Evolution of India’s Monetary Policy

In this article, we will see how did evolution of India’s monetary policy took place, what were the key drivers in monetary policy so far, and what kind of impact it caused.

Note: This article take reference from RBI speech. Do visit RBI website (rbi.org.in) for more informative article on India’s economy.

1935 to 1949: Initial Phase of monetary policy

Important to note: RBI came into being when global economy was facing great depression.  Preamble to the RBI Act, 1934 provided the edifice for the evolution of monetary policy framework.

Key highlights of monetary policy

• Reserve Bank of India Act 1934
• Maintaining sterling parity by regulating liquidity
• Liquidity is provided through Open market operations (OMO), bank rate and cash reserve ratio (CRR)
• Prime focus of monetary policy is exchange rate
• Agriculture based economy which is prone to risks like flood, draughts thus leading to supply side shock. Inflation was a concerning factor
• Price control measures and rationing of essential commodities was undertaken by the Government
• Reserve Bank also used selective credit control and moral suasion to restrain banks from extending credit for speculative purposes

1949 to 1969: Monetary Policy in sync with the Five-Year Plans

Important to note: With independence, there was euporia associated with being self-dependent , ensuring socialistic pattern of society, encouraging industrialistion and implementing big projects. Planning commission also came into being in this period.

Key highlights of monetary policy

• Emphasis on credit allocation to productive sectors
• Role of monetary policy revolves around requirement of five years plan.
• Administering the supply of and demand for credit in the economy
• Regulating the credit availability were bank rate, reserve requirements and open market operations (OMOs)
• Enactment of the Banking Regulation Act in 1949
• Statutory liquidity ratio (SLR) requirement prescribed for banks emerged as a secured source for government borrowings and also served as an additional instrument of monetary and liquidity management

1969 to 1985: Credit Planning

Points to note: This era marked nationalization, Indo-Pak war in 1971, drought in 1973, global oil price shocks in 1973 and 1979, and collapse of the Bretton-woods system in 1973. The main objective of nationalisation of banks was to ensure credit availability to a wider range of people and activities.

Highlights of monetary policy

• Average growth rate hovered around 4.0 per cent, while wholesale price index (WPI) based inflation was around 8.8 per cent.
• Sharp rise in money supply emanating from credit expansion
• Reserve Bank faced the challenge of maintaining a balance between financing economic growth and ensuring price stability
• High inflation due to wars, Droughts and oil shocks in this period
• High inflation in the domestic economy coincided with stagflation – high inflation and slow growth – in advanced economies.
• Banks were flushed with deposits under the impact of deficit financing, undermined the efficacy of Bank Rate as a monetary policy instrument
• Limited scope of OMOs due to underdeveloped government securities market
• Bank Rate and OMOs were found inadequate to address the implications of money supply for price stability

1985 to 1998: Monetary Targeting

This is time of economics stress and then economic liberalization of India. India had a payment crisis in 1990, which resulted in opening of Indian markets. With collapse of global communist order, more and more countries started opening their economies. India too opened its markets for private companies, and witnessed a strong growth post 1991.

Key Highlights of monetary policy

• Average domestic growth rate was 5.6 per cent and average WPI-based inflation was 8.1 per cent.
• Fiscal dominance accentuated
• Automatic monetisation of budget deficit through ad hoc treasury bills and progressive increase in SLR
• Inflationary impact of deficit financing warranted tightening of monetary policy – both the CRR and Bank Rate were raised significantly
• Formal monetary policy framework in 1985 on the recommendations of the Chakravarty Committee
• Monetary policy in dealing with the objectives of containing inflation and promoting growth eventually led to adoption of monetary targeting
• Controlling inflation through limiting monetary expansion, reserve money was used as operating target and broad money as intermediate target.
• The targeted growth in money supply was based on expected real GDP growth and a tolerable level of inflation.
• CRR was used as the primary instrument for monetary control.
• Due to continued fiscal dominance, both SLR and CRR reached their peak levels by 1990.
• The worsening of fiscal situation in late 1980s was manifested in deterioration of external balance position and collapse in domestic growth in 1991-92, in the backdrop of adverse global shocks – the gulf war and disintegration of the Soviet Union.
• The resultant balance of payments crisis triggered large scale structural reforms, financial sector liberalization and opening up of the economy to achieve sustainable growth with price stability.
• Shift from fixed exchange rate regime to a market determined exchange rate system in 1993.
• Notable shift towards market-based financing for both the government and the private sector.
• Automatic monetisation through ad hoc treasury bills was abolished in 1997
• System of ways and means advances (WMAs).

1998 to 2015: Multiple Indicators Approach

Key highlights of monetary policy

• Average domestic growth rate improved to 6.4 per cent and WPI based inflation moderated to 5.4 per cent
• Reserve Bank of India adopted multiple indicators approach in April 1998
• Monetary policy consider number of parameters like credit, output, inflation, trade, capital flows, exchange rate, returns in different markets and fiscal performance
• Fiscal Responsibility and Budget Management (FRBM) Act in 2003
• Shift from direct to indirect instruments of monetary policy, with increased market orientation of the domestic economy and deregulation of interest rates
• Greater emphasis on rate channels relative to quantity instruments for monetary policy formulation
• Short-term interest rates became instruments to signal monetary policy stance of RBI
• For stabilizing short term interest rates, emphasis on the integration of money market with other market segments
• Liquidity adjustment through changes in reserve requirements, standing facilities and OMOs
• Bank rate and repo/reverse repo rates used for adjusting price of liquidity
• Introduction of the Liquidity Adjustment Facility (LAF) in 2000-01 as a tool for both liquidity management and also a signaling device for interest rates in the overnight money market.

2013-2016: Preconditions Set for Inflation Targeting

Points to note – This era was also known as post global financial crisis period (post 2008). This period saw co-existence of high inflation and low growth

Key Highlights of monetary policy

• Multiple indicators approach was junked as it did not provided clear nominal anchor
• US Fed’s taper talk in May/June 2013. Challenges in maintaining balance between growth, inflation and financial stability.
• Inflation was chosen as main anchor for monetary policy
• Inflation was brought down from 11.5% in Nov 2013 to 5% in 2016-17 Q4

2016 onwards: Flexible Inflation Targeting

Key highlights of monetary policy

• Monetary Policy Framework Agreement (MPFA) between the Government of India and the Reserve Bank on February 20, 2015
• Flexible inflation targeting (FIT) was adopted with the amendment of the RBI Act in May 2016
• Flexible inflation targeting (FIT) framework define inflation target of 4% and tolerance band of +/- 2%
• The main objective of monetary policy is to maintain price stability and keep growth in mind
• Forward looking approach for monetary policy
• Liquidity management framework was also fine-tuned since April 2016. This was done through fixed and variable rate repo/reverse repo of various maturities, the marginal standing facility (MSF) and outright open market operations – complemented at times by the cash management bills and foreign exchange swaps.

Factors influencing monetary policy

 

Financial markets play a critical role in effective transmission of monetary policy impulses to the rest of the economy. Within the financial system, money market is central to monetary operations conducted by the central bank.

Monetary policy transmission framework

Key points to note

Money market before 1980s, was highly immature. Liquidity was skewed with few lenders and chronic borrowers.  Treasury bills before 1980s were not successful due to fixed interest rate under the system of automatic monetization. Administered interest rates and captive investor base in government securities market further impeded open market operations. There was little or no integration of different market segments which are required for effective policy transmissions. Thus, monetary policy initially relied mainly on credit planning and selective credit controls and eventually on monetary targeting through quantitative instruments.

Early 1990s say the dismantling of price controls in financial system, and integration of financial markets. Reform measures are introduced

• encompassed removing structural bottlenecks
• introducing new players/instruments
• ensuring free pricing of financial assets
• relaxing quantitative restrictions
• strengthening institutions
• improving trading
• clearing and settlement practices
• encouraging good market practices
• promoting greater transparency.

These reforms gradually facilitated the price discovery in financial markets and interest rate emerged as a signaling mechanism.

End Note

We hope that this article helped you in visualizing how monetary policy of India evolved so far has. Do share your comment/opinion regarding this article, by commenting in the discussion threads below.

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