the credit needs of thehitherto neglected sectors, particularly the weakersections of the society engaged in non-industrialactivities. The two organisations – the DIC and theCredit Guarantee Corporation of India Ltd – weremerged in 1978, leading to formation of the DepositInsurance and Credit Guarantee Corporation of India(DICGC) with the ‘twin and cognate’ objectives ofgiving protection to small bank depositors andproviding guarantee cover to credit facilities extendedto certain categories of small borrowers belonging tothe weaker sections of society.

4.35 The establishment of the banking and otherspecialised institutions had significant implications forthe working of the Reserve Bank in that it widenedthe spectrum of the financial sector and heightenedthe supervisory role of the Bank. The institutionalbuild-up was largely complementary to the monetarypolicy on the following counts. First, a well-developedfinancial system assisted the Bank in implementingits general and selective credit policies by providingeffective channels for transmitting their impulses.Second, to the extent the growth of savings and theability of banks to mobilise the same increased, theirdependence on the Reserve Bank for accommodationwas reduced. Once the banking system was betterable to meet the expanding demand for credit fromits own resources, the traditional instruments ofmonetary policy could be expected to fully come intoplay. Third, the mobilisation of savings by theinstitutional agencies led to a better convergencebetween the demand for investible funds in theeconomy and their supply.

Social Control and Nationalisation

4.36 The events that were crucial in strengtheningthe institutional credit delivery mechanism were thepolicy of ‘social control’ launched in 1967 and thenationalisation of 14 private commercial banks in1969, which usurped the responsibilities of the Bankin the development planning process. Social controlover banks was envisaged through the “Banking Laws(Amendment) Bill, 1967”, which sought to amendcertain provisions of the Banking Regulation Act,1949, the Reserve Bank of India Act, 1934 and theState Bank of India Act, 1955. The need for it wasfelt in the context of the major lacuna that many ruraland urban areas still remained inadequate in banking,notwithstanding the considerable progress made inboth functional and geographic coverage of the Indianbanking system during the plan era. Also, the large

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industries and big and established business werefound to be receiving a major portion of the creditfacilities, which was detrimental to the interests of thepreferred sectors such as agriculture, small scaleindustries and exports. Accordingly, a National CreditCouncil (NCC) was set up in December 1967 toassess the demand for bank credit from the varioussectors of the economy, determine the priorities forthe grant of loans and advances commensurate withthe availability of resources and the requirements ofpr iority sectors and to coordinate lending andinvestment policies of various institutional agenciesto ensure the efficient use of the overall resources.

4.37 The Government of India nationalised 14major Indian scheduled banks having deposits ofRs.50 crore and above through the BankingCompanies (Acquisition and Transfer of Undertakings)Act, 1969. The objectives of bank nationalisation wentfar beyond the objective of social control. Theobjective of the ‘takeover’ as illustrated in the preambleof the Act was “to control the heights of the economyand to meet progressively, and serve better, the needsof development of the economy in conformity withnational policy and objectives”. In essence, thenationalisation of banks aimed at accelerating thepace of expansion of commercial banks branches inrural areas and augmenting the flow of bank credit toagriculture and to the weaker sections of the society(RBI, 1985).

4.38 With nationalisation, the ownership of thebanks was vested with the Central Government, whilethe operational aspects of banks continued to be thelook out of the Reserve Bank. This paved the way toa ‘centralised control and direction’ over the bankingsystem. While the main objective of nationalisationwas that credit should be available to a wider rangeof people than before, the major task of the ReserveBank was to ensure the compliance to its policies bythe nationalised banks. This called for significantchanges in the institutional arrangements and morestringent control and supervision of the bankingsystem.

4.39 In terms of outcome, this phase ofnationalisation greatly succeeded in mobilising privatesavings through the banks. The savings so mobilisedwere used for supporting public borrowing as well asfor meeting hitherto neglected genuine credit needs.This success led to the nationalisation of six moreprivate commercial banks in 1980 through the BankingCompanies (Acquisition and Transfer of Undertakings)Ordinance, 1980. With the second phase ofnationalisation, the public sector banks accounted for

over 90 per cent of the total deposits of all scheduledcommercial banks. While the Reserve Bank had notbeen a party to the bank nationalisation in 1969, theinitiative for the second phase of nationalisation in1980 came from the Reserve Bank, the reason beingthe need to supervise private banks to ensure theircompliance with social control norms, given the factthat several small pr ivate banks had grown torespectable size and it was not easy to control theiractivities in practice (RBI, 2005a).

Credit Control

4.40 Since the 1970s, the Reserve Bank faced thetwin problems of making provisions for financingeconomic growth and ensuring price stability in thewake of a sharp increase in money supply emanatingfrom the rapid expansion in credit. The increasedpublic expenditure and the coincident rise in banksdeposits began to place a greater pressure on theeffectiveness of monetary policy. The Reserve Bankhad to adopt a balancing approach to handle thisknife-edged problem and resorted to the policy of a‘controlled expansion’ of credit to meet the twinobjectives of making provision of credit for attainingfaster rate of economic growth and ensuring pricestability.

4.41 A key issue in this context was that thetraditional instruments of credit control, viz., the BankRate and OMOs were found inadequate for controllingthe banks’ power in expanded credit creation. Thefact that the deposits of commercial banks were risingrapidly under the impact of deficit financing and thecommercial banks did not have the need to approachthe central bank for accommodation, the Bank Rateas an instrument of monetary policy became lesseffective. Moreover, in the absence of an articulateand broad-based market for government securities,the scope for OMOs as a monetary policy instrumentwas also relatively limited. This warranted theintroduction of additional instruments of credit control.

4.42 An important requirement was the flexibilityto alter the reserve requirements of the commercialbanks. The amendments of the RBI Act (Section 42prescribing the reserve requirements of scheduledbanks) and the Banking Regulation Act (Section 18dealing with the cash reserve requirements for non-scheduled banks) in 1962 provided the flexibility inthis regard. Originally, under the RBI Act, scheduledbanks were required to maintain with the ReserveBank a minimum cash reserve of 5 per cent of theirdemand liabilities and 2 per cent of their time liabilitiesin India at the close of business on any day. The

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amendment to the RBI Act in 1956 empowered theBank to vary the reserve requirement between 5 percent and 20 per cent of banks’ demand liabilities andbetween 2 per cent and 8 per cent of their timeliabilities in India. The 1962 amendment fixed thereserve requirement uniformly at 3 per cent of banks’total demand and time liabilities in India (doing awaythe distinction between demand and time liabilities)and the cash reserve requirement could be variedbetween 3 per cent and 15 per cent. These legislativemeasures added more instruments at the disposal ofthe Reserve Bank to control the credit expansion ofcommercial banks.

4.43 Another measure was the activation ofselect ive credit controls. The Reserve Bankintroduced selective credit control for the first time inMay 1956 in the context of multiplication of banks’advances. The continued loss of foreign reservestowards plan financing again forced the Bank to usean additional credit restraint measure viz., ‘quota-slab’system, instituted in October 1960. This was in theform of credit rationing through a price instrument.The advantage of this instrument was that it would atthe same time not directly increase the cost ofgovernment borrowing or affect the gilt-edged market.Under this system, each scheduled bank wasassigned a quarterly quota equal to half of the averagevolume of reserves, which it had to maintain underSection 42(1) of the RBI Act during each week of thepreceding year. The quota slab system could beliberalised or tightened as necessary for effectivequantitative check on credit expansion.

4.44 The quota-slab system, where availability ofcredit was the key control variable, was replaced in1964 by a scheme of accommodation based onbanks’ net l iquid i ty rat io (NLR), which wasconsidered to be a less discretionary form of centralbank control over the expansion of commercial bankcredit than the quota-slab system. The NLR formulaenvisaged using a variant of the statutory liquidityratio (SLR) to regulate the cost of the Bank’s loansto scheduled commercial banks. The net liquidityrepresented the propor tions of a bank’s cash,balances with the Reserve Bank, current accountdeposits in the notified banks and investment inGovernment and other approved securities, less itstotal borrowing from the Reserve Bank, SBI and IDBIto its aggregate demand and time liabilities. The NLRnormally equaled the prevailing overall liquidity ratio(SLR plus CRR).

4.45 The credit authorisation scheme (CAS) as aninstrument of credit control was introduced in

November 1965 to align credit policies closely withthe Five Year Plan. Under the scheme, scheduledcommercial banks were required to obtain theReserve Bank’s authorisation before sanctioning anyfresh credit of Rs.1 crore or above to any one borroweror any fresh limit which would take the total limitsengaged by the borrowers from the entire bankingsystem to Rs.1 crore. This scheme also helped inpreventing the problem of pre-emption of scarce bankreserves by a few large borrowers and enforcing ameasure of financial discipline on them.

Exchange Management and Control

4.46 Mention was made in the preceding sectionabout the role of the Reserve Bank in the repatriationof India’s sterling debt during the Second World Warperiod. While that related to the problem of “plenty”,the problem relating to the external sector of theIndian economy in the subsequent years that engagedthe attention of the Government and the ReserveBank was one of dealing with the “scarcity” of foreignexchange, which assumed serious proportions duringthe 1970s.

4.47 Prior to the Second World War, India was anet debtor country with a large surplus in the tradeaccount. The then British Government introducedexchange control in India using its emergency powersunder the Defence of India Rules. The ForeignExchange Regulation Act (FERA), 1947, which wasenacted under the British regime as a temporarymeasure, was later made a permanent Act in 1957and it remained in force up till January 1974. Thelimited objective of the Act was to regulate the inflowof foreign capital, in view of the concerns aboutsubstantial non-resident interests and employment offoreigners. The prevailing mood in independent Indiawas one of preserving and consolidating freedom andnot permitt ing once again any sor t of foreigndomination, polit ical or economic. The controlframework was essentially transaction-based - alltransactions in foreign exchange including thosebetween residents and non-residents were prohibited,unless specifically permitted. The Second Five YearPlan with a substantial step-up in the investment onindustr ialisation put a heavy strain on foreignexchange resources. Exports were not picking upwhile imports were surging, aggravating the balanceof payments crisis.

4.48 During the period from 1950-51 until mid-December 1973, India followed an exchange rateregime in which the Rupee was linked to the pound-sterling, except for the devaluations in 1966 and 1971.

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There were several uncertainties in the situationhaving bearing on the balance of payments. Largequantities of food-grain and essential wage goods hadto be imported. This led to concerns about capitaloutflows, reinforced by the repeated stress on balanceof payments due to droughts, wars and oil shocks. Inthis context and with the adoption of developmentplanning, emphasis was placed on utilising domesticsavings for domestic investment.

4.49 In this backdrop, the recommendation of thePublic Accounts Committee concerning the leakageof foreign exchange through invoice manipulation(June 1971) and the Report of the Law Commissionon ‘Trial and Punishment of Social and EconomicOffences’ (April 1972) induced the Government ofIndia to re-focus on the FERA, 1947 for conservingforeign exchange rather than regulating the entry offoreign capital. The FERA, 1973 was drafted with theobjective of introducing the changes necessary foreffective implementation of the Government policyand removing the difficulties in the working of theprevious enactment. As a crisis-driven legislation,the FERA, 1973 naturally contained several draconianprovisions. Any offence under the FERA was acriminal offence liable for imprisonment. Severerestrictions on current account transactions continuedtill the mid-1990s when relaxations were made in theoperations of the legislation of 1973 to enableconvertibility on current account.

4.50 The control framework was equally valid forthe capital account, though the capital account wasnegligible till the 1980s. Most receipts on capitalaccount were on Government account and throughexternal assistance in addition to the bilateralarrangement with erstwhile USSR. In the 1980s,there were significant private capital flows throughExternal Commercial Borrowings (ECB) and depositsfrom Non-Resident Indians (NRI). The positionchanged in the 1990s, with gradual liberalisation ofthe capital account.

4.51 The FERA empowered the centralGovernment to give to the Reserve Bank suchgeneral or special directions as it thought fit and theBank was obliged to comply with these directions indischarge of its functions under the Act. To a largeextent , the exchange contro l re lated to andsupplemented by the trade control administered bythe Chief Controller of Imports and Exports in theMinistry of Commerce of the Government of India.Exchange controls had a wider scope vis-à-vis thetrade controls, as it involved supervision over thesettlement of financial transactions in respect of all

exports and imports as also invisibles and capitaltransactions, whereas trade control was concernedwith the physical transfer of goods (mostly confinedto imports). The major functions of the Reserve Bankrelating to exchange control included grantinglicenses to certain scheduled commercial banks todeal in foreign exchange (authorised dealers); andissuing directions to the authorised dealers and otherentities (airline, shipping companies, travel agentsand insurance companies) in matters concerningtheir operat ions having foreign exchangeimplications.

Monetary Framework and Policy Initiatives duringthe 1980s

4.52 The high inflation all over the world in the1970s and the collapse of the Bretton Woods systemled to a paradigm shift in monetary policy from theKeynesian to the Monetarist approach. Tracking thefactors contr ibuting to causes and sources ofinflation, the developed countries began to targeteither inflation or monetary (or reserve) targeting.This influenced the thinking of the policy makers inthe Indian context as well. The large deficits ofGovernment and its financing by the Reserve Bankleading to a significant rise in money supply relativeto output prompted a new look for evolving a broaderapproach in assessing the size and growth of overallmoney supply. The Committee to Review the Workingof the Monetary System (Chairman: SukhamoyChakravarty) suggested that the monetary authorityshould embark on monetary targeting in a moreformal and secured manner. The level of themonetary target needs to be determined on the basisof desired growth in output and the tolerable level ofinf lat ion. The monetary budgeting exercisesundertaken hitherto provided the monetary authoritywith useful insights into the problems of formalmonetary targeting.

4.53 The Chakravar ty Committee suggestedtargeting the broad measure of money supply (M3)with feedback. The Committee outlined a systematicoperating procedure, in particular, the planning of themonetary and credit budget. The monetary budgetwas estimated using the core parameters of realgrowth and inflat ion and was fol lowed with aconsistency check with the estimated movements inthe sources of money supply viz., net domestic credit(net Reserve Bank credit to Government and thecommercial sector), Net Foreign Assets (NFA) andNet Non-Monetary Liabilities (NNML) of the ReserveBank. While movements in NFA and NNML are

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determined on the basis of past trends, the ReserveBank credit to the Government and the commercialsector was projected in a manner consistent with theoverall size of the estimated monetary budget. TheCommittee also suggested an independentassessment of the seasonal demand for credit andrecommended Reserve Bank support in the form ofrefinance for the shortfall, if any. Finally, the expectedlevel of bank credit, so estimated, was to be used fordeveloping appropriate sectoral allocation in the lightof the plan priorities. Formulation of monetary policythus became a formal mechanism of the restructuredmonetary policy programme. The Reserve Bankevolved a formal framework of monetary policy by themid-1980s with M

3 as a nominal anchor to be targeted,

broadly based on the recommendations of theChakravarty Committee.

4.54 The Working Group on Money Market(Chairman: N. Vaghul), which examined therecommendations of the Chakravarty Committeeregarding the development of the money market,submitted its report in January 1987. Following thereport, a number of money market instruments wereintroduced: 182-day Treasury Bil ls, inter-bankparticipation certificates (IBPCs), certificates ofdeposits (CDs) and commercial papers (CPs). TheDiscount and Finance House of India (DFHI) was setup in 1988 for promoting a secondary market invarious money market instruments.

4.55 The process of expansion in the bankingnetwork in terms of geographical coverage andheightened controls affected the quality of banksassets and strained their profitability. In response tothese developments, a number of measures wereundertaken in the mid-1980s for consolidation anddiversification and, to some extent, deregulation ofthe financial sector. The consolidation measuresaimed at strengthening banks’ structures, training,house-keeping, customer serv ices, internalprocedures and systems, credit management, loanrecovery, staff productivity and profitability. A healthcode system for banks was introduced in 1985.Certain initiatives were also taken to impart greateroperational flexibility to banks. These includepermitting the banks to enter into the business ofequipment leasing and mutual funds, doing away withthe requirement of prior authorisation under the CAS,rationalisation of bank deposit and lending rates byraising coupon rates on government securities andby removing the ceiling of 10 per cent call/noticemoney fixed by the Indian Banks’ Association(Jadhav, 2003).

III. REFORM PHASE (1991-2005)

4.56 The process of liberalisation and globalisationof the Indian economy initiated since 1991 addedseveral new dimensions to the responsibilities of theReserve Bank. Along with financial sector reforms,the monetary policy framework has been fine-tunedand the conventional central banking functionsincluding those of currency management andpayment and sett lement systems have beenrevamped in tandem with the global trends anddomestic expediency.

Financial Sector Reforms

4.57 During the 1980s, the financial markets werehighly segmented and controlled and the interestrates in the government securities market and thecredit market were tightly regulated. The bankingsector remained dominated by public sector bankswith a significant quantum of non-performing assets.Credi t was extended to the Gover nment bymandating the maintenance of a minimum SLRwhereby the commercial banks set aside substantialportions of their liabilities to investment in governmentsecurities at below market interest rates. The stateof the development of financial markets turned outto be yet another major constraint. Removal of theinstitutional, technological and legal obstacles for thehealthy growth of financial markets for effectivetransmission of the policy signals formed a majoragenda for the reform of the financial sector sincemid-1991.

4.58 Increasing globalisation of the Indian economynecessitated integration of domestic markets withinternational financial markets for full realisation ofthe benefits of globalisation. Financial sector reformswere initiated in India in 1992 with a view to improvingthe eff ic iency in the process of f inancialintermediation, enhancing the effectiveness in theconduct of monetary policy and creating conditionsfor integration of the domestic financial sector withthe global system. The first phase of reforms, guidedby the recommendations of the Committee onFinancial System (Narasimham Committee I), aimedat enhancing the operational flexibility and functionalautonomy of the financial sector with a view tofostering efficiency, productivity and profitability. Thesecond phase, based on the recommendations of theCommittee on Banking Sector Reforms (NarasimhamCommittee I I) , focused on strengthening thefoundations of the banking system and bringing aboutstructural improvements (Mohan, 2003).

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Reforms in the Banking Sector

4.59 The first phase of reforms in the financialsector focused on deregulation of the banking industryincluding permitting the entry of new private sectorbanks. Simultaneously, measures were undertakento strengthen the institutional framework in banking,non-banking financial companies, financial institutionsand the capital markets through prudential norms,capital adequacy stipulations, improvements inpayments and settlement systems and strengtheningof the supervisory framework. Institutional measuresalso included setting up of the Board for FinancialSupervision for strengthening the Bank’s supervisorymechanisms, recapital isat ion of banks andimprovements in debt recovery.

4.60 The second phase of reforms focused on thebanking sector with an emphasis on the prudentialnorms. Prudential norms have been introducedgradually to meet international standards. Action hasbeen initiated to increase the capital adequacy ratio;assign r isk weights to Government approvedsecurities to take care of market risks; assign riskweights to open position in forex and gold. Therequired level of capital adequacy after implementingthe recommendations of the Narasimham Committee IIwarranted a substantial infusion of capital into thebanking system. Similarly, internationally acceptednorms of income recognition have been introducedexcept that income on assets is not recognised if notreceived within two quarters after it is past the perioddue (i.e., due date plus thirty days). A significantdecision relates to the treatment of assets guaranteedby the State Government as non-performing undercertain circumstances.

Reforms in Other Segments of the Financial Sector

4.61 Measures aimed at fostering competition andestablishing prudential regulation and supervisionhave also been introduced for the non-bank financialintermediaries. The non-banking financial companies(NBFCs), especially those involved in public deposittaking activities, the Development Finance Institutions(DFIs), specialised term-lending institutions, urbancooperative banks all have been brought under theregulation of the Reserve Bank. With the aim ofregulatory convergence for entities involved in similaractivities, prudential regulation and supervision normshave also been introduced for DFIs, NBFCs andcooperative banks.

4.62 The insurance business remained within theconfines of public ownership until the late 1990s.

Subsequent to the passage of the InsuranceRegulation and Development Authority (IRDA) Actin 1999, several measures have been initiated,including allowing newer players/joint ventures toundertake insurance business on a risk-sharing/commission basis.

4.63 A package of reform measures to liberalise,regulate and develop the capital market wasintroduced for improving market efficiency, increasingtransparency, integration of national markets andprevention of unfair trading practices. An importantstep was the establishment of the Securities andExchange Board of India (SEBI) in February 1992 asthe regulator for equity markets. Since 1992, reformmeasures in the equity market have focused mainlyon regulatory effectiveness, enhancing competitiveconditions, reducing information asymmetr ies,developing modern technological infrastructure,mitigating transaction costs and controlling ofspeculation in the securit ies market. Anotherimportant development under the reform process hasbeen the opening up of mutual funds to the privatesector in 1992, which ended the monopoly of UTI.

4.64 The Indian capital market was opened up forforeign institutional investors (FIIs) in 1992. The Indiancorporate sector has been allowed to tap internationalcapital markets through American depository receipts(ADRs), global depository receipts (GDRs), foreigncurrency convertible bonds (FCCBs) and ExternalCommercial Borrowings (ECBs). Similarly, overseascorporate bodies (OCBs) and non-resident Indians(NRIs) have been allowed to invest in Indian companies.FIIs have been permitted in all types of securitiesincluding Government securities and they enjoy fullcapital convertibility. Mutual funds have been allowedto open offshore funds to invest in equities abroad.

Complementary Policy Changes

4.65 Reform measures across sectors as well aswithin each sector (notably, monetary, fiscal andexternal) were planned and sequenced in such a wayso as to reinforce each other. The major aspects ofsuch complementary reform measures are set out inthe following paragraphs.

Debt Market Reforms

4.66 Several impor tant reforms have beenundertaken in the sphere of government securitiesmarket. The Reserve Bank entered into a historicagreement with the Government of India inSeptember 1994 for gradual phasing out of ad hoc

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treasury bills. Accordingly, the ad hoc treasury billswere discontinued with effect from April 1, 1997.

4.67 The management of publ ic debt andoperations of government securities market aregoverned by the Public Debt Act, 1944. Theprocedures prescribed are archaic and some of theprovisions have ceased to be of relevance in thepresent context. A new legislat ion t i t led theGovernment Securities Act to repeal and replace thePublic Debt Act was approved by the Union Cabinetand is awaiting Parliament clearance. However, sincethe Public Debt Act, 1944, is applicable for marketableloans raised by the Reserve Bank on behalf of boththe Central and State Governments, the proposalrequires consent of all State Governments. Upon theenactment of the new legislation, the Reserve Bankwould have substantive powers to design and introducean instrument of transfer suited to the electronicenvironment. As a debt manager, the Reserve Bankhas the obligation of minimising the cost of borrowingto the Government. Normally, with an upward slopingyield curve, longer the maturity of the security, higheris the cost; thus there is a trade-off between tenor ofborrowing and its cost (Mohan 2004a).

4.68 Interest rates on Government paper have beenmade market related and the maturity periodschanged to reflect market preferences. Since April1992, the Central Government borrowing programmehas been conducted largely through auctions enablingmarket based price discovery. As a result of theinstitutions of market related interest rates onGovernment borrowing, OMOs, hitherto ineffective,gained considerable momentum. There has been agradual shift in emphasis from direct to indirectinstruments of policy - OMOs and repos have beenactively used to influence the level of reservesavailable with banks. To augment the effectivenessof this instrument, greater efforts are being made towiden and deepen the money, foreign exchange andgilts markets and strengthen the banking system.

4.69 Liquidity management is under taken byinjecting and absorbing liquidity through a liquidityadjustment facility (LAF). Initially, under an interimadjustment facility introduced in 1999, injection ofl iquidity took the form of expor t ref inance tocommercial banks, collateralised lending facility (CLF)and additional collateralised lending facility (ACLF)to scheduled commercial banks and liquidity supportat two levels, i.e., level 1 and level 2 to Primary Dealers(PDs) by way of lending against the collateral oftreasury bills and government securities. CLF andLevel 1 were provided at the Bank Rate and ACLF

and level II at Bank Rate plus 2 per cent. Followingthe recommendations of the Narasimham CommitteeII, Stage I and Step I of Stage II of a full-fledged LAFwere implemented effective June 5, 2000 and May 5,2001 respectively.

4.70 Collateral ised borrowing and lendingobligations (CBLOs) were operationalised as a moneymarket instrument through the Clearing Corporationof India Limited (CCIL) on January 20, 2003. With aview to developing the market for this instrument, theReserve Bank introduced automated value-freetransfer of securities between market participants andthe CCIL during 2004-05. A repo market outside theLAF has been assiduously developed by the ReserveBank to provide an avenue for bank and non-bankparticipants to trade funds after the conversion of thecall/notice money market into a pure inter-bankmarket. In order to broaden the market, non-scheduled urban cooperative banks (UCBs) and listedcompanies with gi l t accounts with scheduledcommercial banks were allowed, subject to eligibilitycriteria and safeguards, to participate in the repomarket outside the Reserve Bank. The minimummaturity period of CDs was reduced from 15 days to7 days effective April 29, 2005 to align it with theminimum maturity of CPs and fixed deposits withbanks. With the initiation of the process of financialliberalisation along the 1990s, financial markets havebecome progressively integrated as evident from thecloser alignment of interest rates. Market integrationhas also implied that the interest rate channel ofmonetary transmission has gained some strength inrecent years.

External Sector Reforms

4.71 The broad approach to external sector reformswas laid out in the Report of the High Level Committeeon Balance of Payments (Chairman: C. Rangarajan).The Committee recommended, inter alia , theintroduction of a market-determined exchange rateregime within limits; liberalisation of current accounttransactions leading to current account convertibility;compositional shift in capital flows away from debtto non-debt creating flows; strict regulation ofexternal commercial borrowings, especially short-term debt; discouraging volatile elements of flowsfrom non-resident Indians; full freedom for outflowsassociated with inflows (i.e., principal, interest,dividend, profit and sale proceeds) and gradualliberalisation of other outflows; and the dissociationof the Government in the intermediation of flow ofexternal assistance.

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4.72 The developments in the subsequent yearsgenerally followed these recommendations. TheLiberalised Exchange Rate Management System(LERMS) involving a dual exchange rate mechanismwas instituted in March 1992 along with othermeasures of liberalisation in the areas of trade,industry and foreign investment. The dual exchangerate system was essentially a transitional phase,culminating in the unified exchange rate systemeffective from March 1, 1993. This brought about theera of market determined exchange rate regime ofthe rupee. It also marked an important step in theprogress towards current account convertibility, whichwas finally achieved in August 1994 when Indiaaccepted Article VIII of the Articles of Agreement ofthe International Monetary Fund.

4.73 As a follow-up measure for the developmentof the foreign exchange market in India, an ExpertGroup (Chairman: O. P. Sodhani) was appointed inNovember 1994, which submitted its report in June1995. This Group made several recommendations todevelop, deepen and widen the forex market, ensurerisk management, foster efficiency in the market byremoving restrictions, introducing new products andtightening internal controls. Many of the subsequentactions were based on this Report.

4.74 In 1997, the Committee on Capital AccountConvertibility (CAC) [Chairman: S. S. Tarapore],constituted by the Reserve Bank, indicated the roadmap for CAC – three crucial preconditions being,

fiscal consolidation, a mandated inflation target andstrengthening of the f inancial system – andrecommended a number of liberalisation measuresincluding change in the legislative frameworkgoverning foreign exchange transactions. Theliberalisation measures related to foreign directinvestment, portfolio investment, Indian overseasinvestment in joint ventures/whol ly ownedsubsidiaries, project exports, opening of Indiancorporate offices abroad, raising of exchange earners’foreign currency (EEFC) entitlement to 50 per cent,forfaiting, allowing acceptance credit for exports andallowing FIIs to cover forward a part of their exposuresin the debt and the equity markets.

4.75 The FERA, 1973 was repealed and replacedby a new legislation - Foreign Exchange ManagementAct (FEMA), 1999 - with effect from June 2000. Theobjective of the new legislation as stated in thepreamble to the Act was to facilitate external tradeand payments and promote the orderly developmentand maintenance of the foreign exchange market inIndia – a shift in the approach from “conservation offoreign exchange resources of the country and theproper utilisation thereof “ under the old Act. The shiftin the policy approach entailed significant implicationsfor the operations of the Reserve Bank (Box IV.2).Under the new system, all current account paymentsexcept those notified by the government are eligiblefor appropriate foreign currency in respect of genuinetransactions from the authorised dealers without any

The reforms in industrial and trade policies initiated in theearly 1990s, consistent with the changing internationaleconomic and trade relations, gave rise to the need for amore conducive climate for increased inflow of foreigninvestment and capital to accelerate the pace of industrialgrowth and export promotion. A comprehensive newlegislation – the Foreign Exchange Management Act - wasenacted in 1999, which in fact provided a de jure status tothe shift in the external sector policies that began in 1990-91. More importantly, the FEMA diluted the rigorousenforcement provisions - unlike in FERA, the prosecutionhas to prove the guilt of the accused person. Further, FEMAprovided for only monetary penalty for contraventions.Contravention of FEMA provisions are dealt with under civilprocedures, for which separate administrative mechanismsin the form of Compounding Rules, Adjudicating Authority,Special Director (Appeals) and Appellate Tribunal have beenestablished. Furthermore, for each process of law atimeframe has been provided in the Act.

Box IV.2 Foreign Exchange Management Act, 1999

The concept of compounding is another distinguishingfeature of the FEMA. Under the FERA, all violations weresubject to separate investigation and adjudication of theDirectorate of Enforcement. The FEMA provides anopportunity of seeking compounding of contraventions, interms of which a contravener has a suo moto opportunityof making an application to the compounding authorityseeking the contravention to be compounded. Thecompounding authority is required to dispose of theapplication within 180 days.

The Government of India, in one of the recent Notifications,has designated the Reserve Bank as the compoundingauthority for all contraventions under the FEMA, exceptfor those involving hawala transactions for which theDirectorate of Enforcement would be the compoundingauthority. The new procedure would provide quick andhassle-free disposal of the cases involving contravention(s)of FEMA.

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restrictions. The surrender requirements in respectof exports of goods and services continue to operate.The Reserve Bank would, however, have thenecessary regulatory jurisdiction over capital accounttransactions.

4.76 The Reserve Bank has delegatedconsiderable powers to the authorised dealers torelease foreign exchange for a variety of purposesand has been focusing on the development of theforeign exchange market. In order to deepen theforeign exchange market, a large number of productshave been introduced and the entry of newer playershas been allowed. Additional hedging instruments,such as, foreign currency-rupee options have beenintroduced and authorised dealers have beenpermitted to use innovative products like cross-currency options, interest rate and currency swaps,caps/collars and forward rate agreements (FRAs) inthe international forex market.

Changes in Monetary Policy Framework

4.77 Globally, the period since the 1990s has beencharacterised by certain striking similarities in thetools that monetary authorities employ to assessmacroeconomic developments, the choice ofinstruments and the operating procedures. There isa greater activism in liquidity management and a focuson the short-end of the market spectrum engenderedby the growing integration of financial marketsdomestically and internationally. There is greatercoordination between central banks, fiscal authoritiesand regulatory bodies governing financial markets.There is also a greater sophistication in the conductof monetary policy and central bankers are constantlyengaged in refining their technical and managerialskills to deal with the complexities of financial markets.Broadly in line with the global trends, the emphasisof monetary policy formulation in India has been onprogressive deregulation of the financial sector,providing an impetus to market development andpaving the way for increased use of indirectinstruments of monetary control.

Deregulation of Interest Rates

4.78 The process of simpl i f icat ion in theadministered interest rate structure began inSeptember 1990 with the reduction in the number ofslabs for which lending rates were prescribed. In amajor move, the minimum lending rate was abolishedand the lending rates were freed in October 1994 forcredit limits of over Rs.2 lakh. As a consequence ofderegulation and simplification of interest rates, banks

now enjoy ample flexibility in deciding their depositand lending rates. At present, except for theprescribed ceilings for the interest rates on exportcredit and small loans up to Rs.2 lakh, all other lendingrates have been deregulated. On the deposits side,only savings deposit rates and NRI deposit rates areprescribed by the Reserve Bank. As per the currentpractice, banks set their lending rates with referenceto a pre-announced benchmark prime lending rate(BPLR) by taking into account the risk premia and/orterm premia. The BPLR is decided by taking intoaccount various factors, such as, actual cost of funds,operating expenses, minimum margin to cover theregulatory requirements of provisioning/capital chargeand profit margin. The BPLR also serves as the ceilingrate for small loans up to Rs.2 lakhs.

Reactivation of Bank Rate

4.79 The Bank Rate was reactivated in April 1997as a reference rate and as a signalling device to reflectthe stance of monetary policy. The interest rates ondifferent types of accommodation from the ReserveBank including refinance are linked to the Bank Rate.The activation of the Bank Rate endowed the ReserveBank with an additional instrument.

New Monetary Aggregates

4.80 A Working Group on Money Supply: Analyticsand Methodology of Compilation (Chairman: Dr. Y. V.Reddy) set up in December 1997 to re-examine theanalytical aspects of monetary survey in the contextof the emerging dynamics in the nature, quality anddimension of the money stock submitted its report inJune 1998. Major recommendations of the workinggroup included: comprehensive analytical surveys ofthe Reserve Bank, commercial and co-operativebanks and the organised financial sector at regularintervals; compilation of four monetary aggregates [M

0

(monetary base), M1 (narrow money), M

2 and M

3

(broad money)]; introduction of three l iquidiyaggregates (L

1, L

2 and L

3); broadening of the definition

of credit by including items not reflected in theconventional bank credit; redefining the NFAs of thebanking system to comprise banks’ holdings of foreigncurrency assets net of (a) their holdings of FCNR(B)deposits and (b) foreign currency borrowings.

The Policy Focus – Shift to the Multiple IndicatorsApproach

4.81 Under the “f lexible monetary target ingapproach” that India followed since the mid-1980s,growth in broad money (M

3) was projected in a manner

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consistent with expected GDP growth and a tolerablelevel of inflation. The M3 growth thus worked as thenominal anchor for policy. Reserve Money (RM) wasused as the operating target and bank reserves asthe operating instrument. As deregulation enhancedthe role of market forces in the determination ofinterest rates and the exchange rate, the monetarytargeting framework came under stress due toincreasing liquidity mainly on account of capitalinflows. There was also increasing evidence ofchanges in the underlying transmission mechanismof monetary policy with interest rates and theexchange rate gaining importance vis-à-vis quantityvariables. These developments warranted reviews inthe monetary policy framework and the Reserve Bankswitched over to a more broad-based “multipleindicators approach” since 1998-99. Under thisapproach, policy perspectives are obtained frominterest rates or the rates of return in different markets(money, capital and government securities), highfrequency data on currency and credit extended bybanks and financial institutions, fiscal situation, tradeand capital flows, inflation rate, exchange rate,refinancing and transactions in foreign exchange andoutput data.

4.82 A number of institutional arrangements havebeen put into place to monitor the multiple indicators.The Financial Markets Committee monitors thedevelopment in financial markets on a daily basis. TheCommittee reviews the developments in money rates,foreign exchange, spot and forward rates, movementsin volume of funds both in money and forex markets,yield rates and volumes in government securitiesmarket and other developments in money and forexmarkets and banking and other market indicators. TheCommittee makes a quick assessment of the liquidityconditions and recommends strategies for interventionin money and security markets.

4.83 The informal monetary pol icy strategymeetings review monetary and liquidity conditionsand related indicators and discuss policy strategies,based on the findings of technical studies on relevantissues and review the follow up actions on therecommendation of various committees relating tomonetary pol icy. The Resource ManagementDiscussions with banks focus on reviewing andobtaining projection of banks’ major sources anduses of funds, collecting qualitative information onthe goals perceived and the strategies proposed tobe adopted by the banks in achieving these goals,obtaining feedback on the policy announcements andsuggestions on future course of policy and seeking

banks’ perception on liquidity and market conditions.The Technical Advisory Committee on Money andGovernment Securities and Forex Markets advisesthe Bank, on an ongoing basis, on development ofthe money and government securities markets. Theviews and decisions taken are crystallised intopolicy actions to achieve the desired objectives ofmonetary policy.

Short-term Liquidity Management

4.84 As reliance on direct instruments of monetarypolicy declined, liquidity management in the systemcould be increasingly undertaken through OMOs inthe form of outright purchases/sales of governmentsecurities and daily repo and reverse repo operations.The OMOs are supplemented by access to ReserveBank’s standing facilities and direct interest ratesignals through changes in the bank rate/repo rate.Short-term liquidity management is aided by conductof repos on a regular basis. The nomenclature of repoand reverse repo was interchanged in conformity withthe international usages (repos/reverse repos denoteinjection/absorption of liquidity by the Reserve Bank)with effect from October 29, 2004.

4.85 During the period between December 1992and March 1995, the Reserve Bank undertook reposinitially for one, two or three days covering five daysin a weekly cycle, which was later replaced by a 14-day cycle covering the reserve make-up period. Therepos were discontinued after March 1995 due to alack of demand under tight liquidity conditions andresumed in early 1997. Repos of 3-4 days cyclewere re-introduced, as shorter period repos providegreater maneuverability to the Reserve Bank indeciding the quantum of liquidity to be absorbed,depending upon the supply and demand conditions.The repo rates, apar t from reflecting l iquidityconditions, provide a floor for the overnight callmoney rates. In the event of tight liquidity conditions,the Reserve Bank’s liquidity support to primarydealers enables it to directly intervene in the market,thereby moderating pressures on the overnight callmoney rates. The LAF has emerged as the principaloperating instrument of monetary policy, enabling theReserve Bank to modulate short-term liquidity undervaried financial market conditions. The LAF operatesthrough daily repo and reverse repo auctions that seta corridor for the short-term interest rates consistentwith the policy objectives. In order to fine-tune themanagement of l iquidi ty and in response tosuggestions from market participants, the ReserveBank has introduced from November 28, 2005 a

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second liquidity adjustment facility (SLAF). Thus, atpresent, repos and reverse repos are being conductedtwice a day. Although there is no formal targeting ofovernight interest rates, the LAF has enabled theReserve Bank to de-emphasise targeting of bankreserves and focus increasingly on interest rates. Thisalso has helped reducing the CRR withoutengendering liquidity pressure.

Monetary Management under Capital Inflows

4.86 Following the adoption of structural reformsand external sector liberalisation in the early 1990s,the Indian economy experienced surges of capitalflows. While the capital inflows eased the externalfinancing constraint, they also posed dilemmas for theconduct of the monetary pol icy. Under thecircumstances, the objectives of containing exchangerate volati l i ty and the maintenance of order lyconditions in the forex markets become difficult toachieve. More particularly, if capital inflows outstripthe demand for foreign exchange, the appreciation ofthe domestic currency often necessitatesinterventions by the central bank to drain off theexcess supply of foreign currency. In doing so, theaccretion to official reserves implies an immediateexpansion in primary money supply with attendantconsequences for maintaining price stability.

4.87 Apart from the LAF, which is essentially aninstrument of day-to-day liquidity management,sterilisation operations are conducted through severalother means. Under the Reserve Bank of India Act,1934, the Reserve Bank is not allowed to borrowbeyond its paid-up capital of Rs.5 crore withoutcollateral. In the past, the Reserve Bank hadaugmented its ability to carry out OMOs by convertingnon-marketable special securities (mainly funded fromad hoc treasury bills) into marketable paper. Withthe full conversion of the entire stock of such paperin September 2003, the Reserve Bank was unable toresort to such operations. The Reserve Bank cannotissue its own paper under the extant provisions ofthe Reserve Bank of India Act, 1934 and such anoption has generally not been favoured in India. Inaddition, central bank bills/bonds would impose theentire cost of sterilisation on the Reserve Bank’sbalance sheet. Besides, the existence of two sets ofrisk-free paper – gilts and central bank securities –tends to fragment the market. Finally, as theGovernment cannot statutorily receive interest onsurplus balances with the Reserve Bank, its surplusesare ‘invested’ in its own securities held by theReserve Bank to avoid costs for the Government in

terms of idle funds. This arrangement, however,diminishes the availability of the stock of Governmentsecurities for sterilisation operations and overallliquidity management.

4.88 The Market Stabilisation Scheme (MSS) wasintroduced in April 2004 to provide the Reserve Bankwith an additional instrument of liquidity managementand to relieve the LAF from the burden of sterilisationoperations. The MSS is an arrangement between theGovernment of India and the Reserve Bank to mopup the excess liquidity generated on account of theaccretion of the foreign exchange assets of the Bankto neutralise the monetary impact of capital flows.Under the scheme, the Reserve Bank issues treasurybills/dated Government securities by way of auctionsand the cost of ster i l isat ion is borne by theGovernment.

Shifts in Basic Functions

Currency Management

4.89 Currency management is currently passingthrough an interesting phase. A number of significantsteps have been taken in this sphere, which include:building up of the capacity of note printing presses,reforms in the operations of the Issue Departmentincluding in the note distribution network, introductionof new security features and a shift towards higherdenomination notes in circulation.

4.90 The period in the 1990s was marked by asupply constraint as the capacity of the note printingpresses fell far short of the demand for fresh notes.It was only in the last year of the decade thatadequate capacity was built up with the setting upof two printing presses of the Bharatiya ReserveBank Note Mudran Private Ltd (BRBNMPL), awholly owned subsidiary of the Reserve Bank, atMysore (Karnataka) and Salboni (West Bengal),which became fully operational in 1999 and 2000respectively. Equipped with modern facilities forprinting, process control, accounting and qualitycheck in a secure environment, these are capableof printing notes in all denominations. The combinedcapacity of the presses is 19.8 billion pieces per yearon a 3-shift basis. The BRBNMPL presses are one ofthe first bank note presses in the world to be awardedthe ISO 9001:2000 certification by M/s RheinsichWestfalischer, TUV, Germany in March 2001.

4.91 The operationalisation of the printing pressesof BRBNMPL enabled the Reserve Bank to embarkon the “Clean Note Policy” in 1999. The objective of

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the Clean Note Policy is to withdraw non-issuablenotes well in time and put fresh notes in circulation intheir place. This exercise is dependent on the capacityof the Bank to cope with the need to process anddispose of the notes so withdrawn. While movementof soiled notes from currency chests to Issue Officescould be expedited by several methods, the real issuewas the manner in which the processing capacity inthe Issue Offices could be augmented so as to matchthe huge flow of notes from the chests. In view of thelimitation to expansion of capacity manually, it becameimperative to supplement the effor t of manualprocessing by mechanical processing. The Bankadopted mechanisation of the note processing activityin a big way with instal lat ion of 48 CurrencyVerification and Processing Systems (CVPS) and 27Shredding and Briquetting System (SBS) in 18 IssueOffices. The CVPS are high-speed fully automaticmachines designed to sort currency notes into fit andunfit categories capable of processing 50,000-60,000pieces of soiled notes per hour. The fit notes arecounted and banded to make packets of 100 pieceseach while the unfit notes pass on automatically tothe on-line shredding unit where they are shreddedinto very small pieces. The shredded pieces are thensucked into the briquetting unit of the SBS wherethese are converted under high air pressure intocompact br iquet tes and disposed of in anenvironment-friendly manner. A beginning has beenmade in the direction of mechanisation of cashhandling activity by the commercial banks as well.As a first step for easing the pressure on thedistribution channels, coin distribution has beenoutsourced to private transport operators and thepractice of Reserve Bank staff and police personnelaccompanying coin remittances has been doneaway with.

4.92 The security features of banknotes arereviewed and updated from time to time, takingadvantage of the research and technology in the field.The approach has been to improve the securityfeatures on the existing design so as to combatcounterfeiting and to incorporate a mixture of securityfeatures on a completely new series of notes. Withthe advancement of reprographic techniques,traditional security features were deemed inadequate.A new series of notes stylised as the ‘MahatmaGandhi Series’ was introduced in 1996. A changedwatermark, windowed security thread, latent imageand intaglio features for the visually handicapped areamongst the new features. In tune with theinternational trends in security features, the ReserveBank has now come out with banknotes of 2005 series

with machine-readable security features. In view ofthe greater risk perception in higher denominationbanknotes, the banknotes of Rs 100, Rs 500 and Rs1000 have been strengthened with more securityfeatures. It is noteworthy that all notes issued in anydesign by the Reserve Bank continue to be legaltender, although, over a period of time, notes in aparticular design may not be seen any more becauseof lack of fresh issues in that design.

4.93 In tandem with the technological innovations,the Reserve Bank has taken up the task of putting inplace an Integrated Computer ised CurrencyOperations and Management System (ICCOMS) witha view to ushering in greater operational efficiency,improved customer service and providing decisionsupport tools for policy making in the area of currencymanagement. The project involves computerisationand networking of the currency chests with theReserve Bank’s Offices to facilitate prompt, efficientand error-free reporting and accounting of thecurrency chest transactions in a secure manner. Thesystem will provide a uniform computing platformacross all the Regional Offices for transactionprocessing, accounting and management informationsystems relating to currency.

4.94 The circulation of currency in India hasincreased phenomenally (both in volume and valueterms). At the time of establishment of the ReserveBank in 1935, the volume of notes in circulation stoodapproximately at 100 million pieces. As on March31, 2005, the notes in circulation had risen to 36,985million pieces (Rs.3,61,229 crore in value terms). Aspart of management of the demand for currency, ithas been the endeavour of the Reserve Bank tocontain the volume of notes in circulation bycoinisation of lower denomination notes and aconscious shift towards higher denomination notesin circulation.

4.95 The Reserve Bank continues to conduct itscurrency management operations with a view toensuring the optimal customer service through anadequate supply of good quality and secure notesand coins in the country. Clean notes and intensifiedanti-counterfeiting measures remains a concurrentobjective, alongside continuous up-gradation of thesecurity features. With the modernisation ofinfrastructure, di f fusion of IT ini t iat ives incomputerisation of bank branch operations and theadvances in the communication facilities are expectedto bring about further improvements in customersatisfaction and create the necessary environmentfor ongoing improvements in currency management.

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Payment and Settlement Systems

4.96 Payment and settlement systems featureprominently as the backbone of economic activity inany modern society. One of the characteristic featuresof the Indian economy is the widespread use of cashin the settlement of most of the financial transactions.

While this has been the trend for several years, it isnoteworthy that India had pioneered the use of non-cash based payment systems long ago, which not onlystood the test of time but had also establishedthemselves as strong instruments for the conduct oftrade and business (Box IV.3). With the gathering

The earliest payment instruments known to have been usedin India were coins, which were either punch-marked or castin silver and copper. While coins represented a physicalequivalent, credit systems involving bills of exchangefacilitated inter-spatial transfers. The most important formof credit instruments that evolved in India was termed asHundis. Their use was most widespread in the twelfth centuryand has continued till today. Hundis were either used asremittance instruments (to transfer funds from one place toanother) or credit instruments (to borrow money [IOUs]) orfor trade transactions (as bills of exchange).

With the steady growth in volumes of trade and commerceand the growing confidence of the public in the usage ofcheques etc., transactions through these paymentinstruments grew rapidly. Bank employees had tofrequently walk to other banks, collect cheques and drafts,present them to drawee banks and collect cash over thecounter, which had the danger of loss in transit. Moreover,such methods could only serve the purpose of limitedvolumes of instruments. With the development of thebanking system and a higher turnover in the volume ofcheques, the need for an organised cheque clearingsystem emerged. Clearing associations were formed inthe Presidency towns and the final settlement betweenmember banks was effected by means of cheques drawnon the Presidency Banks. With the setting up of theImperial Bank in 1921, settlement was done throughcheques drawn on that bank.

In a country marked by the overwhelming usage of cashas a means for settlement of payments, the switch over tonon-cash based modes has been a gradual but definitivetrend. The most significant one has been the use of non-cash paper based systems (cheque-based) in which banksplay a pivotal role. In order to ensure that cheques issuedget transformed into cash, the process of settlement ofthese cheques which were exchanged between the bankwhose customer had deposited the cheque and the bankon which the cheque was drawn on, commenced. Thedevelopment of the banking system and higher turnoverin the volume of cheques gave rise to the need for anorganised cheque clearing process. Clearing associationswere formed by banks in the Presidency towns and thefinal settlement between member banks was effected bymeans of cheques drawn upon the Presidency Banks.

The Calcutta Clearing Banks’ Association, which was thelargest bankers’ association at that time, adopted

Box IV.3 Evolution of Payment and Settlement Systems in India

clearing-house rules in 1938. The association had twenty-five large banks as members and eight sub-members.However, the association did not cover many banksfunctioning in Calcutta. The cheques, drafts etc. of suchnon-clearing banks were collected by the clearing bankson payment of charges. This affected their businessadversely, as the public was not likely to maintainaccounts with banks whose cheques suffered a serioushandicap of market acceptability. To overcome thisproblem, these banks formed themselves into a groupcalled the Metropolitan Banking Association with fiftymembers, which conducted the Metropolitan ClearingHouse, in 1939. This associat ion reached anunderstanding with the Calcutta Clearing House in 1940.In addition, two other clearings were conducted inCalcutta - the Pioneer Clearing and the Walks Clearing.The Bombay Clearing House was the only association toconduct clearings in Bombay. It had no parallel systems/institutions comparable to the Metropolitan ClearingHouse of Calcutta. The uniform procedures and chargesfor collection of non-clearing banks’ cheques, drafts,dividend warrants etc. were adopted by the BombayClearing House in 1941-42.

After the setting up of Reserve Bank in 1935, the ClearingHouses in the Presidency towns were taken over by theReserve Bank. The Reserve Bank, by virtue of extendingthe facility of maintaining the current accounts of banks,could facilitate the settlement arrived out of the clearingprocess. Thus began the early processes of clearingfacilities extended by the Central bank. With the extensionof current account facilities for banks at the variouslocations where the Reserve Bank had its offices, themanagement of clearing-houses at these locations alsocame under the purview of the Reserve Bank.

The Reserve Bank continued to extend clearing-housefunctions for almost five decades as a customary function.In view of the regulatory role played by the Reserve Bankand since the members of the clearing houses werecommercial banks regulated by the Central bank, theReserve Bank also took upon itself the role of regulatingthe clearing functions. Some of the initiatives in this regardincluded the formulation of Uniform Regulations and Rulesfor Bankers’ Clearing Houses and the monitoring ofpayment flows through the larger clearing-houses.

Source: Reserve Bank of India (1998).

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pace of globalisation and advances in technology,the importance of safe, sound, secure and efficientpayment and settlement systems is recognised bythe banks, the world over. It is in this context thatthe Core Principles for Systemically ImportantPayment Systems of the Bank for InternationalSettlements (BIS) assumes significance.

4.97 Recognising the importance of payment andsettlement systems, the Reserve Bank had takenupon itself the task of setting up a safe, efficient androbust payment and settlement system for the countryfor more than a decade now. Since clear ingoperations were at the heart of efficient payment andsettlement systems, the thrust area was on suchsystems. One of the key driving factors in the reformsaimed at improving the existing systems wastechnology. With the technological developments,which have had a significant impact on the bankingsector, the pace in reforms was accelerated with thefillip provided by technology for use by modernpayment and settlement systems. In the recent past,the Reserve Bank has been placing emphasis onreforms in the area of payment and settlementsystems. The efforts of the Reserve Bank have beento ensure full compliance to the core principles of BIS(mentioned above) and one of the moves aimed atreducing risks – especially settlement and systemicrisks – has been the introduction of the Real TimeGross Settlement (RTGS) system.

4.98 Prime among the concerns of the ReserveBank are the factors relating to risk management andrisk reduction, with specific reference to systemicrisks (which are risks capable of having a negativeimpact on the entire group of participants in anypayment and settlement system). It was with thisobjective that the RTGS system was planned, whichhas now become a reality. The system, in its presentform, would take care of all inter-bank transactionsand other features would be added on soon. Bankshave risen to the occasion in ushering in a system,which uses the latest technology and relies, to a largeextent, on network-based information flows.

4.99 In view of the positive response of the financialsector to the initiatives of the Reserve Bank and thebanking sector also coming of age, the Reserve Bankhas now taken the policy perspective of migratingaway from the actual management of retail paymentand settlement systems. Thus, for a few years now,the task of setting up new MICR based chequeprocessing centres has been delegated to thecommercial banks. This approach has yielded goodresults and the Reserve Bank now envisions the

normal processing functions to be managed andoperated by professional organisations, which couldbe constituted through participation from banks. Thiswould be applicable to the clearing houses as well,which will perform the clearing activities, but thesettlement function will continue to rest with theReserve Bank, which would ensure that thesettlement is done in Central Bank money, as requiredin terms of the Core Principles of the BIS (op cit).With this, the Reserve Bank will continue to haveregulatory oversight over such functions withoutactually acting as the service provider. The exceptionto this would be the RTGS, which, on account of itssystemic importance, is retained by central banksthe world over. The RTGS, which provides for fundstransfer across participants in electronic mode withreduced risk, will be operated by the Reserve Bank.Th is system, apar t f rom ensur ing systemicefficiency, would also be attuned to the canons ofthe monetary policy.

Information Technology

4.100 Information technology (IT) has transformedthe functioning of businesses, the world over. It hasbridged the gaps in terms of the reach and thecoverage of systems and enabled better decision-making based on latest and accurate information,reduced costs and overall improvement in efficiency.In the Indian context, the financial sector, especiallythe banking sector, has been a major beneficiary fromthe inroads made by IT. Many new processes,products and services offered by banks and otherfinancial intermediaries are now IT-centred. Effectiveintegration of technology with sound businesspractices requires business process re-engineeringand banks in India need to follow up on the beginningsmade in this regard. Newer delivery channels tocustomers – Automated Teller Machines (ATMs), andthe networking of ATMs in the form of SharedPayment Networks, Internet Banking - andimplementation of Core Banking solutions by mostbanks are some examples.

4.101 The Reserve Bank has played a proactive rolein the implementation of IT in the banking sector. ITbased initiatives would focus on meeting the threepronged objective of better house keeping, improvedcustomer service and overall systemic efficiency.Within the Reserve Bank, initial efforts in the 1980saimed at mechanisation of activities were expandedduring the 1990s into computerisation of critical areasof operation. The Reserve Bank has come out with aFinancial Sector Technology Vision Document

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outl ining the approach to be fol lowed for ITimplementation for the medium term period of aboutthree years. This document will help banks infinalising their IT plans in tandem with the overallapproach for the banking sector, as envisioned by theReserve Bank.

4.102 In recent years, there has been a renewedthrust on putting in place comprehensive systemsfollowing the Generic Architecture within the ReserveBank and providing solutions to enhance theefficiency of the payment and settlement systems inIndia. Priority is being attached to the strengtheningof the institutional framework for the regulation andsupervision of payment and settlement systems. Asa part of this initiative, the Reserve Bank hasconstituted the Board for Regulation and Supervisionof Payment and Settlement Systems (BPSS) as aCommittee of its Central Board. The functions andpowers of BPSS include policy formulation relatingto the regulation and supervision of all types ofpayment and settlement systems, setting standardsfor existing and future systems, authorisation of thepayment and settlement systems and determinationof criteria for membership to these systems. A newdepartment called the Department of Payment andSettlement System (DPSS) has also been constitutedin the Reserve Bank. The National Payments Council,functioning since 1999, received recognition of aTechnical Advisory Committee to the BPSS. Thedirection provided in the Vision Document wouldprovide a road map for streamlining and refining thepayment systems in the medium term.

Regulation and Supervision

4.103 Regulation and supervision of the financialsystem has received renewed focus in recent yearsin the context of the phenomenal expansion of thefinancial sector, technology-enabled innovations infinancial products and deepening of global integration.The strategic importance of the banks in the financialsystem make it imperative for the central bank –historically, the lender of the last resort and thesupervisor of the banking system - to pursue financialstability as an important macroeconomic objective,although, in India, there are separate institutions (viz.,the SEBI and the IRDA) to oversee the functioning ofindividual segments of the financial system. A numberof initiatives have been taken by the Reserve Bank inreorienting the supervisory and regulatory frameworkand aligning it with the international best practices,while providing sufficient flexibility to the financialinstitutions to respond to the growing competition and

taking advantage of the business opportunitiesunfolded by technological advancements.

4.104 The Narasimham Committee II made a rangeof recommendations for improving the vigour of thebanking system (capital adequacy, asset quality, non-performing assets, etc.) as also for strengthening thesupervisory systems. The Committee observed thatthe issue of ‘autonomous status’ for the Board forFinancial Supervision (BFS) of the Reserve Bankshould be considered to segregate the regulatory andsupervisory funct ions of the apex bank. TheCommittee made specific recommendations torestructure the BFS and to set up a separate Boardfor Financial Regulation and Supervision (BFRS). TheCommittee also recommended that the regulatory andsupervisory authorities should take note of thedevelopments taking place elsewhere in the area ofdevising effective regulatory norms and to apply themin India taking into account the special characteristicsbut not in any way diluting the rigor of the norms sothat the prescriptions match the best practicesabroad. The committee also highlighted the need fora review of banking sector laws, such as, the RBIAct, the Banking Regulation Act, the NationalisationAct and the State Bank of India Act. Therecommendations made by the Committee are beingprogressively implemented.

4.105 Fol lowing the recommendations of theNarasimham Committee II and more recently in thecontext of the Basel II Accord, the Reserve Bank hastaken several measures to strengthen its regulatoryand supervisory framework with a view to ensuring asound, efficient and vibrant financial system in thecountry. The measures to contain the level of non-performing assets (NPAs) include the setting up ofDebt Recovery Tribunals for expeditious adjudicationand recovery of debts due to banks and financialinstitutions, Lok Adalats (people’s courts) and AssetReconstruction Companies and Corporate DebtRestructuring (CDR) mechanisms. In order to ensurethe functioning of institutions and markets on thebasis of informed decisions, the Reserve Bank hasissued guidelines to banks to enhance the level oftransparency and disclosures with regard to theirfinancial position (RBI, 2005).

4.106 In recent years, centra l banks areincreasingly focusing their attention not only onindividual banks but also on the issues of financialstability. Banks are subjected to more intenseregulation as compared to the non-financial firms,in view of the special characteristics of banks. Banksare much more leveraged than the other firms due

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to their capacity to garner public deposits. Theasset-liability structure of banks is different fromother financial firms. The deposits, which constitutea major part of the liability of banks, are repayableon demand, unsecured and their principal amountdoes not change in value whereas the loans of abank are illiquid and there can be erosion in the valueof loans and of other assets.

4.107 Bank regulation is increasingly getting risk-based with the realisation that the tradit ionalsupervisory practices were out of step with thesophisticated risk management techniques. TheInternational Convergence of Capital Measurementand Capital Standards: A Revised Framework(popularly known as Basel II) has brought regulationand risk management to the center stage. Basel IIrests on three pillars: minimum capital requirements,supervisory review process and market discipline.India has decided that all the commercial banks wouldhave to be Basel II compliant by adopting, at aminimum, the Standardised Approach for credit riskand Basic Indicator Approach for operational riskunder Pillar 1, with effect from March 31, 2007. Asregards the supervisory review process (Pillar 2), therole of supervisors is to evaluate whether or not thebanks are assessing their capital requirementsproperly in relation to their risks and if necessary thesupervisors may intervene to mandate a higher capitalrequirement. As regards Pillar 3, the Reserve Bankhas been advising banks to make disclosures in orderto enhance market discipline.

4.108 The implementation of Basel II will initiallyrequire more capital for banks in India due to the factthat operational risk is not captured under Basel Iand the capital charge for market risk was notprescribed until recently. As commercial banks arescheduled to start implementing Basel II with effectfrom end-March 2007, the Reserve Bank will focuson supervisory capacity-building measures to identifythe gaps and to assess as well as quantify the extentof additional capital, which may have to be maintainedby such banks. Finally, while recognising theimportance of consolidation, competition and riskmanagement to the future of banking, the ReserveBank wil l continue to lay stress on corporategovernance and financial inclusion.

IV. CONTEMPORARY ISSUES

4.109 The narrative in the preceding three sectionsrevealed s ign i f icant expans ion as wel l astransformation in the central banking functions inIndia over the period since 1935. The initiatives that

the Reserve Bank undertook in developing financialinstitutions and markets reflect the structuralfeatures of the economy, in particular, the financialsector, as also the Bank’s response to the unfoldingof circumstances. Nonetheless, monetary policyremains the central preoccupation of the ReserveBank as that of any other central bank. A numberof issues – transparency, policy focus and centralbank autonomy – have been the subject matters ofintense debate, especially in the context of adoptionof international best practices. A related questionis whether the pursuit of financial stability as anexplicit objective reduces the maneuverability ofmonetary policy (Nachane, 2005). It deserves ament ion that these issues are inter-re lated.Transparency goes a long wi th cent ra l bankindependence - if the monetary policy decisions areto be taken independently then the public at largeand the legislature in par t icular needs to beexplained the rationale. The announcement ofexplicit policy objectives is a crucial ingredient oftransparency in monetary policy formulation and theoperational autonomy of the Reserve Bank is seenas a pre-requisite in the move towards ensuringtransparency.

4.110 A comparison of the monetary framework inIndia in a global setting would be in order. In theIndian context, discretion gets a higher score thanthe specific short and medium-term policy focusobjectives (exchange rate focus, money focus orinflation focus). Central bank independence gets ahigher score vis-à-vis accountability and transparency.The emphasis on independence, in fact, finds thetop rank in the monetary framework of central banksin most countr ies, although accountabi l i ty toGovernment scores over independence in a numberof developing economies. Financial stability issuesget a high score in India, which is comparable to thecrisis-affected Asian economies (Indonesia, Korea,Malaysia and Thailand). In the case of policyanalysis, India’s focus lies in the money and bankingsectors. In the spheres of the analysis of inflationexpectation and the use of models and forecasts,India’s position is unenviable (Table 4.1).

Transparency in Monetary Policy Formulation

4.111 The traditional approach to central bankingpolicy formulation characterised by “secrecy” or“unanticipated monetary policy” was relevant in atightly regulated system where the financial marketslooked to the central banks for direction and centralbanks were regarded as an arm of the government;

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central banks were not accountable to the public. Inthe context of f ree-enterpr ise markets, i t isincreasingly being recognised that f inancia linstitutions would be able to take rational decisionsif they have the complete background to the policies.Thus, transparency is being viewed not only anaspect of good governance but a pre-requisite to thesoundness of f inancial inst i tut ions. With theincreasing convergence of views in this regard, theIMF recommended to the member countries to adopta Code of Good Practices on Transparency inMonetary and Financial Policies (September 1999).Effective transparency, as per the IMF Code, requiresmore than just the release of adequate informationon monetary and financial policies – it involves clarityof roles, responsibilities and objectives of centralbanks and an insight into the analytical underpinningof its policy action.

4.112 Against this backdrop, the Reserve Bankconstituted a Standing Committee on InternationalFinancial Standards and Codes and a number ofAdvisory Groups to examine the specific aspects. TheAdvisory Group on Transparency in Monetary andFinancial Policies (Chairman: M. Narasimham) made

a cr i t ical evaluat ion of the exist ing state oftransparency of monetary and financial policies inIndia, identifying the areas where improvements wererequired. With a view to moving towards a moretransparent system, the Advisory Group consideredit best “to veer towards prescribing to the ReserveBank a single objective while the government couldhave for itself a clearly set out hierarchy of objectivesfor which it could use its other instruments of policy”.Considering the fact that transparency is intricatelyrelated to the legislative framework, it highlighted theneed for an amendment of the RBI Act to give asharper focus to the objectives of monetary policy andto provide, through legislat ive amendments,“reasonable secur i ty of tenure” to the TopManagement of the Bank. The recommendations ofthe Advisory Group include: separation of debtmanagement and monetary policy functions so as toprovide the Reserve Bank the “headroom” to operatemonetary policy; setting up of a Monetary PolicyCommittee (MPC) as a Committee of the RBI CentralBoard; and assigning to the Reserve Bank a singleobjective for monetary policy, viz., the inflation rateand then giving unrestricted instrument freedom tothe Bank.

Table 4.1: Summary Scores for Monetary Framework Characteristics in Select Countries(Percent of maximum)

Country Short and medium term policy focus on Institutional Characteristics Use and importance of various Structuralparticular objectives forms of monetary analysis Characteristics

Exchange Money Inflation Discretion* Indepen- Accountab- Policy Inflation Analysis Importance Importancerate focus focus focus dence ility of Explana- Expecta- using of of

Central tions tions models analysis FinancialBank to and of money Stability

Government forecasts and Issues inbanking setting

sector instruments

1 2 3 4 5 6 7 8 9 10 11 12

Bangladesh 31 75 44 63 56 83 39 25 6 56 17China 25 88 31 41 68 100 63 83 72 78 33India 6 50 44 75 83 67 75 0 11 89 67Indonesia 6 63 50 66 56 83 83 50 100 89 83Malaysia 38 0 44 75 85 83 71 67 17 56 67Sri Lanka 6 19 19 94 54 58 48 17 11 56 33Thailand 6 6 31 75 82 50 67 0 83 67 83Germany 13 88 19 28 96 17 70 50 56 56 33Japan 0 0 50 50 93 … 89 75 72 78 50Korea 6 75 63 59 73 83 88 17 78 100 58Sweden 13 0 100 6 97 83 95 100 78 33 42Switzerland 19 75 19 44 90 17 86 33 50 56 8UK 0 0 100 0 77 100 94 100 94 56 16USA 0 25 19 84 92 83 95 83 89 33 33

* Discretion depends only on the scores for exchange rate targeting, money targeting and inflation targeting. Discretion is calculated as twice themaximum of these scores minus the sum of the other two. It is converted to an index between zero and 100, where a high score implies morediscretion.

Source: Fry et al (2000).

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4.113 In Section III mention has been made aboutthe measures undertaken by the Reserve Bank inevolving and adopting international best practices. Itmay be added that the Reserve Bank has beenadopting a consultative approach - setting up workinggroups and committees with a wider participation ofacademicians and exper ts from the market todeliberate on various policy issues. The draft reportsare generally placed in public domain for inputs, inpar ticular, from industry associations and self-regulatory bodies. In conformity with international bestpractices and with a view to strengthening theconsultative process in monetary policy formulation,the Reserve Bank set up in July 2005 a TechnicalAdvisory Committee on Monetary Policy (TACMP)with external exper ts in the areas of monetaryeconomics, central banking, financial markets andpublic finance. The Committee would meet at leastonce in a quarter to review the macroeconomic andmonetary developments and advise the Reserve Bankon the stance of monetary policy. The views of theTACMP would be discussed in the following meetingof the Committee of the Central Board of the ReserveBank. In the direct ion of separat ion of debtmanagement from monetary policy formulation, twoaspects – the initiatives taken by the Reserve Bankto strengthen the government debt market (elaboratedin Section III) and the setting up of a separatedepartment named Financial Market Department inthe Reserve Bank in July 2005 – merit mention.

Rules Versus Discretion

4.114 In the sphere of monetary management, acrucial issue relates to policy focus, i .e., theannouncement of specific short and medium-termpolicy focus objectives. Since the 1990s, explicittargets are being widely used and a number ofcountries have adopted inflation targeting (Fry et al,2000). In India, however, as mentioned earlier, the“multiple indicator approach” is being pursued. On this,the Advisory Group on Transparency in Monetary andFinancial Policies (op cit) observed: “There is greatcomfort in a multiple objective approach in thatprecision is not required in defining the objectives andthe Reserve Bank in turn does not have muchaccountability as it juggles with the almost impossibletask of fulfilling contradictory objectives and as suchaccountability is blurred” (RBI, 2000).

4.115 Is the emphasis on discretion or the multipleindicators approach vis-à-vis the global convergencetowards a single objective misplaced? From ahistorical perspective, the monetary policy stance in

India has been guided by the specific circumstances,at times deviating from the prevailing wisdom (Section I).In the present case, the emphasis on discretionreflects several factors. At an abstract level, thepreference of central banks to exercise discretion inthe use of policy instruments is based on the followingargument. The continuous flow of new information andthe process of expectation formation adding to thebase level information about the current state of theeconomy might make the application of the rigid rules– based on histor ical information or abstracthypotheses – ineffective in addressing the unfoldingproblems (Vasudevan, 2003). There are also severalpractical difficulties in pursuing a single objective suchas the explicit inflation target. Structural factors andsupply shocks – both from within the economy andoutside – render inflation dependent on monetary andnon-monetary factors. A fully dependable measureof inflation for targeting purposes needs to bedeveloped. Given the institutional features (thepersistence of f iscal dominance), the debtmanagement function gets inextricably linked with themonetary management function while steering theinterest rates. In the absence of fully integratedf inancial markets, the effect iveness of thetransmission channel of policy is yet to be established.Under these circumstances, it is necessary tocareful ly measure and balance the possibleoutcomes, taking into account the movements in avariety of monetary and other indicators.

Central Bank Independence

4.116 The debate on central bank independence inIndia is as old as the institution itself. At the time ofthe establishment of the Reserve Bank, public opinionin India was strongly in favour of an independentcentral bank. The “London Committee” (which wasappointed to draft the Reserve Bank of India Bill,1933) took the view that the Reserve Bank should befree from any political influence and consideredprivate share holding as the best course to attain thisobjective. Whereas in those days it was essentially aquestion of ownership of the Reserve Bank, thecontemporary debate on central bank autonomygenerally focuses on the operational aspects - thefiscal dominance or what is described as the use ofmonetary policy as a ‘handmaiden’ to fiscal policy(Nachane, 2005); and the legislative provisions thatconstrain the operational flexibility of the ReserveBank (RBI, 2000).

4.117 In the development phase, the growingborrowing programmes of the Government and its

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The Union Finance Minister in his budget speech inFebruary 2000 had observed that the fast changing worldof modern finance had made it imperative to accord greateroperational flexibility to the Reserve Bank in conductingmonetary policy and regulation of the financial system andthat he intended to bring to the Parliament proposals foramending the relevant legislation. The Reserve Bank ofIndia (Amendment) Bill, 2005, as introduced in the LokSabha, aims at bestowing the enabling powers on theReserve Bank to use a larger variety of f inancialinstruments than hitherto and more flexibility to set thecash reserve ratio. The major provisions of the RBI(Amendment) Bill 2005 are as follows.

The Bill proposes to permit dealing in derivatives, and,with the approval of the Central Board, in any other financialinstrument, by inserting a clause (6A) to Section 17. Itseeks to specify the underlyings in respect of whichderivates may be dealt in by Reserve Bank so that thepowers of Reserve Bank to deal in derivatives are notrestricted as in the case of derivatives over which it hasregulatory powers.

Box IV.4The Reserve Bank of India (Amendment) Bill, 2005

In order to clear ambiguities in the use of repos and reverserepos for liquidity management by the Reserve Bank, it isproposed to specifically authorise the Bank to lend orborrow securities, whether of Central Government, Stategovernments, or any local authority or foreign securities.It is proposed to add clause (12AA) permitting the ‘lendingor borrowing of securities of the Central Government or aState Government or of such local authorities as may bespecified in this behalf by the Central Government orforeign securities;’ and clause (12AB) dealing in repo orreverse repo.

The Bill proposes to introduce a new chapter IIID,containing the definitions of the concepts (derivatives, repoand reverse repo) and the powers of the Reserve Bank toregulate the Money Market. In order to provide greateroperational flexibility to the Reserve Bank, the Bill proposesto remove the minimum and maximum limits of the cashreserve ratio (CRR) under Section 42 of the RBI Act. Further,it is proposed to remove the provision for payment of interestto banks on the excess CRR maintained, as it reduces theeffectiveness of CRR as a monetary policy tool.

monetisation by the Reserve Bank - gave rise toquestions regarding the relative roles of the fiscalpolicy and the monetary policy. Monetary policy,particularly in the 1980s, had to address itself to thetask of neutralising the inflationary impact of risingfiscal deficits. The Chakravarty Committee stronglyadvocated a system of monetary targeting that wouldbind the Government and the Reserve Bank to amutually agreed level of net Reserve Bank credit tothe Government. The case for according greateroperational flexibility to the Reserve Bank in theconduct of monetary policy and regulation of thefinancial system has become stronger since the1990s, especially in the context of increasing globalintegration of the Indian economy. Rangarajan (1993)defined the independence of central banks as “theinstitutional arrangements for the conduct of monetarypolicy” and condemned the practice of automaticmonetisation of the Government’s fiscal deficitthrough the issue of ad hoc treasury bills as theprincipal factor impinging on the effective conduct ofmonetary policy in the Indian context.

4.118 The phasing out of ad hoc Treasury Bills andthe enactment of Fiscal Responsibility and BudgetManagement (FRBM) legislation are two importantmilestones in providing safeguards to monetarypolicy from the consequences of fiscal expansionand ensuring better monetary-fiscal co-ordination.The FRBM Act 2003, which became effective from

July 5, 2004, mandates the Central Government toeliminate the revenue deficit by March 2009 andreduce fiscal deficit to an amount equivalent to 3per cent of GDP by March 2008. The proposedlegislation to amend the RBI Act seeks to providemore operational flexibility to the Reserve Bank inconducting monetary policy, guiding the developmentof the financial sector and securing the stability ofthe financial sector (Box IV.4).

V. CONCLUSIONS

4.119 In the context of growing research interest oninst i tut ions as a determinant of economicdevelopment, this chapter provided a brief narrativeon the evolution of central banking in India since 1935when the Reserve Bank of India was established. TheReserve Bank was founded on the pattern ofEuropean central banks; but the evolution of itsfunctions has undergone radical transformations fromtraditional central banking in the formative years tothat of building institutional infrastructure during thedevelopment phase and ensuring financial sectorsoundness in the reform phase.

4.120 With the onset of economic planning and alongwith the structural transformation of the Indianeconomy, the functions of the Reserve Bank expandedmanifold. As the central bank of a developing countyemancipated from centuries old colonial rule, the

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Reserve Bank had to take a proactive role in thenation building process in filling the resource gapsof the Governments in Plan financing and in creatingnecessary financial infrastructure. As a ‘mother-of-institutions’, the Reserve Bank played a crucial rolein the development of the financial sector in India.In the initial years, the emphasis was on putting inplace the inst i tut ional machinery to suppor tdevelopmental planning, whereas in the reform era,the focus has been on developing and nurturing thefinancial markets.

4.121 Global developments (such as, the SecondWor ld War, breakdown of the Bretton Woodssystem) did influence the functioning of the ReserveBank; but the major milestones in the evolution ofcentral banking in India emerged out of the criticalrole devolved on the Bank. The monetary policyframework in India has undergone shifts along withthe global evolution in the art of central banking.In fact, India was the forerunner among developingcountries to adopt monetary targeting in 1985. Thetransformations in the monetary framework sincethe 1990s – notably, the shift from direct to indirectinstruments of control – have been in line with theglobal trends, while concerns regarding financials tab i l i ty have been paramount in monetarymanagement in India, as in other economies

(Jadhav, 2005). The Reserve Bank has chosen aconsultative approach in policy formulation and anumber of institutional arrangements have been putin place. On the issue of integrating Indian financialmarkets with the global financial system, however,India has chosen to proceed cautiously and in agradual manner, adjusting the pace of liberalisationwith the underlying macroeconomic developments,the state of readiness of the domestic financialsystem and the dynamics of international financialmarkets. The Reserve Bank has taken a number ofini t iat ives to strengthen the supervisory andregulator y f ramewor k, whi le s imul taneouslyproviding suff icient f lexibi l i ty to the f inancialinstitutions to respond to the growing competitionand take advantage of the business opportunitiesunfolded by technological advancements. Whilepursuing the reforms, the Reserve Bank has alsomade conscious ef for ts to improve systemicef f ic iency by appropr ia te ly re-or ient ing thet rad i t iona l funct ions inc lud ing cur rencymanagement and regulation of payments andsettlement systems. All these initiatives havestrengthened the financial sector in India, enablingit to adapt to the emerging environment and this isreinforced in the change in the perception of theworld community towards India as an upcomingeconomic powerhouse.

IV CENTRAL BANKING IN INDIA - Reserve Bank of India · of the Bank. After the separation of Burma,...

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