Dynamism in Reserve Bank of India policies in past 2 decades, is this sufficient?

Department of management studies, IIT Roorkee 12 Oct, 2010

Abhishek Laxmi Narasimha Boddu Udit Gupta Vema Jagdish

1. Abstract:
With economy opened up in 1991, the central banks role has become even more crucial in the economy. At this power Reserve Bank of India has been very dynamic and has received various accolades in this front of controlling Indian economy. But are these measures taking away autonomy from financial institutions. Is it making innovation in financial economics suffocated? How stringent policies are? The paper will be discussing about major moves in monetary policy and towards financial stability.

2. Introduction:
Indias central bank, the Reserve Bank of India (RBI), has an unenviable task. It is not really independent, it has multiple objectives (not all of its own making), it has to deal with a country that is extremely heterogeneous in terms of economic structures and development levels, and it often lacks good data for its decision-making. In the circumstances, one might agree with senior RBI officials who argue that it does a good job under the circumstances, especially in helping to keep Indias financial house in order and externally-generated crises at bay. Others, outside the RBI, have pressed for greater simplicity, transparency and predictability in the RBIs functioning. Critics have argued that the RBIs monetary policy in recent times has been inconsistent and, thus, a source of some confusion to observers and market participants. More specifically, the RBI remains very elusive as to what is being targeted and how the target is being attained. Rather, the RBIs monetary policy framework has been based on a rather ad hoc combination of sterilized foreign exchange intervention (via Monetary Stabilization Scheme (MSS) bonds), interest rate changes along with nonmarket mechanism (hikes in the cash reserve ratio (CRR), ad hoc capital controls etc).

3. RBI Monetary policy1,4

3.1 Objectives of monetary policy
Central banks derive their objectives from their respective mandates. Monetary policy could have either a single objective of price stability or multiple objectives besides price stability. In the literature and in practice, price stability is considered as the dominant objective of monetary policy. The preamble to the Reserve Bank of India Act, 1934 delineates the basic functions of the Bank as to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage. The objectives of monetary policy evolved from this broad guideline as maintaining price stability and ensuring adequate flow of credit to the productive sectors of the

economy. In practice, monetary policy endeavored to maintain a judicious balance between economic growth and price stability. The question is how do we define price stability? Price stability does not mean zero inflation. It is considered as a low and stable order of inflation. This is because both high inflation and deflation impose costs on the economy by way of loss of output and misallocation of resources. For advanced economies, an inflation rate of about 2 per cent is equated with price stability. For an emerging market economy(EME) like India, going through significant structural changes, a slightly higher rate of inflation which allows relative prices to adjust smoothly can be considered appropriate. The Chakravarty Committee (1985) had defined an inflation rate of 4 per cent per annum as tolerable for India. India is considered to be a moderate inflation country with the long-term average inflation rate remaining in a single digit of about 7.5 per cent since 197071. Over this 40-year period, the average inflation rate, however, has decelerated to about 5.5 per cent in the decade of 2000s. The medium term objective of monetary policy is to bring down the average inflation rate to around 3.0 per cent consistent with Indias integration with the global economy. While a low level of inflation is essential to sustain high levels of growth, it is not sufficient to maintain financial stability, as has been demonstrated by the recent global financial crisis. Consequently, besides price stability, ensuring orderly conditions of financial markets has become a key policy concern. In this context, it may be indicated that financial stability had emerged as another important objective of monetary policy in India much before the crisis. Thus, monetary policy in India has evolved to have multiple objectives of price stability, financial stability and growth. These objectives are not inherently contradictory, rather mutually reinforcing. Price and financial stability are important for sustaining high levels of growth which is the ultimate objective of public policy.

3.2 Evolution of monetary policy framework

3.2.1 Monetary framework before liberalization
In India also, monetary policy framework has undergone significant transformation over time. In the 1960s, as inflation was considered to be structural and inflation volatility was mainly caused by agricultural failures, there was greater reliance on selective credit controls. The aim was to regulate bank advances to sensitive commodities to influence production outlays, on the one hand and to limit possibilities of speculation, on the other. In the 1970s, there was a surge in inflation on account of monetary expansion induced by expansionary fiscal policies besides the oil price shocks. By the early 1980s, there was a broad agreement on the primary causes of inflation. It was argued that while fluctuations in agricultural prices and oil price shocks did affect prices, sustained inflation since the early 1960s could not have occurred unless it was

supported by the continuous excessive monetary expansion generated by the large-scale monetization of the fiscal deficit3. Against the backdrop, the Committee to Review the Working of the Monetary System (Chairman: Prof. Sukhamoy Chakravarty;1985), set up by the Reserve Bank of India, recommended a monetary targeting framework to target an acceptable order of inflation in line with desired output growth. It also recommended for limiting monetary expansion through the process of monetization of fiscal deficit by an agreement between the Reserve Bank and the Government. With empirical evidence supporting reasonable stability in the demand function for money, broad money (M3) formally emerged as an intermediate target. Under this approach, a monetary projection is made consistent with the expected real GDP growth and a tolerable level of inflation. The framework was, however, a flexible one allowing for various feedback effects. Moreover, money supply target was relatively well understood by the public at large.

3.3.2 Monetary framework after liberalization

3.3.2.1 Monetary targeted approach After the liberalization, the pace of trade and financial liberalization gaining momentum following the initiation of structural reforms in the early 1990s, the efficacy of broad money as an intermediate target of monetary policy came under question. The Reserve Banks Monetary and Credit Policy for the First Half of 199899 observed that financial innovations emerging in the economy provided some evidence that the dominant effect on the demand for money in the near future need not necessarily be real income, as in the past. Since the mid-1990s, apart from dealing with the usual supply shocks, monetary policy had to increasingly contend with external shocks emanating from swings in capital flows, volatility in the exchange rate and global business cycles. Subsequently, increase in liquidity emanating from capital inflows raised the ratio of net foreign assets (NFA) to Reserve Money (Chart 1). This rendered the control of monetary aggregates more difficult. Consequently, there was also increasing evidence of changes in the underlying transmission mechanism of monetary policy with interest rate and the exchange rate gaining importance vis--vis quantity variables. Bank credit to private sector as a per cent of GDP also started rising, though it still remains low as compared to advanced economies and many EMEs underscoring the potential for greater credit penetration (Table1). These developments necessitated refinements in the conduct of monetary policy.

3.3.2.2 Multiple indicator approach The Reserve Bank formally adopted a multiple indicators approach in April 1998 with a greater emphasis on rate channels for monetary policy formulation. As a part of this approach, information content from a host of quantity variables such as money, credit, output, trade, capital flows and fiscal position as well as from rate variables such as rates of return in different markets, inflation rate and exchange rate are analyzed for drawing monetary policy perspectives. The multiple-indicators approach, as conceptualized when Dr. Bimal Jalan was the Governor, continued to evolve and was augmented by forward looking indicators and a panel of parsimonious time series models. The forward looking indicators are drawn from the Reserve Banks industrial outlook survey, capacity utilization survey, professional forecasters survey and inflation expectations survey. The assessment from these indicators and models feed into the projection of growth and inflation. Simultaneously, the Reserve Bank also gives the projection for broad money (M3), which serves as an important information variable, so as to make the resource balance in the economy consistent with the credit needs of the government and the private sector. Thus, the current framework of monetary policy can be termed as an augmented multiple indicators approach as illustrated below (Exhibit1).

This large panel of indicators is at times criticized as a check list approach, as it does not provide for a clearly defined nominal anchor for monetary policy. However, given the level of financial market development, the evolving nature of monetary transmission and the need to maintain the resource balance between the government and the private sector, monetary policy assessment becomes inherently complex. Globally, it is now recognized that the task of monetary management has become more challenging. In view of central banks operating in an environment of high uncertainty regarding the functioning of the economy as well as its prevailing state and future developments, a single model or a limited set of indicators may not be a sufficient guide for monetary policy. Instead, an encompassing and integrated set of data is required. This reinforces the usefulness of monitoring a number of macroeconomic indicators in the conduct of monetary policy. In the context of the recent crisis, it is argued that monitoring money and credit may help policymakers interpret asset market developments and draw implications from them for the economic and financial outlook. There is a need to raise awareness in the central banking community of the importance of monetary analysis and its implications, both for economies individually and globally. Thus, there is now increasing support for a broad-based approach to monetary policy.

4. Working of multiple indicator approach

The process of financial liberalization and deregulation of interest rates introduced since the early 1990s enhanced the role of market forces in the determination of interest rates and the exchange rate. Accordingly, the Reserve Bank of India placed greater emphasis on the money market as the focal point for the conduct of monetary policy and for fostering its integration with other market segments. Following the Narsimham Committee (1998) recommendations, the Reserve Bank introduced the liquidity adjustment facility (LAF) in June 2000 to manage market liquidity on a daily basis and also to transmit interest rate signals to the market. Collateralized borrowing and lending operations (CBLO) was introduced as a new money market instrument in January 2003. The call money market was transformed into a pure inter-bank market by August 2005 in a phased manner. As a result, the money market developed significantly over the years as reflected in increased turnover in various market segments (Table 2). Along with developing money markets, the Reserve Bank has also undertaken various measures to develop the government securities and foreign exchange market, increasing the depth of the financial markets (Chart 2). All these reforms have also led to improvements in liquidity management operations by the Reserve Bank of India as reflected in general containment of call rates within the LAF corridor except occasional volatility. Apart from imparting stability in call money rates, this has also resulted in greater market integration as reflected in close co-movement of rates in various

segments of the money market (Chart3). The rule-based fiscal policy pursued under the Financial Responsibility and Budget Management (FRBM) Act, by easing fiscal dominance, contributed to overall improvement in monetary management. During the recent period, the issue of managing large and persistent capital inflows in excess of the absorptive capacity of the economy added another dimension to the liquidity management operations. Initially, the liquidity impact of large capital inflows were sterilized through open market operation (OMO) sales and LAF operations. Given the finite stock of government securities in the Reserve Banks portfolio and the legal restrictions on issuance of its own paper, additional instruments other than LAF were needed to contain liquidity of a more enduring nature. This led to the introduction of the market stabilization scheme (MSS) in April 2004. Under this scheme, short term government securities were issued but the amount remained impounded in the Reserve Banks balance sheet for sterilization purposes. Interestingly, in the face of reversal of capital flows during the recent crisis, unwinding of such sterilized liquidity under the MSS helped to ease liquidity conditions (Chart4). The efficient conduct of monetary policy is judged ultimately in terms of its ability to stabilize real economic activity and inflation and also ensuring financial stability consistent with the policy objectives. An assessment of the multiple indicators approach for the period 199899 to 200809 reveals that actual outcome of GDP growth has been generally higher than the projections indicated in the monetary policy statements, while it has generally been lower in case of inflation (Table 3).

5. Drawbacks in Monetary policy framework6

WPI - In India the WPI, calculated by Office of the Economic Adviser, is a weekly index. It is neither the international equivalent of the producers price index nor the consumer price index. This technically makes Indias inflation measure incomparable with the rest of the world. The various retail measures of inflation are of extremely poor quality. Besides, the four retail measures CPI for rural laborers, agricultural laborers, industrial workers and urban nonmanual employees are too narrowly targeted, making them irrelevant for macro policy formulation. The Reserve Bank of India (RBI) should be particularly worried about price measures and the large divergence between the WPI and consumer price index in reference to its monetary policy stance.[Source: economic times, 28th September, 2010] IIP Construction of the IIP involves identifying important units that account for a large (70 %) share of overall production to get a fair representation of growth. This process has two inherent problems; the first one is the fixed base index, which does not account for changing production pattern in the economy. Therefore, as we move further away from the base year, the index becomes less and less representative of the actual production in the economy. The second problem is in the way the data is collected. As data is collected from units, which have an

important value in production, these units are generally large in size. This is most true for the capital goods industry in which a few industries account for a major share in production, as the production process is capital intensive and enjoy economies of scale. Volatility has been built into the way IIP is constructed. The source of volatility can be traced to the way orders are booked. Industrial units follow different production cycles, which also show up as spurts in production in different periods. But the structure of the economy should not impede data collection. The index increased by over 40% four times since FYI 1991, and fell by over 40% three times since that year.

6. Autonomy of RBI3
The Reserve Bank of India (RBI) is an autonomous body created under an act of the Indian parliament i.e. The Reserve Bank of India Act, 1934. But over the past time the Ministry of Finance has taken every opportunity to clip its wings. Whether on capital account convertibility or sovereign borrowing (both of which have investment banks salivating at the prospect of commissions and fees, never mind that it is not in the long-term interests of the country), the RBI has successfully resisted pressure from vested interests. The fact that the crisis ultimately proved it right and left the ministry with egg on its face should have humbled the latter. Instead it seems to have riled it. Consequently, the ministry has taken every opportunity to clip the bank's wings. Starting with the decision to set up an FSDC (Financial Stability and Development Council), to setting up a working group on foreign investment without a single member from the RBI, to the ordinance , now enacted as The Securities and Insurance Laws (Amendment and Validation) Act 2010, that downgrades the RBI governor from his earlier position as first among equals to officially playing second fiddle to the finance minister and most recently, to the decision to appoint a search committee to find a successor to UshaThorat, one of its most competent officers, the ministry has steadily chipped away at RBI's powers. The most glaring attack on the bank's autonomy, of course, is the decision to set up an FSDC under the chairmanship of the finance minister. At a time when most countries are giving more powers to their central banks - the UK government went so far as to scrap the Financial Services Authority - the government's decision to reverse gear is incomprehensible. The potential danger of setting up a committee of this type is that it confers powers on the government to formally intervene in financial regulatory issues, including monetary policy. This development is dangerous because governments, particularly elected governments have a shortterm perspective. Governments don't think beyond the next election. Strong central banks are necessary to protect us from the worst excesses of government. Today when central banks all over the world are busy buying government debt, central bank independence might seem a bit of

a myth and the government's latest attempts to cut the ground from under its feet a matter of trifling detail. But it is not! It is only the thin edge of the wedge; another attempt to chip away at the hard-won operational autonomy the bank has gained over the years. As Adam Posen , an external member of the Bank of England monetary policy committee put it, what matters for (central bank) independence is (the) ability to say 'no' (to political pressure) and mean it, while still holding the right to buy bonds when the economy needs it. With the government snipping away at the RBI's de-facto (though not de-jure independence) the fear is that the RBI will lose its ability to say no. That will be a sad day for both the RBI and for India. Strong institutions are the only guardians of democracy, especially in a fledgling democracy

7. Economists view on Monetary policy2,7,8,9

Tony Cavoli and Ramkishen S. Rajan in their paper mentioned that Critics have argued that the RBIs monetary policy in recent times has been inconsistent and, thus, a source of some confusion to observers and market participants. More specifically, the RBI remains very elusive as to what is being targeted and how the target is being attained. Rather, the RBIs monetary policy framework has been based on a rather ad hoc combination of sterilized foreign exchange intervention (via Monetary Stabilisaion Scheme (MSS) bonds), interest rate changes along with nonmarket mechanism (hikes in the cash reserve ratio (CRR), ad hoc capital controls etc) Research done by Inoue, Takeshi (07-2010) shows that Monetary aggregates such as M1, M2, M3 had a causal relationship with at least either output (IIP) or price level (WPI or inflation), but indicators like stock prices and exchange rate, which have a causal relationship with the output(IIP) level, were not taken into consideration. So in nutshell the monetary policy during this period would have been more effective if the stock prices and exchange rate werent ignored. SS Bhalla criticized as Monetary Policy- Just Pain, No gain. The RBI still thinks in overheating terms because for it there is only one variable the rate of growth of money supply. For something held so sacred, it is strange to find that the monetarist model (i.e. inflation is a function of the rate of growth of output and the rate of growth of money supply) finds little, actually zero, analytical support from Indian data. To be sure, there are some quasi research papers that relate the levels, rather than the rate of growth, of these variables. But estimating relationships between levels is akin to stating that the number of TVs causes mental illness both go up steadily over time.

Maybe the RBI is just doing what officials of other fast-growing economies are doing. This wont necessarily make the actions right, but it would mean that the RBI is following the global

herd and we all know that nobody can hold you responsible if you follow the crowd. China has stopped raising rates and settled at a negative real rate of around -3.5 per cent. Korea just raised rates by 25 basis points, but to a level of -0.75 per cent real rate. Thus, Indian firms face a cost of capital some 2 to 5 percentage points higher than its competitors. Both New Zealand and the Czech Republic have lowered rates by 25 basis points each. Both cited the fact that the inflation is global, probably conjectured (different than the RBI) that $150/barrel oil should not be the reference price for monetary policy, and therefore cut rates to provide for inclusive growth to its citizens.

8. Conclusion
The monetary policies of RBI over the last two decades have had positive effects mostly inspite of some criticsm by some economic experts. The current state of Indian economy is relatively stable as compared to other world economies. This itself is a testimony of sound policies of RBI. Experts and economies around the world are now trying to emulate Indian model wherein regulation and growth go hand in hand. Inspite of these positive outcomes, there are various areas where improvements can be made. Rather than following a global herd, a system has to be made to collect Indian data extensively and policies be framed based on Indian perspective. Improvements can be made in calculating WPI and IIP, which would help RBI in framing policies efficiently and also in comparing the inflation levels with other economies around the world. The last but not the least issue is the autonomy of RBI.It has been observed that Government has been forming committees which formally intervene in financial regulatory issues. The governance of RBI must be autonomous without any intervention from the government as it has extensive resources and information to take the most appropriate decisions.

List of charts:

List of tables:

Table2: Activity in Money Market Segment

Table3: Multiple indicator approach: Projections versus Achievements

References:
1. Deepak mohanty;Feb 21st 2010; Speech by Mr Deepak Mohanty, Executive Director of the Reserve Bank of India, at the Conference of the Orissa Economic Association, Baripada, Orissa. 2. Karthik R; March 19th, 2007; Article; http://rkarthik.blogsome.com/2007/05/19/monetarypolicy-and-crangarajan/ 3. Mythili Bhusnurmath,ET Bureau; Sept 6th, 2010; http://economictimes.indiatimes.com/opinion/columnists/mythili-bhusnurmath/Shooting-itself-inthe-foot/articleshow/6503962.cms 4. Nirvikar singh; Aug 31st, 2009; Article; http://www.roubini.com/emergingmarketsmonitor/257592/uncovering_the_monetary_policy_rule_in_india 5. Rakesh Moahan; March 2007; Speech at 9th Global conference of Actuaries. 6. Rishi Shah, ET Bureau; Sep 17th, 2010; Article; http://economictimes.indiatimes.com/news/economy/indicators/RBIsaysitcantfigureoutIIPmaths/ articleshow/6569394.cms 7. Rituparna Benerjee, Saugata Bhattacharya; Jan 2008; Paper submitted for annual conference on Money and finance, 2008, IGIDR; 8. SS Bhalla; Aug 10th, 2008;Blog; http://jvcl.wordpress.com/2008/08/10/monetary-policy-justpain-no-gain-critics-by-ss-bhalla/ 9. Takesh; July 2010; Discussion paper. No. 242.2010.07; http://hdl.handle.net/2344/901