The Evolution of India’s Monetary Policy

Monetary Policy

The importance of monetary policy in the modern economy is well understood and widely recognized. The central banks have a mandate to ensure price stability, growth and employment. In India, the Reserve Bank of India that plays this crucial role- As per the RBI act, “to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage; to have a modern monetary policy framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in mind the objective of growth.”

While the RBI was set up in 1934, the process began much earlier. In 1926, the Royal Commission on Indian Currency (Hilton Young Commission) recommended the establishment of a central bank called the ‘Reserve Bank of India’. There were many attempts in the past, going back all the way to 1773, towards the setting up of a central bank or an institution that would act as a banker to the government.

The evolution
The focus and use of the tools available to the central bank have varied since its inception; as have the anchors.
Monetary policy, usually understood to represent “policies, objectives, and instruments directed towards regulating money supply and the cost and availability of credit in the economy”, is highly dependent on the prevailing context. The context, in turn, is determined by domestic and external factors.

Domestic factors such as economic and political structure, the demands of growth, poverty reduction, financial inclusion and the gradual development of institutions and markets are considered while making monetary policy decisions. External factors such as changes in global monetary policy, external shocks, dependence on foreign capital and the impact of opening up the economy are also considered. At different points in time, the degree of influence of these factors has changed, and as has the strategy of the central bank. From the 1950’s to the late 1980’s, the focus of the central bank was largely on stability and development.

There was a huge requirement of funds to finance development in the country. The RBI then had to manage short term pressures arising from inflation and balance of payments, while also keeping in mind the investment targets laid out in the five-year plans. There is an inherent struggle between managing inflation to promote saving and investment on one hand and managing large fiscal deficits on the other. This is a recurrent theme throughout much of the history of the monetary policy India. Inflation has always been a major problem in the country. This period was no exception.

The bank rate was a major tool during this period. The RBI increased the bank rate to 3.5 per cent and kept it there until 1957 as inflation started falling. However, with the increase in inflationary pressure, the RBI successively kept increasing the bank rate until 1965 when it reached 6 per cent, before lowering it to 5 per cent in March 1968. The second five-year plan had an ambitious outlay of investment which caused inflation to rise. The bank followed the path of ‘controlled expansion’ of generally restraining demand in the economy while selectively easing credit. The RBI always used its tool of moral suasion by ‘advising’ (sometimes exhorting) commercial banks to observe restraint in lending. We must remember, this was a time before the nationalization of banks where banks were privately owned.

During the early 50s, the RBI decided to ‘refrain’ from buying government securities. This was a major departure from past practice, as one of the major roles of the bank is help finance the deficit of the government. The central bank focused on increasing priority sector lending as an intermediate target, in line with the five-year plans. During this period, the exchange rate was a pegged exchange rate. The global monetary policy was largely influenced by the Bretton Woods system. Even after the collapse of the Bretton Woods system, India continued with a pegged exchange rate. However, to minimize the risk associated with one currency, they expanded to a basket of currencies in 1975.

With the 1991 crisis and the liberalization of the economy, the RBI also had to shift its approach. The focus for the next decade was on inflation and credit supply. The intermediate target shifted to monetary targeting with annual growth in money supply (M3, to be specific). It used instruments such as Gradual interest rate deregulation CMR; Direct instruments (selective credit control, SLR, CRR). By 1994, selective credit control operations had been phased out. Current account and partial capital account liberalization were accompanied by a gradual move towards a more flexible exchange rates.

The sequencing of the entire process was well thought out and executed. While controls continued on domestic portfolios and debt inflows, equity inflows were liberalized as there is repayment burden linked to equity. On foreign debt, the sequence of relaxation favored commercial credit and longer-term debt. Major reforms were undertaken towards development of equity, forex money and government securities markets. Although low by developing country standards, Indian inflation was higher than world rates.

Accumulation of large public debt made the fiscal-monetary combination followed in the past unsustainable. The automatic monetization of the government deficit was stopped and auction based market borrowing adopted for meeting the fiscal deficits. The repressed financial regime was dismantled, interest rates became more market determined and the government began to borrow at market rates. From 1998-99 to till about 2014, most of the focus has been on inflation and growth with multiple intermediate targets. The RBI has used a host of Direct (CRR, SLR) and indirect instruments (repo operations under LAF and OMOs) to achieve its mandate.

Since 2014, after Raghuram Rajan took over as governor, the central bank has moved to directly targeting inflation. Under the current governor, Urjit Patel, the RBI has continued to focus on its objective of inflation targeting. The current target is of 4% with (with a tolerance level of 2% either ways). This has been done in order to set expectations in the economy regarding inflation and ensure price stability in the economy. Under inflation targeting, rates are set is response to inflation and the ‘output gap’ (the difference between the potential output and actual output).

How this gets transmitted throughout the economy is that changes in rates affect long-term and short-term interest rates, asset prices and exchange rates. These in turn affect bank credit and the aggregate demand in the economy which helps bring the economy bridge the output gap. Thus, over time, a marked evolution in monetary policy has taken place. Today, India has monetary policies that are in line with international standards, as envisioned  by highly respectable and influential governors.

-Contributed by Bhargav Dhakappa
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