monetary policy transmission in india* rakesh mohanrakeshmohan.com/docs/rbibulletinapril2007.pdf ·...

RBIMonthly Bulletin

April 2007 421

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Monetary PolicyTransmission

in India

Rakesh Mohan

* Paper presented by Dr. Rakesh Mohan, Deputy Governor,Reserve Bank of India at the Deputy Governor’s Meetingon Transmission Mechanism of Monetary Policy inEmerging Market Economies – What is New? at Bank ofInternational Settlements, Basel on December 7-8, 2006.Assistance of Michael D. Patra and Sanjay Hansda inpreparing this paper is gratefully acknowledged.

Key to the efficient conduct of monetarypolicy is the condition that it must exert asystematic influence on the economy in aforward-looking sense. A priori economictheory backed by some empirical evidencehas identified the main channels throughwhich monetary policy impacts its finaltargets, viz., output, employment andinflation. Broadly, the vehicles of monetarytransmission can be classified into financialmarket prices (e.g., interest rates, exchangerates, yields, asset prices, equity prices) andfinancial market quantities (money supply,credit aggregates, supply of governmentbonds and foreign currency denominatedassets). It is recognised that, whereas thesechannels are not mutually exclusive, therelative importance of each channel maydiffer from one economy to anotherdepending on a number of factors includingthe underlying structural characteristics,state of development of financial markets,the instruments available to monetary policy,the fiscal stance and the degree of openness.

Traditionally, four key channels ofmonetary policy transmission are identified,viz., interest rate, credit aggregates, assetprices and exchange rate channels. Theinterest rate channel emerges as thedominant transmission mechanism ofmonetary policy. An expansionary monetarypolicy, for instance, is expected to lead to alowering of the cost of loanable funds, which,in turn, raises investment and consumptiondemand and should eventually get reflectedin aggregate output and prices. Monetarypolicy also operates on aggregate demandthrough changes in the availability ofloanable funds, i.e., the credit channel. It is,however, relevant to note that the ‘creditchannel’ is not a distinct, free-standing

Monetary PolicyTransmission in India*

Rakesh Mohan

RBIMonthly BulletinApril 2007422

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Monetary PolicyTransmissionin India

Rakesh Mohan

alternative to the traditional transmissionmechanism but should rather be seen as achannel that can amplify and propagateconventional interest rate effects (Bernankeand Gertler, 1995). Nevertheless, it is fair toregard the credit channel as runningalongside the interest rate channel toproduce monetary effects on real activity(RBI, 2002). Changes in interest rates by themonetary authorities also inducemovements in asset prices to generate wealtheffects in terms of market valuations offinancial assets and liabilities. Higher interestrates can induce an appreciation of thedomestic currency, which in turn, leads to areduction in net exports and, hence, inaggregate demand and output.

In the recent period, a fifth channel –expectations – has assumed prominence inthe conduct of forward-looking monetarypolicy in view of its influence on thetraditional four channels. For example, thelink between short- and long-term real ratesis widely believed to follow from theexpectational hypothesis of the termstructure of interest rates. In a generalisedcontext, the expectations channel ofmonetary policy postulates that the beliefsof economic agents about future shocks tothe economy as also the central bank’sreactions can affect the variables that aredetermined in a forward-looking manner.Thus, “open-mouth operation” by thecentral bank, i.e., an announcement offuture central bank policy influencesexpectations in financial markets and leadsto changes in output and inflation. Clearly,the credibility of the monetary authoritydrives the expectations channel.

The rest of the paper focuses on theIndian experience with monetary policy

transmission. Section I delineates theobjectives of monetary policy in India.Section II presents the framework andinstruments of monetary policy alongsidethe evolution of institutional developmentswhich were to have a fundamental bearingon the monetary policy transmission.Section III discusses the monetary policytransmission channels: operatingprocedures, channel of bank lending andrates, debt market channel, exchange ratechannel, and communication andexpectations channel. Section IV makes anassessment of monetary transmission interms of the ultimate objectives ofmonetary policy: price stability andgrowth. Section V discusses what is neededto improve monetary transmission. SectionVI sums up the challenges and dilemmasof monetary policy.

I. Objectives of Monetary Policy

The short title to the Reserve Bank ofIndia Act, 1934 sets out the objectives of theBank: “to regulate the issue of Bank notesand the keeping of reserves with a view tosecuring monetary stability in India andgenerally to operate the currency and creditsystem of the country to its advantage”.Although there has not been any explicitlegislation for price stability, the twinobjectives of monetary policy in India arewidely regarded as (i) price stability and (ii)provision of adequate credit to productivesectors of the economy so as to supportaggregate demand and ensure high andsustained growth. With the increasingopenness of the Indian economy, greateremphasis has been laid in recent years onstrengthening the institutional capacity inthe country to support growth consistent

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with stability in the medium term. Giventhe overarching consideration for sustainedgrowth in the context of high levels ofpoverty and inequality, price stability hasevolved as the dominant objective ofmonetary policy. The underlyingphilosophy is that it is only in a low andstable inflation environment that economicgrowth can be sustained.

In recent years, financial stability hasassumed priority in the conduct ofmonetary policy in view of the increasingopenness of the Indian economy, financialintegration and possibility of cross bordercontagion. Strong synergies andcomplementarities are observed betweenprice stability and financial stability inIndia. Accordingly, regulation, supervisionand development of the financial systemremain in India within the legitimate ambitof monetary policy, broadly interpreted.

II. Framework and Instruments

Prior to the mid-1980s, there was noformal enunciation of monetary policyobjectives, instruments and transmissionchannels in India other than that ofadministering the supply/ allocation of anddemand for credit in alignment with theneeds of a planned economy. Over theperiod from 1985 to 1997, India followed amonetary policy framework that couldbroadly be characterised as one of loose andflexible monetary targeting with feedback(Annex I). Under this approach, growth inbroad money supply (M3) was projected ina manner consistent with expected GDPgrowth and a tolerable level of inflation. TheM3 growth thus worked out was considereda nominal anchor for policy. Reserve money

(RM) was used as the operating target andbank reserves as the operating instrument.As deregulation increased the role of marketforces in the determination of interest ratesand the exchange rate, monetary targeting,even in its flexible mode, came under stress.Capital flows increased liquidityexogenously, put upward pressure on themoney supply, prices and the exchangerates, the latter having gained importancevis à vis quantity variables. While moststudies in India showed that moneydemand functions had been fairly stable, itwas increasingly felt that financialinnovations and technology hadsystematically eroded the predictivepotential of money demand estimationsrelative to the past. Interest rates gainedrelative influence on the decision to holdmoney. Accordingly, the monetary policyframework was reviewed towards the late1990s, and the Reserve Bank switched overto a more broad-based multiple indicatorapproach from 1998-99. In this approach,policy perspectives are obtained byjuxtaposing interest rates and other rates ofreturn in different markets (money, capitaland government securities markets), whichare available at high frequency with mediumand low frequency variables such as currency,credit extended by banks and financialinstitutions, the fiscal position, trade andcapital flows, inflation rate, exchange rate,refinancing and transactions in foreignexchange and output. For simplicity and tofacilitate greater understanding, the quarterlypolicy statements of the Reserve Bankcontinue to be set in a framework in termsof money, output and prices.

Since the late 1980s, there has been anenhanced emphasis by many central banks


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on securing operational freedom formonetary policy and investing it with asingle goal, best embodied in the growingindependence of central banks and inflationtargeting as an operational framework formonetary policy, which has importantimplications for transmission channels. Inthis context, the specific features of theIndian economy have led to the emergenceof a somewhat contrarian view: ‘‘In India,we have not favoured the adoption ofinflation targeting, while keeping theattainment of low inflation as a centralobjective of monetary policy, along with thatof high and sustained growth that is soimportant for a developing economy. Apartfrom the legitimate concern regardinggrowth as a key objective, there are otherfactors that suggest that inflation targetingmay not be appropriate for India. First,unlike many other developing countries wehave had a record of moderate inflation,with double digit inflation being theexception, and largely socially unacceptable.Second, adoption of inflation targetingrequires the existence of an efficientmonetary transmission mechanism throughthe operation of efficient financial marketsand absence of interest rate distortions. InIndia, although the money market,government debt and forex markets haveindeed developed in recent years, they stillhave some way to go, whereas the corporatedebt market is still to develop. Thoughinterest rate deregulation has largely beenaccomplished, some administered interestrates still persist. Third, inflationarypressures still often emanate fromsignificant supply shocks related to theeffect of the monsoon on agriculture, wheremonetary policy action may have little role.Finally, in an economy as large as that of

India, with various regional differences, andcontinued existence of marketimperfections in factor and product marketsbetween regions, the choice of a universallyacceptable measure of inflation is alsodifficult’’ (Mohan, 2006b).

The success of a framework that relieson indirect instruments of monetarymanagement such as interest rates iscontingent upon the extent and speed withwhich changes in the central bank’s policyrate are transmitted to the spectrum ofmarket interest rates and exchange rate inthe economy and onward to the real sector.Clearly, monetary transmission cannot takeplace without efficient price discovery,particularly, with respect to interest ratesand exchange rates. Therefore, in theefficient functioning of financial markets,the corresponding development of the fullfinancial market spectrum becomesnecessary. In addition, the growingintegration of the Indian economy with therest of the world has to be recognized andprovided for. Accordingly, reforms focusedon improving operational effectiveness ofmonetary policy have been put in process,while simultaneously strengthening theregulatory role of the Reserve Bank, tighteningthe prudential and supervisory norms,improving the credit delivery system anddeveloping the technological and institutionalframework of the financial sector.

Market Development

Given the pivotal role of the moneymarket in transmission, efforts initiated inthe late 1980s were intensified over the fullspectrum. Following the withdrawal of theceiling on inter-bank money market ratesin 1989, several financial innovations in

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terms of money market instruments suchas certificate of deposits, commercial paperand money market mutual funds wereintroduced in phases. Barriers to entry weregradually eased by increasing the numberof players and relaxing the issuance andsubscription norms in respect of moneymarket instruments, thus fostering betterprice discovery. Participation in the callmoney market was widened to coverprimary and satellite dealers and corporates(through primary dealers), besides otherparticipants. In order to improve monetarytransmission as also on prudentialconsiderations, steps were initiated in 1999to turn the call money market into a pureinter-bank market and, simultaneously, todevelop a repo market outside the officialwindow for providing a stable collateralisedfunding alternative, particularly to non-banks who were phased out of the callsegment, and banks. The Collateralised

Borrowing and Lending Obligation (CBLO),a repo instrument developed by the ClearingCorporation of India Limited (CCIL) for itsmembers, with the CCIL acting as a centralcounter-party for borrowers and lenders,was permitted as a money marketinstrument in 2002. With the developmentof market repo and CBLO segments, the callmoney market has been transformed into apure inter-bank market, including primarydealers, from August 2005. A recentnoteworthy development is the substantialmigration of money market activity fromthe uncollateralised call money segment tothe collateralised market repo and CBLOmarkets (Annex II). Thus, uncollateralisedovernight transactions are now limited tobanks and primary dealers in the interestof financial stability (Table 1).

The Government securities market isimportant for the entire debt market as it

TTTTTable 1: Activity in Money Markable 1: Activity in Money Markable 1: Activity in Money Markable 1: Activity in Money Markable 1: Activity in Money Market Segmentset Segmentset Segmentset Segmentset Segments(Rupees billion)

AAAAAverage Daily Tverage Daily Tverage Daily Tverage Daily Tverage Daily Turnover (One leg)urnover (One leg)urnover (One leg)urnover (One leg)urnover (One leg) CommercialCommercialCommercialCommercialCommercial Certificates ofCertificates ofCertificates ofCertificates ofCertificates of

YYYYYear/Monthear/Monthear/Monthear/Monthear/Month Call MoneyCall MoneyCall MoneyCall MoneyCall Money MarkMarkMarkMarkMarket Repoet Repoet Repoet Repoet Repo CBLOCBLOCBLOCBLOCBLO TTTTTerm Moneyerm Moneyerm Moneyerm Moneyerm MoneyPPPPPaperaperaperaperaper DepositDepositDepositDepositDeposit

MarkMarkMarkMarkMarketetetetet MarkMarkMarkMarkMarketetetetet(Outstanding)(Outstanding)(Outstanding)(Outstanding)(Outstanding) (Outstanding)(Outstanding)(Outstanding)(Outstanding)(Outstanding)

1 2 3 4 5 6 7

2003-04 * 86 26 3 3 78 322004-05 * 71 43 34 3 117 612005-06 * 90 53 100 4 173 2732006-07April 85 55 163 5 165 441May 90 90 172 5 169 502June 87 106 138 6 197 564July 91 97 157 4 211 592August 107 78 156 5 229 656September 118 92 148 6 244 653October 132 97 170 5 232 658November 128 94 161 4 242 689December 121 72 155 5 233 686

CBLO : Collateralised Borrowing and Lending Obligation.* : The average daily turnover (one leg) for a year is arrived at by adding daily turnovers (one leg) and then dividing

the sum by the number of days in the year.Source :Source :Source :Source :Source : Macroeconomic and Monetary Developments, various issues, Reserve Bank of India.


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serves as a benchmark for pricing other debtmarket instruments, thereby aiding themonetary transmission across the yieldcurve. The key policy development that hasenabled a more independent monetarypolicy environment as well as thedevelopment of government securitiesmarket was the discontinuation ofautomatic monetisation of thegovernment’s fiscal deficit since April 1997through an agreement between theGovernment and the Reserve Bank of Indiain September 1994 (Annex III).Subsequently, enactment of the FiscalResponsibility and Budget Management Act,2003 has strengthened the institutionalmechanism further: from April 2006onwards, the Reserve Bank is no longerpermitted to subscribe to governmentsecurities in the primary market. This stepcompletes the transition to a fully marketbased system for government securities.Looking ahead, consequent to therecommendations of the Twelfth FinanceCommission, the Central Governmentwould cease to raise resources on behalf ofState Governments, which, henceforth, willhave to access the market directly. Thus,State Governments’ capability in raisingresources will be market determined andbased on their own financial health. Forensuring a smooth transition, institutionalprocesses are being revamped towardsgreater integration in monetary operations.

As regards the foreign exchange market,reforms have been focused on marketdevelopment incorporating prudentialsafeguards so that the market would not bedestabilised in the process. The movetowards a market-based exchange rateregime in 1993, the subsequent adoption of

current account convertibility and de-factocapital account convertibility for selectcategories of non-residents were the keyenabling factors in reforming the Indianforeign exchange market prior to now.India’s approach to financial integration hasso far been gradual and cautious guided bysignposts/concomitants in terms ofimprovement in fiscal, inflation andfinancial sector indicators, inter alia, effortsare currently underway to move towardsfuller capital account convertibility even forresidents. In the period 2000-06, a numberof measures were initiated to integrate theIndian forex market with the global financialsystem, with increasing freedom given tobanks to borrow abroad and fix their ownposition and gap limits (Annex IV).

The development of the monetary policyframework has also involved a great deal ofinstitutional initiatives in the area of trading,payments and settlement systems along withthe provision of technological infrastructure.The interaction of technology withderegulation has also contributed to theemergence of a more open, competitive andglobalised financial market. While the policymeasures in the pre-1990s period wereessentially devoted to financial deepening,the focus of reforms in the last decade and ahalf has been engendering greater efficiencyand productivity in the banking system(Annex V). Legislative amendments have alsobeen carried out to strengthen ReserveBank’s regulatory jurisdiction over financialmarkets, providing greater instrumentindependence and hence, ensuringmonetary transmission.

The relative weights assigned to variouschannels of transmission of monetary policy

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also reflect a conscious effort to move fromdirect instruments of monetary control toindirect instruments. Illustratively, the CRRwhich had been brought down from a peak of15 per cent in 1994-95 to 4.5 per cent by June2003, before the onset of withdrawal ofmonetary accommodation since October 2004is now 6.0 per cent (Chart 1). The recentamendment to the RBI Act in 2006 will furtherstrengthen monetary maneuverability sinceit allows for the removal of the floor of 3 percent and ceiling of 20 per cent on CRR.Monetary control is also exercised through theprescription of a statutory liquidity ratio (SLR),which is a variant of the secondary reserverequirement in several countries. It ismaintained in the form of specified assetssuch as cash, gold and ‘approved’ andunencumbered securities – the latter beingexplicitly prescribed – as a proportion to netdemand and time liabilities (NDTL) of banks.Accordingly, the SLR is also important forprudential purposes, i.e., to assure thesoundness of the banking system.The pre-emption under the SLR, which had increasedto about 38.5 per cent of NDTL in thebeginning of the 1990s, was brought to itsstatutory minimum of 25 per cent by October

1997. Banks, however, continue to hold moregovernment securities than the statutoryminimum SLR, reflecting risk perception andportfolio choice. The statutory minimum SLRof 25 per cent has been removed now(January 2007) to provide for greaterflexibility in the Reserve Bank’s monetarypolicy operations. The reform of themonetary and financial sectors has, thus,enabled the Reserve Bank to expand the arrayof instruments at its command andenhanced its ability to respond to evolvingcircumstances.

III. Operating Procedure forMonetary Policy

Short-term interest rates have emergedas the key indicators of the monetary policystance all over the world. It is alsorecognised that stability in financial marketsis critical for efficient price discovery andmeaningful signaling. Since the interest rateand exchange rate are key prices reflectingthe cost of money, it is particularlyimportant for efficient functioning of theeconomy that they be market determinedand easily observed.

CRR SLR

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Chart 1: Reserve Requirements


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Central banks follow a variety ofoperating frameworks and procedures forsignaling and implementing the monetarypolicy stance on a day-to-day basis, with aview to achieving the ultimate objectives –price stability and growth. The choice ofpolicy framework in any economy is alwaysa difficult one and depends on the stage ofmacroeconomic and financial sectordevelopment and is somewhat of anevolutionary process (Mohan, 2006a). In amarket-oriented financial system, centralbanks typically use instruments that aredirectly under their control: required reserveratios, interest charged on borrowed reserves(discount window) provided directly orthrough rediscounting of financial assetsheld by depository institutions, open marketoperations (OMOs) and selective creditcontrols. These instruments are usuallydirected at attaining a prescribed value of theoperating target, typically bank reserves and/or a very short-term interest rate (usually theovernight interbank rate). The optimal choicebetween price and quantity targets woulddepend on the sources of disturbances in thegoods and money markets (Poole, 1970). Ifmoney demand is viewed as highly unstable,greater output stability can be attained bystabilising interest rates. If, however, themain source of short-run instability arisesfrom aggregate spending or unsterilisedcapital inflows, a policy that stabilisesmonetary aggregates could be desirable. Inreality, it often becomes difficult to trace outthe sources of instability. Instead, monetarypolicy is implemented by fixing, at least overthe short time horizon, the value of anoperating target or policy instrument. Asadditional information about the economyis obtained, the appropriate level at whichto fix the policy instrument/ target changes.

The operating procedures of monetarypolicy of most central banks have largelyconverged to one of the following threevariants: (i) a number of central banks,including the US Federal Reserve, estimatethe demand for bank reserves and then carryout open market operations to target short-term interest rates; (ii) another set of centralbanks, of which the Bank of Japan used tobe a part until recently, estimate marketliquidity and carry out open marketoperations to target bank reserves, whileallowing interest rates to adjust; and (iii) agrowing number of central banks, includingthe European Central Bank and the Bank ofEngland, modulate monetary conditions interms of both quantum and price of liquidity,through a mix of OMOs, standing facilitiesand minimum reserve requirement andchanges in the policy rate. The operatingprocedure, followed in India, however,presents a fourth variant.

III.1 Money Markets and the LiquidityAdjustment Facility

In the Indian context, reforms in themonetary policy operating framework,which were initiated in the late 1980scrystallised into the Liquidity AdjustmentFacility (LAF) in 2000 (Annex VI). Under theLAF, the Reserve Bank sets its policy rates,i.e., repo and reverse repo rates and carriesout repo/reverse repo operations, therebyproviding a corridor for overnight moneymarket rates (Chart 2). The LAF avoidstargeting a particular level of overnightmoney market rate in view of exogenousinfluences impacting liquidity at theshorter end, viz., volatile government cashbalances and unpredictable foreignexchange flows.

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Although repo auctions can be conductedat variable or fixed rates on overnight orlonger-term, given market preference and theneed to transmit interest rate signals quickly,the LAF has settled into a fixed rate overnightauction mode since April 2004. With theintroduction of Second LAF (SLAF) fromNovember 28, 2005 market participants nowhave a second window during the day to fine-tune their liquidity management (Chart 3).LAF operations continue to be supplementedby access to the Reserve Bank’s standingfacilities linked to repo rate: export creditrefinance to banks and standing liquidityfacility to the primary dealers.

The introduction of LAF has hadseveral advantages. First and foremost, itmade possible the transition from directinstruments of monetary control toindirect instruments. Since LAF operationsenabled reduction in CRR without loss ofmonetary control, certain dead weight lossfor the system was saved. Second, LAF hasprovided monetary authorities withgreater flexibility in determining both thequantum of adjustment as well as the ratesby responding to the needs of the systemon a daily basis. Third and mostimportantly, though there is no formaltargeting of a point overnight interest rate,

Call Rate Repo Rate Reverse Repo Rate CBLO Rate Market Repo Rate

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Chart 3: Repo (+)/ Reverse Repo (-) under LAF

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LAF helped to stabilise overnight call rateswithin a specified corridor, the differencebetween the fixed repo and reverse reporates currently being 150 basis points. Ithas thus enabled the central bank to affectdemand for funds through policy ratechanges. In this sense, LAF rates performthe role of nominal anchor effectively.Although call money rates edged above therepo rate during January-February 2006,the rates in the collateralised segment ofthe money market – market repos andCBLO, which account for nearly 80 per centof the market turnover – remained belowthe repo rate.

III.2 Market Stabilisation Scheme

In the context of increasing opennessof the economy, a market-determinedexchange rate and large capital inflows,monetary management may warrantsterilising foreign exchange marketintervention, partly or wholly, so as to retainthe intent of monetary policy. Initially, theReserve Bank sterilised capital inflows byway of OMOs. Such sterilisation, however,involves cost in terms of lower returns on

international assets vis-à-vis domestic assets(Chart 4). The finite stock of governmentsecurities with the Reserve Bank alsolimited its ability to sterilise. The LAFoperations, which are essentially designedto take care of frictional daily liquidity beganto bear the burden of stabilisationdisproportionately.

The Reserve Bank, therefore, signed inMarch 2004 a Memorandum ofUnderstanding (MoU) with the Governmentof India for issuance of Treasury Bills anddated Government Securities under theMarket Stabilisation Scheme (MSS), inaddition to normal Government borrowings(Annex VII). The new instrumentempowered the Reserve Bank to absorbliquidity on a more enduring but stilltemporary basis while leaving LAF for dailyliquidity management and usingconventional OMO on more enduring basis(Chart 5). The MSS has provided the ReserveBank flexibility not only to absorb but alsoinject liquidity in times of need by way ofunwinding. Therefore, short-terminstruments are generally preferred for MSSoperations.

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Chart 4: Changes in Net Domestic Assets and Net Foreign Assets

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The various tools of liquiditymanagement have thus enabled theReserve Bank to maintain liquidityconditions, orderly movement in both

exchange rates and interest rates andconduct monetary policy in accordancewith its stated objectives (Annex VIII andTable 2).

TTTTTable 2: Phases of Reserable 2: Phases of Reserable 2: Phases of Reserable 2: Phases of Reserable 2: Phases of Reserve Bank’s Liquidity Management Operationsve Bank’s Liquidity Management Operationsve Bank’s Liquidity Management Operationsve Bank’s Liquidity Management Operationsve Bank’s Liquidity Management Operations

(Rupees billion)

VVVVVariation duringariation duringariation duringariation duringariation during

ItemItemItemItemItem 2003-042003-042003-042003-042003-04 2004-052004-052004-052004-052004-05 2005-062005-062005-062005-062005-06 2006-07 Q12006-07 Q12006-07 Q12006-07 Q12006-07 Q1 2006-07 Q22006-07 Q22006-07 Q22006-07 Q22006-07 Q2

1 2 3 4 5 6

AAAAA..... Drivers ofDrivers ofDrivers ofDrivers ofDrivers of Liquidity Liquidity Liquidity Liquidity Liquidity 721721721721721 581581581581581 –––––317317317317317 355355355355355 –––––158158158158158(1+2+3+4)(1+2+3+4)(1+2+3+4)(1+2+3+4)(1+2+3+4)1. RBI’s Foreign Currency Assets 1414 1150 688 285 105

(adjusted for revaluation)2. Currency with the Public –434 –409 –573 –215 –13. Surplus Cash Balances of the

Centre with the Reserve Bank –177 5 –227 402 –2624. Others (residual) -83 –165 –205 –118 –1

B.B.B.B.B. Management of LiquidityManagement of LiquidityManagement of LiquidityManagement of LiquidityManagement of Liquidity –––––464464464464464 –––––567567567567567 580580580580580 –––––390390390390390 320320320320320(5+6+7+8)(5+6+7+8)(5+6+7+8)(5+6+7+8)(5+6+7+8)5. Liquidity impact of LAF Repos –322 153 121 –353 4076. Liquidity impact of OMO (Net) * –176 12 107 5 17. Liquidity impact of MSS 0 –642 351 –42 -888. First round liquidity impact

due to CRR change 35 –90 0 0 0C.C.C.C.C. Bank ReserBank ReserBank ReserBank ReserBank Reserves (A+B) #ves (A+B) #ves (A+B) #ves (A+B) #ves (A+B) # 257257257257257 1414141414 263263263263263 –––––3535353535 162162162162162

(+) : Indicates injection of liquidity into the banking system.(–) : Indicates absorption of liquidity from the banking system.# : Includes vault cash with banks and adjusted for first round liquidity impact due to CRR change.* : Adjusted for Consolidated Sinking Funds (CSF) and Other Investments and including private placement.NoteNoteNoteNoteNote ::::: Data pertain to March 31 and last Friday for all other months.Source :Source :Source :Source :Source : Annual Report and Macroeconomic and Monetary Developments, various issues, Reserve Bank of India.

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Chart 5: Liquidity Management

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Net LAF MSS GOI Cash Balances Net Forex Intervention


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Government cash balances with theReserve Bank often display sizeablevolatility. First, due to operationalrequirements which are difficult to predict(except for salary payments, coupon/interest payments, redemption of loans andthe like), Government needs to maintain asubstantial cash position with the ReserveBank. Second, there is the need formaintaining or building up cash balancesgradually over many weeks ahead of large,known disbursements such as lumpyredemption of bonds contracted forfinancing high fiscal deficit and,particularly, benchmark bonds, if marketsare not to be disrupted. Third, while a majorpart of outflows from government cashbalances is regular, inflows by way of directtax revenues and other sources are lumpyand irregular in nature.

Accumulating Government cashbalances with the central bank, in effect, actas withdrawal of liquidity from the systemand have the same effect as that ofmonetary tightening, albeit without anyintention to do so by the monetaryauthority. Similarly, there would beinjection of liquidity into the system ifGovernment cash balances maintained withthe central bank decline, despite a situationin which, for instance, monetary policy isbiased towards tightening liquidity. Thus,volatile Government cash balances couldcause unanticipated expansion orcontraction of the monetary base, andconsequently, money supply and liquidity,which may not necessarily be consistent withthe prevailing stance of the monetary policy.In the presence of fluctuating Governmentcash balances, the task of monetarymanagement becomes complicated, often

warranting offsetting measures, partly orwholly, so as to retain the intent ofmonetary policy.

III.3 Bank Credit and Lending RateChannels

There is some evidence of the banklending channel working in addition to theconventional interest rate channel. In viewof the asymmetry in the resource base,access to non-deposit sources, assetallocation and liquidity, big and small banksare found to respond in significantlydifferent ways. In particular, small banks aremore acutely affected by contractionarymonetary policy shocks as compared to bigbanks, i.e., smaller banks curtail theirlending more sharply vis-à-vis large banks(Pandit et al, 2006). Available empiricalevidence also indicates that prudentialnorms, as proxied by banks’ capitaladequacy ratios, exert a significant influenceon bank lending (Annex IX, Nag and Das,2002; Pandit et al, 2006).

The monetary policy stance of the Bankis often articulated as a commitment toensure that all genuine requirements forbank credit are adequately met in order tosupport investment and export demandconsistent with price stability (Annex X).Liquidity operations are conducted with aview to ensuring that the demand forreserves is satisfied and credit projectionsconsistent with macroeconomic objectivesare achieved. Simultaneously, improvementsin the delivery of bank credit are pursuedin recognition of the possibility of marketfailure in efficiently auctioning credit. Anintegral element of the conduct of monetarypolicy has, therefore, been the direction ofbank credit to certain sectors of priority

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such as agriculture, exports, small scaleindustry, infrastructure, housing, micro-credit institutions and self help groups. Anon going policy endeavour is enhancing andsimplifying the access to credit with a viewto securing the widest inclusion of societyin the credit market (Table 3).

Available empirical evidence coveringthe period September 1998 - March 2004suggests that the interest rate pass-throughfrom changes in the policy rate was 0.61 and0.42 for lending and deposit rates,respectively, i.e., a reduction/increase of 100basis points (bps) in the Bank Rate led to areduction/increase of almost 40 bps in thebanks’ deposit rates and 60 bps in theirprime lending rate (Tables 4 & 5). Rolling

regressions suggest some improvement inpass-through to lending rates and deposits.Thus, though pass-through is less thancomplete, there are signs of an increase inpass-through over time (RBI, 2004b).

The improvement in the pass-throughcan be attributed to policy efforts to impartgreater flexibility to the interest ratestructure in the economy through variousmeasures such as advising banks: tointroduce flexible interest rate option fornew deposits; to review their maximumspreads over prime lending rate (PLR) andreduce them wherever they areunreasonably high; to announce themaximum spread over PLR to the publicalong with the announcement of their PLR;

TTTTTable 3: Sectoral Shares in Non-food Bank Creditable 3: Sectoral Shares in Non-food Bank Creditable 3: Sectoral Shares in Non-food Bank Creditable 3: Sectoral Shares in Non-food Bank Creditable 3: Sectoral Shares in Non-food Bank Credit

(Per cent)

Sector/IndustrSector/IndustrSector/IndustrSector/IndustrSector/Industryyyyy OutstandingOutstandingOutstandingOutstandingOutstanding MarchMarchMarchMarchMarch MarchMarchMarchMarchMarch MarchMarchMarchMarchMarchon Octoberon Octoberon Octoberon Octoberon October 20062006200620062006 2005 2005 2005 2005 2005 20042004200420042004

27, 200627, 200627, 200627, 200627, 2006

Non-food Gross Bank Credit 100 100 100 100

1. Agriculture and Allied Activities 12 12 13 12

2. Industry (Small, Medium and Large) 39 39 43 432.1 Small Scale Industries 6 6 8 9

3. Services 2 3 3 …3.1 Transport Operators 1 1 1 …3.2 Professional and Others 1 1 1 …

4. Personal Loans 26 25 25 …4.1 Housing 14 13 13 …4.2 Advances against Fixed Deposits 2 3 3 44.3 Credit Cards 1 1 1 …4.4 Education 1 1 1 …4.5 Consumer Durables 1 1 1 1

5. Trade 6 6 6 3

6. Others 9 14 11 416.1 Real Estate Loans 2 2 1 16.2 Non-Banking Financial Companies 2 2 2 2

Memo Item:

Bank Credit-GDP ratio 40.3 * 42.2 35.2 30.4

*: Approximately.Note :Note :Note :Note :Note : Sectoral shares may not add up to 100 due to rounding off.SourceSourceSourceSourceSource ::::: Annual Report 2005-06, Reserve Bank of India.


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and, to switch over to “all cost” concept forborrowers by explicitly declaring the variouscharges such as processing and servicecharges (Table 6)2. Besides, interest rates

have emerged as a more potent instrumentthan before with the move towards floatingas against fixed rate products under whichthe transmission is limited at the margin.

2From October 18, 1994, banks have been free to fix the lending rates for loans above Rupees 2,00,000. Banks were

required to obtain the approval of their respective Boards for the PLR which would be the minimum rate charged forloans above Rs. 2,00,000. In the interest of small borrowers as also to remove the disincentive for credit flow to suchborrowers, PLR was converted into a ceiling rate for loans up to Rs. 2,00,000 in 1998-99. Sub-PLR lending was allowedin 2001-02 in keeping with international practice. For customers' protection and meaningful competition, bank-wisequarterly data on PLR, and maximum and minimum lending rates have been placed at the Reserve Bank's website,starting from June 2002. Towards greater transparency in loan pricing in the context of sticky behaviour of lendingrates, the system of BPLR (i.e., benchmark PLR) was introduced in 2003-04. Banks were advised to specify their BPLRtaking into account (a) actual cost of funds, (b) operating expenses and (c) a minimum margin to cover regulatoryrequirements of provisioning and capital charge, and profit margin. Whereas, conceptually the BPLR should turn out tobe a median lending rate in practice, the specification of BPLR by banks has turned out to be sticky. Movements in theactual interest rate charged take place less transparently through changes in the proportion of loans above or below theannounced BPLR. The share of sub-BPLR lending has, in recent times, increased to over 75 per cent reflecting theoverall decline in interest rates, until recently. This has undermined the role of BPLR as a reference rate, complicatingthe judgment on monetary transmission in regard to lending rates.

TTTTTable 5: Outstanding Lable 5: Outstanding Lable 5: Outstanding Lable 5: Outstanding Lable 5: Outstanding Loans of Scheduled Commercial Banks by Interest Roans of Scheduled Commercial Banks by Interest Roans of Scheduled Commercial Banks by Interest Roans of Scheduled Commercial Banks by Interest Roans of Scheduled Commercial Banks by Interest Rateateateateate(At the end of March)

(Per cent to total loans)

InterestInterestInterestInterestInterest 19901990199019901990 19951995199519951995 19971997199719971997 19981998199819981998 19991999199919991999 20002000200020002000 20012001200120012001 20022002200220022002 20032003200320032003 20042004200420042004 20052005200520052005RRRRRate Slabate Slabate Slabate Slabate Slab

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

<6% 2.7 2.3 1.1 1.0 0.3 0.2 0.2 0.1 0.1 0.4 0.46-10% 6.8 2.1 0.5 0.4 3.7 1.0 0.6 3.2 5.3 13.6 19.510-12% 4.8 2.3 1.4 2.3 3.3 7.9 17.0 24.5 22.9 16.1 17.512-14% 21.4 10.6 10.7 13.2 20.3 26.8 28.6 22.5 25.1 25.7 22.414-15% 4.4 6.7 10.9 14.9 9.7 11.5 12.6 14.1 19.4 16.2 16.6> 15% 59.8 76.0 75.4 68.2 62.7 52.6 41.0 35.6 27.1 28.0 23.6

Source :Source :Source :Source :Source : Basic Statistical Returns of Scheduled Commercial Banks in India, various issues, Reserve Bank of India.

TTTTTable 4: Outstanding Table 4: Outstanding Table 4: Outstanding Table 4: Outstanding Table 4: Outstanding Term Deposits of Scheduled Commercial Banks by Interest Rerm Deposits of Scheduled Commercial Banks by Interest Rerm Deposits of Scheduled Commercial Banks by Interest Rerm Deposits of Scheduled Commercial Banks by Interest Rerm Deposits of Scheduled Commercial Banks by Interest Rateateateateate(At the end of March)

(Per cent to total deposits)

InterestInterestInterestInterestInterest 19961996199619961996 19971997199719971997 19981998199819981998 19991999199919991999 20002000200020002000 20012001200120012001 20022002200220022002 20032003200320032003 20042004200420042004 20052005200520052005RRRRRate Slabate Slabate Slabate Slabate Slab

1 2 3 4 5 6 7 8 9 10 11

< 8% 10.8 11.2 11.5 13.3 16.8 16.9 25.0 53.7 74.0 86.48 – 9% 2.4 5.2 4.8 6.1 6.5 10.5 22.6 16.4 9.9 5.89 – 10% 4.5 7.1 6.4 9.0 14.3 16.1 19.8 12.0 7.3 3.110 – 11% 15.2 14.1 13.7 17.7 20.9 23.9 17.3 10.5 5.1 2.511 – 12% 13.9 14.3 16.3 20.2 19.2 17.9 9.1 4.5 2.3 1.112 – 13% 23.4 20.9 22.3 19.2 13.9 9.1 4.3 2.3 1.1 0.5>13% 29.8 27.2 25.0 14.5 8.4 5.6 1.9 0.8 0.5 0.7

Source :Source :Source :Source :Source : Basic Statistical Returns of Scheduled Commercial Banks in India, various issues, Reserve Bank of India.

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In recent times, there has been sometendency to widen the net of administeredinterest rates to cover bank loans foragriculture. While such a tendency may notbe an unlikely outcome given thepredominance of publicly-owned financialintermediaries, it needs to be recognisedthat the current system of pricing of bankloans appears less than satisfactoryparticularly in respect of agriculture andsmall scale industries (SSI). Competitionhas turned the pricing of a significantproportion of loans far out of alignmentwith the BPLR and in a non-transparentmanner. Thus, there is a public perceptionthat banks’ risk assessment processes areless than appropriate and that there isunderpricing of credit for corporates, whilethere could be overpricing of lending to

agriculture and SSI. Therefore, the currentpractices on pricing of credit need to berevamped by banks through wellstructured, segment-wise analysis of costsat various stages of intermediation in thewhole credit cycle.

The Indian financial system appears tohave responded favourably to reformsinitiated in the early 1990s with relativelyhigher efficiency, competitiveness andresilience. This has enabled banks toincrease their lending to the commercialsector. Non-food credit extended byscheduled commercial banks recorded anaverage annual growth of 26.4 per centbetween 2002-03 and 2005-06, notablyhigher than that of 14.5 per cent recordedduring the preceding four-year period (1998-

TTTTTable 6: Lable 6: Lable 6: Lable 6: Lable 6: Lending Rending Rending Rending Rending Rates of Scheduled Commercial Banks in Indiaates of Scheduled Commercial Banks in Indiaates of Scheduled Commercial Banks in Indiaates of Scheduled Commercial Banks in Indiaates of Scheduled Commercial Banks in India

(Per cent)

Public Sector BanksPublic Sector BanksPublic Sector BanksPublic Sector BanksPublic Sector Banks FFFFForeign Banksoreign Banksoreign Banksoreign Banksoreign Banks Private Sector BanksPrivate Sector BanksPrivate Sector BanksPrivate Sector BanksPrivate Sector Banks

Demand LDemand LDemand LDemand LDemand Loansoansoansoansoans TTTTTerm Lerm Lerm Lerm Lerm Loansoansoansoansoans Demand LDemand LDemand LDemand LDemand Loansoansoansoansoans TTTTTerm Lerm Lerm Lerm Lerm Loansoansoansoansoans Demand LDemand LDemand LDemand LDemand Loansoansoansoansoans TTTTTerm Lerm Lerm Lerm Lerm Loansoansoansoansoans

1 2 3 4 5 6 7

Jun-02 12.75 - 14.00 12.75 - 14.00 13.00 - 14.75 13.00 - 15.50 13.75 - 16.00 14.00 - 16.00Sep-02 12.00 - 14.00 12.25 - 14.00 13.00 - 14.75 12.75 - 14.50 14.00 - 16.00 13.50 - 15.00Dec-02 11.85 - 14.00 12.25 - 14.00 12.00 - 14.75 11.70 - 13.63 13.50 - 15.75 13.50 - 15.00Mar-03 11.50 - 14.00 12.00 - 14.00 10.50 - 12.75 10.25 - 13.50 13.50 - 15.50 13.00 - 15.00Jun-03 11.50 - 14.00 11.50 - 14.00 10.00 - 14.00 9.73 - 13.00 13.00 - 15.00 12.50 - 14.75Sep-03 11.50 - 13.50 11.00 - 13.50 9.50 - 12.75 9.25 - 13.50 13.00 - 14.50 12.00 - 14.50Dec-03 11.50 - 13.00 11.00 - 13.25 7.75 - 13.65 9.00 - 13.00 12.50 - 14.50 11.50 - 14.50Mar-04 11.00 - 12.75 11.00 - 12.75 7.50 - 11.00 8.00 - 11.60 12.00 - 14.00 11.25 - 14.00Jun-04 10.50 - 12.50 10.75 - 12.75 6.50 - 11.50 7.25 - 10.95 11.50 - 13.75 11.00 - 14.00Sep-04 10.50 - 12.50 9.50 - 12.25 6.75 - 9.00 7.25 - 11.00 11.25 - 13.25 9.50 - 13.00Dec-04 9.00 - 12.50 8.38 - 12.13 7.25 - 9.00 7.38 - 10.95 10.00 - 13.00 9.25 - 13.00Mar-05 9.00 - 12.50 8.38 - 12.00 7.13 - 9.00 7.63 - 9.50 10.00 - 12.50 9.00 - 13.00Jun-05 8.00 - 12.13 8.00 - 11.88 7.75 - 9.00 7.50 - 9.50 10.00 - 12.75 9.00 - 13.00Sep-05 8.00 - 11.63 8.00 - 11.88 7.00 - 10.25 7.35 - 9.50 10.00 - 12.50 9.00 - 13.00Dec-05 8.00 - 11.63 8.00 - 11.63 7.00 - 9.50 7.20 - 9.50 10.00 - 13.00 9.25 - 13.00Mar-06 8.00 - 11.63 8.00 - 11.63 8.00 - 9.75 7.53 - 9.75 9.50 - 13.00 9.00 - 13.18Jun-06 8.00 - 11.25 8.00 - 12.00 7.63 - 9.75 7.53 - 9.75 9.75 - 13.50 9.23 - 13.75Sep-06 8.25 - 11.50 8.50 - 12.13 8.08 - 9.57 7.85 - 9.75 10.00 - 13.50 9.45 - 13.50Dec-06 8.00 - 11.88 8.50 - 12.00 8.05 - 10.00 8.00 - 9.50 10.00 - 13.13 9.23 - 12.63

NoteNoteNoteNoteNote ::::: Median lending rates in this table are the range within which at least 60 per cent business is contracted.SourceSourceSourceSourceSource ::::: Reserve Bank of India, available at http://rbidocs.rbi.org.in/lendingrate/home.html.


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99 to 2001-02) as well as the long-runaverage of 17.8 per cent (1970-2006).Reflecting the growth in bank credit, theratio of bank credit to GDP has alsowitnessed a sharp rise. The credit-GDP ratio,after moving in a narrow range of around30 per cent between mid-1980s and late1990s, started increasing from 2000-01onwards to 35 per cent during 2004-05 andfurther to 40 per cent during 2006-07. Thestagnation in credit flow observed duringthe late 1990s, in retrospect, was partlycaused by reduction in demand on accountof increase in real interest rates, the cyclicaldown turn and the significant businessrestructuring that occurred during thatperiod. The sharp expansion in bank creditin the past 4-5 years also reflects, in part,policy initiatives to improve flow of creditto sectors like agriculture. While demand foragricultural and industrial credit hasremained strong in the current cycle,increasingly, retail credit has emerged as thedriver of growth. The strengthening of thebanking system has thus worked towardsfinancial widening and deepening. In theprocess, greater monetisation and financialinclusion are extending the net of theformal financial system and hence,enhancing the scope of monetarytransmission.

The increasing reach of formal financehas gradually expanded to cover largersegments of the population. The‘demographic dividend’ of a larger andyounger labour force has meant that bankshave been able to expand their loanportfolio rapidly, enabling consumers tosatisfy their lifestyle aspirations at arelatively young age with an optimalcombination of equity and debt to finance

consumption and asset creation. In theprocess, interest has become a much morepotent tool of monetary policy, affectingconsumption and investment decisions ofthe population in a fashion much morerapidly than was the case earlier. This isevident in the share of retail credit in totalbank credit, increasing from around 6 percent in March 1990 to over 22 per cent inMarch 2005. A large part of this increase hastaken place in the past 5-6 years. In view ofthis growing share of household credit, it islikely that household consumptiondecisions, in the coming years, may be morestrongly influenced by monetary policydecisions with implications for themonetary transmission mechanism.Consequently, the monetary authority mayneed to contend increasingly with publicopinion on monetary management, muchmore than hitherto in the context of therising share of personal/ household loans.In the context of large scale publicownership of banks, such pressures ofpublic opinion would also manifestthemselves into political pressures.

In brief, there is increasing evidencethat the bank credit and lending rateschannels of monetary transmission aregaining in strength with the widening anddeepening of the financial system and theprogress towards greater price discovery. Anumber of constraints continue, however,to interfere with monetary transmission.First, the stipulation of priority sectorlending of 40 per cent of net bank creditaffects flexibility in sectoral credit allocationeven though there is no interest ratestipulation for the priority sector. Second,allocational flexibility is further constrainedunder the extant prescription of a SLR of

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25 per cent of net demand and timeliabilities (NDTL), though now the relevantAct has been amended to give the ReserveBank flexibility to reduce this statutoryliquidity ratio. Third, the system of BPLRfor credit pricing has proved to be relativelysticky downward and more so for specificsectors like agriculture and SSI. As the BPLRhas ceased to be a reference rate,assessment of the efficacy of monetarytransmission has become difficult. Fourth,the Government of India continues to ownaround 70 per cent of banks’ assets. Whilethe Government, as a legitimate owner, isentitled to issue direction to public sectorbanks, such exercise by the Governmentinfuses elements of uncertainty and marketimperfections, impacting monetarytransmission.

III.4 Debt Market Channel

While government debt managementwas one of the motivating factors for thesetting up of central banks in manycountries, currently the function with itsfocus on lowering the cost of public debt isoften looked upon as constraining monetarymanagement, particularly whencompulsions of monetary policy amidstinflation expectations may necessitate atighter monetary policy stance. Therefore,it is now widely believed that the twofunctions - monetary policy and public debtmanagement – need to be conducted in amanner that ensures transparency andindependence in monetary operations. Thefuller development of financial markets,reasonable control over the fiscal deficit andnecessary legislative changes are regardedas pre-conditions for separation of debtmanagement from monetary management.

The Reserve Bank currently performs thetwin function of public debt and monetarymanagement.

‘‘The logical question that follows iswhether the experience of fiscal dominanceover monetary policy would have beendifferent if there had been separation of debtmanagement from monetary management inIndia? Or, were we served better with boththe functions residing in the Reserve Bank?What has really happened is that there wasa significant change in thinking regardingoverall economic policy during the early1990s, arguing for a reduced direct role ofthe Government in the economy. A consciousview emerged in favour of fiscal stabilisationand reduction of fiscal deficits aimed ateliminating the dominance of fiscal policyover monetary policy through the priorpractice of fiscal deficits being financed byautomatic monetisation. It is this overalleconomic policy transformation that hasprovided greater autonomy to monetarypolicy making in the 1990s.

The Indian economy has madeconsiderable progress in developing itsfinancial markets, especially thegovernment securities market since 1991.Furthermore, fiscal dominance in monetarypolicy formulation has significantly reducedin recent years. With the onset of a fiscalconsolidation process, withdrawal of theReserve Bank from the primary market ofGovernment securities and expectedlegislative changes permitting a reductionin the statutory minimum StatutoryLiquidity Ratio (SLR), fiscal dominancewould be further diluted.

All of these changes took place despitethe continuation of debt management by


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the Reserve Bank. Thus, one can argue thateffective separation of monetary policyfrom debt management is more aconsequence of overall economic policythinking rather than adherence to aparticular view on institutionalarrangements’’ (Mohan, 2006b).

The Fiscal Responsibility and BudgetManagement (FRBM) Act, 2003 has set thestage for a front-loaded fiscal correctionpath for the Central Government. Similarenactments have also taken place in anumber of States. As already mentioned, theFRBM Act, 2003 has prohibited the ReserveBank from participating in primaryissuances of government securities witheffect from April 1, 2006, except underexceptional circumstances. In preparation,the institutional structures within theReserve Bank have been modified tostrengthen monetary operations with aview to moving towards functionalseparation between debt management andmonetary operations. Accordingly, a newFinancial Markets Department (FMD) hasbeen constituted to undertake (i) monetaryoperations, (ii) regulation and developmentof money market instruments and (iii)monitoring of money, governmentsecurities and foreign exchange markets.The enactment of the FRBM Act has arguablystrengthened monetary transmissionthrough the debt market. It has alsomitigated the possibility of conflict inmonetary policy in order to contain the costof Government borrowing.

The auction-based issue of governmentdebt according to a pre-announced calendarhas enabled price discovery and liquidity inthe market. A Negotiated Dealing System(NDS) was introduced in February 2002 to

facilitate electronic bidding, secondary markettrading and settlement and to disseminateinformation on trades on a real-time basis. Inthe context of the Reserve Bank’s absencefrom primary auctions, ‘when, as and ifissued’ market in government securities hasbeen allowed recently.

Vibrant secondary market trading hashelped to develop a yield curve and the termstructure of interest rates. This has facilitatedpricing of debt instruments in various marketsegments and, thereby, monetarytransmission across maturity and financialinstruments. While market yields, at times,turn out to be puzzling, particularly in thewake of global policy signaling as also intimes of re-pricing of risks, the reverse reporate set out by the Reserve Bank remains theovernight floor for the market. The fallinginterest rate scenario witnessed up to 2003-04 and the comfortable liquidity position inthe system had helped to bring down theyields and the yield curve turned relativelyflat. The long-term yields, however, continueto be impervious across the globe tosubsequent reversal of the interest rate cycle,giving rise to a ‘conundrum’ a la Greenspan(2005). In the Indian context, thetransmission from shorter to longer end ofthe yield curve has been vacillating linked,inter alia, to changes in monetary policyrates, inflation rates, international interestrates and, on other occasions, the SLRstipulation. With the increasing openness ofthe domestic economy, it appears thatinternational economic developments are setto exert a greater influence on the domesticyield curve than before. Thus, even in theabsence of fuller capital accountconvertibility, monetary transmission mayneed to contend with impulses that arise

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from international developments.Furthermore, the process of fiscalconsolidation currently underway couldpotentially lead to a situation of excessdemand for government securities inrelation to their supply, which would, inturn, impact the shape of the yield curveand, thereby, impede monetarytransmission. The stipulation for SLR couldalso undergo a change guided by prudentialconsiderations, affecting, in the process, thedemand for government securities andthereby, the yield curve as banks remaininvested with government securities for thepurpose of SLR. Such developments,however, may not be in consonance withthe monetary policy stance and hence, couldcome in the way of intended monetarytransmission.

While the government securitiesmarket is fairly well developed now, thecorporate debt market remains to bedeveloped for facilitating monetarysignaling across various market segments.In the absence of a well developedcorporate debt market, the demand fordebt instruments has largely concentratedon government securities with theattendant implications for the yield curveand, in turn, for monetary transmission.The secondary market for corporate debthas suffered from lack of market makingresulting in poor liquidity. Corporatescontinue to prefer private placements topublic issues for raising resources in viewof ease of procedures and lower costs.There is a need for development ofmortgage-backed securities, credit defaultswaps, bond insurance institutions forcredit enhancement, abridgment ofdisclosure requirements for listed

companies, rating requirements forunlisted companies, real time reporting ofprimary and secondary trading, retailaccess to bond market by non-profitinstitutions and small corporates andaccess to RTGS. A concerted effort is nowbeing made to set up the institutional andtechnological structure that would enablethe corporate debt market to operate.Furthermore, the on-going reforms in thearea of social security coupled with theemergence of pension and provident fundsare expected to increase the demand forlong-term debt instruments. In the process,the investor base for government securitieswould be broadened, extending themonetary transmission across new playersand participants.

III.5 Exchange Rate Channel

The foreign exchange market in Indiahas acquired increasing depth with thetransition to a market determined exchangerate system in March 1993 and thesubsequent gradual but significantliberalisation of restrictions on variousexternal transactions. Payments restrictionson all current account transactions havebeen removed with the acceptance of theobligations of Article VIII of the IMF’sArticles of Agreement in August 1994. Whilethe rupee remains virtually convertible onthe capital account for foreign nationals andnon-resident Indians (NRIs), similar movesare on course for the domestic residents.Significant relaxations have been allowed forcapital outflows in the form of direct andportfolio investment, non-resident deposits,repatriation of assets and funds held abroad.Indian residents can now open foreigncurrency accounts with banks in India.


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The major initiatives taken to widen anddeepen the Indian forex market and to linkit with the global financial system havebeen: (i) freedom to banks to fix netovernight position limits and gap limits,initiate trading positions in the overseasmarkets, and use derivative products forasset-liability management; (ii) permissionto authorised dealers (ADs) in foreignexchange to borrow abroad up to limitsrelated to their capital base as a prudentialmeasure; and (iii) freedom to corporates tohedge anticipated exposures, cancel andrebook forward contracts. The CCIL hascommenced settlement of forex operationsfor inter-bank US Dollar/Indian rupee spotand forward trades from November 2002and inter-bank US dollar/Indian rupee cashand tom trades from February 2004.

The annual turnover in the foreignexchange market has increased more thanthreefold from US $ 1434 billion in 2000-01 to US $ 4413 billion in 2005-06 (Table7). The inter-bank transactions continue toaccount for bulk of the transactions in theforex market, albeit with a declining share

over the years. The forward marketsegment (swaps plus forward) is alsogrowing at a faster pace. Reflecting thebuild-up of forex reserves, the strongcapital flows and the confidence in theIndian economy, the forward premia hascome down sharply from the peak reachedin 1995-96. Under the market determinedexchange rate regime, the Indian rupee hasexhibited two way movements and theforeign exchange market has displayedstable conditions as reflected in the annualcoefficient of variation of 0.9-2.3 per centduring 2000-01 to 2005-06. The exchangerate policy of the Reserve Bank in recentyears has been guided by the broadprinciples of careful monitoring andmanagement of exchange rates withflexibility, without a fixed target or a pre-announced target or a band, coupled withthe ability to intervene, if and whennecessary.

Exchange rate flexibility, coupled withthe gradual removal of capital controls, haswidened the scope for monetarymaneuverability, enabling transmission

TTTTTable 7: Fable 7: Fable 7: Fable 7: Fable 7: Foreign Exoreign Exoreign Exoreign Exoreign Exchange Markchange Markchange Markchange Markchange Market – Activity Indicatorset – Activity Indicatorset – Activity Indicatorset – Activity Indicatorset – Activity Indicators

YYYYYearearearearear FFFFForeign Exoreign Exoreign Exoreign Exoreign Exchangechangechangechangechange Gross VGross VGross VGross VGross Volumeolumeolumeolumeolume RBI’s FRBI’s FRBI’s FRBI’s FRBI’s Foreignoreignoreignoreignoreign C.VC.VC.VC.VC.V. of. of. of. of. of Col. 2Col. 2Col. 2Col. 2Col. 2 Col. 2Col. 2Col. 2Col. 2Col. 2MarkMarkMarkMarkMarket-Annualet-Annualet-Annualet-Annualet-Annual of BoPof BoPof BoPof BoPof BoP CurrencyCurrencyCurrencyCurrencyCurrency ExExExExExchangechangechangechangechange over Col. 3over Col. 3over Col. 3over Col. 3over Col. 3 over Col. 4over Col. 4over Col. 4over Col. 4over Col. 4

TTTTTurnoverurnoverurnoverurnoverurnover TransactionsTransactionsTransactionsTransactionsTransactions Assets*Assets*Assets*Assets*Assets* RRRRRate of Rate of Rate of Rate of Rate of Rupeeupeeupeeupeeupee(US $ billion)(US $ billion)(US $ billion)(US $ billion)(US $ billion) (US $ billion)(US $ billion)(US $ billion)(US $ billion)(US $ billion) (US $ billion)(US $ billion)(US $ billion)(US $ billion)(US $ billion) (per cent) (per cent) (per cent) (per cent) (per cent)

1 2 3 4 5 6 7

2000-01 1434 258 40 2.3 5.6 36

2001-02 1487 237 51 1.4 6.3 29

2002-03 1585 267 72 0.9 5.9 22

2003-04 2141 362 107 1.6 5.9 20

2004-05 2892 481 136 2.3 6.0 21

2005-06 4413 657 145 1.5 6.7 30

* At end-March. BoP : Balance of Payments. C.V. : Coefficient of Variation.Source : Source : Source : Source : Source : Reserve Bank of India.

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through exchange rates. In the event ofinterest rate arbitrage triggered bymonetary policy action, foreign exchangeinflows can tend to pick up until theinterest rate parity is restored by exchangerate adjustments. An appreciatingexchange rate, in turn, would have adampening effect on aggregate demand,containing inflationary pressures.However, if large segments of economicagents lack adequate resilience towithstand volatility in currency and moneymarkets, the option of exchange rateadjustments may not be available, partiallyor fully. Therefore, the central bank mayneed to carry out foreign exchangeoperations for stabilising the market. In theprocess, the injection of liquidity into thesystem by the central bank would goagainst its policy stance and weakenmonetary transmission. Thus, monetarymanagement becomes complicated, andthe monetary authority may need toundertake offsetting sterilisationtransactions in defence of monetarystability and intended transmission. In theIndian context, faced with similarcircumstances, sterilisation operations arebeing carried out from 2004 by issuancesof government securities under the MSS.

Available evidence suggests thatexchange rate depreciation has the expectedeffect of raising domestic prices and thecoefficient of exchange rate pass-through todomestic inflation ranges between 8-17basis points (depending upon the measureof inflation), i.e., a 10 per cent depreciationof the Indian rupee (vis-a-vis the US dollar)would, other things remaining unchanged,increase consumer inflation by less thanone percentage point and the GDP deflator

by 1.7 percentage points. Rolling regressionssuggest some decline in exchange rate pass-through coefficient in the recent years (RBI,2004b). The coefficient on the exchange rateexhibits a declining trend although theestimates turn out to be somewhatimprecise. This suggests a possible declinein exchange rate pass-through to domesticinflation. The decline in pass-throughduring the 1990s is consistent with thecross-country evidence. In India, inflationrates have declined significantly since thesecond half of the 1990s and this could beone explanation for the lower pass-through.Another key factor that could have loweredthe pass-through is the phased decline intariffs as well as non-tariff barriers such asquotas. Average import duties are now lessthan one-third of what they were a decadeago. This steep reduction in tariffs couldhave easily allowed domestic producers toabsorb some part of the exchange ratedepreciation without any effect on theirprofitability.

Another factor that could reduce thepass-through is related to globalisation and“Walmartisation”. The increased intensityof globalisation and the commodificationof many goods have perhaps reduced thepricing power of producers, particularly oflow technology goods in developingcountries, whereas the pricing power oflarge retailers like Walmart has risen. Thedecline in pass-through across a numberof countries, as suggested by variousstudies, has implications for the efficacyof exchange rate as an adjustment tool. Thelower pass-through suggests that, in thenew globalised economy, exchange rateadjustments as a means of correction ofimbalances may have become less potent;


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if so, then the swing in exchange rates tocorrect emerging imbalances will have tobe much larger than before, bringing intheir wake greater instability eventually(Mohan, 2004).

III.6 Communication and ExpectationsChannel

In a market-oriented economy, well-informed market participants are expectedto enable an improved functioning of themarkets, and it is held that a central bankis in the best position to provide such usefulinformation to the market participants.Whether providing information wouldresult in shaping and managingexpectations, and if so, whether it isdesirable, remain unsettled issues. Thereare several dilemmas faced by central bankswhile designing an appropriatecommunications policy. What should becommunicated and to what degree ofdisaggregation? The second set relates to:at what stage of evolution of internalthinking and debate should there bedissemination? The third set relates to thetiming of communication with reference toits market impact. The fourth relates to thequality of information and the possibleways in which it could be perceived. Thus,alleged incoherence or an element ofambiguity at times on the part of centralbankers in explaining policies is as much areflection of the complexity of the issuesas it is of the differing perceptions of avariety of audiences to which thecommunication is addressed. It is essentialto appreciate that communication policy isnot merely about explaining or getting afeedback on policy, but may includeelements of influencing the policy direction

itself. A central bank does this throughseveral channels, including researchpublications and speeches (Reddy, 2001;2006). It is recognised that crediblecommunication and creative engagementwith the market and economic agents haveemerged as the critical channel of monetarytransmission as against the traditionalchannels. For example, the US FederalReserve, since 1994, appears to have beenproviding forward guidance, while theEuropean Central Bank appears to be in themould of keeping the markets informedrather than guiding it.

With the widening and deepening ofinter-linkages between various segments offinancial markets, the Reserve Bank hasadopted a consultative process for policymaking in order to ensure timely andeffective implementation of the measures.The Bank has taken a middle path of sharingits analysis in addition to providinginformation, but in no way guiding themarket participants. However, in doing so,the Reserve Bank has the benefit of theprocess of two-way communication, ofinformation as well as perceptions, betweenthe market participants and the ReserveBank. In the process, the Bank’s signaling/announcements are increasingly seen tohave an influence on the expectationsformation in the market.

The more complex is the mandate forthe central bank, the more is the necessityof communication (Mohan, 2005). TheReserve Bank of India clearly has complexobjectives. Apart from pursuing monetarypolicy, financial stability is one of theoverriding concerns of the Reserve Bank.Within the objective of monetary policy,both control of inflation and providing

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adequate credit to the productive sectors ofthe economy so as to foster growth areequally important. This apart, the ReserveBank acts as a banking regulator, public debtmanager, government debt market regulatorand currency issuer. Faced with suchmultiple tasks and complex mandate, thereis an utmost necessity of clearercommunication on the part of the ReserveBank.

In general, for a central bank, there isnecessity of three kinds of communication,viz., (a) policy measures, (b) reasons behindsuch policy measures and (c) analysis of theeconomy. The Reserve Bank is engaged withall these three kinds of communication. Infact, by international standards the ReserveBank has a fairly extensive and transparentcommunication system. Policy statements(quarterly since April 2005 onwards and bi-annual prior to this period) have traditionallycommunicated the Reserve Bank’s stance onmonetary policy in the immediate future ofsix months to one year. The practice ofattaching a review of macroeconomicdevelopments to the quarterly reviews givesan expansive view of how the central banksees the economy. In the bi-annual policymeetings with leading bankers, the Governorexplains the rationale behind the measuresat length. These policy meetings are not one-way traffic. Each banker present in themeeting interacts with the Governor toexpress his or her reaction to the policyannouncement. After the policyannouncement is over, the Governoraddresses a press conference in theafternoon. The Deputy Governor in chargeof monetary policy normally gives liveinterviews to all the major televisionchannels on the same day. The Governor also

gives interviews to print and electronicmedia over the next few days after themonetary policy announcement.

Communication of policy also takes placethrough speeches of the Governor andDeputy Governors, and various periodicreports. A significant step towardstransparency of monetary policyimplementation is formation of variousTechnical Advisory Committees (TACs) in theReserve Bank with representatives frommarket participants, other regulators andexperts. In line with the international bestpractices and with a view to furtherstrengthening the consultative process inmonetary policy, the Reserve Bank, in July2005, set up a Technical Advisory Committeeon Monetary Policy (TACMP) with externalexperts in the areas of monetary economics,central banking, financial markets and publicfinance. The Committee meets at least oncein a quarter, reviews macroeconomic andmonetary developments and advises theReserve Bank on the stance of monetarypolicy. The Committee has contributed toenriching the inputs and processes ofmonetary policy setting in India. Recognisingthe importance of expectations in theconduct and formulation of monetary policy,the Reserve Bank has recently initiatedsurveys of business and inflationexpectations.

Finally, in the context of growingopenness of the Indian economy andincreasing integration with the rest of theworld, global economic and financialdevelopments – such as monetary policydecisions of the US Fed and other majoreconomies and trends in internationalcrude oil prices – are also shaping


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expectations. The Reserve Bank takes suchfactors and expectations also into account.3

The process of monetary policyformulation in India is now relativelytransparent, consultative and participativewith external orientation and this hascontributed to stabilising expectations ofmarket participants. Illustratively, animportant element in coping with liquiditymanagement has been smootheningbehaviour of the Reserve Bank and itscommunication strategy. In August 2004,the headline inflation rate shot up to 8.7per cent, partly on account of rising globaloil prices and partly due to resurgence inmanufacturing inflation. The turning of theinterest rate cycle looked imminent. Theissue was addressed through burdensharing by appropriate monetary and fiscalcoordination and by preparing markets fora possible interest rate reversal. Inmeasured and calibrated steps themonetary policy stance was changed andmeasures such as those on CRR and reverserepo were taken in a phased manner. Also,banks were allowed to transfer HFT (Heldfor Trading) and AFS (Available for Sale)securities to HTM (Held to Maturity)

category, thereby affording them somecushion against the possible interest rateshock. Markets were prepared with a carefulcommunication on the stance of themonetary policy that the central bank wouldstrive for provision of appropriate liquiditywhile placing equal emphasis on pricestability. Monetary management thussucceeded in building credibility andkeeping inflation expectations low.

In brief, there has been a noteworthyimprovement in the operational efficiencyof monetary policy from the early 1990s.Financial sector reforms and thecontemporaneous development of themoney market, government securitiesmarket and the foreign exchange markethave strengthened monetary transmissionby enabling more efficient price discovery,and improving allocative efficiency even asthe Reserve Bank has undertakendevelopmental efforts to ensure thestability and smooth functioning offinancial markets. The approach has beenone of simultaneous movement on severalfronts, graduated and calibrated, with anemphasis on institutional andinfrastructural development andimprovements in market microstructure.The pace of the reform was contingent uponputting in place appropriate systems andprocedures, technologies and marketpractices. There has been close co-ordination between the Government andthe Reserve Bank, as also between differentregulators, which helped in orderly andsmooth development of the financialmarkets in India. Markets have now grownin size, depth and activity, paving the wayfor flexible use of indirect instruments. TheReserve Bank has also engaged in refining

3 Illustratively, the Reserve Bank in its Annual PolicyStatement for 2006-07 (April 2006) stressed that:"Domestic macroeconomic and financial conditionssupport prospects of sustained growth momentum withstability in India. It is important to recognise, however,that there are risks to both growth and stability fromdomestic as well as global factors. At the current juncture,the balance of risks is tilted towards the global factors.The adverse consequences of further escalation ofinternational crude prices and/or of disruptive unwindingof global imbalances are likely to be pervasive acrosseconomies, including India. Moreover, in a situation ofgeneralised tightening of monetary policy, India cannotafford to stay out of step. It is necessary, therefore, tokeep in view the dominance of domestic factors as in thepast but to assign more weight to global factors thanbefore while formulating the policy stance" (RBI, 2006).

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the operating procedures and instrumentsas also risk management systems, incomerecognition and provisioning norms,disclosure norms, accounting standards andinsolvency in line with international bestpractices with a view to fostering theseamless integration of Indian financialmarkets with global markets.

IV. How Well Do MonetaryTransmission Channels Work?

Turning to an assessment of monetarypolicy transmission, it would be reasonableto assert that monetary policy has beenlargely successful in meeting its keyobjectives in the post-reforms period. Therehas been a fall in inflation worldwide sincethe early 1990s, and in India since the late1990s. Inflation has averaged close to fiveper cent per annum in the decade gone by,notably lower than that of eight per cent inthe previous four decades (Chart 6).Structural reforms since the early 1990scoupled with improved monetary-fiscalinterface and reforms in the governmentsecurities market enabled better monetarymanagement from the second half of the

1990s onwards. More importantly, theregime of low and stable inflation has, inturn, stabilised inflation expectations andinflation tolerance in the economy has comedown. It is encouraging to note that despiterecord high international crude oil prices,inflation remains low and inflationexpectations also remain stable (Table 8).Since inflation expectations are a keydeterminant of the actual inflationoutcome, and given the lags in monetarytransmission, the Reserve Bank has beentaking pre-emptive measures to keepinflation expectations stable. As discussedearlier, a number of instruments, bothexisting as well as new, were employed tomodulate liquidity conditions to achieve thedesired objectives. A number of otherfactors such as increased competition,productivity gains and strong corporatebalance sheets have also contributed to thislow and stable inflation environment, but itappears that calibrated monetary measureshad a substantial role to play as well.

In the context of the recent firming upof core as against headline inflationparticularly in industrial countries,

Per

cent

WPI Inflation CPI Inflation GDP Growth

Chart 6: GDP Growth and WPI and CPI Inflation


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primarily on account of higher non-oilcommodity prices, issues of propermeasurement of inflation and inflationarypressures have attracted renewed debate. Inparticular, the debate involves the relevanceof core inflation as a guide for the conductof monetary policy vis-à-vis the use ofheadline inflation. In India, core inflationis not considered as relevant for severalreasons, but specially because the two majorsources of supply shock, food and fuel,account for a large share of the index.Further, in the absence of a harmonisedconsumer price index for India, use of coreinflation based on wholesale prices may notbe much meaningful. While the permanentcomponent is judgmental, broadmagnitudes could be perceived andarticulated. Such an explanatory approachto headline and underlying inflationpressure in monetary policy has addedcredibility to the policy and influenced andguided the inflation expectations in India.

How did monetary policy support thegrowth momentum in the economy? Asinflation, along with inflation expectations,fell during the earlier period of this decade,policy interest rates were also brought down.

Consequently, both nominal and realinterest rates fell. The growth rate ininterest expenses of the corporates declinedconsistently since 1995-96, from 25.0 percent to a negative of 5.8 per cent in 2004-05(Table 9). Such decline in interest costs hassignificant implications for theimprovement in bottom lines of thecorporates. Various indicators pertaining tointerest costs, which can throw light on theimpact of interest costs on corporate sectorprofits have turned positive in recent years.

V. What is Needed to ImproveMonetary Transmission?

While the changes in policy rates arequickly mirrored in the money market ratesas well as in government bond yields,lending and deposits rates of banks exhibita degree of downward inflexibility. In thiscontext, administered interest rates fixedby the Government on a number of smallsaving schemes and provident funds are ofspecial relevance as they generally offer arate higher than corresponding instrumentsavailable in the market as well as taxincentives (RBI, 2001; RBI, 2004a). As bankshave to compete for funds with small saving

TTTTTable 8: Wholesale Price Inflation (WPI) and Consumer Price Inflation (CPI)able 8: Wholesale Price Inflation (WPI) and Consumer Price Inflation (CPI)able 8: Wholesale Price Inflation (WPI) and Consumer Price Inflation (CPI)able 8: Wholesale Price Inflation (WPI) and Consumer Price Inflation (CPI)able 8: Wholesale Price Inflation (WPI) and Consumer Price Inflation (CPI)(Year-on-Year)

(Per cent)

InflationInflationInflationInflationInflation MarchMarchMarchMarchMarch MarchMarchMarchMarchMarch MarchMarchMarchMarchMarch MarchMarchMarchMarchMarch MarchMarchMarchMarchMarch MarchMarchMarchMarchMarch MarchMarchMarchMarchMarch FFFFFebruarebruarebruarebruarebruaryyyyyMeasureMeasureMeasureMeasureMeasure 20002000200020002000 20012001200120012001 20022002200220022002 20032003200320032003 20042004200420042004 20052005200520052005 20062006200620062006 20072007200720072007

1 2 3 4 5 6 7 8 9

WPI Inflation (end-Month) 6.5 5.5 1.6 6.5 4.6 5.1 4.1 6.6 +CPI-IW 4.8 2.5 5.2 4.1 3.5 4.2 4.9 6.9 *CPI- UNME 5.0 5.6 4.8 3.8 3.4 4.0 5.0 6.9 *CPI-AL 3.4 –2.0 3.0 4.9 2.5 2.4 5.3 9.5 $CPI-RL — –1.6 3.0 4.8 2.5 2.4 5.3 8.9 $

— : Not available. IW : Industrial Workers. UNME : Urban Non-Manual Employees. AL : Agricultural Labourers.RL : Rural Labourers. * : As in December 2006. + : As on February 10, 2007. $ : As in January 2007.Source :Source :Source :Source :Source : Annual Report and Handbook of Statistics on the Indian Economy, various issues, Reserve Bank of India.

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schemes, the rates offered on long-termdeposits mobilised by banks set the floorfor lending rates at a level higher thanwould have obtained under competitivemarket conditions (Chart 7). In fact, this wasobserved to be a factor contributing todownward stickiness of lending rates, withimplications for the effectiveness ofmonetary policy (Table 10).

These small savings schemesadministered by the government throughthe wide reach of post offices, and somethrough commercial banks, provide smallsavers access to tax savings instruments thatare seen as safe and stable. Benchmarkingthese administered interest rates to marketdetermined rates has been proposed fromtime to time. Whereas some rationalisation

TTTTTable 9: Monetarable 9: Monetarable 9: Monetarable 9: Monetarable 9: Monetary Py Py Py Py Policy and Corporate Policy and Corporate Policy and Corporate Policy and Corporate Policy and Corporate Performance – Interest Rerformance – Interest Rerformance – Interest Rerformance – Interest Rerformance – Interest Rate related Indicatorsate related Indicatorsate related Indicatorsate related Indicatorsate related IndicatorsYYYYYearearearearear Growth RGrowth RGrowth RGrowth RGrowth Rate in Interestate in Interestate in Interestate in Interestate in Interest Debt SerDebt SerDebt SerDebt SerDebt Service tovice tovice tovice tovice to Interest CoverageInterest CoverageInterest CoverageInterest CoverageInterest Coverage

Expenses (%)Expenses (%)Expenses (%)Expenses (%)Expenses (%) TTTTTotal Uses of Fotal Uses of Fotal Uses of Fotal Uses of Fotal Uses of Funds Runds Runds Runds Runds Ratio*atio*atio*atio*atio* RRRRRatio#atio#atio#atio#atio#

1990-91 16.2 22.4 1.91991-92 28.7 28.3 1.91992-93 21.6 24.4 1.61993-94 3.1 20.9 2.01994-95 8.1 27.2 2.41995-96 25.0 21.5 2.71996-97 25.7 18.7 2.11997-98 12.5 8.1 1.91998-99 11.1 17.6 1.61999-00 6.7 17.6 1.72000-01 7.1 14.0 1.72001-02 -2.7 19.4 1.72002-03 -11.2 8.9 2.32003-04 -11.9 12.7 3.32004-05 -5.8 21.8 4.6

* : Represents ratio of loans and advances plus interest accrued on loan to total uses of funds.# : Represents the ratio of gross profit (i.e., earning before interest and taxes) to interest expenses.SourceSourceSourceSourceSource: The data is based on selected non-government non-financial public limited companies, collected by RBI.

Bank Lending Rate Term Deposit Rate Small Saving Rate

Chart 7: Bank Lending Rate, Deposit Rate and Small Saving Rate

Per

cent


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in such schemes has taken place, furtherprogress in this direction will depend on theprovision of better social security andpension systems, and perhaps easier accessto marketable sovereign instruments(Mohan, 2006c).

In consonance with the objective ofenhancing efficiency and productivity ofbanks through greater competition – fromnew private sector banks and entry andexpansion of several foreign banks – therehas been a consistent decline in the shareof public sector banks in total assets ofcommercial banks. Notwithstanding suchtransformation, public sector banks stillaccount for over 70 per cent of assets andincome of commercial banks. While thepublic sector banks have responded well tothe new challenges of competition, this verypublic sector character does influence theiroperational flexibility and decision makingand hence, interferes, on occasions, with the

transmission of monetary policy impulses.Similar influence on monetary transmissionis exerted by the priority sector directives interms of allocation of 40 per cent of creditfor specified sectors. The impact is, however,much limited now with the deregulation oflending rates and the rationalisation of thesectors for priority credit allocation.

VI. Summing up

The brief survey of monetary policytransmission in India suggests thatmonetary policy impulses impact outputand prices through interest rates andexchange rate movements in addition to thetraditional monetary and credit aggregates.It is necessary, however, to take note of afew caveats. First, the transmission lags aresurrounded by a great deal of uncertainty.In view of the ongoing structural changesin the real sector as well as financialinnovations, the precise lags may differ in

TTTTTable 10: Small Savings and Bank Depositsable 10: Small Savings and Bank Depositsable 10: Small Savings and Bank Depositsable 10: Small Savings and Bank Depositsable 10: Small Savings and Bank Deposits

(Amount in Rupees billion)

Average InterestAverage InterestAverage InterestAverage InterestAverage Interest Small SavingsSmall SavingsSmall SavingsSmall SavingsSmall Savings Average InterestAverage InterestAverage InterestAverage InterestAverage Interest Bank TBank TBank TBank TBank Termermermermerm Small SavingsSmall SavingsSmall SavingsSmall SavingsSmall SavingsRRRRRate on Smallate on Smallate on Smallate on Smallate on Small OutstandingOutstandingOutstandingOutstandingOutstanding RRRRRate on Banks’ate on Banks’ate on Banks’ate on Banks’ate on Banks’ DepositsDepositsDepositsDepositsDeposits as % of Bankas % of Bankas % of Bankas % of Bankas % of Bank

Savings (%)Savings (%)Savings (%)Savings (%)Savings (%) TTTTTerm Deposits (%)erm Deposits (%)erm Deposits (%)erm Deposits (%)erm Deposits (%) OutstandingOutstandingOutstandingOutstandingOutstanding Deposits Deposits Deposits Deposits Deposits

1 2 3 4 5 6

1991-92 9.95 586 9.1 2,308 25.41992-93 9.48 609 9.6 2,686 22.71993-94 12.21 677 8.7 3,151 21.51994-95 13.20 833 7.0 3,869 21.51995-96 11.33 937 8.5 4,338 21.61996-97 13.03 1,061 9.4 5,056 21.01997-98 11.92 1,268 8.8 5,985 21.21998-99 10.34 1,553 8.9 7,140 21.71999-00 11.50 1,875 8.6 8,133 23.12000-01 11.60 2,251 8.1 8,201 27.42001-02 11.61 2,629 9.6 9,503 27.72002-03 11.56 3,138 8.7 10,809 29.02003-04 10.88 3,758 6.5 12,794 29.42004-05 9.37 4,577 6.2 14,487 31.62005-06 8.91 5,246 17,444 30.1

SourceSourceSourceSourceSource: Annual Report and Handbook of Statistics on the Indian Economy, various issues, Reserve Bank of India.

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each business cycle. Second, the period wasalso marked by heightened volatility in theinternational economy, includingdevelopments such as the series of financialcrises beginning with the Asian crisis. Third,the period under study has been marked bysharp reductions in customs duties andincreasing trade openness which could haveimpacted the transmission process. The1990s were also witness to globaldisinflation. Overall, the period has beenone of substantial ongoing changes invarious spheres of the Indian economy aswell as in its external environment. Fourth,the period of study has been characterisedby significant shifts in the monetary policyoperating framework from a monetary-targeting framework to a multiple indicatorapproach. Fifth, the size of interest ratepass-through has increased in recent years,with implications for transmission. Finally,empirical investigation is constrained by theuse of industrial production as a measureof output in the absence of a reasonablylong time series on quarterly GDP of theeconomy. In view of the significantstructural shifts towards the services sectorand the inter-linkages between agriculture,industry and services, the results of theseempirical exercises should be consideredtentative and need to be ratified with acomprehensive measure of output, as alsoby considering alternative techniques.

On the whole, the Indian experiencehighlights the need for emerging marketeconomies to allow greater flexibility inexchange rates but the authorities can alsobenefit from the capacity to intervene inforeign exchange markets in view of thevolatility observed in international capitalflows. Therefore, there is a need to maintain

an adequate level of foreign exchangereserves and this in turn both enables andconstrains the conduct of monetary policy.A key lesson is that flexibility andpragmatism are required in the managementof the exchange rate and monetary policy indeveloping countries rather than adherenceto strict theoretical rules.

References

Bernanke, B. and M. Gertler (1995), ‘‘Insidethe Black Box: the Credit Channel ofMonetary Policy Transmission’’, Journal ofEconomic Perspectives, 9 (4).

Greenspan, A. (2005), Testimony before theCommittee on Banking, Housing, and UrbanAffairs, US Senate, February 16.

Mohan, Rakesh (2004), ‘‘Orderly GlobalEconomic Recovery: Are Exchange RateAdjustments Effective Any More?’’, ReserveBank of India Bulletin, April.

(2005), ‘‘Communications in CentralBanks: A Perspective’’, Reserve Bank of IndiaBulletin, October.

(2006a), “Coping with LiquidityManagement in India: Practitioner’s View”,Reserve Bank of India Bulletin, April.

(2006b), “Evolution of Central Bankingin India”, Reserve Bank of India Bulletin,June.

(2006c), “Monetary Policy andExchange Rate Frameworks: The IndianExperience”, Reserve Bank of India Bulletin,June.

Nag, A. and A. Das (2002), ‘‘Credit Growthand Response to Capital Requirements:Evidence from Indian Public Sector Banks’’,Economic and Political Weekly, August 10.


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Pandit, B.L., A. Mittal, M. Roy and S. Ghosh(2006), ‘‘Transmission of Monetary Policyand the Bank Lending Channel: Analysis andEvidence for India’’, Development ResearchGroup Study No. 25, Reserve Bank of India.

Poole, W. (1970), ‘‘Optimal Choice ofMonetary Policy Instrument in a SimpleStochastic Macro Model’’, Quarterly Journalof Economics, 84 (2), May, 197-216.

Reserve Bank of India (2001), Report of theExpert Committee to Review the System ofAdministered Interest Rates and OtherRelated Issues (Chairman: Y.V. Reddy),September.

(2002), Report on Currency andFinance 2000-01, January, Mumbai.

(2004a), Report of the AdvisoryCommittee to Advise on the AdministeredInterest Rates and Rationalisation of SavingInstruments (Chairman: Dr. RakeshMohan), RBI, July.

(2004b), Report on Currency andFinance, 2003-04, December.

(2006), Annual Policy Statement for2006-07, April.

Reddy, Y.V. (2001), ‘‘Communications Policyof the Reserve Bank of India’’, Reserve Bankof India Bulletin, September.

(2006), ‘‘Central Bank Communications:Some Random Thoughts’’, Reserve Bank ofIndia Bulletin, January.

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AnneAnneAnneAnneAnnex I: Reforms in the Monetarx I: Reforms in the Monetarx I: Reforms in the Monetarx I: Reforms in the Monetarx I: Reforms in the Monetary Py Py Py Py Policy Folicy Folicy Folicy Folicy Frameworkrameworkrameworkrameworkramework

Objectives● Twin objectives of “maintaining price

stability” and “ensuring availability ofadequate credit to productive sectors ofthe economy to support growth”continue to govern the stance ofmonetary policy, though the relativeemphasis on these objectives has varieddepending on the importance ofmaintaining an appropriate balance.

● Reflecting the increasing development offinancial market and greaterliberalisation, use of broad money as anintermediate target has been de-emphasised and a multiple indicatorapproach has been adopted.

● Emphasis has been put on developmentof multiple instruments to transmitliquidity and interest rate signals in theshort-term in a flexible and bi-directionalmanner.

● Increase of the interlinkage betweenvarious segments of the financial marketincluding money, government securityand forex markets.

Instruments● Move from direct instruments (such as,

administered interest rates, reserverequirements, selective credit control) toindirect instruments (such as, openmarket operations, purchase andrepurchase of government securities) forthe conduct of monetary policy.

● Introduction of Liquidity AdjustmentFacility (LAF), which operates throughrepo and reverse repo auctions,

effectively provide a corridor for short-term interest rate. LAF has emerged asthe tool for both liquidity managementand also as a signalling devise for interestrate in the overnight market.

● Use of open market operations to dealwith overall market liquidity situationespecially those emanating from capitalflows.

● Introduction of Market StabilisationScheme (MSS) as an additionalinstrument to deal with enduring capitalinflows without affecting short-termliquidity management role of LAF.

Developmental Measures● Discontinuation of automatic

monetisation through an agreementbetween the Government and theReserve Bank. Rationalisation ofTreasury Bill market. Introduction ofdelivery versus payment system anddeepening of inter-bank repo market.

● Introduction of Primary Dealers in thegovernment securities market to play therole of market maker.

● Amendment of Securities ContractsRegulation Act (SCRA), to create theregulatory framework.

● Deepening of government securitiesmarket by making the interest rates onsuch securities market related.Introduction of auction of governmentsecurities. Development of a risk-freecredible yield curve in the governmentsecurities market as a benchmark forrelated markets.


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● Development of pure inter-bank callmoney market. Non-bank participants toparticipate in other money marketinstruments.

● Introduction of automated screen-basedtrading in government securitiesthrough Negotiated Dealing System(NDS). Setting up of risk-free paymentsand system in government securitiesthrough Clearing Corporation of IndiaLimited (CCIL). Phased introduction ofReal Time Gross Settlement (RTGS)System.

● Deepening of forex market andincreased autonomy of AuthorisedDealers.

Institutional Measures● Setting up of Technical Advisory

Committee on Monetary Policy withoutside experts to reviewmacroeconomic and monetarydevelopments and advise the ReserveBank on the stance of monetary policy.

● Creation of a separate Financial MarketDepartment within the Reserve Bank.

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AnneAnneAnneAnneAnnex II: Money Markx II: Money Markx II: Money Markx II: Money Markx II: Money Market Instruments for Liquidity Managementet Instruments for Liquidity Managementet Instruments for Liquidity Managementet Instruments for Liquidity Managementet Instruments for Liquidity Management

The Reserve Bank has been makingefforts to develop a repo market outside theLAF for bank and non-bank participants, soas to provide a stable collateralised fundingalternative with a view to promotingsmooth transformation of the call/noticemoney market into a pure inter-bankmarket and for deepening the underlyinggovernment securities market. Thus, thefollowing new instruments have beenintroduced.

Collateralised Borrowing andLending Obligation (CBLO)

● Developed by the Clearing Corporationof India Limited (CCIL) and introducedon January 20, 2003, it is a discountedinstrument available in electronic bookentry form for the maturity periodranging from one day to ninety days (canbe made available up to one year as perReserve Bank guidelines).

● In order to enable the market participantsto borrow and lend funds, CCIL providesthe Dealing System through IndianFinancial Network (INFINET), a closeduser group to the Members of theNegotiated Dealing System (NDS) whomaintain Current account with ReserveBank and through Internet for otherentities who do not maintain Currentaccount with Reserve Bank.

● Membership (including AssociateMembership) of CBLO segment isextended to banks, financialinstitutions, insurance companies,mutual funds, primary dealers, NBFCs,

non-Government Provident Funds,Corporates, etc.

● Eligible securities are CentralGovernment securities includingTreasury Bills.

● Borrowing limits for members is fixed byCCIL at the beginning of the day takinginto account the securities deposited byborrowers in their CSGL account withCCIL. The securities are subjected tonecessary hair-cut after marking them tomarket.

● Auction market is available only to NDSMembers for overnight borrowing andsettlement on T+0 basis. At the end ofthe Auction market session, CCILinitiates auction matching process basedon Uniform Yield principle.

● CCIL assumes the role of the centralcounter party through the process ofnovation and guarantees settlement oftransactions in CBLO.

● Automated value-free transfer ofsecurities between market participantsand the CCIL was introduced during2004-05.

● Members can reckon unencumberedsecurities for SLR calculations.

● The operations in CBLO are exemptedfrom cash reserve requirement (CRR).

Market Repo

● To broaden the repo market, the ReserveBank enabled non-banking financial


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companies, mutual funds, housingfinance companies and insurancecompanies not holding SGL accounts toundertake repo transactions with effectfrom March 3, 2003. These entities werepermitted to access the repo marketthrough their ‘gilt accounts’ maintainedwith the custodians.

● Subsequently, non-scheduled urban co-operative banks and listed companieswith gilt accounts with scheduledcommercial banks were allowed toparticipate.

● Necessary precautions were built intothe system to ensure ‘delivery versuspayment’ (DvP) and transparency, whilerestricting the repos to Governmentsecurities only.

● Rollover of repo transactions ingovernment securities was facilitated withthe enabling of DvP III mode of settlementin government securities which involvessettlement of securities and funds on a netbasis, effective April 2, 2004. This providedsignificant flexibility to marketparticipants in managing their collateral.

Some Assessments

● CBLO and market repo helped in aligningshort-term money market rates to theLAF corridor.

● Mutual funds and insurance companiesare generally the main supplier of fundswhile banks, primary dealers andcorporates are the major borrowers inthe repo market outside the LAF.

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AnneAnneAnneAnneAnnex III: Reforms in the Government Securities Markx III: Reforms in the Government Securities Markx III: Reforms in the Government Securities Markx III: Reforms in the Government Securities Markx III: Reforms in the Government Securities Market Institutional Measureset Institutional Measureset Institutional Measureset Institutional Measureset Institutional Measures

● Administered interest rates ongovernment securities were replaced byan auction system for price discovery.

● Automatic monetisation of fiscal deficitthrough the issue of ad hoc TreasuryBills was phased out.

● PDs were introduced as market makersin the government securities market.

● For ensuring transparency in the tradingof government securities, DvP settlementsystem was introduced.

● Repurchase agreement (repo) wasintroduced as a tool of short-termliquidity adjustment. Subsequently, theLAF was introduced.

● LAF operates through repo and reverserepo auctions and provide a corridor forshort-term interest rate. LAF hasemerged as the tool for both liquiditymanagement and also signalling devicefor interest rates in the overnightmarket. The Second LAF (SLAF) wasintroduced in November 2005.

● MSS has been introduced, which hasexpanded the instruments available tothe Reserve Bank for managing theenduring surplus liquidity in thesystem.

● Effective April 1, 2006, Reserve Bank haswithdrawn from participating in primarymarket auctions of governmentsecurities.

● Banks have been permitted to undertakeprimary dealer business while primarydealers are being allowed to diversifytheir business.

● Short sales in government securities isbeing permitted in a calibrated mannerwhile guidelines for ‘When Issued’market have been issued recently.

Increase in Instruments in theGovernment Securities Market● 91-day Treasury bill was introduced for

managing liquidity and benchmarking.Zero Coupon Bonds, Floating Rate Bonds,Capital Indexed Bonds were issued andexchange traded interest rate futureswere introduced. OTC interest ratederivatives like Interest Rate Swaps (IRS)/Forward Rate Agreements (FRAs) wereintroduced.

● Outright sale of central governmentdated security that are not owned havebeen permitted, subject to the samebeing covered by outright purchasefrom the secondary market within thesame trading day subject to certainconditions.

● Repo status has been granted to stategovernment securities in order toimprove secondary market liquidity.

Enabling Measures● Foreign Institutional Investors (FIIs)

were allowed to invest in governmentsecurities subject to certain limits.

● Introduction of automated screen-basedtrading in government securitiesthrough Negotiated Dealing System(NDS).

● Setting up of risk-free payments andsettlement system in government


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securities through Clearing Corporationof India Limited (CCIL).

● Phased introduction of Real Time GrossSettlement System (RTGS).

● Introduction of trading in government

securities on stock exchanges forpromoting retailing in such securities,permitting non-banks to participate inrepo market.

● Recent measures include introduction ofNDS-OM and T+1 settlement norms.

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AnneAnneAnneAnneAnnex IVx IVx IVx IVx IV: Reforms in the F: Reforms in the F: Reforms in the F: Reforms in the F: Reforms in the Foreign Exoreign Exoreign Exoreign Exoreign Exchange Markchange Markchange Markchange Markchange Marketetetetet

Exchange Rate Regime● Evolution of exchange rate regime from

a single-currency fixed-exchange ratesystem to fixing the value of rupeeagainst a basket of currencies andfurther to market-determined floatingexchange rate regime.

● Adoption of convertibility of rupee forcurrent account transactions withacceptance of Article VIII of the Articlesof Agreement of the IMF. De facto fullcapital account convertibility for nonresidents and calibrated liberalisation oftransactions undertaken for capitalaccount purposes in the case ofresidents.

Institutional Framework● Replacement of the earlier Foreign

Exchange Regulation Act (FERA), 1973 bythe market friendly Foreign ExchangeManagement Act, 1999. Delegation ofconsiderable powers by Reserve Bank toAuthorised Dealers to release foreignexchange for a variety of purposes.

Increase in Instruments in theForeign Exchange Market● Development of rupee-foreign currency

swap market.

● Introduction of additional hedginginstruments, such as, foreign currency-rupee options. Authorised dealerspermitted to use innovative productslike cross-currency options, IRS andcurrency swaps, caps/collars and FRAsin the international forex market.

Liberalisation Measures● Authorised dealers permitted to initiate

trading positions, borrow and invest inoverseas market subject to certainspecifications and ratification byrespective banks’ Boards. Banks are alsopermitted to fix interest rates on non-resident deposits, subject to certainspecifications, use derivative productsfor asset-liability management and fixovernight open position limits and gaplimits in the foreign exchange market,subject to ratification by Reserve Bank.

● Permission to various participants in theforeign exchange market, includingexporters, Indians investing abroad, FIIs,to avail forward cover and enter intoswap transactions without any limitsubject to genuine underlying exposure.

● FIIs and NRIs permitted to trade inexchange-traded derivative contractssubject to certain conditions.

● Foreign exchange earners permitted toretain up to 100 per cent of their foreignexchange earnings in their ExchangeEarners’ Foreign Currency accounts.Residents are permitted to remit up toUS $ 50, 000 per financial year.

● Authorised dealer banks may borrowfunds from their overseas branches andcorrespondent banks (includingborrowing for export credit, externalcommercial borrowings (ECBs) andoverdrafts from their Head Office/Nostroaccount) up to a limit of 50 per cent oftheir unimpaired Tier I capital or US $10 million, whichever is higher.


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● Borrowers eligible for accessing ECBs canavail of an additional US $ 250 millionwith average maturity of more than 10years under the approval route.Prepayment of ECB up to US $ 300million without prior approval of theReserve Bank.

● The existing limit of US $ 2 billion oninvestments in Government securitiesby foreign institutional investors (FIIs)to be enhanced in phases to US $ 3.2billion by March 31, 2007.

● The extant ceiling of overseasinvestment by mutual funds of US $ 2billion is enhanced to US $ 3 billion.

● Importers to be permitted to bookforward contracts for their customs dutycomponent of imports.

● FIIs to be allowed to rebook a part of thecancelled forward contracts.

● Forward contracts booked by exportersand importers in excess of 50 per centof the eligible limit to be on deliverablebasis and cannot be cancelled.

● Authorised dealer banks to be permittedto issue guarantees/letters of credit forimport of services up to US $ 100,000for securing a direct contractual liabilityarising out of a contract between aresident and a non-resident.

● Lock-in period for sale proceeds of theimmovable property credited to theNRO account to be eliminated, providedthe amount being remitted in anyfinancial year does not exceed US $ onemillion.

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AnneAnneAnneAnneAnnex Vx Vx Vx Vx V: Reforms in the Banking Sector: Reforms in the Banking Sector: Reforms in the Banking Sector: Reforms in the Banking Sector: Reforms in the Banking Sector

Competition Enhancing Measures● Granting of operational autonomy to

public sector banks, reduction of publicownership in public sector banks byallowing them to raise capital fromequity market up to 49 per cent of paid-up capital.

● Transparent norms for entry of Indianprivate sector, foreign and joint-venturebanks and insurance companies,permission for foreign investment in thefinancial sector in the form of ForeignDirect Investment (FDI) as well asportfolio investment, permission tobanks to diversify product portfolio andbusiness activities.

● Roadmap for presence of foreign banksand guidelines for mergers andamalgamation of private sector banksand banks and NBFCs.

● Guidelines on ownership andgovernance in private sector banks.

Measures Enhancing Role ofMarket Forces● Sharp reduction in pre-emption through

reserve requirement, marketdetermined pricing for governmentsecurities, disbanding of administeredinterest rates with a few exceptions andenhanced transparency and disclosurenorms to facilitate market discipline.

● Introduction of pure inter-bank callmoney market, auction-based repos-reverse repos for short-term liquiditymanagement, facilitation of improvedpayments and settlement mechanism.

● Significant advancement indematerialisation and markets forsecuritised assets are being developed.

Prudential Measures● Introduction and phased implementation

of international best practices and normson risk-weighted capital adequacyrequirement, accounting, incomerecognition, provisioning and exposure.

● Measures to strengthen riskmanagement through recognition ofdifferent components of risk,assignment of risk-weights to variousasset classes, norms on connectedlending, risk concentration, application ofmarked-to-market principle forinvestment portfolio and limits ondeployment of fund in sensitive activities.

● ‘Know Your Customer’ and ‘Anti MoneyLaundering’ guidelines, roadmap forBasel II, introduction of capital charge formarket risk, higher graded provisioningfor NPAs, guidelines for ownership andgovernance, securitisation and debtrestructuring mechanisms norms, etc.

Institutional and Legal Measures● Setting up of Lok Adalats (people’s

courts), debt recovery tribunals, assetreconstruction companies, settlementadvisory committees, corporate debtrestructuring mechanism, etc., forquicker recovery/ restructuring.

● Promulgation of Securitisation andReconstruction of Financial Assets andEnforcement of Securities Interest

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(SARFAESI) Act, 2002 and its subsequentamendment to ensure creditor rights.

● Setting up of Credit Information Bureauof India Limited (CIBIL) for informationsharing on defaulters as also otherborrowers.

● Setting up of Clearing Corporation ofIndia Limited (CCIL) to act as centralcounter party for facilitating paymentsand settlement system relating to fixedincome securities and money marketinstruments.

Supervisory Measures● Establishment of the Board for Financial

Supervision as the apex supervisoryauthority for commercial banks,financial institutions and non-bankingfinancial companies.

● Introduction of CAMELS supervisoryrating system, move towards risk-based

supervision, consolidated supervision offinancial conglomerates, strengtheningof off-site surveillance through controlreturns.

● Recasting of the role of statutoryauditors, increased internal controlthrough strengthening of internalaudit.

● Strengthening corporate governance,enhanced due diligence on importantshareholders, fit and proper tests fordirectors.

Technology Related Measures

● Setting up of INFINET as thecommunication backbone for thefinancial sector, introduction ofNegotiated Dealing System (NDS) forscreen-based trading in governmentsecurities and Real Time GrossSettlement (RTGS) System.

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AnneAnneAnneAnneAnnex VI: Liquidity Adjustment Fx VI: Liquidity Adjustment Fx VI: Liquidity Adjustment Fx VI: Liquidity Adjustment Fx VI: Liquidity Adjustment Facilityacilityacilityacilityacility

● As part of the financial sector reformslaunched in mid-1991, India began tomove away from direct instruments ofmonetary control to indirect ones. Thetransition of this kind involvesconsiderable efforts to develop markets,institutions and practices. In order tofacilitate such transition, Indiadeveloped a Liquidity AdjustmentFacility (LAF) in phases consideringcountry-specific features of the Indianfinancial system. LAF is based on repo/reverse repo operations by the centralbank.

● In 1998 the Committee on BankingSector Reforms (NarasimhamCommittee II) recommended theintroduction of a LAF under which theReserve Bank would conduct auctionsperiodically, if not necessarily daily. TheReserve Bank could reset its Repo andReverse Repo rates which would in asense provide a reasonable corridor forthe call money market. In pursuance ofthese recommendations, a major changein the operating procedure becamepossible in April 1999 through theintroduction of an Interim LiquidityAdjustment Facility (ILAF) under whichrepos and reverse repos were formalised.With the introduction of ILAF, thegeneral refinance facility was withdrawnand replaced by a collateralised lendingfacility (CLF) up to 0.25 per cent of thefortnightly average outstanding ofaggregate deposits in 1997-98 for twoweeks at the Bank Rate. Additionalcollateralised lending facility (ACLF) foran equivalent amount of CLF was made

available at the Bank Rate plus 2 per cent.CLF and ACLF availed for periods beyondtwo weeks were subjected to a penal rateof 2 per cent for an additional two weekperiod. Export Credit refinance forscheduled commercial banks wasretained and continued to be providedat the Bank Rate. Liquidity support toPDs against collateral of governmentsecurities at the Bank Rate was alsoprovided. ILAF was expected to promotestability of money market and ensurethat the interest rates move within areasonable range.

● The transition from ILAF to a full-fledgedLAF began in June 2000 and wasundertaken in three stages. In the firststage, beginning June 5, 2000, LAF wasformally introduced and the AdditionalCLF and level II support to PDs wasreplaced by variable rate repo auctionswith same day settlement. In the secondstage, beginning May 2001 CLF and levelI liquidity support for banks and PDs wasalso replaced by variable rate repoauctions. Some minimum liquiditysupport to PDs was continued but atinterest rate linked to variable rate in thedaily repos auctions as determined byReserve Bank from time to time. In April2003, the multiplicity of rates at whichliquidity was being absorbed/injectedunder back-stop facility was rationalisedand the back-stop interest rate was fixedat the reverse repo cut-off rate at theregular LAF auctions on that day. In caseof no reverse repo in the LAF auctions,back-stop rate was fixed at 2.0 percentagepoint above the repo cut-off rate. It was


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also announced that on days when norepo/reverse repo bids are received/accepted, back-stop rate would be decidedby the Reserve Bank on an ad-hoc basis.A revised LAF scheme wasoperationalised effective March 29, 2004under which the reverse repo rate wasreduced to 6.0 per cent and aligned withBank Rate. Normal facility and backstopfacility was merged into a single facilityand made available at a single rate. Thethird stage of full-fledged LAF had begunwith the full computerisation of PublicDebt Office (PDO) and introduction ofRTGS marked a big step forward in thisphase. Repo operations today are mainlythrough electronic transfers. Fixed rateauctions have been reintroduced sinceApril 2004. The possibility of operatingLAF at different times of the same day isnow close to getting materialised. In thatsense we have very nearly completed thetransition to operating a full-fledged LAF.

● With the introduction of Second LAF(SLAF) from November 28, 2005 marketparticipants now have a second window

to fine-tune the management ofliquidity. In past, LAF operations wereconducted in the forenoon between9.30 a.m. and 10.30 a.m. SLAF isconducted by receiving bids between3.00 p.m. and 3.45 p.m. The salientfeatures of SLAF are the same as thoseof LAF and the settlement for both isconducted separately and on grossbasis. The introduction of LAF has beena process and the Indian experienceshows that phased rather than a bigbang approach is required for reformsin the financial sector and in monetarymanagement.

References:

Reserve Bank of India (1999), RepurchaseAgreements (Repos): Report of the Sub-group of the Technical Advisory Committeeon Government Securities Market, April,1999, Mumbai.

—— (2003), Report of the Internal Groupon Liquidity Adjustment Facility, December2003, Mumbai.

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AnneAnneAnneAnneAnnex VII: Markx VII: Markx VII: Markx VII: Markx VII: Market Stabilisation Scheme (MSS)et Stabilisation Scheme (MSS)et Stabilisation Scheme (MSS)et Stabilisation Scheme (MSS)et Stabilisation Scheme (MSS)

● The money markets operated in liquiditysurplus mode since 2002 due to largecapital inflows and current accountsurplus. The initial burden of sterilisationwas borne by the outright transaction ofdated securities and T-bills. However, dueto the depletion in stock of governmentsecurities, the burden of liquidityadjustment shifted on LAF, which isessentially a tool of adjusting for marginalliquidity. Keeping in view the objectiveof absorbing the liquidity of enduringnature using instruments other than LAF,the Reserve Bank appointed a WorkingGroup on Instruments of Sterilisation(Chairperson: Smt Usha Thorat). TheGroup recommended issue of T-bills anddated securities under MarketStabilisation Scheme (MSS) where theproceeds of MSS were to be held by theGovernment in a separate identifiablecash account maintained and operated byReserve Bank. The amounts credited intothe MSS Account would be appropriatedonly for the purpose of redemption and /or buy back of the Treasury Bills and / ordated securities issued under the MSS.In pursuance of the recommendation theGovernment of India and Reserve Banksigned a Memorandum of Understanding(MoU) on March 25, 2004. As part of theMoU, the scheme was made operationalsince April 2004. It was agreed that theGovernment would issue Treasury Billsand/or dated securities under the MSSin addition to the normal borrowingrequirements, for absorbing liquidityfrom the system. These securities wouldbe issued by way of auctions by theReserve Bank and the instruments

would have all the attributes of existingT-bills and dated securities. They wereto be serviced like any other marketablegovernment securities. MSS securitiesare being treated as eligible securitiesfor Statutory Liquidity Ratio (SLR), repoand LAF.

● The proceeds of the MSS are held by theGovernment in a separate identifiablecash account maintained and operatedby the Reserve Bank. The amount heldin this account is appropriated only forthe purpose of redemption and/orbuyback of the Treasury Bills and/ordated securities issued under the MSS.The payments for interest and discounton MSS securities are not made from theMSS Account. The receipts due topremium and/or accrued interest arealso not credited to the MSS Account.Such receipts and payments towardsinterest, premium and discount areshown in the budget and other relateddocuments as distinct componentsunder separate sub-heads. Thus, theyonly have a marginal impact on revenueand fiscal balances of the Governmentto the extent of interest payment on theoutstanding under the MSS.

● For mopping up enduring surplusliquidity, policy choice exist betweencentral bank issuing its own securitiesor government issuing additionalsecurities. A large number of countries,such as, Chile, China, Colombia,Indonesia, Korea, Malaysia, Peru,Philippines, Russia, Sri Lanka, Tawianand Thailand have issued central banksecurities. However, central banks of


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many of these countries faceddeterioration in their balance sheets. Assuch, there are merits in issuingsterilisation bonds on governmentaccount. This is more so, in case of analready well established government debtmarket, where issuing of new centralbank bills of overlapping maturity couldcause considerable confusion andpossible market segmentation whichcould obfuscate the yield curve, reduceliquidity of the instruments and makeoperations that much more difficult.

● MSS has considerably strengthened theReserve Bank’s ability to conductexchange rate and monetary

management operations. It has allowedabsorption of surplus liquidity byinstruments of short term (91-day, 182-day and 364-day T-bills) and themedium-term (dated Governmentsecurities) maturity. Generally, thepreference has been for the short-terminstruments. This has given themonetary authorities a greater degree offreedom in liquidity management duringtransitions in liquidity situation.

Reference:

Reserve Bank of India (2003), Report of theWorking Group on Instruments ofSterlisation, Mumbai, December.

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Annex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD RedemptionAnnex VIII: Liquidity Management during IMD Redemption

● The India Millennium Deposits (IMDs)were foreign currency denominateddeposits issued by State Bank of Indiain 2000, on advice of the Governmentof India. It mobilised a sum of US $ 5.5billion for a tenor of five years. IMDcarried coupons of 8.50 per cent, 7.85 percent and 6.85 per cent on US dollar,Pound Sterling and Euro denominateddeposits, respectively. IMD subscriptionwas limited to non-resident Indians,persons of Indian origin and overseascorporate bodies. The interest incomeearned on IMD was exempted from taxand there was provision of prematureencashment after six months only innon-repatriable Indian rupees. TheseIMDs matured on December 28-29, 2005and the large sums involved threw achallange for liquidity management.

● Liquidity management in face of IMDredemptions was carried out to containdisequilibrium while retaining monetarypolicy stance with a medium-termobjective. Outflows on account of theredemptions were met by smootharrangements worked out in this regard.During December 27-29, 2005, ReserveBank sold foreign exchange out of itsforeign exchange reserves to State Bank

of India totaling nearly US$ 7.1 billion,which in rupee equivalent terms wasabout Rs.32,000 crore. SBI on its part hadbuilt up the necessary rupee resourcesto meet the obligations. Temporarytightness in liquidity, was met by releaseof liquidity through repo window(including the second LAF) averagingabout Rs.23,000 crore per day in the lastweek of December coinciding with theIMD redemptions, outflows due toadvance tax payments and the continuedsurge in credit offtake. The second LAFwindow made available since November28, 2005 provided an additionalopportunity to market participants tofine tune their liquidity management.The smooth redemption of the IMDliability of this size, bunched at a pointof time, reflects the growing maturity ofthe financial markets and the strengthof the liquidity management system thathas been put in place. Short-term moneymarket rates eased remarkably in thefirst week of January 2006 reflectingsmooth redemptions of IMDs but againfirmed up in the second week reflectingpressures emanating from scheduledauctions of Government securities.

Source: Source: Source: Source: Source: Mohan (2006a).


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AnneAnneAnneAnneAnnex IX: Prudential Guidelines Impacting Monetarx IX: Prudential Guidelines Impacting Monetarx IX: Prudential Guidelines Impacting Monetarx IX: Prudential Guidelines Impacting Monetarx IX: Prudential Guidelines Impacting Monetary Ty Ty Ty Ty Transmission in Indiaransmission in Indiaransmission in Indiaransmission in Indiaransmission in India

The Reserve Bank has issued severalprudential capital requirement andsupervisory guidelines which could haveimpact on the transmission of monetarypolicy in India. These include, inter alia:

● For ensuring smooth transition to Basel IInorms, banks were required to maintaincapital charge for market risk on theirtrading book exposures (includingderivatives) by March 31, 2005 and on thesecurities included under Available for Salecategory by March 31, 2006.

● Banks in India have been advised toadopt the Standardised Approach forcredit risk and Basic Indicator Approachfor operational risk under the NewCapital Adequacy Framework with effectfrom March 31, 2008.

● Effective from March 31, 2002, bankswere permitted to have single or groupborrower credit exposure up to 15 percent and 40 per cent of their capital funds(Tier I and Tier II capital) with anadditional allowance of 5 per cent and 10per cent of their capital funds forinfrastructure sector. In May 2004 bankswere permitted to consider enhancementof their exposure to the borrower up to afurther 5 per cent of capital funds, subjectto the banks making disclosure in theirannual reports.

● Banks’ aggregate exposure to the capitalmarket was restricted to 40 per cent oftheir net worth on a solo andconsolidated basis. The consolidateddirect capital market exposure wasrestricted to 20 per cent of the banks’consolidated net worth.

● The Reserve Bank issued a ‘GuidanceNote on Management of OperationalRisk’ in October 2005 to enable the banksto have a smooth transition to the NewCapital Adequacy Framework. Banksusing the Basic Indicator Approach wereencouraged to comply with ‘SoundPractices for the Management andSupervision of Operational Risk’ issuedby the Basel Committee on BankingSupervision in February 2003.

● In order to encourage banks for earlycompliance with the guidelines formaintenance of capital charge for marketrisks, banks were advised in April 2005that such banks which have maintainedcapital of at least 9 per cent of the riskweighted assets for both credit risk andmarket risks for both Held For Trading(HFT) and Available For Sale (AFS)category may treat the balance in excessof 5 per cent of securities included underHFT and AFS categories, in theInvestment Fluctuation Reserves (IFR),as Tier I capital.

● In view of strong growth of housing andconsumer credit, risk containmentmeasures were put in place and the riskweights were increased in October 2004from 50 per cent to 75 per cent in thecase of housing loans and from 100 percent to 125 per cent in the case ofconsumer credit including personalloans and credit cards. The risk weighton banks’ exposure to commercial realestate was increased from 100 per centto 125 per cent in July 2005 and furtherto 150 per cent in April 2006.

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● It was decided in April 2006 that bank’stotal exposure to venture capital fundswill form a part of their capital marketexposure and banks should, henceforth,assign a higher risk weight of 150 percent to these exposures.

● Taking into account the trends in creditgrowth, the general provisioningrequirement for ‘standard advances’ wasincreased in October 2005 from 0.25 percent to 0.40 per cent. Banks’ directadvances to agricultural and SME sectorswere exempted from the additionalprovisioning requirement. In April 2006,the Reserve Bank further increased thegeneral provisioning requirement onstandard advances in specific sectors,i.e., personal loans, loans and advancesqualifying as capital market exposures,residential housing loans beyond Rs.20lakh and commercial real estate loansfrom the existing level of 0.40 per centto 1.0 per cent. These provisions areeligible for inclusion in Tier II capital forcapital adequacy purposes up to thepermitted extent.

● Having regard to the trends in the creditmarkets, a supervisory review processwas initiated with select banks havingsignificant exposure to some sectors,

namely, real estate, highly leveragedNBFCs, venture capital funds and capitalmarkets, in order to ensure that effectiverisk mitigates and sound internalcontrols are in place for managing suchexposures.

● In October 2005, the Reserve Bankrestricted banks’ aggregate exposure tothe capital market to 40 per cent of theirnet worth on a solo and consolidatedbasis. The consolidated direct capitalmarket exposure has been restricted to20 per cent of the banks’ consolidatednet worth.

● In January 2007, provisioningrequirement was increased to two percent for standard assets in the real estatesector, outstanding credit cardreceivables, loans and advances qualifyingas capital market exposure and personalloans (excluding residential housingloans); provisioning requirement was alsoincreased to two per cent for the banks’exposures in the standard assets categoryto the non-deposit taking systemicallyimportant non-banking financialcompanies (NBFCs); risk weight wasincreased to 125 per cent for banks’exposure to the non-deposit takingsystemically important NBFCs.


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AnneAnneAnneAnneAnnex X: The Evolving Stance of Monetarx X: The Evolving Stance of Monetarx X: The Evolving Stance of Monetarx X: The Evolving Stance of Monetarx X: The Evolving Stance of Monetary Py Py Py Py Policy in Indiaolicy in Indiaolicy in Indiaolicy in Indiaolicy in India

Highlights●●●●● The statement on the stance of the

monetary policy was introduced from thepolicy statement of April 1996.

●●●●● The emphasis on price stability andprovision of credit to support growth hassince run through the statements onstance.

●●●●● Exchange rate stability was underlined inthe stance of April 1996.

●●●●● The pursuit of financial reforms,accelerated investment, improvement incredit delivery mechanisms particularlyfor agriculture and small and mediumsectors, soft interest rate regime, interestrate signaling and liquidity managementfound place for the first time in the stanceof April 1998.

●●●●● The role of active debt management wasemphasised in the stance of April 1999.

●●●●● Ensuring financial stability came to berecognised from the stance of October1999.

●●●●● Macroeconomic stability was emphasizedin the stance of April 2004.

●●●●● The need for support to export demand,stabilisation of inflation expectations andcalibrated actions was underlined in thestance of October 2004.

●●●●● Prompt and effective response to theevolving situation was underlined in thestance of July 2005.

●●●●● The aspect of credit quality wasemphasised in the stance of January 2006.

●●●●● Swift response to evolving globaldevelopments was promised in thestance of April 2006.

●●●●● Financial inclusion was emphasised, forthe first time, in the stance of January2007.

DetailsDetailsDetailsDetailsDetails

YYYYYearearearearear Annual PAnnual PAnnual PAnnual PAnnual Policyolicyolicyolicyolicy Mid-TMid-TMid-TMid-TMid-Term Reviewerm Reviewerm Reviewerm Reviewerm Review

1996-97

1997-98

1998-99

Credit support to sustain growth and areasonable degree of price and exchangerate stability.

Maintaining reasonable price stabilityand ensuring availability of adequatebank credit to support the growth of thereal sector.

Need to accelerate industrial investmentand output in the economy;maintenance of low rates of inflation;continued pursuit of financial reform;reduction in interest rates; and

Price stability and adequate supply ofbank credit to the productive sectors ofthe economy.

Promoting price stability and ensuringavailability of adequate bank credit tomeet the requirements of productivesectors of the economy.

Flexible use of interest rateinstruments to signal RBI’s stanceregarding monetary conditions andmanagement of the flow of liquidity inthe system.

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1999-00

2000-01

2001-02

2002-03

improvement in credit deliverymechanisms, particularly for agricultureand medium and small sectors.

Provision of reasonable liquidity; stableinterest rates with policy preference forsoftening to the extent circumstancespermit; active debt-management;orderly development of financialmarkets; and further steps in financialsector reforms.

Continue the current stance ofmonetary policy and ensure that alllegitimate requirements for bank creditare met while guarding against anyemergence of inflationary pressures dueto excess demand.

Provision of adequate liquidity to meetcredit growth and support revival ofinvestment demand while continuing avigil on movements in the price level.

Within the overall framework ofimparting greater flexibility to theinterest rate regime in the medium-term, to continue the present stableinterest rate environment with apreference for softening to the extentthe evolving situation warrants.

Provision of adequate liquidity to meetcredit growth and support revival ofinvestment demand while continuing avigil on movements in the price level.

Within the overall framework ofimparting greater flexibility to the

Provision of reasonable liquidity; stableinterest rates with preference forsoftening to the extent possible withinthe existing operational and structuralconstraints; orderly development offinancial markets and ensuringfinancial stability.

Same as outlined in Annual Policy ofApril 2002.


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2003-04

2004-05

interest rate regime in the medium-term, to continue the present stableinterest rate environment with apreference for softening to the extentthe evolving situation warrants.

Provision of adequate liquidity to meetcredit growth and support investmentdemand in the economy whilecontinuing a vigil on movements in theprice level.

In line with the above, to continue thepresent stance on interest ratesincluding preference for soft interestrates.

To impart greater flexibility to theinterest rate structure in the medium-term.

Provision of adequate liquidity to meetcredit growth and support investmentdemand in the economy whilecontinuing a vigil on movements in theprice level.

In line with the above, to continue withthe present stance of preference for asoft and flexible interest rateenvironment within the framework ofmacroeconomic stability.

Same as outlined in Annual Policy ofApril 2003.

Provision of appropriate liquidity tomeet credit growth and supportinvestment and export demand in theeconomy while placing equal emphasison price stability.

Consistent with the above, to pursuean interest rate environment that isconducive to macroeconomic and pricestability, and maintaining themomentum of growth.

To consider measures in a calibratedmanner, in response to evolvingcircumstances with a view to stabilisinginflationary expectations.

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YYYYYearearearearear Annual PAnnual PAnnual PAnnual PAnnual Policyolicyolicyolicyolicy FirstFirstFirstFirstFirst MidMidMidMidMid ThirdThirdThirdThirdThirdQuarter ReviewQuarter ReviewQuarter ReviewQuarter ReviewQuarter Review TTTTTerm Reviewerm Reviewerm Reviewerm Reviewerm Review Quarter ReviewQuarter ReviewQuarter ReviewQuarter ReviewQuarter Review

Same stance forthe remainingpart of the year asset out in theannual policyStatement ofApril 2005, butthe Reserve Bankwould respond,promptly andeffectively, to theevolving situationdepending on theunfolding of therisks.

To ensure amonetary andinterest rate

Provision ofappropriateliquidity to meetcredit growth andsupportinvestment andexport demandin the economywhile placingequal emphasison price stability.

Consistent withthe above, topursue an interestrate environmentthat is conduciveto macroeconomicand price stability,and maintainingthe momentum ofgrowth.

To considermeasures in acalibrated manner,in response toevolvingcircumstanceswith a view tostabilisinginflationaryexpectations.


2005-06

2006-07

Consistent withemphasis on pricestability, provisionof appropriateliquidity to meetgenuine creditneeds andsupport exportand investmentdemand in theeconomy.

Ensuring aninterest rateenvironment thatis conducive tomacroeconomicand pricestability, andmaintaining thegrowthmomentum.

To considermeasures in acalibrated andprompt manner,in response toevolvingcircumstanceswith a view tostabilisinginflationaryexpectations.


To maintain theemphasis on pricestability with a viewto anchoringinflationaryexpectations.

To continue tosupport export andinvestment demandin the economy formaintaining thegrowth momentumby ensuring aconducive interestrate environmentfor macroeconomic,price and financialstability.

To provideappropriate liquidityto meet genuinecredit needs of theeconomy with dueemphasis on quality.

To considerresponses asappropriate toevolvingcircumstances.

To reinforce theemphasis on pricestability and well


SPEECH


Rakesh Mohan

YYYYYearearearearear Annual PAnnual PAnnual PAnnual PAnnual Policyolicyolicyolicyolicy FirstFirstFirstFirstFirst MidMidMidMidMid ThirdThirdThirdThirdThirdQuarter ReviewQuarter ReviewQuarter ReviewQuarter ReviewQuarter Review TTTTTerm Reviewerm Reviewerm Reviewerm Reviewerm Review Quarter ReviewQuarter ReviewQuarter ReviewQuarter ReviewQuarter Review

environment thatenablescontinuation ofthe growthmomentumconsistent withprice stabilitywhile being inreadiness to actin a timely andprompt manneron any signs ofevolvingcircumstancesimpinging oninflationexpectations.

To focus on creditquality andfinancial marketconditions tosupport exportand investmentdemand in theeconomy formaintainingmacroeconomic,in particular,financialstability.

To respondswiftly toevolving globaldevelopments.

environment thatenablescontinuation ofthe growthmomentum whileemphasising pricestability with aview to anchoringinflationexpectations.

To reinforce thefocus on creditquality andfinancial marketconditions tosupport exportand investmentdemand in theeconomy formaintainingmacroeconomicand, in particular,financial stability.

To considermeasures asappropriate to theevolving globaland domesticcircumstancesimpinging oninflationexpectations andthe growthmomentum.

environment thatsupports exportand investmentdemand in theeconomy so as toenablecontinuation ofthe growthmomentumwhile reinforcingprice stabilitywith a view toanchoringinflationexpectations.

To maintain theemphasis onmacroeconomicand, in particular,financialstability.

To considerpromptly allpossiblemeasures asappropriate tothe evolvingglobal anddomesticsituation.

anchored inflationexpectations whileensuring a monetaryand interest rateenvironment thatsupports export andinvestment demandin the economy soas to enablecontinuation of thegrowth momentum.

To re-emphasisecredit quality andorderly conditions infinancial markets forsecuringmacroeconomic and,in particular,financial stabilitywhilesimultaneouslypursuing greatercredit penetrationand financialinclusion.

To respond swiftlywith all possiblemeasures asappropriate to theevolving global anddomestic situationimpinging oninflationexpectations andthe growthmomentum.

monetary policy transmission in india* rakesh mohanrakeshmohan.com/docs/rbibulletinapril2007.pdf ·...

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