UNIVERSITY OF MUMBAI

PROJECT ON

CHANGING ROLE OF CENTRAL BANK IN DEVELOPING

ECONOMY – A CASE STUDY OF INDIA

SUBMITTED BY
LAVINA .H. UDASSI

PROJECT GUIDE
PROF. MRS. SUNITI NAGPURKAR

BACHELOR OF MANAGEMENT STUDIES

SEMESTER V
(2009-2010)

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE,

SINDHI COLONY, CHEMBUR – 400071

1
 UNIVERSITY OF MUMBAI

PROJECT ON
CHANGING ROLE OF CENTRAL BANK IN DEVELOPING
ECONOMY – A CASE STUDY OF INDIA

Submitted
In Partial Fulfillment of the requirements
For the Award of the Degree of
Bachelor of Management
By
LAVINA .H. UDASSI

PROJECT GUIDE
PROF. MRS. SUNITI NAGPURKAR

BACHELOR OF MANAGEMENT STUDIES

SEMESTER V
(2009-2010)

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE,

SINDHI COLONY, CHEMBUR – 400071

2
 Declaration

I, LAVINA .H. UDASSI student of BMS – Semester V (2009-2010)

hereby declare that I have completed this project on CHANGING
ROLE OF CENTRAL BANK IN DEVELOPING ECONOMY – A
CASE STUDY OF INDIA.

The information submitted is true & original to the best of my

knowledge.

Student’s Signature
LAVINA .H. UDASSI
Name of Student

3
 CERTIFICATE

This is to certify that Ms. LAVINA .H. UDASSI of TYBMS has

successfully completed the project on CHANGING ROLE OF
CENTRAL BANK IN DEVELOPING ECONOMY – A CASE
STUDY OF INDIA under the guidance of PROF. MRS. SUNITI
NAGPURKAR.

Project Guide Principal

Prof. Mrs. Suniti Nagpurkar Dr. (Mrs) J. K. Phadnis

Course Co-ordinator
Mrs. A. Martina

External Examiner

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 ACKNOWLEDGEMENT

It gives me great pleasure to submit this project to the University of Mumbai as a part of
curriculum of my BMS course. I take this opportunity with great pleasure to present before you
this project on “CHANGING ROLE OF CENTRAL BANK IN DEVELOPING ECONOMY
– A CASE STUDY OF INDIA” which is a result of co-operation, hard work and good wishes
of many people.

I would like to thank Mrs. J. K. Phadnis, Principal of V.E.S College of Arts, Science &
Commerce and Prof. Mrs. Martina, BMS Co-ordinator for enabling me to take up this
project. Also, I would like to thank my project guide Prof. Mrs. Suniti Nagpurkar for her
friendly guidance, constant involvement and handful information in my project.

I would also like to appreciate contribution of my family and friends who have extended their
complete support in completion of this project.

Last but not the least; I am thankful to Mr. Kunal Jadhwani, Financial Analyst for his constant
support and library staff for providing books related to this project.

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 Executive Summary
India is a democratic country where economy plays a very important role. The economy
was characterized by extensive regulation, protectionism, and public ownership, leading to
pervasive corruption and slow growth. Since 1991, continuing economic liberalization has
moved the economy towards a market-based system.

The Indian economy has undergone substantial changes since the introduction of
economic reforms in 1991. They included various measures like deregulating the markets and
encouraging private participation; trade liberalization; dismantling the restrictions on domestic
and foreign investments; reforming the financial sector and the tax system, etc.

Today, Banking is also an important factor in Indian Financial System. The banking
system in India has undergone significant changes during last 16 years. There have been new
banks, new instruments, new windows, new opportunities and, along with all this, new
challenges. While deregulation has opened up new vistas for banks to augment incomes, it has
also entailed greater competition and consequently greater risks.

Central banking is the responsibility of the Reserve Bank of India, which in 1935
formally took over these responsibilities from then Imperial Bank of India, relegating it to
commercial banking functions. After India's independence in 1947, the Reserve Bank was
nationalized and given broader powers.

The Reserve Bank of India has achieved transparency in its operations, especially in
terms of evolving communication policy aimed at addressing a wide range of audiences.
Notwithstanding the changing challenges of different regimes, the Reserve Bank has managed to
evolve constructively on a continuous basis to cope with demands for stable macroeconomic
management and financial stability, while meeting the objectives of economic growth and
development. As the economy becomes increasingly open and global, the role of the Reserve
Bank will undergo further change and it will need to equip it for coping with these emerging
challenges on a continuous basis.

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 INDEX
Sr no. Chapter Title Pg. no.
no.
1 I Introduction 1–6

1.1 Indian Economy 1–2

1.2 Banking 3–4

1.3 Different periods of Banking Sector 5–6

2 II Indian Financial System 7 – 15

2.1 Financial sector & its importance 8–9

2.2 Measures 10 – 11

2.3 Changing role of RBI in financial sector 12 – 15

3 III Introduction to Central Bank in India 16 – 20

3.1 Reserve Bank of India 16 – 18

n

3.2 Functions 18

3.3 Role 19 – 20

4 IV Monetary Policy & its objectives 21 – 26

5 V Techniques of monetary control used by RBI 26 – 38

5.1 Open Market Operations 27 – 29

5.2 Repo rate and Reverse Repo rate 29 – 30

5.3 Bank rate

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 31
5.4 Cash Reserve Ratio
32 – 34
5.5 Statutory Liquidity Ratio
35 – 37
5.6 Interest Rate
38

6 VI Equities in India
39 – 45
6.1 Introduction of Sensex for 10 years
39 – 40
6.2 Picture of GDP
40 – 41
6.3 RBI: Review on Bank Financing of equities
41 – 45

7 VII Crisis & India

46 – 55
7.1 Introduction of Crisis
46 – 47
7.2 Various actions taken by RBI
47 – 50
7.3 Challenges forward to be faced by RBI
51 – 55

8 VIII Inflation in India

56 – 65
8.1 Introduction
56 – 57
8.2 Steps taken by RBI to control it
58 – 61
8.3 Observations & Suggestions
62 – 65

9 IX Conclusion
66
10 X Bibliography

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 CHANGING ROLE OF CENTRAL BANK IN
DEVELOPING ECONOMY – A CASE STUDY OF INDIA

9
 CHAPTER I
Introduction to Indian Economy

The economy of India is the twelfth largest in the world by market exchange rates and the
fourth largest in the world by GDP, measured on a purchasing power parity (PPP) basis. The
country was under socialist-based policies for an entire generation from the 1950s until the
1980s. The economy was characterized by extensive regulation, protectionism, and public
ownership, leading to pervasive corruption and slow growth. Since 1991, continuing economic
liberalization has moved the economy towards a market-based system.

Previously a closed economy, India's trade has grown fast. According to the WTO India
currently accounts for 1.5% of World trade as of 2007. According to the World Trade Statistics
of the WTO in 2006, India's total merchandise trade (counting exports and imports) was valued
at $294 billion in 2006 and India's services trade inclusive of export and import was $143 billion.
Thus, India's global economic engagement in 2006 covering both merchandise and services trade
was of the order of $437 billion, up by a record 72% from a level of $253 billion in 2004. India's
trade has reached a still relatively moderate share 24% of GDP in 2006, up from 6% in 1985.

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 The Indian economy has undergone substantial changes since the introduction of
economic reforms in 1991. These reforms were a comprehensive effort consisting of three main
components namely, liberalization, privatization and globalization. They included various
measures like deregulating the markets and encouraging private participation; trade
liberalization; dismantling the restrictions on domestic and foreign investments; reforming the
financial sector and the tax system, etc. All such policy initiatives radically changed the
economic set-up of the country and integrated it with the rest of the world. Thus, India was
placed in a globally competitive position so as to fully utilize its potentials and opportunities for
rapid growth of the economy.

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 Introduction to Banking
Banking in India originated in the last decades of the 18th century. The oldest bank in
existence in India is the State Bank of India, a government-owned that is the largest commercial
bank in the country. Central banking is the responsibility of the Reserve Bank of India, which in
1935 formally took over these responsibilities from then Imperial Bank of India, relegating it to
commercial banking functions. After India's independence in 1947, the Reserve Bank was
nationalized and given broader powers. In 1969, the government nationalized the 14 largest
commercial banks; the government nationalized the six next largest in 1980.

Currently, India has 88 scheduled commercial banks (SCBs) - 27 public sector banks
(that is with the Government of India holding a stake), 31 private banks (these do not have
government stake; they may be publicly listed and traded on stock exchanges) and 38 foreign
banks. They have a combined network of over 53,000 branches and 17,000 ATMs.

The banking system in India has undergone significant changes during last 16 years.
There have been new banks, new instruments, new windows, new opportunities and, along with
all this, new challenges. While deregulation has opened up new vistas for banks to augment
incomes, it has also entailed greater competition and consequently greater risks. India adopted
prudential measures aimed at imparting strength to the banking system and ensuring its safety
and soundness, through greater transparency, accountability and public credibility.

Our banking sector reform has been unique in the world in that it combines a
Comprehensive reorientation of competition, regulation and ownership in a non disruptive and
cost-effective manner. Indeed our banking reform is a good illustration of the dynamism of the
public sector in managing the overhang problems and the pragmatism of public policy in
enabling the domestic and foreign private sectors to compete and expand. There has been no
banking crisis in India.

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 The Government took steps to reduce its ownership in nationalized banks and inducted
private ownership but without altering their public sector character. The underlying rationale of
this approach is to assure that the salutary features of public sector banking was not lost in the
transformation process. On account of healthy market value of the banks’ shares, the capital
infusion into the banks by the Government has turned out to be profitable for the Government.

Banking Sector between 1947 -1969

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 During the first phase the growth was very slow and banks also experienced periodic
failures between 1913 and 1948. There were approximately 1,100 banks, mostly small. To
streamline the functioning and activities of commercial banks, the Government of India came up
with The Banking Companies Act, 1949 which was later changed to Banking Regulation Act
1949 as per amending Act of 1965. Reserve Bank of India was vested with extensive powers for
the supervision of banking in India as the Central Banking Authority. During those day’s public
has lesser confidence in the banks. As an aftermath deposit mobilization was slow. Abreast of it
the savings bank facility provided by the Postal department was comparatively safer. Moreover,
funds were largely given to traders.

Banking Sector between 1969 -1991

Government took major steps in this Indian Banking Sector Reform after independence.
In 1955, it nationalized Imperial Bank of India with extensive banking facilities on a large scale
especially in rural and semi-urban areas. It formed State Bank of India to act as the principal
agent of RBI and to handle banking transactions of the Union and State Governments all over the
country

Seven banks forming subsidiary of State Bank of India was nationalized in 1960 on 19th
July, 1969, major process of nationalization was carried out. It was the effort of the then Prime
Minister of India, Mrs. Indira Gandhi. 14 major commercial banks in the country were
nationalized.

Second phase of nationalization Indian Banking Sector Reform was carried out in 1980
with seven more banks. This step brought 80% of the banking segment in India under
Government ownership. After the nationalization of banks, the branches of the public sector
bank India rose to approximately 800% in deposits and advances took a huge jump by 11,000%.
Banking in the sunshine of Government ownership gave the public implicit faith and immense
confidence about the sustainability of these institutions.

Banking Sector from 1991 onwards

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 This phase has introduced many more products and facilities in the banking sector in its
reforms measure. In 1991, under the chairmanship of M. Narasimha, a committee was set up by
his name which worked for the liberalization of banking practices. The country is flooded with
foreign banks and their ATM stations. Efforts are being put to give a satisfactory service to
customers. Phone banking and net banking is introduced. The entire system became more
convenient and swift. Time is given more importance than money.

The financial system of India has shown a great deal of resilience. It is sheltered from any
crisis triggered by any external macroeconomics shock as other East Asian Countries suffered.
This is all due to a flexible exchange rate regime, the foreign reserves are high, the capital
account is not yet fully convertible, and banks and their customers have limited foreign exchange
exposure.

The industrial sector has been going through a process of restructuring and consolidation
after liberalization. The industries have responded to the reforms through mergers and
acquisitions, adoption of cost cutting measures, foreign collaboration, technology up gradation
and outward orientation in sectors such as cement, steel, aluminium, pharmaceuticals, and
automobiles. Industrial growth increased sharply in the first five years after the reforms, but then
slowed to an annual rate of 4.5 percent in the next five years. From low growth rate of 2.7 per
cent in 2001-02, the industry sector grew at a rate of 7.1 per cent in 2002-03 and further to 9.8
per cent in 2004-05.There has been steady and continuous rise in supply of money in the
economy since initiation of reforms. Reserve Money has increased from Rs.99, 505 crores in
1991-92 to Rs.573066 crores in 2005-06.

Performance of the Indian economy on the inflation front, with price stability as one of
the prime objectives of the reform process has been satisfactory, particularly after the mid 1990s.
The annual average inflation rate based on Wholesale Price Index (WPI) was 10.6 per cent
between 1991-96, which fell down to 5.1 per cent in the period 1996-2001 and then to 4.7 per
cent in 2001-06.

15
 Indian

Financial
Indian Financial System

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16
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CHAPTER II

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 Financial Sector
The Indian financial system of the pre-reform period, before 1991, essentially catered to
the needs of planned development in a mixed-economy framework, where the Government
sector had a predominant role in economic activity. Interest rates on Government securities were
artificially pegged at low levels, which were unrelated to the market conditions. The system of
administered interest rates was characterized by detailed prescriptions on the lending and the
deposit side, leading to multiplicity and complexity of interest rates.

Consequently, by the end of the eighties, directed and concessional availability of bank
credit to certain sectors adversely affected the viability and profitability of banks. Thus, the
transactions of the Government, the Reserve Bank and the commercial banks were governed by
fiscal priorities rather than sound principles of financial management and commercial viability. It
was then recognized that this approach, which, conceptually, sought to enhance efficiency
through a co-ordinate approach, actually led to loss of transparency, accountability and incentive
to seek efficiency.

Need and importance of financial sector

The New Economic Policy (NEP) of structural adjustments and stabilization programme
was given a big thrust in India in June 1991. The financial system reforms have received special
attention as a part of this policy because of the perceived interdependent relationship between the
real and financial sectors of the modern economy.

The need for financial reforms had arisen because the financial institution and markets
were in a bad shape. The banking sector suffered from lack of competition, low capital base, low
productivity, and high intermediation costs. The role of technology was minimal, and the quality
of service did not receive adequate attention. Proper risk management system was not followed,
and prudential norms were weak. All these resulted in poor assets quality. Development
financial institutions operated in an over – protected environment with most of the funding
coming from assured sources. There was little competition in insurance and mutual funds
industries. Financial markets were characterized by control over pricing of financial assets,
barriers to entry, and high transactions costs. The banks were running either at a loss or on very

17
low profits, and, consequently were unable to provide adequately for loan defaults, and build
their capital.

There had been organizational inadequacies, the weakening of management and control
functions, the growth of restrictive practices, the erosion of work culture, and flaws in credit
management. The strain on the performance of the banks had emanated partly from the
imposition of high Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR) and directed
credit programmes for the priority sectors - all at below market or concessional or subsidized
interest rates. This, apart from affecting bank profitability adversely, had resulted in the low or
repressed or depressed interest rates on deposits and in higher interest rates on loans to the larger
borrowers from business and industry.

Further, the functioning of the financial system, and the credit delivery as well as
recovery process had become politicized, which damaged the quality of lending and the culture
of repaying loans. The widespread write-offs of the loans had seriously jeopardized the viability
of banks. As the closure of sick industrial units was discouraged by the government, banks had
to continue to finance non-viable sick units, which further compromised their own viability. The
legal system was not of much help in recovering loans. There was a lack of transparency in
preparing statements of accounts by banks.

In other words, the reforms had become imperative on account of the facts that despite its
impressive quantitative growth and achievements, the financial health, integrity, autonomy,
flexibility, and vibrancy in the financial sector had deteriorated over the past many years. The
allocation of resources had become severely distorted, the portfolio quality had deteriorated, and
productivity, efficiency and profitability had been eroded in the system. Customer service was
poor, work technology remained outdated, and transaction costs were high. The capital base of
the system remained low, the accounting and disclosure practices were faulty, and the
administrative expenses had greatly soared. The system suffered also from a lack of delegation
of authority, inadequate internal controls and poor housekeeping.

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Measures
For a long time, an alarming increase of sickness in the Indian financial system had
required urgent remedial measures or reforms which were introduced in 1991.

Main and sub-objectives of financial reforms introduced in 1991:

(i) To develop a market-oriented, competitive, world-integrated, diversified, autonomous,

transparent financial system.

(ii) To increase the allocative efficiency of available savings and to promote accelerated
growth of the real sector.

(iii) To increase or bring about the effectiveness, accountability, profitability, viability,

vibrancy, balanced growth, operational economy and flexibility, professionalism and
depoliticisation in the financial sector.

(iv) To increase the rate of return on real investment.

(v) To promote competition by creating level-playing fields and facilitating free entry and exit
for institutions and market players.

(vi) To ensure that the rationalization of interest rates structure occurs, that interest rates are
flexible, market-determined or market-related, and that the system offers to its users a
reasonable level of positive real interest rates. In other words, the goal has been to
dismantle the administered system of interest rates.

(vii) To reduce the levels of resource pre-emptions and to improve the effectiveness of directed
credit programmes.

(viii) To build a financial infrastructure relating to supervision, audit, technology, and legal
matters.

(ix) To modernize the instruments of monetary control so as to make them more suitable for the
conduct of monetary policy in a market economy i.e. to increase the reliance on indirect or
market-incentives based instruments rather than direct or physical instruments of monetary
control.

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 The key words describing reforms have been liberalization, deregulation, marketisation,
privatization, and globalization, all of which convey reforms objectives in a clear manner. The
basic premise underlying the reforms has been that the state ownership and regulation have
harmed the financial system, particularly the banks and the investors, and that such regulation is
no longer relevant and adequate. To use the well-known academic terminology, the objective of
financial reforms has been to correct and eliminate financial repression; and to transform a
financially repressed system into a free system.

Financial sector reforms are said to be grounded in the belief that the competitive
efficiency in the real sectors of the economy cannot be realized to its full extent unless the
allocative efficiency of the private sector was improved. The main thrust of financial sector
reforms was on the creation of efficient and stable financial institutions and markets, the removal
if structural bottlenecks, introduction of new players and instruments, introduction of free pricing
of financial assets, relaxation of quantitative restrictions, improvement in trading, clearing and
settlement practices, promotion of institutional infrastructure, refinement of market micro-
structure, creation of liquidity, depth, and the efficient price discovery process, and ensuring
technological up gradation.

Impact of Financial Reforms

The reform process appears to have yielded some positive results at least in the banking
sector as reflected in the relatively cleaner balance sheets of banks, reduction in non-performing
assets in relative terms, improvement in operating profits, and fairly good progress in attaining
capital adequacy ratio and other prudential norms. The operating profits of 27 public sector
banks improved from Rs 3135 crores in 1992-93 to Rs 3, 696 crores in 1993-94, Rs 5, 629 crores
in 1994-95, and Rs 7, 569 crores in 1995-96, and Rs 29, 715 crores in 2002-03.

The non-performing assets of NBFCs have increased substantially in the immediate past.
After a brief period of great strides, the mutual fund industry has come to be afflicted by a host
of serious problems. The funds mobilized by them have declined drastically over the reform
period. The net asset values of their various schemes have declined. The volume of fresh capital
raised on the primary stock market has declined significantly. The secondary market reforms

20
have not really progressed because of the recalcitrance of market operators and SEBI’s lack of
will. The stock markets are plagued by uncommonly high number of drawbacks, weaknesses,
malpractices and so on.

Changing Role of RBI in financial sector

Having talked about financial sector and the ongoing reform process in the sector, let us
now turn our attention to what exact role RBI is playing for the financial sector in general and
the financial reform process in particular. As all of us know, RBI is the central bank of the
country. Central banks are very old institutions. The Bank of England was set up way back in
1694, the Bank of France is more than 200 years old and the Federal Reserve Bank was set up in
1913. As aptly stated by our Governor, Dr. Bimal Jalan, although RBI, set up in 1935, may
appear a ‘toddler or at most a young adult’, it is one of the oldest central banks among the
developing world. Traditionally, central banks have performed roles of currency authority,
banker to the Government and banks, lender of last resort, supervisor of banks and exchange
control (now it would be more appropriate to call it exchange management) authority. Generally,
central banks in developed economies have price or financial stability as their prime objective.

The RBI has the twin objectives of maintaining price stability and promoting growth. The
objectives are as follows:

1. Provision of adequate liquidity to meet credit growth and support investment demand in the
economy while continuing a vigil on movements in the price level.
2. In line with the above to continue the present stance on interest rates including preference for
soft interest rates.
3. To impart greater flexibility to the interest rate structure in the medium-term

In developing economies, however, the growth objective assumes greater importance.

Recent experience has shown that during recessionary or deflationary conditions achievement of
12 higher growths becomes the dominant objective of central banks, both in developing and
developed economies. Let us now look at the evolution of RBI and its changing role and strategy
over time. RBI was set up to regulate the issue of currency and keep reserves with a view to

21
securing monetary stability in India and generally to operate the currency and credit system of
the country to its advantage (RBI Act, 1934). Within these overall objectives, RBI performs a
wide range of promotional functions, which are designed to support the country’s efforts to
accelerate the pace of economic development with social justice. In keeping with the overall
logic of reforms that market based allocation rather than directed allocation of resources led to
greater efficiency, the functions of the RBI have undergone a strategic shift under the current
reforms. The strategy shifted from controlling institutions and markets to facilitation of efficient
functioning of markets and strengthening of the supporting institutional infrastructure. The
preemptions in the form of CRR and SLR have been progressively reduced. The scope of priority
sector has been expanded.

The interest rate has been deregulated both on deposits and advances. From conservation
of foreign exchange through control of transactions, the focus has shifted to facilitation of
foreign exchange transactions. Intervention in the foreign exchange market has shifted from
fixing of exchange rate to merely curbing speculative volatility. Stability issues came to the fore
especially after the crises in South East Asian countries in late 1990s. The RBI progressively
strengthened prudential regulation relating to capital adequacy, income recognition, asset
classification, provisioning, disclosures and transparency. Furthermore, institutional
strengthening was undertaken to ensure the progressive development and integration of the
securities, money and forex markets. The RBI has made significant improvements in the quality
of performance of regulatory and supervisory functions. Our standards 13 are comparable to the
best in the world. Attention is being paid to several contemporary issues such as, relative roles of
onsite and off-site supervision, functional versus institutional regulation, relative stress on
internal management, market discipline and regulatory prescriptions, consolidated approach to
supervision, etc. Several legislative initiatives have also been taken up with Government,
covering procedural law, debt recovery systems, Credit Information Bureau, Deposit Insurance,
etc.

Progress in these is critical for effectiveness of RBI in the regulatory sphere. A recent
important legislative development, which will improve the momentum of recovery of dues, is the
enactment of Securitization and Reconstruction of Financial Assets and Enforcement of

22
Security Interest (SRFAESI) Act. Under this Act RBI has been entrusted with the role of
stipulating suitable norms for registration of securitization or reconstruction companies,
prescribing prudential norms, recommending proper and transparent accounting and disclosure
standards and framing appropriate guidelines for the conduct of asset reconstruction and
securitization.

Financial liberalization has heightened competition among banks, and between banks and
other financial institutions. But competition has engendered certain serious problems. For
example, the distinction between commercial banking, investment banking, development
banking, other specialized institutions, and manufacturing corporate is getting blurred. Banks
are entering into para-banking and other financial services; development financial institutions,
mutual funds and insurance companies are entering into banking and each other’s fields; and
manufacturing corporate are entering into banking and financial activities. Financial reforms
have given rise to new issues of financial industry structure, systematic or social costs of
oligopoly.

The market-based exchange rate system has helped to open up the Indian economy, and
to integrate it with the rest of the world. But the exchange rate has become far more volatile; it
has become subject to severe external pressures; its management has become difficult; and there
has been a partial loss of autonomy of domestic monetary policy.

The primary impulses for establishing central banks in many parts of the world in the
twentieth century emanated from exigency of financing wars. The necessity to finance wars also
led to nationalization of many of the early central banks, which were functioning as private
entities. Central banking efforts in India after independence were geared towards mobilizing
resources for planned economic development and ensuring price stability. Central bank mandates
in developing countries such as India have gone well beyond typical central banking functions to
encompass a wide range of developmental pursuits in order to promote economic growth.

Central banking was initially practiced with a large number of informal norms,
conventions and self-imposed codes of conduct. Instituting a medium of exchange and currency
management along with monetary policy had been globally in focus till the Great Depression.

23
 With the passage of time, however, central banks took over a whole range of functions,
becoming multi-tasking institutions that conduct monetary policy, regulate and supervise the
banking system and perform a crucial role in the payment system. Crisis situations that emerged
from time to time led to redefining of central bank mandates.

The role of the lender of last resort evolved over-time and enlarged into that of the
regulator and supervisor, as also the custodian of financial stability. This gained credence in the
face of danger of contagion as economies got integrated. The necessity to manage government
debt emanated from the historic reasons of financing wars. The hazards of financing the
persistent government deficits were, however, well recognized and such financing is being
increasingly avoided. In the wake of South-East Asian crisis of 1997, many central banks in
developing countries initiated financial reforms. In this direction, central banks also played a
vital role in development of the financial markets to strengthen the monetary policy transmission
channels. Institutional development has been one of the major objectives of central banks in
developing economies in order to spread the umbrella of organized credit in such economies.
The functions of the Reserve Bank of India have been changing over time as it has responded to
the emerging requirements of the macro economy and continuously diversifying financial
system.

Central banks around the world have been vested with a variety of additional
responsibilities such as preparing macroeconomic data-bases, data dissemination, putting in
place advanced clearing systems, coordinating with the international agencies, undertaking
policy-oriented research activities and bridging gaps in information.

24
 CHAPTER III
Reserve Bank of India
The RBI, as the central bank of the country, is the centre of the Indian financial and
monetary system. As an institution, it has been guiding, monitoring, regulating, controlling, and
promoting the destiny of the Indian financial system. However, it is an oldest among the central
banks in the developing countries. It started functioning from April 1, 1935 on the terms of the
Reserve Bank of India Act, 1934. It was a private shareholders institution till January 1949, after
which it became a State-owned institution under the Reserve Bank of India Act, 1948. The share
capital was divided into shares of Rs. 100 each fully paid which was entirely owned by private
shareholders in the beginning. The Government held shares of nominal value of Rs. 2, 20,000.

25
 The Bank is managed by a Central Board of Directors, four Local Boards of Directors,
and a committee of the central board of directors. The functions of the Local Boards are to
advise the Central Board on matters referred to them. The final control of the Bank vests in the
Central Board which comprises the Governor, four Deputy Governors, and fifteen Directors
nominated by the Central government.

26
 The internal organizational set-up of the Bank has been modified and expanded from
time to time in order to cope with the increasing volume and range of the Bank’s activities. The
principle of the internal organization is functional specialization with adequate coordination.

During the war and post-war years, the major preoccupation of the Bank was facilitation
of war finance, repatriation of sterling debt and planning and administration of exchange control.
The issues relating to regulation and supervision of banks came to occupy centre-stage in the
backdrop of a number of bank failures. The Banking Companies Act was enacted in 1949 to
empower the Reserve Bank with supervisory control over banks in order to ensure their
establishment and operation along sound lines. The Reserve Bank of India was nationalized on
January 1, 1949.

With the launch of Five-Year Plans in 1951, the Reserve Bank’s functions became more
diversified in terms of Plan financing, establishment of specialized institutions to promote
savings and investment in the Indian economy and to meet credit requirements of the priority
sectors. This was a novel feature for any central bank at that point of time. The Agricultural
Refinance Corporation was set up in 1963 for extending medium and long-term finance to
agriculture. Other institutional developments included setting up of the Industrial Finance
Corporation of India (1948), the Industrial Development Bank of India (1964) and Unit Trust of
India (1964). The role of monetary and credit policy in maintaining price stability was explicitly
emphasized for the first time in the First Five Year Plan. Plan financing by the Reserve Bank
evolved as deficit financing which took the form of system of issuance of ad hoc Treasury Bills.
This arrangement of financing the Government was intended to be temporary but acquired a
permanent character over time.

Devaluation of the rupee in June 1966 and nationalization of fourteen private sector
banks in July 1969 multiplied the responsibilities of the Reserve Bank. The move helped to
bridge the gaps in credit availability in many rural and urban areas and ensured sufficient funds
availability to the preferred sectors. In terms of the outcome, this phase succeeded in mobilizing
private savings through the banks and paved the way for nationalization of six more private
sector banks in 1980.

27
 For conserving foreign exchange reserves, the Government re-examined the provisions of
the Foreign Exchange Regulation Act, (FERA) 1947 and introduced changes in 1973 which
incorporated necessary changes for effective implementation of Government policy and
removing difficulties in the working of the existing legislation. In the light of concerns about
capital outflows, reinforced by repeated stress on balance of payments due to drought, war and
oil shocks, the emphasis was placed on utilizing domestic savings for domestic investment, while
continuing to preserve foreign exchange reserves.

Functions of RBI
The RBI functions within the framework of a mixed economic system. With regard to
framing various policies, it is necessary to maintain close and continuous collaboration between
the government and the RBI. In the event of a difference of opinion or conflict, the government
view or position can always be expected to prevail.

Main functions of the RBI

(i) To maintain monetary stability so that the business and economic life can deliver welfare
gains of a property functioning mixed economy.

(ii) To maintain financial stability and ensure sound financial institutions so that monetary
stability can be safely pursued and economic units can conduct their business with
confidence.

(iii) To maintain stable payments system so that financial transactions can be safely and
efficiently executed.

(iv) To promote the development of financial infrastructure of markets and systems, and to
enable it to operate efficiently i.e., to play a leading role in developing a sound financial
system so that it can discharge its regulatory function efficiently.

(v) To ensure that credit allocation by the financial system broadly reflects the national
economic priorities and social concerns.

28
 (vi) To regulate the overall volume of money and credit in the economy with a view to ensure
a reasonable degree of price stability.

Roles of RBI

1. Note Issuing Authority

The RBI has the sole right or authority or monopoly of issuing currency notes other than
one rupee notes and coins, and coins of smaller denominations. The issue of currency notes
is one of its basic functions.

2. Government Banker

The RBI is the banker to the Central and State governments. It provides to the
governments all banking services such as acceptance of deposits, withdrawal of funds by
cheques, making payments as well as receipts and collection of payments on behalf of the
government, transfer of funds, and management of public debt.

3. Banker’s Bank

The RBI, like all central banks, can be called a bankers bank because it has a very special
relationship with commercial and co-operative banks, and the major part of its business is with
these banks. The bank controls the volume of reserves of commercial banks and thereby
determines the deposits creating ability of the banks. The banks hold a part or all of their
reserves with the RBI. Similarly, in times of need, the banks borrow funds from the RBI. It is
therefore, called the bank of last resort.

4. Supervising Authority

The RBI has vast powers to supervise and control commercial and co-operative banks
with a view to developing an adequate and sound banking system in the country. Initially, they
used to give only orders but now it undertakes inspection of commercial banks and recommends
measures. It has the following powers:

(a) To issue licenses for the establishment of new banks and setting up of bank branches.

29
(b) To prescribe minimum requirements regarding paid-up capital and reserves, transfer to
reserve fund, and maintenance of cash reserves and others.

(c) To inspect the working of banks in India as well as abroad in respect of their organizational
setup, branch expansion, mobilization of deposits, investments, and credit portfolio
management, credit appraisal, region-wise performance, profit planning, manpower
planning, and so on.

5. Exchange Control

One of the essential functions of the RBI is to maintain the stability of the external value
of the rupee. It pursues this objective through its domestic policies and the regulation of the
foreign exchange market. As far as the external sector is concerned, the task of the RBI has the
following dimensions:

(a) To administer the foreign exchange control.

(b) To choose the exchange rate system and fix or manage the exchange rate between the
rupee and other currencies.

(c) To manage exchange reserves.

(d) To interact with the monetary authorities of other countries and with international
financial institutions such as IMF.

6. Promoter of the financial system

Apart from performing the functions already mentioned, the RBI has been rendering
developmental services which have strengthened the country’s banking and financial structure.
This has helped in mobilizing savings and directing credit flows to desired channels, thereby
helping to achieve the objective of economic development with social justice.

CHAPTER IV

Monetary Policy

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 Monetary policy is the management of money supply and interest rates by central banks
to influence prices and employment. Monetary policy works through expansion or contraction of
investment and consumption expenditure. Monetary policy is the process by which the
government, central bank, or monetary authority of a country controls (i) the supply of money,
(ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of
objectives oriented towards the growth and stability of the economy.

Monetary policy is referred to as either being an expansionary policy, or a contractionary

policy, where an expansionary policy increases the total supply of money in the economy, and a
contractionary policy decreases the total money supply. Expansionary policy is traditionally used
to stop unemployment in a recession by lowering interest rates, while contractionary policy
involves raising interest rates in order to stop inflation. Monetary policy is contrasted with fiscal
policy, which refers to government borrowing, spending and taxation.

Monetary policy rests on the relationship between the rates of interest in an economy,
that is the price at which money can be borrowed, and the total supply of money. Monetary
policy uses a variety of tools to control one or both of these, to influence outcomes like economic
growth, inflation, exchange rates with other currencies and unemployment. Where currency is
under a monopoly of issuance, or where there is a regulated system of issuing currency through
banks which are tied to a central bank, the monetary authority has the ability to alter the money
supply and thus influence the interest rate.

The beginning of monetary policy as such comes from the late 19th century, where it was
used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size
of the money supply or raises the interest rate. An expansionary policy increases the size of the
money supply, or decreases the interest rate. Furthermore, monetary policies are described as
follows: accommodative, if the interest rate set by the central monetary authority is intended to
create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or
tight if intended to reduce inflation.

On the external front, rupee value has been linked to the market forces. Current account
convertibility was achieved in August 1994. FERA was repealed and replaced by a new
legislation - Foreign Exchange Management Act (FEMA), in 1999. Further, the Exchange

31
Control Department of the Reserve Bank was renamed as Foreign Exchange Department.
Besides, a large number of innovative products and newer players have come to play active role
and new hedging instruments have been introduced, viz., foreign currency-rupee options, etc.
Authorized dealers could use cross-currency options, interest rate and currency swaps,
caps/collars and forward rate agreements (FRAs) in the international forex market.

In the context of monetary policy framework, there has been a greater focus on liquidity
management engendered by the growing integration of financial markets, domestically and
internationally. With the near total deregulation of interest rates, the Bank Rate has been
reactivated since April 1997 as a reference rate and as a signaling device to reflect the stance of
monetary policy. Following the recommendations of the Working Group on Money Supply:
Analytics and Methodology of Compilation (Chairman: Y. V. Reddy), the Reserve Bank has
commenced compilation and publication of four monetary aggregates [M0 (monetary base), M1
(narrow money), M2 and M3 (broad money)]; and introduced three new liquidity aggregates (L1,
L2 and L3) by incorporating deposits with post- office savings banks, term deposits, term
borrowings and certificates of deposits of term lending and refinancing institutions and public
deposits of non-banking financial institutions; broadening of the definition of credit by including
items not reflected in the conventional bank credit; redefining the net foreign assets of the
banking system to comprise banks’ holdings of foreign currency assets net of (a) their holdings
of FCNR(B) deposits and (b) foreign currency borrowings.

With the liberalization of the external sector, the monetary targeting framework came
under stress due to increasing liquidity mainly on account of increased capital inflows,
necessitating a review of the monetary policy framework and the Reserve Bank switched over to
a more broad-based "multiple indicators approach" since 1998 in monetary policy formulation.
The informal monetary policy strategy meetings review the monetary and liquidity conditions
and the process has been made consultative. The Financial Markets Committee (FMC) monitors
the developments in financial markets on a daily basis. The Committee makes quick assessment
of the liquidity conditions and recommends strategies for intervention in the money and
securities markets.

32
 Monetary and credit aggregates have witnessed deceleration since their peak levels in
October 2008. The liquidity overhang emanating from the earlier surge in capital inflows has
substantially moderated in 2008-09. The Reserve Bank is committed to providing ample liquidity
for all productive activities on a continuous basis.

In its mid- term review of monetary policy on October 24, 2008, the Reserve Bank had
indicated that it would closely and continuously monitor the liquidity and monetary situation and
respond swiftly and effectively to the impact of the global developments on Indian financial
markets. The Reserve Bank had also indicated that the challenge for the conduct of monetary
policy is to strike an optimal balance among preserving financial stability, maintaining price
stability and sustaining the growth momentum.

In response to emerging global developments, the Reserve Bank has taken a number of
measures since mid-September 2008. The aim of these measures was to augment domestic and
forex liquidity and to enable banks to continue to lend for productive purpose while maintaining
credit quality so as to sustain the growth momentum.

On a further review of the evolving developments, the Reserve Bank has taken the
following measures:

Enhancing Rupee Liquidity

The special term repo facility, introduced for the purpose of meeting the liquidity
requirements of mutual funds and non-banking finance companies would continue till end-march
2009. Banks can avail of this facility either on incremental or on rollover basis within their
entitlement of up to 1.5 per cent of net demand and time liabilities.

As the upside risks to inflation have declined, monetary policy has been responding to
slackening economic growth in the context of significant global stress. Accordingly, for policy
purposes, money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this,
aggregate deposits of scheduled commercial banks are projected to grow by 18.0 per cent. The
growth in adjusted non-food credit, including investment in bonds/debentures/shares of public
sector undertakings and private corporate sector and CPs, is placed at 20.0 per cent. Given the

33
wide dispersion in credit growth noticed across bank groups during 2008-09, banks with strong
deposit base should endeavour to expand credit beyond 20.0 per cent.

Objectives of monetary policy

The objectives of monetary policy have undergone a change in emphasis over the years.
In the planned economy, they perforce were very much similar to the objectives of economic
planning. Accordingly, the objectives of monetary policy in India were (a) to accelerate
economic development in an environment of reasonable price stability, and (b) to develop
appropriate institutional set-up to aid this process. The key note of monetary policy may be said
to be controlled expansion of bank credit and money supply, with special attention to seasonal
requirements for credit. The Bank has been directing its attention to ensure that credit expansion
takes place in the light of price variations without affecting the output, particularly the industrial
output adversely. In other words, the objective has been one of disinflation without deflation.
The authorities have come to hold that monetary policy is able to make more effective
contribution to price stability than other objectives.

Further, it has come to be believed that by achieving reasonable price stability, it is possible to -

(a) Avoid waste of resources because inflation results in such a waste by increasing uncertainty
about the future.

(b) Create an environment in which efficient decisions are taken and greater employment,
poverty alleviation, and balanced growth.

In India, while the basic objectives of monetary policy, namely, price stability and
adequate credit flow to the productive sectors of the economy, have remained the same, the
operating environment has changed significantly. As pointed out in the RBI’s Report on
Currency and Finance 2003-04, there is an increasing focus on the maintenance of financial
stability in the context of better linkages between various segments of the financial markets
including money, Government securities and forex markets. Managing the capital flows has
emerged as an important concern of monetary policy. The phasing out of adhoc treasury bills and
their automatic monetization in 1997 imparted a lot of flexibility to the RBI in monetary
management. Simultaneously, however, reserve flows through the balance of payments M3 in

34
2004-05 is projected to expand by 14.0 per cent. Non-food credit adjusted for investment in
commercial paper, shares/ debentures/bonds of public sector undertakings (PSUs) and private
corporate sector was projected to increase by 16.0 to 16.5 per cent in the annual policy statement
of May 2004. This magnitude of credit expansion was expected to adequately meet the credit
needs of all the productive sectors of the economy. Contrary to the assumptions underlying the
annual policy statement for 2004-05, the south west monsoon turned out to be deficient by 13 per
cent in the current year. There was a surge in inflation following the rise in international oil and
metal prices. The carry forward of liquidity compounded matters.

With a view to addressing these issues, the RBI increased the CRR by 50 basis points, in
two stages, to 5.0 per cent, thus bringing down the liquidity in the banking system by about Rs.
9,000 crores. The interest rate on eligible CRR balances was de-linked from the Bank Rate and
was reduced to 3.5 per cent per annum. The Government of India raised the ceiling of MSS from
Rs. 60,000 crores to Rs. 80,000 crores on August 26, 2004 to enable the RBI to effectively deal
with the problem of overhang of liquidity. As the inflation was supply induced, the Government
also reduced the duty rates on petroleum products twice in the year 2004-05. Taking the above
developments into account, the RBI in its mid-term review of the annual policy statement for
2004-05 (October 26, 2004), revised its GDP growth projection in 2004-05 from a range of 6.5
to 7.0 per cent to 6.0 to 6.5 per cent. Inflation projection on a point to point basis was raised
upwards to 6.5 per cent from around 5.0 per cent projected earlier. RBI has not affected any
change in its earlier projection of M3 and aggregate deposit target of commercial banks.
Considering credit growth in the first half, the projection of adjusted non-food bank credit has
been revised to 19.0 per cent from 16.0 to 16.5 per cent projected earlier. The mid-term review
increased the fixed reverse repo rate by 25 basis points under the LAF to 4.75 per cent.

And increase in the prices of crude petroleum in the international markets has posed new
challenges for monetary policy. As indicated earlier, in the current year, the two major
constraints facing monetary management were carry forward of excess liquidity of over Rs.
81,000 crores from the previous year and rise in inflation following the rising international prices
of petroleum crude. The annual policy statement for 2004- 05 had placed the growth of GDP in
2004-05 in the range of 6.5 to 7.0 per cent, on the assumption of sustained growth in industrial
sector, normal monsoon and good performance of exports. On the assumption of no significant

35
supply shocks and appropriate management of liquidity, inflation rate in 2004-05, on a point-to
point basis, was placed at around 5.0 per cent. The mid-term review also proposed a switch over
to the international usage of the terms repo and reverse repo effective October 29, 2004. In the
mid-term review, RBI proposed reduction in the spread between the reverse repo rate and repo
rate by 25 basis points from 150 basis points to 125 basis points. Accordingly, the fixed repo rate
under LAF will continue to remain at 6.0 per cent. The RBI has continued with its policy of
active demand management of liquidity through OMOs, including the LAF, MSS and CRR, and
using the policy instruments at its disposal flexibly, as and when the situation warrants consistent
with the objective of price stability. At the same time, RBI has also been ensuring adequate
liquidity in the system so that all legitimate requirements of credit to maintain the growth
momentum are met. The other important policy initiatives announced in the mid-term review
relate to raising the ceiling on NRE interest rates, reduction of tenure of domestic term deposits,
dispensing with the restrictive provisions of service area approach for delivery of agricultural
credit, and measures for improving credit delivery to agriculture and small-scale industry (SSI)
sectors.

CHAPTER V

36
 Techniques of Monetary Control
Many techniques of monetary control- some old and well known have been used in India.
Among these are: (a) Open Market Operations (OMO), (b) Bank Rate, (c) Cash Reserve Ratio
(CRR), (d) Statutory Liquidity Ratio (SLR), (e) Interest Rates.

Some of the important features and evolution of these techniques are given below:

Open Market Operations

Open market operations are the means of implementing monetary policy by which a
central bank controls its national money supply by buying and selling government securities, or
other financial instruments. Monetary targets, such as interest rates or exchange rates, are used to
guide this implementation. Since most money is now in the form of electronic records, rather
than paper records such as banknotes, open market operations are conducted simply by
electronically increasing or decreasing ('crediting' or 'debiting') the amount of money that a bank
has, e.g., in its reserve account at the central bank, in exchange for a bank selling or buying a
financial instrument. Newly created money is used by the central bank to buy in the open market
a financial asset, such as government bonds, foreign currency, or gold. If the central bank sells
these assets in the open market, the amount of money that the purchasing bank holds decreases,
effectively destroying money.

Under OMO, RBI buys or sells government bonds in secondary market. By absorbing
bonds, it drives up bond yields and injects money into market. When it sells, it does so to stuck
money out of the system.

OMO is an actively used technique of monetary control in the US, the UK and many
other countries. Through the open market sales and purchases of government securities, the RBI
can affect the reserves position of banks, yields on government securities, and volume and cost
of bank credit. However, it is the technique least used by the Bank, though it has wide powers to
use it. There is no restriction the quantity or maturity of government securities which it can buy
or sell or hold. Technically, the Bank can conduct OMOs in treasury bills, state government
securities, and central government securities; but in practice they are conducted only in central
government securities of all maturities.

37
 The open market operations, repo and reverse repo operations have emerged as important
liquidity management tools. Further, Liquidity Adjustment Facility (LAF), which was introduced
in June 2000, has emerged as the principal operating instrument of monetary policy, enabling the
Reserve Bank to modulate short-term liquidity under varied financial market conditions. In order
to fine-tune the management of liquidity and in response to suggestions from market participants,
the Reserve Bank has introduced a Second Liquidity Adjustment Facility (SLAF) from
November 28, 2005. Further, to address the dilemma of keeping a balance between the twin
objectives of containing exchange rate volatility and maintenance of domestic price stability in
the face of surging capital inflows, the Market Stabilization Scheme (MSS) was introduced in
April 2004 to provide the Reserve Bank with an additional instrument of liquidity management.
Under the MSS, the cost of sterilization is borne by the Government. Under this program, the
RBI injected more than Rs. 60, 000 crores in one week’s time to counter balance the FPI activity,
when the financial melt down in American Economy happened.

As part of management of the demand for currency, it has been the endeavour of the
Reserve Bank to contain the volume of notes in circulation by coinciding the lower denomination
notes and conscious shift towards higher denomination notes in circulation. Major developments
in this regard include following a ‘clean note policy’, mechanization of note counting operations
by the commercial banks, outsourcing of coin distribution to the private operators to ease
pressure on distribution channels, regular reviews of security features of bank notes and
mechanization of destruction of soiled notes, etc. These operations are aimed at ensuring the
optimal level of customer service through adequate supply of good quality and secure notes and
coins in the country.

OMO: Goals and Objectives

The OMOs have both monetary policy and fiscal policy goals. Their multiple objectives
include: (a) To control the amount of and changes in bank credit and monetary supply through
controlling the reserve base of banks, (b) To make bank rate policy more effective, (c) To
maintain stability in government securities market, (d) To support government borrowing
programme, and (e) To smoothen the seasonal flow of funds in the bank credit market.

38
 In India, OMOs have mostly been used for the purpose of debt management and this has
undermined their effectiveness as a tool of monetary policy. The fact that government securities
market in India is not well-organized, broad-based and deep, and also that interest rates on
government securities, like other interest rates, were administered have reduced the efficacy of
OMOs so far. However, the authorities are now determined to make OMOs a major tool of
monetary policy. Similarly, the coupon rates of government securities have been raised and
made market-related and competitive, and a large number of measures have been taken to
develop and activise the government securities market in India.

This does not mean that OMOs did not contribute anything at all to monetary
management in the past. They have indirectly helped in the regulation of supply of bank credit
to the private sector in two ways. First, the bank has often conducted OMOs for switching
operations, i.e., the sale of long term scrips in exchange for short term ones. This has helped to
lengthen the maturity structure of government securities, which in turn, has been favorable for
the working of monetary policy. Second, the volume of the Bank’s net sales of government
securities has increased over the years.

Repo rate

Repo is a repurchase agreement i.e. Selling a security under an agreement to repurchase

at a pre-determined date and rate. Repo is money market instrument which enables short-term
borrowing and lending through sale/purchase operation. It introduced in December 1992.
Whenever the banks have any shortage of funds they can borrow it from RBI. Repo rate is the
rate at which our banks borrow rupees from RBI. A reduction in the repo rate will help banks to
get money at a cheaper rate. When the repo rate increases borrowing from RBI becomes more
expensive.
The repo rate is the rate at which RBI lends private and public sector banks while reverse
repo is the opposite. After cut, repo rate now stands at 4.75 pc while the reserve repo stands at
3.25 pc.

Repo rate is the discounted interest rate at which a central bank repurchases government
securities. The central bank makes this transaction with commercial banks to reduce some of the

39
short-term liquidity in the system. The repo rate is dependent on the level of money supply that
the central bank chooses to set as part of its monetary policy.

The central bank has the power to lower the repo rates while expanding the money supply
in the country. This enables the banks to exchange their government security holdings for cash.
In contrast, when the central bank decides to reduce the money supply, it implements a rise in the
repo rates.

When the central bank of the nation makes a decision regarding the money supply level
the repo or repurchase rate is determined by the market in response to the rules of supply and
demand.

The securities that are being evaluated and sold are transacted at the current market price
plus any interest that has accrued. When the sale is concluded, the securities are subsequently
resold at a predetermined price. This price is comprised of the original market price and interest,
and the pre-agreed interest rate, which is the repo rate.

Reverse repo rate

Reverse Repo rate is the rate at which Reserve Bank of India (RBI) borrows money from
banks. It introduced by RBI during 1994 – 95. Banks are always happy to lend money to RBI
since their money is in safe hands with a good interest. An increase in Reverse repo rate can
cause the banks to transfer more funds to RBI due to these attractive interest rates. It can cause
the money to be drawn out of the banking system. The reverse repo rate or reverse repurchase
rate is applicable when a country's reserve borrows money from banks. If reverse repo rates
raise, it means that banks will provide more funds to the reserve. This is a safe proposition as
lending money to most reserves is an extremely safe financial transaction. In cases of reserves
borrowing money from banks, excess money left with the particular bank is channeled into the
reserve. This causes money to be taken out of the economic system. Reverse repo rates come into
play when there is a fund shortage being faced by the reserve. “The repo rate in India is currently
7.75%. The reverse repo rate is 6.00%.”

Bank Rate

40
 Bank rate, also referred to as the discount rate, is the rate of interest which a central bank
charges on the loans and advances that it extends to commercial banks and other financial
intermediaries. Changes in the bank rate are often used by central banks to control the money
supply. The term bank rate is commonly used by consumers to refer to the current rate of
interest given on a savings certificate of Deposit. The term bank rate is most commonly used by
consumers who are interested in either obtaining a purchase money mortgage, or a refinance
loan, when referring to the current mortgage rate.
The RBI provides financial accommodation in the form of rediscounting of bills of
exchange and promissory notes, and loans and advances to scheduled commercial and co-
operative banks and other approved financial institutions for financing bonafide internal and
external commercial, trade and production transactions. The Bank Rate is the basic cost of
refinance and discounting facilities. Section 49 of the RBI Act, 1934 defines it as the standard
rate at which the Bank is prepared to buy or rediscount bills of exchange or other eligible
commercial paper. In the early years, financial accommodation from the Bank was largely
provided at the Bank rate. Subsequently, owing to differential rates prescribed for various
sector-specific refinance facilities as also due to the absence of a genuine bill market, the Bank
rate application was confined to (a) the ways and means advances to the state governments, (b)
advances to primary co-operative banks for SSI, and (c) state financial corporations besides
penal rates on shortfalls in reserve requirements.

Cash Reserve Ratio

41
 The present banking system is called a “fractional reserve banking system”, because the
banks need to keep only a fraction of their deposit liabilities in the form of liquid cash. The
authorities earlier used to change this fraction mainly for the purpose of ensuring the safety and
liquidity of deposits. Over the years, however, it has become an important and effective tool for
directly regulating the lending capacity of banks. The RBI has been using two ratios- the Cash
Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR) – as instruments of credit control.

CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of
bank deposits, however over the years it has become an important and effective tool for directly
regulating the lending capacity of banks and controlling the money supply in the economy.
When the RBI feels that the money supply is increasing and causing an upward pressure on
inflation, the RBI has the option of increasing the CRR thereby reducing the deposits available
with banks to make loans and hence reducing the money supply and inflation.

Cash Reserve Ratio is a bank regulation that sets the minimum reserves each bank must
hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands,
and would normally be in the form of fiat currency stored in a central bank.

The reserve ratio is sometimes used as a tool in monetary policy, influencing the
country’s economy, borrowing, and interest rates. Western central banks rarely alter the reserve
requirements because it would cause immediate liquidity problems for banks with low excess
reserves; they prefer to use open market operations to implement their monetary policy. The
People’s Bank of China does use changes in reserve requirements as an inflation-fighting tool,
and raised the reserve requirement nine times in 2007. As of 2006 the required reserve ratio in
the United States was 10% on transaction deposits (component of money supply “M1″), and zero
on time deposits and all other deposits. An institution that holds reserves in excess of the
required amount is said to hold excess reserves.

Cash reserve Ratio (CRR) in India is the amount of funds that the banks have to keep
with RBI. If RBI decides to increase the percent of this, the available amount with the banks
comes down. RBI is using this method, to drain out the excessive money from the banks.

In terms of Section 42(1) of the RBI Act 1934, Scheduled Commercial Banks are
required to maintain with RBI an average cash balance, the amount of which shall not be less

42
than three percent of the total of the Net Demand and Time Liabilities (NDTL) in India, on a
fortnightly basis and RBI is empowered to increase the said rate of CRR to such higher rate not
exceeding twenty percent of the Net Demand and Time Liabilities (NDTL) under the RBI Act,
1934. In June 14, 2003, the rate of CRR is 4.50 per cent of the NDTL.

In terms of Section 42(1A) of RBI Act, 1934, the Scheduled Commercial Banks are
required to maintain, in addition to the balances prescribed under Section 42(1) of the Act, an
additional average daily balance, the amount of which shall not be less than the rate specified by
the RBI in the notification published in the Gazette of India, such additional balance being
calculated with reference to the excess of the total of the NDTL of the bank as shown in the
return referred to in section 42(2) of the RBI Act, 1934 over the total of its NDTL at the close of
the business on the date specified in the notification. At present no incremental CRR is required
to be maintained by the Scheduled Commercial Banks.

The CRR refers to the cash which banks have to maintain with the RBI as a certain
percentage of their demand and time liabilities. Till 1962, a separate CRR was fixed in respect
of demand liabilities (5 percent) and time liabilities (2 percent). The Bank had powers to vary
these ratios up to a maximum of 20 percent and 8 percent respectively. Subject to these ceilings,
the RBI could ask banks to maintain with itself additional reserves as a specified percentage of
additional demand and time liabilities after certain specified date. This marginal CRR cannot
exceed 100 percent.

In 1962, the separate CRRs were merged and one CRR came to be fixed as a certain
percentage of both demand and time liabilities with the maximum of 15 percent. The rules
regarding the marginal CRR were not changed. The actual minimum CRR fixed in 1962 was 3
per cent. The CRR is applicable to all scheduled banks including scheduled cooperative banks
and the Regional Rural Banks (RRBs), and non-scheduled banks. However, co-operative banks,
RRBs, and non scheduled banks have to maintain the CRR of merely 3 per cent, and so far it has
not been changed by the RBI. The CRR is applicable to various NRI deposit accounts also but
the level of CRR in their case differs from the CRR for domestic deposits, and also among
themselves.

43
 The RBI has powers to impose penal interest rates on banks in respect of their shortfall in
the prescribed CRR. The penal interest rate is normally 3 percent above the Bank rate for the
first week of default and 5 percent for the subsequent weeks till the default are made good. In
addition, the Bank can disallow fresh access to its refinance facility to defaulting banks and
charge additional interest over and above the basic refinance rate on any accommodation availed
of, and which is equal to the shortfall in CRR. In addition, from January 1985, default in CRR
results in graduated penalty by way of loss of interest on the defaulting bank’s cash balances.

The RBI pays, since 1973, at its discretion, interest on that portion of cash reserves which
is the difference between the prescribed CRR and the minimum CRR of 3 percent, provided the
bank has not defaulted in respect of maintaining the prescribed CRR. Interest is not paid on
excess reserves.

With a view to providing flexibility to banks in choosing an optimum strategy of holding

reserves depending upon their intra period cash flows, all Scheduled Commercial Banks, are
required to maintain minimum CRR balances upto 70 per cent of the total CRR requirement on
all days of the fortnight. If any Scheduled Commercial Bank fails to observe the minimum level
of CRR on any days during the relevant 8 fortnight, the bank will not be paid interest to the
extent of one fourteenth of the eligible amount of interest, even if there is no shortfall in the CRR
on average basis.

Statutory Liquidity Ratio

44
 In addition to the CRR, the RBI has made active use of another ratio, namely the SLR.
While the CRR enables the Bank to impose primary reserve requirements the SLR enables it to
impose secondary and supplementary reserve requirements, on the banking system. There are
three objectives behind the use of SLR: (a) to restrict expansion of bank credit (b) to increase
banks investment in government securities, and (c) to ensure solvency of banks. Through
variations in the SLR, the Bank is in a position to insulate a part of the government debt from the
open market impact because banks are then prevented from disinvesting government securities in
favour of commercial credit.

Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is
the amount which a bank has to maintain in the form:

1. Cash

2. Gold valued at a price not exceeding the current market price

3. Unencumbered approved securities (Government securities or Gilts come under this)

valued at a price as specified by the RBI from time to time.

The quantum is specified as some percentage of the total demand and time liabilities (i.e.
the liabilities of the bank which are payable on demand anytime, and those liabilities which are
accruing in one month’s time due to maturity) of a bank. This percentage is fixed by the Reserve
Bank of India. The maximum and minimum limits for the SLR are 40% and 25% respectively.
Following the amendment of the Banking regulation Act (1949) in January 2007, the floor rate of
25% for SLR was removed. Presently, the SLR is 24% with effect from 8 November, 2008.

The SLR is the ratio of cash in hand (exclusive of cash balances maintained by banks to
meet the required CRR, but not the excess reserves); balances in current account with the SBI, its
subsidiaries, other nationalized banks and the RBI; gold and unencumbered, approved securities,
i.e. central and state government securities, securities of local bodies and government guaranteed
securities to total DTL of banks. Between years 1949 to 1962, while calculating SLR, no
distinction was made between cash on hand and balances held with the RBI to meet CRR
requirements. The SLR, like CRR, is applicable to co-operative banks, non-scheduled banks,
and the RRBs, but it is maintained at a constant level of 25 percent. While the SLR defaults do

45
not invite penal interest payment and the loss of interest on cash reserves, they do result in
restrictions on the access to refinance from the RBI and in the higher cost of refinance. The RBI
is empowered to increase the SLR for scheduled commercial banks up to 40 percent.

The SLR remained at the level of 20 percent between years 1949 to 1962 in terms of the
definition then prevailing. Thereafter, it has been raised frequently and substantially. In 1990,
SLR has been increased from 20 percent to 38.5 percent. The significant increase in the SLR
does not mean that the monetary policy became quite restrictive during 1963 to 1990. An
increase in the SLR does not restrain total expenditure in the economy; it may restrict only the
private sector expenditure while helping to increase the government expenditure. In a sense,
therefore, the SLR is not a technique of monetary control; it only distributes bank resources in
favour of the government sector. It is therefore, not correct to indicate, as it often done, the
extent of immobilization of bank resources in terms of the combined level of the CRR and SLR.

As in the case of CRR, the post 1991 period is characterized by a declining phase for
SLR also; its level was reduced and it came to be much criticized during this phase. After 1992,
banks were required to maintain SLR based on multiple prescriptions. For example, in October
1992, the SLR was fixed at 38.25 percent, 38 percent and 37.25 percent of net DTL as on 3 April
1992 with effect from fortnights beginning 9 January 1993, 6 February 1993, and 6 March 1993
respectively. The October 1997 credit policy rationalized this system of multiple rates of SLR
by collapsing them into a single prescription of 25 percent of banks. SLR has remained
unchanged at 25 percent since 1997 till today.

The SLR is commonly used to contain inflation and fuel growth, by increasing or
decreasing it respectively. This counter acts by decreasing or increasing the money supply in the
system respectively. Indian banks’ holdings of government securities (Government securities)
are now close to the statutory minimum that banks are required to hold to comply with existing
regulation. When measured in rupees, such holdings decreased for the first time in a little less
than 40 years (since the nationalization of banks in 1969) in 2005-06.

Statutory Liquidity Ratio refers to the amount that the commercial banks require to
maintain in the form of cash, or gold or government approved securities before providing credit
to the customers. Statutory Liquidity Ratio is determined and maintained by the Reserve Bank of

46
India in order to control the expansion of bank credit. Statutory Liquidity Ratio refers to the
amount that all banks require maintaining in cash or in the form of Gold or approved securities.
Here by approved securities we mean, bond and shares of different companies.
This Statutory Liquidity Ratio is determined as percentage of total demand and
percentage of time liabilities. Time Liabilities refer to the liabilities, which the commercial banks
are liable to pay to the customers on there anytime demand. The liabilities that the banks are
liable to pay within one month's time, due to completion of maturity period, are also considered
as time liabilities.
In India, Reserve Bank of India always determines the percentage of Statutory Liquidity
Ratio. There are some statutory requirements for temporarily placing the money in Government
Bonds. Following this requirement, Reserve Bank of India fixes the level of Statutory Liquidity
Ratio. At present, the minimum limit of Statutory Liquidity Ratio that can be set by the Reserve
Bank is 25%.

47
Interest rates

The RBI has been following a policy stance of imparting flexibility to the interest rate
structure. Concerned over the downward rigidity of lending rates, even while deposit rates were
coming down, RBI advised banks to announce their benchmark prime lending rates (BPLRs)
based on their actual cost of funds, operating expenses and a minimum margin to cover
regulatory requirement. In response to this policy directive, all banks put in place a system of
BPLRs in 2003-04. The BPLRs of five major banks are lower by 25 to 50 basis points in
December, 2004 compared to the rates prevailing a year ago. During the current year, there has
been a marginal firming up of deposit rates by 25 basis points. Interest rates on housing loans
have firmed up marginally in the current year for banks. Call money rates firmed up from the
second half of the year, reflecting lower liquidity on account of large increase in bank credit. The
Bank Rate remained unchanged at 6.0 per cent in the current year.

The repo rate (reverse repo rate since October 29, 2004) under LAF was raised by 25
basis points to 4.75 per cent from October 27, 2004. The spread between reverse repo and repo
was narrowed by 25 basis points to 125 basis points.

Towards this end, steps have been initiated to deregulate interest rates, to ease operational
constraints in the credit delivery system, to introduce new money market instruments, and so on.
The monetary policy is now geared towards (a) reducing the rigidities, (b) introducing flexibility,
(c) encouraging diversification, (d) promoting more competitive environment, and (e) imparting
greater discipline and prudence in the operations of the financial system.

48
 CHAPTER VI

Equities in India

Let’s review the performance of equities in India from past ten years. Equities in India
did provide attractive returns from 1979-91 however; they fared poorly in the decade of 1991-
2001.

49
 If we see the compounded annual returns generated by Sensex, the most widely followed
equity index in India, at the end of 2001 were as follows for various investment periods:

Investment Period Compound Return

1 year -20.5 %

2 years -23.3 %

3 years -2.0 %

5 years 1.2 %

7 years -2.6 %

10 years 5.5 %

Thus, we can see that equities have under performed even bank deposits for each of the periods
considered above.

What is the Picture of Key Economic Numbers?

During the decade of 1991-2001, the nominal GDP of the country increased by about 3.7
times, forex reserves soared from a near zero level to a record of US $ 48 billion, exports
multiplies by 2.4 times, the prime lending rate fell from around 19% to 11.5%, and the earnings
of Sensex stocks grew at a compound rate of 13.3%.

It seems surprising that the growth of the economy and corporate earnings has not been
reflected in equity returns. What could have caused this discrepancy? The factors that have
contributed to this appear to be as follows:

1. The market was very bullish at the beginning of the decade of 1991-2001, but extremely
bearish at the end of the decade.

50
2. During the decade of 1991-2001, the maximum growth occurred in the services sector (which
now accounts for nearly 50% of the GDP), whereas the services sector accounts for less than the
quarter of Sensex.

3. The excessive volatility of the Indian stock market has perhaps driven away long-term
investors who can contribute to grater rationality in price movement.

4. The periodic scams that occurred during this period have shaken investor’s confidence.

RBI and SEBI Review on ‘Bank Financing of Equities’

Background:

Accordingly, the RBI-SEBI Technical Committee has reviewed the guidelines on bank financing
of equities and investments in shares issued by the Reserve Bank of India keeping in view the
position of banks’ investments in shares as also advances against shares and other connected
exposures.

Methodology:

The Committee reviewed the policy formulated by the Board of Directors of banks; the
ceilings prescribed by the Boards for exposure to capital market, the operational mechanism put
in place as also the data reported by the banks in respect of investment in shares, advances
against shares and guarantees issued on behalf of the brokers.

The Committee observed that banks have by and large adhered to RBI guidelines.
However, a few banks had overextended exposure by way of advances against shares, in
violation of the spirit of the RBI guidelines. The Committee also took into account the abnormal
decline observed in the prices of equity shares after the presentation of the Union Budget for the
year 2001-2002 in the Parliament on February 28, 2001, leading to the payment problems by
some brokers in the Calcutta Stock Exchange, the Stock Exchange, Mumbai and NSE. The
Committee observed from the provisional data collected by Reserve Bank of India that bank

51
guarantees amounting to Rs.69.29 crore had been invoked by the Calcutta Stock Exchange in
order to meet the payment obligations of some of its members.

Guidelines:

(i) Ceiling on bank’s investments in shares and debentures:

a) Within the overall exposure to sensitive sectors, a bank’s investment in shares, convertible
debentures and units of equity oriented mutual funds should not exceed 5% of the bank’s total
outstanding domestic credit ( excluding inter- bank lending and advances outside India) as on
March 31 of the previous year.

b) The above ceiling for investments in shares, etc., is the maximum permissible ceiling and a
bank’s Board of Directors is free to adopt a lower ceiling, keeping in view its overall risk profile.
Where the present outstanding investments in shares are relatively small and below the overall
ceiling, the Board should lay down an annual ceiling for fresh investments in equities.

c) Banks may make investment in shares directly taking in to account the in-house expertise
available within the bank as per the investment policy approved by the Board of Directors.

d) Banks may also make investment in units of UTI and SEBI approved other diversified mutual
funds with good track records as per the investment policy approved by the Board of Directors.
Banks should make investments in specific schemes of mutual funds / UTI and not place funds
with mutual funds / UTI for investments in the capital market on their behalf.

e) Underwriting commitments taken up by the banks in respect of primary issues through book
building route would also be within the above overall ceiling.

f) Investments in shares and debentures / bonds should as hitherto, be reckoned for the purpose
of arriving at the prudential norm on single borrower and borrower – group exposure ceilings.

g) Credit substitutes like Commercial Paper, non-convertible debentures, etc., may not be
reckoned as part of credit portfolio for arriving at the ceiling on bank’s investments in shares and
debentures.

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(ii) Financing of Initial Public Offerings (IPOs):

(a) Banks are permitted to grant advances for subscribing to IPOs to individuals. The maximum
amount of finance that can be extended to an individual against IPOs should be Rs.10 lakh, as
applicable to advances against physical shares. The other terms and conditions for financing of
IPOs (including the minimum margin of 50% and 25% against physical and dematerialized
shares, respectively) should be the same as those applicable to advances against shares to
individuals. The corporate should not be extended credit by banks for investment in other
companies’ IPOs. Similarly, banks should not provide finance to NBFCs for further lending to
individuals for IPOs.

(b) Finance extended by a bank for IPOs should be reckoned as an exposure to capital market.

(iii) Issue of guarantees on behalf of brokers:

A minimum margin of 25% inclusive of cash margin should be obtained by banks for issue of
guarantees on behalf of share brokers. Banks may, at their discretion, obtain margin higher than
25% as per the policy approved by their Board of Directors.

(iv) Advances against shares and debentures to individuals and share brokers:

(a) The terms and conditions for financing of individuals against shares and debentures, viz.,
maximum amount of finance of Rs.10 lakh and Rs.20 lakh against physical and dematerialized
shares with a minimum margin of 50% and 25%, respectively within the overall policy approved
by the Board, remain unchanged.

(b) Banks are free to provide need based credit facilities to share brokers and market makers
against shares and debentures held by them as stock-in-trade after making a careful assessment
of the requirements for finance. Banks may decide on the basis of the commercial judgment, the
quantum as well as margin on the finance provided to the stock brokers and market makers.

(c) Loans sanctioned to corporate against the security of shares for meeting promoters’
contribution to the equity of new companies in anticipation of raising resources and bridge loans

53
sanctioned to companies for a period not exceeding one year against expected equity
flows/issues, expected proceeds of non-convertible debentures, external commercial borrowings,
GDRs and / or funds in the nature of foreign direct investments, would continue to be within the
overall ceiling of 5%.

(v) Risk Management and internal control:

Banks desirous of making investments in equity shares, etc. within the above ceiling and
financing of equities, should observe the following guidelines:

a) Build up adequate expertise in equity research by establishing a dedicated equity research

department, as warranted by their scale of operation,

b) Formulate a transparent policy and procedure for investment in shares, etc.

c) The decision in regard to individual investments in shares, etc. should be taken by the
Investment Committee set up by the bank. The Investment Committee should be held
accountable for the investments made by the bank.

d) Banks should review on an ongoing basis, their investment in shares with a view to assessing
the risks due to volatility in asset prices.

e) As a prudential measure, a bank’s exposure to investment in equities whose prices are subject
to volatility (e.g. shares, convertible debentures and units of equity-oriented mutual funds )
should not normally exceed 20% of its net worth.

f) In addition to the ceiling of 5% on investments, the Board of Directors of banks should also fix
an overall ceiling on advances against shares, i.e. financing of IPOs, advances to individuals and
share brokers and market makers, issue of guarantees on behalf of brokers, advances to corporate
to meet promoters’ contribution, etc.

g) The following may be excluded for reckoning the bank’s aggregate exposure by way of
financing of equities:

54
 i. Advances against collateral security of shares.
ii. Advances to individuals for personal purposes like education, housing,
consumption, etc. against the security of shares.

(vi) Valuation and disclosure:

Banks should mark to market their investment portfolio in equities like other investments
as per the valuation norms prescribed by RBI. Further, banks should disclose the total
investments made in shares, convertible debentures and units of equity oriented mutual funds as
also aggregate advances against shares, etc., in the ‘Notes on Accounts’ to their balance sheets,
beginning from the year ending March, 2001. In 2008, in case of FPI, RBI was sucking
liquidity from the market through selling of government securities and in the same year, in case
of Lehman Brothers collapse, RBI was injecting liquidity into the market so, in this contradictory
case, the role of RBI has changed to maintain the liquidity stability.

(vii) Review of Guidelines:

The Standing Technical Committee of RBI and SEBI will review the guidelines after six months
in consultation with banks keeping in view their institutional set up, operational mechanism and
the experience gained.

55
 CHAPTER VII

The Crisis and India

Like all emerging economies, India too has been impacted by the crisis, and much more
than was expected earlier. GDP growth has moderated reflecting lower industrial production,
negative exports, deceleration in services activities, dented corporate margins and diminished
business confidence. There are some comforting factors — well-functioning financial markets,
robust rural demand, lower headline inflation and comfortable foreign exchange reserves —
which buffered us from the worst impact of the crisis. The fiscal stimulus packages of the
Government and monetary easing and regulatory action of the Reserve Bank have helped to
arrest the moderation in growth and keep our financial markets functioning normally.

In order to provide liquidity support to the housing sector, and particularly to housing
finance companies (HFCs) which have been adversely affected by the recent financial market
developments, it has been decided to provide a refinance facility of an amount of Rs 4,000 crore
to the National Housing Bank (NHB) under the provisions of Section 17(4DD) of the Reserve
Bank of India Act, 1934. This refinance will be available against the NHB's loans and advances
to HFCs. The facility will be available at the prevailing repo rate under the LAF for a period of
90 days. During this 90-day period, the amount can be flexibly drawn and repaid. At the end of
the 90-day period, the withdrawal can also be rolled over. This refinance facility will be
available up to March 31, 2010. The utilization of funds will be governed by the policy approved
by the Board of the NHB.

With a view to mitigating the pressures on account of the recent developments on loan
disbursements to Indian exporting companies and for honoring disbursements under export lines
of credit extended at the behest of the Government of India to overseas financial institutions,
sovereign governments and other entities for financing imports from India, it has been decided to

56
provide a refinance facility to the EXIM Bank under the provisions of Section 17(4J) of the
Reserve Bank of India Act, 1934. The refinance facility will be of an amount of Rs 5,000 crores.
It will be available at the prevailing repo rate under the LAF for a period of 90 days. During this
90-day period, the amount can be flexibly drawn and repaid. At the end of the 90-day period,
the withdrawal can also be rolled over. This refinance facility will be available up to March 31,
2010. The utilization of funds will be governed by the policy approved by the Board of the
EXIM Bank.

The Reserve Bank will continue to closely monitor the developments in the global and
domestic financial markets and will take swift and effective action as appropriate. The Reserve
Bank will endeavour to minimize the stress on various sectors of the economy on account of the
international financial crisis and the global slowdown. The policy objective is to ensure adequate
availability of liquidity in the system and to maintain conditions conducive for flow of credit for
all productive purposes, particularly to the housing, export and small and medium industry
sectors.

The Reserve Bank of India (RBI) announced it will develop a regulatory and oversight
framework for mobile banking, and made clear its concern over the safety of transactions
through mobile phones. “The large scale spread of mobile telephony has opened up new vistas
for banking in the form of mobile banking and the potential in this new sphere is enormous;
adequate steps to ensure safety and security in a mobile based computing / communicating
environment have to, however, be made.”

Reserve Bank has decided to take up the following actions which measure the current assessment
of macroeconomic and monetary conditions.

Monetary Policy action

It Reduce the repo rate under the LAF by 25 basis points from 5.0% to 4.75% with
immediate effect. Reduce the reverse repo rate under the LAF by 25 basis points from 3.5% to
3.25% with immediate effect. Keep the CRR unchanged at 5.0% of net demand and time
liabilities (NDTL).

57
Reserve Bank’s Policy thrust
The thrust of the Reserve Bank's policy stance since mid-September 2008 has been aimed
at providing ample rupee liquidity, ensuring comfortable dollar liquidity and maintaining
continued credit flow to productive sectors. Taken together, the policy measures of the Reserve
Bank have ensured that the Indian financial markets continue to function in an orderly manner.
These measures have added actual/potential liquidity in the financial system by over Rs.
4,20,000 crores. This should assure financial markets that the Reserve Bank will continue to
maintain comfortable liquidity.

Interest Rate Response from Banks

Within the policy rate adjustment already effected by the Reserve Bank, there is scope for
banks to further reduce lending rates so as to ensure credit flow for all productive economic
activity. They hope and expect that banks will play their part in the economic adjustment process
by passing on the benefits of lower interest rates to their customers.

Government Borrowing
Government borrowing increased substantially in 2008-09. Net borrowing by the Central
Government in 2008-09 was increased nearly by three times than that in 2007-08. As per
estimates in the interim budget, net borrowing in the current year, 2009-10, will also be at this
elevated level. Even as the increase in borrowing was large and abrupt in the fourth quarter of
2008-09, they managed that in a non-disruptive manner through a combination of measures such
as unwinding of the MSS securities, open market operations and monetary easing. Admittedly,
yields had increased. But for the offsetting liquidity easing done by the Reserve Bank, yields
would have increased even more. Government will manage the borrowing in 2009-10 in a
similarly non-disruptive manner. An effort in this regard is the planned OMO purchases and
MSS unwinding in the first half of 2009/10 that will add primary liquidity of about Rs.1, 20,000
crore, the monetary impact of which is equivalent to CRR reduction by 3 percentage points.

Growth Outlook

In the January 2009 policy review, they projected growth for 2008-09 of 7.0 per cent with
a downward bias. The downside risks have since materialized, and GDP growth for 2008-09 is
now projected to turn out to be in the range of 6.5-6.7 per cent. Going forward, the fiscal and

58
monetary stimulus measures initiated during 2008-09 coupled with lower commodity prices will
cushion the downturn by stabilizing domestic economic activity. On balance, with the
assumption of a normal monsoon, for policy purpose real GDP growth for 2009-10 is placed at
around 6.0 per cent.

Inflation Outlook
On the price stability front, India's performance has been fairly good. Since
independence, the inflation rate, in terms of the wholesale price index (WPI), on an average
basis, was above 15 per cent in only five out of fifty years. In thirty-six out of fifty years,
inflation was in single digit and on most occasions high inflation was due to shocks – food or oil.
The tolerance level to inflation has been low, relative to many developing countries, especially
on account of the democratic pressures in the country. The inflation rate accelerated steadily
from an annual average of 1.7 per cent during the 1950s to 6.4 percent during the 1960s and
further to 9.0 per cent in the 1970s before easing marginally to 8.0 per cent in the 1980s.
However, the inflation rate declined from an average of 11.0 per cent during 1990-95 to
5.3 per cent during the second half of the 1990s (1995-2000) and further to 4.9 per cent during
2003-07. More recently during 2006-07, WPI based inflation rate increased from 4.1 per cent at
the end of March 2006 to an intra-year peak of 6.7 per cent at end-January 2007 and remained
firm in the range of 6.1-6.6 per cent in the succeeding weeks before moderating to 5.9 per cent
by the end of the financial year (i.e., as on March 31, 2007). Since then, the inflation has further
moderated and as on June 16, 2007, the WPI inflation rate was 4.0 per cent. In recent period,
there has been considerable improvement in the fiscal position. The average gross fiscal deficit
of the central government as per cent to GDP during the 5 decade of 1980s was 6.8 per cent as
against 3.8 per cent in the 1970s. The Government of India is pursuing the path of rule-based
fiscal consolidation from the year 2004-05 under the Fiscal Responsibility and Budget
Management Act, 2003 where under time-specific targets have been mandated.
The underlying purpose of the targets is to reduce the ratio of gross fiscal deficit (GFD)
to gross domestic product (GDP) to three per cent by 2008-09. Furthermore, the revenue deficit
(RD) to GDP ratio has been targeted to touch 0.0 per cent by 2008-09 so that borrowed resources
can be used to meet only capital expenditures. The progress of targeted fiscal consolidation has
been satisfactory so far and GFD/GDP and RD/GDP ratios are budgeted to reduce to 3.3 per cent

59
and 1.5 per cent, respectively, in 2007-08. The objective is to meet the targets under the Fiscal
Responsibility Act by 2008-09.
The average current account deficit since 1950-51 has been around one per cent of the
GDP. During this period, except for 11 years when there was marginal surplus in the current
account, they had modest deficit during the rest of the years. In the aftermath of the balance of
payment crisis in the early 1990s, several stabilization and structural reform measures were
undertaken. Keeping in view the global trend in commodity prices and domestic demand-
supply balance, it project WPI inflation at around 4.0 per cent by end-March 2010. Headline
WPI inflation decelerated sharply after August 2008 reflecting the fall in global commodity
prices. CPI inflation continues to be at near double-digit level but is expected to moderate in the
coming months. WPI inflation, however, is expected to be in the negative territory in the early
part of 2009-10 which is only of statistical significance and is not a reflection of demand
contraction as is the case in advanced economies.

60
Money Supply
Money supply (M3) growth for 2009-10 is placed at 17.0 per cent. Consistent with this,
the aggregate deposits of commercial banks are projected to grow by 18.0 per cent. The growth
in adjusted non-food credit, including investment in bonds/debentures/ shares of public sector
undertakings and private corporate sector and CPs, is placed at 20.0 per cent. As always, these
numbers are indicative projections and not targets.

Challenges on the way forward

There are several immediate challenges facing the economy. These include: (a)
supporting the drivers of aggregate demand to enable the economy to return to its high growth
path; (b) boosting the flow of credit to all productive sectors of the economy; (c) managing the
large government borrowing programme in 2009-2010 in a non-disruptive manner; (d) restoring
the fiscal consolidation process; (e) ensuring an orderly withdrawal of the large liquidity injected
in the system since September 2008 by the Reserve Bank to support the economy's productive
requirements; and (f) the continued challenge of preserving the stability of our financial system
drawing from the lesson of the global crisis.

Here in India, there are several immediate challenges facing the economy which would
need to be addressed going forward. First, after five years of high growth, the Indian economy
was headed for a moderation in the first half of 2008-09. However, the growth slowdown
accentuated in the third quarter of 2008-09 on account of spillover effects of international
developments. While the moderation in growth seems to have continued through the fourth
quarter of 2008-09, it has been cushioned by quick and aggressive policy responses both by the
Reserve Bank and the Government. Notwithstanding the contraction of global demand, growth
prospects in India continue to remain favorable compared to most other countries.

While public investment can play a critical role in the short-term during a downturn,
private investment has to increase as the recovery process sets in. A major macroeconomic
challenge at this juncture is to support the drivers of aggregate demand to enable the economy to
return to its high growth path.

The second challenge going forward is meeting the credit needs of the non-food sector.
Although, for the year 2008-09 as a whole, credit by the banking sector expanded, the pace of

61
credit flow decelerated rapidly from its peak in October 2008. This deceleration has occurred
alongside a significant decline in the flow of resources from non-bank domestic and external
sources. The deceleration in total resource flow partly reflects slowdown in demand, drawdown
of inventories by the corporate and decline in commodity prices. The expansion in credit,
however, has been uneven across sectors. There is, therefore, an urgent need to boost the flow of
credit to all productive sectors of the economy, particularly to MSMEs, to aid the process of
economic recovery. The Reserve Bank continues to maintain and will maintain ample liquidity in
the system. It should be the endeavour of commercial banks to ensure that every creditworthy
borrower is financed at a reasonable cost while, at the same time, ensuring that credit quality is
maintained.

It may be noted that bank credit had accelerated during 2004-07. This, combined with
significant slowdown of the economy in 2008-09, may result in some increase in NPAs. While it
is not unusual for NPAs to increase during periods of high credit growth and downturn in the
economy, the challenge is to maintain asset quality through early actions. This calls for a focused
approach, due diligence and balanced judgment by banks.

Third, the Reserve Bank was able to manage the large borrowing programme of the
Central and State Governments in 2008-09 in an orderly manner. The market borrowings of the
Central and State Governments are expected to be higher in 2009-10. Thus, a major challenge is
to manage the large government borrowing programme in 2009-10 in a non-disruptive manner.
Large borrowings also militate against the low interest rate environment that the Reserve Bank is
trying to maintain to spur investment demand in keeping with the stance of monetary policy. The
Reserve Bank, therefore, would continue to use a combination of monetary and debt
management tools to manage government borrowing programme to ensure successful completion
of government borrowings in a smooth manner. The Reserve Bank has already announced an
OMO calendar to support government market borrowing programme through secondary market
purchase of government securities. During the first half of 2009-10, planned OMO purchases and
MSS unwinding will add primary liquidity of about Rs.1,20,000 crores which, by way of
monetary impact, is equivalent to CRR reduction of 3.0 percentage points. This should leave
adequate resources with banks to expand credit.

62
 Fourth, another challenge facing the Indian economy is to restore the fiscal consolidation
process. The fiscal stimulus packages by the Government and some other measures have led to
sharp increase in the revenue and fiscal deficits which, in the face of slowing private investment,
have cushioned the pace of economic activity. However, it would be a challenge to unwind fiscal
stimulus in an orderly manner and return to a path of credible fiscal consolidation. In this
context, close monitoring of the performance of the economy and the proper sequencing of the
unwinding process would have to be ensured.

Fifth, a continued challenge is to preserve our financial stability. The Reserve Bank
would continue to maintain conditions which are conducive for financial stability in the face of
global crisis. A sound banking sector, well-functioning financial markets and robust payment and
settlement infrastructure are the pre-requisites for financial stability. The banking sector in India
is sound, adequately capitalized and well-regulated. By all counts, Indian financial and economic
conditions are much better than in many other countries of the world. The single factor stress
tests carried out as part of the report of the Committee on Financial Sector Assessment (CFSA)
have revealed that the banking system in India can withstand significant shocks arising from
large potential changes in credit quality, interest rate and liquidity conditions. These stress tests
for credit, market and liquidity risk show that Indian banks are generally resilient.

Sixth, the Reserve Bank has injected large liquidity in the system since mid-September
2008. It has reduced the CRR significantly and instituted some sector-specific facilities to
improve the flow of credit to certain sectors. The tenure of some of these facilities has been
extended to provide comfort to the market. While the Reserve Bank will continue to support all
the productive requirements of the economy, it will have to ensure that as economic growth
gathers momentum, the large liquidity injected in the system is withdrawn in an orderly manner.
It is worth noting that even as the monetary easing by the Reserve Bank has potentially made
available a large amount of liquidity to the system, at the aggregate level this has not been out of
line with our monetary aggregates unlike in many advanced countries. As such, the challenge of
unwinding will be less daunting for India than for other countries.

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 Finally, we will have to address the key challenge of ensuring an interest rate
environment that supports revival of investment demand. Since October 2008, as the inflation
rate has decelerated and the policy rates have been reduced, market interest rates have also come
down. However, the reduction in interest rates across the term structure and across markets has
not been uniform. Given the cost plus pricing structure, banks have been slow in reducing their
lending rates citing high cost of deposits. In this context, it may be noted that the current deposit
and lending rates are higher than in 2004-07, although the policy rates are now lower. Reduction
in deposit rates affects the cost only at the margin since existing term deposits continue at the
originally contracted cost. So lending rates take longer to adjust. Judging from the experience of
2004-07, there is room for downward adjustment of deposit rates. With WPI inflation falling to
near zero, possibly likely to get into a negative territory, albeit for a short period, and CPI
inflation expected to moderate, inflationary risks have clearly abated. The Reserve Bank’s
current assessment is that WPI inflation could be around 4.0 per cent by end-March 2010. Banks
have indicated that small savings rate acts as a floor to banks’ deposit interest rate. It may,
however, be noted that small savings and bank deposits are not perfect substitutes. Banks should
not, therefore, be overly apprehensive about reducing deposit interest rates for fear of
competition from small savings, especially as the overall systemic liquidity remains highly
comfortable. There is scope for the overall interest rate structure to move down within the policy
rate easing already effected by the Reserve Bank. Further action on policy rates is now being
taken to reinforce this process.

The Reserve Bank has been constantly monitoring global developments along with the
domestic economic situation. On the positive side, inflationary pressures have eased
significantly. Inflation as measured by year-on-year variations in the wholesale price index
(WPI) has declined to 3.36 per cent as on February 14, 2009, down by about three-fourths from
the high of 12.91 per cent as on August 2, 2008. However, consumer price inflation, as reflected
in various consumer price indices, is in the range of 9.85-11.62 per cent as of December 2008-
January 2009, has yet to show moderation. Consumer price inflation has remained at elevated
level due to increase in primary articles prices.

With WPI inflation having moderated significantly, consumer price inflation may also be
expected to decline, though with a lag.

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 At the same time, there is evidence of further slowing down of economic activity.
Exports registered negative growth for the four recent consecutive months, October 2008-
January 2009. Overall exports growth during 2008-09 (April-January) at 13.2 per cent was
significantly lower than 24.2 per cent during the same period of the last year. The index of
industrial production (IIP) registered a negative growth of 2.0 per cent during December 2008,
with the manufacturing sector returning a negative growth of 2.5 per cent.

IIP growth during April-December 2008 at 3.2 per cent was about one-third of 9.0 per
cent during the corresponding period of the previous year due to slowdown in all the major
sectors. Real GDP growth in the third quarter of 2008-09 (September-December 2008) has been
placed at 5.3 per cent by the Central Statistical Organization (CSO). The services sector, which
has been the main engine of growth during the last several years, has also been slowing down.
Business confidence has been dented significantly and investment demand has decelerated.

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 CHAPTER VIII

Inflation in India
Inflation is the supply of excess money and credit relative to the goods and services
produced, resulting in increased prices. As the layman understands it, inflation results in the
increase in the price of some set of goods and services in a given economy over a period of time.
It is measured as the percentage rate of change of a price index.

Inflation in India is also a grave issue of concern, given the vast disparity between the
rich and the poor on the one hand or the Rural and the Urban on the other. Skyrocketing inflation
robs the poor, and hurts others, though much less grievously. The fruits of the much-talked about
economic growth have not reached large sections, especially in the rural areas.

Under extant conditions, the benefit of high prices paid by consumers does not flow back
to primary producers, but is siphoned away by middlemen and speculators who enjoy a free run
in an economy of shortages. If attention to agriculture has been limited to rendering lip service,
inefficiencies in the physical market remain unattended. With production trailing demand in
recent years, shortages of essential commodities have widened. Imports have become expensive
because of high global market prices.

It may be instructive to remember that inflation is not an overnight phenomenon. It is

benign to the extent that it allows us time to cover our self. In India, the onus to control and take
control of the situation of inflation is upon the Reserve Bank of India (RBI).

The Reserve Bank of India (Amendment) Act, 2006 gives discretion to the Reserve Bank
to decide the percentage of scheduled banks' demand and time liabilities to be maintained as
Cash Reserve Ratio (CRR) without any ceiling or floor. Consequent to the amendment, no
interest will be paid on CRR balances so as to enhance the efficacy of the CRR, as payment of
interest attenuates its effectiveness as an instrument of monetary policy.

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 The Reserve Bank of India (RBI) follows a multiple indicator approach to arrive at its
goals of growth, price stability and financial stability, rather than targeting inflation alone. This,
of course, leads to criticism from mainstream economists. In its effort to balance many
objectives, which often conflict with each other, RBI looks confused, ineffective and in many
cases a cause of the problems it seeks to address.

The RBI has certain weapons which it wields every time and in all situations to counter
any form of inflationary situation in the economy. These weapons are generally the mechanisms
and the policies through which the Central Bank seeks to control the amount of credit flowing in
the market. The general stance adopted by the RBI to fight inflation is discussed in brief the
mechanism used by the RBI needs to take up a holistic approach to the same. Then it would deal
with very briefly suggestions that may shed some light on what could be the possible steps RBI
could take to control rising prices.

It is interesting to note that the Reserve Bank of India Governor. Dr Y. V. Reddy started
his stint with the aim of cutting down the Cash Reserve Ratio to 3 per cent (from the then 4.5 per
cent) but rising commodities inflation has forced him to raise it now to 6.5 per cent. But even this
6.5 per cent is way below what would truly contain inflation and it is almost certain that he will
be chasing the inflation curve for the next few years or so.

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 Steps Generally Taken By the RBI To Tackle Inflation

According to the Annual Statement on Monetary Policy for the Year 2007- 08, a careful
assessment of the manner in which inflation is evolving in India reveals that primary food
articles have contributed significantly to inflation during 2006-07. At the same time, prices of
manufactured products account for well above 50 per cent of headline inflation. The recent
hardening of international crude prices has heightened the uncertainty surrounding the inflation
outlook.

The steps generally taken by the RBI to tackle inflation include a rise in repo rates (the
rates at which banks borrow from the RBI), a rise in Cash Reserve Ratio and a reduction in rate
of interest on cash deposited by banks with RBI. The signals are intended to spur banks to raise
lending rates and to reduce the amount of credit disbursed. The RBI's measures are expected to
suck out a substantial sum from the banks. In effect, while the economy is booming and the
credit needs grow, the central bank is tightening the availability of credit.

The RBI also buys dollars from banks and exporters, partly to prevent the dollars from
flooding the market and depressing the dollar — indirectly raising the rupee. In other words, the
central bank's interactions have a desirable objective — to keep the rupee devalued — which will
make India's exports more competitive, but they increase liquidity.

To combat this, the RBI does what it calls "sterilization" — it sucks out the rupees it pays
out for dollars through sale of sterilization bonds. It then sells these bonds to banks. Economists
point out that there has not been much success in such sterilization attempts in India. The central
bank's attempt to offload Government bonds on banks has not been too successful in as much as
the banks sell the bonds and get rupees instead.

Economists also contrast this with the successful experience of China, where the state-
owned banks strictly abide by the central bank's dictates and absorb the sterilization bonds. That
discipline is lacking in India. The net effect is that the RBI has to resort to indirect methods of
sterilization, such as raising interest rates and raising CRR to contract liquidity. This makes India

68
more attractive for foreign capital flows that seek better returns and a vicious cycle follows. RBI
has to buy more foreign currency and sterilize.

Consequences of RBI Policy

The economy was growing at a stupendous 9 per cent, second only to China worldwide, however
the brakes have been firmly pressed by the RBI due to their anti – inflationary policy. If the CRR
and REPO rate are hiked frequently, the economy may take a U - turn, as most commercial
banks religiously increase their lending rates, without actually studying the impact.

The last time that the RBI had imposed its policy, the markets had signaled their
resounding reaction by a sharp fall in the Sensex by nearly 500 points. The impact on economic
growth is also likely to be sharp, judging by effects of similar therapy applied with disastrous
effect in the mid-1990s.

This would reduce the level of investment activity in the economy, particularly in the
infrastructure sector. Big corporate may ask for, and get, access to external commercial
borrowing, but not so favored are the bulk of small and medium entrepreneurs (SME). Housing
activity will suffer an impact because most loanees are on floating rates and will face increased
equated installments.

These measures generally taken by the RBI do not effectively tackle inflation but on the
other hand effectively stunts the growth pattern of the economy. The RBI seems to believe that
by merely reducing the credit flow and money flow in the economy, inflation can be curtailed.
Inflation is a consequence of increasing demand Vis – a – Vis the supply in the economy. The
demand must be effectively curtailed or pushed down, which the present CRR policy is not
managing to do effectively. The RBI, in an ideal world, would have also looked towards a
mechanism to bolster the supply forces to meet the requirements of the consumers and thereby
combat inflation.

Economists admit that while RBI’s efforts to contain inflation will reduce borrowings,
prices would continue to rise. Inflation, according to Bimal Jalan, a former governor of the
central bank himself and now a member of India’s upper house of parliament, is yet to peak.

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“Inflation is a function of rising expectations and going by that, we have some amount of
inflationary steam left in the economy.”

While the central bank’s efforts may have achieved part of their objective, of slowing
down credit growth, it clearly may not have done enough to curb inflation. Chetan Ahya, an
economist at Morgan Stanley, estimates that growth in bank credit will slow to between 20% and
22% by the end of 2007 from the earlier level of 30%.

There are two major drawbacks in the CRR – REPO policy adopted by the
RBI to combat inflation.

Firstly, monetary tools have proved more effective in economies with greater financial inclusion.
They are less effective in economies such as India's, where the majority of the population still
has no access to banks, and those with access barely have the resources to open bank accounts.

The increasing cost of funds and rising interest rates are of little consequence in the
economic life of a financially excluded population. The impact will be critical on smaller
segments and will take a while to yield results for the economy. Much more remains to be
achieved on the financial inclusion front. To cite Mr V. Leeladhar, Deputy Governor of the RBI,
from a recent speech: "Compared to the developed world, the coverage of our financial services
is quite low. As per a recent survey commissioned by the British Bankers' Association, 92-94 per
cent of the population of the UK has either a current or a savings bank account."

This contrasts poorly with India, where the ratio of deposit accounts to total adult
population is only 59 percent. But even this figure is suspect, as the average urban middle-class
income-earner often has more than one bank account. This is bound to reduce further the
percentage of people with bank accounts. Most account holders are urban-centric, leaving large
segments of the rural population with no access to banks or the means to save or borrow.

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 Their huge numbers are attested to by the RBI figures, which reveal that the 85
commercial banks, with a predominant presence in urban India, account for 78 per cent of the
country's financial assets. The 3,000 cooperative banks and Regional Rural Banks, with greater
presence in semi-urban and rural pockets, contribute a meager nine per cent and three per cent
respectively.

Secondly, in spite of its being an indirect weapon of credit control, CRR does impact the
level of money supply in the economy and plays some role in the fight against inflation. But the
impact of the CRR hike will not distinguish as between productive credit and credit meant for
consumption. This will hurt growth and the creation of assets in the economy.

Farmers today keep several acres of land uncultivated as the financial returns are not
commensurate with the expenses incurred for cultivation. Irrespective of the increasing cost of
funds, large segments of the borrowing public, especially the small, medium and large farmers,
have no option but to approach the commercial and cooperative banks, or the multitude of
unregulated moneylenders at the beginning of every crop cycle.

As a result, lendable resources of the system will be reduced to that extent and bank
credit will be dearer. This hike will result in increase of the lending rates, whether for production
or consumption. The RBI can address only the demand side through such an approach. The need
of the hour is to curb only consumption credit and not production. On the other hand, there is
urgent need to increase supplies of food products and manufactured goods, for which credit flow
to the farm sector and industry must increase.

The combined effect of the CRR hike and the REPO rate hike will tell upon expansion of
productive credit as well and this is not desirable at this stage.
The monetary measures are meant to increase the cost of funds for banks, make loans dearer and
temper the demand for credit. While there is a greater possibility of banks passing on the
increased costs to the consumer, it is debatable whether this will choke the demand for funds in
some specific inflation-impacting sectors.

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 Suggestions

Based on the data and opinions mentioned above, this paper comes to the conclusion that,
the CRR – REPO mechanism adopted by the RBI has overshot its utility. No doubt, the RBI is
the only authority which is empowered as well as capable to handle the situation. It is also not
disputed that the monetary policy is important to fight inflation.

Right now, the RBI seems to be concentrating only on the Demand end of inflation, as a
result the entire perspective of supply is completely ignored. Inflation may also be curtailed if the
supply is bolstered to meet the demands of the people. With the increase in supply, prices would
inevitably come down and thus inflation may be controlled.

Granted, the supply side would not be strengthened so easily, as it would require
infrastructure development, planning, large scale investments etc. However, this is where the
RBI could play an extremely important role.

The RBI already regularly issues master circulars, through which they direct various
aspects of banking and certain corporate matters. The RBI also regulates and governs matters
regarding inflow of foreign funds, foreign institutional investment (FII) into India, Utilization of
External Commercial Borrowings etc. The RBI does so for various reasons, especially because
not all sectors and industries are at the same level. Some would benefit from external input while
some would be best left alone.

For the purpose of bolstering agricultural growth, development of infrastructure and all
other avenues which the RBI may deem fit; it may lay down regulations to direct money either
directly or indirectly with special importance to these sectors. To direct foreign capital in these
fields and thus bolster infrastructure would not be a difficult task, as the RBI already does this
function. Only this time it shall do it with the purpose of meeting the ever – rising demand.

This would serve a twin purpose. With the RBI increasing the CRR and other interest
rates, it becomes difficult for the farmers to get their loans before their projects. It also becomes
difficult for SME to obtain loans to fulfill their targets as well. Through this carefully routed

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capital, there may be an access to the required finance for these groups of people notwithstanding
the high interest rate.

Secondly and most importantly this would also enable the government to lay down
measures to utilize this money to develop the infrastructure which would bolster supply and thus
would be a huge boost in the fight against inflation in the long run.

The government would also have to play an important role in controlling inflation
without harming the economic growth by ensuring greater transparency in the RBI's sterilization
operations. The Governments at the Centre and the States should take urgent action to make
available adequate credit at competitive interest rates and offer other incentives. Inflation can be
contained only if supply-side and demand issues are effectively addressed, apart from initiating
appropriate fiscal and monetary measures.

The practice adopted by the Central bank right now seems to be an ostrich approach. It is
sufficiently clear that the reason that we have inflation is because the economic status and
mindsets of the people of India are advancing. The Indian consumer is no longer afraid to spend
tomorrow’s money today. The average Indian consumer has reached a comfortable economic
position where he now starts to demand products and services which were earlier not available to
him. This is an indicator of an improved standard of living. Why should this be considered a
disadvantage? The problem here is that the country’s infrastructure is not capable of meeting
these requirements.

But, surprisingly, instead of giving any attention to the supply factors, by simply
lowering money and credit in the market, the RBI is artificially pushing demand down. It is
stifling the needs and requirements of the consumers and is attempting to create an illusion that
there is no demand.

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 The evolution of central banking, not only in India but also globally, indicates that the
central banks have continued to adapt to the changing economic environment. In the interaction
between the financial intermediaries and the central bank, the focus has been the welfare of the
general public. The central banks carefully watch the market trends and monitor numerous
variables, both quantity and rates, in the domestic and global economy. The information
contained in these indicators and the direct feedback from the market participants helps in
calibrating and crafting an appropriate monetary policy to ensure financial stability. In the last
hundred years, a period of time when most central banks were established, the markets, the
objectives and instruments of monetary policy have changed. Despite these changes, the central
banks have established themselves as necessary and permanent part of the financial system.

The Reserve Bank of India had a fair degree of success in achieving the twin
objectives of growth with stability, especially in the post-reform period. The well calibrated
strategies of the Reserve Bank in refining monetary policy operating procedures, managing the
capital flows, ensuring evolution of competitive markets and sustaining a healthy financial
system, while also performing the developmental role have yielded visible results. While
successfully facing the challenges of globalization, the Reserve Bank has earned international
credibility in terms of efficacy of its policies.

The Reserve Bank of India has achieved transparency in its operations, especially in
terms of evolving communication policy aimed at addressing a wide range of audiences.
Notwithstanding the changing challenges of different regimes, the Reserve Bank has managed to
evolve constructively on a continuous basis to cope with demands for stable macroeconomic
management and financial stability, while meeting the objectives of economic growth and
development. As the economy becomes increasingly open and global, the role of the Reserve
Bank will undergo further change and it will need to equip it for coping with these emerging
challenges on a continuous basis.

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 In sum, the changing role of financial regulation and supervision of the Reserve Bank
focuses on prudential supervision, while emphasizing the creation of an environment in which
the banks think freely and innovate. More importance is being given to ‘principles’ and greater
attention to ‘risk assessment and risk containment’. In future, the regulatory and supervisory role
would not only be ‘friendly’ and ‘frank’, but also ‘prompt’ and ‘firm’. The changing face of
regulation and supervision would accord importance to intensified use of technology in
supervisory processes and substantially enhance the skills and capacities of the supervisors.
While fully meeting the socio-economic objectives, it would continue to maintain stable and
orderly conditions in the financial system.

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 Conclusion

To conclude, the role of RBI has been redefined through gradual evolution and
adaptation, along with some statutory changes, and not through any radical restructuring.
Further, while assessing the autonomy of the RBI, one should recognize that RBI is not a pure
monetary authority but is responsible for several other functions also, as a central bank. The
developments in the recent past lead one to the conclusion that, de facto, there has been
enhancement of the autonomy of the RBI. As regards monetary policy framework, the objectives
remained the same but the framework has been changed from time to time in a gradual fashion in
response to the evolving circumstances.

Contextually, there are three important issues in the conduct of monetary policy viz., the
assessment of potential output, the measurement of unemployment and appropriate measure of
inflation. While the policy tries to cope with these issues, a combination of instruments is
necessarily used in a flexible manner to meet these complexities. Every effort has been made to
improve the transmission channels especially through the financial markets, and through
regulatory and institutional reforms. In addition, there are some constraints in the conduct of
monetary policy, in particular, the fiscal impact, predominant public ownership, prevalence of
administered interest rate, etc. While these challenges and dilemmas persist in the Indian context,
every effort is made by the RBI to meet the broader objectives set forth, from time to time.

The endeavour of the RBI is to create conditions for the common person to pay
Government dues at his/her bank branch of choice, while ensuring instantaneous credit to the
Government account with Reserve Bank. This can be achieved with a high degree of
computerization with appropriate connectivity / net-working, encompassing agency banks,
Government Departments and Central Bank for expeditious, cost effective and seamless financial
flows, in a paperless environment. This arrangement will be analogous to the Cash and Debt
Management Group in which Government of India and the RBI are involved.

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 Bibliography

• Websites
- www.wikipedia.com
- www.questia.com
- www.bis.org
- www.ecb.int
- www.bos.frb.org
- www.icfai.org
- www.nyif.com
- www.rbi.org.in
- www.google.com

• Books
- Financial Institutions and Markets
- Indian Financial System

• Newspaper
- The Economic Times

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