The Reserve Bank of India Volume 5 covers the eleven-year period of 1997–2008. This is an institutional history of the RBI and thus records developments in policies and operations in its major functional areas. The time period covered in this volume is unique as it was flanked by two major crises in the international economy. The RBI not only responded to the underlying developments and challenges but also took upon itself the remarkable role of the leader in initiating reform measures in several critical areas. These included rationalising and strengthening of monetary policy operating instruments, namely institution of the Liquidity Adjustment Facility (LAF) and the Market Stabilisation Scheme (MSS), establishment of financial market institutions (for example, Clearing Corporation of India Ltd.) and building up of payment system infrastructure (for example, Real Time Gross Settlement System, Delivery versus Payment, Negotiated Dealing System, Electronic Clearing Service, and so on), putting in place firm and sound legal structure for providing flexibility yet ensuring clear outcome and accountability (for example, Foreign Exchange Management Act, 1999, Government Securities Act, 2006, Payment and Settlement Systems Act, 2007, and so on), consolidating and strengthening the banking and non-banking sectors, improving the rural credit system and the financial inclusion. Thus, one may say that much of the plumbing was done during this period on which the present-day modern system stands. In the process, however, this volume documents the evolution of the RBI itself.

Another distinguishing feature of this period was that it was characterised by a stable relationship between the government and the RBI though some differences surfaced during the latter part in such policy areas as monetary management, exchange rate and reserve management, and the quality of capital flows without having any bearing on the macro-economic stability.

The journey of preparation of this Volume 5 had been a fascinating one. It was prepared by a team of consultants under the guidance of the author Professor Tirthankar Roy of London School of Economics. The focus had been on capturing the core areas of public policy interface of the RBI with the functions of other non-core service departments kept to the minimum.

Introduction

Between 1997 and 2008, the Indian foreign exchange (or forex) market underwent a major transformation in terms of the scale of turnover, players, institutional arrangements, and instruments. Although the Indian rupee had become convertible on current account in 1994, some of the current account transactions were still subjected to limits. These were either removed or relaxed subsequently and brought under a new legal framework, the Foreign Exchange Management Act (FEMA), 1999, which replaced the earlier, and far more restrictive, Foreign Exchange Regulation Act (FERA) 1973. Authorised dealers (ADs) were provided with more flexibility to undertake forex operations and greater freedom to manage risks.

The liberalisation of the capital account, by contrast, was a more gradual process and marked by cautious optimism. The period witnessed ‘effective’ full capital account convertibility for non-resident Indians (NRIs) and the introduction of limited liberalisation measures for capital transactions of residents. The underlying aim was to open up the forex market in line with the ongoing reforms. That expectation was so well fulfilled that the resultant transition posed problems for capital account management. Between 2001 and 2008, capital inflows occurred on a scale beyond the absorbing capacity of the economy, forcing the Reserve Bank to explore ways in which the ‘problem of plenty’ could be handled (Table 4.1).

In terms of the powers conferred by FEMA, the Reserve Bank is responsible for development and regulation of the forex market as well as management of the capital account. The measures that were taken to further open up the market during 1997–2008 necessitated changes in the legal framework and introduction of a large number of specific regulatory measures on the part of the Bank. The focus of the present chapter is on these measures.

The rest of the chapter has two main sections, dealing with the forex market and management of the capital account.

Foreign Exchange Market

Until the late 1990s, the Indian forex market was relatively shallow and had an uneven flow of demand and supply. Most transactions were spot and trade based. Transactions emanating from market expectations were rare because arbitrage opportunities between onshore and offshore financial asset markets were not freely allowed to be exploited.

Introduction

During the period under reference, globalisation, rapid economic growth, advances in information technology (IT), new responsibilities and increasing public scrutiny of its policies and functions posed enormous challenges to the Reserve Bank’s organisational set-up. At the same time, there was a fall in staff size. The Bank addressed new challenges by trying to upgrade the skills, technical expertise and professionalism of its employees, by means of in-house and external training, and strategic changes in placement and recruitment policy. Employee welfare measures received special attention, and efforts were undertaken to make the Bank’s compensation package competitive and attract talented individuals to its service. Mechanisation and computerisation, especially in the operational departments, were accorded top priority. A few new regional offices were opened after the formation of new states. And new departments were carved out to address emerging challenges. The system of internal inspection and audit was changed to adopt a risk-based approach of surveillance. Alongside, accounting norms were strengthened, and annual accounts of the Bank became more transparent in terms of dissemination of information relating to the composition of the balance sheet, valuation practices, changes in accounting practices, and different sources of income and expenditure.

The present chapter outlines these changes. The chapter is divided into ten main topics: the boards and committees, central and regional offices, new departments, human resource and staff matters, IT, rationalisation of systems and procedures, audit, inspection, balance sheet and ownership of institutions.

Boards and Committees

The Central Board of Directors carries out the general superintendence and provides direction to the affairs of the Bank. The Board is appointed by the Government of India in keeping with the provisions of Reserve Bank of India (RBI) Act. There are official and non-official Directors. While the former comprises the Governor and the Deputy Governors, the latter consists of Directors nominated by the government. Of these, ten are drawn from various fields, one is a government official and four are nominated from the local boards. There are four local boards – Western, Eastern, Northern and Southern. These boards are set up to advise the Central Board on local matters, to represent territorial and economic interests of local cooperatives and banks, and to perform such other functions as delegated by the Central Board from time to time.

This volume of the history of the Reserve Bank of India (RBI) covers events during the eleven financial years from 1997–98 to 2007–08 (the ‘reference period’). Over this period, the Reserve Bank faced several major external shocks and had to function in a rapidly changing economic environment within India. While the economic liberalisation process had begun in the early 1990s, key institutional and financial market reforms occurred, and integration of the Indian economy with the world economy accelerated, during the reference period.

The Bank shaped the transition, and adapted to it, by adjusting its approach to containing inflation and maintaining financial stability, focusing on financial market institutions and infrastructure, taking legal and other steps to achieve operational autonomy, making improvements in organisational capability and communication practices. It also worked not only to improve customer service in banks and the rural credit system but also to enhance financial inclusion. In all these efforts, the Bank relied on its own expertise as well as that available outside the organisation.

This is an institutional history. It thus records developments in policies and operations of the Bank in its functional areas and documents the evolution of the organisation itself. While the details of policies, operations and organisational changes appear in subsequent chapters, this introductory chapter presents a compact account of these developments during the reference period. The chapter begins with a brief review of the macroeconomic trends and political situation, followed by a review of the major areas of activity of the Bank during the reference period, and a brief chapter outline.

Backdrop

The beginning of the reference period witnessed several stressful events. The Asian currency and financial crisis (1997) posed major challenges for the policy environment in India. In the aftermath of the nuclear tests in Pokhran in May 1998, several Western nations imposed sanctions on India, leading to the partial suspension of multilateral lending, downgrading by international rating agencies and reduction in investment by foreign institutional investors.

Despite these shocks, the reference period saw robust growth of the Indian economy. Continuing from previous years, the corporate sector responded to increasing openness and global competition by improving productivity. All relevant financial parameters relating to solvency, liquidity and profitability improved.

Introduction

Between 1997–98 and 2007–08, the Reserve Bank of India functioned in a fast-changing economic environment. The two defining features of the process of change were the continuation of the economic liberalisation process begun earlier and the increasing openness of the Indian economy. This chapter provides a review of these two developments and a descriptive account of the behaviour of key macroeconomic variables during the period under reference. The review will serve as a backdrop to the succeeding chapters dealing with the Reserve Bank’s policies and operations.

Three themes dominate the narrative: growth, institutional change and openness. During the reference period, India maintained relatively high economic growth, with an intervening period of slowdown. A debate exists on when the economy moved to a higher growth path, to which a reference will be made later in the chapter. The higher growth rate, especially in the latter half of the reference period, was supported by growing domestic savings and investment rates, besides capital flows from abroad. Despite frequent changes of governments, political stance was generally in favour of continuing with economic and financial sector reforms initiated in the early 1990s. Interestingly, more than any other sector of the economy, the services sector propelled growth; services came to occupy a dominant share in the gross domestic product (GDP).

Inflation was relatively moderate despite high monetary and credit expansion. However, increasing global oil prices and domestic food price inflation started exerting pressure on prices towards the end of the period. Crucial to Reserve Bank operations, the fiscal situation at both the centre and states gradually improved after 2003. This was achieved thanks to cooperative efforts taken by the government and the Bank to contain deficits at sustainable levels by introducing rule-based fiscal reforms. India’s external sector expanded owing to increasing openness and progressive liberalisation of current and capital account transactions. Growth in the invisibles, especially remittances, supported the current account, where deficit was near-persistent, and unprecedented capital inflows sustained the overall balance of payments position.

The Reserve Bank coordinated closely with the government to sustain the growth process, contain inflation and maintain financial stability through banking and financial sector reforms.

Introduction

The Reserve Bank manages the debt of the central and state governments and acts as a banker to them under the provisions of the Reserve Bank of India (RBI) Act, 1934. While these functions are obligatory in the case of the central government, the Bank undertakes similar functions for state governments by agreement with the governments of the respective states. All states have such agreements.

During the years covered in the book, major institutional reforms were undertaken that redefined the relationship between the Government of India and the Reserve Bank, facilitated market borrowing, introduced new instruments and participants in the government securities market, and contributed to a significant improvement in the state governments’ fiscal and debt management. Many of these changes followed the Fiscal Responsibility and Budget Management Act, 2003 (FRBM Act), and similar legislation passed at the level of the states.

The chapter describes this transition. It covers four main topics, which are the system of public debt management, operation of the system in respect of the central government and state governments during the reference period and miscellaneous issues not covered elsewhere.

The System of Public Debt Management

Objectives

As the manager of public debt, the Bank’s overall objective was to ensure smooth completion of the annual market borrowing programmes (MBPs) of the central and state governments. The Bank tried to pursue debt management in such a manner that the design of the programme was consistent with monetary policy and financial development goals. While performing this role, the Bank tried to achieve three broad aims: minimise cost, mitigate risk and develop the government securities market. During the reference period, cost minimisation was sought to be achieved by proper demand estimation and planned issuance and offering of appropriate debt instruments.

The sovereign debt portfolio is exposed to rollover risk (risk associated with old debt maturing and rolling over into new debt), currency and exchange risks and sudden-stop risks (abrupt cessation of capital flow). Even though raising debt in foreign currency might at times be cost-effective, and provide a wide and varied investor base, such dependence could mean exposure to sharp volatility in the exchange rate. Given these considerations, no sovereign foreign currency bonds were issued by India.

This chapter shifts the focus to Europe in the early nineteenth century, where three important archetypes of economic nationalism were conceived. The first two were isolationist. Protectionists in France promoted disengagement from the world economy to forestall a rise in economic inequality which they feared might undermine national unity. Romanticist philosophers such as Adam Müller and Johann Gottlieb Fichte in Germany saw intensifying trade as eroding ‘traditional’ national and cultural values, which led them to advocate strict autarky. Friedrich List drew on these ideas, but also on developmental American approaches, in particular Alexander Hamilton’s ideas. He crafted an intellectual synthesis that sought to spur industrialisation by managing trade. However, List was unable to solve the tension between an ideology defending the economic sovereignty of small nations and one advocating imperialist expansion in search for markets, land and resources.

The conclusion draws the historical threads together and explains the causes of economic nationalism. It is most useful to think of nationalists as reacting to economic inequality. If inequality occurs between nations, we are more likely to witness expansionist ideas gain prominence. If inequality occurs within nations and is blamed on integration with the world economy, this is most likely to give rise to isolationist ideas. Both kinds of economic inequality are often accentuated by political inequalities. The motive for catch-up growth becomes more pressing if the nation is seen as politically subordinate within a system of imperial rule. Domestic inequalities are frequently given salience if they correspond to ethnic divisions within society. Based on these insights, the conclusion casts its gaze forward and predicts that both strands of economic nationalism will continue to shape economic policy in the near future.

Appendices

Introduction

The conduct of monetary policy underwent significant changes during the years 1997–98 to 2007–08. Changes occurred in objectives, instruments, monitoring of economic indicators and the process of policymaking, including legal procedures. The present chapter will describe these changes. The rest of the chapter is divided into seven sections. Six of these deal with, in that order, the shift from monetary targeting to multiple indicators approach to monetary management, the liquidity adjustment facility (LAF), the Market Stabilisation Scheme (MSS), implications of the new regime for the Bank Rate, pricing of bank credit, and changes in process and legal procedures.

A brief account of the main areas of change may be useful, to begin with, to set the stage for a more detailed narrative the rest of the chapter will present.

An Overview

Objectives of Monetary Policy

Monetary policy traditionally served two objectives: keeping inflation under control and ensuring adequate flow of credit to the economy. During the reference period, these two remained the main aims. The relative emphasis, as usual, could shift from one to the other, depending on market conditions. From the late 1990s, a third objective was added. The change came mainly in response to developments in the external sector. This was to achieve financial stability by maintaining orderly conditions in financial markets (money, government securities and foreign exchange markets) and sustaining the health of the banking system in the face of increasing exposure to foreign currency inflows and external shocks.

Instruments

The instruments of monetary management changed during the reference period. Until 1997, regulation of bank credit via direct and indirect means, mainly interest rate regulation, was the most important instrument. Monetary management was earlier carried out through open market operations (OMOs) in the form of outright purchase or sale of government securities, regulation of the reserve ratio (or cash reserve ratio, CRR) and the statutory liquidity ratio (SLR), or mandatory holding of government securities by banks. The CRR was the major instrument for absorbing liquidity in the period before India’s economic liberalisation began and was usually set at a relatively high level. In addition, various refinance facilities helped the Reserve Bank ration out liquidity among banks for short periods.

Introduction

While regulations provide the policy framework to ensure solvency and liquidity of banks and financial institutions (FIs), supervision refers to the instruments used to ensure compliance to this framework. Internationally, different models are followed in the performance of these two functions. In some countries, the two functions are entrusted to different agencies. In the Reserve Bank, the two functions were kept apart in respect of commercial banks, and these were handled by two different departments. However, in respect of non-banking financial companies (NBFCs), FIs and urban cooperative banks (UCBs), there was one department/division each responsible for both regulation and supervision during the reference period. The National Bank for Agriculture and Rural Development (NABARD) exercised supervisory powers over regional rural banks (RRBs) and banks in the rural cooperative structure.

As the previous chapters have shown, major changes happened in the Indian financial sector during the period covered in this volume. These changes offered consumers a broader range of products, complex and new business processes, and a reformed financial system. The changes also led to a blurring of the distinction between banking and non-banking businesses. Supervision, as this chapter shows, needed to adapt to these changes.

The chapter discusses the supervisory role of the Bank in four segments: commercial banks, NBFCs, UCBs and FIs. It also discusses how important episodes involving individual banks and institutions under stress led to changes in supervisory practices and policies.

Supervision of Commercial Banks

The Framework of Supervision

While conventionally the Reserve Bank relied on periodic on-site inspection of banks as the main instrument of supervision, the system was modified from time to time. In December 1993, the Bank bifurcated the regulatory and supervisory functions by entrusting the supervisory function to a newly created Department of Supervision. The setting up of the Board for Financial Supervision (BFS) in November 1994 was a milestone. The jurisdiction of the BFS, which originally covered commercial banks, was extended to FIs, NBFCs, UCBs, local area banks and primary dealers (PDs). The BFS laid down broad policies for on-site supervision and off-site monitoring, modalities for follow-up of inspection reports, and correction strategies for weaknesses observed in the functioning of banks and FIs.

Introduction

A payment system is defined as ‘a system that enables payment to be effected between a payer and a beneficiary, involving clearing, payment or settlement service or all of them, but does not include a stock exchange’, and includes ‘the systems enabling credit card operations, debit card operations, smart card operations, money transfer operations or similar operations’. Settlement means ‘settlement of payment instructions and includes the settlement of securities, foreign exchange or derivatives or other transactions which involve payment obligations’ (Payment and Settlement Systems Act, 2007). Clearing operations are subsumed in payment and settlement systems. A standard classification of the payment and settlement systems relevant for the reference period is shown in Table 8.1.

The economic liberalisation process had led to growth and innovation in financial markets, as well as increased risks. Responding to these challenges and opportunities, the Reserve Bank redesigned and developed the payment and settlement infrastructure. Several major initiatives had begun before 1997, including the introduction of magnetic ink character recognition (MICR) technology, electronic clearing service (ECS), electronic funds transfer (EFT) and delivery versus payment (DvP) in government securities transactions. In the capital market, the National Securities Depository Ltd. (established in 1996) pioneered dematerialisation of securities. In 1996, the Bank set up the Institute for Development and Research in Banking Technology (IDRBT) in Hyderabad. From 1 January 1995, the Bank carved out a separate department, the Department of Information Technology (DIT) out of the Management Services Department. Until 2005, the DIT oversaw initiatives based on information technology (IT) within the Bank and the industry, and improved the infrastructure of the payment-and-settlement-related services. The organisational evolution culminated in March 2005 with the establishment of the Department of Payment and Settlement Systems (DPSS) and a Board for Regulation and Supervision of Payment and Settlement Systems (BPSS). A Payment and Settlement Systems Act, 2007, accorded regulatory and supervisory powers to the Bank over all payment systems in the country.

This chapter outlines the major initiatives undertaken and implemented by these bodies during the reference period to improve speed, convenience, efficiency and safety in financial transactions.

The System in 1997–98

The banking network as at the end of March 1998 consisted of 66,306 bank offices belonging to 299 commercial banks (27 in the public sector, 34 in the private sector, 42 foreign banks and 196 regional rural banks) .