Evolving Monetary Policy in India: Some Perspectives

Author(s): A. Vasudevan
Source: Economic and Political Weekly, Vol. 37, No. 11 (Mar. 16-22, 2002), pp. 1055-1061
Published by: Economic and Political Weekly
Stable URL: http://www.jstor.org/stable/4411878
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 Evolving Monetary Policy in India
Some Perspectives
This paper reviews the process of monetary policy formulation, with some stylised facts
monetary policy currently pursued. Issues concerning the objectives and conduct with reference
to targets and the indicators are discussed. Some possible areas where future research on
monetary policy could be focused are also suggested.

A VASUDEVAN

he main purpose of this paper is to measures has in fact been high in the 1980s of directors of the Reserve Bank giving
discuss the formulation and content and 1990s, reflecting the large economic support. It must be noted that the central
of monetary policy in India in re- uncertainties and sharp policy regime shifts. board itself meets at least six times (gen-
cent years with reference to the analytical To appreciate this point, Table 1 provides erally seven times) a year, but it is repre-
expectations. The discussion would be in the number of times the main instruments sented by a committee that meets once a
the context of the policy regime since of policy are used since the 1970s in week. The records of their meetings are,
1992-93, focusing more particularly on the response to economic circumstances. The however, not published. The board has a
period beginning with 1998. table shows that the number of times the broader purpose than being concerned with
For purposes of this paper, we shall first three instruments (the Bank Rate, CRRonly monetary policy: it is concerned with,
review the formulation processes along and SLR) were used was the maximum inin fact, all aspects of the functioning of
with some stylised facts concerning mon- the 1990s compared with the 1980s andthe institution.2 The board is chaired by
etary policy presently pursued in India. the 1970s. It however shows that the the governor, and in his absence the
Following from this, we shall discuss the minimum ratios/rates were lower in 1990- senior most deputy governor. To be fair,
issues concerning the objectives and con- 2000 than in the preceding decades. During the views of the board on policy matters
duct with reference to targets and the in- the 1990s, the Reserve Bank used the Bank should in the circumstances be taken as
dicators. It also suggests the possible areas rate and SLR on more occasions in the the views of a cross section of interests.
where future research on monetary policy 1990s than in the 1970s and the 1980s. While taking them into account, the policy-
could be centred. CRR, however, was most frequently used makers within the bank (viz, the governor
in the 1980s (31 times). But even in the
and deputy governors) will build a con-
1990s, CRR use was fairly high, havingsensual position that would be consistent
Policy Formulation been changed as many as 29 times. As with
on the objectives of the institution and
Process the legal framework in which the bank
end-August 2001, the Bank rate has been
7.0 per cent, and CRR and SLR have been
operates.
The governor of the Reserve Bank of at 7.5 per cent and 25 per cent, respec- This does not mean that monetary policy
India makes two major statementstively. of Since 1998, the maximum of theformulation in India is a black box. All it
monetary and credit policies a year - once means is that it goes through a complex
Bank rate and CRR has also been brought
in April/May, and next in October/No- down. The Bank rate has been used process much of it is internal to the
vember, essentially to signal the policy more sharply between 1998-2000organisation.
- five The bank has internalised a
stance and to announce the measures being times, as against eight times during the
monitoring process over time to regularly
newly undertaken along with those that are eight years of 1992-2000, thus indicating
track the developments in all the financial
being reoriented or abandoned.1 Since the growing significance of the rate vari- For instance, the 'quotes' in the
markets.
1992-93, the policy statements have been ables in the Indian economy. This deve- exchange, money, and capital
foreign
increasingly focusing on structural and lopment is reflective of the heightened markets in India and abroad, as available
institutional reforms as well. Policy-mak- financial sector development and the
on the PC screens, are very closely fol-
ers in India are convinced, as elsewhere, increase in financial innovations. CRR lowed on almost a minute-to-minute basis
that measures that fall in the area of was used six times since April 1, 1998,by the respective departments, which in
out
monetary policy per se have to be wielded of the 27 times that it was deployed turn interpret them to the policy-makers
as and when economic and financial cir- in 1992-2000. (governor, deputy governors and at times
cumstances warrant, and cannot be pro-The governor's statements represent the executive directors) at regular intervals.
grammed to be announced at two discrete The policy-makers use them as an addi-
final stage of the processes in the formu-
intervals of time. In a world where events lation of monetary policy. They are not,tional input to what they themselves scan,
occur without any prior notice, monetary however, based on the recommendationsand what they individually gather from
policy-makers may have to use some of any monetary policy committee as markets in and other policy-making sources.
measures more frequently than others, to UK or an 'open market committee' as The is bank has considerable amount of
be understood. In respect of India, the prevalent in US. They are delivered, as is information on payments in its internal
frequency of the use of monetary policy commonly believed, with the central board data systems. The data on cash reserves

Economic and Political Weekly March 16, 2002 1055

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position of banks, the number and value cial environment that triggers announce- II
of cheques cleared, the governments' ment of major monetary policy actions, the Institutional Changes
balances with the Reserve Bank, the amount work of the financial markets committee
would be crucial. This is not the same as
and Operating Procedures
of refinancing availed of by banks, the
of Policy
borrowings and lendings in the inter-day having a monetary policy committee in
(overnight) call market, the transactions in place. At present, monetary policy-makingThe institutional arrangements set in
the secondary market for government place since 1992 for policy formulation
continues to be internal, although this does
securities and treasury bills, and the num- not preclude the policy-makers to draw on
purposes help to reduce information asym-
bers and amounts in respect of repo auc- the expertise from outside its own metries and to enhance technical analyses.
tions are closely watched on a daily basis. But they need to be structured to ensure
organisation - the bankers, academics, and
Besides, the bank monitors other macro- that decisions follow definitive transpar-
other professionals and policy-makers. For
economic indicators as and when they instance, inputs from resource manage-
ency practices comparable to the ones laid
become available. Thus indicators such as ment discussions with select scheduled down as part of international standards and
prices (available weekly), commercial
commercial banks where the bank's codes-4
pro-Now that financial supervision
banks' major balance sheet items (avail- jections of sources and uses of its funds, mechanisms are in place and more fre-
able every 14 days), Reserve Bank's own its goals and strategies, its perceptions quent
on data on financial markets are col-
balance sheet items (available weekly), the liquidity and market conditions, lectedandand disseminated through publica-
its expectations of monetary policy strat-
foreign trade (monthly), industrial produc- tions and websites, it should be possible
tion (montly), quarterly movementsegies, in together with special consultations for the Reserve Bank to move towards
GDP, monthly developments in industrial with select bankers, and other market what the advisory group on the code of
production and in important fiscal mag- transparency practices of monetary and
players have gained in significance in recent
years. In addition, the bank gets offsite
nitudes, are, for example, found to be very financial policies has specifically recom-
useful in policy-making. supervision data every quarter on a wide mended in 2000 for setting up of a formal
Monitoring of data is a bread and buttervariety of operations from each commer- monetary policy committee and dissemi-
business of all central banks. It is, as in
cial bank. The special consultations help nating its deliberations on the lines of what
other central banks, done by a host the
ofbank to form its views on the non- is now in existence in some of the
departments. A financial markets commit- performing assets of banks and other fi- industrialised countries.
tee3 which came into being since 1997, nancial institutions, the state of the credit There is in general a wide appreciation
and capital markets, and the strategies that
consisting of an executive director or deputy of the recommendation of the advisory
governor and heads of departments deal- are being adopted by banks for improving group on the code referred to above. There
ing with money, government securities their business performance. is no reason why it should not be accepted,
considering the fact that there is increasing
The governor's major policy statements,
and foreign exchange markets and research,
meets every day with the latest market
as stated earlier, contain major initiatives
evidence of growing financial integration.
information, and other financial and in respect of on financial reforms. These Assuming that the recommendation of the
macroeconomic indicators to make quickare drawn largely from the deliberations
advisory group is accepted, will it improve
assessment of the liquidity situation, of the Technical Advisory Committee on
the quality and conduct of monetary policy?
The chances are that it will. For, such a
Money and Government Securities Market
and to recommend to the deputy governor
in charge of monetary policy and the which has market men and academics,committee is likely to set out (a) in clear,
governor, the strategies that may havebesides bankers as members and which (often in quantitative) terms, the objective
to be adopted for meeting the evolvingmeets periodically (once in 2-3 months) or objectives of monetary policy, (b) the
situation in money, government secu-to address issues relating to the develop- intermediate target, if any, (c) the operat-
rities, and foreign exchange markets forment of these markets. Besides, the finan- ing target, and (d) the underlying method-
the day. cial reforms are also fashioned out of the ology of liquidity projections. The com-
The role of this internal financial mar- deliberations at the High Level Committeemittee will take into account the given
kets committee is not adequately compre-on Capital Market, which is chaired by the institutional setting and also influence it,
hended outside the Reserve Bank. Appar- RBI governor. The minutes of the meet-the nature of operations in government
ently, the day-to-day monetary manage- ings of these two committees, however,securities and treasury bills and foreign
ment has an input in the form of recom-are not published. exchange, the auction procedures, the
mendations of this committee. Notwith-
standing the fact that the committee is Table 1: Frequency of Changes in Major Monetary Policy Instruments
overseen by a deputy governor or an (Number of times)
executive director, there is little of evi-
Fiscal Bank Rate CRR SLR
dence that the deliberations in this com-
mittee are minutised and recorded. If this 1970-80 5 (9.0-5.0) 11 (7.0-3.0) 7 (34.0-26.0)
perception is correct, publishing their 1980-90 1 (10.0-9.0) 31 (15.0-6.0)* 8 (34.0-34.0)
1990-2000 15 (12.0-7.0) 29 (15.0*-8.0) 12 (38.5-25.0)
deliberations at this stage would not be 1990-92 2 (12.0-10.0) 2 (15.0-15.0)* 2 (38.5-38.0)
possible. But this is an area where there1992-2000 8 (12.0-7.0) 27 (15.0-8.0) 10 (38.5-25.0)
is scope for introducing transparency prac-Memo: 1998-2000 5 (11.0-7.0) 6 (11.0-9.0) - (-)
tices.
Niotes:Figures in brackets are rates/ratios in percentages. First
However, to the extent the day-to-day * When CRR touched 15 per cent, it was accompanied b
monetary management influences finan- percentage points on incremental net demand time liab

1056 Economic and Political Weekly March 16, 2002

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payment infrastructure, and the guidelines specified public welfare function), or it
and large assured if there exists domestic
concerning the standing facilities or the price stability. could be near or below the average rate
performance of the 'lender of last resort' of inflation recorded in the medium-term
Price stability in the Indian context of
function. Once the committee's main tasks monetary policy, has not been defined past
in (and as such consistent with the 'adap-
are defined, it should be possible to pub- the sense in which the pure 'inflation tive' rate). The projected inflation is ex-
lish the deliberations. The voting or con- nutters' define it, nor is it defined in the pressed in terms of percentage change in
sensus adopted in favoring a policy action sense of 'flexible inflation targeting' ad- the wholesale price index (WPI) of 'all
would come into open. When the actionvocated recently by a number of writers, commodities'. The WPI, however, repre-
is implemented, market expectations for- most notably by Lars Svensson.6 In fact, sents neither a producer price nor a price
mation would be greatly facilitated. This price stability is viewed in the literature that a consumer pays.
in turn would give credibility. on monetary policy very differently from The acceptance of WPI as the price
As against this approach, let us look at the manner in which the Indian planning indicator ignores the estimated biases that
some of the attributes of monetary policy exercises of public investments view it. arise In on account of elongated updates of
that have evolved since 1992-93 and are the planning exercises, the price level base weighting and other statistical prob-
presently in operation, and assess the obtaining in a specified year (generally lems a related to the construction of the
objectives, the targets, and the main sig- year or two prior to the initial year of the index (for instance, the 'formula' bias).7
nalling mechanism (Table 2).5 The table plan period) was assumed to be stable over In an economy where 'new' goods are
has in all eight categories of which the last the plan period. In other words, zero in- introduced almost continuously and 'qual-
four are operational details which could flation was implicitly assumed, to ensure ity' changes occur fairly regularly on
be changed, if need be, depending upon that planned investments are internally account of improved application of new
the objectives and the mechanisms of policy consistent, with 'physical' and 'financial' computer-based technologies, the esti-
flows (in terms of input-output, and flow
transmission. In this paper, it is on the first mated losses implicit in the currently-
four categories that we shall bestow our of funds analyses) matching each other. followed procedure of WPI - based pro-
attention, essentially because clarity in thisThe Reserve Bank has for long followed jection of inflation, could be significant.
regard helps to improve market expecta- this tradition, even while recognising that This problem exists even in industrialised
tions, and lead to more effective transmis- the actual inflation outcomes deviated from economies, where the bias, excluding those
sion of policy. the estimates, implicit orexplicit. The bank related to quality changes, is said to be as
has rarely specified an inflation target; nor much as two percentage points.8 Indeed,
II A did it target a price level. But governors' in the US, attempts are being made of late
Objectives of Policy major policy statements have been con- to capture the relative price changes oc-
taining projections of inflation for the year curring due to introduction of superior
There has been a clear preference of RBI ahead since about the later part of the 'quality' in the commodities produced by
for two objectives, rather than a single one, 1980s. These projections, however, do not new technology - adaptations, through
of monetary policy. The RBI Act, in its emerge from any model of inflation or a construction of 'hedonic' indexes.9 Most
preamble provides the purposes of the bank. macro or a monetary model. The projec- industrialised economies also carefully
It does not specify price stability but tion, if one could interpret, is essentially study asset price alignments with the long-
"monetary stability" and states that the the best quantifiable number that would term expectations of commodity price
bank has to operate "currency and credit be consistent with the projected growth of changes, and see how far the misalignments
system of the country to its advantage". output and nominal money demand. The could be accounted for.10 In the Indian
The wordings in the preamble are such that projected inflation could therefore be case, this has not so far been possible
they could be given differing interpreta- variously viewed: it could, for instance, be mainly owing to paucity of data. More-
tions. Monetary stability would not strictly a "desirable" rate of inflation ('desirable' over, there are virtually no surveys of
speaking refer to price stability, but given apparently from the policy-maker's view- inflation expectations. In so far as asset
the negligible 'openness' of the Indian point, and not necessarily flowing from a prices are concerned, while the movement
economy at least at the time of the pro-
mulgation of the RBI Act in the 1930s, it
is difficult to ascribe to this expression, Table 2: Some Attributes of Monetary Policy in India
the idea of stable external value of the No Attribute The Indian Position

Indian rupee. Yet, it is often interpreted

1 Objectives (1) Price stability.
as meaning exchange rate stability. Nor (2) To ensure that credit is supplied to fu
can one regard monetary stability as in- productive activities.
2 Intermediate target M3
volving 'financial stability', a concept that
is not so well articulated in the 1930s or 3 Operating target Bank reserves.
4 The main signalling mechanism Bank rate (perhaps exchange rate?).
stability in the expansion of money supply,
5 Liquidity assessment Projections not published; Review of liquidity done daily by an
which would not make sense unless it is interdepartmental financial market committee. The reviewis
not published.
related to output and prices. The most
6 Market operation OMO, repo auctions, outright transactions in Gol securities
reasonable interpretation that one could (including treasury bills), foreign exchange swaps.
give is that it refers to price stability,
7 Auction procedures Variable rates; simple as well as multiple pricing; The cut-off rate
sometimes regarded as a good proxy for announced but the process of its determination not disseminated.
8 Standing facilities and payment Export credit refinance exists; deferred net payment system;
exchange rate stability. To put it differ-
infrastructure collateralised accommodation permitted in case of liquidity shortage.
ently, exchange rate stability would be by

Economic and Political Weekly March 16, 2002 1057

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in the values of a few financial assets such ciation between bank credit disbursed or inflation targeting - cannot be advocated
as equities, and foreign exchange, and other increase in bank credit and output orfor India owing to compulsions of eco-
assets such as gold could be obtained on nomic development? If this is true, why
increase in output. The projections of output
a daily basis, the movements in real estate growth contained in governor's policy
cannot there be consensual attempt, some-
prices are hardly captured by any reliable statements do not seem to be derived from times described as 'just do it' approach
source on a regular basis. But weight has what the banks could extend as credit, butthat is adopted by the Fed in the US?
to be given to real estate prices in the are based on real sector developments, as Consideration of the need for attaining
measurement of inflation, since real estate for instance the information on the trends relatively high growth in the context of
prices seem to be better related, as reported in industrial production in recent monthswidespread poverty could be only one part
by Charles Goodhart, with output and of the explanation. For, there could still
(not on capacity utilisation), the monsoon
commodity price changes than other asset conditions, and the recent trends in the be assignment of priorities for different
prices such as equities and foreign cur- services sector performance. The output policy authorities over a time-path or
rency assets.ll In the Indian context, in- depending on economic circumstances of
projection thus would not reflect an esti-
flation, however, is used only with refer- a particular period.15 If such assignment
mate of potential output or a medium-term
ence to commodity price changes. path of output growth. In general, theis not possible, one could at least focus
The projected inflation rate in governor's endeavor seems to be to contain fluctua- on the extent to which inflation could be
major policy statements is, it is clear, not tions around the mean or median rate of tolerated, if growth were to be optimised.
an inflation target. It is also not an inflation In the case of India, such a threshold rate
growth or to reduce the spread between the
expectation. The question is whether it can of inflation was placed at about 6 per
peak and the trough rate of growth. Actual
be taken as a close proxy to inflation target. cent. 16
output outcome could deviate from the
The answer depends on how good is the trended rate or could be seen in the back-
From a practical point of view, it is
projection and whether it could be related ground of the minimisation of the spread necessary that policies are such as to
with any settled or proposed medium-term as stated here. Such a deviation could well minimise price variability year by year
policy path. But as it often partakes the be described as variability in growth, andbelow such a threshold rate, and to contain
nature of a 'desired' rate and/or an average is, at this stage of working out the potential growth variability not at the optimal rate,
rate of a given past period, it would stand output, an initial step towards minimisa-as the literature would suggest but at the
to reason that the proxy to an inflation tion of potential output gap. potential output growth. For a policy-
target could well be actual mean or a median If the above reasoning is correct, it ismaker who is concerned about both growth
rate of inflation or be set to contain the necessary for the Reserve Bank to moveand inflation, there is a need to know
spread between the peak and trough ratestoward some policy rule, Taylor-like ifwhether there is trade-off between growth
of inflation during the recent past. Devia- feasible, and to make the rate of interestvariability and inflation variability.
the prime area of its focus. Apparently, There is not much of empirical work that
tion of the actual inflation rate in each year
from the 'proxy' target could give policy going by the recent adoption of the liquid- has been carried out in this regard insofar
insights about the rate of interest that ity adjustment facility mechanism, the bankas India is concerned. A simple two-di-
would be consistent with, if not equili- seems to be bestowing a higher degree ofmensional graph relating inflation and
brate, the demand and supply conditionsemphasis on the rate of interest than everoutput growth, if drawn, would show that
in the financial markets. Minimising thebefore. However, there is no officially there is no trade-off during the period
deviation could be regarded as movingannounced potential output or potentialunder view. In general, the curve moves
toward 'inflation targeting'. growth rate, notwithstanding the expressedup and down, at times steeply, creating
The second task, as given in the RBI Act,preferences for higher rates of annual doubt whether at all the minimisation of
of operating 'the currency and creditgrowth as desirable or realisable.12 It isvariability in inflation and growth is
system' to country's advantage, has oftennecessary that academic research is en- amenable to policy influence. The vari-
been codified by the Reserve Bank as couraged on the estimation of potential ability in growth, however, is much less
ensuring adequacy of bank credit tooutput in India. The present lack of aca-than that in inflation. The standard devia-
finance genuinely productive activities.demic interest in this area perhaps is duetions over the period in respect of growth
Such a description is loosely viewed asto the fact that the data on national income and inflation were 1.145 and 2.963 respec-
RBI's activism for triggering real outputand its components are not as comprehen- tively. But this by itself does not mean
growth through the banking system. Butsive and frequent as they should be, not- that output responds more positively to
it is well known that the share of bank withstanding the recent efforts at provid- policies than prices.
financing in total financing would decline ing quarterly estimations of national in- From the point of view of the monetary
over time with financial sector reforms come growth. The two papers on the subject policy-maker, the empirical verification
that promote the development of equity so far have emanated from the researchers about the trade-off has to be robust. But
and debt markets. No doubt, such 'marketof the Reserve Bank but they need to be this does not mean that the theoretical
financing' will take time, to become promi-sharpened further.13 reasoning behind 'rules' is weak. In fact,
nent. Nevertheless, policy-makers will have Even in regard to inflation targeting in it could be argued that it is fairly strong,
to, in the transition period, know the elas- India, there is a need to encourage aca- rules here being interpreted to mean that
ticity of response of output to the amountdemic research. The references to it so far flexibility would be allowed for, in case
of credit extended. The elasticity couldhave emanated mostly from those associ-of shocks or severe economic disturbances.
vary, depending on the level and applica-ated either contemporaneously or in theThis approach need not necessarily be the
tion of technology. There are, however nopast, with policy-making institutions. 14 Is same as 'constrained discretion', where
firm estimates about the degree of asso- it because a 'single' objective - say of the constraint is applied voluntarily by the

1058 Economic and Political Weekly March 16, 2002

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 mercial banks, development finance insti-
authority that enjoys discretion, whether has been left unspecified. However, the
the economy faces a shock or not.17 Thetutions and major non-bank financial in- bank has been making internal assessments
termediaries), seem to have favoured the
rules, however, have to help realise align- of liquidity situation on a daily basis. Such
ment between the financial and commod- 'multiple indicators' approach to a single assessments would be good guides for
ity markets, and for achieving the bestintermediate target. Domestic liquidity understanding the demand for bank re-
combination of maximal growth withconditions are seen by market players to serves. The Reserve Bank could place
minimal inflation. This would not be be a more important factor than mere money pressure on bank reserves, not merely by
possible unless allocative efficiency is Liquidity is influenced by open altering the cash reserve ratio (CRR), but
supply.
optimised and the only way to gaining marketit and repo operations which are by other market-based operations, in order
is through the price variable on which conducted
the with an eye to stabilising the to control short-term interest rates, which,
monetary authority has preponderant in- rates of interest in a way that the as we noted earlier, would be the best
market
fluence. Such a variable in the Indian yield curve will be smooth and in accor- device to allocate resources efficiently.
dance with the market expectations. The Although the target money market rate is
context of a relatively less open economy
has to be the rate of interest. operations in question, however, would not specified or announced, the bank's
impact on market expectations, depending preference for levels of money market rates
II B on the size, timing, and maturity periods is suggestive of an implicit band, rendered
Intermediate Target of the securities placed on market in sales possible indirectly through OMO and repo
and purchases. The experience of the year operations as well as standing facilities.
The intermediate target, prior to 1998, 2000-01 shows that the yield curve is The standing facilities represent (a) RBI's
was broad money (M3). It was not regarded shaping up in accordance with the theo- refinancing of export credit extended by
as a rigid number for the year: it was retical expectations.20 As the secondary banks (with certain limitations) and
subjected to 'feedback rule', thereby market in government securities goes (b) collateralised lending to banks in the
imparting to it an element of flexibility. beyond the predominantly financial insti- form of automatic and 'back-stop' facility
The target is announced not as a target but tution-centric position and turns retail, it drawals. The Reserve Bank's repo opera-
as one that is consistent with the projected will grow further in size and further tions are for differing periods and the
increases in output and prices, given the strengthen the growing financial integra- government securities involved are of
output elasticity of demand for money. tion of money, government securities and different maturities.
Since the elasticity could assume differing foreign exchange markets. The equity The bank is committed to an interest rate
values (depending upon the period of market which is presently the missing link corridor in the sense that the daily average
estimation and specification of the money should, theoretically speaking, follow the inter-bank call rate would move within a
demand function), say between 1.2 and rest of the financial markets. width of 200-basis points of the repo rate
1.7, the projected money supply growth The projection of M3 expansion, in the (floor) and the reverse repo rate (ceiling).22
could be manipulated to fall within a range. evolving market environment, would haveThe Bank rate is often slightly above the
In general, money demand functions for limited usefulness as an intermediate tar- floor set by the repo rate. The automatic
India have exhibited relatively high degree get. But it can still be a signal of policycollateralised lending is at the Bank rate
of stability, but such stability cannot be stance. That is why, the April 1998 policyand would be twice the amount drawn
taken for granted as financial sector de- statement, by adding on the supporting under the back-stop facility that is up
velops and financial innovations take place. indicators to M3 has attempted to under- wardly linked to the variable reverse
The third working group on money supply score the fact that monetary policy has torepo rate.
gave a hint of weakening stability in money be based on broad-based information in The corridor has been kept fairly wide
demand in recent years and indicated that the transition phase of financial develop-as in the case of many central banks to give
while money supply would continue for ment.21 Whether this approach will scope suc- for market rates to fluctuate signifi
some time to be a major indicator as well ceed and whether it can be generalisedcantly.
and The alternative of narrow corrido
as an instrument of policy, the rate of would not be useful since it would often
applied to economies undergoing transi-
interest could emerge as a critical variable tion phases such as our own, would depend result in banks substituting central bank's
in policy-making.18 on the strength of the links betweenstandingthe facilities for money market bor-
It is against this background, in the April indicators used to trigger policy actionrowing,
and thereby weakening central bank's
1998 statement on monetary policy, gov- the final objective(s) of policy. It is influence
here over market interest rates.
ernor indicated that given the vast array future research in India has to focus its The corridor technique has worked rea-
of financial reforms, it would be appro- maximum attention. sonably well.23 It provided a cloak of
priate that the policy is led by 'multiple interest rate targeting.24 Its success could
indicators' rather than by monetary target- IIC be due to the fact that the credit market
ing alone.19 Under the proposal, money Operating Target has not been buoyant enough to place
supply becomes one of the many indica- severe pressures on banks' liquidity. It has
tors, bringing about a qualitative change Bank reserves would be the natural choicealso benefited from the existence of two
in the content of the 'intermediate target'. characteristics. The institutional participa-
as an operating target, when M3 is targeted,
Implicitly, it would mean that the link as indeed was the case with the Indian tion being predominant in the government
between M3 expansion and the final monetary policy conduct till almost securities
the market, the processes of auc-
objective(s) would be weak. end of 1997. Since then, there has been
tioning conduct have not come under
sufficient scrutiny so far. More impor-
It appears that in general market players a gradual shift to a multiple indicator
(the foreign institutional investors, com- approach wherein the intermediate target
tantly, there is the reserve averaging over

Economic and Political Weekly March 16, 2002 1059

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the length of the maintenance period of rate; in the Euro-region, it is the refinancecompared to the rate obtaining in trading
two weeks to take care of any problems rate; in the UK, it is the repo rate; and inpartner countries, the policy-makers will
in making accurate liquidity assessments. Japan, it is the overnight call rate. Adopt- have to allow for some underlying rupee
Reserve averaging would often help ing a benchmark market rate would be a depreciation vis-a-vis the major currency
stabilise the market interest rate, within the better allocative device than any other rate,(currencies) of invoice.
wide corridor, because it encourages banks as the experience of industrialised coun- The bank has not revealed its preference
to postpone (bring forward) borrowing tries seems to suggest. In India, financial for exchange rate levels but has been
when the interest rate is high (low) early integration is growing and repo auctions disseminating to the market both the
in the maintenance period to the later part have now become regular. The amount ofnominal and real effective exchange rate
of the period. Even when reserve averag- funds that attract the Bank rate is limited indices, every month, on different bases,
ing is not allowed for the entire mainte- compared to the funds turnover in money, in order to create an environment of
gilt, or capital markets. There is also very
nance period, it still reduces volatility of market expectations. Given the relatively
market interest rates. Central banks also
little evidence to show that as the signal- constrained openness of the economy-
ensure that reserve averaging is done byling device, the Bank rate had been effec- constrained by structural causes as well
banks by providing incentives for the tive. It appears that with some additional as by deliberate policy preference - and
purpose. Most banks in India try to meetinstitutional reforms, it should be possible the relatively low inflation outcomes in
the reserve requirements essentially be- to use either the repo rate or the inter-Bank relation to the inflation rates in many
cause of price and non-price penalties for call rate as the official rate representing other emerging market economies, the bank
non-compliance. market expectations in not too distant a has not found it advantageous to anchor
Bank reserves would still work as useful future. Such a switchover, however, calls its currency to any other, and has striven
operating target, since the demand for bank for more thorough research on financial to 'manage' the rate. This approach to-
reserves has to be assessed, and the gaps integration, and the evolving market struc- gether with liquidity and interest rate
in liquidity provided for. This is not in- tures and behaviour. leveraging has represented the main thrust
consistent with the pursuit of the level of of monetary and exchange rate policy.
the market rate of interest that promotes Ill
allocative efficiency. Could There Be Other IV
Pointers? Conclusions
II D
Interest Rate Indicator In the absence of any information on Our discussion shows that the Bank has
inflation target or potential output, and ihbeen cautiously adopting 'just do it' ap-
The bank has been announcing the Bankview of the weakening of the influence of proach, and not any rule-based regime.
rate more frequently since 1992 than evermoney supply on prices and output, it has This is not because of any given policy
before. In the two years since 1998, asbecome even more difficult to construct strategy but because of indefiniteness
mentioned earlier, the Bank rate was about the market behaviour and market
a typical policy reaction function for'the
changed as many as five times. The bankIndian economy. However, there are in- developments in the context of financial
rate change is officially treated as a sig-stances where the bank seems to have development and the related uncertainties.
nalling device about the bank's policy intervened to influence the exchange In general, the bank has signalled its
rate
intention, towards the end of the twentieth
stance. However, frequent changes in itmovements either directly or through trans-
could place undue pressure on the marketactions in other financial markets. This century, to move away from monetary
expectations formation processes, givingwas sharply evident in 1997-98, and again targeting. Although not clearly specified,
rise to uncertainties. in 1998-99. The main purpose of such the policies pursued so far indicate their
The Bank rate has served as a near-floor/ activism is to contain exchange rate vari-focus on interest and exchange rates
with a view to achieving a better alloca-
ceiling rate ever since the introduction of ability and to ensure that the real effective
repo auctions. It was a near-ceiling rate rates do not appreciate. Given the higher tive efficiency of resources over the
when the fixed rate repos were in place. inflation rate in tradable goods in India medium term. m[
It has acted as a near-floor rate ever since
fixed rate repos gave way to variable rate
repos. War Against the Planet
It has now become important to inquire The Fifth Afghan War, Imperialism and
whether the official rate could be a market-
Other Assorted Fundamentalisms
related rate, reflecting the influence of
official actions or directly impacting on Vijay Prashad
the behaviour of governments and banks, This wide-ranging book examines the US response to 9/11, and elucidates
as is the case now, whenever the rate the reasons for the rise of the Islamic right, the demise of the left, the role
changes. In countries where financial of oil in the modern world, and the tragic fate of Afghanistan.
market integration is high, the official v> Demy 8vo, pp. viii + 110, paperback Rs 75/$ 7

interest rate is generally market-based and
announcement of changes in its signals
policy stance. For example, the US em-
0D
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Phone: (91-11) 335 9456, 355 6966. Email: leftword@vsnl.com
rate. In Canada, it is the overnight funding

1060 Economic and Political Weekly March 16, 2002

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 Notes Federal Reserve Bank of Kansas City, 1999, from year to year depending on economic
pp 195-259. The number of economists in circumstances. Also see, C Rangarajan, 'The
[The views expressed in this paper are the central banks who strongly support such Changing Context of Monetary Policy',
author's own. The author is highly thankful flexible inflation targeting is so large that (Lecture delivered in March 1997), in
to Mridul Saggar and Partha Ray for their help- it is difficult to find out now as to how many C Rangarajan, Indian Economy - Essays on
ful comments on the first draft, and to Abhay central bankers could be outside the ring in Money and Finance, UBS Publishers'
Pethe for the comments made as a discussant of which the revised version of 'inflation nutters' Distributors, New Delhi 1998, wherein it
the paper presented at the Annual Conference on can be placed. was said that the assignment rule favours
Money and Finance of the Indira Gandhi Institute 7 See A Vasudevan, 'Some Practical Issues in monetary policy as the most appropriate
for Development Research, Mumbai, December Monetary Policy-making', Reserve Bank of instrument to achieve the objective of price
13-15, 2001. The usual disclaimer, however, India Bulletin, January 1999. stability.
remains.] 8 Cf Charles Freedman, 'What Operating 16 See A Vasudevan, 'Analytical Issues in
Procedures Should Be Adopted to Maintain Monetary Policy in Transition', C N Vakil
1 Historically the practice of giving two major Price Stability' in Practical Issues in Achieving Memorial Lecture, Reserve Bank of !ndia
policy statements arose out of the perception Price Stability, A Symposium sponsored by the Bulletin, January 1998; also see A Vasudevan,
that India's credit needs were seasonal in Federal Reserve Bank of Kansas City, Jackson B K Bhoi and S C Dhal, 'Inflation Rate and
character. The seasons, for purposes ofHole, Wyoming, 1996. Freedman held the Optimal Growth - Is there a Gateway to
view that the best estimate of CPI bias was
convenience, were categorised into busy and 'Nirvana'?' in A Vasudevan, D M Nachane,
well under one percentage point in mostand A V Karnik (eds), Fifty Years of
slack season. Just before the beginning of the
slack seasons, i e, before May 1, the main
industrialised countries. Development Economics, Essays in Honour
9 Hedonic Price indexes have come into
policy stance for the fiscal year (April-March) of Professor P R Brhamananda, Himalaya
Publishing
prominence as a result of a large-scale
ahead is revealed. The busy season is supposed use House, Mumbai, 1999.
to start from November 1. The seasonal of computers in business. Hedonic 17 The expression
price in- 'constrained discretion'
character was derived from the cyclesdexes of are statistical tools for developing
does not provide flexibility to the monetary
agricultural operations. Now that the share of
standardised per unit prices for goodspolicy-maker,
whose if he/she is constrained to
agriculture in India's GDP has declinedquality
to and characteristics are changing
seek government's support for the proposed
about one-fourth, no mention is made of the rapidly. See, for example, J Steven Landefeld action.
seasons. But the practice of having two policy and Bruce T Grimm, 'A Note on the 18 See the Report of the Working Group on
Impact
statements in a year has been continued of Hedonics and Computers on Real GDP',
Money Supply : Analytics and Methodology
essentially to provide an opportunity for the Survey of Current Business, Decemberof2000, Compilation, Reserve Bank of India,
Reserve Bank to explain its stance and policies pp 17-22. On the methodology of constructing Mumbai 1998.
to banks and to other members of the financial the indexes, see Robert C. Feenstra, 'Exact 19 See for the 'Monetary and Credit Policy
community. Hedonic Price Indexes', Review of Economics Statement of April 1998', on RBI website
2 See the relevant sections of the RBI Act, 1934. and Statistics, Vol 77(4), November 1995, <<www.rbi.org.in>>.
See Sections 7(2) to be read together with pp 634-53. 20 The yield curve should move upward up to a
Section 17 of the RBI Act. 10 See Sushil Wadhwani, 'The Exchange Rate certain point when the slope would generally
3 Reference to this committee was first made and the MPC: What Can We Do?', Bank of taper off. This position has been held well. See
in the Bank's Annual Report for 1998-99, England Quarterly Bulletin, August 2000. Annual Report, 2000-2001, Reserve Bank of
p 170. Wadhwani argued that asset price India, p 96, Chart V.7, for the yield curve for
4 The Code of Good Practices on Transparency misalignments can convey information that is Government of India dated securities for the
in Monetary and Financial Policies was issued not necessarily available in the inflation year 2000-2001.
by as a part of the need for compliance of the forecast. 21 This perceptible shift to a multiple indicator
international standards regime by the 11 See Charles Goodhart, 'What Weight Should approach and the attendant conditions and
International Monetary Fund in 1999. This is Be Given to Asset Prices in the Measurement policy dilemmas that brought about such a
available from the IMF website of Inflation?', Economic Journal, Vol 111, shift have been discussed in K Kanaga-
<<www.imf.org>>. No 472, June 2001, pp F 335-56. sabapathy, 'Monetary Policy Underpinnings:
5 See Bank for International Settlements 12 The Prime (BIS),
Minister's Economic Advisory A Perspective', Economic and Political
Monetary Policy Operating Procedures in a reportentitled 'Economic
Council brought out Weekly, Vol 36, No 4, January 27-February
Emerging Market Economies, Reforms: Basle, A 1999.
Medium Term Perspective' in 2, 2001, pp 303-10.
6 The expression, 'inflation nutter' 2001. It argued that implementation 22 See C E V Borio, 'The Implementation of
is attributed
February
to Mervyn King, Deputy Governor of its proposals
of Bank will give the economy "the Monetary Policy in Industrialised Countries:
additional thrust
of England. See Mervy King, 'Changes in UK it needs to break through A Survey', BIS Economic Papers, No 47, 1997
Monetary Policy: Rules and Discretion
the 6.5 per cent in growth achieved thus far for use of interest rate corridors.
Practice', Journal of Monetarytowards higher levels of 8 per cent or more". 23 See the Annual Report, Reserve Bank of
Economics,
Vol 39, June 1997, pp 81-97. An inflation
This report is available on the Government of India, 2000-2001, Chapter IX, especially
India
nutter regards the coefficient of website. gap
output pp 148-49.
to be zero in the central bank's loss function
13 See Kshitija Donde and Mridul Saggar, 24 The possibility of transition from the
and views only inflation target as critical. 'Potential Output and Output Gap: Rev;ew', conventional monetary targeting framework
But this interpretation was not found and Sarat Chandra Dhal, 'Potential Growth in to the interest rate targeting has been clearly
acceptable to many economists since it India: Viable Alternatives to Time Series
recognised since 1997. See A Vasudevan,
sounded to be an extreme position to take. Approaches', both from RBI Occasional
referred to in footnote 16 above, and also the
Therefore, the deviations from potential real Papers, Vol 20, No 3, Winter, 1999. third working group report referred to in
output and from the targeted inflation were footnote 18 above. On possibility of change
14 See forexample R Kannan, 'Inflation Targeting:
Issues and Relevance for India', Economic and
considered as important for central banks while in transmission mechanism as a result,
determining a nominal interest rate. On this see Partha Ray, Himanshu Joshi and Mridul
Political Weekly, January 16-23, Vol XXXIV,
premise, the flexible inflation targeting Nos 3 and 4, 1999. Saggar, 'New Monetary Transmission
approach was built. See Lars O Svensson,15 See C Rangarajan, 'Monetary Policy: Some Channels: Role of Interest Rates and Exchange
'How Should Monetary Policy Be Conducted Questions Answered', RBI Bulletin, Rate in Conduct of Indian Monetary Policy',
in an Era of Price Stability?' in a symposium November 1997. He stated that the emphasis Economic and Political Weekly, Vol 34, No 44,
on New Challenges for Monetary Policy, at as between the two objectives has changed October 31-November 4, 1998.

Economic and Political Weekly March 16, 2002 1061

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