Changes in Monetary and Fiscal Policy in India during Reform Period
In India, prior to 1991, interest rates and returns on all types of financial investments were strictly regulated and banks had to operate under numerous restrictions imposed by the Government of India. There was virtually no competition in the banking sector and the nationalized banks were required to perform many social duties, like lending to priority sectors at subsidized rates of interest. Heavy regulation, lack of competition and accountability along with emphasis on social responsibility, at the cost of profitability, led to cumulative rise in inefficiency and non-performing assets (NPA) over the decades.
RBI did not have ï¿½desired autonomyï¿½ during pre-reform period and monetary policy virtually played an accommodative role to fiscal policy. The central government could borrow without limit from the RBI through ad hoc treasury bills (which were basically overdrafts on the RBI). In addition to CRR, commercial banks were statutorily required to hold a specified percentage of their assets (statutory liquidity ratio, SLR) in the form of government bonds. These bonds had zero risk of default, but yielded very low returns. SLR was the mechanism by which the banks were forced to lend to the Government of India at interest rates that were kept artificially low. In the early 1990s more than 60 per cent of incremental bank deposits used to be allocated to meet the CRR and SLR requirements.
The GOI used to interest rates on government bonds at levels much lower than those on other assets with the obvious intention of minimising its cost of borrowing. As a result, general public did not show much interest in these bonds. These bonds were held, under compulsion, mostly by banks, provident funds, and nationalised insurance companies.
In India, the process of economic reform began in 1991. Banking reform has been an important component of that process. On the recommendations of the Narasimham Committee on Financial System (1991), the GOI has adopted measures to restructure the banking system.
The major steps include:
Filling of regulations on interest rates on deposits and advances; allowing entry of private banker; liberalisation of branching regulations for both public and private sector banks; introduction of capital adequacy, income recognition, and provisioning norms; and reduction of the appropriation of loanable funds by the GOI through gradual decrease in CRR and SLR. Banks have now more funds at their disposal for lending on commercial terms.
The monetary reform undertaken in India was characterised by the 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.
The GOI no longer has the power to control interest rates on government bonds and the SLR has been progressively reduced. SLR was as high as 38.5 per cent in 1992, but gradually reduced to only 25 per cent in 2005. A secondary market for government securities is developing. Banks continue to hold a larger portion of their portfolio in the form or such securities because of these are of low risk and high liquidity, but banks are no longer forced to do so. Through the use of ad hoc treasury bills the GOI used to enjoy unlimited access to the RBI credit. More than 90 per cent of the variations in reserve money, on an average, during 1980s, were due to the deficit financing or the RBI credit to the central government. This is known as automatic monetization of deficit. Such automatic monetization of deficit severly degraded the ability of the monetary authorities (RBI and Ministry of Finance) to pursue independent monetary policy.
As part of fiscal consolidation, issue of ad hoc treasury bills has been abolished and a system of Ways and Means Advances (WMA), with a mutually agreed prior limit, introduced to meet temporary mismatch between receipts and expenditures of the GOI. Significantly, greater autonomy of the RBI has been one of the major positive results of financial reform in India. The enactment of the FRBM Act has strengthened this further. RBI is no longer permitted to subscribe to government securities in the primary market since 2006.
Monetized deficit as a proportion of GDP has declined from 2 per cent over the decade 1980-91 to 0.5 per cent over 1992-2004. This has restricted the growth of money supply in the economy. As a result, inflation has come down to moderate levels.
With budget deficits not being automatically monetized now, fiscal policy does not determine reserve money any more. On the contrary, it is ï¿½increasingly reflecting the RBIï¿½s assessment of market liquidity and absorptive-capacityï¿½ (RBI, Annual Report, 2000-01). The monetary authorities now have much more discretionary control over the stock of reserve money. In the pre-reform days, the yield on government bonds was kept at such a low level that there was not much demand for it. Since the market for government debt was very narrow and undeveloped earlier, OMOs as an instrument of credit control was ineffective. Situations are now changing.
Written by princy