Domestic Monetary Management

Exchange Rate Management

Policy Measures

Banking Sector Reforms

Financial Market Developments

Annexure : Chronology of Major Policy Measures April 1998-July 1999

1.1 The year 1998-99 provided yet another evidence of resilience of the Indian economy to withstand several domestic and international uncertainties. Not only was the real GDP growth estimated to be higher in 1998-99 than in 1997-98, but also the inflation rate was significantly lower (Appendix Table I.1). The foreign currency reserves increased substantially, while foreign exchange market, despite the uncertain international environment and deceleration in world trade, remained orderly in general. Agriculture made a recovery. The performance of the services sector remained significant. However, there was some slowdown in industrial output. Monetary -fiscal policy co-ordination ensured that aggregate demand-supply balance was secured without constraining growth impulses. Against this background, this report presents the policy environment under which the real, monetary, fiscal, financial market and external developments took place during 1998-99 and in the first quarter of 1999-2000.

Domestic Monetary Management

1.2 During 1998-99, monetary policy had to contend with a number of domestic and international economic uncertainties. The considerations in the domestic sphere called for careful balancing of objectives between growth and inflation control even as several adverse international developments had impacted on forex market and on the design and conduct of interest rate policy. The course of monetary policy was also influenced by fiscal developments, which required financing of Government deficit of a large magnitude with implications for interest rates and investment.

1.3 Monetary policy was conducted in conjunction with long-term structural and institutional reforms in the financial sector with a view to imparting stimulus to potential growth impulses. The reforms aimed to impart flexibility to the market participants in management of resources, improve the supervisory and regulatory framework for financial system and promote market integration towards enhancing allocative efficiency of resources and improving the transmission channels of monetary policy.

Policy Stance

1.4 The April 1998 monetary and credit policy was framed against the backdrop of the South-East Asian market crisis, and the need to accelerate industrial investment and output in the economy. The policy placed emphasis on maintenance of low rates of inflation, continued pursuit of financial sector reforms, reduction in interest rates and improvement in credit delivery mechanisms, particularly for agriculture and medium and small sectors. Given the comfortable liquidity situation at the beginning of the year and the need to contain inflation and to ensure availability of sufficient credit to realise the potential growth in the economy, the target growth of broad money(M₃) was projected to be in the range of 15.0 to 15.5 per cent during 1998-99. However, given the limitations in the stability of money demand function in the short-run, it was felt useful to carefully monitor a multiple set of indicators also for policy purposes.

1.5 The monetary management during the course of 1998-99 had to cope with several unexpected developments which could not be fully anticipated in the April 1998 policy statement. First, the emerging international developments during the year posed a major challenge for monetary management. The South-East Asian economic crisis continued to remain serious and the contagion spread to Russia and major parts of Latin America. The world economy, as a whole, faced considerable uncertainty, with prospects of large scale decline in GDP of major economies and recession in world trade during the course of the year. Secondly, India was also confronted with some other related developments after the Pokhran nuclear test in May 1998, notably economic sanctions imposed by certain industrial countries, suspension of fresh multilateral lending, downgrading by some international credit rating agencies and reduction in net foreign institutional investment. Thirdly, there was a creeping rise in the annual rate of inflation mainly caused by supply shocks in a few food items up to October 1998.

1.6 The October 1998 monetary and credit policy undertook a mid-term review of developments in the macro-economic and monetary front. The rate of growth of money supply at the time of the mid-term review was higher than necessary in relation to the expected real GDP growth and the prevailing inflation rate. On strict analytical grounds, this situation warranted monetary tightening measures in order to control liquidity and to maintain price stability. However, in the presence of persisting industrial slow down, monetary tightening measures like increases in cash reserve ratio (CRR) and in interest rates would have dampened emerging signs of incipient recovery in the real sector. This, in turn, could have resulted in lower revenue for the Government and the need for higher borrowing requirement of the Government. These conflicting considerations underlying the balancing of objectives between growth and inflation control reflected the monetary policy dilemma faced by the Reserve Bank at that juncture. Instead of resorting to increase in CRR or interest rates, the Reserve Bank continued to manage liquidity through active use of open market operations (OMO) and repo transactions. The policy of flexible use of interest rates to signal the Reserve Bank's stance regarding monetary conditions and management of liquidity emerged as an important feature during 1998-99. The Reserve Bank also felt that the rise in inflation rate up to October 1998 was due to temporary supply shortages in certain agricultural commodities and would reverse itself in subsequent months once the availability position improved. On balance of considerations, the Bank, therefore, did not resort to any monetary tightening measures in October 1998 and decided to wait until the impact of seasonal factors on the prices of agricultural commodities was clear. In the event, this judgement turned out to be correct and the annual rate of inflation declined very sharply later in the year.

1.7 The stance of monetary policy for 1999-2000 took into account the significant improvement that was achieved in the year-end price situation, agricultural production and stability of the external sector in 1998-99. Keeping in view the paramount need to improve industrial growth, the stance of monetary policy continued to place emphasis on facilitating availability of liquidity in the economy along with stable medium and long-term interest rates, with policy preference for softening to the extent circumstances permitted. In April 1999 monetary expansion for 1999-2000 was projected within the range of 15.5-16.0 per cent, consistent with the objective of a real GDP growth of 6.0 to 7.0 per cent and inflation rate of around 5.0 per cent.

1.8 Developments in the money and forex markets during 1998-99 warranted intensive use of an approach based on a multiple set of indicators. The need for such a flexible approach stemmed particularly from the short-term policy challenges necessitating preemptive monetary policy measures to bring about required adjustments in interest rates so as to ensure stability of the foreign exchange market, support growth, contain inflationary pressures and facilitate public debt management operations.

Developments in Fiscal Policy

1.9 Co-ordination of monetary policy with the evolving fiscal situation emerged as an important aspect of the monetary management during the year. In view of the large market borrowing programme proposed in the Central budget for 1998-99 and the prevailing market uncertainties, the Reserve Bank had indicated on June 11, 1998 its intention to accept private placement of securities from time to time, depending on the market assessment of interest rates, and then release them to the market as conditions improved, in order to minimise the adverse effect of Government borrowing on interest rates. During the course of the year, the actual market borrowing of the Central Government far exceeded the budget anticipation, due to slippage in the fiscal position. Consequently, the Reserve Bank had to absorb a large part of the gross borrowings in its own portfolio and subsequently divest them through OMOs during the year. This practice was facilitated to a large extent by the availability of surplus liquidity in the system, stemming from a significant deceleration in the demand for non-food credit and injection of additional funds by way of the proceeds from the Resurgent India Bonds (RIBs) which flowed into the banking system in August 1998.

1.10 The overall impact of the Government's borrowing programme on the monetary situation is indicated by an increase in the growth of reserve money to 14.6 per cent in 1998-99 from 13.2 per cent in 1997-98. However, the approach of private placement combined with active OMOs proved effective in containing the adverse interest rate effect of the Government's large borrowing from the market without distorting the yield curve and market expectations regarding interest rates. The medium and long-term interest rates, therefore, remained fairly stable during the year.

Operating Procedures

1.11 During 1998-99, the operating aspects of monetary management were highlighted by the active use of the Bank Rate, repo rate and CRR to meet short-term monetary policy objectives. These policy instruments were used more than once in response to the emerging domestic and external situation. The Bank Rate and short-term repo rate announced by the Reserve Bank were increasingly perceived by the market as signals for movements in market rates of interest, in particular short-term rates. This development was significant in that it increased the range of instruments available to the Reserve Bank for influencing money market developments. While the adjustment in the Bank Rate was kept to the minimum during 1998-99, the fixed repo rate was varied flexibly, in both directions, to influence the flow and cost of funds in the short run. Adjustments in CRR also served as one of the important instruments for regulating liquidity in the economy. Its active use in 1998-99 showed that intra-year variations in CRR could be an effective instrument in meeting the short-term challenges in domestic money and forex markets. While the long-term objective of monetary policy continued to be in the direction of reducing the average level of CRR, it became evident that in the short-term, the level of CRR could be varied in both directions depending on the assessment of the overall monetary situation.

1.12 The Reserve Bank continued to make conscious efforts to promote the use of indirect policy instruments in the conduct of monetary policy. Instruments such as CRR and export credit and general refinance limits were however, used to meet specific circumstances. A major challenge of the monetary policy during the year was in the area of liquidity management arising out of the inflow of funds into the banking system on account of the RIBs, the spillover effects of forex market volatility on the money market and the absorption of excess liquidity arising from private placement of Government debt with the Reserve Bank. Both repos and open market operations were put to active use in the management of day-to-day liquidity in the system so as to ensure stability in money, forex and Government securities markets. A major aspect of the repo operation by the Reserve Bank in 1998-99 was its increasing use to transmit interest rate signals across the whole range of short-term interest rates, taking advantage of the greater degree of integration among the money, forex and Government securities markets.

1.13 In order to deepen the Government securities market, liquidity support to Primary Dealers against their holdings of securities in the Subsidiary General Ledger (SGL) accounts in place of liquidity support through reverse repos was introduced. It was decided on September 8, 1998 that pending the use of the RIB rupee resources, temporary surpluses of the banks mobilising such funds could be deployed in Treasury Bills and dated securities. In order that banks undertaking such investments did not face unanticipated liquidity problems, a special liquidity support facility by way of refinance was introduced. Effective September 17, 1998 such banks were provided liquidity support to the extent of their excess holdings of Government securities/Treasury Bills purchased through OMO over the Statutory Liquidity Ratio (SLR) required to be maintained. This refinance facility was, however, withdrawn with effect from April 1, 1999.

1.14 A major innovation in the operating procedure in the current financial year (1999-2000) has been the introduction of an Interim Liquidity Adjustment Facility (ILAF) through repos and lending against collateral of Government of India securities. Pending the upgradation of technology and legal/procedural changes required to switch over to a system of electronic transfer and settlement, ILAF is intended to be an interim arrangement towards the transition to a full fledged liquidity adjustment facility by way of repos and reverse repos for providing a corridor for short-term interest rates (Box I.1). Such a facility enables the Reserve Bank to inject liquidity into the market at various interest rates and absorb when necessary at the fixed repo rate so as to promote stability of money market and ensure that the interest rates move within a reasonable range.

Box I.1

Interim Liquidity Adjustment Facility

In recent years, development, deregulation and integration of financial markets have had significant implications for the choice of operating procedures of monetary policies of central banks. Currently, a majority of central banks in developed countries use short-term interest rates as the operating target in transmitting their day-to-day policy response to money market.

The choice of an operating target (overnight inter-bank rate or other short-term interest rates) depends on the degree of flexibility exercised by the central bank over the target and on the design of the central bank's instruments. The central bank decides how much volatility in the operating target is acceptable to it, given the underlying monetary policy stance and strategy. In countries like Germany and Brazil, the central bank tries to contain the volatility in the short-term interest rates by providing an interest rate corridor through the use of standing (refinance) facilities. While the ceiling of the corridor is generally a Lombard-type credit facility, the floor is either a subsidised lending facility (e.g., a discount window at below market cost) or a deposit facility at a low rate of return. The central bank tries to fine-tune its market operations to keep the overnight and other money market rates within the formal interest rate corridor.

Country-experiences reveal that Germany (prior to launching of Euro), Brazil and Hong Kong use standing (refinance) facilities to define the corridor while Colombia sets the corridor through the sale of central bank paper and repurchase operations in Treasury Bills. Hong Kong also used the corridor system until September 1998 whereby banks could access the Liquidity Adjustment Facility (LAF) at the end of the day from the Hong Kong Monetary Authority (HMA) against the collateral of Exchange Fund bills and notes under a reverse repo arrangement at a rate declared by HMA. During the day, the inter-bank rates could move beyond the margin set by the LAF. The LAF helped in ensuring stability in interest rates in Hong Kong besides enabling the HMA to identify the sources of liquidity pressure during the course of the day.

In India, no explicit interest rate is used as an operating target of policy. However, the Reserve Bank has been placing some reliance on interest rates also in its day-to-day conduct of monetary policy in recent years through various instruments such as repurchase agreements and the Bank Rate.

The Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham) had, inter alia, suggested that for orderly movements of interest rates in the inter-bank call money market, the Reserve Bank's support to the market should be through liquidity adjustment facility "under which it would periodically, if not necessarily daily, reset its Repo and Reverse Repo rates which would in a sense provide a reasonable corridor for market play" (Annexure to Chapter V (page 58) of the Committee's Report). In the October 1998 'Mid-Term Review of Monetary and Credit Policy for 1998-99', it was indicated that the Reserve Bank broadly agreed with the Narasimham Committee's suggestion that the RBI support to the market should be through a LAF operated by way of repo and reverse repos. It was also indicated that though repo is an efficient route for LAF, in view of certain procedural and technological constraints in transfer and settlement of securities, it might not be immediately possible to introduce a LAF. As a transitory measure, the Reserve Bank announced the introduction of an Interim Liquidity Adjustment Facility (ILAF) in its April 1999 Monetary and Credit Policy for 1999-2000 to minimise volatility in the money market by ensuring movement of short-term interest rates within a reasonable range. The features of the ILAF are as below:

- Effective April 21, 1999 the general refinance facility was withdrawn and replaced by a collateralised lending facility (CLF) up to 0.25 per cent of the fortnightly average outstanding aggregate deposits in 1997-98 which would be available for two weeks at the Bank Rate.

- An additional collateralised lending facility (ACLF) for an equivalent amount of CLF would also be available at the Bank Rate plus two per cent.

- CLF and ACLF availed for periods beyond two weeks would be subject to a penal rate of 2 per cent for an additional period of two weeks. There would be a cooling period of two weeks thereafter.

- In order to facilitate systemic adjustment in liquidity, the current restriction on participation in money market was withdrawn.

- Scheduled commercial banks became eligible for export credit refinance facility (ERF) at the Bank Rate with effect from April 1, 1999.

- Liquidity support against collateral of Government securities, based on bidding commitment and other parameters would be available to Primary Dealers (PDs) at the Bank Rate for a period of 90 days and the amounts would remain constant throughout the year. Additional liquidity support against collateral of Government securities would be provided to PDs for a period not exceeding two weeks at a time and at the Bank Rate plus two per cent.

- Absorption of liquidity in the market would continue to be through fixed rate repos.

- The above facilities would be supplemented by OMOs by the Reserve Bank.

References

1.

Bank for International Settlements, (1999), 'Monetary Policy Operating Procedures in Emerging Market Economics', BIS Policy Papers, No.5, March.

2.

Deutsche Bundesbank, (1995), The Monetary Policy of the Bundesbank, October.

3.

Government of India, (1998), Report of the Committee on Banking Sector Reforms, Chairman: Shri M. Narasimham, New Delhi.

4.

Thomas, F. C., (1991), Money, the Financial System and Monetary Policy, Prentice-Hall.

Exchange Rate Management

1.15 The management of the exchange rate during 1998-99, particularly in the early part of the year, was a challenge in view of the turbulence in the South-East Asian financial markets, the spread of contagion to other markets such as Russia and Brazil, and the economic sanctions in addition to some domestic uncertainties. The exchange rate of the rupee moved sharply from Rs.39.73 per US dollar at the beginning of May 1998 to Rs. 42.38 per US dollar on June 11, 1998. The Reserve Bank announced a package of policy measures on June 11, 1998 to contain the volatility in foreign exchange market. These included: (a) announcement of the Reserve Bank's readiness to sell foreign exchange in the market to meet any mismatch between demand and supply; (b) allowing foreign institutional investors (FIIs) to manage their exchange risk exposure by undertaking foreign exchange cover on their incremental equity investment with effect from June 12, 1998; (c) advising importers as well as banks to monitor their credit utilisation so as to meet genuine foreign exchange demand and discourage undue build-up of inventory; (d) allowing domestic financial institutions, with the Reserve Bank's approval, to buy back their own debt paper or other Indian papers from international markets; (e) allowing banks/ ADs, acting on behalf of the FIIs, to approach the Reserve Bank for direct purchase of foreign exchange; and (f) advising banks to charge a spread of not more than 1.5 percentage points above LIBOR on export credit in foreign currency as against the earlier norm of not exceeding 2-2.5 percentage points.

1.16 Responding to the policy measures, the foreign exchange market returned to normalcy for some time and exhibited orderly conditions during most part of the second quarter. The foreign exchange market again came under pressure in August 1998, reflecting the adverse sentiment with the deepening of financial crisis in Russia and the fear of devaluation of the Chinese renminbi. Responding to these developments, the Reserve Bank announced a fresh package of measures on August 20, 1998 in order to prevent speculative sentiments building up pressure on the orderly functioning of the market. These measures included: (a) a hike in CRR from 10.0 per cent to 11.0 per cent, (b) an increase in the repo rate from 5 per cent to 8 per cent, (c) enhancement of forward cover facilities to FIIs, (d) withdrawal of facility of rebooking the cancelled contracts for imports and splitting forward and spot legs for a commitment and (e) allowing flexibility in the use of Exchange Earners Foreign Currency (EEFC) accounts while restricting the extension of time limit for repatriation of export proceeds to exceptional circumstances.

1.17 These measures coincided with the launching of the scheme of Resurgent India Bonds in August 1998, in line with the announcement made in the Union Budget for 1998-99. The RIB scheme was designed to address the unusual events that followed the imposition of sanctions on India, which could have temporarily affected normal capital flows. The issue of RIBs was also to address the need to counteract the possible adverse sentiments in the international markets due to downgrading of India's sovereign rating and to set a benchmark for future corporate borrowings without disrupting the domestic and foreign exchange markets (Box I.2).

1.18 In contrast to cumulative sales by the Reserve Bank amounting to US $ 2,502 million during May-July 1998, the subsequent period from August 1998 to March 1999 witnessed cumulative purchases of US $ 4,143 million resulting in net market purchases at US $ 1,842 million for the year as a whole by the Reserve Bank. The exchange rate, by and large, remained stable during September 1998 -March 1999, moving within a range of Rs.42.27 to Rs.42.63 per US dollar. During the first quarter of 1999-2000, the rupee depreciated to Rs.43.36 per US dollar by end-June 1999.

Policy Measures

1.19 Monetary policy measures during 1998-99 along with the day-to-day liquidity management, focussed on adjustment of interest rates. In August 1998, the Reserve Bank signalled hardening of monetary conditions, while in March 1999, it signalled the easing of the conditions. On each of these occasions, the Reserve Bank used a package of multiple instruments - both direct and indirect - to influence money market developments, even as it remained committed to a gradual reduction in the CRR over the medium-term and to provide temporary liquidity support for addressing unanticipated liquidity problems arising out of investment of rupee resources from RIBs in Government securities. Three distinct phases in terms of relative emphasis were evident in monetary policy developments during 1998-99 and 1999-2000 so far. During the first phase spanning April to mid-August 1998, the primary emphasis was on promoting growth. During the second phase beginning from mid-August 1998 to February 1999, the emphasis shifted to containing volatility in foreign exchange market. With the restoration of stability in the foreign exchange market, the monetary policy measures were focussed once again on helping the recovery of industrial growth during the third phase (March 1999 till date).

Box I.2

Resurgent India Bonds: Issues and Implications

Following the announcement in the Union Budget 1998-99, the State Bank of India floated the Resurgent India Bonds (RIBs) scheme during August 1998 for subscription by non-resident Indians (NRIs) and overseas corporate bodies (OCBs) (predominantly owned by NRIs) either on a single name or jointly to be held with any Indian resident. The bonds were issued in three different currencies, viz., the US Dollar, the Pound Sterling and the Deutsche Mark at interest rates of 7.75 per cent, 8 per cent and 6.25 per cent, respectively, with a maturity period of 5 years and redeemable on maturity in the currency of subscription. Interest could be paid either on cumulative basis, compounding every half-year or on a bi-annual non-cumulative basis. While no exchange loss on the RIBs would be borne by the Reserve Bank, the proceeds from RIBs would attract SLR at the rate of 25 per cent. The principal amount of the instrument and the interest thereon will be fully repatriable in foreign currency in respect of non-resident holders. No premature encashment of bonds is allowed until 6 months. The bonds can be transferred among NRIs and gifted to a resident only once with no transfers among the donees. Income from RIBs will be exempted from income tax, wealth tax and gift tax.

Total mobilisation through RIBs amounted to the equivalent of US $ 4.23 billion, the bulk of which was in US dollar (US $ 3.99 billion). The Reserve Bank's purchase from the State Bank of India on account of RIBs amounted to US $ 3.71 billion up to end-March 1999, which was reflected in the increase in India's foreign currency assets by US $ 3.55 billion during 1998-99. The rupee resources received by banks against RIBs were to be used to meet normal credit requirements, particularly for infrastructure financing and investments in infrastructure bonds issued by financial institutions. Pending deployment of rupee resources, the temporary surpluses with banks were allowed to be parked in Treasury Bills and Government dated securities. In order that banks investing in such Treasury Bills/securities do not face unanticipated liquidity problems, the Reserve Bank provided a special liquidity support facility, on the same terms as the general refinance facility during September 1998 to March 1999.

The Reserve Bank maintains a 'maintenance of value' (MoV) account to take care of the exchange losses, if any, which will be periodically funded by the State Bank of India and the Central Government in agreed proportions. Apart from improving the qualitative composition of external debt, especially towards longer end of maturity, RIBs helped in bolstering positive market sentiment and provided indirect support to Government's market borrowing programme. The amount mobilised by RIBs came at a moderate cost considering the difficult international environment at the time of floatation and the prevailing market spreads on developing country papers. RIBs also substituted for normal debt and non-debt capital flows.

The impact of the RIB proceeds on reserve money was addressed by undertaking simultaneous open market operations to absorb the excess liquidity by issuing Government securities from the Reserve Bank's portfolio. The rupee resources flowing to the banking system on account of RIB proceeds were reflected on their time deposits. If the residency criteria of compilation as recommended by the Working Group on Money Supply: Analytics and Methodology of Compilation (Chairman: Dr. Y.V.Reddy) are applied, such resource inflows will need to be excluded from broad money (M₃).

Reference

Reddy Y.V. (1999), 'Managing Capital Flows', Reserve Bank of India Bulletin, January.

Phase I: (April to mid-August 1998)

1.20 The first phase was the continuation of the process of the reversal of the monetary policy measures announced in January 1998 to contain the spill-over effects of the SouthEast Asian currency crisis. As stability returned to the foreign exchange market, and as liquidity conditions turned easy, the Reserve Bank signalled the need for lowering of interest rates in April 1998 in order to give fillip to investments, and to promote industrial recovery. Accordingly, the Bank Rate was reduced by 150 basis points in April 1998 to the pre-January 16, 1998 level of 9.0 per cent, while the fixed repo rate was reduced in three stages from 8.0 per cent at end-March 1998 to 5.0 per cent by June 15, 1998. In consecutive fortnights beginning March 28, 1998, CRR was also lowered from 10.5 per cent to 10.0 per cent with a cut of 0.25 percentage point each fortnight, injecting liquidity in the overall by about Rs.2,600 crore. The emergence of the Bank Rate as a signalling rate has become evident with the decline in the interest rates both in the money and credit markets following successive cuts in this rate during 1998-99. While the call rates, 14-day and 91-day Treasury Bill rates and CP rates reacted sharply to the Bank Rate cut, a majority of banks reduced their lending and deposit rates as well in response to the reduction in the Bank Rate (Appendix Table 1.2). In the light of the experience of the South-East Asian countries, the interest rate ceilings on FCNR(B) deposits on short-term and long-term deposits were revised in April 1998 to encourage banks to mobilise long-term deposits. The export credit refinance limits of commercial banks were restored in May 1998 to 100 per cent of the increase in export credit eligible for refinance over the level of such credit as on February 16, 1996. Moreover, the rates of interest on export credit as well as of export credit refinance were reduced in April 1998 and again on August 6, 1998 (as a temporary measure valid up to March 31, 1999) (Appendix Table I.3).

Phase II : Mid-August 1998 to February 1999

1.21 As the foreign exchange market turned volatile in August 1998, necessitating the tightening of monetary conditions, the Reserve Bank announced a package of short-term policy measures. While the Bank Rate was left unchanged, the repo rate was raised sharply by 300 basis points and CRR was raised by 100 basis points. These measures resulted in an increase in the short-term money market and Treasury Bill rates. The rates at the longer end of the maturity spectrum in the Government securities market as well as the deposit and lending rates of banks, however, remained relatively unaffected in view of the sluggish growth in non-food credit.

Phase III : March 1999 till date

1.22 The restoration of orderly conditions in the foreign exchange market and the presentation of the Union Budget 1999-2000 which estimated a lower order of fiscal deficit provided the background for easing of liquidity conditions in March 1999. Thus, the Bank Rate and the fixed repo rate were reduced to 8.0 per cent and 6.0 per cent, respectively; CRR was also lowered by 100 basis points to 10.0 per cent by May 8, 1999 thereby injecting liquidity to the tune of Rs.6,350 crore to the banking system. The reduction in the Bank Rate in March 1999 as well as the availability of ample lendable resources of the banking sector prompted the major public sector banks to reduce their deposit rates as well as prime lending rates (PLRs). Effective April 1, 1999, export credit refinance was made available to banks at the Bank Rate (i.e. 8.0 per cent per annum). The General Refinance Facility, introduced on April 26, 1997 was withdrawn, effective April 21, 1999. The cost of refinance to state co-operative banks was lowered and brought at par with that of scheduled commercial banks, effective April 21, 1999.

Structural Policy Measures

1.23 Apart from the measures directly relevant to the liquidity and interest rate management during the year, the Reserve Bank continued with the rationalisation of credit delivery system and liberalisation of the operating environment of the banking system. In order to remove disincentives for flow of credit to small borrowers, it was announced in April 1998 that interest rate on credit limits of Rs.2 lakh and below would not exceed PLR. Effective April 20, 1999, banks were given freedom to operate different PLRs for different maturities and were also permitted to offer fixed rate term loans so as to facilitate project finance. The existing system of charging interest rates equivalent to PLR on advances against fixed deposits of both residents and non-residents was modified.

1.24 In view of the immediate priority to further facilitate the flow of credit to the commercial sector, the Reserve Bank announced a number of measures to improve the credit delivery system particularly for sectors like exports, information technology, infrastructure, agriculture, etc. As regards export credit, the Reserve Bank issued guidelines in February 1999 simplifying the export credit procedures so as to ensure their accessibility to all exporters, particularly the small and medium sized exporters. A Monitoring Group of Bankers was constituted for supervising the progress in the implementation of the guidelines. The Reserve Bank also issued a set of guidelines to banks in August 1998 on various aspects of lending to the software industry. In view of the national importance attached to infrastructure development, operational guidelines were issued in respect of financing of infrastructure projects in April 1999. Apart from these, a number of policy measures were undertaken to improve the flow of credit to micro-credit organisations, to facilitate timely availability of credit through rationalisation of procedures for loan approval, to institute an effective monitoring mechanism for project implementation, and to liberalise conditions for granting bridge loans by banks and FIs to companies.

Banking Sector Reforms

1.25 The recent banking crisis in South-East Asia and Japan has brought to the fore the problem that a weak and fragile domestic financial sector can pose for the economy. The stability of the financial sector and a proper safeguard system to prevent financial problems assuming crisis proportions of systemic nature has, thus, assumed critical importance in this context (Box I.3). A country's ability to withstand international instability and to access capital markets as well as investments abroad is likely to depend on whether domestic financial system is perceived to be stable and broadly conform to international prudential and supervisory norms.

1.26 The progress already made in the reform of the financial sector in a substantial yet non-disruptive manner has generated confidence to give a further push to reforms in the banking sector. In this background, a Committee on Banking Sector Reforms (the Second Narasimham Committee) was constituted. The Committee submitted its Report in April 1998. In pursuing the objective of further improving the soundness of the Indian banking system, the Reserve Bank announced a package of reform measures in October 1998 in areas relating to prudential norms in conformity with the recommendations of the Second Narasimham Committee. The details of the measures announced alongside the recommendations of the Committee are indicated in Box I.4. These measures aim at increasing the minimum capital adequacy ratio in the banking system from 8 per cent to 9 per cent by March 31, 2000; recognising the market risks and prescribing a risk weight of 2.5 per cent in Government/approved securities by March 31, 2000; providing 100 per cent risk weight for foreign exchange and gold open position limits from the year ended March 31, 1999; moving towards tighter asset classification, income recognition and provisioning norms; putting in place a formal Asset-Liability Management (ALM) system with effect from April 1, 1999; and further enhancing transparency in accounting and disclosure practices.

Box I.3

Financial Stability as a Goal of Public Policy

In recent times, there has been a considerable amount of discussion on the issue of financial stability. It is by now well recognized that safeguarding financial stability is of central importance to the effective functioning of a market economy. It provides the basis for rational decision-making with respect to the allocation of real resources through time, thereby improving the climate for savings and investment. The absence of stability can engender uncertainties that might distort the allocation of resources, reduce the willingness of economic agents to enter into inter-temporal contracts and make it difficult to accurately assess the future trajectories of not only the financial aggregates but also those of the real variables of the system. Maintaining stability is thus a key objective of financial intermediaries.

In the first place, a distinction needs to be made between monetary and financial stability. Monetary stability can broadly be defined as the stability of the general price level; financial stability, on the other hand, refers to the smooth functioning of institutions and markets that comprise the financial system. Clearly, the two are related. Stability in one domain facilitates the achievement of stability in the other.

For many years, the two standard explanations of episodes of financial distress were characterised as cyclical and monetarist. Several authors including Minsky (1977) and Kindleberger (1978) focused on the various forces making for cyclical excess. Subsequently, monetarists (Friedman and Schwartz, 1963) contended that it was monetary policy mistakes that either initiated financial instability or led to significant disruptions with far-reaching consequences. In recent years, insights obtained from game theory and the economics of decision-making under uncertainty have provided explanations as to why agents act in ways that produce instability in financial institutions. Notable among these include the presence of asymmetric information, 'runs' on financial intermediaries, 'herd behaviour' syndrome, disaster myopia and principal-agent problems. Likewise, instabilities in equity markets have been explained on the basis of (a) irrational speculative excesses, and (b) instability in macroeconomic policies. Another potential source of macroeconomic instability lies in fluctuations in the prices of real assets. Such effects are more pronounced when the asset under consideration comprises a significant proportion of the private sector's real wealth and when such price movements create generalised inflationary or deflationary pressures. In the foreign exchange market, instabilities can arise consequent upon a discrete change in the external value of the currency (a la a currency crisis) or when the amplitude of fluctuations in the market exchange rate far exceeds those that can be explained on the basis of fundamental economic factors (exchange rate volatility). Another significant source of instability lies in instabilities in commodity prices. The most striking example of this is to be found in two rounds of oil price increases in the 1970s. Significant changes in energy prices have an effect both on production costs as well as on the relative cost of factor inputs.

It is, therefore, important that the authorities devise policies that can safeguard stability in the financial system. White (1999) has observed that most central banks are currently devoting far more resources to the issue of financial stability than before. The fundamental reason for this, he argues, has been the growth of liberalised financial markets, responding to both technological developments and the search for efficiency, and the associated increase in the risk for financial stability. The key policy challenge in securing financial stability is the adaptation of the framework of checks and balances in the liberalised financial marketplace. Safeguarding financial stability is based on two complementary strategies: promoting soundness of institutions through prudential regulation and supervision (the "micro-prudential" level), and improving the robustness of the linkages across institutions and markets (the "macro-prudential" level). Under the former, policy actions have been undertaken in recent years in areas that allow for enlarging the domain and improving the transparency as well as the quality of public disclosures in line with international best practices, designing regulatory constraints so as to make them less vulnerable to financial arbitrage; and limiting the impact of such forms of intervention that provide protection without commensurate oversight, thereby limiting incentives for imprudent behaviour. Efforts under the category of macro prudential strategy include measures to streamline the payments and settlement systems, increasing the transparency of the risks involved in the arrangements and raising the level of tolerance of individual institutions so as to contain the systemic ramifications of idiosyncratic failures. As Stiglitz (1997) has observed, the basic building blocks for the development of a healthy financial system comprise the need for strong incentives for prudential behaviour coupled with an effective regulatory system. Such incentives are provided both by capital requirements and franchise value (the value of future profits), so that financial entities have more to lose as a result of excessively risky behaviour than otherwise. Regulation needs to percolate to every level of economic activity, from ensuring robust risk management systems to safeguarding individual transactions.

Achieving financial stability, therefore, necessitates judicious management coupled with a system of incentives and penalties. Such mechanisms would ensure that the financial institutions take risks, but only those that are beneficial in the long run. Successful monetary management requires an optimum blend of regulatory and market discipline and a correct dose of supervisory controls necessary to maintain financial stability while allowing financial innovations to promote economic growth. There are no theoretical criteria for determining the optimal mix of regulation and oversight but the markets need to believe that the action of policy makers are credible for economic management to be effective.

Select References

1.

Bank for International Settlements, (1997), The Annual Report, Basle, Switzerland.

2.

Caprio, G. Jr. and D. Klingebiel, (1996), 'Bank Insolvency: Bad Luck, Bad Policy, or Bad Banking?', Annual World Bank Conference on Development Economics, 79-104.

3.

Stiglitz, J.E., (1997), Statement to the Meeting of Finance Ministers of ASEAN plus 6 with the IMF and the World Bank, Kuala Lampur, Malaysia.

4.

White, William R., (1999), Evolving International Financial Markets: Some Implications for Central Banks, BIS Working Paper No.66, Basle, Switzerland.

Box I.4

Follow-up to the Second Narasimham Committee Recommendations

Recommendations

Policy Announcements by the Reserve Bank

1.

Capital Adequacy Ratio

A minimum target of 9 per cent CRAR to

Banks should achieve a minimum CRAR of 9 per cent as on

be achieved by the year 2000; the target

March 31, 2000.

should be raised to 10 per cent for the

year 2002.

2.

Risk Weights on Investments in

Government securities, approved

securities and other than approved

securities

A risk-weight of 5 per cent for market

2.5 per cent risk weight for market risk with effect from the

risk for Government/ approved securities.

year ending March 31, 2000 for Government/ approved

securities. Risk weight of 20 per cent on investments in other

approved securities not guaranteed by Governments and also

on investments in Government guaranteed securities of

Government undertakings which do not form part of the

approved market borrowing programme to be introduced from

the financial year 2000-2001.

3.

Risk weights on Government guaranteed

advances

Risk-weight on Government guaranteed

Risk weights for Government guaranteed advances from

advances to be the same as other advances

April 1, 1999 are as:

Against the guarantee of

Risk weight

(per cent)

(a) Central Government

0

(b) State Governments

0

(c) State Governments which have remained in

     default as on March 31, 2000 in cases where

     the guarantee has been invoked

20

(d) State Governments which continue to be in

     default even after March 31, 2001 in respect

     of such invoked guarantees

100

4.

Foreign Exchange Open Position Limit

To carry 100 per cent risk weight.

Implemented from the financial year ended March 31, 1999.

5.

Provisioning Norms

i)

A general provision of 1 per cent on

As a first step, banks have been directed to make a general

standard assets.

provision of a minimum of 0.25 per cent for the year ending

March 31, 2000.

ii)

An asset to be classified as doubtful

An asset will be treated as doubtful, if it has remained in sub-

if it is in the sub-standard category

standard category for 18 months, instead of 24 months, by

for 18 months in the first instance

March 31, 2001. Banks may make provision in two phases, as

and eventually for 12 months and loss

under:

if it has been so identified but not

written off.

As on March 31, 2001: Provisioning of not less than 50 per

cent on the assets which have become doubtful on account of

the new norms.

As on March 31, 2002: Balance 50 per cent of the provisions

should be made in addition to provisions needed as on March

31, 2002.

iii)

The Government guaranteed advances

The state Government guaranteed advances in respect of which

which have turned sticky to be classified

guarantee has been invoked and the concerned Government is

as NPAs.

in default for more than two quarters are to be classified as

NPAs with effect from April 1, 2000.

iv)

Income recognition, asset classification

Provisions against existing/old state Government guaranteed

and provisioning norms should apply to

advances where guarantee stands invoked as on March 31,

Government guaranteed advances.

2000 are to be made during the next four years from the year

ending March 31, 2000 to March 31, 2003 with a minimum of

25 per cent, each year.

6.

Other Recommendations

i)

Banks and financial institutions should

The Reserve Bank reiterated that banks and financial

avoid the practice of evergreening.

institutions should adhere to the prudential norms on asset

classification, provisioning, etc. and to avoid the practice of

"evergreening".

ii)

Any effort at financial restructuring

The banks were advised to take effective steps for reduction of

must go hand in hand with operational

NPAs and also put in place risk management systems and

restructuring. With the cleaning up of the

practices to prevent re-emergence of fresh NPAs.

balance sheet, simultaneously steps to be

taken to prevent/limit re-emergence of

new NPAs.

iii)

To enable banks in difficulties to issue

Public sector banks were encouraged to raise their Tier II

bonds for Tier II capital, Government

capital. Government guarantee to these instruments does not

will need to guarantee these instruments

seem appropriate.

which would then make them eligible for

SLR investment.

iv)

There is a need for disclosure in a phased

Instructions were issued to banks to disclose these additional

manner of the maturity pattern of assets

information from the year ending March 31, 2000.

and liabilities, foreign currency assets

and liabilities, movements in provision

account and NPAs.

v)

Concentration ratios need to be indicated

Banks were advised to strictly comply with instructions which

in respect of bank's exposure to any

are already in place.

particular industrial sector as also to

sectors sensitive to asset price

fluctuations such as stock market and real

estate.These exposure norms need to be

carefully monitored.

vi)

Banks should bring out revised

Banks were advised to bring out revised operational manual

operational manuals and update them

and ensure regular updating. Compliance to be reported to the

regularly.

Reserve Bank by September 30, 1999.

vii)

There is need to institute an independent

Banks should ensure a loan review mechanism for larger

loan review mechanism especially for

advances soon after their sanction and continuously monitor

large borrowal accounts and to identify

the weaknesses developing in the accounts for initiating

potential NPAs.

corrective measures in time.

1.27 Following the recommendations of the Second Narasimham Committee on converting the Development Financial Institutions (DFIs) into banks or non-bank finance companies, a Working Group (Chairman: Shri S.H. Khan) was constituted by the Reserve Bank to examine the harmonisation of the role and operations of the DFIs and banks. The Working Group submitted its Report in April 1998 highlighting the need for eventually granting full banking licence to the DFIs, while in the interim they may be permitted to have banking subsidiaries. Subsequently, the Reserve Bank released a 'Discussion Paper' in January 1999 with a view to soliciting wider public debate on the issue. The 'Discussion Paper' emphasised the need for adoption of an approach whereby universal banking should be guided by international experience and domestic requirement and it should provide for transitional path for the DFIs to convert themselves into full fledged banking or non-banking institutions (Box I.5).

Capital Adequacy and Recapitalisation of Banks

1.28 Out of the 27 public sector banks, 26 banks achieved the minimum capital to risk weighted assets ratio (CRAR) of at least 8 per cent by March 1998. While 19 banks had CRAR exceeding 10 per cent, 7 banks had CRAR between 8 and 10 per cent. Following the announcement in monetary and credit policy in October 1998 banks have been advised to maintain a minimum CRAR of 9 per cent by end-March 2000. During 1998-99, the Central Government contributed a sum of Rs.400 crore to the capital of three nationalised banks, viz. Indian Bank (Rs.100 crore), UCO Bank (Rs.200 crore) and United Bank of India (Rs.100 crore). The overall capital contributions by the Government to nationalised banks as at end-March 1999 amounted to Rs.20,446 crore, out of which Rs.642.8 crore was returned to the Government by four banks.

Box I.5

Universal Banking

Pursuant to the financial sector reform measures initiated since 1991 aimed at evolving an efficient and competitive financial system, the Reserve Bank constituted a Working Group (KWG) under the Chairmanship of Shri S.H. Khan, the then Chairman and Managing Director of Industrial Development Bank of India, in December 1997 to review the role, structure and operations of Development Financial Institutions (DFIs) and commercial banks in emerging environment and suggest measures for bringing about harmonisation in their roles and operations. The KWG, in its report submitted in May 1998, recommended a progressive move towards universal banking and the development of an enabling regulatory framework for this purpose. In the interim, it suggested that DFIs may be permitted to have a banking subsidiary (with holdings up to 100 per cent). Earlier, the Second Narasimham Committee, appointed by the Government of India, in its Report submitted in April 1998, observed that following the trends in the other and especially many European countries, a move towards universal banking is visible in India too and felt that DFIs over a period of time should convert themselves into banks and be subjected to the same discipline of regulatory and prudential norms as applicable to the commercial banks. Envisaging that there will be only two types of financial intermediaries in future viz., banking companies and Non-banking finance companies (NBFCs), the Committee suggested that those DFIs which do not become banks, would be categorised as NBFCs. Taking into account the recommendations of these reports and following the Monetary and Credit Policy announcement of April 1998, the Reserve Bank prepared a 'Discussion Paper' (DP) which was released in January 1999. The DP contains some draft proposals mainly addressed to three issues viz., (i) approach to universal banking, (ii) meeting the long-term capital requirements of the corporate sector and (iii) the future role of DFIs and refinancing institutions (RFIs).

The DP noted that the approach to universal banking should be guided both by international experience and domestic requirements and proposed that the process of enabling, both by banks and DFIs, the provision of diversified services, either in-house or through the subsidiary route as a conglomerate, should continue, albeit in a gradual and orderly fashion, subject to appropriate regulation and supervision. The DP recognised that until the long-term debt market improves, in terms of liquidity and depth, there is a definite role for DFIs in providing long-term development finance, especially to small and medium-sized firms. However, the DFIs should have the freedom to operate as NBFCs or convert themselves into banks over a period of time. One option in pursuing banking activity in-house could be through mergers and acquisitions, providing them with an adequate branch network. Another option for a DFI is to have a 100 per cent owned subsidiary. As regards the opportune time for a DFI to consider the transformation into a bank, the DP suggested a possible time frame of five years during which other financial intermediaries can develop project appraisal capabilities, while DFIs can acquire necessary expertise in offering various banking services in-house and develop an appropriate branch network. In the meantime, the policy environment as well as regulatory and supervisory framework can be evolved for transformation of DFIs into banks. When a DFI chooses to transform itself into a bank, the transitory arrangements, on a time-bound basis, could be worked out, after a detailed examination by the Reserve Bank, on a case by case basis. The case by case approach is essential because each DFI would be in a unique position in terms of its capacity to transform into a bank, necessitating a transition period and a tailor-made transition path to be worked out. However, if a DFI can demonstrate its capacities to transform into a bank quickly and conform to the totality of regulatory framework applicable to a bank, there should be no objection to such transformation at any point of time.

In brief, the DP envisaged the following architecture for the financial sector:

First, international experience and domestic requirements should guide the approach to universal banking. The process of enabling the provision of diversified services both by banks and DFIs, either in-house or through the subsidiary route as a conglomerate, should continue albeit in a gradual and orderly fashion, subject to appropriate regulation by the Reserve Bank.

Second, in terms of institutions, ultimately there should be only banks and re-structured NBFCs.

Third, recognising the special role of DFIs, a transitional path has been envisaged for them to become either a full-fledged NBFC or a bank.

Fourth, since banks are special, any conglomerate, in which a bank is present, should be subject to a consolidated approach to supervision and regulation.

Fifth, a corporate form of organisation under the Companies Act should be preferred to provide the financial intermediaries the necessary flexibility for mergers, acquisitions and diversification in order to meet the needs of the evolving situation.

Sixth, the supervisory functions would have to be delinked from the refinancing institutions and brought under a consistent supervisory framework.

Seventh, the ownership role should be transferred from the Reserve Bank to the Government of India in respect of financial intermediaries so that there is a focussed attention on its supervisory/regulatory functions.

Eighth, harmonisation in the working of various institutions should be at the initiative of the organisations themselves, with the Reserve Bank being available for guidance and consultation.

Ninth, various efficiency issues pertaining to each organisation have to be addressed individually by the banks/DFIs and they are encouraged to deliberate among themselves and take necessary decisions urgently.

The draft proposals of the DP are being widely discussed and commented upon by experts, banks/FIs, other market participants and the public in general.

Reference

Reserve Bank of India, (1999), Harmonising the Role and Operations of Development Financial Institutions and Banks: A Discussion Paper.

1.29 The Government has written down a sum of Rs.2,066.64 crore during 1998-99 from the existing capital base of four nationalised banks which included Andhra Bank (Rs.243.37 crore), Bank of Maharashtra (Rs.418.18 crore), Punjab & Sind Bank (Rs.462.47 crore) and Syndicate Bank (Rs.942.62 crore) against the accumulated losses of equivalent amount. The consequent reduction in Government's investments in these banks would enable them to go for an early public issue. So far, investments in 10 nationalised banks amounting to Rs.6,037.2 crore were permitted to be written down by the Government against accumulated losses. Banks were given autonomy to raise rupee denominated subordinated debt as Tier II capital in February 1999. However, in view of the high level of cross holding of such instruments among the banks and financial institutions, which did not necessarily add capital to the financial system, banks were advised in April 1999 that a bank's aggregate investment in Tier II bonds issued by other banks and financial institutions would be permitted up to 10 per cent of the investing bank's total capital.

Prudential Accounting Norms

1.30 The Reserve Bank continued the process of strengthening the prudential accounting norms reflecting the criticality of reform in this area in the wake of the SouthEast Asian financial crisis. With a view to moving closer to international practices in regard to provisioning norms, banks were advised in October 1998 to make a general provision on standard assets of a minimum of 0.25 per cent from the year ending March 31, 2000. Besides, an asset should be classified as doubtful if it has remained in the substandard category for 18 months instead of 24 months by March 2001. Banks could achieve this norm for additional provisioning in two phases - provisioning of not less than 50 per cent as on March 31, 2001 on the assets which have become doubtful on account of new norm, and provisioning of the balance amount carried forward from the previous year in addition to the provisions needed as on March 31, 2002 on that date. Provisioning norm in respect of advances guaranteed by State Governments where guarantee has been invoked and has remained in default for more than two quarters is being introduced effective April 1, 2000, as a prudent measure to strengthen the banks' efforts to recover such dues expeditiously as well as to discourage delay in payments by State Governments. After a re-examination of the issue of non-performing assets (NPAs) among agricultural advances, banks were advised in December 1998 that these loans would be treated as NPA if interest and/or instalment of principal remains unpaid, after it has become past due, for two harvest seasons which, however, shall not exceed two half years. In case of cyclical downturns, where loans have been rescheduled but borrowers have started servicing the interest and instalment of loans regularly after a short gap, the waiting period of satisfactory performance under the rescheduled terms was reduced from two years to one year for upgradation of the loan account.

1.31 The 'mark-to-market' proportion of approved securities was enhanced from 70 per cent for 1998-99 to 75 per cent for 1999-2000. Banks were advised during March 1999 that excess provision towards depreciation on investment should be appropriated to 'investment fluctuation reserve account' instead of 'capital reserve account' and would be eligible for inclusion in Tier II capital. The amount held in 'investment fluctuation reserve account' could be utilised to meet the depreciation requirement on investments in securities in future.

1.32 As prudential measures against credit and market risks, risk weights in the following categories of securities were introduced: a) 2.5 per cent to cover market risks due to fluctuations in prices in respect of investments in Government securities and securities guaranteed by Central/State Governments by March 31, 2000; b) 20 per cent for State Government guarantees which have been invoked and have remained in default as on March 31, 2000; c) 20 per cent on investments in the Government guaranteed securities of Government undertakings which do not form part of the approved market borrowing programme from 2000-01; and d) a uniform risk weight of 20 per cent on investments in other approved securities not guaranteed by Central/State Governments and in the bonds/ securities of certain specified public financial institutions (PFIs), effective the year ended March 31, 1999.

Asset Liability Management (ALM) System

1.33 The liberalisation of the Indian financial system and the integration among various segments of the financial markets - domestic and external - has complicated the risk management process of banks by exposing them to various kinds of risks such as interest rate risk, forex risk, equity price risk and liquidity risk. An unfavourable movement in interest/exchange rates adversely affects the banks' net interest margin and ultimately the market value of equity. The Reserve Bank, therefore, advised the banks, to put in place an ALM system, effective April 1, 1999 and set up internal Asset Liability Management Committees at the top management level to oversee its implementation. As per the final ALM guidelines issued in February 1999, banks were advised to ensure coverage of at least 60 per cent of their liabilities and assets in the interim and cover 100 per cent of their business by April 1, 2000.

Disclosure Norms

1.34 Presently, banks are required to disclose certain important business parameters including financial ratios in the 'Notes on Accounts' to their balance sheet. The Second Narasimham Committee had recommended, inter alia, that banks should disclose, in a phased manner, the maturity pattern of loans and advances, investments in securities, foreign currency assets and liabilities, movements in non-performing assets, lending to sensitive sectors, etc., in order to bring the disclosure standards of Indian banks on par with the international accounting standards. These recommendations were accepted and announced in October 1998.

Legal Issues

1.35 Based on the recommendations of the Second Narasimham Committee Report, the Reserve Bank had constituted a Working Group in March 1998 to review the functioning of Debt Recovery Tribunals (DRTs) and to suggest measures for their effective functioning (Chairman: Shri N.V. Deshpande). The Working Group in its final Report submitted to the Reserve Bank in August 1998 recommended certain legislative amendments to the Recovery of Debts due to Banks and Financial Institutions Act, 1993 and measures to improve the functioning of DRTs. The recommendations were forwarded to the Government for consideration. In September 1998, the banks were advised, inter alia, to take steps to ensure expeditious recovery procedure at DRTs. It has also been decided by the Central Government to set up 5 more DRTs and 4 more Debt Recovery Appellate Tribunals.

1.36 The Central Government has constituted an Expert Committee to propose precise legal amendments in the key laws governing banking and financial practices (Chairman: Shri T.R.Andhyarujina). The Committee would address amendments in the various external Acts affecting banking sector such as, the Transfer of Property Act, Stamp Act, Indian Contract Act, DRT Act, foreclosure laws, etc. The Reserve Bank has set up a Working Group (Chairman: Shri M. Damodaran) to suggest amendments to various banking acts to ensure that the provisions of these Acts are in line with the reforms process.

1.37 As amended in the Union Budget 1999-2000, public sector banks were encouraged to set up Settlement Advisory Committees (SAC) so that chronic cases of overdue loans leading to lock-up of banks' funds and long drawn litigation in recovery suits are settled in a timely and speedy manner. In April 1999, the Reserve Bank announced finalisation of a scheme for SAC, specially those relating to the small sector.

Technological Developments in Banking

1.38 Information technology and the communication networking systems have a crucial bearing on the efficiency of money, capital and foreign exchange markets and have manifold implications for the conduct of monetary policy. In India, banks as well as other financial entities have recently entered the world of information technology and computer networking.

1.39 The Indian Financial Network (INFINET), a wide area satellite based network using VSAT technology, being jointly set up by the Reserve Bank and Institute for Development and Research in Banking Technology (IDRBT) at Hyderabad would facilitate connectivity within the financial sector. The network has been inaugurated in June 1999. The INFINET would cover, in a phased manner, 100 commercially important centres and serve as the communication backbone of the proposed Integrated Payment and Settlement System (IPSS). It is planned to introduce the Real Time Gross Settlement (RTGS) system in about one and half year's time (Box I.6). A National Payments Council with a Deputy Governor as the Chairman and representative membership has been constituted.

Box I.6

Real Time Gross Settlement (RTGS) System

Settlement of payment transactions can be either on a net basis or on a gross basis. The timing of settlement can be either i) immediate, which is described as being in 'real time' or ii) on the same day, either in batches at pre-determined intervals ('discrete') or at end of day ('deferred'). A payment system which operates as "a gross settlement system in which both processing and final settlement of funds transfer instructions can take place continuously (i.e., in real time)" is termed as Real Time Gross Settlement (RTGS) system (BIS, 1997).

One of the key elements of an RTGS system is the queuing of transaction messages. All participants send messages to a central system. These messages are put in a queue and the transactions settled in a certain order, with option for the sender to change priorities of his transactions. The order of queuing of messages and their disposal are intrinsic to the design of the RTGS system.

Another major requirement of the RTGS system is the resolution of gridlock which may arise when a series of inter-dependent payments are stalled due to insufficient funds to settle the primary transaction. For example, a debit to a bank cannot be made for want of sufficient balance in its account, while it awaits a credit that may be in the queue. This leads to a bottleneck which cannot be resolved until the first debit entry is effected. This type of gridlock in an RTGS system is avoided by providing for intra-day liquidity to the participants. Since each transaction has to be settled individually, the liquidity requirement under the RTGS system is significantly higher than that of the netted system.

RTGS is critical for an effective risk control strategy. The risks inherent in a net settlement system, viz. settlement risk, principal (credit) risk and systemic risk are such that default by one bank may lead to a 'knock-on' or domino effect on the system. Gross settlement reduces the chances of occurrence of these risks significantly. This has been the main driving consideration behind the switch over to an RTGS system in large value funds transfers in many countries.

The primary objective of the payment system reforms in India has been to migrate to RTGS environment in a gradual manner. Towards that end, the Reserve Bank has been endeavouring to put in place an integrated payment system for the Indian financial system. The focus of the integrated payment system has been on computerisation of major bank branches, establishing their inter-connectivity and interface with their Treasury/ Funds Department, setting up controlling offices and providing connectivity among banks in an on-line and real-time environment. This would lead to optimisation of use of available resources in the banking sector in addition to faster movement of funds and information among various constituents of the financial sector.

Reference

Bank for International Settlements, (1997), Real Time Gross Settlement Systems, Report prepared by the Committee on Payment and Settlement Systems, Basle, March.

1.40 The Reserve Bank in co-ordination with Indian Banks' Association (IBA), banks and other sectors of the financial system is pro-actively dealing with the Year 2000 (Y2K) problem. In order to address the Y2K problem, a High Level Working Group with members drawn from banking, regulatory, supervisory and information technology departments of the Reserve Bank, representatives of IBA, commercial banks and the National Institute of Bank Management (NIBM) has been constituted. The Working Group has been reviewing the progress made by banks, their subsidiaries and financial institutions in complying with the Y2K requirements at frequent intervals. Commencing October 1, 1998, banks have been advised to continuously validate their renovated systems through testing and to identify alternative approaches wherever required. Testing is required to be done with reference to critical dates relevant to Year 2000. Similar monitoring and compliance has to be ensured by non-banking subsidiaries of commercial banks, financial institutions, co-operative banks, regional rural banks and non-banking financial companies. Each bank has been advised to constitute an internal Core Group and the progress is to be monitored regularly by the top management and the Board. In addition, the Reserve Bank has been undertaking periodic inspections. IBA has been taking up awareness campaigns in order to highlight the millennium problem and the need to resolve it well in time. Banks have also been advised to prepare contingency plans.

Rural Credit

1.41 In respect of agricultural credit, the Reserve Bank advised public sector banks to prepare Special Agricultural Credit Plans. For the financial year 1997-98, the aggregate disbursement to agriculture under the plan was Rs.14,808.35 crore as against the projection of Rs.16,069.04 crore. For 1998-99, the disbursement to agriculture under the plan was Rs.17,787.63 crore as against the projection of Rs.18,503.51 crore. Banks were advised in July 1998 to formulate a suitable scheme relating to quick settlement of chronic cases of overdue loans of farmers due to circumstances beyond their control. Under the scheme, public sector banks have settled 71,555 cases as at end-December 1998 involving loan amount of Rs.96.56 crore. In response to the Union Budget 1998-99 regarding formulation of a model scheme for issue of Kisan Credit Cards (KCCs) to farmers which would enable them to readily purchase agricultural inputs and draw cash for their production needs, all scheduled commercial banks were advised to introduce the scheme on the lines of the scheme formulated by NABARD in August 1998. As on March 31, 1999, the 27 public sector banks had issued 6,43,463 KCCs involving an aggregate credit limit of Rs.1,569.60 crore. In view of the targeted extension of the coverage to 20 lakh farmers in 1999-2000 as announced in the Union Budget 1999-2000, necessary instructions have been issued to the banks to fulfil this target.

1.42 The policy to channelise shortfall in priority sector lending by banks into rural infrastructure investment continued during 1998-99. A Rural Infrastructural Development Fund (RIDF) with a corpus of Rs.2,000 crore was constituted at NABARD in April 1995 for giving loans to state Governments and state owned corporations for quick completion of ongoing projects relating to medium and minor irrigation, soil conservation, watershed management and other forms of rural infrastructure. Subsequently, RIDF II-IV were established between 1996-97 and 1998-99; the details of the schemes are provided in Table 1.1. Following the announcement in the UnionBudget 1999-2000, RIDF - V with a corpus of Rs.3,500 crore has been set up at NABARD. Indian commercial banks having shortfall in priority sector lending to agriculture as on the last reporting Friday of March 1999 will contribute to the corpus of RIDF-V. The repayment period for loans under RIDF-V has been extended to 7 years and the scope of RIDF-V is being widened to include lending to Gram Panchayats, Self Help Groups and other eligible organisations for implementing village level infrastructure projects. The availment of RIDF funds continued to be low in relation to loans sanctioned with the proportion of funds disbursed to total sanctions at 38.8 per cent as at end-June 1999. The low order of disbursal of RIDF funds was on account of the difficulties associated with identifying appropriate projects by some of the State Governments, the lack of budgetary support where only part funding from RIDF was visualised and delays in finalisation of formalities for drawal of funds and in completing the necessary spade work for irrigation projects involving land acquisition and tendering procedures.

Table 1.1 : RIDF Loans Sanctioned and Disbursed

(As at end-June 1999)

(Amount in Rupees crore)

Year of

Corpus

Loans

Loans

establish-

sanctioned

disbursed

ment

1

2

3

4

5

RIDF-I

1995

2,000

1,826 (21)

1,546 (20)

RIDF-II

1996

2,500

2,614 (16)

1,462 (16)

RIDF-II

1997

2,500

2,679 (18)

743 (17)

RIDF-IV

1998

3,000

3,141 (22)

230 (15)

Total

10,000

10,260

3,981

Figures in brackets indicate the number of states.

1.43 The process of recapitalisation of Regional Rural Banks (RRBs) received further momentum during 1998-99. The budgeted allocation of Rs.264.65 crore for 1998-99, however, was lowered down to Rs.152.65 crore in the revised estimates. During 1998-99, 19 RRBs which were partially recapitalised in 1996-97 and 1997-98 were infused with further capital, while 24 RRBs were provided with additional equity for the first time. As at end-March 1999, 19 RRBs remained outside the recapitalisation programme and 175 RRBs were fully/partially recapitalised while 2 RRBs did not need recapitalisation support. A sum of Rs.168 crore has been earmarked for recapitalisation of RRBs for 1999-2000. The coverage of the priority sector was also broadened, effective July 31, 1998, to include incremental credit (over March 31, 1998 level) given to NBFCs by banks for on-lending to small road and water transport operators and units in the tiny sector of industry and investments in venture capital.

1.44 In order to promote a strong and self-sustaining financial support system for agriculture and rural sector, the refinancing capacity of National Bank for Agriculture and Rural Development (NABARD) was substantially enhanced by increasing the capital base and the General Line of Credit (GLC) limit from the Reserve Bank. The paid-up capital of NABARD was further raised by Rs.500 crore (with the Reserve Bank and the Central Government contributing Rs.400 crore and Rs.100 crore, respectively) to Rs.2,000 crore during 1998-99 with the share of the Reserve Bank and the Central Government increasing to Rs.1,450 crore and Rs.550 crore, respectively. However, as the proposal for amending the relevant provision of NABARD Act, 1981 enhancing the capital of NABARD from Rs.500 crore to Rs.2,000 crore is under consideration of the Central Government, the additional contribution has been released as an advance to NABARD. For the year 1998-99 (July-June), the Reserve Bank renewed the credit limit of Rs.5,700 crore, sanctioned in the previous year, consisting of Rs.4,850 crore under GLC I (for seasonal agricultural operations) and Rs.850 crore under GLC II (for various other approved short term purposes). In view of the increase in sanction of credit limit by NABARD to cooperatives and RRBs, an additional limit of Rs.100 crore under GLC I was sanctioned in April 1999, for the year 1998-99 (July-June).

1.45 The Reserve Bank accepted the major recommendations of the Committee on Agricultural Credit through Commercial Banks (Chairman: Shri R.V.Gupta) which had suggested measures for improving the credit delivery system as well as simplification of procedures for agricultural credit and advised all scheduled commercial banks regarding their implementation. All scheduled commercial banks were advised to set up internal groups at senior management level for monitoring progress in implementation of the recommendations. Some of the recommendations, viz., abolition of stamp duty for agricultural loans, assistance from state Governments for recovery of bank dues, mortgage of land, subsidy linked credit, loans to tenant farmers, etc., requiring action by Central/State Governments were referred to the Central Government for their implementation.

Credit to Small Scale Industries

1.46 Banks were advised that village industries, tiny industries and other units in small scale industries (SSI) (new as well as existing) having aggregate fund-based working capital limit up to Rs.5 crore from the banking system may be provided working capital limits computed on the basis of a minimum of 20 per cent of their projected annual turnover. The banks have also been given freedom to decide their own norms in respect of credit appraisal and assessment of the working capital requirements of the borrowers. It has been decided that with a view to increasing the outreach of banks to the tiny sector, lending by banks to NBFCs or other financial intermediaries for on-lending to the tiny sector may be included within the ambit of priority sector lending. As at the end of March 1999, 386 specialised SSI bank branches were operationalised.

1.47 The Reserve Bank had appointed a one-man committee (Chairman: Shri S.L. Kapur) to suggest measures for improving the delivery system and simplification of procedures for credit to SSI sector. The Committee submitted its report in June 1998. Fourty recommendations of the Committee have been accepted and commended to the banks for immediate implementation. Some of the important recommendations include delegation of more powers to the branch managers, simplification of application forms, opening of more specialised SSI branches, enhancement in the limit for composite loans, strengthening of recovery mechanism, etc.

Prompt Settlement of Bills of SSI Units

1.48 With a view to ensuring prompt settlement of dues to SSI units as also for encouraging 'bills culture', banks were advised to ensure that, with effect from January 1,1998, not less than 25 per cent of the total inland credit purchases of the borrowers were to be paid through bills drawn on them by concerned sellers. Banks were also advised to monitor the compliance with this requirement through a suitable information system and charge penal interest in cases of non-compliance. In July 1998, banks were advised to ascertain periodically from their medium/ large industrial borrowers, the extent of their dues to the SSI suppliers and the action proposed to be taken by them to clear the overdues, if any. In case there are still overdues towards SSI suppliers, banks were advised not to hesitate to take it as a negative factor while fixing the rate of interest on the borrowings of such corporate bodies.

Non-Banking Financial Companies (NBFCs)

1.49 The Reserve Bank had put in place a comprehensive regulatory framework for NBFCs in January 1998 (detailed in the last year's Annual Report), to ensure that the NBFCs function on sound and healthy lines and that only financially sound and well run NBFCs are allowed to access public deposits. Protection of depositors' interest has been accorded prime importance and the Reserve Bank has initiated various measures in this regard. NBFCs accepting/holding public deposits are subject to accounting standards, prudential norms of asset classification, income recognition and capital adequacy which are in alignment with those applicable to banks in India. NBFCs not accepting/holding public deposits are regulated only to a limited extent. The Reserve Bank has put in place a supervisory framework for overseeing the implementation of regulatory framework, which comprises a system of compulsory registration, on-site examination of their books, off-site surveillance, a comprehensive market intelligence system and exception reports from statutory auditors of NBFCs.

Prudential Regulation and Capital Adequacy Norms

1.50 In the light of the increased incidence of financial problems faced by NBFCs, policy announcements were made to strengthen the health of NBFCs and improve their operational transparency. Capital adequacy ratio was raised in a phased manner to 10.0 per cent and thereafter to 12.0 per cent to be achieved by end-March 1998 and end-March 1999, respectively. The credit concentration norms in respect of a single borrower and single group of borrowers were kept unaltered at 15 per cent and 25 per cent of the owned funds, respectively. The investment concentration norms stipulated that investments in a single company and in a group of companies be subject, respectively, to a ceiling of 15 per cent and 25 per cent of the owned funds of NBFCs. Composite limits on credit and investments by an NBFC in a single entity and a single group of entities were prescribed at 25 per cent and 40 per cent, respectively, of its owned funds. Certain restrictions have been placed on NBFCs' investment in real estate; such investments, except for their own use, should not exceed 10 per cent of their owned funds. Further, a ceiling has been prescribed for investment in unquoted shares of other than group/subsidiary companies, the amount of which shall not exceed i) 10 per cent of the owned fund for equipment leasing and hire purchase finance companies; and ii) 20 per cent of the owned fund for loan/investment companies. Three years' time period has been allowed to the companies to bring down the excess assets held as also for disposal of such assets acquired by the company in satisfaction of its debts in case the company surpasses the ceiling.

1.51 The statutory requirement of minimum NOF of Rs.25 lakh in terms of the RBI (Amendment) Act, 1997 for obtaining a certificate of registration (COR) from the Reserve Bank and commencing/carrying on the business of an NBFC has been raised to Rs.200 lakh for NBFCs whose applications are received on or after April 21, 1999. Of the 37,445 applications for registration received by the Reserve Bank before June 30, 1999, 10,399 satisfied the statutory requirement of minimum NOF. The Reserve Bank has approved certificate of registration to 7,661 companies. Of these companies, 607 are permitted to hold/accept public deposits. The applications for COR of 1,104 companies have been rejected whereas the applications of 26,929 companies and 1,751 companies are pending for not satisfying the minimum prescribed NOF and other reasons, respectively. Companies not satisfying the minimum prescribed NOF were given three years' time for augmenting the owned fund which will expire on January 8, 2000.

Residuary Non-Banking Companies (RNBCs)

1.52 The quantum of deposits that can be accepted by Residuary Non-Banking Companies (RNBCs) is not linked to their NOF. For the purpose of safeguarding depositors' interest, they are enjoined upon to invest at least 80 per cent of the deposit liabilities in securities as per the pattern prescribed by the Reserve Bank. These securities are required to be entrusted to a public sector bank and can be withdrawn only for the purpose of repayment to the depositors. RNBCs are required to pay interest on their deposits which shall not be less than 6 per cent per annum (to be compounded annually) on daily deposit schemes and 8 per cent (to be compounded annually) on other deposit schemes of higher duration or term deposits. Other provisions of the directions relate to minimum and maximum period of deposits, prohibition from forfeiture of any part of the deposit or interest payable thereon, disclosure requirements in the application forms and the advertisements soliciting deposits, furnishing of periodical returns and information to the Reserve Bank.

Mutual Benefit Financial Companies (Nidhis)

1.53 While the deposit acceptance activities of Nidhis are regulated by the Reserve Bank, the directions for deployment of their funds are issued by the Department of Company Affairs (DCA) of the Government of India. To ameliorate the difficulties faced by non-notified companies working like Nidhis which were treated as loan companies for the purpose of acceptance of public deposits, a new set of guidelines was announced by the Reserve Bank in April 1999 in consultation with the Central Government. As an interim measure, these companies will be classified as Mutual Benefit Companies (MBCs) subject to their satisfying certain eligibility conditions prescribed by the Reserve Bank in this regard and the privileges enjoyed by Nidhi companies shall be extended to these companies on their compliance.

Task Force on NBFCs

1.54 In August 1998, a Task Force on NBFCs was constituted under the Chairmanship of Shri C.M. Vasudev. The terms of reference of the Task Force were to (i) examine the adequacy of the present legislative framework, (ii) devise improvements in the procedure relating to customer complaints, (iii) consider the need, if any, for a separate regulatory agency and (iv) examine whether state Governments could be involved in the regulation of NBFCs. The Task Force submitted its recommendations to the Government on October 28, 1998. The major recommendations of the Task Force which have been acted upon include i) doing away with the requirement of minimum investment credit rating for Equipment Leasing and Hire Purchase (EL & HP) Finance Companies for acceptance of public deposits up to Rs.10 crore or 1.5 times their NOF, whichever is less, provided they have minimum CAR of 15 per cent, and ii) prescribing a minimum investment grade credit rating and CAR of 15 per cent for loan/investment companies to be eligible for acceptance of public deposits up to 1.5 times their NOF. The details of implementation of major recommendations of the Task Force are given in Box VIII.1 of the Report.

Financial Institutions: Policy Changes

1.55 Select (eight) all-India financial institutions (AIFIs) were permitted to raise resources by way of term money borrowings, certificates of deposit, term deposits and Inter-Corporate Deposits (ICDs). While three institutions, viz., IDBI, ICICI and IFCI had umbrella limits equivalent to 100 per cent of their respective NOF as on March 31, 1997, EXIM Bank and SIDBI had umbrella limits equivalent to 75 per cent and 50 per cent of their respective NOF for raising of resources through these instruments; the remaining three had instrument-wise limits. In December 1998, two more institutions, viz. IIBI and TFCI were given umbrella limits in place of instrument-wise limits. Moreover, with a view to providing flexibility in raising resources, the uniform umbrella limits were fixed equivalent to the 100 per cent of NOF of institutions as per their latest available audited balance sheets. Consequently, the aggregate limits of AIFIs for raising of resources through these instruments increased to Rs.19,572 crore as on March 31, 1999 from Rs.15,923 crore as on March 31, 1998.

Financial Market Developments

Money Market

1.56 With a view to developing an efficient money market, effective May 9, 1998, (i) the minimum size of operation per transaction by entities routing their lending through PDs in the call money market was reduced from Rs.5 crore to Rs.3 crore and (ii) the minimum lock-in period for CDs and units of MMMFs was reduced from 30 days to 15 days.

1.57 In April 1999, with a view to enabling non-bank participants to deploy their short-term resources, measures were initiated to develop and widen the repos market with proper regulatory safeguards, e.g. delivery vs. payment (DVP), uniform accounting, etc. Subsequently, in July 1999, non-bank participants (e.g., UTI, LIC, IDBI and others) in the money market were also allowed to access short term liquidity through repos, on par with banks and PDs, thereby facilitating their cash management. This would help the non-bank participants to gradually move out of the call money market so that it would be possible to ultimately move towards a pure inter-bank call/notice/term money market, including PDs. Further, there would be no restriction on the maximum period for which repos can be undertaken. MMMFs were permitted to offer 'cheque writing facility' to provide more liquidity to unit holders which would be in the nature of a tie-up arrangement with a bank.

1.58 With a view to further deepening the money market as also to enable banks, PDs and AIFIs to hedge interest rate risks and ensure orderly development of derivatives market, the Reserve Bank issued guidelines on interest rate swaps (IRS) and forward rate agreements (FRAs) in July 1999. It was indicated that participants who intend to undertake FRAs/IRS should ensure that appropriate infrastructure and risk management systems are put in place before they undertake market making activities and also that a sound internal control system whereby a clear functional separation of trading, settlement, monitoring, control and accounting activities is provided.

Government Securities Market

1.59 With a view to improving the effectiveness of debt management policy towards optimising the cost of borrowings to Government as well as broad-basing and deepening the Government securities market, a number of policy measures were undertaken during 1998-99. These included notifying the amounts in respect of all Treasury Bills auctions, keeping the non-competitive bids outside the notified amount, permitting foreign institutional investors (FIIs) to invest in Treasury Bills, introducing uniform auction system in respect of 91-day Treasury Bills and enhancing the number of Primary Dealers (PDs). A flexible approach to market borrowing programme of State Governments was introduced, whereby State Governments were given option to raise 5 to 35 per cent of their market borrowings allocation in a flexible manner as regards timing, maturity and rate of interest. Further, the system of Ways and Means Advances and Overdraft Regulation Scheme for State Governments was revised on the basis of recommendations of an informal Advisory Committee on Ways and Means Advances (WMA) to State Governments (Chairman: Shri B.P.R. Vithal), details of which are given in Section IV of this Report.

1.60 A further push to Government securities market was given by the monetary and credit policy announcement for 1999-2000 made in April 1999. The measures included: the re-introduction of 182-day Treasury Bills, announcement of a calendar for Treasury Bills, consolidation of outstanding loans by issuing dated securities on price basis in order to facilitate the evolution of benchmark securities and re-issuance of the existing Government dated securities, obtaining minimum bidding commitment from each Primary Dealer (PD) for the auctions of Treasury Bills so that together PDs commit to 100 per cent of the notified amount, offering an enhanced underwriting option to PDs for the entire notified amount in auctions of dated securities, permitting State Governments to invest their surplus funds as non-competitive bidders in Treasury Bills of all maturities as against only 14-day and 91-day Treasury Bills earlier and permitting the State Governments to avail of special Ways and Means Advances without an upper limit against their holdings of Government dated securities and auctioned Treasury Bills.

1.61 It has been widely recognised that in order to widen and deepen the Government securities market, it is essential to diversify the investor base. In this context, retailing of the Government securities market assumes critical importance. The Reserve Bank has already established a system of PDs and satellite dealers (SDs) and made provisions for liquidity support to them. Seven new PDs were given final approval, taking the total number of PDs to thirteen. With the increase in the number of PDs, it is expected that PDs will take on a larger role in the primary as well as secondary markets for Government securities. The liquidity support arrangements will help PDs to make markets and minimise volatility in security prices. The system of underwriting is being oriented towards facilitating larger absorption by PDs, keeping in view the Reserve Bank's ultimate objective of moving away from the primary market. In the case of auctions for Treasury Bills, each PD will be required to make a minimum bidding commitment and all PDs taken together are expected to absorb the entire amount of primary issue. In the case of dated securities, the present system will be retained except that against 50 per cent currently being offered for underwriting, it is proposed to allow PDs to underwrite 100 per cent of the notified amounts.

1.62 The Reserve Bank has announced special liquidity support for dedicated gilt funds. Banks have been allowed to freely buy and sell Government securities on an outright basis and retail Government securities to non-bank clients without any restriction on the period between the sale and purchase. With a view to enabling the dematerialisation of securities of retail holders, National Securities Depository Ltd. (NSDL), Stock Holding Corporation of India Ltd. (SHCIL) and National Securities Clearing Corporation Ltd. (NSCCL) have been allowed to open SGL accounts with the Reserve Bank. In order to further encourage the retail segment of the market, the Reserve Bank and the Government of India would jointly work out a package, which will include promotion and publicity campaigns, etc.

Capital Market

Advances against Shares/Debentures

1.63 A number of policy initiatives were announced during the year to revive the capital market from the depressed condition. In August 1998, it was clarified that banks may grant working capital facilities for a short duration to stock brokers who are registered with the Securities and Exchange Board of India (SEBI) and have complied with capital adequacy norms prescribed by SEBI/stock exchanges to meet the cash flow gap between delivery and payment for DVP transactions undertaken on behalf of institutional clients viz. FIs, FIIs, mutual funds and banks. Banks were also advised to lay down a detailed loan policy for granting advances to stock brokers and market makers and also a policy for grant of guarantees on behalf of brokers, keeping in view the general guidelines issued by the Reserve Bank. The ceiling of Rs.10 lakh/Rs.20 lakh for advances against shares/ debentures to individuals would not be applicable in the case of market makers.

1.64 Banks were advised to increasingly accept shares in dematerialised form as collateral for secured loans to borrowers other than stockbrokers and market makers. Banks were also allowed to obtain collateral security of shares and debentures by way of margin, pending mobilisation of long-term resources, in situations where borrowers (other than NBFCs) were not able to find the required funds towards margin.

Measures Relating to Banks' Investments

1.65 The policy relating to banks' investments in the equity market was continued in 1998-99. Banks were allowed to invest in equity as well as in units of dedicated venture capital funds meant for information technology within the 5 per cent limit prescribed for investments in equity shares including PSU shares, convertible debentures of corporate and in units of mutual fund schemes, the corpus of which is not exclusively invested in corporate debt instruments. In order to encourage flow of finance for venture capital, it was decided in April 1999 that the overall ceiling of 5 per cent of the incremental deposits of the previous year would stand automatically enhanced to the extent of bank's investments in venture capital (including units of dedicated venture capital funds meant for information technology) subject to the condition that the venture capital funds/ companies are registered with SEBI.

Surveillance Issues and Transparency Standards

1.66 In the present transitory stage of the Indian capital market, effective surveillance is essential for ensuring investors' protection and improving micro-foundations of the market for efficient price discovery. Surveillance has remained a cornerstone of SEBI's activities since its inception. With a view to detecting market manipulations, SEBI regularly monitors market movements, identifies price volatility, analyses its causes and oversees the surveillance activities of the stock exchanges. Inter-Exchange Market Surveillance Group (ISG) comprising all the major stock exchanges has become instrumental in SEBI's efforts to ensure a coordinated approach to surveillance issues. A group has been constituted by SEBI for streamlining, rationalising and refining the margin system.

1.67 The orderly development of the capital market also requires adequate transparency in respect of the trading system as well as in the operations of the market participants. SEBI introduced transparency standards and put in place strict disclosure requirements. SEBI also decided to prescribe regulations for credit rating agencies and collective investment schemes. It is also reviewing accounting standards for listed companies to bring them in line with international standards to ensure enhanced disclosure. Recognising the importance of corporate governance for the efficient working of the securities market and as a measure of investor protection, SEBI has set up a Committee (Chairman: Shri K.M. Birla) to suggest measures for incorporation in the listing agreement executed by the stock exchanges with the companies. The new standards would put pressure on the management to adhere to principles of corporate governance.

1.68 In view of the need for flexibility in capital restructuring for the corporate entities, SEBI, in pursuance of the provisions of the Companies (Amendment) Ordinance, 1998, laid down regulations, which permitted Indian companies to buy-back their own shares. In another attempt to reform the capital market, the existing requirement for issuing shares at common denomination of Rs.10 or Rs.100 for all companies was done away with. Companies will now be allowed to offer dematerialised shares for any amount (of not less than Re.1 or in multiples of Re.1) determined by them. SEBI also changed the prevailing system of minimum marketable lot to attract retail investors.

Measures Relating to Revival of Primary Market

1.69 In view of the continued sluggish conditions in the primary capital market, SEBI removed various bottlenecks on floatation of new capital issues, particularly for infrastructure projects. In particular, the requirements, such as making a minimum public offer of 25 per cent of the security, five shareholders per Rs.1 lakh of offer and minimum subscription of 90 per cent would not be mandatory for infrastructure companies. In respect of unlisted companies, the existing requirement of a track record of dividend payment in at least three of the preceding five years for making an initial public offer (IPO) was relaxed. Under the new norms, the companies will have to demonstrate an ability to pay dividend instead of showing an actual dividend paying record.

Measures for Revival of Mutual Fund Industry

1.70 The year 1998-99 witnessed a substantial decline in resource mobilisation by mutual funds due mainly to net outflow of funds from the UTI in the latter half of the year following redemption pressure in respect of its flagship scheme, US-64. In view of the problems faced by the US-64 scheme, a high level Committee (Chairman: Shri Deepak Parekh) was constituted by the Government to review the objectives, features and structure of the scheme and to suggest measures for sustaining investor confidence and strengthening the scheme. The Committee, as a one-time-measure, recommended infusion of at least Rs.500 crore as unit capital. Among its suggestions for better working of the scheme, the Committee favoured conversion of US-64 into a net asset value (NAV) driven scheme over a period of three years. It also emphasised a thorough revamping of the dividend distribution policy to ensure that the scheme is responsive to the changing market conditions.

1.71 In order to give a boost to the mutual fund industry, the Union Budget for 1999-2000 announced three years' dividend tax exemption for US-64 Scheme and for all open-ended equity oriented schemes (with more than 50 per cent investment in equity) of UTI and other mutual funds. It also announced exemption from income tax for all income from UTI and other mutual funds received in the hands of investors.

Industrial Policy

1.72 Industries which were delicensed during 1998-99 were coal and lignite, petroleum (other than crude) and its distillation products and sugar. Presently, only six items of strategic importance continue to remain under the purview of industrial licensing. The Government announced disinvestment of specified portions of equity from select public sector enterprises like IOC, GAIL, CONCOR and VSNL. A number of items including some farm implements and tools were removed from the list reserved for exclusive manufacture by SSI sector. The customs tariff structure was revised by imposing an additional non-modvatable duty of 4 per cent on a majority of imports. As far as foreign direct investment (FDI) is concerned, foreign equity up to 100 per cent was permitted in electricity generation, transmission and distribution (excluding atomic reactor power plants) and in construction and maintenance of roads, highways, vehicular bridges, toll roads, vehicular tunnels, ports and harbours. However, foreign equity in projects of these industries under the automatic approval route should not exceed Rs.1,500 crore.

Trade Policy

1.73 The revised Export Import (EXIM) Policy 1997-2002 announced on March 31, 1999 made significant progress in improving the procedural norms governing India's foreign trade. The policy reflected continued emphasis on establishing a trust-based regime and reduction in avoidable interface between the exporter/importer and Government authorities. The revised policy has imparted flexibility in the operation of various incentive schemes. These measures include relaxation of administered control on export and import of samples, issue of licences on self-declaration basis in the absence of input-output norms, issue of annual advance licences to existing exporters without stipulation on value addition, introduction of pilot scheme for filling up of applications for licences in electronic form and extension of the permissible period for fulfillment of export obligations. On the basis of their past performance, special privileges would be extended to the manufacturer-exporters and merchant-exporters, through the issue of "Green Card" and "Golden Status", respectively. Further, irrespective of their existing level of export performance, large manufacturing companies and industrial houses would be eligible for the status of Star Trading House and Super Star Trading House, respectively, on the basis of their future export commitment.

1.74 The modified policy has made significant strides towards the deepening of liberalisation process. This has been accompanied by steps to align trade policy with India's commitments to the World Trade Organisation (WTO). In this context, the past convention of announcing Negative Lists for exports and imports has been discontinued. Further, 894 additional items have been placed in the Free List of imports and 414 products have been added to the list of items importable under Special Import Licence (SIL). This would mean that only 667 items now remain in the Restricted List. Furthermore, to facilitate foreign trade, the Ministry of Commerce has taken initiative to strengthen the infrastructure for Electronic Data Interchange (EDI) and Electronic Commerce (EC) (see Box VI.2 on E-Commerce).

Foreign Exchange Market

Authorised Dealers (ADs)

1.75 With a view to relaxing the exchange control policy, the Reserve Bank allowed branches of foreign companies operating in India to remit profits to their head offices through the ADs without its prior approval. ADs were permitted in June 1998 to provide forward cover facility to FIIs in respect of their fresh investments in India in equity, effective June 12, 1998. ADs were also allowed to extend forward cover facility to FIIs to the extent of 15 per cent of their investments as on June 11, 1998 to cover the appreciation in the market value of their existing investments in India. The amount eligible for cover was the (i) difference between the market value of their investments as at the close of business on June 11, 1998 converted at the Reserve Bank reference rate of Rs.42.38 per US dollar and the market value of investments at the time of providing the cover converted at the current rate; or (ii) fresh inflows (including reinvestments of cash balances lying in the accounts of the FIIs at the close of business on June 11, 1998) since June 11, 1998, whichever was higher. The ADs were given the option of extending the cover fund-wise or FII-wise according to their operational feasibility. The same facility was extended to the NRIs/ OCBs for their portfolio investments, effective June 16, 1998. The cut-off date for providing forward exchange cover to FIIs in respect of their equity investment was changed in April 1999 from June 11, 1998 to March 31, 1999 and ADs were permitted to provide forward exchange cover to FIIs to the extent of 15 per cent of their outstanding equity investment as at the close of business on March 31, 1999 converted into dollar terms at the rate of Rs.42.43 per US dollar, as well as for the entire amount of any additional investment made after March 31, 1999. Existing forward contracts booked in accordance with earlier instructions are allowed to continue even if the amount thereof exceeded 15 per cent of the value of investment as on March 31, 1999.

1.76 ADs were allowed to reimburse International Credit Cards (ICCs) organisations up to US $ 15,000 per transaction towards advance for import of software through Internet even before the downloading of the software. They were advised to report their peak intra-day positions. ADs were permitted to grant any type of fund based and/or non-fund based facilities to residents against the collateral of fixed deposits in NRE accounts subject to certain conditions and to handle the documents in respect of exports against the receipt of proceeds through the ICCs. With the introduction of Euro, ADs were permitted to accept deposits denominated in Euro under FCNR(B) scheme with effect from 1st January 1999 and also to continue to accept FCNR(B) deposits in Deutsche Marks up to December 31, 2001. They were permitted to allow remittances related to registration or renewal of registration of Patents and Trade Marks with overseas government/regulatory authorities/ international organisations without any monetary ceiling on the basis of documentary evidence in support of payment of such fees. ADs and/or their subsidiaries were permitted to issue rupee credit cards valid in India, Nepal and Bhutan to NRIs/PIOs and allow settlement of bills in rupee arising out of use of such cards by debit to their NRSR/NRO/NRE account.

Foreign Direct Investment

1.77 The Reserve Bank granted general permission to Indian companies to issue and export of shares/securities to foreign investors in respect of investment under the Government route (i.e., approvals issued by SIA/FIPB) and to issue and export of shares/securities by Indian companies in respect of items included in Part "D" also of Annexure III list (viz., Electricity generation, transmission and distribution), which are eligible for FDI under the Reserve Bank's automatic route.

Direct Investment by NRIs/PIOs/OCBs

1.78 The Reserve Bank granted general permission for issue and export of shares/ convertible debentures by Indian companies to non-resident Indians (NRIs)/overseas corporate bodies (OCBs) investors under 24 per cent and 40 per cent investment schemes. The Reserve Bank introduced a scheme for investment by NRIs/OCBs up to 51 per cent of the new issues by Indian companies not listed on stock exchanges and also granted general permission to issue and export of shares/securities. As a result, the earlier 40 per cent scheme was abolished. The Reserve Bank granted general permission to domestic mutual funds to issue units or any other similar instruments under the schemes floated by them with the approval of SEBI, wherever required, to NRIs/PIOs/OCBs on non-repatriation/repatriation basis subject to certain conditions. The Reserve Bank granted exemption for sale/transfer of shares/bonds or debentures of Indian companies by NRIs/ PIOs/OCBs, through stock exchanges, in favour of Indian citizens or persons of Indian origin resident in India or in favour of a company or body corporate incorporated under any law in India subject to certain conditions.

Portfolio Investment by FIIs/NRIs/OCBs

1.79 The existing ceiling of 24 per cent of the paid-up equity capital, as applicable to NRIs/ OCBs/FIIs, was made applicable exclusively to FIIs which could be raised up to 30 per cent by Indian companies. Similarly, single FII's or the concerned group of FIIs' ceiling on holding was enhanced from 5 per cent to 10 per cent of the total paid up capital. The existing overall ceiling of (a) 5 per cent of the total paid-up equity capital of the concerned company and (b) 5 per cent of the total paid-up value of each series of convertible debentures issued by the company to all NRIs/OCBs taken together both on repatriation and non-repatriation basis was raised to 10 per cent which could be raised up to 24 per cent by Indian companies. This limit is over and above the limit prescribed for investment by FIIs. The individual ceiling (applicable to NRIs/OCBs) of one per cent of the total paid-up equity capital or preference capital or total paid-up value of each series of convertible debentures of Indian companies was raised to 5 per cent.

Investments by Residents in Joint Ventures etc.

1.80 General permission was granted to resident individuals/proprietorship concerns/ partnership firms to avail of interest bearing loans from NRIs/PIOs subject to certain conditions on non-repatriation basis. EEFC account holders were permitted to use the funds in the account for making bonafide payments in foreign exchange in India or abroad connected with their trade and business related transaction and for investment in overseas joint ventures (JVs)/wholly owned subsidiaries (WOS) abroad up to US $ 15 million under the EEFC Fast Track Window. Indian commercial banks were permitted to extend credit/non-credit facilities (viz., letters of credit and guarantees) to Indian JVs/WOS abroad subject to certain conditions. Indian banks were permitted to provide, at their discretion, buyers' credit/ acceptance finance to overseas parties for facilitating export of goods and services from India subject to certain conditions. Indian entities having genuine underlying exposures were permitted to access international commodity exchanges for Exchange Traded Futures Contract/Option (purchase only) for hedging commodity price exposures except oil and petroleum. ADs were empowered to permit investment up to US $ 15 million out of EEFC funds held in account of the investing Indian company under EEFC Fast Track Route. The ceiling on investment abroad under Fast Track Route was uniformly raised to US $ 15 million for all countries and Rs.60 crore in cases of Rupee investment in Nepal and Bhutan. A Blanket Investment Approval Scheme was introduced for eligible software companies under which blanket approval is granted by the Reserve Bank for investment abroad by such companies up to 50 per cent of their average export earning of three consecutive years subject to a maximum of US $ 25 million. It has been decided to consider applications from employees of Indian promoter company in the field of software to subscribe to the shares of Overseas Joint Ventures/Wholly Owned Subsidiaries abroad to the extent of 5 per cent of the paid-up capital of the overseas company subject to a ceiling of US $ 10,000 per employee in a block of 5 years.

Foreign Exchange Management Bill, 1998

1.81 A new legislation termed as the Foreign Exchange Management Act (FEMA), consistent with full current account convertibility and containing provisions for progressive liberalisation of capital account transactions was introduced in the Parliament in August 1998 to replace the Foreign Exchange Regulation Act, 1973. The bill was referred to the Standing Committee of Parliament on Finance. The Committee has submitted its report and its recommendations are under consideration of the Central Government.

External Commercial Borrowings

1.82 The guidelines for external commercial borrowings (ECBs) were relaxed for 1998-99 and 1999-2000; while ECBs were permitted for project related rupee expenditure in all sectors (except stock markets and real estate), the average minimum maturity was relaxed and fixed at 5 years for all ECBs above US $ 20 million. The average maturity requirement under long-term maturity window outside the ECB cap was reduced to 8 and 16 years for ECBs up to US $ 200 million and US $ 400 million, respectively. Eligibility for ECB for exporters was raised to three times of their average export performance, subject to a maximum of US $ 200 million. The ECB limit of US $ 3 million or its equivalent at a minimum simple maturity of three years was raised to US $ 5 million or its equivalent. The Reserve Bank was also empowered by the Central Government to consider proposals for raising ECBs up to US $ 10 million or its equivalent with a minimum average maturity of three years for utilising the proceeds thereof for business related expenses including expenditure to be incurred in Indian rupees under various windows i.e., Exporters' /Foreign Exchange Earners' Scheme, Infrastructure Project Scheme and Long-term Borrowers' Scheme. This is in addition to the scheme under which the Reserve Bank considers applications from corporates etc., for raising ECBs up to US $ 5 million and short-term credit for imports for a period of less than three years.

Non-Resident Special Rupee Account

1.83 In order to simplify the procedures applicable to operation of bank accounts and financial transactions in India by non-resident individuals of Indian nationality/persons of Indian origin, the Reserve Bank introduced, with effect from 15th April 1999, a new type of account viz., Non-Resident Special Rupee Account [NR(S)RA] for such persons who would voluntarily undertake not to seek repatriation of funds held in such accounts and interest/ income accrued thereon. These accounts would have the same facilities as well as restrictions as are applicable to domestic resident accounts of individuals in respect of repatriation of funds held in these accounts, with the exception that investment of funds held in these accounts in shares/securities and immovable property would be governed by the extant exchange control regulations.

* While the Reserve Bank of India's accounting year is July-June, data on a number of variables are available on a financial year basis, i.e., April-March, and hence, the data are analysed on the basis of the financial year. Where available, the data have been updated up to June 1999 and in some vital areas information beyond end-June 1999 is also discussed. For the purpose of analysis, and for providing proper perspectives on policies, reference to past years as also to prospective periods wherever necessary have been made in this Report.