by Rakesh Mohan
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VII
THE FINANCIAL SECTOR: AN OPPORTUNITY FOR INNOVATION AND GROWTH
21
Reforms and the Transformation of the Monetary and Banking Sectors
C. Rangarajan
If growth is to be achieved with stability, much depends on how monetary policy is operated. Results depend on the sagacity and wisdom of the policymakers. The external sector went through a complete regime change. Financial-sector reforms have been gradual but substantial. It has been done in a way that it did not disrupt the system.
In the post-Independence economic history of the country, 1991 marks an important watershed. The country then faced a severe economic crisis, triggered largely by an acute balance-of-payments problem. The response to the crisis was to put in place a set of policies aimed at stabilization and structural reform. While the stabilization policies were designed at correcting weaknesses that had developed on the fiscal and balance-of-payment fronts, the structural reforms were meant to remove the rigidities that had entered the various segments of the Indian economy and to make the system more competitive and efficient. Thus the crisis was turned into an opportunity to effect some fundamental changes in the content and approach to economic policy, resulting in a paradigm shift.
This break with the past came in three important directions. The first was to dismantle the complex regime of licences, permits and controls that dictated almost every facet of production and distribution. Barriers to entry and growth were removed. The second change in direction was to reverse the strong bias towards state ownership of means of production and proliferation of public-sector enterprises in almost every sphere of economic activity. Areas once reserved exclusively for the state were thrown open to private enterprise. The third change in direction was to abandon the inward-looking trade policy. By embracing international trade, India signalled that it was boldly abandoning its export pessimism and was accepting the challenge and opportunity of integrating into the world economy.
Even as reforms were introduced in the real sector, it became obvious that without corresponding reforms in the financial sector, the expected results would not be achieved. In this article, we propose to outline the key changes that occurred in the monetary and banking sectors. We also examine the changes in relation to the exchange-rate regime, which was part of the external-sector reforms. In Section I, a brief review of the developments in the three sectors in the 1980s is given. Section II outlines in some detail the measures introduced in the first few years after the launch of the reforms. Section III is devoted to the developments over the last decade and a half. Section IV provides an assessment.
I. Developments in the 1980s
Developments in the monetary and banking sectors in the 1980s were a prelude to the reforms that happened post 1991. They were in the same direction but were not as fundamental as the 1991 reforms. In the monetary sector, the 1980s saw a shift in focus. Prior to 1982, the emphasis was on the quantum of credit and its allocation. In the 1980s, attention shifted to larger aggregates such as money supply. The quantum of credit and its allocation became part of an overall picture. It was realized that inflation control required regulation of money supply and the regulation of money supply, in turn, required an understanding with the government on the quantum of government borrowing and its monetization. The Chakravarty Committee, which reported in 1985, outlined an approach to money-supply growth. The targeted growth rate in money supply was related to the expected increase in real income and the acceptable level of inflation. Obviously, such an approach rested on a stable-demand function for money and, therefore, on a reasonably constant
income elasticity of demand for money. This approach, which was accepted, could broadly be described as ‘flexible monetary targeting’. The Chakravarty Committee assumed that the administered structure of interest rates would continue. However, it outlined some principles on the basis of which the deposit rates and consequently the lending rates could be prescribed. In fact, a very serious attempt was made to reduce the complex structure of the administered interest rates. By September 1990, the number of prescribed slabs was drastically reduced. The decade also saw the introduction of a number of money-market instruments and the menu of financial products available expanded.
In the banking sector, while broadly the structure remained the same, there was an attempt to look at the quality of assets and classify them based on quality. Attempts were also made to streamline the administration of priority-sector credit. Computerization of the banking operations made its beginning.
With respect to exchange-rate management, the system continued to remain the same as it was in the beginning of the 1980s and that was to relate the rate to a basket of currencies with a band. However, two important changes occurred. The adjustment of exchange rate was frequent and an attempt was made to ensure that the exchange rate of the rupee in real terms did not appreciate. Thus the nominal value of the rupee depreciated significantly in view of the higher level of inflation in India. Second, in order to assess the value of the rupee, the Reserve Bank of India (RBI) for the first time computed the Nominal Effective Exchange Rate (NEER) and the Real Effective Exchange Rate (REER).
II. Reforms between 1991–1997
Monetary Sector Reforms
The institutional framework within which monetary policy operated underwent several changes. The most important change was the phasing out of the system of the issue of ad hoc treasury bills by the government to the RBI. Under that system, whenever the cash balances of the Government of India fell below a particular level, it could issue these ad hoc treasury bills and replenish its cash balances. This innocuous arrangement had the effect of automatically monetizing the fiscal deficit of the central government. Under such an arrangement, the RBI virtually lost control over the regulation of money supply. The fiscal dominance was complete. I had argued even prior to 1991 to do away with this system. As governor, I pressed the finance minister to make this change and he readily agreed. This may indeed be considered as the first step towards giving autonomy to the RBI in relation to the conduct of monetary policy. This was followed up later when the Fiscal Responsibility and Budget Management Act, 2003, put an end to the RBI entering the primary market in government securities. These are essential reforms to enable the RBI to regulate liquidity in the system according to its judgement. Coupled with the decision to phase out the system of ad hoc treasury bills was the decision to compel the government to go to the market and raise funds at market-determined rates. The statutory liquidity ratio, which is the proportion of deposits to be kept by banks in the form of government securities, was also brought down steadily from 38.5 per cent in 1991 to 25 per cent by 1996. As a consequence, an elaborate system for auctioning of government bonds of various maturities had to be put in place. The system of primary dealers in government securities was also introduced. The most important consequence of this move for monetary policy was that open-market operations emerged for the first time as an instrument of monetary control. So long as rates of interest on government bonds were artificially fixed, there was no scope for open-market operations to be used as an instrument of credit control. Under those circumstances, the cash-reserve ratio became the primary instrument of credit control. Yet another change was the dismantling of the administered structure of interest rates. With the freeing of the interest-rate structure, the bank rate also became a potential instrument of credit control. If today we are able to talk in terms of the repo rate, which is only a cousin of bank rate as a signal rate, the foundation for that was laid in the early years of the reform period. There is a continuing debate on what the objectives of monetary policy should be. However, the instrumental freedom which is necessary for the conduct of monetary policy was achieved in the early years of the reform process.
Banking Sector Reforms
The Indian banking system, as it was in 1990, was dominated by two features. First, the public sector accounted for the bulk of the banking assets. Second, it operated under a heavily controlled regime. It had evolved in an environment of administered interest rates and stipulations on asset allocation. Growth of the banking system during the first two decades after the nationalization of banks in 1969 was marked by a spectacular spread of banking with an increase in the number of branches from 8187 in 1969 to 59,752 at the end of March 1990. The growth of rural branches was even faster, increasing from 1443 in 1969 to 34,791 as at the end of March 1990. While the banking sector widened its reach, its own health had got impaired. Low operational efficiency contributed to low profitability and consequently to erosion of its capital base. There was therefore an urgent need to address the issue and the move towards reforms was a natural corollary. A committee was set up under the chairmanship of M. Narasimham which had recommended the steps to be taken to revitalize the banking system. A set of prudential norms relating to income recognition, asset classification, provisioning and capital adequacy were introduced. Prudential and capital-adequacy norms were prescribed to ensure the safety and soundness of the system. In line with international standards, the public-sector banks were required to progressively achieve a capital to risk assets ratio of 8 per cent. A frequently asked question at that time was since these banks were owned by government, whether there was a need to prescribe norms such as the capital-adequacy ratio. Prudential norms are required to make the system stand on its own strength. The imposition of the capital-adequacy norms required the government, which owned the public-sector banks, to contribute to capital in order to reach the prescribed ratio. This was indeed a difficult task at a time when the government as part of its fiscal-policy reforms was trying to contain fiscal deficit. But the government did not flinch and for over several years, it continued to contribute to the capital of the public-sector banks. The term ‘non-performing assets’ was unknown in India till 1991. The RBI progressively tightened the definition of what constitutes a non-performing asset.
Three other important changes in relation to the banking system must also be noted. First, the Nationalization Act was amended to enable the government to reduce its share of holding in the public-sector banks to 51 per cent. This was indeed a difficult legislation. The members of the Congress party had a sentimental attachment to the nationalization of banks. However, the public character of the institutions was maintained as the majority holding was still in the hands of the government. But the induction of the private sector into the ownership structure had its own effect in terms of performance. Second, reforms in the banking sector would not be of any avail unless the administered structure of interest rates was dismantled. With interest rates stipulated by the RBI, there was hardly any competition. But the dismantling had to be done in a measured way so that banks could get adjusted to the new regime. It took almost two to three years before we could move to a system in which the banks had the freedom to determine the deposit and lending rates. Third, in order to create a more competitive environment in the banking system, after several decades, licences were granted to the private sector to open new banks, with new norms set for the opening of banks. Initially, long-term lending institutions that were already in existence were given licences to open banks.
The introduction of prudential norms did create an uncomfortable situation for the banks. Several of the public-sector banks had to show losses. This was indeed a traumatic experience. As the reforms were introduced, profitability and efficiency increased and the non-performing-asset ratio progressively came down. Care was taken to ensure that the social content of lending was not reduced. The Indian banking system has emerged considerably stronger because of the changes introduced.
External Sect
or Reforms
The external sector went through a complete regime change. This is to be expected since the crisis itself was triggered by an acute balance-of-payments problem. The reform of the external sector comprised two elements. The first related to changes in the trade sector. Quantitative controls over imports were being removed step by step. The tariff rates were also brought down steadily from the high levels at which they stood at that time. The changes in the trade sector signalled the movement away from an inward-looking approach to the adoption of an open policy of integrating with the rest of the world. The second element in the external-sector reforms related to the changes in exchange-rate management. The steep devaluation effected in early July 1991 was followed by the introduction of the exim scrip scheme which enabled exporters to import a certain percentage of their export earnings without restrictions. This effectively meant a selective devaluation. In 1991, the government appointed a High Level Committee on Balance of Payments under my chairmanship to look at the capital account of India’s balance of payments. Apart from recommendations relating to the management of capital account, the committee also made key recommendations with respect to exchange rate. Based on the recommendations of the interim report of this committee and other inputs, the government and the RBI moved to a dual exchange-rate system in March 1992. Until that time, the exchange value of the rupee was determined by the RBI every day. Under the new system, 40 per cent of the current receipts were required to be surrendered to the RBI at an official exchange rate while the rest was allowed to be sold at the market-determined exchange rate. The high-level committee in its final report recommended the adoption of a unified market-determined exchange-rate system. In fact, the experience with the dual exchange-rate system provided courage to move to a full-fledged market-determined exchange-rate system. Under the dual exchange-rate system, while the official rate continued to be Rs 25.80 per dollar, the market rate ranged between Rs 30 to Rs 31.50 per dollar. In March 1993, we moved to a unified market-determined exchange-rate system. In fact, the transition was smoother than expected. Though the rupee weakened a bit immediately after the Budget, subsequently the rupee strengthened and a remarkable stability was seen in the behaviour of the exchange rate which remained steady at the level of Rs 31.37 against the US dollar for a long period. This new system that was introduced did not preclude intervention by the RBI. In the context of the reasonably good capital flows, the value of the rupee remained stable because of the intervention of the RBI in the market which resulted in the accumulation of foreign-exchange reserves. There was a compelling necessity at that time to raise the level of the reserves. The RBI from time to time has clarified its position regarding the policy of intervention. Post 1992-93, it must be said that the balance-of-payments position of India has remained strong, unlike what it used to be prior to 1991. Though the system that was adopted is described as ‘managed float’, it nevertheless remains mostly determined by the demand and supply of foreign exchange. The Indian rupee became convertible on the current account in 1994.
