Financial Sector Reforms and Monetary Policy: The Indian Experience

Rakesh Mohan∗

I. Introduction The Indian economy has achieved high growth since the early 1980s in an environment of macroeconomic and financial stability. The period has been marked by broad based economic reform that has touched every segment of the economy. These reforms were designed essentially to promote greater efficiency in the economy through promotion of greater competition. The story of Indian reforms is by now well-documented (e.g., Ahluwalia, 2002); nevertheless, what is less appreciated is that, India achieved this acceleration in growth while maintaining price and financial stability in the 1990s and in the current decade so far. As a result of the growing openness, India has not been totally insulated from exogenous shocks since the second half of the 1990s. These shocks, global as well as domestic, included a series of financial crises in Asia, Brazil and Russia, 9/11 terrorist attacks in the US, border tensions, sanctions imposed in the aftermath of nuclear tests, political uncertainties, changes in the Government, and the oil and commodity price shock of 2007-08. The stability of the Indian financial sector has again been tested by the ongoing global financial and economic crisis – the severest crisis to hit the global economy since the Great Depression. Nonetheless, stability could be maintained in financial markets, including in the ongoing episode of global financial market turmoil, reflecting prudent, cautious and calibrated approach to financial globalisation. Indeed, inflation has been contained since the mid-1990s to an average of around five per cent, distinctly lower than that of around eight per cent per annum over the previous four decades. Simultaneously, the health of the financial sector has recorded very significant improvement.

India's path of reforms has been different from most other emerging market economies: it has been a measured, gradual, cautious, and steady process, devoid of many flourishes that could be observed in other countries. I shall argue in this paper that reforms in the financial sector and monetary policy framework have been a key component of the overall reforms that provided the foundation of an increased price and financial stability. Reforms in these sectors have been well-sequenced, taking into account the state of the markets in the various segments.

The main objective of the financial sector reforms in India initiated in the early 1990s was to create an efficient, competitive and stable financial sector that could then contribute in greater measure to stimulate growth. Concomitantly, the monetary policy framework made a phased shift from direct instruments of monetary management to an increasing reliance on indirect instruments. However, as appropriate monetary transmission cannot take place without efficient price discovery of interest rates and exchange rates in the overall functioning of financial markets, the corresponding development of the money market, the Government securities market and the foreign exchange market became necessary. Reforms in the various segments were therefore coordinated. In this process, growing integration of the Indian economy with the rest of the world also had to be recognised and provided for.

∗ This is a revised and updated (May 2009) version of the paper presented at the Conference on Economic Policy in Asia at Stanford, organised by Stanford Center for International Development and Stanford Institute for Economic Policy Research, on June 2, 2006. I am indebted to R. Kannan, Muneesh Kapur, Indranil Bhattacharyya and Partha Ray for their assistance in preparing the paper. The usual disclaimer applies. The paper has also benefitted from comments from anonymous referees.

Against this backdrop, the coverage of this paper is threefold. First, I will give a synoptic account of the reforms in financial sector and monetary policy. Second, this is followed by an assessment of these reforms in terms of outcomes and the health of the financial sector. Finally, lessons emerging from the Indian experience for issues of topical relevance for monetary authorities are considered in the final section.

II. Financial Sector and Monetary Policy: Objectives and Reforms Till the early 1990s the Indian financial sector could be described as a classic

example of “financial repression” a la McKinnon and Shaw. Monetary policy was subservient to the fisc. The financial system was characterised by extensive regulations such as administered interest rates, directed credit programmes, weak banking structure, lack of proper accounting and risk management systems and lack of transparency in operations of major financial market participants (Mohan, 2004b). Moreover, after the nationalisation of banks in 1969 and 1980, 90 per cent of banking assets were in government owned banks and financial institutions, while entry of foreign banks was restricted. Hence, there was a significant lack of competition in the financial sector. Such a system hindered efficient allocation of resources. Financial sector reforms initiated in the early 1990s have attempted to overcome these weaknesses in order to enhance efficiency of resource allocation in the economy.

Simultaneously, the Reserve Bank took a keen interest in the development of financial markets, especially the money, government securities and forex markets in view of their critical role in the transmission mechanism of monetary policy. As for other central banks, the money market is the focal point for intervention by the Reserve Bank to equilibrate short-term liquidity flows on account of its linkages with the foreign exchange market. Similarly, the Government securities market is important for the entire debt market as it serves as a benchmark for pricing other debt market instruments, thereby aiding the monetary transmission process across the yield curve. The Reserve Bank had, in fact, been making efforts since 1986 to develop institutions and infrastructure for these markets to facilitate price discovery. These efforts by the Reserve Bank to develop efficient, stable and healthy financial markets accelerated after 1991. There has been close co-ordination between the Central Government and the Reserve Bank, as also between different regulators, which helped in orderly and smooth development of the financial markets in India.

What have been the major contours of the financial sector reforms in India? For the sake of completeness, these include: removal of the erstwhile existing financial repression; creation of an efficient, productive and profitable financial sector; enabling the process of price discovery by the market determination of interest rates that improves allocative efficiency of resources; providing operational and functional autonomy to institutions; preparing the financial system for increasing international competition; introduction of private equity in public sector banks and their listing; opening the external sector in a calibrated manner; and promoting financial stability in the wake of domestic and external shocks.

The financial sector reforms since the early 1990s could be analytically classified into two phases.1 The first phase - or the first generation of reforms - was aimed at creating an efficient, productive and profitable financial sector which would function in an

1 Reddy (2002) noted that the approach towards financial sector reforms in India has been based on five principles: (i) cautious and appropriate sequencing of reform measures; (ii) introduction of mutually reinforcing norms; (iii) introduction of complementary reforms across monetary, fiscal and external sectors; (iv) development of financial institutions; and (v) development of financial markets.

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environment of operational flexibility and functional autonomy. In the second phase, or the second generation reforms, which started in the mid-1990s, the emphasis of reforms has been on strengthening the financial system and introducing structural improvements. Against this brief overview of the philosophy of financial sector reforms, let me briefly touch upon reforms in various sectors and segments of the financial sector.

Banking Sector The main objective of banking sector reforms was to promote a diversified, efficient and competitive financial system with the ultimate goal of improving the allocative efficiency of resources through operational flexibility, improved financial viability and institutional strengthening. The reforms have focussed on removing financial repression through reductions in statutory pre-emptions, while stepping up prudential regulations at the same time. Furthermore, interest rates on both deposits and lending of banks have been progressively deregulated (Annex I).

As the Indian banking system had become predominantly government owned by the early 1990s, banking sector reforms essentially took a two pronged approach. First, the level of competition was gradually increased within the banking system while simultaneously introducing international best practices in prudential regulation and supervision tailored to Indian requirements. In particular, special emphasis was placed on building up the risk management capabilities of Indian banks while measures were initiated to ensure flexibility, operational autonomy and competition in the banking sector. Second, active steps were taken to improve the institutional arrangements including the legal framework and technological system. The supervisory system was revamped in view of the crucial role of supervision in the creation of an efficient banking system (RBI, 2008).

Measures to improve the health of the banking system have included (i) restoration of public sector banks' net worth through recapitalisation where needed; (ii) streamlining of the supervision process with combination of on-site and off-site surveillance along with external auditing; (iii) introduction of risk based supervision; (iv) introduction of the process of structured and discretionary intervention for problem banks through a prompt corrective action (PCA) mechanism; (v) institutionalisation of a mechanism facilitating greater coordination for regulation and supervision of financial conglomerates; (vi) strengthening creditor rights (still in process); and (vii) increased emphasis on corporate governance.

Consistent with the policy approach to benchmark the banking system to the best international standards with emphasis on gradual harmonisation, Indian banks that have presence outside and all foreign banks operating in India migrated to the standardised approach for credit risk and the basic indicator approach for operational risk under Basel II in April 2008. All other scheduled commercial banks migrated to these approaches under Basel II in April 2009. Recognising the differences in degrees of sophistication and development of the banking system, it has been decided that the banks will initially adopt the Standardised Approach for credit risk and the Basic Indicator Approach for operational risk. After adequate skills are developed, both by the banks and also by the supervisors, some of the banks may be allowed to migrate to the Internal Rating Based (IRB) Approach. Although implementation of Basel II will require more capital for banks in India, the cushion available in the system - at present, the Capital to Risk-weighted Assets Ratio (CRAR) is around 13 per cent - provides some comfort. In order to provide banks greater flexibility and avenues for meeting the capital requirements, the Reserve Bank has

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issued policy guidelines enabling issuance of several instruments by the banks viz., innovative perpetual debt instruments, perpetual non-cumulative preference shares, redeemable cumulative preference shares and hybrid debt instruments.

Reforms in the Monetary Policy Framework

The basic emphasis of monetary policy since the initiation of reforms has been to reduce market segmentation in the financial sector through increased interlinkages between various segments of the financial market including money, government security and forex markets. The key policy development that enabled a more independent monetary policy environment as well as the development of the Government securities market was the discontinuation of automatic monetisation of the government's fiscal deficit since April 1997 through an agreement between the Government and the Reserve Bank of India in September 1994. This provision has got strengthened with the enactment of the Fiscal Responsibility and Budget Management (FRBM) Act in 2003, which has prohibited the Reserve Bank, since April 2006, from subscribing to government securities in the primary market. In order to meet the challenges thrown up by financial liberalisation and the growing complexities of monetary management, the Reserve Bank switched from a monetary targeting framework to a multiple indicator approach from 1998-99. Short-term interest rates have emerged as the key indicators of the monetary policy stance. A significant shift is the move towards market-based instruments away from direct instruments of monetary management. In line with international trends, the Reserve Bank has put in place a liquidity management framework in which market liquidity is managed through a mix of daily reverse repo/repo operations under the liquidity adjustment facility (LAF), open market operations (OMOs), changes in reserve requirements and standing facilities, reinforced by changes in the the short term (overnight) policy rates. In order to carry out these market operations effectively, the Reserve Bank has initiated several measures to strengthen the health of its balance sheet.

Over the past few years, the process of monetary policy formulation has become relatively more articulate, consultative and participative with an external orientation, while the internal work processes have also been re-engineered. A notable step in this direction is the constitution of a Technical Advisory Committee on Monetary Policy comprising external experts to advise the Reserve Bank on the stance of monetary policy (Annex II).

Following the reforms, the financial markets have now grown in size, depth and activity paving the way for flexible use of indirect instruments by the Reserve Bank to pursue its objectives. It is recognised that stability in financial markets is critical for efficient price discovery. Excessive volatility in exchange rates and interest rates masks the underlying value of these variables and gives rise to confusing signals. Since both the exchange rate and interest rate are the key prices reflecting the cost of money, it is particularly important for the efficient functioning of the economy that they be market determined and be easily observed. The Reserve Bank has, therefore, put in place a liquidity management framework in the form of a liquidity adjustment facility (LAF) for the facilitation of forex and money market transactions that result in price discovery sans excessive volatility. The LAF coupled with OMOs and the Market Stabilisation Scheme (MSS) has provided the Reserve Bank greater flexibility to manage market liquidity in consonance with its policy stance. The introduction of LAF had several advantages (Mohan, 2006b). First, it helped the transition from direct instruments of monetary control to indirect and, in the process, certain dead weight loss for the system was saved. Second, it has provided monetary authorities with greater flexibility in determining both the quantum of adjustment as well as the rates by responding to the needs of the system on a

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daily basis. Third, it enabled the Reserve Bank to modulate the supply of funds on a daily basis to meet day-to-day liquidity mismatches. Fourth, it enabled the Reserve Bank to affect demand for funds through policy rate changes. Finally, and most important, it helped stabilise short-term money market rates.

The LAF has now emerged as the principal operating instrument of monetary policy. Although there is no formal targeting of a point overnight interest rate, the LAF is designed to nudge overnight interest rates within a specified corridor, the difference between the fixed repo and reverse repo rates. The width of the corridor has varied over time - currently (May 2009) being 150 basis points 2 - taking into account evolving macroeconomic and monetary conditions as well as the level of uncertainty. In case the Reserve Bank is in a tightening mode, the LAF repo rate becomes the effective signalling rate; in the case of accommodative stance, the LAF reverse repo rate takes the place of the signalling rate. The evidence suggests that the LAF has been largely successful with the overnight interest rate moving out of this corridor for only a few brief periods. The LAF has enabled the Reserve Bank to de-emphasise targeting of bank reserves and focus increasingly on interest rates. Initially, this helped in reducing the cash reserve ratio (CRR) without loss of monetary control. The CRR, however, continues to remain one of the monetary policy tools. While the medium-term policy objective of reducing the CRR to 3 per cent (of net demand and time liabilities) remains, the Reserve Bank retains the flexibility to change the CRR in either direction, as the macroeconomic and financial conditions may warrant. Thus, the CRR was initially reduced from 15 per cent in the early 1990s to 4.5 per cent by March 2004 as a part of the financial sector reforms process. However, in view of large and growing volume of net capital inflows, well in excess of the current account deficit, and in order to manage domestic liquidity so as to maintain macroeconomic and financial stability, the CRR was raised to 9.0 per cent by August 2008 in stages. Subsequently, in response to the large portfolio equity outflows in the aftermath of the ongoing global financial crisis and its impact on domestic liquidity conditions, the CRR was scaled back in quick succession to 5 per cent by January 2009. Thus, the instrumentality of the CRR (along with operations under the MSS, as explained later) has served as a highly effective and symmetric buffer of liquidity management by the Reserve Bank: absorption of liquidity in terms of large and copious capital flows and injection in times of reversals.

Given the growing role played by expectations, the stance of monetary policy and its rationale are communicated to the public in a variety of ways. As mentioned, the enactment of the FRBM Act, 2003 has strengthened the institutional mechanism further: from April 2006 onwards, the Reserve Bank is no longer permitted to subscribe to government securities in the primary market. The development of the monetary policy framework has also involved a great deal of institutional initiatives to enable efficient functioning of the money market: development of appropriate trading, payments and settlement systems along with technological infrastructure.

Financial Markets The success of a framework that relies on indirect instruments of monetary

management such as interest rates is contingent upon the extent and speed with which changes in the central bank's policy rate are transmitted to the spectrum of market interest

2 The width of the corridor was initially reduced from 150 basis points in March 2004 to 100 basis points by April 2005, but was then increased in stages to 300 basis as of July 2008. It has again been reduced to 150 basis points by November 2008 in response to the global financial crisis.

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rates and exchange rate in the economy and onward to the real sector. Given the critical role played by financial markets in this transmission mechanism, the Reserve Bank has taken a number of initiatives to develop a pure inter-bank money market. A noteworthy and desirable development has been the substantial migration of money market activity from the uncollateralised call money segment to the collateralised market repo and collateralised borrowing and lending obligations (CBLO) markets. The shift of activity from uncollateralised to collateralised segments of the market has largely resulted from measures relating to limiting the call market transactions to banks and primary dealers only. This policy-induced shift is in the interest of financial stability and is yielding results.

Concomitantly, efforts have been made to broaden and deepen the Government securities market and the foreign exchange market so as to enable the process of efficient price discovery in respect of interest rates and the exchange rate (Annexes III and IV).

It is pertinent to note that the phased approach to development of financial markets has enabled RBI's withdrawal from the primary market since April 1, 2006. This step completed the transition to a fully market based system in the G-sec market. According to the recommendations of the Twelfth Finance Commission, the Central Government has ceased to raise resources on behalf of State Governments, who now access the market directly (Mohan, 2006c). These steps are helping to achieve the desired integration in the conduct of monetary operations.

As regards the foreign exchange market, reforms focused on market development with inbuilt prudential safeguards so that the market would not be destabilised in the process (Reddy, 2002). The move towards a market-based exchange rate regime in 1993 and the subsequent adoption of current account convertibility were the key measures in reforming the Indian foreign exchange market. Banks are increasingly being given greater autonomy to undertake foreign exchange operations. In order to deepen the foreign exchange market, a large number of products have been introduced and entry of new players has been allowed in the market (Annex IV).

Summing up, reforms were designed to enable the process of efficient price discovery and induce greater internal efficiency in resource allocation within the banking system. While the policy measures in the pre-1990s period were essentially devoted to financial deepening, the focus of reforms since the early 1990s has been engendering greater efficiency and productivity in the banking system. Reforms in the monetary policy framework were aimed at providing operational flexibility to the Reserve Bank in its conduct of monetary policy by relaxing the constraint imposed by passive monetisation of the fisc.

III. Financial Sector and Monetary Policy Reforms: An Assessment

Banking Sector An assessment of the banking sector shows that banks have experienced strong balance sheet growth in the post-reform period in an environment of operational flexibility. Improvement in the financial health of banks, reflected in significant improvement in capital adequacy and improved asset quality, is distinctly visible. It is noteworthy that this progress has been achieved despite the adoption of international best practices in asset classification in terms of tightening of classification of non-performing loans. Competitiveness and productivity gains have also been enabled by proactive technological deepening and flexible human resource management. These significant

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gains have been achieved even while renewing our goals of social banking viz., maintaining the wide reach of the banking system and directing credit towards important but disadvantaged sectors of society. A brief discussion on the performance of the banking sector under the reform process is given below.

Spread of Banking

The banking system's wide reach, judged in terms of expansion of branches and the growth of credit and deposits indicates continued financial deepening (Table 1). The population per bank branch has not changed much since the 1980s, and has remained at around 15,000.

Table 1: Progress of Commercial Banking in India

Indicators June June March March March March 1969 1980 1991 1995 2000 2008 1 2 3 4 5 6 8 1. No. of Commercial Banks 89 153 276 284 298 174 2. No. of Bank Offices 8,262 32,419 60,220 62,367 67,868 77,773 Of which 3. Rural and semi-urban bank offices 5,175 23,227 46,550 46,345 47,193 48,633 4. Population per Office (’000s) 64 21 14 15 15 15 5. Per capita Deposit (Rs.) 88 494 2,368 4,242 8,542 28,610 6. Per capita Credit (Rs.) 68 327 1,434 2,320 4,555 21,218 7. Priority Sector Advances@ (per cent) 14.0 33.0 37.7 33.7 35.4 32.9 @: Share in total non-food credit of scheduled commercial banks. Source: Reserve Bank of India.

In the post-reform period, banks have consistently maintained high rates of growth in their assets and liabilities. On the liability side, deposits continue to account for about the bulk – at present, 77 per cent - of the total liabilities. On the asset side, the shares of loans and advances on the one hand and investments on the other hand have seen marked cycles, reflecting banks' portfolio preferences as well as growth cycles in the economy. The share of loans and advances declined in the second half of 1990s responding to slowdown in investment demand as well as tightening of prudential norms. With investment demand again picking up from 2003-04 onwards, the credit portfolio of banks has witnessed sharp growth. Banks' excess investments in gilts have accordingly seen a significant decline. Thus, while in the 1990s, greater investments and aversion to credit risk exposure may have deterred banks from undertaking their ‘core function’ of financial intermediation viz., accepting deposits and extending credit, they seem to have struck a greater balance in recent years between investments and loans and advances (Table 2). The improved atmosphere for recovery created in the recent years also seems to have induced banks to put greater efforts in extending loans.

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Table 2: Consolidated Balance Sheet of Scheduled Commercial Banks

(Amount in Rs. billion) As at end-March

Item 2000 2002 2005 20081 2 3 4 5 Liabilities 0.0 0 1. Capital and Reserves 623

(5.6)842

(5.5)1,496 (6.4)

3,157(7.3)

2. Deposits 9,003(81.1)

12,027(78.3)

18,376 (78.0)

33,200(76.7)

3. Borrowings 454(4.1)

1,072(7.0)

1,681 (7.1)

2,973(6.9)

4. Other Liabilities and Provisions 1,024(9.2)

1,415(9.2)

2,007 (8.5)

3,935(9.1)

Total Liabilities/Assets 11,104(100.0)

15,355(100.0)

23,560 (100.0)

43,265(100.0)

Assets 0 0 1. Cash, balances with RBI and banks, & money at call and short notice

1,664(15.0)

2,043(13.3)

2,134 (9.1)

4,333(10.1)

2. Investments 4,139(37.3)

5,880(38.3)

8,697 (36.9)

11,761(27.2)

2.1 Government Securities 2,882(26.0)

4,317(28.1)

6,988 (29.7)

9,258(21.3)

2.2 Other Approved Securities 252(2.3)

217(1.4)

163 (0.7)

106(0.2)

2.3 Non-Approved Securities 1,004(9.1)

1,345(8.8)

1,547 (6.6)

2,398(5.5)

3. Loans and Advances 4,435(39.9)

6,457(42.1)

11,508 (48.8)

24,770(57.3)

4. Fixed and Other Assets 866(7.8)

974(6.3)

1,219 (5.2)

2,400(5.6)

Note: Figures in parenthesis indicate percentage share in total liabilities/assets.

Capital Position and Asset Quality

Since the beginning of reforms, a set of micro-prudential measures have been stipulated aimed at imparting strength to the banking system as well as ensuring safety. With regard to prudential requirements, income recognition and asset classification (IRAC) norms have been strengthened to approach international best practice. Initially, while it was deemed to attain a CRAR of 8 per cent in a phased manner, it was subsequently raised to 9 per cent with effect from 1999-2000.

The overall capital position of commercial banks has witnessed a marked improvement during the reform period (Table 3). Illustratively, as at end-March 2008, all the 79 commercial banks operating in India maintained CRAR at or above 9 per cent. The corresponding figure for 1996-97 was 77 out of 100 banks. Improved capitalisation of public sector banks was initially brought through substantial infusion of funds by government to recapitalise these banks. Subsequently, in order to mitigate the budgetary impact and to introduce market discipline, public sector banks were allowed to raise funds from the market through equity issuance subject to the maintenance of 51 per cent public

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ownership. Ownership in public sector banks is now well diversified. As at end-March 2008, the holding by the general public in 10 nationalised banks (out of a total of 20) ranged between 40 and 49 per cent and in 3 banks, it was between 30 and 49 per cent. Only in two nationalised banks, the Government holding remains 100 per cent.

Table 3: Distribution of Commercial Banks According to Risk-weighted Capital Adequacy

(Number of banks)Year Below 4

per cent Between

4-9 per centBetween

9-10 per cent Above

10 per cent Total

1 2 3 4 5 61996-97 5 18 12 65 1002000-01 3 2 11 84 1002004-05 1 1 8 78 882007-08 0 0 2 77 79Source: Reserve Bank of India.

Despite tightening norms, there has been considerable improvement in the asset quality of banks. India transited to a 90-day NPL recognition norm (from 180-day norm) in 2004. Nonetheless, non-performing assets (NPAs), as ratios of both total advances and assets, have declined substantially and consistently since the mid-1990s (Table 4). Improvement in the credit appraisal process, upturn of the business cycle, new initiatives for resolution of NPLs (including promulgation of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act), and greater provisioning and write-off of NPLs enabled by greater profitability, have kept incremental NPLs low.

Table 4: Non-Performing Assets (NPAs) of Scheduled Commercial Banks

(Per cent) Gross NPAs/

advancesGross NPAs/

AssetsNet NPAs/

advances Net NPAs/

Assets 1 2 3 4 5 1996-97 15.7 7.0 8.1 3.31997-98 14.4 6.4 7.3 3.01998-99 14.7 6.2 7.6 2.91999-00 12.7 5.5 6.8 2.72000-01 11.4 4.9 6.2 2.52001-02 10.4 4.6 5.5 2.32002-03 8.8 4.0 4.4 1.92003-04 7.2 3.3 2.8 1.22004-05 5.2 2.5 2.0 0.92005-06 3.1 1.8 1.2 0.72006-07 2.4 1.5 1.0 0.62007-08 2.3 1.3 1.0 0.6Source Reserve Bank of India.

Stress tests recently undertaken by the Committee on Financial Sector Assessment (CFSA) (Chairman: Rakesh Mohan) (RBI, 2009) show that the commercial banks can withstand significant shocks arising from large potential changes in credit quality, interest

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rate and liquidity conditions. Under the worst-case scenario (150 per cent increase in gross NPAs), the overall capital adequacy position of the banking sector would have declined to 10.6 percent in September 2008 – still well-above the regulatory requirement of 9 per cent. Thus, even under the worst case scenario, CRAR remains comfortably above the regulatory minimum.

As noted above, non-performing assets have seen a significant decline over the past decade. However, some commentators such as Banerjee, Cole and Duflo (2004) have expressed some scepticism about this improvement. For instance, they observe:

“banks may engage in creative accounting or “evergreening,” and the current classification norms mapping loan repayment delay to NPL do not yet meet international norms”.

“An informative check, conducted by Petia Topalova, is to use data from corporate balance sheets to estimate the ability of firms to repay their loans. Firms whose (income defined as earnings before interest, taxes, depreciation, and amortization) is less than their reported interest expense are either defaulting, are very close to default, or would be defaulting if their loans were not “evergreened.” This share of “potential NPAs” has increased significantly in the past five years, while banks reported level of NPAs have stayed fairly constant.” (Banerjee et al., pages 315-316),

Although these observations are now dated, it is important to put them in context.

First, banks’ NPAs reporting is subject to audit and is also checked by the Reserve Bank in its periodic inspections. Banerjee et al. refer to skepticism, but no hard evidence. Second, NPA recognition by the Indian banking system, since March 2004, is based on the international norm of 90-day recognition. Third, the Topolova study, which Banerjee et al. (2004) quote, was published in 2004 and the analysis is based on the period of the preceding five years at that point of time – a period coinciding with the slowdown in the Indian economy at the turn of the century. In a cyclical downswing, some NPA increase could be normal. Fourth, in the period subsequent to the Topolova study, corporate profitability has recorded strong growth. Profits after tax recorded an annual average growth of around 41 per cent per annum over the 5-year period ended 2003-04 to 2007-08. The ratio of interest expenditure to total expenditure more than halved from an average of 6.0 per cent during 1997-2003 to 2.7 per cent during 2003-08 (see Table 8).The interest coverage ratio which was fluctuating around 2 from 1990-91 to 2002-03 recorded significant improvement in the subsequent period reaching 7.3 in 2007-08. Thus, corporate profitability has seen a total turnaround over the past five years, cash flows have improved significantly and balance sheets have become fairly robust. Therefore, concerns based on corporate balance sheets, even if conceptually valid, are no longer relevant. Fifth, Banerjee et al. presume corporate loans and corporate sector NPAs to be synonymous with overall NPAs. As noted later, the share of industry in total bank credit is only 38 per cent and their share has been declining over the past two decades. The share of retail credit has increased significantly and these loans are now almost a fourth of total loans. Finally, Banerjee at al. have ignored the important interpretational and conceptual caveats stressed by Topolova in the use of interest coverage ratio (ICR) as a proxy for NPAs. To quote:

“.... However, caution should be exercised in interpreting this measure. First, ICRs do not necessarily account for all the resources that a company may have at its disposal to meet its debt service payments. Second, with profitability fluctuating over the business cycle and due to idiosyncratic shocks at the company level, the persistence rather than incidence of a low ICR may be a more useful indicator of stress to monitor. Third, other liquidity indicators (e.g., current ratios)

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may be needed to get a more complete picture of problems facing companies. Lastly, the measure of potential NPLs derived from ICRs is not intended to be a substitute for other measures of NPLs, including those from banking data. Rather, it can serve as one additional indicator of the prospective health of the financial system (Topolova, 2004, page 17).

Competition and Efficiency

In consonance with the objective of enhancing efficiency and productivity of banks through greater competition - from new private sector banks and entry and expansion of several foreign banks - there has been a consistent decline in the share of public sector banks in total assets of commercial banks. Notwithstanding such transformation, the public sector banks still account for nearly 70 per cent of assets and income. Public sector banks have also responded to the new challenges of competition, and have maintained their share in the overall profit of the banking sector. This suggests that, with operational flexibility, public sector banks are competing relatively effectively with private sector and foreign banks. Public sector bank managements are now probably more attuned to the market consequences of their activities (Mohan, 2006a). Shares of Indian private sector banks, especially new private sector banks established in the 1990s, in the total income and assets of the banking system have improved considerably since the mid-1990s (Table 5). The share of foreign banks in total income and assets has been broadly unchanged over the past decade.

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Table 5: Bank Group-wise Shares: Select Indicators

(Per cent) Item 1995-96 2000-01 2004-05 2005-06 2006-07 2007-08

1 2 3 4 5 6 7 Public Sector Banks Income 82.5 78.4 75.6 72.4 68.4 66.7Expenditure 84.2 78.9 75.8 73.0 68.9 68.5Total Assets 84.4 79.5 74.4 72.3 70.5 69.9Net Profit -39.1@ 67.4 73.3 67.3 64.6 62.2Gross Profit 74.3 69.9 75.9 69.8 64.1 60.3New Private Sector Banks Income 1.5 5.7 11.8 14.4 17.8 19.3Expenditure 1.3 5.5 11.4 14.1 17.9 19.5Total Assets 1.5 6.1 12.9 15.1 16.9 17.2Net Profit 17.8 10.0 15.0 16.7 17.1 17.7Gross Profit 2.5 6.9 10.7 13.8 16.7 18.7Foreign Banks Income 9.4 9.1 7.0 8.0 9.0 9.5Expenditure 8.3 8.8 6.6 7.4 8.3 7.3Total Assets 7.9 7.9 6.8 7.2 8.0 8.4Net Profit 79.8 14.8 9.7 12.5 14.7 15.5Gross Profit 15.6 15.7 9.0 12.2 14.6 16.7@: Public sector banks, as a group, had recorded net losses during 1995-96. Source: Reserve Bank of India.

Efficiency gains are also reflected in containment of the operating expenditure as a

proportion of total assets (Table 6). This has been achieved in spite of large expenditures incurred by Indian banks in installation and upgradation of information technology and, in the case of public sector banks, large expenditures under voluntary retirement of nearly 12 per cent of their total staff strength.

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Table 6: Earnings and Expenses of Scheduled Commercial Banks (Rs. billion)

Fiscal Year ending March 31

Total Assets

Total Earnings

Interest Earnings

Total Expenses

Interest Expenses

Establishment Expenses

Net Interest

Earnings

1 2 3 4 5 7 8 91969 68 4 4 4 2 1 2 (6.2) (5.3) (5.5) (2.8) (2.1) (2.5)1980 582 42 38 42 27 10 10 (7.3) (6.4) (7.2) (4.7) (1.7) (1.8)1991 3,275 304 275 297 190 76 86 (9.3) (8.4) (9.1) (5.8) (2.3) (2.6)2000 11,055 1,149 992 1,077 690 276 301 (10.4) (9.0) (9.7) (6.2) (2.5) (2.7)2005 23,560 1,902 1,556 1,693 891 501 667 (8.1) (6.6) (7.2) (3.8) (2.1) (2.8)2007 34,600 2,747 2,332 2,435 1,424 663 893 (7.9) (6.7) (7.0) (4.1) (1.9) (2.6)2008 43,265 3,689 3,096 3,262 2,080 772 1,016 (8.5) (7.2) (7.5) (4.8) (1.8) (2.3)Note: Figures in brackets are ratios to total assets. Source: Reserve Bank of India.

Bank group-wise, the intermediation cost of PSBs is now substantially lower than that of new private banks and foreign banks (Table 7). However, intermediation costs of banks in India still tend to be higher than those in developed countries, although these are comparable to most emerging market economies (EMEs) (RBI, 2008). The cost income-ratio (defined as the ratio of operating expenses to total income less interest expense) of Indian banks has shown a declining trend during the post reform period (Mohan, 2006a). For example, Indian banks paid roughly 50 per cent of their net income towards managing labour and physical capital in 2006-07 as against nearly 72 per cent in 1992-93. Indian banks thus recorded a net cost saving of nearly 22 per cent of their net income during the post reform period.

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Table 7: Intermediation Cost* of Scheduled Commercial Banks

(as percentage to total assets)Fiscal Year ending March

Public Sector Banks

New Private Banks

Foreign Banks All Scheduled Commercial Banks

1 2 3 4 5

1996 2.99 1.89 2.77 2.941997 2.88 1.94 3.00 2.851998 2.66 1.76 2.97 2.631999 2.66 1.74 2.59 2.672000 2.53 1.42 3.22 2.502001 2.72 1.75 3.05 2.642002 2.29 1.10 3.00 2.192003 2.25 1.96 2.79 2.242004 2.21 2.04 2.75 2.212005 2.09 2.06 2.88 2.132006 2.05 2.12 2.94 2.132007 1.77 2.11 2.82 1.922008 1.54 2.28 2.84 1.78* Intermediation cost = operating expenses. Source: Report on Trend and Progress of Banking in India, RBI, various years.

Productivity

What is most encouraging is the very significant improvement in the productivity of the Indian banking system, in terms of various productivity indicators. The business per employee of Indian banks increased almost five-fold (in real terms) between 1992 and 2007, exhibiting an annual compound growth rate of around 11 per cent (Table 7). The profit per employee, over the same period, recorded a compound growth of around 18 per cent per annum. Branch productivity also recorded concomitant improvements. These improvements could be driven by two factors: technological improvement, which expands the range of production possibilities and a catching up effect, as peer pressure amongst banks compels them to raise productivity levels. Here, the role of new business practices, new approaches and expansion of the business that was introduced by the new private banks has been of the utmost importance.

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Table 8: Select Productivity Indicators of Scheduled Commercial Banks* (Rs. million at 1999-00 prices)

Business per Profit Business per Year (ending March)

employee per employee branch

1 2 3 4

1992 8.6 0.03 162.71996 9.6 0.01 182.32000 14.3 0.08 252.72005 30.6 0.21 450.22006 33.6 0.22 522.92007 39.7 0.26 603.0*Excluding RRBs Note: Business includes Deposits and Advances. Source: Statistical Tables relating to Banks in India.

Efficiency and productivity based on economic measures corroborate the findings

of those based on the above noted accounting measures or financial ratios (RBI, 2008). Such an analysis suggests that in the Indian context, there is no relationship between ownership and efficiency, i.e., most efficient banks are from all the three segments, i.e., public, private and foreign. However, size seems to have a significant relationship with efficiency. Large and diversified banks are found to be more efficient. Productivity in banks rose many fold largely driven by technological innovation and enabling policy environment. However, while some domestic banks, especially public sector and new private sector banks, were able to reach the enhanced output potential, some other domestic banks were not able to catch up or utilise the enhanced output potential resulting from technological innovations.

Monetary Policy What has been the impact of the monetary policy? From the innumerable dimensions of impact of monetary policy, let me focus on some select elements.

Inflation

Turning to an assessment of monetary policy, it would be reasonable to assert that monetary policy has been largely successful in meeting its key objectives in the post-reforms period. Just as the rest of the world witnessed a fall in inflation since the late 1990s, so too has India. No doubt, reduction of trade protection, both internationally and in India, has contributed to this moderation. A number of other factors such as increased competition, productivity gains and strong corporate balance sheets have also contributed to this low and stable inflation environment, but it appears that calibrated monetary measures had a substantial role to play as well. Inflation has averaged close to five per cent per annum in the decade gone by, notably lower than that of eight per cent in the previous four decades (Chart 1). Structural reforms since the early 1990s coupled with improved monetary-fiscal interface and reforms in the Government securities market enabled better monetary management from the second half of the 1990s onwards. More importantly, the regime of low and stable inflation has, in turn, stabilised inflation

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expectations and inflation tolerance in the economy has come down. Since inflation expectations are a key determinant of the actual inflation outcome, and given the lags in monetary transmission, we have been taking pre-emptive measures to keep inflation expectations stable. As discussed further below, a number of instruments, both existing as well as new, were employed to modulate liquidity conditions to achieve the desired objectives. A cross-country comparison of G-20 economies indicates that growth in India has been amongst the highest while inflation remains relatively low (Mohan, 2007).

Challenges Posed by Large Capital Inflows

It is pertinent to note that inflation could be contained since the mid-1990s, despite challenges posed by large capital flows. Following the reforms in the external sector, foreign investment flows have been encouraged. Reflecting the strong growth prospects of the Indian economy, the country has received large investment inflows, both direct and portfolio, since 1993-94 as compared with negligible levels till the early 1990s. Total (net) foreign investment flows (direct and portfolio) increased from US$ 103 million in 1990-91 to US$ 45 billion by 2007-08. Over the same period, current account deficits remained modest – averaging one per cent of GDP since 1991-92 and in fact recorded small surpluses during 2001-04. With capital flows remaining in excess of the current financing requirements, the overall balance of payments recorded persistent surpluses leading to an increase in reserves. Despite such large accretion to reserves, inflation could be contained reflecting appropriate policy responses by the Reserve Bank and the Government.

The emergence of foreign exchange surplus lending to continuing and large accretion to reserves since the mid 1990s has been a novel experience for India after

16

experiencing chronic balance of payment problems for almost four decades. These surpluses began to arise after the opening of the current account, reduction in trade protection, and partial opening of the capital account from the early to mid 1990s. The exchange rate flexibility practiced since 1992-93 has been an important part of the policy response needed to manage capital flows.

The composition of India's balance of payments has undergone significant change since the mid 1990s. In the current account, the growth of software exports and of business process outsourcing has increased the share of service exports on a continuing basis. Even more significant is the growth in remittances from non-resident Indians (NRIs), now amounting to about 3 per cent of GDP. The latter exhibit a great deal of stability. The remittances appear to consist mainly of maintenance flows that do not seem to be affected by exchange rate, inflation, interest rate or growth rate changes. Thus, the Indian current account exhibits only a small deficit, despite the existence of a large merchandise trade deficit that has grown from 3.2 per cent of GDP in the mid 1990s to 7.7 per cent by 2007-08. On the capital account, unlike other emerging markets, portfolio flows have generally far exceeded foreign direct investment in India in recent years. In the past 2-3 years, FDI inflows have picked up strongly and during 2007-08 inward FDI inflows (US $ 32 billion), in fact, exceeded portfolio flows (which were also quite large at US $ 29 billion in net terms). Coupled with other capital flows consisting of official and commercial debt, NRI deposits, and other banking capital, net capital flows amounted to over 9 per cent of GDP in 2007-08, far in excess of the current account deficit of 1.5 per cent of GDP). In sharp contrast to the trend of large and growing volume of capital flows of the previous 3-4 years, and reflecting the impact of deleveraging in the major advanced economies, capital flows (net) recorded a sharp fall in 2008-09: such flows fell to US $ 15 billion during April-December 2008 from US $ 82 billion in the same period of 2007. These developments once again highlight the fact that capital flows are highly volatile and there can be sharp turnarounds over very short periods of time, with implications for monetary and liquidity management and for financial stability for the recipient economy.

The downturn in the Indian business cycle during the early part of this decade led to the emergence of a current account surplus, particularly because the existence of the relative exchange rate insensitive remittance flows. Since 2004-05, the current account balance has again recorded deficits. However, over the same period (upto 2007-08), there was an even larger increase in the volume of capital flows (net). Consequently, foreign exchange reserves grew by more than US $ 272 billion between March 2000 and March 2008. During 2008-09, reflecting the slump in net capital inflows and the valuation factors, the foreign exchange reserves declined by US $ 58 billion.

The management of capital flows involved a mix of policy responses that had to keep an eye on the level of reserves, monetary policy objectives related to the interest rate, liquidity management, and maintenance of healthy financial market conditions with financial stability. Decisions to do with sterilisation involve judgements on the character of the excess forex flows: are they durable, semi-durable or transitory? This judgement itself depends on assessments about both the real economy and of financial sector developments. Moreover, at any given time, some flows could be of an enduring nature whereas others could be of short term, and hence reversible.

On an operational basis, sterilisation operations through open market operations (OMOs) should take care of durable flows, whereas transitory flows can be managed through the normal daily operations of the LAF. As the flows moderate, open market operations can be reversed to inject back the liquidity sterilised, after a brief period if the

17

flows are transitory and after a longer period if the flows are durable. It is, of course, arguable that if sterilisation should be conducted at all if the flows are deemed to be permanent.

By 2003-04, sterilisation operations, however, started appearing to be constrained by the finite stock of Government securities held by the Reserve Bank. The legal restrictions on the Reserve Bank on issuing its own paper also placed constraints on future sterilisation operations. Accordingly, an innovative scheme in the form of Market Stabilisation Scheme (MSS) was introduced in April 2004 wherein Government of India dated securities/Treasury Bills are issued to absorb enduring surplus liquidity. These dated securities/Treasury Bills are the same as those issued for normal market borrowings and this avoids segmentation of the market. Moreover, the MSS scheme brings transparency in regard to costs associated with sterilisation operations. Hitherto, the costs of sterilisation were fully borne by the Reserve Bank in the first instance and its impact was transmitted to the Government in the form of lower profit transfers. With the introduction of the MSS, the cost in terms of interest payments is borne by the Government itself in a transparent manner.

It is relevant to note that the MSS has provided the Reserve Bank the flexibility to not only absorb liquidity but also to inject liquidity in case of need. Illustratively, during the second half of 2005-06, liquidity conditions became tight in view of strong credit demand, increase in Government’s surplus with the Reserve Bank and outflows on account of bullet redemption of India Millennium Deposits (about US $ 7 billion). In view of these circumstances, fresh issuances under the MSS were suspended between November 2005 and April 2006. Redemptions of securities/Treasury Bills issued earlier – along with active management of liquidity through repo/reverse repo operations under Liquidity Adjustment Facility - provided liquidity to the market and imparted stability to financial markets (Chart 2). With liquidity conditions improving, it was decided to again start issuing securities under the MSS from May 2006 onwards. Similarly, in view of the impact of the ongoing global financial crisis on net capital inflows and hence on domestic liquidity conditions, fresh issuances under MSS were stopped (auctions of dated securities were stopped in April 2008 and those of Treasury Bills in September 2008). Buyback of existing MSS securities (effective November 2008) and desequestering of outstanding MSS balances (effective March 2009) was also resorted to to inject liquidity into the system. Reflecting the various operations, MSS balances declined from Rs.1,75,362 crore at end-May 2008 to around Rs.40,000 crore by mid-May 2009. As these episodes show, the MSS operates symmetrically as a store of liquidity: it helps to absorb excess liquidity in times of large capital flows and to inject liquidity in periods of reversals in capital flows. The MSS operations, therefore, strengthen the effectiveness of the CRR and OMOs. The MSS has thus enabled the Reserve Bank to improve liquidity management in the system, to maintain stability in the foreign exchange market and to conduct monetary policy in accordance with the stated objectives.

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The Indian experience highlights the need for emerging market economies to allow

greater flexibility in exchange rates but the authorities can also benefit from having the capacity to intervene in foreign exchange markets in view of the volatility observed in international capital flows. A key lesson is that flexibility and pragmatism are required in the management of the exchange rate and monetary policy in developing countries, rather than adherence to strict theoretical rules (Mohan, 2004a).

Three overarching features marked the transition of India to an open economy. First, the administered exchange rate became market determined and ensuring orderly conditions in the foreign exchange market became an objective of exchange rate management. Second, as already indicated, vicissitudes in capital flows came to influence the conduct of monetary policy. Third, lessons of the balance of payments crisis highlighted the need to maintain an adequate level of foreign exchange reserves and this in turn both enabled and constrained the conduct of monetary policy. From hindsight, it appears that the strategy paid off with the exchange rate exhibiting reasonable two-way movement (Chart 3).

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Credit Delivery

Given that the Indian financial system is still predominantly bank based, bank credit continues to be of great importance for funding different sectors of the economy. Consequent to deregulation of interest rates and substantial reduction in statutory pre-emptions, there was an expectation that credit flow would be correspondingly enhanced. In the event, banks continued to show a marked preference for investments in government securities with no reduction in the proportion of their assets being held in investments in government securities, until recently, when credit growth picked up in 2003-04. With the shift in approach from micro management of credit through various regulations, credit allocation targets, and administered interest rates, to a risk based system of lending and market determined interest rates, banks have to develop appropriate credit risk assessment techniques. Apart from promoting healthy credit growth, this is also critical for the efficiency of monetary management in view of the move to use of indirect instruments in monetary management.

Whereas there was some suspicion that the risk-averse behaviour of banks in the late 1990s and early part of this decade reflected the tightening of prudential norms, and possibly their predominant government ownership, strong growth in credit – averaging almost 30 per cent per year during 2004-07 - suggests that this behaviour was more reflective of movements in the business cycle. Moreover, real interest rates have softened over this period and a great degree of business restructuring has taken place in the Indian corporate sector making it more creditworthy. Overall, a sharp recovery took place all round.

The credit-GDP ratio, after moving in a narrow range of around 30 per cent between the mid-1980s and late 1990s, started increasing from 2000-01 onwards (Chart 4). It increased from 30 per cent at end-March 2000 to 41 per cent at end-March 2005 and further to 54 per cent by end-March 2008. However, sharp growth of credit in the past 4-5

20

years, especially in those sectors witnessing very high growth, has also led to some areas of policy concern and dilemmas, as discussed later.

Chart 4: Credit-GDP Ratio

10

15

20

25

30

35

40

45

5019

70-7

1

1972

-73

1974

-75

1976

-77

1978

-79

1980

-81

1982

-83

1984

-85

1986

-87

1988

-89

1990

-91

1992

-93

1994

-95

1996

-97

1998

-99

2000

-01

2002

-03

2004

-05

Per c

ent

How did monetary policy support the growth momentum in the economy? As inflation, along with inflation expectations, fell during the earlier period of this decade, policy interest rates were also brought down. Consequently, both nominal and real interest rates fell. The growth rate in interest expenses of the corporates decelerated consistently during 1996-2001 and subsequently turned negative during 2001-06 (Table 8). As a result, the ratio of interest expenses to total expenditure witnessed a significant decline from 6.5 per cent during 1997-98 to 2.4 per cent during 2006-07. The decline in interest costs has been amongst the important factors beyond the recent improvement in corporate profitability, balance sheets and corporate investment. During 2007-08 and 2008-09, reflecting the upturn in the interest rate cycle, interest payments again rose. The ratio of interest payments to total expenditure, however, still remains substantially less than that witnessed during the 1990s.

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Table 8: Monetary Policy and Corporate Performance: Interest Rate related Indicators

Interest Expenses to Year Growth Rate in Interest Expenses (Per

cent) Total Expenditure (Per

cent)

Interest Coverage Ratio#

1990-91 16.2 5.8 1.91991-92 28.7 6.3 1.91992-93 21.6 6.8 1.61993-94 3.1 6.1 2.01994-95 8.1 5.5 2.41995-96 25.0 5.4 2.71996-97 25.7 6.1 2.11997-98 12.5 6.3 1.91998-99 11.1 6.5 1.61999-00 6.7 6.2 1.72000-01 7.1 6.1 1.72001-02 -5.1 6.1 1.72002-03 -9.8 5.0 2.12003-04 -11.9 3.6 3.32004-05 -5.8 2.8 4.62005-06 -2.0 2.4 5.52006-07 24.9 2.4 6.22007-08 28.8 2.7 7.32008-09 @ 65.4 3.4 4.4 Source: Reserve Bank of India. # Represents the ratio of gross profit (i.e., earning before interest and taxes) to interest expenses. @: Data pertain to April-December.

Global Financial Crisis: Impact and Policy Responses

The direct effect of the sub-prime crisis and the Lehman failure on Indian banks/financial sector was almost negligible because of prudential policies already in place, which, inter alia, limited the exposure of Indian banks to complex derivatives. However, following the Lehman failure, there was a sudden change in the external environment. As in the case of other major EMEs, there was a sell-off in domestic equity markets by portfolio investors reflecting deleveraging. Consequently, as noted earlier, there were large capital outflows by portfolio investors during September-October 2008, which adversely affected both external and domestic financing for the corporate sector (Mohan, 2009). Overall, reflecting the slowdown in external demand, and the consequences of reversal of capital flows, real GDP growth slowed to 6.9 per cent in the first three quarters of 2008-09 from 9.0 per cent in the corresponding period of 2007-08 and the average growth of 8.8 per cent during 2004-08. Financial markets and banks have functioned normally throughout the period. Thus, unlike many other advanced and emerging economies where the authorities had to extend guarantees for banks’ deposits as well as a host of other liabilities, no such need was felt in our case.

In view of the lower level of capital inflows and its impact on domestic liquidity conditions, the Reserve Bank has been pro-actively managing rupee and forex liquidity

22

since mid-September 2008. Analytically, the various policy actions by the Reserve Bank have been aimed at offsetting the contraction caused to its balance sheet due to fall in its foreign assets. In order to improve rupee liquidity, as noted earlier, a number of steps were taken: cuts in the cash reserve ratio (CRR) by 400 basis points, stopping of fresh issuances under MSS, buyback of existing MSS securities and desequestering of outstanding MSS cash balances. Other measures included cut in the statutory liquidity ratio (SLR), opening of new refinancing windows for mutual funds and non-banking financial companies, refinance to select apex financial institutions, and clawing back of prudential norms in regard to provisioning and risk weights. The measures to improve forex liquidity included increase in interest rate ceilings on non-resident deposits, and easing of restrictions on external commercial borrowings and on short-term trade credits. Finally, the reduction in policy rates amounted to an effective cut of 575 basis points - from 9.00 per cent (repo rate) in mid-September 2008 to 3.25 per cent now (reverse repo rate). The various monetary and liquidity measures, taken together, have released actual/potential liquidity amounting to over Rs.4,900 billion (about 9 per cent of GDP) since mid-September 2008. Overall, the existing set of monetary instruments has provided adequate flexibility to manage the evolving situation. In view of this flexibility, unlike central banks in major advanced economies, the Reserve Bank did not have to dilute the collateral requirements to inject liquidity. In contrast to the trends in major advanced economies, there has been no excessive expansion of reserve money. Hence, the issue of unwinding and exit of the current excessively accommodative monetary and liquidity policies, which is of extreme concern in the major advanced economies, is not relevant for us in view of the consistent growth in reserve money (Mohan, 2009).

IV. Some Emerging Issues This review of financial sector reforms and monetary policy has documented the calibrated and coordinated reforms that have been undertaken in India since the 1990s. In terms of outcomes, this strategy has achieved the broad objectives of price stability along with reduced medium and long term inflation expectations; the installation of an institutional framework and policy reform promoting relatively efficient price discovery of interest rates and the exchange rate; phased introduction of competition in banking along with corresponding improvements in regulation and supervision approaching international best practice, which has led to notable improvement in banking performance and financials. The implementation of these reforms has also involved the setting up or improvement of key financial infrastructure such as payment and settlement systems, and clearing and settlement systems for debt and forex market functioning. All of this financial development has been achieved with the maintenance of a great degree of financial stability, along with overall movement of the economy towards a higher growth path.

With increased deregulation of financial markets and increased integration of the global economy, the 1990s were turbulent for global financial markets: 63 countries suffered from systemic banking crises in that decade, much higher than 45 in the 1980s. Among countries that experienced such crises, the direct cost of reconstructing the financial system was typically very high: for example, recapitalisation of banks had cost 55 per cent of GDP in Argentina, 42 per cent in Thailand, 35 per cent in Korea and 10 per cent in Turkey. There were high indirect costs of lost opportunities and slow economic growth in addition (McKinsey & Co., 2005). The adverse consequences of financial crisis

23

on output and employment are turning out to be even more severe in the case of the ongoing financial crisis. Global output is expected to contract by 1.3 per cent in 2009 - the first contraction in the post-war period. Fiscal costs of the financial crisis are turning out to be quite significant: 13 per cent of GDP for the US, 12 per cent for the UK, and 14 per cent for Ireland (IMF, 2009). It is therefore particularly noteworthy that India could pursue its process of financial deregulation and opening of the economy without suffering financial crises during this turbulent period in world financial markets. The cost of recapitalisation of public sector banks at less than 1 per cent of GDP is therefore low in comparison and even these costs have been more than recouped by the Government. Whereas we can be legitimately gratified with this performance record, we now need to focus on the new issues that need to be addressed for the next phase of financial development.

That annual GDP growth of around 9 per cent could be achieved in India with an investment rate of about 36 per cent rate suggests that the economy is functioning quite efficiently. We need to ensure that we maintain this level of efficiency and attempt to improve on it further. As the Indian economy continues on such a growth path and attempts to accelerate it, new demands are being placed on the financial system.

Growth Challenges for the Financial Sector

Higher sustained growth is contributing to the movement of large numbers of households into ever higher income categories, and hence higher consumption categories, along with enhanced demand for financial savings opportunities. In rural areas in particular, there also appears to be increasing diversification of productive opportunities. Thus, the banking system has to extend itself and innovate to respond to these new demands for both consumption and production purposes. This is particularly important since banking penetration is still low in India: there are only about 10-12 ATMs in India per million population, as compared with over 50 in China, 170 in Thailand, and 500 in Korea. Moreover, the deposit to GDP ratio or the loans/GDP ratio is also low compared to other Asian countries (McKinsey & Co., 2005).

On the production side, before the recent setback on the back of the global financial crisis, industrial expansion had accelerated and merchandise trade growth was high. But, there are still vast demands for infrastructure investment, from the public sector, private sector and through public private partnerships. Furthermore, the service sector has exhibited consistently high growth rates: the hospitality industry, shopping malls, entertainment industry, medical facilities, and the like, are all expanding fast. Thus a great degree of diversification is taking place in the economy and the banking system has to respond adequately to these new challenges, opportunities and risks.

In dealing with these new consumer demands and production demands of rural enterprises and of SME's in urban areas, banks have to innovate and look for new delivery mechanisms that economise on transaction costs and provide better access to the currently under-served. Innovative channels for credit delivery for serving these new rural credit needs, encompassing full supply chain financing, covering storage, warehousing, processing, and transportation from farm to market will have to be found. The budding expansion of non-agriculture service enterprises in rural areas will have to be financed to generate new income and employment opportunities. Greater efforts will need to be made on information technology for record keeping, service delivery, reduction in transactions costs, risk assessment and risk management. Banks will have to invest in new skills through new recruitment and through intensive training of existing personnel.

24

It is the public sector banks that have the large and widespread reach, and hence have the potential for contributing effectively to achieve financial inclusion. But it is also they who face the most difficult challenges in human resource development. They will have to invest very heavily in skill enhancement at all levels: at the top level for new strategic goal setting; at the middle level for implementing these goals; and at the cutting edge lower levels for delivering the new service modes. Given the current age composition of employees in these banks, they will also face new recruitment challenges in the face of adverse compensation structures in comparison with the freer private sector. A key policy issue that arises is how to relieve the public sector banks of the constraints they face in re-skilling themselves which will be essential in the light of these challenges. Meanwhile, the new private sector banks will themselves have to innovate and accelerate their reach into the emerging low income and rural market segments. They have the independence and flexibility to find the new business models necessary for serving these segments.

A number of policy initiatives are underway to aid this overall process of financial inclusion and increase in banking penetration. The Parliament has passed the Credit Information Bureau Act that will enable the setting up of credit information bureaus through the mandatory sharing of information by banks. As this process gathers force, it should contribute greatly in reducing the costs of credit quality assessment. Second, considerable work is in process for promoting micro-finance in the country, including the consideration of possible legislation for regulation of micro-finance institutions. Third, the Reserve Bank has issued guidelines to banks enabling the outsourcing of certain functions including the use of agencies such as post offices for achieving better outreach. These are all efforts in the right direction, but much more needs to be done to really achieve financial inclusion in India.

The challenges that are emerging are right across the size spectrum of business activities. On the one hand, the largest firms are attaining economic sizes such that they are reaching the prudential exposure limits of banks, even though they are still small relative to the large global MNCs. On the other hand, with changes in technology, there is new activity at the small and medium level in all spheres of activity. To cope with the former, the largest Indian banks have to be encouraged to expand fast, both through organic growth and through consolidation; and the corporate debt market has to be developed to enable further direct recourse to financial markets for the largest firms. For serving and contributing to the growth of firms at the lower end, banks have to strengthen their risk assessment systems, along with better risk management. Funding new entrepreneurs and activities is a fundamentally risky business because of the lack of a previous record and inadequate availability of collateral, but it is the job of banks to take such risk, but in a measured fashion. Given the history of public sector banks outlined earlier, such a change in approach requires a change in mind set, but also focused training in risk assessment, risk management, and marketing.

Various policy measures are in process to help this transition along. The Reserve Bank issued new guidelines in 2004 on "Ownership and Governance in Private Sector Banks". These guidelines have increased the minimum capital for private sector banks to Rs.3 billion; provided enhanced guidance on the fit and proper nature of owners, board members and top management of these banks; and placed limitations on the extent of dominant shareholdings. These measures are designed to promote the healthy growth of private sector banks and along with better corporate governance as they assume greater weight in the economy. An issue of relevance here is that of financial stability. To a certain extent, the predominance of government owned banks has contributed to financial stability in the country. Experience has shown that even the deterioration in bank

25

financials does not lead to erosion of consumer confidence in such banks. This kind of consumer confidence does not extend to private sector banks. Hence, as they gain in size and share, capital enhancement and sound corporate governance become essential for financial stability. Second, the lending ability of banks has been potentially constrained by the still-high pre-emption of funds for investment in government securities. In this context, it may be noted that the amendment to the Banking Regulation Act has eliminated the requirement of minimum SLR of 25 per cent, providing the Reserve Bank flexibility to reduce SLR below 25 per cent. In response to the global financial crisis, the SLR was cut to 24 per cent in November 2008. Any further reduction in SLR would, however, be contingent, inter alia, upon the fiscal situation. Government finances, which had exhibited a noteworthy correction starting 2002-03, have now come under renewed pressure on account of fiscal stimulus measures in response to the crisis, but also due to higher expenditure outgoes due to oil/fertiliser subsidies, the Sixth Pay Commission award and debt waiver scheme. Reflecting these factors, the Central Government’s fiscal deficit more than doubled from 2.7 per cent of GDP in 2007-08 to 6.0 per cent in 2008-09, reaching again the levels seen around the end of the 1990s.. Consequently, net market borrowings have increased substantially, which could hinder any reduction in the SLR stipulation.

Greater Capital Market Openness: Some Issues

An important feature of the Indian financial reform process has been the calibrated opening of the capital account along with current account convertibility. The Government and the Reserve Bank appointed a Committee in 2006 to advise on a roadmap for fuller capital account convertibility (Report of the Committee on Fuller Capital Account Convertibility; Chairman: Mr. S. S. Tarapore). Decisions on further steps are being taken gradually subsequent to the submission of that committee's report. Meanwhile, we can note some of the issues that will need attention as we achieve fuller capital account openness.

A key component of Indian capital account management has been the management of volatility in the forex market and of its consequential impact on the money market and hence on monetary operations guided by the extant monetary policy objectives. This has been done, as outlined, through a combination of forex market intervention, domestic liquidity management, and administrative instructions on regulating external debt in different forms. Correspondingly, progress has been made on the functioning of the government securities market, forex market and money market and their progressive integration. Particular attention has been given to the exposure of financial intermediaries to foreign exchange liabilities, and of the government in their borrowing programme. So far, some degree of success has been achieved in that the exchange rate responds to the supply demand conditions in the market and exhibits two-way flexibility; the interest rate is similarly flexible and market determined, although there are some rigidities on account of the administered interest rate mechanism in some segments; healthy growth has taken place in trade in both goods and services; and inward capital flows have been healthy.

A sufficiently large menu of instruments for hedging forex and interest rate risks are available to the economic agents. Illustratively, for managing forex risks the Indian market offers forwards, currency swaps, options and futures while for interest rates there are interest rates swaps, forward rate agreements and interest rate futures. However, the derivative markets are not very liquid in the longer maturities and the interest rate futures market has not taken off for a variety of reasons. Efforts are on to impart vibrancy to the interest rate futures market. The corporates are being sensitised continuously about the

26

need to remain hedged but it seems that their preference is to remain substantially unhedged, primarily on cost considerations. As we progress with the development of the financial markets and the financial institutions (mainly banks), the need for intervention for the reasons of modulating volatility will reduce progressively.

We have to recognise that fuller capital account openness will lead to a confrontation with the impossible trinity of simultaneous attainment of independent monetary policy, open capital account, and managed exchange rate. At best, only two out of the three would be feasible. With a more open capital account as a `given' and if a choice is made of an `anchor' role for monetary policy, exchange rate management will be affected. A freely floating exchange rate should, in fact, engender the independence of monetary policy. It needs to be recognised, however, that the impact of exchange rate changes on the real sector is significantly different for reserve currency countries and for developing countries like India. For the former which specialise in technology intensive products the degree of exchange rate pass through is low, enabling exporters and importers to ignore temporary shocks and set stable product prices to maintain monopolistic positions, despite large currency fluctuations. Moreover, mature and well developed financial markets in these countries have absorbed the risk associated with exchange rate fluctuations with negligible spillover on the real activity. On the other hand, for the majority of developing countries which specialise in labour-intensive and low and intermediate technology products, profit margins in the intensely competitive markets for these products are very thin and vulnerable to pricing power by large retail chains. Consequently, exchange rate volatility has significant employment, output and distributional consequences (Mohan, 2004a; 2005). In this context, managing exchange rate volatility would continue to be an issue requiring attention.

A further challenge for policy in the context of fuller capital account opennes will be to preserve the financial stability of different markets as greater deregulation is done on capital outflows and on debt inflows. The vulnerability of financial intermediaries can perhaps be addressed through prudential regulations and their supervision; risk management of non-financial entities will have to be through further developments in both the corporate debt market and the forex market, which enable them to manage their risks through the use of newer market instruments. This will require market development, enhancement of regulatory capacity in these areas, as well as human resource development in both financial intermediaries and non-financial entities. Given the volatility of capital flows, it remains to be seen whether financial market development in a country like India can be such that this volatility does not result in unacceptable disruption in exchange rate determination with inevitable real sector consequences, and in domestic monetary conditions. If not, what will be the kind of market interventions that will continue to be needed and how effective will they be?

Another aspect of greater capital market openness concerns the presence of foreign banks in India. The Government and Reserve Bank outlined a roadmap on foreign investment in banks in India in February 2005, which provided guidelines on the extent of their presence until April 2009. This roadmap is consistent with the overall guidelines issued simultaneously on ownership and governance in private sector banks in India. The presence of foreign banks in the country has been very useful in bringing greater competition in certain segments in the market. They are significant participants in investment banking and in development of the forex market. In view of the current global financial market turmoil, there are uncertainties surrounding the financial strength of banks around the world. Further, the regulatory and supervisory policies at national and international levels are under review. In view of this, the Reserve Bank, in April 2009,

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decided to continue with the roadmap set out in 2005 governing the presence of foreign banks in India. The review will now be taken up once there is greater clarity regarding stability, recovery of the global financial system, and a shared understanding on the regulatory and supervisory architecture around the world.

In view of the changes that took place in the United States and other countries during the 1990s and till the onset of the current crisis, where the traditional barriers between banking, insurance and securities companies havd been removed, the size of the largest financial conglomerates had become extremely large. Between 1995 and 2004, the size of the largest bank in the world had grown three-fold by asset size, from about US $ 0.5 trillion to US $ 1.5 trillion, almost double the size of Indian GDP. This has happened through a great degree of merger activity: for example, J.P.Morgan Chase is the result of mergers among 550 banks and financial institutions. The ten biggest commercial banks in the US control almost half of that country's banking assets, up from 29 per cent just 10 years ago (Economist, 2006).

In the context of these developments and in the event of fuller capital account convertibility and greater presence of foreign banks over time, a number of issues will arise. First, if these large global banks have emerged as a result of real economies of scale and scope, how will smaller national banks compete in countries like India, and will they themselves need to generate a larger international presence? Second, there is considerable discussion today on overlaps and potential conflicts between home country regulators of foreign banks and host country regulators: how will these be addressed and resolved in the years to come? Supervisory colleges are being set up to deal with such issues but their effectiveness remains to be tested. Third, given that operations in one country such as India are typically small relative to the global operations of these large banks, the attention of top management devoted to any particular country is typically low. Consequently, any market or regulatory transgressions committed in one country by such a bank, which may have a significant impact on banking or financial market of that country, is likely to have negligible impact on the bank's global operations. These issues have come to the forefront recently in the context of the failures of major global financial institutions such as Bear Sterns and Lehman Brothers. It has been seen in recent years that even relatively strong regulatory action taken by host country regulators against global banks has had negligible market or reputational impact on them in terms of their stock price or similar metrics. Thus, there is loss of regulatory effectiveness as a result of the presence of such financial conglomerates. Hence there is inevitable tension, reinforced by the current financial market turmoil in the advanced economies, between the benefits that such global conglomerates bring and some regulatory and market structure and competition issues that may arise.

Along with the emergence of international financial conglomerates we are also witnessing similar growth of Indian conglomerates. As in most countries, the banking, insurance and securities companies each come under the jurisdiction of their respective regulators. A beginning has been made in organized cooperation between the regulators on the regulation of such conglomerates, with agreement on who would be the lead regulator in each case. In the United States, it is a financial holding company that is at the core of each conglomerate, with each company being its subsidiary. There is, as yet, no commonality in the financial structure of each conglomerate in India: in some the parent company is the banking company; whereas in others there is a mix of structure. For Indian conglomerates to be competitive, and for them to grow to a semblance of

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international size, they will need continued improvement in clarity in regulatory approach. The Reserve Bank has released a discussion paper on this issue.

As the country's financial system faces each of these challenges in the coming years, we will also need to adapt monetary policy to the imperatives brought by higher growth and greater openness of the economy.

High Credit Growth and Monetary Policy

High and sustained growth of the economy in conjunction with low inflation is the central concern of monetary policy in India. As noted above, we have been reasonably successful in meeting these objectives. In this context, one issue still remains: whether monetary policy should have only price stability as its sole objective, as suggested by proponents of inflation targeting. Several central banks, such as, Bank of Canada, Bank of England, and the Reserve Bank of New Zealand, have adopted explicit inflation targets. Others, whose credibility in fighting inflation is long established (notably, the US Federal Reserve), do not set explicit annual inflation targets. Central banks are thus clearly divided on the advisability of setting explicit inflation targets. In view of the difficulties encountered with monetary targeting and exchange rate pegged regimes, a number of central banks including some in emerging economies have adopted inflation targeting frameworks.3

The simple principle of inflation targeting thus is also not so simple and poses problems for monetary policy making in developing countries. Moreover, concentrating only on numerical inflation objectives may reduce the flexibility of monetary policy, especially with respect to other policy goals, particularly that of growth.

In India, we have not favoured the adoption of inflation targeting, while keeping the attainment of low inflation as a central objective of monetary policy, along with that of high and sustained growth that is so important for a developing economy. Apart from the legitimate concern regarding growth as a key objective, there are other factors that suggest that inflation targeting may not be appropriate for India. First, unlike many other developing countries we have had a record of moderate inflation, with double digit inflation being the exception, and which is largely socially unacceptable. Second, adoption of inflation targeting requires the existence of an efficient monetary transmission mechanism through the operation of efficient financial markets and absence of interest rate distortions. In India, although the money market, government debt and forex market have indeed developed in recent years, they still have some way to go, whereas the corporate debt market is still to develop. Though the process of interest rate deregulation has suffered some setback in the recent past , and a number of administered interest rates still persist. Third, inflationary pressures still often emanate from significant supply shocks related to the effect of the monsoon on agriculture, where monetary policy action may have little role. Finally, in an economy as large as that of India, with various regional differences, and continued existence of market imperfections in factor and product markets between regions, the choice of a universally acceptable measure of inflation is also difficult. India currently has a multiplicity of price indices: the wholesale price index and four consumer price indices. Whereas a harmonised price index can indeed be constructed, the meaning of such an index and targeting it in such a large and diverse country would be open to question.

3 Although these inflation targeting countries were able to reduce inflation or maintain low inflation during the 1990s, stylised evidence shows that even non-IT countries were successful in this endeavour.

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Globally, too, the inflation targeting framework is being questioned in the context of the global financial crisis (IMF, 2009; de Larosiere Report, 2009). The single-minded pursuit of price stability apparently led to the neglect of large and growing financial imbalances in other sectors of the economies. In this regard, a related contemporary issue in central banking is the appropriate response of monetary policy to sharp asset price movements, that may accompany high corporate growth. In an era of price stability and well-anchored inflation expectations, imbalances in the economy need not show up immediately in overt inflation. Increased central bank credibility is a double-edged sword as it makes it more likely that unsustainable booms could take longer to show up in overt inflation. For instance, unsustainable asset prices artificially boost accounting profits of corporates and thereby mitigate the need for price increases; similarly, large financial gains by employees can partly substitute for higher wage claims. In an upturn of the business cycle, self-reinforcing processes develop, characterised by rising asset prices and loosening external financial constraints. 'Irrational exuberance' can drive asset prices to unrealistic levels, even as the prices of currently traded goods and services exhibit few signs of inflation (Crockett, 2001). These forces operate in reverse in the contraction phase. In the upswing of the business cycle, financial imbalances, therefore, get built-up. There is, thus, a 'paradox of credibility' (Borio and White, 2003). These developments, fuelled by the large volatility in monetary policy in the major advanced economies, seem to be at the crux of the current financial crisis (Mohan, 2009). In view of these developments, it is felt that credit and monetary aggregates – which are being ignored by many central banks in view of the perceived instability of money demand - need to be monitored closely since sharp growth in these aggregates is a useful indicator of future instability. Moreover, monetary policy needs to be supported by calibrated pre-emptive prudential measures, as discussed below. Such an objective can be achieved successfully only if responsibilities for monetary policy and financial regulation and supervision are entrusted to the same authority, as is the case with the Reserve Bank of India

In India, like other countries, we have also seen large rallies in asset prices. Concomitantly, credit to the private sector exhibited sharp growth during 2004-07 - averaging almost 30 per cent per annum – before showing some moderation in 2007-08. While the credit growth has been largely broad-based, credit to the retail sector has emerging as a new avenue of deployment for the banking sector led by individual housing loans. To illustrate, the share of credit to the retail sector in the overall bank credit rose from 6.4 per cent in March 1990 to 22.3 per cent in March 2007, almost evenly divided between housing and non-housing segments. While the share of housing sector in the overall bank credit increased from 2.4 per cent at end-March 1990 to 11.8 per cent by end-March 2007, that of other retail segments rose from 4.0 per cent to 10.5 per cent. On the other hand, the share of industry went down from 48.7 per cent to 38.1 per cent over the same period.

Nonetheless, in the light of high credit growth, there is a need to ensure that asset quality is maintained. Since growth in bank credit in our case during 2004-07 was relatively higher in a few sectors such as retail credit and real commercial estate, monetary policy faced a dilemma in terms of instruments. An increase in policy rate across the board could adversely affect even the productive sectors of the economy such as industry and agriculture. While policy rates were indeed raised, they were mainly aimed at reining in inflation expectations in view of continuing pressures from high and volatile crude oil prices. Therefore, while ensuring that credit demand for the productive sectors of the economy is met, the Reserve Bank resorted to prudential measures in order to engineer a ‘calibrated’ deceleration in the overall growth of credit to the commercial sector. Accordingly, the Reserve Bank raised risk weights on loans to these sectors. It also

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increased provisioning requirements on standard loans for the specific sectors from 0.25 per cent in March 2005 to 2.0 per cent by January 2007. These tightened provisioning norms and risk weights were rolled back in November 2008 in the wake of slowdown in order to ensure flow of credit to the productive sectors of the economy. This “dynamic provisioning” approach has facilitated adequate buffers within the banking system. Such “dynamic provisioning” is now being advocated as general practice internationally. Therefore, unlike the banking system in the Western world, domestic banks have not recorded losses so far and there has been no need for any government bailout. The basic objective has been to ensure that the growth process is facilitated while ensuring price and financial stability in the economy.

It is in this context, and consistent with the multiple indicator approach adopted by the Reserve Bank, that monetary policy in India has consistently emphasised the need to be watchful about indications of rising aggregate demand embedded in consumer and business confidence, asset prices, corporate performance, the sizeable growth of reserve money and money supply, the rising trade and current account deficits and, in particular, the quality of credit growth. In retrospect, this risk sensitive approach has served us well in containing aggregate demand pressures and second round effects to an extent. It has also ensured that constant vigil is maintained on threats to financial stability through a period when inflation was on the upturn and asset prices, especially in housing and real estate, are emerging as a challenge to monetary authorities worldwide. Significantly, it reinforced the growth momentum in the economy, while ensuring macroeconomic and financial stability.

V. Concluding Observations To conclude, the financial system in India, through a measured, gradual, cautious,

and steady process, has undergone substantial transformation. It has been transformed into a reasonably sophisticated, diverse and resilient system through well-sequenced and coordinated policy measures aimed at making the Indian financial sector more competitive, efficient, and stable. Concomitantly, effective monetary management has enabled price stability while ensuring availability of credit to support investment demand and growth in the economy. Finally, the multi-pronged approach towards managing capital account in conjunction with prudential and cautious approach to financial liberalisation has ensured financial stability in contrast to the experience of many developing and emerging economies. This is despite the fact that we faced a large number of shocks, both global and domestic. Even in the face of the ongoing global financial crisis, the severest of the shocks that we have faced so far, our financial sector and financial markets have generally worked normally. While there has been a substantial slowdown of the real economy in response to the crisis, the financial sector has exhibited resilience in sharp contrast to the developments in the most advanced financial markets. Continuing refinements and flexibility in the conduct of monetary policy and financial sector reforms in India based on the principles of a cautious and calibrated approach to financial globalisation have enabled us to meet the challenges emanating from all these shocks. Viewed in this light, the success in maintaining price and financial stability is all the more creditworthy.

Some commentators have criticised the Indian approach to financial sector reforms as unclear, timid and conservative in the context of the cross-country experience and have advocated more bold and drastic measures so as to speed up the transition to higher growth. Admittedly, we have been cautious and somewhat conservative in our approach

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to financial sector reforms relative to some other EMEs. Nonetheless, the actual outcomes in terms of growth and inflation have been quite noteworthy. In the current decade so far (2000-2008), among the G-20 countries, India’s growth has been the second highest, while inflation has remained relatively low.

The ongoing global financial crisis is leading to a serious re-thinking on the model of financial development and liberalisation and light-touch regulation adopted in the advanced economies and, till the onset of the current financial crisis, being increasingly recommended for the emerging market economies. The single objective oriented inflation targeting framework of monetary policy could not avoid the build-up of financial imbalances and does not appear to have proven resilient to shocks. The theoretical proposition of full capital account convertibility being growth-enhancing is not at all borne out by empirical evidence (CGFS, 2009). Approaches based on light-touch regulation, full capital account liberalisation and single-objective monetary policy have also been recommended for adoption in India by some of recent high-powered committees [Percy Mistry Committee (2007) and Raghuram Rajan Committee (2008)]. Globally, there is now a clear recognition of serious regulatory and supervisory failures and there is a questioning of the existing intellectual assumptions with respect to the functioning of markets, and the nature of financial risk. The theory of efficient and rational markets – underlying the paradigm that prevailed during the 1990s and until recently – are now subject to extensive challenge on both theoretical and empirical grounds, with potential implications for the appropriate design of regulation and for the role of regulatory authorities (Turner Review, 2009, p.30).

Against this backdrop, and in view of our low income levels and the limited capacity of the majority of the population to bear downside risks, it would be advisable for us to continue with our cautious and calibrated approach to financial sector development. As the economy returns to its higher growth path once the global crisis is beyond us, and as it is subjected to greater opening and financial integration with the rest of the world, the financial sector in all its aspects will need further considerable development, along with corresponding measures to continue regulatory modernization and strengthening. The overall objective of maintaining price stability in the context of economic growth and financial stability will remain. References Ahluwalia, M. S. (2002). “Economic Reforms in India since 1991: Has Gradualism

Worked?” Journal of Economic Perspectives, 16, (3), 67-88. Banerjee, Abhijit, Shawn Cole, and Esther Duflo (2004), “Banking Reform in India”,

India Policy Forum 2004. Borio, Claudio and William White (2003), "Whither Monetary and Financial Stability?

The Implications of Evolving Policy Regimes", BIS Working Paper No. 147.

Committee on the Global Financial System (2009), Report of the Working Group on Capital flows to Emerging Market Economies (Chairman: Rakesh Mohan), Bank for International Settlements, Basel.

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Crockett, A (2001), "Monetary Policy and Financial Stability, Lecture Delivered at

the HKMA Distinguished Lecture, February. de Larosiere Report (2009), “Report of the High-Level Group on Financial

Supervision in the EU” (Chairman: Jacques de Larosiere), Brussels. International Monetary Fund (2009a), “Initial Lessons of the Crisis”, February. International Monetary Fund (2009b), Global Financial Stability Report, April. McKinsey & Company (2005), Indian Banking 2010: Towards a High Performing

Sector New Delhi. Mohan, Rakesh (2004a), "Challenges to Monetary Policy in a Globalising Context",

Reserve Bank of India Bulletin, January. Mohan, Rakesh (2004b), "Financial Sector Reforms in India: Policies And Performance

Analysis", Reserve Bank of India Bulletin, October. Mohan, Rakesh (2005), "Some Apparent Puzzles for Contemporary Monetary Policy",

Reserve Bank of India Bulletin, December. Mohan, Rakesh (2006a), "Reforms, Productivity And Efficiency in Banking: The Indian

Experience", Reserve Bank of India Bulletin, March. Mohan, Rakesh (2006b), "Coping with Liquidity Management in India: Practitioner's

View", Reserve Bank of India Bulletin, April. Mohan, Rakesh (2006c), "Recent Trends in the Indian Debt Market and Current

Initiatives", Reserve Bank of India Bulletin, April. Mohan, Rakesh (2006d), "Evolution of Central Banking in India", Reserve Bank of India

Bulletin, June. Mohan, Rakesh (2007), “India's Financial Sector Reforms: Fostering Growth While

Containing Risk”, Reserve Bank of India Bulletin, December. Mohan, Rakesh (2009), “Global Financial Crisis: Causes, Impact, Policy Responses and

Lessons”, Reserve Bank of India Bulletin, May Reddy, Y.V. (2006a), "Challenges and Implications of Basel II for Asia", Reserve Bank of

India Bulletin, June. Reddy, Y.V. (2006b) "Global Imbalances-An Indian Perspective", Reserve Bank of India

Bulletin, June. Report of the Committee on Financial Sector Reforms (Chairman: Raghuram Rajan), New Delhi: Government of India, 2008.

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Report of the High Powered Expert Committee on Making Mumbai an International Financial Centre (Chairman: Percy Mistry), New Delhi: Sage India, 2007 Reserve Bank of India (2004), Report on Currency and Finance, 2003-04. ------------ (2006), Report of the Committee on Fuller Capital Account Convertibility (Chairman: Shri S. S. Tarapore), July. Reserve Bank of India (2008), “The Banking Sector in India: Emerging Issues and

Challenges”, Report on Currency and Finance 2006-08. Reserve Bank of India (2009), “India’s Financial Sector: An Assessment”, Committee on

Financial Sector Assessment (Chairman: Rakesh Mohan), March. The Economist (2006), "Special Report on International Banking". May 20-26, 2006.

Topolova, Petia (2004), Overview of the Indian Corporate Sector: 1989-2002”,

Working Paper 04/64, International Monetary Fund. Turner Review (2009), “The Turner Review: A Regulatory Response to the Global

Banking Crisis” by Lord Turner, Chairman, Financial Services Authority, UK.

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Annex I Reforms in the Banking Sector

A. Competition Enhancing Measures • Granting of operational autonomy to public sector banks, reduction of public

ownership in public sector banks by allowing them to raise capital from equity market up to 49 per cent of paid-up capital.

• Transparent norms for entry of Indian private sector, foreign and joint-venture banks and insurance companies, permission for foreign investment in the financial sector in the form of Foreign Direct Investment (FDI) as well as portfolio investment, permission to banks to diversify product portfolio and business activities.

• Roadmap for presence of foreign banks and guidelines for mergers and amalgamation of private sector banks and banks and NBFCs.

• Guidelines on ownership and governance in private sector banks. B. Measures Enhancing Role of Market Forces

• Sharp reduction in pre-emption through reserve requirements, market determined pricing for government securities, disbanding of administered interest rates with a few exceptions and enhanced transparency and disclosure norms to facilitate market discipline.

• Introduction of pure inter-bank call money market, auction-based repos-reverse repos for short-term liquidity management, facilitation of improved payments and settlement mechanism.

• Significant advancement in dematerialisation and markets for securitised assets are being developed.

C. Prudential Measures • Introduction and phased implementation of international best practices and norms on

risk-weighted capital adequacy requirement, accounting, income recognition, provisioning and exposure.

• Measures to strengthen risk management through recognition of different components of risk, assignment of risk-weights to various asset classes, norms on connected lending, risk concentration, application of marked-to-market principle for investment portfolio and limits on deployment of fund in sensitive activities.

• 'Know Your Customer' and 'Anti Money Laundering' guidelines, roadmap for Basel II, introduction of capital charge for market risk, higher graded provisioning for NPAs, guidelines for ownership and governance, securitisation and debt restructuring mechanisms norms, etc.

D. Institutional and Legal Measures

• Setting up of Lok Adalats (people’s courts), debt recovery tribunals, asset reconstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for quicker recovery/ restructuring.

• Promulgation of Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, 2002 and its subsequent amendment to ensure creditor rights.

• Setting up of Credit Information Bureau of India Limited (CIBIL) for information sharing on defaulters as also other borrowers. Enactment of Credit Information Companies (Regulation) Act, 2005 to enable collection and sharing of credit histories.

• Setting up of Clearing Corporation of India Limited (CCIL) to act as central counter party for facilitating payments and settlement system relating to fixed income securities and money market instruments.

E. Supervisory Measures • Establishment of the Board for Financial Supervision as the apex supervisory authority

for commercial banks, financial institutions and non-banking financial companies. • Introduction of CAMELS supervisory rating system, move towards risk-based

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supervision, consolidated supervision of financial conglomerates, strengthening of off-site surveillance through control returns.

• Recasting of the role of statutory auditors, increased internal control through strengthening of internal audit.

• Strengthening corporate governance, enhanced due diligence on important shareholders, fit and proper tests for directors.

F. Technology Related Measures

• Setting up of INFINET as the communication backbone for the financial sector, introduction of Negotiated Dealing System (NDS) for screen-based trading in government securities and Real Time Gross Settlement (RTGS) System.

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Annex II Reforms in the Monetary Policy Framework

Objectives • Twin objectives of “maintaining price stability” and “ensuring availability of

adequate credit to productive sectors of the economy to support growth” continue to govern the stance of monetary policy, though the relative emphasis on these objectives has varied depending on the importance of maintaining an appropriate balance.

• With the opening up of the Indian economy and the spread of financial sector reforms, considerations of financial stability have assumed greater importance in recent years alongside the increasing openness of the Indian economy. The objective of maintaining financial stability has, therefore, ascended the hierarchy of monetary policy objectives since the second half of the 1990s.

• Reflecting the increasing development of financial market and greater liberalisation, use of broad money as an intermediate target has been de-emphasised and a multiple indicator approach has been adopted.

• Emphasis has been put on development of multiple instruments to transmit liquidity and interest rate signals in the short-term in a flexible and bi-directional manner.

• Increase of the interlinkage between various segments of the financial market including money, government security and forex markets.

Instruments • Move from direct instruments (such as, administered interest rates, reserve

requirements, selective credit control) to indirect instruments (such as, open market operations, purchase and repurchase of government securities) for the conduct of monetary policy.

• Introduction of Liquidity Adjustment Facility (LAF), which operates through repo and reverse repo auctions, effectively provide a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also as a signalling devise for interest rate in the overnight market.

• Use of open market operations to deal with overall market liquidity situation especially those emanating from capital flows.

• Introduction of Market Stabilisation Scheme (MSS) as an additional instrument to deal with enduring capital inflows without affecting short-term liquidity management role of LAF.

Developmental Measures • Discontinuation of automatic monetisation through an agreement between the

Government and the Reserve Bank. Rationalisation of Treasury Bill market. Introduction of delivery versus payment system and deepening of inter-bank repo market.

• Introduction of Primary Dealers in the government securities market to play the role of market maker.

• Amendment of Securities Contracts Regulation Act (SCRA), to create the regulatory framework.

• Deepening of government securities market by making the interest rates on such securities market related. Introduction of auction of government securities. Development of a risk-free credible yield curve in the government securities market as a benchmark for related markets.

• Development of pure inter-bank call money market. Non-bank participants to participate in other money market instruments.

• Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS). Setting up of risk-free payments and system in government securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time Gross Settlement (RTGS) System.

• Deepening of forex market and increased autonomy of Authorised Dealers.

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Institutional Measures • Setting up of Technical Advisory Committee on Monetary Policy with outside

experts to review macroeconomic and monetary developments and advise the Reserve Bank on the stance of monetary policy.

• Creation of a separate Financial Market Department within the RBI.

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Annex III Reforms in the Government Securities Market

Institutional Measures • Administered interest rates on government securities were replaced by an auction system

for price discovery. • Automatic monetisation of fiscal deficit through the issue of ad hoc Treasury Bills was

phased out. • Primary Dealers (PD) were introduced as market makers in the government securities

market. • For ensuring transparency in the trading of government securities, Delivery versus

Payment (DvP) settlement system was introduced. • Repurchase agreement (repo) was introduced as a tool of short-term liquidity adjustment.

Subsequently, the Liquidity Adjustment Facility (LAF) was introduced. • LAF operates through repo and reverse repo auctions and provide a corridor for short-term

interest rate. LAF has emerged as the tool for both liquidity management and also signalling device for interest rates in the overnight market. The Second LAF (SLAF) was introduced in November 2005 and withdrawn in August 2007.

• Market Stabilisation Scheme (MSS) was introduced in 2004, which has expanded the instruments available to the Reserve Bank for managing the enduring surplus liquidity in the system.

• Effective April 1, 2006, RBI has withdrawn from participating in primary market auctions of Government paper.

• Banks have been permitted to undertake primary dealer business while primary dealers are being allowed to diversify their business.

• Short sales in Government securities and trading in ‘when issued’ market have been permitted in a calibrated manner since February 2006 and August 2006, respectively.

Increase in Instruments in the Government Securities Market

• 91-day Treasury bill was introduced for managing liquidity and benchmarking. Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issued and exchange traded interest rate futures were introduced. OTC interest rate derivatives like IRS/ FRAs were introduced.

• Outright sale of Central Government dated security that are not owned have been permitted, subject to the same being covered by outright purchase from the secondary market within the same trading day subject to certain conditions.

• Repo status has been granted to State Government securities in order to improve secondary market liquidity.

Enabling Measures

• Foreign Institutional Investors (FIIs) were allowed to invest in government securities subject to certain limits.

• Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS).

• Setting up of risk-free payments and settlement system in government securities through Clearing Corporation of India Limited (CCIL).

• Phased introduction of Real Time Gross Settlement System (RTGS). • Introduction of trading in government securities on stock exchanges for promoting

retailing in such securities, permitting non-banks to participate in repo market. • Introduction of NDS-OM and T+1 settlement norms.

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Annex IV REFORMS IN THE FOREIGN EXCHANGE MARKET

Exchange Rate Regime • Evolution of exchange rate regime from a single-currency fixed-exchange rate system to

fixing the value of rupee against a basket of currencies and further to market-determined floating exchange rate regime.

• Adoption of convertibility of rupee for current account transactions with acceptance of Article VIII of the Articles of Agreement of the IMF. De facto full capital account convertibility for non residents and calibrated liberalisation of transactions undertaken for capital account purposes in the case of residents.

Institutional Framework • Replacement of the earlier Foreign Exchange Regulation Act (FERA), 1973 by the market

friendly Foreign Exchange Management Act, 1999. Delegation of considerable powers by RBI to Authorised Dealers to release foreign exchange for a variety of purposes.

Increase in Instruments in the Foreign Exchange Market • Development of rupee-foreign currency swap market. • Introduction of additional hedging instruments, such as, foreign currency-rupee options.

Authorised dealers permitted to use innovative products like cross-currency options, interest rate swaps (IRS) and currency swaps, caps/collars and forward rate agreements (FRAs) in the international forex market.

• Work in progress to introduce currency futures. Liberalisation Measures • Authorised dealers permitted to initiate trading positions, borrow and invest in overseas

market subject to certain specifications and ratification by respective Banks’ Boards. Banks are also permitted to fix interest rates on non-resident deposits, subject to certain specifications, use derivative products for asset-liability management and fix overnight open position limits and gap limits in the foreign exchange market, subject to ratification by RBI.

• Permission to various participants in the foreign exchange market, including exporters, Indians investing abroad, FIIs, to avail forward cover and enter into swap transactions without any limit subject to genuine underlying exposure.

• FIIs and NRIs permitted to trade in exchange-traded derivative contracts subject to certain conditions.

• Foreign exchange earners permitted to maintain foreign currency accounts. Residents are permitted to open such accounts within the general limit of US $ 25, 000 per year.

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