10

Monetary and Credit Policy Reforms in India

V. R. Prabhakaran Nair

10.1 Introduction

The monetary and credit policies of the Reserve Bank of India (RBI), coupled with the fiscal policy of the Government of India, influence the pace and direction of the economic development. The comfortable liquidity, stable interest rate and timely flow of credit to the productive economic activities induce investment and production with the result that the growth process gets a stimulus. India’s Monetary and Credit Policy (MCP) in the reform period has attracted attention since it has undergone pertinent changes. Along with the financial sector reform adopted in 1991, the MCP reforms were initiated with the short-term interest rate playing a prominent role than the other channels in the monetary policy transmission mechanism (Bhattacharya and Sensarma, 2008). Contrary to the traditional stance of the monetary policy intend to regulate the issue of bank notes and the keeping of reserves, and to achieve monetary stability mainly through the currency and credit system, the post-reform period aimed at price stability and economic growth by adjusting the interest rates under the multiple-indicator approach. In terms of the objectives, framework and instruments, the MCP has undergone major changes to reflect the transition from a closed and controlled to an open and liberalized regime. In this context, the chapter traces the reforms in the MCP of India to examine the imperatives and features involved in it.

10.2 MCP in the Pre-Reform Period

Prior to the financial reforms, the instruments of control in the financial sector included various interest rates on the deposits and lending being fixed by the central bank, the high reserve requirements, the quantitative credit restrictions and the concessional interest rates for specified sectors along with cross-subsidization and restrictions on the scope of activities of the financial institutions. The financial markets were thus characterized by barriers to the entry, control and over pricing of the financial assets, the high transaction costs and restrictions on the movement of funds from one market segment to another in the controlled regime. The main features of the MCP in the pre-reform period are discussed below.

10.2.1 Administered Interest Rate Regime

The financial system has evolved in an environment of administered interest rates and maintaining stipulations on credit distribution. The deposit and lending rates of banks were fixed by a complex web of regulations. A substantial part of the credit was channellized to the government and the priority sectors at below market rates. The financial system was dominated by public institutions and there was hardly any competition.¹ These government controls were intended to provide cheap credit to the specific sectors and economic activities and to finance the budget constraints at a relatively low cost. In order to meet these objectives, there was cross-subsidization in the financial system. An element of crosssubsidization implicit in an administered system of lending rates meant that some borrowers had to pay higher rates than the others. The Indian financial system remained largely segmented due to an administered interest rate regime and direct credit controls, which prevented proper pricing of the instruments. Since then, the government raised resources from the banking system at interest rates, which were not market-related. In short, in the pre-reform period, the Government of India determined the quantum, allocation and price of credit, a situation referred to as ‘financial repression’ in the financial system.

10.2.2 High Statutory Preemptions and Monetization of Fiscal Deficit

In the pre-reform period, the RBI had to resort to direct instruments like the interest rate regulations, the selective credit control and the Cash Reserve Ratio (CRR) as major monetary instruments. These instruments were used intermittently to neutralize the monetary impact of the government’s budgetary operations. The RBI imposed relatively high reserve requirements consisting of the CRR and the Statutory Liquidity Ratio (SLR)² in the prereform period. As a percentage of the Net Demand and Time Liabilities (NDTL), the CRR was hiked to 15 per cent in July 1989 from 3 per cent in September 1962. The SLR also attained its peak 38.5 per cent of NDTL in 1991 from 25 per cent in 1964. The negative implication of the preemptions was evident from the fact that by 1991 the statutory preemptions under the CRR and SLR, on an incremental basis, reached a level of 63.5 per cent; and even of the balance 36.5 per cent, there were preemptions under the priority sector of 40 per cent—export credit, food credit and other formal and informal preemptions (Tarapore, 1997). Thus the credit policy under the financial repression regime resulted in distortions in the resource mobilization and restricted the freedom of intermediation of banks. The retail lending to more risk-prone areas at concessional interest rates has raised the costs, also affected the quality of bank assets and strained their profitability. The inefficiency in the deployment of credit and deteriorating bank profitability also went hand in hand with inadequate capitalization and insufficient provision for bad debts by the banks (Government of India, 1991).

Theoretically, the high reserve requirements could lessen the overall resources available to the commercial banks for lending and vice versa. The preempted resources were used to finance the increasing fiscal deficit by way of subscription of the Government Treasury Bills, dated securities and other debt instruments. The RBI’s unlimited subscription of the government securities and debt instruments resulted in the automatic monetization of the fiscal deficit in the economy. The ratio of monetization to the Gross Domestic Product (GDP) almost doubled from 1.1 per cent during the 1970s to 2.1 per cent during the 1980s (Reserve Bank of India, 2003). The net RBI credit to the central government, which constituted about three-quarters of the monetary base (reserve money) during the 1970s, rose to over 92 per cent during the 1980s. This monetization of government deficit resulted in inflation and the increasing liquidity in the banking system further necessitated the RBI to resort to direct instruments of monetary control, particularly hiking the CRR to bring down the impact of inflation from monetization deficit. This ratio was used to neutralize the financial impact of the government’s budgetary operations (neutralizing the inflationary impact of the growing deficit), rather than as an independent monetary instrument.

10.2.3 Prominence of Credit Channel in Transmission Mechanism

The monetary policy has four transmission channels which are—the credit channel (quantum channel), the interest rate channel, the exchange rate channel and the asset prices channel. While the quantum channel operates through changes in the reserve money, the money stock or credit aggregates to directly affect the real output and price level, the other channels are indirect and affect real economy through changes in the interest rates, the exchange rates and the asset prices. For long, since the adoption of the monetary policy, the credit view occupied a prominent place in the India’s monetary policy transmission mechanism.³ From the First Five Year Plan itself, the credit planning was considered as an integral part of the growth process and a mechanism for achieving a balanced growth of all the sectors of the economy. The credit policy was a part of the monetary policy adopted by the RBI. As a plank of the monetary policy, the credit planning was a multidimensional and comprehensive exercise that involved monetary budgeting, the budgeting of financial savings to be mobilized by various financial intermediaries in the general and commercial banks in particular, the macro-level credit allocation among sectors, industries and regions and the evolving of instruments and mechanisms to get the macro projections translated into the macro-1evel decision-making. Prior to the initiation of the financial sector reforms in 1991, the credit market in India was tightly regulated. The credit planning approach initiated during the late 1960s gave emphasis to bank credit, both aggregate as well as sectoral, as a principal target of the monetary policy. As a result, the monetary policy up to the mid-1980s was primarily operated through the direct instruments with credit targets set as a part of the monetary budgeting. The credit market was, however, characterized by the various credit controls and directed the lending policies. The interest rates were determined by the monetary authority. Various credit controls that existed in the credit market resulted in several inefficiencies with a low productivity and profitability in the banking system. To overcome the problems in the credit market, a wide range of regulatory reforms were introduced as a part of the financial sector reforms in the early 1990s.

10.3 Reforms in Monetary and Credit Policy

It has been argued that, the administered interest rate ceilings in the pre-reform period suppress the savings rate, thus reducing the availability of loanable funds and investments, and also leads to an inefficient allocation of resources. Therefore, the financial reforms have been recommended. The foundation for the reform of the monetary and financial system was laid by the Committee to Review the Working of the Monetary System (Chakravarty Committee, 1985) and the Working Group on the Money Market (Vaghul Group, 1987). Later, against the backdrop of the balance of payments crisis in 1991 and the macro-economic adjustment, the Narasimham Committee (1991) was appointed with a view to promote a diversified and competitive financial system as a part of the overall structural reforms. The recommendations of the Chakravarty and Narasimham Committees resulted in many new steps by the RBI to move away from the direct monetary policy instruments to the indirect monetary control. The economic reforms, in fact, necessitated the policy changes pertaining to monetary and credit sector market-based financial systems to achieve the goals of the market-based financial system. In the process, a new institutional framework of the monetary policy became operational, creating a conducive environment for monetary management on a continuing basis since 1991–92.

10.3.1 Objectives in the Post-Reform Period

While the twin objectives of the monetary policy of maintaining price stability and ensuring availability of adequate credit to the productive sectors of the economy to support growth have remained unchanged; the relative emphasis on either of these objectives has varied over the years depending on the circumstances. Reflecting the development of the financial markets and the opening up of the economy, the use of broad money (M3) as an intermediate target has been de-emphasized, but the growth in M3 continues to be used as an important indicator of the monetary policy. The composition of reserve money has also changed with the net foreign exchange assets currently accounting for nearly one-half (Table 10.1).

A multiple-indicator approach was adopted in 1998–99, wherein interest rates or rates of return in the different markets (money, capital and government securities markets) along with such data as on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in the foreign exchange available on a high frequency basis were juxtaposed with the output data for drawing policy perspectives. Such a shift was gradual and a logical outcome of measures taken over the reform period since the early 1990s.

TABLE 10.1 Composition of Monetary Base

In view of the fairly stable demand function for money, the M3 has been treated as an intermediate target in the conduct of monetary policy. The RBI sets indicative broad money expansion targets in line with the expected rate of growth of the GDP and a tolerable level of inflation. On the basis of the targeted level of broad money expansion, the desired level of reserve money expansion is ascertained. The order of the reserve money expansion, however, has to be consistent with the likely fiscal and external payments position. With the recent change in the institutional arrangement resulting in the phasing-out of the automatic financing of the government’s deficit, the RBI has some manoeuvrability with regard to the expansion of the reserve money. The targeted M3 expansion is publicly announced through the Governor’s statement on MCP (Reddy, 1999). However, a number of other indicators such as movement in the interest rates, exchange rate and availability of credit to the productive sectors of the economy are also considered when formulating the monetary policy.

10.3.2 Elimination of Automatic Monetization of Deficit

As the automatic monetization of the government’s fiscal deficit adversely affected the control of the monetary base, there was an imperative need for a change in the institutional arrangement. An important step in this direction was the historic agreement of 1994–95 between the Government of India and the RBI. The relationship between the central bank and the government witnessed a salutary development in September 1994 in terms of the supplemental agreements limiting initially the net issuance of ad hoc treasury bills. This initiative culminated in the abolition of the ad hoc treasury bills effective from 1 April 1997. This was replaced by the limited Ways and Means Advances (WMA). WMA is an overdraft facility from the RBI available for 10 days in which the interest rates and overdraft are linked to the repo rate. Any withdrawals by the government from RBI in excess of the limit of WMA would be permissible only for 10 consecutive days. The crux of WMA is that the RBI would lend money to the government on the basis of its own calculations about the state of the economy. The elimination of automatic monetization of budget deficit, it was expected, will strengthen the monetary authority through increased flexibility and operational autonomy. Moreover, with the introduction of the Fiscal Responsibility and Budget Management Act in 2003, the RBI has withdrawn from participating in the primary issues of the central government securities.

10.4 Reduced Dependency on CRR and SLR

In consonance with the medium-term objectives of the financial sector reform, the SLR was brought down drastically. Moreover, there were sharp cuts in the CRR. The Narasimham committee recommended that RBI should increasingly rely on Open Market Operations (OMOs) and reduce its dependence on CRR. As a result, the CRR, which was 15 per cent in 1991–92, was reduced to 4.75 per cent in 2003–04 (Table 10.2). The SLR provision has created a captive market for the government securities, which increases automatically with the growth in the liabilities of banks. The base SLR that stood at 38.5 per cent in 1990–91 has come down to a uniform level of 25 per cent from 1997–98 onwards (Table 10.2). It suggests that these reductions will have implications on the availability of funds with banks for lending. It is, however, an irony that even though the SLR was reduced to help banks, the banks continue to voluntarily maintain the SLR securities worth more than 25 per cent (in case of some banks, more than 40 per cent) as the interest rates on government securities became competitive without the associated risk. The RBI’s refinance facility was also rationalized while lowering the CRR—the sector-specific refinance facilities were de-emphasized and simultaneously a general refinance window was opened in April 1997.

TABLE 10.2 Movements in CRR, SLR and Bank Rate

Along with a reduction in the CRR and SLR, the bank rate also met with a decline to which all other rates are aligned, but only after 1997 (Table 10.2). The bank rate is the rate at which a bank is prepared to buy or rediscount bills of exchange or other Commercial Papers (CPs) eligible under the RBI Act. In the pre-reform period, the role for the bank rate was limited in the monetary policy and was not subjected to many changes. However, since 1997–98, it was reactivated as the signalling and reference rate. All interest rates on the RBI advances and penal interest rates on shortfalls in reserve requirements have been linked to the bank rate as has been the interest rates on other categories of accommodation. It helps to develop an inter-bank term market giving rise to a signalling and reference rate. Between 1997–98 and 2003–04, the bank rate has changed substantially. However, since liquidity is being provided at reverse repo rate, as and when required, importance of the bank rate as a signalling rate has declined. Since 2003–2004, the bank rate remained unchanged.

10.5 Interest Rate Liberalization

The interest rate liberalization formed an integral part of the monetary policy in the postreform period. In 1991, with freeing interest rates, the structure of the administered interest rate was dismantled (Reddy, 1999). Almost all the major interest rates have been set free with the banks and financial institutions themselves determining their own minimum lending rates and 1-year deposit rates (Table 10.3) except for the saving deposit rate, which is set by the RBI. The government also reduced the volume and burden of directed credits, in order to increase credit to the private sector. The loan rates actually began to be liberalized in 1988, when the maximum rate on non-directed credit was turned into a minimum. After 1992, the number of interest rate categories for different types of loans was reduced sharply, and most of the directed credit (priority sector credit) was gradually shifted to free rates. By March 1998, the banks were allowed to set different rates for the same maturity deposits and set their own penalties for early withdrawal (Hanson, 2004). Consequently, the nominal interest rate structure had undergone drastic changes with all the rates showing declining trend, especially after 1996. In Table 10.3 we show the movement in different interest rates after the reforms.

TABLE 10.3 Lending Rates of Commercial and Term Lending Institutions

Till 1991–92, the interest rates moved upward and started declining afterwards. The country has moved towards liberalized credit allocation mechanism and reduced control over the interest rates by the monetary authorities. By 1997–98, most of the interest rate liberalization was complete and the interest rate structure was rationalized. The banks are now free to determine their domestic term deposit rates and Prime Lending Rates (PLRs), except for certain categories of the export credit and the small loans below Rs 0.2 million. In addition, all the money market rates are also free.

10.6 Credit Policy Reforms

With the regulatory reforms in the early 1990s, the credit market has become highly competitive with the market forces playing a pivotal role in determining the price of credit. A large number of institutions and products were introduced to inject liquidity and competition in the credit market.

10.6.1 Deregulation of Directed Credit

The reforms witnessed the removal of the Credit Authorization Scheme (CAS). Consequenly, the need to seek prior approval from the RBI for big loans was discontinued. To meet the credit targets, while the stipulation for lending to the priority sector⁴ has been retained, its scope and definition have been fine-tuned by including new items. The major categories of the priority sector credit include agriculture and allied activities, the small scale industries, housing loans and education loans, among others. The scope of the priority sector has been expanded over the years to include export activity, education, housing, software industry, venture capital, leasing and hire purchase. The restrictions on the banks’ lending for project finance activity and for personal loans were gradually removed in order to enable the banks to operate in a flexible manner in the credit market.

10.6.2 Regulatory Reforms

As a part of financial liberalization, the internationally accepted prudential norms relating to income recognition, asset classification, provisioning for bad and doubtful debts and capital adequacy norms, etc. have been introduced. These norms are recognized the world over, and are considered fundamental in ensuring the soundness and solvency of the commercial banks. A proper definition of income is essential in order to ensure that the banks take into account income, which is actually realized. The banks have now been given a clear definition of what constitutes a ‘non-performing’ asset and instructions have been issued that no interest should be charged and taken to income account on any ‘non-performing’ asset. The definition of ‘non-performing’ asset is also being tightened over a time. The banks are now required to make provisions on advances depending on four types of classification, viz., standard assets, sub-standard assets, doubtful assets and loss assets (Rangarajan, 1997). The provisioning requirement ranges from 10 per cent to 100 per cent depending on the category of the asset.

The reforms introduced various accounting standards and disclosure norms to improving governance and bringing them in alignment with the international norms. The ownership of the banking institutions has been diversified to bring market accountability and improved efficiency. The access to the capital market increased significantly for many public sector banks to provide a higher capital base and subsequently diluting the government ownership. In the case of institutional strengthening, it has introduced a framework for strengthening the supervisory process and created new institutions like the Board of Financial Supervision, Ombudsman and Debt Recovery Tribunals (DRTs) to make substantial improvement in terms of frequency, coverage, focus and tools of supervision.

10.6.3 Measures to Mitigate Non-Performing Loans (NPLs)

A large magnitude of resources of the credit institutions had become locked up in unproductive assets in the form of non-performing loans (NPLs). This has weakened their profitability and reduced the ability to recycle their funds. The RBI, therefore, has introduced various institutional measures to clear past dues to the banks and the financial institutions and reduce the NPAs such as the DRTs, the Lok Adalats (people’s courts), the Asset Reconstruction Companies (ARCs), the Corporate Debt Restructuring (CDR) mechanism, the Settlement Advisory Committees, etc. The banks were also given the freedom to issue notices under the Securitization and Reconstruction of Financial Assets and the Enforcement of Security Interest (SARFAESI) Act, 2002 for enforcement of the security interest without intervention of courts. In terms of asset classification and provisioning norms prescribed in 1994, the banks are required to classify the assets into four categories, viz., standard assets, substandard assets, doubtful assets and loss assets, with the appropriate provisioning requirements for each category of assets.

10.6.4 Diversification of Risk

The diversification of credit risk was also given a focus for expanding the flow of credit, as excessive concentration of lending to certain sectors leads to a higher risk burden. In this direction, various options were introduced for sharing of risk. For instance, the asset securitization allows the banks to conserve the regulatory capital, diversify the asset risks and structure products to reflect the investors’ preferences. Securitization is a process through which the illiquid assets are transformed into a more liquid form of assets and distributed to a broad range of investors through the capital markets. The lending institution’s assets are removed from its balance sheet and are instead funded by the investors through a negotiable financial instrument. The security is backed by the expected cash flows from the assets (Reserve Bank of India, 2003). With a view to ensuring a healthy development of the securitization market, the RBI issued guidelines on the securitization of standard assets on 1 February 2006 to the banks, financial institutions and non-banking financial companies.

10.6.5 Credit Information Bureaus

Another major measure was the introduction on the credit information bureaus. These bureaus are meant to provide comprehensive credit information such as the credit facilities already availed of by a borrower as well as his repayment track record. The introduction of the credit bureaus was intended to remove lack of credit history and the credit flow to less credit-worthy borrowers. In the presence of credit history through the credit information bureaus, pricing of credit can be accurate and credit risk on account of adverse selection and moral hazards can be reduced considerably. Keeping this in view, in order to facilitate sharing of information relating to credit history, a Credit Information Bureau (India) Limited (CIBIL) was set up in 2000. The credit bureaus, also known as credit reference agencies will help the lenders to assess credit worthiness of individual borrowers and their ability to pay back a loan, since they provide personal financial data on individuals from the financial institutions. The credit market may then allocate credit by taking into account the credit rating and the past behaviour of borrowers supplied by the credit information bureaus.

10.7 New Indirect Instruments of Monetary Policy

The RBI has shifted its strategy from the use of direct to indirect instruments of monetary policy such as the OMOs and the market-related interest rates. The thrust of monetary policy in recent years has been to develop an array of instruments to transmit liquidity and interest rate signals in the short term, in a more flexible and bi-directional manner.

10.7.1 Instruments to Improve Short-Term Liquidity

Many new instruments were introduced to inject short-term liquidity in the financial system. The interbank participation certificates, CPs and Certificate of Deposits (CDs) were introduced in order to help the highly rated corporate borrowers to diversify their sources of short-term borrowings. While the deposits kept with the banks are not ordinarily tradable, when such deposits are mobilized by a bank by the issue of a CD they get securitized and, therefore, become tradable. The banks resort to this source generally when the deposit growth is sluggish but the credit demand is high. The aim of this was to provide flexibility for financial institutions to raise resources from the market. Similarly CPs were introduced to enable the high level corporate borrowers to diversify their sources of short-term borrowings on one hand, and provide an additional instrument to the banks and financial institutions, on the other. The CP is a money market instrument, issued in the form of a promissory note, by the highly rated corporates for a fixed maturity in a discounted form. There is no interest rate restriction on CP The CPs and the CDs started circulating in the money market towards the beginning of the 1990s. The Discount and Finance House of India (DFHI) was set up to promote a secondary market in a range of money market instruments. The treasury bills of varying maturities (14, 91 and 364 days) were introduced. More importantly, the interest rates on money market instruments were left to be determined by the market.

10.7.2 Liquidity Adjustment Facility

A Liquidity Adjustment Facility (LAF) has been introduced, since June 2000, to precisely modulate short-term liquidity and signal the short-term interest rates. The LAF is aimed at meeting day-to-day liquidity mismatches and smoothening volatility in the short-term money market rates. The LAF operates through repo and reverse repo auctions thereby setting a corridor for the short-term interest rate consistent with the monetary policy objectives.

Repo Rates: They are of two types, viz., reverse repo rates and repo rates. While the reverse repo rate is the rate at which banks park their short-term surplus funds with the RBI, the repo rate is the rate at which banks borrow short-term funds from the RBI. These rates are fixed by the RBI. The repo transaction is undertaken when the call rate goes below the repo rate. On the contrary, reverse repo is undertaken when the call rate goes above the reverse repo rates.

The main participants in the LAF are banks and primary dealers in government securities. The LAF helps the RBI to supplement the standard monetary measures by active liquidity management by changes in both the price and the quantum of primary liquidity on daily basis. As internationally, since September 2004, the RBI uses repo when the central bank injects liquidity and reverse repo when it absorbs liquidity.

10.7.3 Open Market Operations

The OMOs have gained a considerable momentum as the RBI now responds more flexibly to market yields when drawing up its price list. In the pre-reform period, the low interest rate on government securities has made the demand confined to the RBI and the banks. However, the market interest rates on the government securities have increased the demand for these securities significantly. This, in turn, helped the RBI to introduce OMOs since 1992–93.

The OMOs refer to the purchase and sale by the central bank of a variety of assets such as foreign exchange, gold, government securities and even company shares. The RBI’s OMOs, however, is mainly confined to the purchase and sale of the government securities. Though the OMOs were resorted for long by the RBI, only recently they were used to control the money supply in the economy. The RBI has also been able to use OMOs effectively to manage the impact of capital flows in view of the stock of marketable government securities at its disposal, and the development of financial markets brought about as a part of the reform. The government securities, endowed with the RBI, have been used for the repo transactions as also for the regular OMO.

10.7.4 Market Stabilization Scheme

The Market Stabilization Scheme (MSS) has recently been adopted by the RBI as a monetary policy instrument. The MSS has been initiated since April 2004 as an additional channel to mop up the excess liquidity generated while releasing rupees for buying dollars. Since the huge stock of government securities has declined over the years, to sterilize the capital inflows, an internal group constituted by the RBI recommended the adoption of the MSS. Accordingly the government will issue treasury bills and dated securities under the MSS in addition to its normal borrowing requirements. However, the government’s resultant cash balance with the RBI cannot be withdrawn. It will be held in a separate identifiable cash account and operated by the RBI. The proceeds in the account will be utilized only for the redemption of treasury bills and dated securities issued under the MSS. Thus, MSS is essentially a monetary management instrument to control the short-term volatility in the forex market.

To conclude, the use of monetary instruments in India has undergone a shift from the direct to indirect instruments (Table 10.4). The process has been facilitated by reforms in the monetary and financial systems. The increasing openness of the economy and a market-determined exchange rate means that the focus of the policy should increasingly be to ensure an orderly movement in the exchange and interest rates. There is a growing evidence of a strengthening of the interest rate channel of the monetary transmission mechanism, which would imply that the interest rates could be used as effective targets of the monetary policy. Although the RBI has been relying on the M3 targets as a guide for conducting the monetary policy, the focus of short-term monetary management in recent times has thus been on the interest rates and the exchange rates.

TABLE 10.4 Monetary Policy Instruments

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