CIAO DATE: 7/99

Creating Autonomous Institutions in a Liberalizing Economy:The Reserve Bank of India

C. Rangarajan

CASI Occasional Paper Number 7
October 1998

Center for Advanced Study of India
University of Pennsylvania

Friends, it gives me very great pleasure to be in your midst this afternoon. I am indeed very grateful to Francine Frankel and the Center for the Advanced Study of India for giving me this opportunity to come back to my old surroundings and meet old faces. I carry very fond memories of the days that I spent here—almost four years—at the beginning of the 1960s. I want to speak to you this afternoon on, as the title says, “Creating Autonomous Financial Institutions in a Liberalizing Economy: The Case of the Reserve Bank of India.” As Francine mentioned, the last six years have seen some far-reaching changes in India’s approach to, and content of, economic policy. With greater emphasis on fiscal prudence, the relationship between fiscal authority and monetary authority is undergoing a change. With the introduction of the liberalization process in the financial sector, we are moving away from micro-management of financial institutions. In this changed context, macroeconomic stability becomes increasingly important and consequently the whole issue of the autonomy of the central bank, or the independence of the central bank, acquires added significance. It is on this aspect I would like to speak to you this afternoon.

 

The Changing Economic Climate in India and its Financial Sector

Let me begin by saying a few words on the changes that are occurring in general in India and in the financial sector in particular. I will follow that up with some comments on the general issue of the autonomy of central banks, and conclude by developing the theme in relation to the Reserve Bank of India, with which I have been associated for the last fifteen years. More particularly, my role in the last five years has been to steer monetary policy. The Indian economy, in a sense, has come a long way from the crisis years of 1990 and 1991. There was a time in 1991 when the foreign currency assets in the Reserve Bank of India had fallen as low as one billion US dollars. Today, the foreign currency assets of the Reserve Bank of India stand at twenty-six billion US dollars. That is not counting the gold that we have. This is one measure of the resilience of the Indian economy. In fact, in some ways, the events of 1990 and 1991 have receded to the background and become part of memory. The Indian economy, in the first three decades of its independence, grew at an average annual rate of about 3.5 percent. In the 1980s, the growth rate picked up. In fact, in the second half of the 1980s, the average rate of growth was close to 5.6 percent.

Nevertheless, the 1980s ended with some serious problems as far as the country was concerned. The fiscal deficit was getting out of control and the balance of payments situation was coming under increasing strain. On the fiscal side, the major problem was the growing fiscal deficit. In the 1970s and 1980s, the fiscal deficit of India was something on the order of six percent. By 1991, the fiscal deficit of the Government of India alone had touched 8.3 percent. Interest payments became the largest single item of expenditure in the Government of India’s budget, and constituted very nearly four percent of the GDP in 1990-91. This growing fiscal deficit, as you all know, has implications for a number of things. It has implications in terms of the crowding-out effect it may have in relation to private investments. But even from a narrow fiscal point of view, the growing fiscal deficit and the increasing debt resulted in a larger share of the revenue receipts being pre-empted for the payment of interest, and in the consequent decline in the allocation of resources for developmental purposes. Therefore, the interest burden was becoming large, and the growing size of this debt, about which I shall talk in greater detail later, also resulted in the distortion of the financial system, inasmuch as banks and other institutions were required to contribute a certain percentage of their deposit liabilities, in the form of investment in government securities at rates of interest that were below the market-determined rates of interest.

On the balance of payments issue, I will not speak in great detail this afternoon, because that is not the main theme today. The current account deficit of India touched about 3.2 percent of the GDP in 1990-91. This may not look like a very high level of current account deficit compared to the level of current account deficit some of the fast-growing economies have incurred. Nevertheless, given the large size of India’s GDP, 3.2 percent of that GDP, in absolute terms, was quite high. Of course, the immediate trigger was the Iraqi-Kuwait war, which resulted in a very abnormal increase in oil prices. India being a net importer of oil, the burden was so large in that particular year that we had to draw down the bulk of our reserves in order to meet the increased oil budget. This drawing down of the reserves, in turn, resulted in a downgrading with respect to the rating of the country, which had further impact upon the financing of the current account deficit. So a vicious cycle was set in motion—the drawing down of the reserves, downgrading of the rating and inability to finance the deficit. All of this resulted in a very serious situation as far as the balance of payments was concerned. In substance, I would say that despite the very strong growth that the Indian economy registered in the second half of the 1980s, the Indian economy entered the 1990s with an unsustainable level of fiscal deficit and balance of payments deficit.

The response to this particular crisis was to put in place a set of policies aimed at stabilization and structural reform. The stabilization policies were aimed at correcting the weaknesses that had developed on the fiscal and the balance of payments side, while the structural reforms were aimed at removing some of the rigidities that had entered into various segments of the Indian economy and to prevent the recurrence of the kind of crisis that we had in 1990-91. Obviously, structural reforms could not be introduced unless a degree of stabilization was achieved. Equally, stabilization by itself would not be adequate unless structural reforms were introduced to prevent the recurrence of such problems. That was why we put in place, simultaneously, a set of policies aimed at both stabilization and structural reform.

The financial sector reforms currently underway in India are an integral part of the overall scheme of structural reforms. The overall package is aimed at enhancing the productivity and efficiency of the economy as a whole and also increasing international competitiveness. The importance of the financial sector reforms in this structural package needs to be understood clearly. Structural reforms in areas such as industrial and trade policy can succeed only if resources are redeployed towards more efficient producers who are encouraged to expand under the new policies. The reforms in the banking sector and in the capital markets are aimed precisely at achieving this primary objective.

On the stabilization side, I will mention a few points. One is the correction of the fiscal deficit. We were able to bring down the fiscal deficit by almost two percentage points in one year, from 8.3 to almost six in 1991-92. Further reductions in the fiscal deficit turned out to be more difficult. Cutting of subsidies was possible at the time of crisis, but later it turned out to be very difficult. So the fiscal deficit, instead of moving steadily down, went up, and then came down. In 1996-97 it came down to five percent of the GDP, and as far as the Government of India is concerned, it had programmed to bring down the fiscal deficit to 4.5 percent of the GDP in the current fiscal year. Perhaps, due to a variety of other factors, we may not succeed in maintaining it at 4.5 percent. Perhaps we might even go back to five percent of the GDP. But certainly, if you look at it over a period of five years, there has been substantial progress in terms of the reduction in fiscal deficit. The effort on the part of the Government of India to reduce the fiscal deficit has had important implications in terms of the conduct of monetary policy.

On the balance of payments side, I would say that the immediate response to the crisis that emanated was to devalue the rupee. This has been done in the past, and if that had been the only thing that we had done, there would not be much to talk about. But we made two fundamental changes. One was to change the foreign trade regime, and the other was to change the exchange rate regime. We had plenty of quantitative controls relating to imports in India. I am happy to say that most of these quantitative controls have been knocked down. There are no quantitative controls, virtually speaking, with respect to capital goods, intermediate goods, or raw materials. There are still certain quantitative controls, particularly in relation to consumer goods, but we are negotiating, and probably over a period of time we will dismantle all of them. The second was the drastic reduction in the tariff rates. The tariff rates that existed in India prior to 1991 were sometimes horrendous, as horrendous as the income tax rates that we used to have. But I think there has been a very conscious effort to bring them down substantially. In fact, our aim is to bring the tariff rates down to the levels that exist in other developing economies.

On the exchange rate side, we used to operate by determining the exchange rate through a basket of currencies. During the ten-year period that I was the Deputy Governor of the Reserve Bank of India, every morning at nine o’clock I used to determine the exchange rate of the rupee—one job that I had to do wherever I was. This task has happily been taken away from the deputy governors, and the exchange rate of the rupee is now determined by the force of supply and demand in the market. We experimented for a year with a dual exchange market system. Even that was given up and in March 1993, we moved toward what may be called the unified market-determined exchange rate system. Many people refuse to believe that the exchange rate of the rupee is being determined by the force of supply and demand. It is not a question of believing; that is what is really happening. We did intervene at certain points in time when we found the Indian rupee appreciating by a very large margin. That had implications in terms of the export competitiveness of India. Therefore, both in 1993 and 1994, and until the first half of 1995-96, we did buy from the market fairly substantial amounts, both to augment our reserves and to prevent the appreciation of the rupee. We had some bouts of turbulence in the second half of 1995 and early 1996. In the very recent period, again there have been some jolts as a consequence of what was happening elsewhere.

By and large, however, I would say that the exchange rate of the rupee has remained reasonably stable. However, it does pose some problems for us. While the currencies of countries surrounding us have depreciated very substantially, the Indian rupee still remains more or less at the same level. This will have implications for India’s competitiveness and export potential. It is possible, of course, to intervene in the market and buy more foreign exchange from the market, thereby bringing about certain changes. As of now, our policy is to leave the exchange rate of the rupee to be determined by market forces. We will intervene only if there is a high degree of volatility, or in order to establish orderly conditions in the market. This is our official position regarding exchange rate management.

This, once again, has implications in terms of monetary policy. We are very consciously aiming at reducing the inflation rate in the country. The inflation rate has come down to about four percent now, which is a very substantial reduction. I think that this rate of inflation is something that has not been achieved in a sustained way in many developing countries. If the inflation rate of the country is out of alignment with the inflation rate in the industrially advanced countries, it creates a hiatus in terms of the real effective exchange rate. India has argued in the meetings of the IMF that as far as developing economies are concerned, the one way in which we can take care of the problem of volatility in exchange rate is to work towards the objective of price stability. This will enable us to solve two problems at the same time. We can create domestic stability, and also avoid disruptive adjustments in the exchange rate.

Very quickly, in relation to the financial sector, I may say that the series of measures that we have introduced constitute an important effort on the part of the Reserve Bank and the government to bring about changes in the financial system which will make it both viable and efficient. It is admitted by all that there has been a considerable widening and deepening of the Indian financial system in the last four decades. The Indian banking system today has a network of branches exceeding 62,000. Nearly half of these are located in the semi-urban and the rural areas. The reach of the Indian banking system is very wide. It has gone into the most interior parts of the country. In fact, the population per bank office today is something like 15,000. Therefore, the functional and geographical coverage of the Indian banking system is truly impressive.

However, questions have been raised, from time to time, on the viability, the efficiency, and the profitability of the system. It is to these concerns that the financial sector reforms are addressed. Broadly speaking, the reform measures fall into three categories: (a) measures aimed at removing the external constraints bearing on the profitability of the banks; (b) measures aimed at improving the financial health of the banks by introducing appropriate prudential norms; and (c) measures aimed at institutional strengthening, including improving the competitiveness of the system.

The Indian banking system has operated for a long time with a high level of reserve requirements, both in the form of the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR). This was indeed a consequence of the high fiscal deficit and a high degree of monetization of that deficit. In mid-1991, preemption in the form of CRR and SLR requirements on incremental deposits amounted to 63.5 percent. Our efforts in the recent period have been to lower both the CRR and the SLR. Apart from removing the incremental CRR, since 1991 the CRR has been brought down to ten percent, which will go down to eight percent by the end of the year. The SLR was brought down from the pre-reform peak of an effective rate of 37.5 percent to an average effective rate of twenty-eight percent at the end of March 1996. The SLR has now been set at twenty-five percent, which is a prudential requirement prescribed under the Banking Regulation Act a long time ago.

The interest rate regime has also undergone a significant change. For long, an administered structure of interest rate has been in vogue in India. The simplification of the interest rate structure that began in September 1990 has continued. At present, the Reserve Bank prescribes only two lending rates for small borrowers. Banks are free to determine the interest rate on deposits and lending rates on all lendings above Rs. 200,000.

Another major element of financial sector reform has been the introduction of prudential norms and regulations aimed at ensuring the safety and soundness of the financial system, imparting greater transparency and accountability in operations, and restoring the credibility of and confidence in the Indian financial system. Prudential norms serve two primary purposes—first, they bring out the true position of a bank’s loan portfolio and secondly, they help to arrest its deterioration. Prudential reforms introduced in India relate to income recognition, asset classification, provisioning for bad and doubtful debts and capital adequacy.

Along with relaxing the external constraints and introducing prudential norms, a major effort has been made to strengthen the banking system in general, and public-sector banks in particular, through appropriate institution building measures of (i) re-capitalization, (ii) instilling a greater element of competition and (iii) strengthening the supervisory process.

An important aspect of institution building is to improve competition. The Nationalization Act has been amended with a view to allow public-sector banks to raise money from the capital market, and thereby reduce the stake of the government in the total equity. Of course, even under the amended Act, the government will still hold fifty-one percent. The proportion of government holding in the total equity can come down to forty-nine percent. This is an important change because the accountability of the bank does change as a consequence. There are a very large number of shareholders to whom the bank becomes responsible, even if these private shareholders are in a minority. Recently, the State Bank of India had to hold its annual general meeting in a cricket stadium because the total number of shareholders was so large. Also, new banks are being allowed to be set up in the private sector. In the last twenty-four months, eleven new private banks have been allowed. This, of course, is in addition to the thirty-eight foreign banks that have been allowed to open branches in India, with a total network of around 170 branches.

In the years to come, the Indian financial system will grow not only in size but also in complexity as the forces of competition gain further momentum and as financial markets acquire greater width and depth.

The first stage of the financial sector reform is coming to an end and we are moving to the next stage of the reform. In the second stage of reform, success would depend primarily on the organizational effectiveness of banks and other financial entities for which, the initiatives would have to come from the institutions themselves. It is against this context one has to examine the role of the central bank and the issue of autonomy.

 

The Autonomy of Central Banks

Before dealing with the Indian experience, let me say a few words on the general issue of central bank autonomy. The legal status of a central bank, in terms of its relationship to government, varies from country to country, and is determined by historical circumstances as well as the practices that have evolved over time. At one end of the spectrum there are central banks which are viewed as being almost subordinate to the government, in the sense that the stance of monetary policy is primarily determined by the government, even though the central banks may play an important role in advising the respective governments. At the other end of the spectrum are countries where central banks remain independent of the government, and make monetary policy decisions on their own. There are other countries in which central banks also make independent decisions, but are subject to some form of government override. While in some countries this override is exercised publicly, in others, there is no such explicit requirement. The government simply retains the power to issue directives.

The concept of autonomy of central banks has traditionally been discussed in terms of the independence a central bank enjoys in making monetary policy decisions. The issue of independence obviously arises only in a system where the central bank has “discretion” in the determination and conduct of monetary policy. The institutional independence of a central bank may not really mean much under a system where the monetary authority is compelled to follow a prescribed rule, such as a fixed rate of growth in money supply, or the gold standard.

The argument in favor of autonomous central banks rests on the premise that monetary stability, which is essential for the efficient functioning of the modern economic system, can best be achieved only if the task is entrusted to professional central bankers who can take a long-term view of the monetary policy stance. Too much concern with the short-term can result in “stop-gap” policies. Implicit in this kind of reasoning is the assumption that political leadership normally tends to take too short-term a view, and such an approach is not conducive to ensuring stability. Historically speaking, the concept of independence of central banks is associated with the concern that in the absence of such independence, governments would finance themselves without limit, through money creation. While this concern is still a potent factor in several countries, more attention is now being paid to the broader issue of the impact of political influence on the pursuit of monetary policy. More than any other objective of economic policy, monetary stability requires the pursuit of consistent policy over a long time. Prices respond with a lag to changes in money. Monetary expansion may initially lower unemployment or stimulate growth, but subsequently inflationary consequences emerge and measures to reverse inflation are initiated only when inflation crosses some threshold level. This sequence gives an upward bias to the price level. If this is to be avoided, the pursuit of a consistent policy over time becomes necessary.

In the discussions of policy effectiveness, a point that is often made is that effectiveness of policy depends upon how the public perceives policy-makers’ commitment and behavior. Based on this premise, it is argued that an autonomous central bank would tend to impart greater credibility to monetary policy and therefore improve its effectiveness.

Vesting in a central bank the sole authority to determine monetary policy has, however, not found universal acceptance. Two arguments are advanced against this idea. The first argument is that in a democratic setup, all policy decisions should be subject to scrutiny by the elected legislature, and therefore, the concept of an autonomous central bank is “undemocratic.” A typical expression of this opinion is found in a statement made by the Democratic floor leader in the American Senate while introducing the Balanced Monetary Policy Act of 1982:

It is time for Congress to wrest control of monetary policy from the hands of a tiny band of monetary ideologues in the White House, the Administration, and the Federal Reserve. It is time for basic economic policy once more to be set by elected officials who must bear the final responsibility. It is time to restore common sense, balance and stability to monetary policy.

It needs to be noted that no central bank is totally autonomous, in the sense that it is not answerable to anyone. Even the most independent central banks have to report, in one form or the other, to the legislature, which in any case has the ultimate power to change the law relating to the central bank. All the same, there is a difference between a situation in which policy decisions are under continuous scrutiny, and an arrangement where the central bank periodically reports to the legislature.

The second argument against the autonomy of central banks is more substantial. If it is argued that as monetary policy is an integral part of overall economic policy, there can be no meaningful separation between fiscal and monetary policies. If such a separation is attempted, and if the two policies run at cross-purposes, then either the fiscal policy or the monetary policy will have to give way. In the process, conflict of policies may inflict considerable damage to the economy. That such a situation is not unlikely was demonstrated in the US in the early 1980s, when fiscal policy was lax and expansionary, while monetary policy was extremely tight. There is, therefore, substance in the argument that an integrated package of policies has a better chance of success than a set of conflicting ones. While admitting this, it can nevertheless be argued that such conflicts are inevitable as long as central banks are charged with the primary responsibility of controlling inflation.

An interesting question that arises in this context is whether autonomous central banks have a better achievement record in the conduct of monetary policy. But then, what constitutes a better record? Almost all empirical studies carried out to find the relationship between independence and performance have judged performance in terms of inflation control. There are considerable differences among researchers in the manner of classifying central banks in terms of autonomy. Several characteristics have been taken into account, ranging from the legal provisions of setting up central banks to the procedures relating to the appointment, term of office and dismissal of the governor of the central bank. However, the empirical evidence is inconclusive. A number of studies have found an inverse link between the two. That is to say, the average rate of inflation is lower in countries that have relatively autonomous central banks. There are, however, some studies that do not establish such an inverse relationship. Even when an inverse relationship is found, it is subject to a number of interpretations. It is quite possible that the factor of independence as well as inflation control may stem from a common cause, such as the congruence of monetary and fiscal policies, in terms of objectives or a deep seated national sentiment against inflation, as in the case of Germany.

Another point of view that arises in the context of the independence of central banks is that the success of the central bank in controlling inflation may arise not so much from its independence from the government as from the nature of the objectives it is expected to fulfill. Economic policies have multiple objectives to achieve. In most countries, they include high growth rate, low unemployment and price stability. In the developing countries, an additional objective of economic policy is redistributive justice. It has been argued that central banks which have had a high degree of success in controlling inflation are those that have been charged specifically to maintain stability in the value of the currency, even though there can be possible conflicts between maintaining the stability of the external and domestic values of the currency.

The argument here is that since monetary policy is essentially a single instrument, it cannot be called upon to achieve more than one objective. It is further argued that among the multiplicity of objectives of economic policy, perhaps price stability is the objective that can best be achieved through monetary policy. In fact, if the central bank has multiple objectives, the net result in terms of the achievement of a single objective, such as price stability, may not be that striking. The central bank will also be compelled to think in terms of trade-off between one objective and another, as in the case of overall economic policy. The conclusion that is drawn from such an analysis is that the success of those central banks which have achieved a high degree of price stability is attributable not so much to their independence as much to the fact that they have statutory objectives with a narrower focus. Central banks that may not enjoy independence from the government can nevertheless succeed in ensuring price stability if they are asked to pursue that single objective.

Central bank independence raises certain issues with respect to the performance evaluation of an autonomous central bank. Easily observable yardsticks will have to be established in order to ensure monetary policy accountability. Perhaps the most striking example in this context is the arrangement that has been introduced in New Zealand, where the central bank is required to achieve a specific inflation target. This raises a further question as to the extent to which monetary policy by itself can achieve price stability.

There are also issues connected with the transmission mechanism of monetary policy actions. Central banks in the industrialized economies have experimented with various intermediate targets in order to influence the economy in general and prices in particular. In the context of money demand instability, central banks in these countries have responded by placing less emphasis on a single monetary aggregate. A range of monetary variables is taken into account for guiding the course of monetary policy.

An aspect of independence of the central bank on which a high degree of consensus is developing is on the funding of the government by the central bank. Many countries have placed legal constraints on central banks’ lending to the government. There are countries in which central banks are totally prohibited from purchasing government paper from the primary market. In countries such as Germany, Switzerland and the Netherlands, legislative limits have been set on direct central bank credit to governments. There are, however, countries in which there are no legal limits but central banks do not normally provide direct credit to the government. It is clearly recognized that since central banks can acquire government securities as part of their open market operations, there cannot be a ban on central banks acquiring government debt. While statutory limits on credit to government can also be gotten around, quite clearly, direct funding of government, without limits by the central bank, will come in the way of the efficient conduct of monetary policy.

Institutional arrangements to make the central banks independent have centered around the appointment, tenure, and dismissal of the governor, as well as the role and the constitution of the board of central banks. The appointment of governors for a reasonably long tenure, coupled with very stringent conditions under which they can be dismissed, are said to favor independent actions on the part of central banks.

Many central banks perform functions that go beyond the core central bank functions. Central banks in a number of countries perform supervisory functions in relation to the banking system. There are several countries in which the supervisory functions are either shared between central banks and other authorities or totally left outside the gambit of the central bank. Since monetary stability cannot be divorced from financial stability, several have argued for the supervisory function to be an integral part of a central bank. However, there are some who perceive a conflict of interest between supervisory and monetary concerns. There can be occasions when a tight monetary policy can force difficulties on the banking system, which, if the central bank as a supervisor tries to moderate, could lead to a situation involving a conflict of interest. However, most of the difficulties associated with financial stability arise out of factors not directly connected with monetary policy, such as poor asset quality, inadequate capital, etc.

Certain broad conclusions emerge from the foregoing analysis. Monetary policy, being part of an overall economic policy, cannot be divorced totally from fiscal policy or other policy perceptions. Economic policy-makers have always had to contend with multiple objectives. While in the long run there may be a congruence of various objectives, in the short run there can be a trade-off which policy-makers may find difficult to resist. It is also accepted that a policy package as a whole is most effective when there is no conflict among the different policy instruments. Hence the need for coordination among policies. Monetary policy, as an instrument of policy, is more efficient in dealing with price stability than other objectives, and this objective can be best achieved if the central bank enjoys a high degree of autonomy. While it is recognized that political leadership represented through government should have the final say on policy matters, there is considerable merit in a system where there is greater transparency in the resolution of conflicts between the government and the central bank. The freedom of the central bank to pursue monetary policy according to its judgment requires that direct funding by the central government is restricted and the limits are made explicit.

 

The Reserve Bank of India

The Reserve Bank of India is an institution that was set up in the pre-independence period. The legislation to set up the Reserve Bank was first introduced in January 1927. However, it was only seven years later, in March 1934, that the enactment was made. There is no specific provision in the Act laying down the objectives of the Bank. However, the Preamble of the Act says that the Bank has been constituted “to regulate the issue of bank notes and keeping of reserves, with a view to securing monetary stability in India, and generally, to operate the currency and credit system of the country to its advantage.” At the time of the enactment, Indian public opinion was strongly in favor of an institution that was not dominated by the British Government. For different reasons, both the government and Indian legislators at that time wanted a central bank that was independent. After much debate, the Bank was set up as a private shareholders’ bank, with some subscription from the government to enable those nominated by the government to be directors. The Finance Member, Sir George Schuster, while introducing the Bill said:

It has generally been agreed in all the constitutional discussions, and the experience of all other countries bears this out, that when the direction of public finance is in the hands of a ministry responsible to a popularly elected legislature, a ministry which would for that reason be liable to frequent changes with a changing political situation, it is desirable that the control of currency and credit in the country should be in the hands of an independent authority, which can act with continuity. Further, the experience of all countries is again united in leading to the conclusion that the best, and indeed, the only practical device for securing this independence and continuity is to set up a central bank independent of political influence.

It is also worth quoting another passage from the speech of the Finance Member that went into the question of the funding of government budgets by the central bank:

...in modern life and in modern economic organizations, there are two important functions: they are the functions of those who have to raise and use money, and there are the functions of those who are responsible for producing the actual tokens of money, the money in circulation. The basis of the whole proposal for setting up an independent central bank is to keep those two functions separate. The largest user of money in a country is the government, and the whole principle of the proposal is that the government, when it wants money to spend, should have to raise that money by fair and honest means in just the same way as every private individual has to raise money which he requires to spend for his own maintenance. If the government is in control of the authority which is responsible for exercising the other function, then all sorts of abuses can intervene.

The Reserve Bank of India was nationalized in 1948. The issue regarding fiscal and monetary policy inter-linkages in India can be understood by undertaking a brief review of the borrowing program of the Government of India through treasury bills. Until 1955, the total outstanding treasury bills had never exceeded Rs. 4.72 billion. Subsequently it rose to Rs. 25.18 billion by March-end 1971 and soared further to Rs. 128.51 billion by March-end 1981. With the sharp deterioration of the fiscal deficit during the 1980s, the outstanding treasury bills rose to Rs. 192.66 billion by March 1993. Indeed, if allowance is made for the funding of treasury bills of Rs. 710.00 billion in aggregate during 1982, 1987, 1988, 1991 and 1992, the actual outstanding treasury bills at the end of March 1993 was placed at a formidable level of Rs. 902.66 billion. An overwhelmingly large proportion of these treasury bills was held by the Reserve Bank of India, thereby monetizing the budget deficit of the government. In fact, in addition to treasury bills, the Reserve Bank has also held government dated securities not picked up by the captive market.

As a consequence, the outstanding reserve money (i.e. money created by the Reserve Bank) as of March 1993 amounted to Rs. 1109.43 billion, of which the net Reserve Bank credit to the central government accounted for as much as Rs. 965.23 billion, or eighty-seven percent. This growing budget deficit and its monetization by the Reserve Bank of India indeed raised important issues on the relative roles of fiscal and monetary policies. Monetary policy, particularly in the 1980s, had to address itself to the task of neutralizing the inflationary impact of growing deficits by continually mopping up the large increases in reserve money. Given the then fully administered interest rate structure, the much-needed absorption of excess liquidity in the system was undertaken by increasing the Cash Reserve Ratio (CRR). Furthermore, given the below-market rates on government securities, the Statutory Liquidity Ratio (SLR) had to be progressively raised so as to meet the large financing requirements of the government. This process inevitably culminated into the CRR reaching its statutory maximum limit, which had to be raised by amending the Act. The SLR reached the phenomenally high level of 38.5 percent.

The genesis of the practice of automatic monetization is a significant revelation in the definitive history of the Reserve Bank for the period 1951-67, written by Dr. G. Balachandran. The Reserve Bank under the Act is authorized to grant to the government advances repayable not later than three months from the date of making the advance. These provisions are enabling and not mandatory, and the provisions of the Act do not require the Reserve Bank to finance unlimited deficits of the government. What the historical documents reveal is that as a matter of operational convenience, an official of the RBI and an official of the Ministry of Finance agreed in early 1955 that whenever the cash balances of the government fell below Rs. 500 million, ad hoc treasury bills would be created to restore the central government’s cash balances to Rs. 500 million. Thus, a seemingly innocuous operational arrangement opened up the floodgates of automatic creation of ad hoc treasury bills to finance the government deficit. The then Finance Minister, Mr. T. T. Krishnamachari, was appreciative of the concerns expressed by the then Governor and had assuaged the anxieties of the Reserve Bank by assuring the Governor that it would be the duty of the Finance Ministry to formulate its proposals for borrowing and deficit financing in consultation with the Reserve Bank. The rest is history.

The Chakravarty Committee to review the working of the monetary system, of which I was a member, in 1985 recognized the dangerous trajectory that the monetary fiscal policy was on and strongly recommended a fundamental restructuring of the monetary system. The Committee argued that price stability should be the dominant objective of monetary policy and inflation control was perceived as the joint responsibility of the government and the Reserve Bank. It was in this context that the Chakravarty Committee laid stress on the net RBI credit to the government as an unambiguous and economically meaningful measure of the monetary impact of fiscal operations. Since 1987, the budget documents also indicate as a memorandum item net RBI credit to the central government. The Chakravarty Committee strongly advocated a system of monetary targeting that will bind the government and the Reserve Bank to a mutually agreed level of RBI credit to government, consistent with the appropriate level of expansion of money supply. The Committee later went on to spell out how to arrive at the appropriate level of money supply growth and linked money supply growth to the expected increase in real output and an acceptable level of increase in prices. In my Presidential Address on “Issues in Monetary Management” at the 71st Annual Conference of the Indian Economic Association at Calcutta in December 1988, I had stated:

The essence of coordination between fiscal policy and monetary policy lies in reaching an agreement on the extent of expansion in Reserve Bank credit to the government, year to year. This will set a limit on the extent of fiscal deficit and its monetization, and thereby provide greater maneuverability to the monetary authorities to regulate the volume of money. It is in this context that the introduction of a system of monetary targeting, mutually agreed upon between the government and the central bank, assumes significance.

In the last few years, there has been a conscious effort to contain the fiscal deficit and the budget deficit. This has facilitated the efforts of the Reserve Bank to moderate the growth in the money supply. However, so long as the practice of issue of ad hoc treasury bills continued, there was no immediate check on the expansion of RBI credit to the government. Even in the few years when year-end deficits have been moderated, deficits during the year have been large. It therefore became necessary to move away from the system of issue of ad hoc treasury bills and the consequent monetization of the budget deficit.

A Supplemental Agreement was signed between the Government of India and the Reserve Bank on September 9, 1994 to phase out the system of ad hoc treasury billls, over a period of three years. It was agreed that the net issue of ad hoc treasury billls at the end of the year 1994-95 was not to exceed Rs. 60 billion and that, if the net issue of ad hoc treasury billls exceeded Rs. 90 billion for more than ten consecutive working days at any time during the year, the Reserve Bank would automatically reduce the level of ad hoc treasury billls, by auctioning them or by selling fresh Government of India dated securities in the market. Similar ceilings at Rs. 50 billion for year end and Rs. 90 billion for intra-year were stipulated for 1995-96 and 1996-97. The scheme of phasing out ad hocs worked reasonably well. While in 1994-95 the agreement was strictly adhered to both in terms of year-end level of ad hoc treasury bills as well as the intra-year limit, in 1995-96 there were prolonged periods in which the intra-year limit was exceeded. Since August 14, 1996 the net issue of ad hocs remained within the year limit throughout the year 1996-97.

The Government of India and the Reserve Bank of India signed a fresh agreement on March 26, 1997 in New Delhi to formally put into effect the announcement made by the Union Finance Minister, P. Chidambaram, in his Budget Speech for 1997-98:

The system of ad hoc Treasury Bills to finance the budget deficit will be discontinued with effect from April 1, 1997. A scheme of ways and means advances (WMA) by the RBI to the Central Government is being introduced to accommodate temporary mismatches in the government’s receipts and payments. This will not be a permanent source of financing the government’s deficit.

The salient features of the agreement are as follows:

1. The system of ad hoc Treasury Bills to finance the budget deficit will be discontinued with effect from April 1, 1997.

2. From April 1, 1997 a scheme of Ways and Means Advances (WMA) by the Reserve Bank of India to the Government of India is introduced to accommodate temporary mismatches in government receipts and payments. The limit and the rate of interest on WMA and the rate of interest on Overdraft will be mutually agreed between RBI and the government from time to time.

   For the fiscal year 1997-98, the limit for Ways and Means Advances would be Rs. 120 billion for the first half of the year (April to September) and Rs. 80 billion for the second half of the year (October to March).

3. Overdraft will not be permissible for periods exceeding ten consecutive working days after March 31, 1999.

An amount of Rs. 160 billion has also been indicated in the Budget for 1997-98 as the “Monetized Fiscal Deficit,” which represents the expected level of the RBI’s support ex ante to central government borrowing. This amount reflects the RBI support to primary issues of central government securities. The actual support ex post could be different from the amount of Rs. 160 billion, on account of open market operations by the Reserve Bank of India, depending upon the emerging monetary situation. Illustratively, in 1993-94, RBI’s support to primary issues was Rs. 70.14 billion but the monetized deficit was only Rs. 2.60 billion.

What has facilitated the move towards the new system has been the recognition by both the government and the RBI of the need to modulate money supply to ensure reasonable price stability and the efforts on the part of the government to bring down the fiscal deficit.

The emergence of an autonomous central bank does not mean that the “state of bliss” has arrived. It only enables the central bank to pursue a consistent monetary policy over a long time without being influenced by short-term pressures to deviate from its path. Naturally, there are other problems to contend with. Monetary economics, more than any other branch of economics, is not a settled science. Controversies rage over several issues. There are many theories to explain how changes in money and credit affect the real economy. And, there is as yet no unanimity on the transmission mechanism. Opinions differ on which should be the appropriate variables to monitor, in order to determine the stance of monetary policy as well as the progress of monetary policy action. While some central banks tend to place emphasis on monetary aggregates, such as broad, narrow or base money, there are others which attach greater importance to movements in interest rates. No wonder opinions differ among experts on when to stimulate an economy or to restrain it. Nevertheless, an autonomous central bank is in a distinctly better position to make monetary policy actions taking both the short- and the medium-term interests together. Autonomy, in any case, is not unrestrained. In a democratic setup it can always be subject to policy directives from the legislature.

With the discontinuation of the automatic monetization of central government deficit, a major step towards functional autonomy has already been taken. However, successful monetary policy requires not only a high degree of operational freedom, but also a clear enunciation of the dominant objective of policy. In the recent period, the conduct of monetary policy in India has been criticized by some as being obsessed with achieving a lower inflation rate. Emphasis on inflation control was not meant to lower the importance of the growth objective. On the other hand, it is the sustained reduction in the rate of inflation that will pave the way for attaining all broad macroeconomic objectives, including higher economic growth. Monetary policy in India is emerging as an independent policy instrument. However, there is need for imparting greater clarity as to what the dominant objective of monetary policy should be. It is this clarity that will enable the Reserve Bank as a central monetary authority to function more effectively.

This is where the Reserve Bank of India stands today as a central banking institution. Someone has said that central banking is neither a science nor an art, but a craft. In many ways it is a craft. It is a balancing act all the time. But the act of balancing becomes extremely difficult if we have not only two sides, but three and four sides. It is almost impossible. We will have to do it in some space—cyberspace? Therefore, besides the operational freedom that is required to pursue a consistent monetary policy, there is also the need for clarity regarding what the dominant objective is to be.

 

Question-Answer Session

Professor Alan Heston, Department of Economics, University of Pennsylvania, and then Acting Director, Center for the Advanced Study of India:

I am going to give Dr. Rangarajan a minute to collect his thoughts, after which he will answer some questions. I would like to thank him very much for his splendid talk and add a little perspective, perhaps, on his modesty. When he took over as Governor of the Reserve Bank, I think anyone who might have thought that these changes could have happened in India, whoever was Governor, would have gotten good odds that they would not have happened. The whole situation, the history that he has described, would not have led one to be very optimistic that these changes could occur. It is true that there was a confluence of some of the conditions which he described that did help this come about, but I think his talk today has made it clear that one of the most important conditions was that he was Governor of the Reserve Bank at this particular time. Since he, as you can well see, has an academic background and an ability to handle all sorts of questions, I am going to let him field questions from the audience.

Ambassador Adrian Basora, President, Eisenhower Exchange Fellowships:

Two questions. You mentioned that four percent is the target for the fiscal deficit. In Europe, the target is three percent, and lower in the United States. The first question is, how sustainable is that policy? The second question is not unrelated. It has to do with the Southeast Asian countries and their currencies. How does this affect India?

Response:

On the fiscal deficit, I think that there is no universal number that is applicable to all countries irrespective of the functions which governments perform, and more importantly, irrespective of what the domestic savings rate of a country is. In India, for example, the railways are run not only as a public-sector enterprise, but also as a department of the government. If the railways had been separated from the government and set up independently, they would have borrowed anyway. But because of the way in which things are organized now, their borrowing, at least in part, is also reflected in what we call the fiscal deficit of the Government of India. There could be an argument about why the Government of India should run the railways. That is a different matter. So long as they run the railways, etc., the fiscal deficit of the Government of India also reflects the deficit or the borrowing of the various commercial enterprises that are treated as departments of the Government of India. In this context, one has also to look at the progress made in relation to the reduction of the fiscal deficit. From something like 8.3 percent of GDP, it has been taken down to four percent of the GDP, which I think is achievable and a creditable record, if it is achieved.

Let me come to the most important point. The domestic savings rate of the country is twenty-six percent. The order of fiscal deficit must be related to this. There are countries in the world where the domestic net savings rate is four or five percent, and a gross savings rate of about ten or eleven percent. If the gross savings rate of a country is about ten to eleven percent, there is a valid argument to say that the government, which is one constituent of the system, should not take away more than three percent. But if the domestic savings rate of a country is twenty-six percent, I do not think that the crowding-out effect of a given fiscal deficit is as strong as it is in a different situation. Therefore, given our domestic savings rate, I think a fiscal deficit of the order of four percent, which we have not yet achieved, will be very significant, and I think it is something that one can accept as an appropriate level. In fact, our own aim is to take the domestic savings rate to a higher level. In the total domestic savings rate there are three elements. One is the household savings rate, another is the corporate savings rate, and the third is the public-sector savings rate. The public sector includes the Center, the state governments, and the public-sector enterprises. Today the public-sector savings rate constitutes 1.9 percent of the GDP. The biggest chunk, of course, is that of the household sector, which is about 19.9 or twenty percent. The corporate sector’s gross savings rate is around three percent. We think that even if the fiscal deficit of the Government of India comes down by one percentage point it will improve the government’s savings rate. Therefore, the overall savings rate will not remain at twenty-six percent, but will, in fact, be higher than that. In that situation, I believe that four percent, or even higher with the Center and the states taken together, is still some level of fiscal deficit that will not have too much of a crowding-out effect.

The other question is about the East Asian economies and their impact. As far as we are concerned, so far the impact of this has been minimal, particularly in relation to the exchange market. We have not had any drastic decline in the value of the rupee in the recent period. There has been some decline, but nothing more than normal. It has been insulated partly for the reason that our external situation is very different from the external situation elsewhere. Our current account deficit in 1996-97 was one percent of the GDP, whereas, as you know, the current account deficit of many of these countries has been ranging from five to six percent of the GDP. Therefore, we are in a totally different ball game. Also, if you look at the manner in which the current account deficit is being financed, you find that the short-term debt is a very small part of our total debt. Our short-term debt constitutes six to seven percent of the total foreign debt, whereas, to cite one example, in Thailand the short-term debt constitutes something like thirty-two percent of the total debt. Therefore, a country that has a very high level of current account deficit plus a very high level of debt in the form of short-term debt becomes more vulnerable. If there is any downturn, which could be due to political or other factors, then the situation gets more aggravated as a consequence of these factors.

However, we do have a particular problem. All the countries around us have had their currencies either devalued, or have seen the values fall as a consequence of the market forces—Thailand twenty-five percent or so, and Malaysia to a similar extent, whereas the value of the Indian rupee has remained more or less at the same level. This can put India’s export position in some difficulty. The competitiveness of Indian exports may be eroded. I think it is not the direct trade between India and East Asia that is most important; it is really the competition in the third countries in relation to certain products. We will have to watch this, but as I said, our policy is to let the exchange rate be determined by market forces. Our intervention will be only to maintain orderly conditions in the market.

Mr. Krishnan Sadasivam, MBA student, Wharton School of Business, University of Pennsylvania:

What is the status of and time frame for current account convertibility? How do you see interest rates converging, given the large discrepancy between rates in India and the developed world?

Response:

As you know, we had appointed a committee on capital account convertibility that has reported, and has given a three-year time frame in which the major restrictions on capital transactions should be removed. In fact, ten days ago, as part of the credit policy for the second half of the year, we announced a number of measures in the direction of capital account convertibility. It is our objective to stick to this time frame, or maybe a little longer one of four years, during which we would like to remove the various restrictions with respect to capital account transactions. I think the world environment is also not at the moment very conducive to introducing some of these changes. Nevertheless, we are set in that particular direction. As you know, foreign institutional investors who make portfolio investments, foreign direct investors, or non-resident Indians already enjoy capital account convertibility. They can bring in money to make investments at any time and take it out at any time. It is only in relation to the resident Indians that the question of capital account convertibility is relevant. We have, in recent years, steadily expanded the avenues given to the resident Indians to raise money from outside, and more recently, also to invest outside India. We will, over a period of time, enlarge the scope so that we move towards more or less greater capital account convertibility.

On the issue of the convergence of interest rates, the most important thing here, of course, is the inflation differential. Unless the inflation differentials are narrowed, you cannot really bring about a convergence of the nominal interest rates. Of course, back home people do tell me that even though we have brought down the inflation rate, the nominal and real interest rates are still very high. I used to tell my audiences back home that everybody has become a pundit in economics these days and talks about real rates of interest. I never heard of any businessman talking about a real rate of interest until about a year ago, but now they talk about it. However, I told them that if one wants to become a pundit in economics one must become a full pundit and not half-a-pundit. The real rate of interest is not simply the nominal rate of interest minus the current inflation rate. Strictly speaking, it is really the nominal rate of interest minus the expected inflation rate. One is not putting money in a deposit for a period of two years looking only at the current inflation rate. What he wants as a nominal rate of interest is related to his expected inflation rate. We have brought down the inflation rate and it is my intention to see that the inflation rate remains at this level for a certain number of years. Then the inflation expectations will be broken, and we will be in a position to reduce the deposit rate. As we reduce the deposit rate, we can reduce the lending rate. Lending rates have fallen. In the last eight months the lending rates have fallen by two hundred basis points. Further reductions in the lending rates will become possible as we are able to maintain the inflation rate at this level, and the deposit rates can be brought down. This is our intention, and when that happens, as I mentioned earlier, there will be no disruptive adjustments in the exchange rate, because there will not be much difference even in the real effective exchange rate basis, and there will be a convergence of the interest rates, domestic and outside. However, at this particular moment, there is a difficult problem. I think the real rate of interest, measured in terms of the current inflation rate, is high, but I am hoping that as the inflation rate remains low, it should be possible to bring down the nominal rate of interest subsequently.

Professor Jitendra Singh, Department of Management, Wharton School of Business, and Faculty Fellow, CASI:

Dr. Rangarajan, my question concerns the so-called underground black economy. I wonder if you have any general observations about where this stands today in the Indian economy and to what extent do your policies as a central banker affect it?

Response:

This, of course, is a phenomenon seen not only in India, but elsewhere in the world as well. People call it by different names—underground economy, or black money as we call it. I always tell people that money is neither black nor white. Black money is really income on which tax has been evaded. All textbooks and all theorists say that the best way to prevent the generation of black income is to get the tax rates down. That is precisely what we have done. I think that the income tax rates in the top bracket have been brought down to thirty percent. I do not know of many countries that have brought them down that far. We have also tried to reduce the import duties very drastically. We are moving in the direction of trying to reduce the tax rates to prevent this incentive for avoiding taxes. Maybe habits die hard, and people who have been used to evading taxes will take some time to get out of that habit. But I do hope that they will, because you cannot get a better tax regime than what we have now. Of course, there are certain other tax rates which also need to be brought down. For example, the stamp duty regarding the transfer of property is very high in India. Therefore, in the real estate business a great deal of unaccounted money gets generated, because of the desire to avoid the registration duty. So we need to look at some of those areas as well.

I think there is another important thing that we have done. After introducing the market-determined exchange rate system, and after the most recent decision to allow the import of gold through specified agencies, even for domestic use, the unofficial foreign exchange market, usually known as the hawala market, is also getting a beating. Therefore, one other route through which this black income was getting circulated—not only within India, but also going out and coming back—also will get a beating after the recent change has been introduced. Therefore, I think these are some measures that will bring about a reduction in the creation of unaccounted money.

Professor Krishna Ramaswamy, Department of Finance, Wharton School of Business, and Faculty Fellow, CASI:

I have a question with respect to the role of competition in the banking sector, and its relation to interest rates.

Response:

As a matter of information, if you look at the interest rates—the lending rates charged by the public-sector banks and the private-sector banks—the public-sector banks are the ones that have lowered the interest rates; the private-sector banks have not. They have lowered them, but their level is much higher than the public-sector banks. This is also true of foreign banks. What the foreign banks and the private-sector banks are doing is playing the role of price-takers.

Now coming back to the basic issue that you raised, in reply I would say two things. One, this element of competition has not been introduced suddenly. This competition in interest rates has been progressively expanded. Until recently, the only deposit rate that the Reserve Bank was prescribing was on deposits for periods of between thirty days and one year. Above one year, it had been freed over the last several years. Therefore, they have been getting into the habit of being able to compete. We had freed the lending rates about three years ago. Beyond Rs. 200,000 they were free to fix the rate. Of course, there is a certain degree of asymmetry between the weak banks and the stronger banks. The stronger banks are in a position to bring down the interest rates much more easily than the weaker banks. I must also say that we have, in a sense, helped the banks to bring down the interest rates. The cash reserve ratio has been reduced steadily. Reduction in the cash reserve ratio by two percentage points implies a release of Rs. 9,600 crores—which is Rs. 96 billion—by the RBI into the hands of the commercial banks. This means that the profitability of the banks will increase as a consequence. On incremental impounded balances kept by banks with RBI, we were not paying any interest. Even if they were to put the money in very safe government paper, they would get ten percent out of it. Therefore, even as we wanted the interest rates to come down, we have enabled them to do this because their earning capacity was also being increased as a consequence of the reduction in the cash reserve ratio.

The other thing is that we were paying interest on the cash balances kept with us on the basis of a very complicated formula. It turned out that the effective rate was 3.5 percent. This complicated formula was abolished recently and we now pay four percent on the cash balances maintained with us. This also results in some extra income accruing to banks, which should enable the banks to bring down the rate of interest.

I think there is a lot of fat in all the banks. It is possible to bring about a reduction in the interest rates by all, including the weak banks. In the case of the weak banks, we have provided capital even more than in the case of others in order to bring their capital adequacy ratio to international standards. For example, in the case of the State Bank of India, neither the RBI nor the Government of India provided any funds in order to expand its capital, whereas the weaker banks were funded. The Government of India has funded the weak banks well enough for them to be able to come up to the required capital adequacy ratio. Almost all public-sector banks, except two, have reached the capital adequacy ratio, which is eight percent of the risk-weighted assets. The public-sector banks were showing net losses until the end of 1995-96. For the accounting year 1996-97, the public-sector banks taken together show a net profit of something like Rs. 30 billion, because all the provisioning that was required with respect to the non-performing assets has been made. Now what they have to do is to prevent further accumulation of non-performing assets.

We have been monitoring this, and I can also tell you that the non-performing assets arising out of the loans made since 1992-93, when the prudential norms were required, comes to only two to three percent. Therefore, in a sense, a kind of norm is getting introduced into the system. Now, of course, there are other problems that people raise. It is being said that because of the prudential norms, banks have become risk averters and they are not providing enough credit. People are saying that the banks are very hesitant to lend now, and a situation is being created, according to them, in which the expansion in bank credit or the rate of growth has come down. Also, in the case of Indian banks, even though they are all national banks with a network of branches all over the country, each has a niche for itself. I think there are some that are concentrated in certain parts of the country, and very strong in some areas, and therefore they have some kind of a competitive advantage in those areas.

Dr. Douglas Verney, Adjunct Professor of South Asia Regional Studies, University of Pennsylvania, and Faculty Fellow, CASI:

About the name—there’s the Bank of England, the Bank of Canada, here it’s the Federal Reserve Bank. What does the name “Reserve Bank of India” mean?

Response:

As you know, historically speaking, most of the central banks that were created in the 1930s, leaving aside the Federal Reserve, have the word “reserve” attached to them—the Reserve Bank of South Africa, the Reserve Bank of Australia, the Reserve Bank of India. There was also a common umbrella, as they were part of the British Empire at one time. Traditionally, one of the major functions of the central bank was the management of the foreign exchange reserves of the country, and that is perhaps the reason why the word “reserve” got attached to it. But names can be misleading. We have banks in India by the name of Central Bank of India, Bank of India and Indian Bank, and all of these are commercial banks. In Pakistan, the central bank is called the State Bank of Pakistan, whereas in India, the State Bank of India is a commercial bank. So I think somebody may write a book on how to name central banks, like the books we now have on how to name a child!

Alan Heston:

I think you all appreciate our speaker’s modesty, strengths, and command of not only his field of financial and monetary economics, but also his forceful way of dealing with them. We have all been very lucky to have you here as our second CASI Faculty Fellows lecturer, and we are very delighted that you were able to come back to Penn to join us. Thank you very much.