Capital Account Liberalisation and Conduct of Monetary Policy: … 2007.pdf · Liberalisation and...

RBIMonthly Bulletin

July 2007 1129

SPEECH

Capital AccountLiberalisation and

Conduct of MonetaryPolicy: The Indian

Experience

Rakesh Mohan

* Paper presented by Dr. Rakesh Mohan, Deputy Governor,Reserve Bank of India at an International MonetarySeminar organised by the Banque de France onGlobalisation, Inflation and Financial Markets in Paris onJune 14, 2007. Assistance of Sanjay Hansda, IndranilBhattacharyya, Partha Ray and M.D. Patra in preparing thepaper is gratefully acknowledged.

I. Overall Approach

The distinguishing feature of our overallreform process initiated in the early 1990shas been the accomplishment of higheconomic growth in an environment ofmacroeconomic and financial stability. Infact, we have achieved acceleration ingrowth while maintaining price andfinancial stability.

During this period, apart from all theother reforms, we have achieved currentaccount convertibility, and also opened thecapital account to a substantial extent. Withthis growing openness, we have not beeninsulated from exogenous shocks. Theseshocks, global as well as domestic, includeda series of financial crises in Asia, Brazil,Russia and Mexico, in the 1990s and otherevents such as 9/11 terrorist attacks in theUS, border tensions, sanctions imposed inthe aftermath of nuclear tests, politicaluncertainties, changes in the Government,and the current oil shock. Nonetheless,stability could be maintained in financialmarkets. Indeed, inflation has beencontained since the late-1990s to an averageof around five per cent, distinctly lowerthan that of around seven to eight per centper annum over the previous four decades.Simultaneously, the health of the financialsector has recorded very significantimprovement.

The story of Indian reforms is by nowwell-documented (e.g., Ahluwalia, 2002);nevertheless, what is less appreciated is thatIndia achieved this acceleration in growthwhile maintaining price and financialstability. With increased deregulation offinancial markets and increased integrationof the global economy, the 1990s were

Capital AccountLiberalisation andConduct of MonetaryPolicy: The IndianExperience*

Rakesh Mohan

RBIMonthly BulletinJuly 20071130

SPEECH

Capital AccountLiberalisation andConduct of MonetaryPolicy: The IndianExperience

Rakesh Mohan

turbulent for global financial markets: 63countries suffered from systemic bankingcrises in that decade, much higher than 45in the 1980s. Among countries thatexperienced such crises, the direct cost ofreconstructing the financial system wastypically very high: for example,recapitalisation of banks had cost 55 percent of GDP in Argentina, 42 per cent inThailand, 35 per cent in Korea and 10 percent in Turkey. There were high indirectcosts of lost opportunities and sloweconomic growth in addition (McKinsey &Co., 2005). It is therefore particularlynoteworthy that India could pursue itsprocess of financial deregulation andopening of the economy without sufferingfinancial crises during this turbulent periodin world financial markets. The cost ofrecapitalisation of public sector banks at lessthan 1 per cent of GDP is therefore low incomparison. Whereas we can be legitimatelygratified with this record, we now need tofocus on the new issues that need to beaddressed for the next phase of financialdevelopment, particularly in the context offuller capital account convertibility andincreasing integration of financial markets.

That the current annual GDP growth ofaround 8.5 to 9.0 per cent can be achievedin India with a level of gross domesticinvestment in the range of 30 to 33 per centover the past 4 years suggests that theeconomy is functioning quite efficiently.Thus our policy of gradual and sequencedreform cannot be said to have been at thecost of growth or efficiency. We need toensure that we maintain this level ofefficiency and attempt to improve on itfurther. As the Indian economy continueson such a growth path and attempts to

accelerate it, new demands are being placedon the financial system.

In examining the conduct of monetarypolicy in India in the presence of continuingand gradual capital account liberalisation, akey lesson is that this process has to beviewed in the context of the overall reformprocess. As an economy undergoes thetransition from a closed to an openeconomy, first on the current account andthen on the capital account, the interest offinancial stability is served by simultaneousaction on a number of different fronts. Theframework of monetary policy itself has toundergo a change from the previous directmethods of control of monetary aggregatesto indirect methods imparting signalsthrough the market. For such a change tobe effective the monetary policytransmission process has to bestrengthened through development of allfinancial markets, and the building ofmarket micro-infrastructure. On theexternal front, the transition from a fixedor pegged exchange rate to a marketdetermined one itself needs carefulassessment of the efficiency of the foreignexchange market, the capabilities of marketplayers and evaluation of effects ofexchange rate volatility. The operation offinancial markets and the degree ofvulnerability that an economy becomesexposed to with greater opening is itselfinfluenced significantly by fiscalconditions. Hence the efficacy of monetarypolicy, efficiency of financial markets, andexternal vulnerability are closely linked tothe practice of prudent fiscal policy.Finally, for efficient monetary policytransmission, and depth, liquidity andefficiency of financial markets, financial

RBIMonthly Bulletin

July 2007 1131

SPEECH



Experience

Rakesh Mohan

intermediaries themselves have to bestrengthened. It is in view of all these inter-linkages that I have chosen to provide a briefoverview of developments in each of theseareas as they have evolved over the pastdecade and a half in India.

II. Process of Setting outMonetary Policy Objectives

General Objectives

Traditionally, central banks pursue thetwin objectives of price stability and growthor employment. In pursuing the basicobjectives, central banks also need to keepin view considerations of orderly financialmarkets and financial stability. Needless tosay, the objectives of monetary policy areinterrelated and have trade-offs as well. Thepreamble to the Reserve Bank of India Act,1934 sets out the Bank’s objectives as “toregulate the issue of Bank notes and thekeeping of reserves with a view to securingmonetary stability in India and generally tooperate the currency and credit system ofthe country to its advantage”. Althoughthere is no explicit mandate for pricestability, as is the current trend in manycountries, the objectives of monetary policyin India have evolved as those ofmaintaining price stability and ensuringadequate flow of credit to the productivesectors of the economy. In essence,monetary policy aims to maintain ajudicious balance between price stabilityand economic growth. The relativeemphasis between price stability andeconomic growth is governed by theprevailing circumstances at a particular timeand is spelt out from time to time in thepolicy announcements of the Reserve Bank.

Considerations of financial stability haveassumed greater importance in recent yearsin view of the increasing openness of theIndian economy, financial integration andthe possibility of cross border contagion. Aswe observed the severe costs of financialinstability elsewhere, financial stability hasascended the hierarchy of monetary policyobjectives since the second half of the 1990s.Strong synergies and complementarities areobserved between price stability andfinancial stability in India. Accordingly, webelieve that regulation, supervision anddevelopment of the financial system remainwithin the legitimate ambit of monetarypolicy broadly interpreted.

Framework

Till 1997-98, monetary policy in Indiaused to be conducted with broad money(M3) as an intermediate target. The aim wasto regulate money supply consistent withthe expected growth of the economy andthe projected level of inflation. The targetedmonetary expansion used to be set on thebasis of estimates of these two crucialparameters. In practice, the monetarytargeting framework was used in a flexiblemanner with feedback from developmentsin the real sector.

In the wake of financial sector reformsand opening up of the economy in the1990s, appropriateness of the monetarytargeting framework was questioned withthe changing inter-relationship betweenmoney, output and prices. Accordingly, theReserve Bank switched over in 1998-99 to amultiple indicator approach. With thisapproach, interest rates or rates of returnin different markets (money, capital and


SPEECH


Rakesh Mohan

government securities markets), along withdata on currency, credit extended by banksand financial institutions, fiscal position,trade flows, capital flows, inflation rate,exchange rate, refinancing and transactionsin foreign exchange available on high-frequency basis, are all examined along withoutput in framing monetary policy.

The specific features of the Indianeconomy, including its socio-economiccharacteristics predicate the investing of themonetary authority with multiple objectivesfor some time to come. While it could bedesirable in the interest of clarity andtransparency to stack up the objectives in ahierarchy, the jury is still out on the meritsof public announcement of the policyweights assigned to each objective.Flexibility in the setting of monetary policyshould override consideration oftransparency so that public indication ofweighting patterns associated withobjectives should not solidify into abinding rule. Moreover, continuousmonitoring of the underlying macroeconomic and financial conditions formonetary policy purposes will necessitatea continuous rebalancing of weightsassigned to various objectives. In apragmatic sense, therefore, it should sufficefor the monetary authority to indicate themain objectives and an ordinal ranking, atbest, to reflect the reading of underlyingdevelopments.

A single objective for monetary policy,as is usually advocated, particularly in aninflation targeting framework, is a luxurythat India cannot afford, at least over themedium term. The cause of monetary policyis not lost, however, analytically, it can beshown that even if one of the multiple

objectives is nominal among others thatmay be real, it can serve as the quintessentialnominal anchor and enable monetary policyto work. This view is supported by apragmatic and influential strand in theliterature which questions the recentproliferation of inflation targeting as amonetary policy framework (Friedman,2000; McCallum, 1981). As regards inflationtargeting, as the monetary policy regimefulfilling the single mandate advocacy, thejury is still out. Even though there has beenan increase in the number of central banksadopting inflation targeting since the early1990s, a number of central banks, notablythe Federal Reserve, retain multipleobjectives. I am not a monetary scholar, butI do feel that, given the current domesticand international complexities, we need tocontinue with a flexible framework formonetary policy. The least we need in thecurrent circumstances is a less simplisticapproach.

‘In India, we have not favoured theadoption of inflation targeting, whilekeeping the attainment of low inflation asa central objective of monetary policy, alongwith that of high and sustained growth thatis so important for a developing economy.Apart from 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 markets

RBIMonthly Bulletin

July 2007 1133

SPEECH



Experience

Rakesh Mohan

and absence of interest rate distortions. InIndia, although the money market,government debt and forex market 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 ofIndia, with various regional differences, andcontinued existence of market imperfectionsin factor and product markets betweenregions, the choice of a universally acceptablemeasure of inflation is also difficult’(Mohan, 2006b).

It is important to recognise the realityof multiple objectives of monetary policyin India. Nonetheless, it needs to beappreciated that relative to the past, weneed to communicate better on theobjective of price stability and as firmly aspossible, albeit without necessarily a precisenumerical objective. Indeed, why should amonetary policy invested with multipleobjectives choose to quantify only one – theinflation rate? Indeed, setting such a precisenumerical objective for inflation runs therisk of loss of central bank credibility in thecontext of the dominance of supply sideshocks emanating from sources such asmonsoon failure and administered pricingof various agricultural commodities andpetroleum products. Whereas the share ofagriculture in GDP has been declining andis now less than 20 per cent, the sectorcontinues to be extremely important since

the majority of the population remainsdependent on agriculture. Therefore,setting precise numerical targets forinflation is fraught with the risk of loss ofreputation across a large constituency.

Nevertheless, as the Indian economybecomes increasingly open with fullercapital account convertibility, the objectiveof progressively bringing inflation down tonear international levels and maintainingprice stability assumes greater importance.The experience of successfully bringingdown inflation from persistent higher levelssince the late 1990s to around 5 per cent inrecent years has already brought downinflation expectations significantly.

As we place greater emphasis on lowinflation and price stability, we also need toimprove communication with respect to theunderstanding of inflation. At present,headline inflation in India is indicated by theweekly release of the All India WholesalePrice Index (WPI). Most countries use theConsumer Price Index (CPI) instead. The CPIis difficult to use in India because of theexistence of 4 indexes of CPI, each reflectingthe consumption basket of different sets ofconsumers in urban and rural areas.

An appropriate inflation indicatorshould (i) reflect price changes ofconstituent items accurately and (ii) providesome understanding of headline inflation.Whereas it is feasible to construct aneconomy wide consumer price index on thelines of the harmonised consumer priceindex (HICP) adopted in the UK and theEuro Area, it is not clear how useful it wouldbe as an indicator of the general price level,given the widely differing consumptionbaskets as between rich and poor, between


SPEECH


Rakesh Mohan

rural and urban areas and even betweenregions in India. In fact, a measure ofproducer prices to which the wholesaleprice index (WPI) is akin, is likely to be morerepresentative and familiar across thecountry, since these prices are more likelyto be uniform across the country.Accordingly, the commodity/services basedprice index should be seen as useful moreas an indicator/information variable than asdefining the inflation objective. Moreover,the WPI is available on a weekly basis, witha two week lag, whereas the CPI indices areonly available on monthly basis, and with a2 month lag.

Monetary policy should be moreexplicitly associated with managing inflationexpectations rather than current inflation.Accordingly, the guiding criterion forinclusion of a variable in the inflationindicators panel should be the informationcontent on future inflation. An importantsub-set would be real sector indicators offuture inflation such as variability of outputaround trend/potential, capacity utilisation,inventory, corporate performance, industrial/investment expectations and otherindicators of aggregate demand. We haveinitiated greater quantitative technical workin these areas over the last couple of yearsto better inform our monetary policy makingwith a forward looking approach.

The Reserve Bank has also initiatedinflation expectation surveys so that we canhave some direct indicators of changinginflation expectations of the public. Thesequarterly surveys are still in the pilot testingstage so their results are not yet in thepublic domain. But the initial results lookpromising.

The more complex is the mandate forthe central bank, the more is the necessityof communication (Mohan, 2005). TheReserve Bank clearly has complex objectives.Apart from pursuing monetary policy,financial stability is one of the overridingconcerns of the Reserve Bank. Within theobjective of monetary policy, both controlof inflation and providing adequate creditto the productive sectors of the economy soas to foster growth are equally important. Thisapart, the Reserve Bank acts as a bankingregulator, public debt manager, governmentdebt market regulator and currency issuer.Faced with such multiple tasks and complexmandate, there is an utmost necessity ofclearer communication on the part of theReserve Bank.

A significant step towards transparencyof monetary policy implementation isformation of various Technical AdvisoryCommittees (TACs) in the Reserve Bank withrepresentatives from market participants,other regulators and experts. In line with theinternational best practices and with a viewto further strengthening the consultativeprocess in monetary policy, the ReserveBank, in July 2005, set up a TechnicalAdvisory Committee on Monetary Policy(TACMP) with external experts in the areasof monetary economics, central banking,financial markets and public finance. TheCommittee meets at least once in a quarter,reviews macroeconomic and monetarydevelopments and advises the Reserve Bankon the stance of monetary policy. TheCommittee has contributed to enriching theinputs and processes of monetary policysetting in India. Whether any furtherinstitutional changes are necessary, however,remains an open question.

RBIMonthly Bulletin

July 2007 1135

SPEECH



Experience

Rakesh Mohan

III. Development of MonetaryPolicy Instruments andTransmission Process

Consistent with the structural changesin the monetary policy framework,improvements in the channels oftransmission emerged early on as aconcurrent objective in order to enhancepolicy effectiveness. Monetary policy clearlycannot work without adequate monetarytransmission and the appropriate monetarytransmission cannot take place withoutefficient price discovery of interest ratesand exchange rates in the overallfunctioning of financial markets and theirintegration. Therefore, the correspondingdevelopment of the money market,government securities market and theforeign exchange market became necessary.Accordingly, from the 1990s, the ReserveBank simultaneously undertook thedevelopment of the domestic financialmarket spectrum, sequenced into theprocess of deregulation of interest rates, thewithdrawal of statutory pre-emptions, thequalitative improvement in monetary-fiscalcoordination and the progressiveliberalisation of the exchange and paymentsregime, including the institution of a marketoriented exchange rate policy. Thedevelopment of financial markets in Indiaencompassed the introduction of newmarket segments, new instruments and asharper focus on regulatory oversight.

We have made a carefully calibratedtransition from an administered interestrate regime to one of market determinedinterest rates over a period of time, whileminimising disruption and preservingfinancial stability. This approach also

provided market participants adequate timeto adjust to the new regime.

The growing market orientation ofmonetary policy has tilted the choice ofinstruments decisively from direct to moreindirect and market-based monetary policymeasures. Until the early 1990s, statutorypre-emptions in the form of cash reserveratio (CRR) and statutory liquidity ratio (SLR)requirements locked away nearly 65 percent of bank deposits, severely eroding theprofitability of the financial system andeffectiveness of monetary policy. The SLRwas brought down from 38.5 per cent of netdemand and time liabilities (NDTL) in early1992 to 25 per cent in October-1997. TheCRR had been reduced progressively from15 per cent in 1991 to 4.5 per cent in 2003,before it had to be increased again in steps to6.5 per cent in the current monetarytightening phase. Monetary manoeuverabilityhas now been strengthened further withremoval of the erstwhile floor of 3 per centand ceiling of 20 per cent in CRR through astatutory amendment. The statutoryminimum SLR of 25 per cent has also beenremoved to provide for greater flexibility inthe Reserve Bank’s monetary policyoperations.

The key policy development that hasenabled a more independent monetary policyenvironment was the discontinuation ofautomatic monetisation of the government’sfiscal deficit since April 1997 through anagreement between the Government and theReserve Bank in September 1994, marking aunique milestone in monetary–fiscalcoordination. Another important institutionalchange was the freeing of the Reserve Bank’sbalance sheet from the burden of exchange


SPEECH


Rakesh Mohan

guarantees accumulated in the pre-reform era.Subsequently, enactment of the FiscalResponsibility and Budget Management Act,2003 has strengthened the institutionalmechanism further: from April 2006 onwards,the Reserve Bank is no longer permitted tosubscribe to government securities in theprimary market. This step completes thetransition to a fully market based system forgovernment securities. Looking ahead,consequent to the recommendations of theTwelfth Finance Commission, the CentralGovernment has now ceased to raise resourceson behalf of State Governments, which nowhave to access the market directly. Thus, StateGovernments’ capability in raising resourceswill be market determined and based on theirown financial health. For ensuring a smoothtransition, institutional processes are beingrevamped towards greater integration inmonetary operations.

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 interms of money market instruments suchas certificates of deposit, 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. In order to improvemonetary transmission as also onprudential considerations, steps wereinitiated in 1999 to turn the call moneymarket into a pure inter-bank market and,simultaneously, to develop a repo market

outside the official window for providing astable collateralised funding alternative,particularly to non-banks who were phasedout of the call segment, and banks. TheCollateralised Borrowing and LendingObligation (CBLO), a repo instrumentdeveloped by the Clearing Corporation ofIndia Limited (CCIL) for its members, withthe CCIL acting as a central counter-partyfor borrowers and lenders, was permittedas a money market instrument in 2002.With the development of market repo andCBLO segments, the call money market hasbeen transformed into a pure inter-bankmarket, including primary dealers, fromAugust 2005. A recent noteworthydevelopment is the substantial migration ofmoney market activity from theuncollateralised call money segment to thecollateralised market repo and CBLOmarkets. Thus, uncollateralised overnighttransactions are now limited to banks andprimary dealers in the interest of financialstability. Technological upgradation hasaccompanied the development of themoney market. Efforts are currentlyunderway to introduce screen-basednegotiated quote-driven dealings in call/notice and term money markets.Information on overnight rates and volumeswould be disseminated by the Reserve Bankin order to enable market participants toassess the liquidity conditions in anefficient and transparent manner.

The government securities market wasmoved to an auction-based system in 1992to obtain better price discovery and toimpart greater transparency in operations.This was a major institutional change,which, along with the freeing of the moneyand foreign exchange market and the

RBIMonthly Bulletin

July 2007 1137

SPEECH



Experience

Rakesh Mohan

phasing out of automatic monetisation offiscal deficits, created a conduciveenvironment for the progressivederegulation that was to follow. The settingup of well capitalised Primary Dealers (PDs)for dealing in government securitiesfollowed in 1995, backed up by theintroduction of Delivery versus Payment(DvP) for government securities, adoptionof new techniques of floatation,introduction of new instruments,particularly Treasury Bills of varyingmaturities and repos on all centralgovernment dated securities and TreasuryBills of all maturities by April 1997.

Since April 1992, the entire centralgovernment borrowing programme in datedsecurities has been conducted throughauctions. In 2005, the Reserve Bank put inplace an anonymous order matching systemto improve price discovery, and settlementprocedures for mitigating risks. To furtheractivate trading and improve the depth ofthe securities market, the introduction of a‘when issued’ market has also beenannounced recently. All these measureshave brought about significant changes anda new treasury culture is developing,contributing to the formation of the termstructure of interest rates. The demand forgovernment securities is now driven moreby considerations of effective managementof liquidity rather than by statutoryliquidity requirements.

The Indian foreign exchange market hasbeen widened and deepened with thetransition to a market-determined exchangerate system in March 1993 and thesubsequent liberalisation of restrictions onvarious external transactions leading up to

current account convertibility under ArticleVIII of the Articles of Agreement of theInternational Monetary Fund in 1994. Sincethe mid-1990s, banks and other authorisedentities have been accorded significantfreedom to operate in the market. Bankshave been allowed freedom to fix theirtrading limits and to borrow and investfunds in the overseas markets up tospecified limits. They have been allowed touse derivative products for hedging risksand asset-liability management purposes.Similarly, corporates have been givenflexibility to book forward cover based onpast turnover and are allowed to use avariety of instruments like interest ratesand currency swaps, caps/collars andforward rate agreements. The swap marketfor hedging longer-term exposure hasdeveloped substantially in recent years. Anumber of steps have also been taken toliberalise the capital account coveringforeign direct investment, portfolioinvestment, outward investment includingdirect investment as well as depositoryreceipt and convertible bonds, opening ofIndian corporate offices abroad and the like.In recent years, the Reserve Bank hasdelegated exchange control procedures tobanks and authorised dealers to such anextent that there is hardly any need toapproach the Reserve Bank for any approval.These reforms are being reflected in vibrancyin activity in various segments of the foreignexchange market with the daily turnover overUS $ 28 billion (as at the end of April 2007).

A key area of emphasis in thedevelopment of financial markets in India isthe provision of the appropriatetechnological infrastructure for trading,clearing, payment and settlement. Since the


SPEECH


Rakesh Mohan

late 1990s, the establishment of a modern,robust payments and settlement systemconsistent with international best practiceshas emerged as an important objective of theReserve Bank. A three-pronged strategy ofconsolidation, development and integrationhas been pursued in this regard. Consolidationrevolves around strengthening the existingpayment system by providing the latest levelsof technology. The developmental dimensionincludes real time gross settlement, centralisedfunds management, securities settlement andstructured electronic financial messaging.Other key elements in the technologicalcontent of market development are electronicclearing (introduced in 1994), electronic fundstransfer (1996), quick funds transfers withcentralised settlement in Mumbai (2003),negotiated dealing system (NDS), screen basedorder matching system (2002) for electronicreporting of trades and online disseminationsystem and submission of bids for primaryissuance of government securities and aClearing Corporation of India Ltd. (CCIL),promoted by banks, financial institutionsand primary dealers for clearing andsettlement of trades in foreign exchange,government securities and other debtinstruments, commenced operations in April2001. The CCIL acts as a central counterparty(CCP) to all transactions and guaranteessettlement of trades executed through itsrules and regulations eliminatingcounterparty risks in adherence tointernational best practices. Oversight overthe payments and settlement system isvested in a National Payments Council, andBoard for Payments and Settlement Systemestablished within the Reserve Bank.

As may be seen from this briefdescription of the various measures that had

to be taken to develop the market andinstitutional framework for efficientmonetary policy transmission, developmentof markets is an arduous and time consumingactivity that requires conscious policy makingand implementation. Markets do not developand function overnight: they have to becreated, nurtured and monitored on acontinuous basis before they startfunctioning autonomously. Efficienttransmission of monetary impulses clearlyneeds integration of markets.

Issues

Interest rate deregulation is essential tosmoothen the transmission channels ofmonetary policy and to enhance thesignaling effects of policy changes. Whereasconsiderable progress has been made in thisdirection, full deregulation is constrainedby the need for various policy interventionsin the context of a still developing economy.The Government had nationalised most ofthe banking system in 1969 in order toensure the spread of banking throughoutthe country. Whereas new private sectorbanks have been introduced since the mid1990s, public sector banks still account for70 per cent of banking assets. These banksneed to continue to perform various publicpolicy activities, particularly in the area ofagriculture, small and medium enterprises,and the cause of overall financial inclusion.This can also include certain degree of creditallocation and interest rate directions.Hence, monetary transmission can getmuted at the margin.

The Government also fixes certainadministered interest rates on a number ofsmall saving schemes and on provident

RBIMonthly Bulletin

July 2007 1139

SPEECH



Experience

Rakesh Mohan

funds, along with providing certain taxincentives, in the absence of well developedsocial security systems. As banks have tocompete for funds with small savingschemes, the rates offered on long-termdeposits mobilised by banks sometimeshave to be set at levels higher than wouldhave obtained under competitive marketconditions. In fact, this has been observedto be a factor contributing to downwardstickiness of lending rates, which has someimplications for the effectiveness ofmonetary policy. This is a reality that wehave to appreciate and live with given theabsence of social security coverage andadequate safety nets in the country. Thesesmall savings schemes administered by thegovernment through the wide reach of postoffices, and some through commercialbanks, provide small savers access to taxsavings instruments that are seen as safeand stable. Whereas they do have someimpact in terms of blunting monetarytransmission mechanisms, they canperhaps be seen as contributing to overallfinancial stability. Benchmarking theseadministered interest rates to marketdetermined rates has been proposed fromtime to time. Whereas some rationalisationin schemes has indeed been done, moreprogress will depend on the emergence ofbetter social security and pension systems,and perhaps easier access to marketablesovereign instruments.

While the government securities marketis fairly well developed now, the corporatedebt market remains to be developed forfacilitating monetary signaling acrossvarious market segments. We understand,however, that it has been difficult todevelop the corporate bond market in most

countries. Almost half the world’s corporatebond market is in the US, and another 15per cent in Japan. Among other countries,while the UK has a long standing bondmarket, the European bond market has onlybegan to really develop after Europeanmonetary integration and introduction ofthe Euro. Among developing countries, it isperhaps only South Korea that has areasonably well developed bond market.

In the absence of a well developedcorporate debt market, the demand for debtinstruments has largely concentrated ongovernment securities with the attendantimplications for the yield curve and, in turn,for monetary transmission. The secondarymarket for corporate debt has suffered fromlack of market making resulting in poorliquidity. Corporates continue to preferprivate placements to public issues forraising resources in view of ease ofprocedures and lower costs.

There is a need for development ofmortgage-backed securities, credit defaultswaps, bond insurance institutions forcredit enhancement, abridgment ofdisclosure requirements for listedcompanies, credit information bureaus,rating requirements for unlisted companies,real time reporting of primary andsecondary trading, and eventual retailaccess to the bond market by non-profitinstitutions and small corporates. Aconcerted effort is now being made to setup the institutional and technologicalstructure that would enable the corporatedebt market to operate. Furthermore, theon-going reforms in the area of socialsecurity coupled with the emergence ofpension and provident funds are expected


SPEECH


Rakesh Mohan

to increase the demand for long-term debtinstruments. In the process, the investorbase for government securities would bebroadened, extending the monetarytransmission across new players andparticipants.

For monetary policy to be moreeffective, the monetary transmissionprocess has to be improved on a continuousbasis so that price discovery is better. In thisendeavour, we need to keep developing thevarious financial markets, increase theirconnection with credit markets, removedistortions in the market and reversecurrent tendency to move back toadministered interest rates.

IV. Development of FinancialMarkets

There has been a great deal of progressin developing the money market,government securities market and forexmarket. With greater capital accountopenness, we need to develop them furtherto enable market participants to absorbgreater volatility and shocks. Each of thesemarkets needs to be deeper. In the contextof progress towards further capital accountconvertibility, the market participants aregoing to be faced with increased risks onmultiple accounts: volatility in capital flows,volatility in asset prices, increasedcontagion and state of ability of legacyinstitutions in managing risks.

Money Market

The money market remains fragmentedwith different segments giving rise todifferent overnight rates. The call moneymarket, which remains an uncollateralised

market has now become a pure inter-bankmarket amongst banks and primary dealerswith the withdrawal of non-banks.Alongside, primarily for non-bankparticipants at the shorter end, there is themarket repo outside the repo market underthe liquidity adjustment facility. This is acollateralised segment of money market.The CBLO market, operated by the CCILamongst its members is yet anothercollateralised money market instrument.With the decision to move graduallytowards a pure inter-bank call/term moneymarket, there is a need to remove theoperational/regulatory constraints in therepo market. One of the perceived hurdlesin the development of the repo market isthe inability to rollover contracts. To enablecontinuous access to funds from the repomarket, rollover of repos has been allowedwith migration to DvP III.

The issue remains what furtherdevelopments are needed in terms ofeligible collaterals, membership, etc., tointegrate the different segments of themoney market so that the money market asa whole is enabled to cope better withmarket fluctuations in the run-up to fullercapital account convertibility. An importantgap in developing the money market is thatterm money market is still to emerge andhence, the evolution of yield curve remainsinadequate. We need to explore what is tobe done to build this market with furtheropening of capital account.

Interest Rate Derivatives

The need for a well developed interestrate derivatives market cannot beoveremphasised in providing effectivehedging tools for interest rate risks present

RBIMonthly Bulletin

July 2007 1141

SPEECH



Experience

Rakesh Mohan

in the balance sheet and in facilitatingtrading based on two-way view on interestrates, which is not possible in theunderlying cash market in the absence ofshort selling. Deregulation of interest rates,which helped in making financial marketoperations efficient and cost effective, hasbrought to the fore a wide array of risksfaced by market participants. To manage andcontrol these risks, several instrumentssuch as Forward Rate Agreements (FRA) andInterest Rate Swaps (IRS) were introducedin July 1999, which could provide effectivehedges against interest rate risks. Further,in June 2003, the Reserve Bank had issuedguidelines to banks/primary dealers/FIs fortransacting in exchange traded interest ratefutures, which were introduced on theexchanges. There has also been a sharpincrease in the volume of transactions inthe OTC products. Though there has beena significant increase in the number andamount of contracts, participation in themarkets continues to remain limited mainlyto select foreign and private sector banksand PDs. In fact, PDs are expected to bemarket makers in this segment. Since somedifficulties have been experienced in theoperation of the exchange traded interestrate futures market, we are now in theprocess of reviewing the structure so thatit can become an active market for interestrate discovery and hedging.

Despite the growing volumes in theOTC derivatives market, as is the caseglobally, there had been someapprehensions regarding the appropriatelegal backing for these instruments. Thisissue has now been addressed with anappropriate amendment to the ReserveBank of India Act. OTC derivatives are now

clearly legally valid, even if they are nottraded on any recognised stock exchange.Exchange traded derivatives have their ownrole to play in the debt market - but by theirvery nature they have to be standardisedproducts. OTC derivatives, on the otherhand can be customised to the requirementsof the trading entities. Thus, both OTC andexchange traded derivatives are essential formarket development.

A central counter party based clearingarrangement for OTC derivatives wouldreduce counterparty risk and extend thebenefits of netting. Accordingly, in order tostrengthen the OTC derivatives market andto mitigate the risks involved, a clearingarrangement for the OTC interest ratederivatives also need to be considered. Thismeasure would strengthen the OTC interestrate derivatives market, and provide greatertransparency as needed through adequatereporting requirements.

While everywhere in the world, mosttrading is in the OTC segment, there is noreason why we cannot innovate and haveelectronic based, order matched trading tohave a wider reach and also thereby enhanceliquidity in the market. Work is now afootto provide for an exchange traded systemfor corporate bonds.

As we make arrangements for theoperation of better markets for interest ratediscovery, trading and hedging instruments,I would like to stress the need andimportance of sound and adequate riskmanagement practices by marketparticipants in the derivatives market.International experience teaches us theneed for greater care in handling theseinstruments. I would expect that the market


SPEECH


Rakesh Mohan

players not only put in place an appropriaterisk management policy and procedures forthese products, but would also give equalimportance to the skills development oftheir human resources to handle theseinstruments and to appreciate theunderlying risks. As interest rate derivativesgrow, an area which requires attention relateto accounting and disclosures. The relevantstandards need to be comprehensive andbenchmarked to international standards.

Government Securities Market

Following the enactment of the FiscalResponsibility and Budget Management Act,2003, from April 2006 onwards, the ReserveBank is no longer permitted to subscribe togovernment securities in the primarymarket. In order to ensure a smoothtransition to the new regime, restructuringof current institutional processes hasalready been initiated (Mohan, 2006a).These steps are helping to achieve thedesired integration in the conduct ofmonetary operations.

In the new milieu, the Reserve Bankmay need to carry out greater open marketoperations (OMO) in the secondary market.Such operations could be qualitativelydifferent from its LAF or MSS operations,which are guided by considerations ofliquidity management primarily at theshorter end. The issue is what should bethe determining factor for such secondarymarket operations. Generally, by controllingthe short-term interest rate while lettingmarkets determine the rest of the yieldcurve, the central bank attempts to transmitmonetary policy impulses across the yieldcurve. The sovereign yield curve in turninfluences the lending and deposit rates in

the economy. Once bank lending getsaffected, interest rates impact real variablessuch as consumption and investment,which in turn impact output and inflationlevels. However, the government securitiesmarket is yet to emerge fully as a deep andliquid market across different maturities.Given such a state, in the interest ofmonetary transmission, there is a case forsecondary market operation across the yieldand maturity spectrum in the governmentsecurities market and more so, in thecontext of Reserve Bank’s withdrawal fromthe primary market.

Efforts are being made to improve theretail holding of government securitiessince the government securities market stilllacks in depth and is dominated by banksand financial institutions often exhibitinguni-directional perceptions about liquidity.To attract retail participation in governmentsecurities market, one of the foremost tasksahead is to create an environment thatprovides a safe and secure investmentavenue for small investors with adequatereturns and liquidity. In this context, theReserve Bank is emphasising the provisionof demat holding facility for non-institutional retail/small investors for riskmitigation in scrip losses or settlement ofdeals in the secondary market. Non-competitive bidding has also beenintroduced since January 2002 for directaccess to the primary issues for non-sophisticated investors.

As part of its constant endeavour toimprove the facilities for trading andsettlement in the government securitiesmarket, the Reserve Bank had formallylaunched, on August 1, 2005, an electronic

RBIMonthly Bulletin

July 2007 1143

SPEECH



Experience

Rakesh Mohan

Order Matching trading module forgovernment securities on its NegotiatedDealing System (NDS-OM in short). TheNDS-OM is an additional facility availableto the participants and the participantscontinue to have the option of using thecurrent reporting and trading platform ofthe NDS. While the NDS-OM now accountsfor a significant share of the total tradedvolume in government securities, thecountrywide, anonymous, screen based,order driven system for trading ingovernment securities introduced in thestock exchanges (NSE, BSE and OTCEI) inJanuary 2003 has continued to suffer fromvery poor trading volumes, which need tobe looked into for revival.

Corporate Debt Market

In order to activate the corporate debtmarket, the government had appointed anexpert committee (Chairman: R.H. Patil) toprovide directions on how this is to be done(Government of India, 2005). A key pointthat I would like to emphasise is thatlearning from the experience of developingthe government securities market, we needto proceed in a measured manner with wellthought out appropriate sequencing fordeveloping the corporate debt market.Financial market development involvesaction on a number of fronts with the keyobjective, obviously, being to enable themost efficient allocation of resources to themost productive uses and efficientintermediation from savers to investors. Inother words, banking development, equitymarket development, debt marketdevelopment all go hand in hand. Andwithin the debt market, an efficientgovernment securities market is essential

for price discovery and for providing reliablebenchmarks to price corporate bonds off thecredit risk free yield curve.

The key problem is that for a corporatebond market to function, we need a largenumber of issuers, a large number ofinvestors and issues of a large size. It maybe noted that each of the problemsmentioned in respect of corporate bondshas been addressed in the context ofdevelopment of government securitiesmarket. That goes to show that theproblems are not insurmountable but onlythat it takes some time to resolve. But wehave just begun and work is now inprogress. It is true that the governmentsecurities market took a long time todevelop, despite being much simpler. Thecorporate debt market being much morecomplex, would require some extra effort tomove ahead. In short, we have a long way togo but we have to make a determined effort.

V. Exchange Rate Policy

Our exchange rate policy in recent yearshas been guided by the broad principles ofcareful monitoring and management ofexchange rates with flexibility, without afixed target or a pre-announced target or aband, coupled with the ability to interveneif and when necessary, while allowing theunderlying demand and supply conditionsto determine the exchange rate movementsover a period in an orderly way. Subject tothis predominant objective, the exchangerate policy is guided by the need to reduceexcess volatility, prevent the emergence ofdestabilising speculative activities, helpmaintain adequate level of reserves, anddevelop an orderly foreign exchange market.


SPEECH


Rakesh Mohan

The Indian market, like otherdeveloping countries markets, is not yetvery deep and broad, and can sometimesbe characterised by uneven flow of demandand supply over different periods. In thissituation, the Reserve Bank has beenprepared to make sales and purchases offoreign currency in order to even out lumpydemand and supply in the relatively thinforex market and to smoothen jerkymovements. However, such intervention isnot governed by a predetermined target orband around the exchange rate. As theforeign exchange exposure of the Indianeconomy expands, the role of such unevendemands can be seen to reduce.

With this approach, we have achievedflexibility along with stability in theexternal sector. Increased earnings fromexports of services and remittances coupledwith enhanced foreign investment inflowshave provided strength to the externalsector. Reflecting the strong growthprospects of the Indian economy, thecountry has received large investmentinflows, both direct and portfolio, since1993-94 as compared with negligible levelstill the early 1990s. Total foreign investmentflows (direct and portfolio) increased fromUS$ 111 million in 1990-91 to US$ 24,748million in 2006-07. Over the same period,current account deficits remained modest– averaging one per cent of GDP since 1991-92 and in fact recorded small surplusesduring 2001-04. With capital flowsremaining in excess of the current financingrequirements, the overall balance ofpayments recorded persistent surplusesleading to an increase in reserves, whichhave now reached US$ 1,99,179 million atend-March 2007. The emergence of foreign

exchange surplus leading to continuing andlarge accretion to reserves since the mid1990s has been a novel experience for Indiaafter experiencing chronic balance ofpayment problems for almost four decades.These surpluses began to arise after theopening of the current account, reduction intrade protection, and partial opening of thecapital account from the early to mid 1990s.

India’s integration with the worldeconomy is also getting stronger, withimplications for the conduct of exchangerate policies in the future. Trade in goods(i.e., exports plus imports) as a proportionof GDP increased from 14.6 per cent in 1990-91 to 32.5 per cent in 2005-06; while grosscurrent account receipts and payments aspercentage of GDP increased from 19.4 percent to 50.2 per cent over the same period,reflecting the buoyant growth in Indian tradein services. The trade deficit is also as highas 6.4 per cent of GDP. Correspondingly, inthe capital account, gross flows (total inflowsplus outflows) have more than doubled asa proportion of GDP: from 12.1 per cent in1990-91 to 32.4 per cent (US$ 260 billion)in 2005-06. Thus, the Indian economy istoday substantially exposed to theinternational economy and arguably moreopen than even the United States in termsof these metrics.

Issues

Dutch Disease

In recent years, the growth in currentpayments has been accompanied by healthygrowth in current receipts - in both goodsand services, thus providing for someconfidence in the sustainability of currenttrade patterns and financial stability.

RBIMonthly Bulletin

July 2007 1145

SPEECH



Experience

Rakesh Mohan

Current receipts pay for up to about 90 percent of current payments. Within currentreceipts, merchandise exports are beingrapidly exceeded in terms of growth ratesby software earnings, currently at 2.9 percent of GDP. Besides, private transferreceipts, comprising mainly remittancesfrom Indians working abroad, seemed tohave acquired a permanent character andhave risen steadily to constitute around 3per cent of GDP in recent years, imperviousto exchange rate movements. These factorshave strengthened the capability of theIndian economy to sustain higher currentaccount deficits (CADs) than in the past. Netcapital flows have thus regularly exceededthe CAD requirements by a fair measure,enabling large accretions to the reserves.

The large inflow of remittances andmajor and sustained spurt in softwareexports coupled with capital inflows havethe potential for possible overvaluation ofthe currency and the resultant erosion oflong-term competitiveness of othertraditional goods sectors – popularly knownas the Dutch disease. Given the fact thatmore people are in the goods sector, thehuman aspects of the exchange ratemanagement should not be lost sight of.Therefore, the Dutch Disease syndrome hasso far been managed by way of reservesbuild-up and sterilisation, the formerpreventing excessive nominal appreciationand the latter preventing higher inflation.However, the issue remains how long andto what extent such an exchange ratemanagement strategy would work given thefact that we are faced with large andcontinuing capital flows apart fromstrengthening current receipts on accountof remittances and software exports. This

issue has assumed increased importanceover the last year with increased capitalflows arising from the higher sustainedgrowth performance of the economy andsignificant enhancement of internationalconfidence in the Indian economy.

Liquidity Management

Volatility in capital flows and hence inliquidity has marked the period during2001-07 and posed considerable problemsin liquidity and exchange rate management.Sharp shifts in capital flows can beexplained as partly frictional and arisingfrom seasonal and transient factors, partlycyclical and associated with the pick up ingrowth momentum and the induceddemand for bank credit, and partly led bygrowth expectation. Moreover, theabsorption of external savings is alsodependent on the stage of a business cyclethat a country may be going through.Further, the stage of business cycle and thetiming of capital flows may not coincide.The early years of this decade werecharacterised by low industrial growth andhence the absorptive capacity of the countrywas constrained. As we have entered anexpansionary phase, the current accounthas widened and the potential for somegreater absorption has manifested itself.

The volatile capital flows havewarranted appropriate monetary operationsto obviate wide fluctuations in market ratesand ensure reasonable stability consistentwith the monetary policy stance. In fact, theIndian experience illustrates the tight linkbetween external sector management anddomestic monetary management. What maybe small movements in capital flows for therest of the world can translate into large


SPEECH


Rakesh Mohan

domestic liquidity movements distortingmarket exchange and interest rates in adeveloping country. Just as foreignexchange reserves can act as a shockabsorber, on the external front, we had tolook for a parallel liquidity shock absorberfor domestic monetary management.

In this context, a new instrument,named as the Market Stabilisation Scheme(MSS) has evolved as a useful instrumentof monetary policy to sustain open marketoperations. The MSS was made operationalfrom April 2004. Under this scheme, whichis meant exclusively for liquiditymanagement, the Reserve Bank has beenempowered to issue Government TreasuryBills and medium duration dated securitiesfor the purpose of liquidity absorption. Thescheme works by impounding the proceedsof auctions of Treasury bill and governmentsecurities in a separate identifiable MSScash account maintained and operated bythe Reserve Bank. The amounts creditedinto the MSS cash account are appropriatedonly for the purpose of redemption and/orbuy back of the Treasury Bills and/or datedsecurities issued under the MSS. MSSsecurities are indistinguishable fromnormal Treasury Bills and government datedsecurities in the hands of the lender. Thepayments for interest and discount on MSSsecurities are not made from the MSSAccount, but shown in the Union budgetand other related documents transparentlyas distinct components under separate sub-heads. The introduction of MSS hassucceeded, in principle, in restoring LAF toits intended function of daily liquiditymanagement. Since its introduction in April2004, the MSS has served as a very usefulinstrument for medium term monetary and

liquidity management. It has beenunwound in times of low capital flows andgreater liquidity needs and built up whenexcess capital flows could lead to excessdomestic liquidity. In principle, the MSSis designed to sterilise excess capital flowsthat are deemed to be durable or semi-durable. In practice this is difficult todiscern ex-ante: hence the range of MSSinstruments in terms of their duration caneffectively modulate the sterilisation on anex-post basis.

Our strategy of introducing this newMSS instrument to manage excess capitalflows and reduce volatility in the exchangerate reflects the overall issue of globalcapital flows that many developingcountries are facing, particularly in Asia.Net private flows (equity + debt) haveincreased from an average of about US$ 180billion over the five year period 1998 to2002, to about US$ 650 billion in 2006,amounting to about 5 per cent of their GDP(World Bank, 2007). Absorption of such avolume of flows would imply acorresponding current account deficit ofabout 5 per cent of GDP. What should bethe approach to exchange ratedetermination in such circumstances? Towhat extent is the current account balancea good guide to evaluation of theappropriate level of an exchange rate? Towhat extent should the capital accountinfluence the exchange rate? What are theimplications of large current accountdeficits for the real economy? Are theysustainable and, if not, what are theimplications for financial stability indeveloping countries? In India’s case, asmentioned, we have almost always had amodest current account deficit though,

RBIMonthly Bulletin

July 2007 1147

SPEECH



Experience

Rakesh Mohan

because of remittances and service exports,the trade deficit has widened significantlyin recent years. These are the issues thatwe have to deal with as we negotiate fullercapital account convertibility, but I believethese are wider questions that are engagingmost countries in Asia.

Going forward, there will be acontinuous need to adapt the strategy ofliquidity management as well as exchangerate management for effective monetarymanagement and short-term interest ratesmoothening. The key questions wecontinue to face with are what should bethe instruments and modes of managementof liquidity in the interest of growth andfinancial stability and how much shouldcapital flows affect exchange rate. Theseissues become even more relevant under afreer regime of capital flows. Globaldevelopments are expected to have anincreasing role in determining the conductof monetary and exchange rate policies inour countries. In an environment of globalconvergence, retaining independence ofmonetary policy may become increasinglydifficult, calling for hard choices in termsof goals and instruments.

VI. Fiscal Situation and FiscalResponsibility and BudgetManagement Act

Some Progress

Public finances have exhibited a mixedtrend in the reforms period. Afterwitnessing some correction till 1996-97,public finances underwent deterioration,reflecting a variety of factors such as thedecline in tax revenues (as per cent to GDP)in consonance with the cyclical downturn

of economic activity, as well as the effectsof the 5th Pay Commission award. Indeed,the combined fiscal deficit of the Centre andStates was higher in 2001-02 than that in1990-91. Since 2002-03 onwards, publicfinances have witnessed a significantimprovement, reflecting both policy effortsat fiscal consolidation as well as the upturnin economic activity (Table 1). A noteworthydevelopment at the federal level is thetransformation of state level sales taxes intothe value added tax (VAT), which hasintroduced a large measure of rationalityand uniformity in the state tax system. Thestate sales tax system had also suffered fromgreat complexity in terms of multiplicityof rates and special provisions. A vitalfeature of this tax reform has been theconsultative process among all the statesas mediated by the central government,which then resulted in this consensus formassive reform.

Issues

Notwithstanding the recent correction,combined public debt remains high (almost79 per cent of GDP at end March 2006). Thelatest most significant measure taken is theintroduction of the Fiscal Responsibility andBudget Management Act (FRBM) in 2004,

Table 1: Combined Deficit Indicators:Centre and States

(As per cent of GDP)

Year Fiscal Revenue PrimaryDeficit Deficit Deficit

2001-02 10.0 7.0 3.72002-03 9.6 6.6 3.12003-04 8.5 5.8 2.12004-05 7.5 3.7 1.42005-06 7.4 3.1 1.62006-07 6.4 2.2 0.8

Source: Reserve Bank of India.


SPEECH


Rakesh Mohan

which enjoins the government to eliminateits revenue deficit and reduce its fiscaldeficit to 3 per cent of GDP by 2009. Similaracts have been passed by most stategovernments (25 states so far). So fiscalresponsibility has now become part of ourlegislative commitments. Together, they,however, amount to a total deficit of aboutsix per cent of GDP, which is consideredhigh by global standards.

After the award of the 5th PayCommission in 1997, public finances hadcome under strain and hence public savingshad become negative. Now the growthprocess has clearly recovered and we seemto be on a sustainable path of annual GDPgrowth in excess of 8.5 per cent. The 8.5 percent plus growth would itself place indemand for higher government wages andthe 6th Pay Commission has to come,complicating the fiscal consolidation process.

Achieving the FRBM target of zerorevenue deficit by 2008-09 requirescontinued focus on containing expenditures,increase in tax revenues and reduction intax exemptions. Revenue augmentationwould critically depend upon improvementin tax/GDP ratio as non-tax revenue is setto decline in the coming years. In thiscontext, the reversal of the declining trendin tax-GDP ratio is welcome. This increasingtrend needs to be maintained throughfurther widening of the tax base andcurtailment in tax exemptions. It is in thiscontext that the erosion of tax base onaccount of various exemptions poses acause for concern.

With the attainment of a sustainablehigher growth path in excess of 8.5 per cent

annual real GDP growth, the prospects forcontinued fiscal consolidation haveimproved. Tax revenues have becomebuoyant with continuing healthy growth incorporate profits and personal incomes.Furthermore, the introduction of the valueadded tax (VAT) system at the state levelprovides further ground for optimism. Whatwe will need to guard against are the usualdemands for exemptions that contribute toerosion of the tax base.

An important point to note in relationto the Indian fiscal situation is that, despitethe long term persistence of high fiscaldeficits by any standards, India has not beensubject to banking or financial marketturbulence. Our fiscal parameters have notbeen too different from some of thecountries that have experienced the mostturbulence, such as Turkey and Argentina.In fact, it is because of our inadequate fiscalperformance that India did not haveinvestment grade rating until earlier thisyear. The main reasons why India has beenable to maintain financial stability in thepresence of such fiscal stress is that almostall the sovereign debt has been domestic,except for bilateral and multilateral externalborrowing, which itself has been smallproportionately. India has eschewedsovereign borrowing in external markets,thereby insulating ourselves from externalvolatility in exchange rates and interestrates. The move to increased marketborrowing has also been useful in providingmarket signals on the cost of borrowing.Finally, coordination between monetarypolicy, domestic debt management, andfinancial sector policies in the ReserveBank and the Government has also helpedin this regard.

RBIMonthly Bulletin

July 2007 1149

SPEECH



Experience

Rakesh Mohan

VII. Strengthening of FinancialSector/Banks

The financial system in India, througha measured, gradual, cautious, and steadyprocess, has undergone substantialtransformation. It has been transformedinto a reasonably sophisticated, diverse andresilient system through well-sequencedand coordinated policy measures aimed atmaking the Indian financial sector morecompetitive, efficient, and stable. Theoverall capital adequacy ratio of the bankingsector as a whole has increased from 10.4per cent at end-March 1997 to 12.3 per centat end-March 2007

1. The asset quality of the

banking sector has recorded a significantimprovement: the ratio of net non-performing assets (NPAs) to net advanceshas declined from 8.1 per cent at end-March1997 to 2.0 per cent at end-March 2007despite tightening of NPA classificationnorms. The profitability of banks as definedby the return on assets increased from 0.7per cent in 1996-97 to 0.9 per cent in 2006-07. Intermediation cost of banks hasdeclined from 2.9 per cent in 1995-96 toaround 2 per cent by 2006-07. The financialsystem is now robust and resilient, and isenabling accelerated economic growth in anenvironment of stability.

Consistent with the policy approach tobenchmark the banking system to the bestinternational standards with emphasis ongradual harmonisation, in a phased manner,all foreign banks operating in India and allIndian commercial banks having foreignoperations are required to startimplementing Basel II with effect fromMarch 31, 2008, while other commercial

banks are required to implement Basel II byMarch 31, 2009

2. Recognising the differences

in degrees of sophistication anddevelopment of the banking system, it hasbeen decided that the banks will initiallyadopt the Standardised Approach for creditrisk and the Basic Indicator Approach foroperational risk. After adequate skills aredeveloped, both by the banks and also by thesupervisors, some of the banks may beallowed to migrate to the Internal Rating Based(IRB) Approach. Although implementation ofBasel II will require more capital for banksin India, the cushion available in the system- at present, the Capital to Risk Assets Ratio(CRAR) is over 12 per cent - provides somecomfort. In order to provide banks greaterflexibility and avenues for meeting thecapital requirements, the Reserve Bank hasissued policy guidelines enabling issuance ofseveral instruments by the banks, viz.,innovative perpetual debt instruments,perpetual non-cumulative preference shares,redeemable cumulative preference sharesand hybrid debt instruments.

The Reserve Bank founded the Board forFinancial Supervision (BFS) in 1994 toupgrade its practice of financial supervisionof banks. In course of time, developmentfinancial institutions, specialised term-lending institutions, non-banking financialcompanies (NBFCs), urban co-operativebanks and primary dealers (PDs) have allbeen brought under the supervision of theBFS. A set of prudential norms for thecommercial banking sector had beeninstituted as early as 1994 with regard tocapital adequacy, income recognition andasset classification, provisioning, exposure

1Data for 2006-07 are unaudited and provisional.

2 They have, however, the option of implementing Basel IIwith effect from March 31, 2008 as well.


SPEECH


Rakesh Mohan

norms and more recently, in respect of theirinvestment portfolio. With the aim ofregulatory convergence for entities involvedin similar activities, prudential regulationand supervision norms were alsointroduced in phases for DFIs, NBFCs, co-operative banks and PDs.

In tandem with the gradual opening upof the economy, the regulatory andsupervisory framework was spruced upcomprising of a three-pronged strategy ofregular on-site inspections, technology-driven off-site surveillance and extensiveuse of external auditors. As a result ofimprovements in the regulatory andsupervisory framework, the degree ofcompliance with the Basel Core Principleshas gradually improved. The supervisoryframework has been further upgraded withthe institution of a framework of Risk-basedSupervision (RBS) for intensifiedmonitoring of vulnerabilities. A scheme ofPrompt Corrective Action (PCA) was effectedin December 2002 to undertake mandatoryand discretionary intervention againsttroubled banks based on well-definedfinancial/prudential parameters. In view ofthe growing emergence of financialconglomerates and the possibility ofsystemic risks arising therefrom, a systemof consolidated accounting has beeninstituted. A half-yearly review based onfinancial soundness indicators is beingundertaken to assess the health ofindividual institutions and macro-prudential indicators associated withfinancial system soundness. The findingsarising thereof are disseminated to thepublic through its various Reports.

The bankruptcy procedures forcontaining the level of NPAs have been

strengthened over the years. Debt RecoveryTribunals (DRTs) were establishedconsequent to the passing of Recovery ofDebts Due to Banks and FinancialInstitutions Act, 1993. With a view toputting in place a mechanism for timely andtransparent restructuring of corporate debtsof viable entities facing problems, a Schemeof Corporate Debt Restructuring (CDR) wasstarted in 2001 outside the purview of BIFR(i.e., Board for Industrial and FinancialReconstruction), DRT and other legalproceedings. Similar guidelines on debtrestructuring of viable or potentially viableSME units were issued in September 2005.To provide a significant impetus to banksto ensure sustained recovery, theSecuritisation and Reconstruction ofFinancial Assets and Enforcement ofSecurity Interest (SARFAESI) Act was passedin 2002 and was subsequently amended toensure creditor rights. With a view toincreasing the options available to banks fordealing with NPAs, guidelines were alsoissued on sale/purchase of NPAs in July 2005.Subsequently, a few Asset ReconstructionCompanies have been registered. Thus, thebankruptcy procedures for recovery of baddebts have been streamlined over the yearseven though the Sick Industrial CompaniesAct (SICA) continues to be in vogue.

A further challenge for policy in thecontext of fuller capital account openneswill be to preserve the financial stability ofthe system as greater deregulation is doneon capital outflows and on debt inflows.This will require market development,enhancement of regulatory capacity in theseareas, as well as human resource developmentin both financial intermediaries and non-financial entities. In consonance with the

RBIMonthly Bulletin

July 2007 1151

SPEECH



Experience

Rakesh Mohan

objective of enhancing efficiency andproductivity of banks through greatercompetition - from new private sector banksand entry and expansion of several foreignbanks - there has been a consistent declinein the share of public sector banks in totalassets of commercial banks. Notwithstandingsuch transformation, the public sector banksstill account for nearly 70 per cent of assetsand income. Public sector banks have alsoresponded to the new challenges ofcompetition, as reflected in their increasedshare in the overall profit of the bankingsector. This suggests that, with operationalflexibility, public sector banks arecompeting relatively effectively with privatesector and foreign banks. Public sector bankmanagements are now probably moreattuned to the market consequences of theiractivities (Mohan, 2006a). But it is also theywho face the most difficult challenges inhuman resource development. They willhave to invest very heavily in skillenhancement at all levels: at the top levelfor new strategic goal setting; at the middlelevel for implementing these goals; and atthe cutting edge lower levels for deliveringthe new service modes. Wide disparitiesexist within the banking sector as far astechnological capabilities are concerned: thepercentage of ‘computer literate’ employeesas percentage of total staff in 2000 wasaround 20 per cent in public sector bankscompared with 100 per cent in new privateand around 90 per cent in foreign banks(Reserve Bank of India, 2002). Data reportedby the RBI suggests that nearly 71 per centof branches of public sector banks are fullycomputerised. However, computerisationneeds to go beyond the mere ‘arithmeticals’,to borrow a term from the Report of theCommittee on Banking Sector Reforms

(Government of India, 1998), and instead,needs to be leveraged optimally to achieveand maintain high service and efficiencystandards. Given the average age of 45 yearsplus for employees in the public sectorbanks, they will also face new recruitmentchallenges in the face of adversecompensation structures in comparisonwith the freer private sector.

The issue of mixed ownership as aninstitutional structure where governmenthas controlling interest is a salient featureof bank governance in India. Such aspectsof corporate governance in public sectorbanks is important, not only because publicsector banks dominate the bankingindustry, but also because, it is likely thatthey would continue to remain in bankingbusiness. To the extent there is publicownership of public sector banks, themultiple objectives of the government asowner and the complex principal-agentrelationships needs to be taken on board.Over the reform period, more and morepublic sector banks have begun to get listedon the stock exchange, which, in its wake,has led to greater market discipline andconcomitantly, to an improvement in theirgovernance aspects as well. The broadbasedand diversified ownership of public sectorbanks has brought about a qualitativedifference in their functioning, since thereis induction of private shareholding as wellas attendant issues of shareholder’s value,as reflected by the market capitalisation,board representation and interests ofminority shareholders. Given the increasedtechnical complexity of most businessactivities including banking and the rapidpace of change in financial markets andpractices, public sector banks would need


SPEECH


Rakesh Mohan

to devise imaginative ways of respondingto the evolving challenges within thecontext of mixed ownership.

Another aspect of greater capital marketopenness concerns the presence of foreignbanks in India. The Government and theReserve Bank outlined a roadmap on foreigninvestment in banks in India in February2005, which provides guidelines on theextent of their presence until 2009. Thisroadmap is consistent with the overallguidelines issued simultaneously onownership and governance in private sectorbanks in India. The presence of foreignbanks in the country has been very usefulin bringing greater competition in certainsegments in the market. They are significantparticipants in investment banking and indevelopment of the forex market. With thechanges that have taken place in the UnitedStates and other countries, where thetraditional barriers between banking,insurance and securities companies havebeen removed, the size of the largestfinancial conglomerates has becomeextremely large. Between 1995 and 2004,the size of the largest bank in the world hasgrown three-fold by asset size, from aboutUS $ 0.5 trillion to US $ 1.5 trillion, aboutone and a half times the size of Indian GDP.This has happened through a great degreeof merger activity: for example, J.P.MorganChase is the result of mergers among 550banks and financial institutions. The tenbiggest commercial banks in the US nowcontrol almost half of that country’sbanking assets, up from 29 per cent just 10years ago (Economist, 2006). Hence, withfuller capital account convertibility andgreater presence of foreign banks over time,a number of issues will arise. First, if these

large global banks have emerged as a resultof real economies of scale and scope, howwill smaller national banks compete incountries like India, and will theythemselves need to generate a largerinternational presence? Second, there isconsiderable discussion today on overlapsand potential conflicts between homecountry regulators of foreign banks and hostcountry regulators: how will these beaddressed and resolved in the years to come?Third, given that operations in one countrysuch as India are typically small relative tothe global operations of these large banks,the attention of top management devoted toany particular country is typically low.Consequently, any market or regulatorytransgressions committed in one country bysuch a bank, which may have a significantimpact on banking or financial market of thatcountry, is likely to have negligible impacton the bank’s global operations. It has beenseen in recent years that even relativelystrong regulatory action taken by regulatorsagainst such global banks has had negligiblemarket or reputational impact on them interms of their stock price or similar metrics.Thus, there is loss of regulatory effectivenessas a result of the presence of such financialconglomerates. Hence, there is inevitabletension between the benefits that such globalconglomerates bring and some regulatoryand market structure and competition issuesthat may arise.

Along with the emergence of internationalfinancial conglomerates we are alsowitnessing similar growth of Indianconglomerates. As in most countries, thebanking, insurance and securities companieseach come under the jurisdiction of theirrespective regulators. A beginning has been

RBIMonthly Bulletin

July 2007 1153

SPEECH



Experience

Rakesh Mohan

made in organised cooperation between theregulators on the regulation of suchconglomerates, with agreement on who wouldbe the lead regulator in each case. In theUnited States, it is a financial holdingcompany that is at the core of eachconglomerate, with each company being itssubsidiary. There is, as yet, no commonalityin the financial structure of each conglomeratein India: in some the parent company is thebanking company; whereas in others there isa mix of structure. For Indian conglomeratesto be competitive, and for them to grow to asemblance of international size, they will needcontinued improvement in clarity inregulatory approach.

VIII. Concluding Remarks

I have described at length the evolutionof India’s macroeconomic and monetarymanagement over the last decade and a halfto demonstrate the complexity of suchmanagement in the context of a developingeconomy that manages its opening up to therest of the world in a gradual manner.Monetary policy and exchange rate regimeshave necessarily to be operated as fuzzy orintermediate regimes not obeying thealmost received wisdom of puristapproaches. The judgement on thelegitimacy of such a regime must be basedon their efficacy as revealed by theoutcomes. On this count, I believe thatIndia’s macroeconomic, monetary andfinancial managers can justifiably claim areasonable degree of success: economicgrowth is high and accelerating; inflationhas shifted to lower sustainable levels;savings and investments are growing;financial markets have been growing anddeveloping in an orderly manner; the health

of the banking system has improvedcontinuously and is approaching bestpractice standards; the external account ishealthy in the presence of robust tradegrowth in both goods and services; andincreasing capital flows indicate growinginternational confidence in the Indianeconomy; and the Indian exchange rate hasbeen flexible in both directions providingfor reasonable market determination, inthe presence of central bank forexinterventions.

These are the achievements of the past.As we ascend to a higher growth path, andas we have fuller capital accountconvertibility, we will face newer challengesand will have to continue to adapt. The keypoint is that with greater capital accountopenness, we have to develop markets suchthat market participants, financial and nonfinancial, are enabled to cope better withmarket fluctuations. As we do this, we needto be cognizant of the vast range ofcapabilities of different market participantsin as diverse a country as India: fromsubsistent farmers to the most sophisticatedfinancial market practitioners.

References

Ahluwalia, M.S. (2002), ‘Economic Reformsin India since 1991: Has GradualismWorked?’, Journal of Economic Perspectives,Vol. 16, No. 3, pp. 67-88.

Friedman, Benjamin (2000), “The Role ofInterest Rates in Federal ReservePolicymaking”, Working Paper 8047,National Bureau of Economic Research.

Government of India (2005), Report of HighLevel Expert Committee on CorporateBonds and Securitisation, (Chairman: R. H.


SPEECH


Rakesh Mohan

Patil), available at http://finmin.nic.in/downloads/reports/Report-Expert.pdf.

McCallum, Bennett T. (1981), “Price LevelDeterminancy with an Interest Rate PolicyRule and Rational Expectations”, Journal ofMonetary Economics, Vol. 8.

McKinsey & Company (2005), IndianBanking 2010: Towards a High PerformingSector, Mumbai: McKinsey & Company.

Mohan, Rakesh (2005), “Communications inCentral Banks: A Perspective”, Reserve Bankof India Bulletin, October 2005.

Mohan, Rakesh (2006a), ‘Recent Trends inthe Indian Debt Market and CurrentInitiatives’, Reserve Bank of India Bulletin,April 2006.

Mohan, Rakesh (2006b), “Evolution ofCentral Banking in India”, Reserve Bank ofIndia Bulletin, June 2006.

Reserve Bank of India (2002), Report onTrends and Progress of Banking in India,2001-02, Mumbai: Reserve Bank of India.

World Bank (2007), Global DevelopmentFinance, Washington D.C: World Bank.

Date post:	24-May-2020
Category:	Documents
Upload:	others
View:	7 times
Download:	0 times

Capital Account Liberalisation and Conduct of Monetary Policy: … 2007.pdf · Liberalisation and...

Documents