Monetary Policy of Reserve Bank of India (RBI)

Monetary Policy of Reserve Bank of India (RBI)!

Introduction:

Monetary Policy is an important instrument of economic policy to achieve multiple objectives.

Like all central banks in the developing countries, Reserve Bank of India has been playing both a regulatory and promotional (i.e., developmental) roles in achieving social objectives. Monetary policy of Reserve Bank has been changing from time to time depending on the prevailing economic situation and circumstances. It is important to note that changes in monetary policy, unlike in case of fiscal policy, can be made at any time during a year.

It needs to be emphasised that monetary policy acts through influencing the availability and cost of credit and growth of money supply in the economy. The effectiveness of monetary policy depends on the institutional framework available for transmitting impulses released by the monetary policy of the central bank.

In its developmental or promotional role, RBI adopted measures to deepen and widen the financial system to promote saving and investment in the Indian economy. RBI was instrumental in the setting up apex institutions for ensuring provision of agricultural credit, providing term finance to industries and adequate credit for export.

Monetary Policy during the Pre-Reforms Period (1972-1991): Tight Monetary Policy:

It is worth noting that prior to 1991 monetary policy in India has been framed in response to fiscal policy of the Government. Fiscal Policy in India during the seventies and eighties had been such that large fiscal deficits were incurred. A good part of fiscal deficit was monetized, that is, financed by borrowing from Reserve Bank which created money against treasury bills issued by the Government.

This resulted in a very large increase in Reserve Bank credit to the Government which caused rapid growth in money supply. This highlights the close link between the fiscal policy and monetary policy and further that there is a need for coordination between two policies. Monetary policy adopted in the seventies and eighties was concerned mainly with the task of neutralizing inflationary impact of the growing budget deficits by continually mopping up large increases in reserve money (which in economic theory is also called high-powered money).

The instruments used were changes brought about mainly in Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) which were quite often raised during seventies to offset the effect of budget deficits and consequently increase in reserve money.

Given the fully administered nature of interest rates during most part of this period, the excess liquidity in the banking system was mopped up by raising the cash reserve ratio to the legally maximum limit, namely, 25 per cent.

Besides, since rates of interest on Government securities were much below the open market rates, excess liquidity from the banking system could not be withdrawn through open market operations. Further, in view of the below market rates of interest, banks and other financial institutions could not be induced to invest in Government securities to meet the borrowing requirements of the Government Statutory Liquidity Ratio (SLR) had therefore to be progressively raised to meet the borrowing needs of the Government and eventually it was increased to the maximum limit of 38.5 per cent.

To quote C. Rangarajan, a former Governor of Reserve Bank of India, “Until the overall reform process was initiated in 1991, the basic goal of monetary policy was to neutralize the impact of the fiscal deficits…. Monetary management took the form of compensatory increases in the cash reserve ratio (CRR) for banks, controls on growth of commercial credit (mainly to the enterprises sector) and adjustments of administered interest rates. The fixation of CRR and SLR at their maximum levels crowded out credit for the commercial sector. Thus, even when money supply was growing at a rapid rate, private sector could not get the needed credit for financing industry and trade.”

The banks were compelled to fund most of the large fiscal deficit at below the market rates of interest as they had to meet the high and rising SLR imposed on them by Reserve Bank of India. This is because rates of interest on Government securities were kept at lower levels than the prevailing market rates of interest.

Thus, Y.V. Reddy, the present Governor of Reserve Bank commenting on the monetary policy of Pre-reform period prior to 1991 writes, “given the command and controlled nature of the Indian economy, the RBI had to resort to direct instruments like interest rate regulation, selective credit control and Cash Reserve Rate (CRR) as major monetary instruments. These instruments were used to neutralize the monetary impact of the Government’s budgetary operations.”

On the recommendation of S. Chakravarty Committee report, in the late eighties and early nineties the rates of interest on Government securities were raised close to the market levels. This had two implications. First, with market rates of interest on Government securities, Reserve Bank could now undertake open market operations.

Secondly, with higher interest rates on Government securities banks and other financial institutions could now be induced voluntarily to invest more in Government securities. Accordingly, statutory liquidity ratio (SLR) was reduced below its maximum statutory level.