The persisting global financial crisis has generated widespread interest in the contours of monetary policy and financial regulation both in the developed countries and in the emerging market economies. This definitive analysis of India’s monetary policy and its financial sector reforms by Rakesh Mohan — a former Deputy Governor of the Reserve Bank of India who was a part of its policy group during a crucial period in the last decade — is a timely contribution to the debate on these issues.
Of the 12 essays in this collection, many are the revised and updated versions of the papers the author had presented at various conferences. The book opens with an analysis of India’s growth record over the last six decades. In the first few decades after Independence, when public sector was visualised as the engine of growth, the accent of fiscal policy was on high levels of taxation to garner resources for investment in that sector. Monetisation of budget deficits was another way of funding the investments. Moreover, there was an air of financial repression, thanks to the administered interest rates and rigid inter-sectoral credit allocation. Even in those days of limited autonomy for the RBI, monetary policy instruments like the SLR and CRR were used to prevent undue expansion of money supply. This, in fact, enabled India to fend off high levels of inflation, a phenomenon several developing countries, notably in Latin America, had to contend with.
Post-liberalisation, the financial sector reforms have served to enhance not just the competitiveness and efficiency of banks, but also their stability. The RBI saw to it that the banks followed internationally acceptable prudential norms of capital adequacy. The policy of risk weighting of the banks’ assets and provisioning requirements ensured that credit was directed towards sound investments rather than speculative transactions.
As a cumulative outcome of all these factors, domestic savings rose progressively to touch 38 per cent in 2008, which in turn supported higher levels of economic growth. Also, Indian banks could remain virtually unaffected by the global turbulence during the East Asian financial crisis (1997) and the North Atlantic countries’ financial meltdown (2007-08).
With the practice of automatic monetisation of the Central government’s deficits getting phased out in the early 1990s, the RBI’s ability to use monetary instruments was greatly strengthened. Nowadays, the Central and State governments borrow money through auctioning of bonds in the market — where the RBI does not figure as a buyer — with the interest rate on their borrowings being determined by the market. Further, the coming into being of the Fiscal Responsibility and Budget Management Act resulted in a substantial reduction in fiscal deficit at the Central and State levels. And the upshot of this is that the private sector could access more resources from the market and the interest rates dropped significantly during 2003-08. Since 2009, however, inflationary pressures seem to have reversed this trend to some extent.
In the management of exchange rate and foreign capital inflow, securing financial markets against volatility has been an important element. On the question of foreign exchange convertibility, the policymakers consciously adopted a gradualist approach in respect of the capital account. While risk capital was allowed to flow liberally in the form of FDI and portfolio investments, short term commercial borrowings were given only a limited scope. The impact of foreign capital volatility on portfolio investments was tempered through open market operations and ‘sterilization’ measures.
Rakesh Mohan puts up a strong, well-constructed defence of the monetary policy pursued by the RBI over the past two decades. Unlike the central banks of many other countries, which focussed exclusively on controlling inflation, the RBI, he says, calculatedly set for itself multiple objectives — price stability, exchange rate management, and financial stability coupled with adequate credit supply to sustain growth.
Mohan argues that, since the RBI functions both as the monetary authority and the regulator of the financial sector, it has been able to maintain price stability and develop a sound financial sector. In his view, separating the two functions and creating a new body to act as the regulator is not desirable.
The RBI has come in for praise both at home and abroad for having been successful in achieving financial stability. But its monetary initiatives for taming inflation have of late come under severe test. Inflation has been adamantly staying close to two-digit, despite the RBI having marked up the policy rates a dozen times in about 18 months. This only suggests that monetary policy instruments have their own limitations in tackling inflation, since there are likely to be other causative factors related to supply and demand.
To be fair, Rakesh Mohan, while giving due credit to the RBI’s monetary policy and financial regulation, admits that the financial system has failed in providing adequate credit to the farm sector and the small and micro enterprises. He asserts that, if the rate of growth achieved in recent years is to be sustained, the development strategy should focus much more on agriculture, urban infrastructure, and human resources.
Overall, the book offers a thorough and balanced analysis of the post-1991 monetary and financial policies by one who has been a part of the establishment when they were formulated. It makes for compulsive reading for students of monetary and financial policy.
GROWTH WITH FINANCIAL STABILITY-Central banking in an emerging market: Rakesh Mohan; Published by Oxford University Press, YMCA Library Building, Jai Singh Road, New Delhi-110001.