6.6 Based on the recommendations of the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham), the minimum CRAR was raised to 9 per cent, effective March 31, 2000. Other measures introduced based on the recommendations of the committee included: (i) an additional risk weight of 20 per cent for investment in Government guaranteed securities issued by PSUs; (ii) 20 per cent risk weight on state government guaranteed advances which remain in default as on March 31, 2000 and 100 per cent weight in the case of continued default after March 31, 2001; (iii) risk weight of 2.5 per cent to account for market risk for Government and approved securities; and (iv) 100 per cent risk weight on the foreign exchange open position limit.

6.7 As regards asset classification, the earlier system of eight 'health codes' was replaced by the classification of assets into four categories, viz., standard, sub-standard, doubtful and loss assets in accordance with international norms. Provisioning requirements were prescribed for sub-standard, doubtful and loss asset categories. Provisioning requirements of a minimum of 0.25 per cent were also introduced for the standard assets from the year ended March 31, 2000. Banks have also been required to progressively 'mark-to-market' their holdings of Government securities, with the marked-to-market proportion rising from 30 per cent in 1993 to 75 per cent by 1999-2000. In the recent Mid-term Review of the Monetary and Credit Policy for 2000-01, banks have been advised to classify their investment portfolio (comprising SLR and non-SLR securities) under three categories, viz., Available for Sale, Held for Trading, and Held to Maturity categories and provided the flexibility to decide the extent of holdings under 'Available for Sale' and 'Held for Trading' categories¹ .

6.8 In order to strengthen banking supervision, an independent Board for Financial Supervision (BFS) under the aegis of the Reserve Bank was constituted in November 1994. The Board is empowered to exercise integrated supervision over all credit institutions in the financial system including select DFIs and NBFCs relating to credit management, prudential norms and treasury operations. A comprehensive rating system based on Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems (CAMELS) methodology has been instituted for domestic banks. As regards foreign banks, the rating system is based on Capital Adequacy, Asset Quality, Compliance and Systems (CACS). This has been supplemented by a technology-enabled quarterly off-site surveillance system.

6.9 The status of banks with regard to their attainment of CRAR and the levels of their Non-Performing Assets (NPAs) over the last several years are presented in Table 6.2 and 6.3, respectively. Over the last four years from 1996-97 to 1999-2000, the capital base as a ratio of risk-weighted assets has improved for all major categories of banks. All the banks belonging to the SBI Group now have a CRAR exceeding 10.0 per cent. Amongst other public sector banks, all banks have met the enhanced CRAR norm of 9.0 per cent with the exception of Indian Bank. Four of the 34 Indian private sector banks had a CRAR below the prescribed norm of 8 per cent in 1996-97. In 1999-2000, three of 32 such banks had a CRAR below the enhanced norm of 9.0 per cent. All the 42 foreign banks operating in India in 1999-2000 had a CRAR exceeding the 9.0 per cent norm. As such, the capital position of banks operating in India is comfortable at present.

6.10 The position on the asset quality front has also improved over the last four years. Three of the eight SBI Group banks had NPA to net assets ratios exceeding 10.0 per cent in 1996-97. Their number increased to four in the following two years but declined to only one in 1999-2000. The number of nationalised banks having NPAs exceeding the 10.0 per cent also declined from six in 1996-97 to four in 1999-2000. In the case of old private sector banks, this number increased from three to five over the same period, indicating some deterioration in their asset quality. In the case of foreign banks operating in India, the number of banks with NPAs exceeding the 10.0 per cent benchmark increased from three in 1996-97 to 14 in 1998-99 but declined to 11 in 1999-2000. None of the new Indian private sector banks have NPAs exceeding the 10.0 per cent. Along with reduction in NPAs, the provisioning and contingencies made against NPAs of all major bank groups, except foreign banks, have declined (Chart VI.1).

6.11 In India, banks' exposure to capital markets, direct and indirect, remain and limited and, therefore, to a large extent, stock market volatility does not impinge on monetary and banking stability. Scheduled commercial banks were allowed to subscribe to shares and debentures of corporate entities (including PSUs) up to 5.0 per cent of their incremental deposits of the previous year with a sub-ceiling of 1.5 per cent for corporate shares in October 1993. Investments in PSU bonds were excluded from the 5.0 per cent ceiling in January 1994. Further, they were allowed to purchase shares and debentures in the secondary market within the existing 5.0 per cent ceiling in October 1996. Preference shares/debentures/ bonds of private sector bodies were excluded from the 5.0 per cent limit in the monetary and credit policy for the first half of 1997-98. As at end-March 2000, banks' investments in equity shares issued by public sector undertakings and private corporate sector amounted to Rs.2,841 crore and their advances to the capital market were limited to a mere Rs.4,890 crore. Banks have been required to publish their advances to the capital market in their balance sheets from 1999-2000.

6.12 The monetary and credit policy statement of October 2000 has revised guidelines on the bank financing of equities and investments in shares. First, bank boards are required to lay down a prudential ceiling on banks' aggregate exposure to the capital market keeping in view their overall risk profile. Second, bank's exposure to capital market by way of shares, convertible debentures and units of mutual funds (other than debt funds) should not exceed 5 per cent of the bank's total domestic credit as on March 31 of the previous year. Third, banks may grant advances for subscribing to initial public offerings only to individuals subject to a maximum of Rs.10 lakh and finance extended by banks for IPOs should be reckoned as an exposure to the capital market. Fourthly, a minimum margin of 25.0 per cent inclusive of cash margin should be obtained by banks for issue of guarantees on behalf of share brokers. Finally, banks should also mark to market their investment portfolio in equities like other investments on a quarterly basis and should disclose the total investments made in shares, convertible debentures and units of equity oriented mutual funds as also aggregate advances against shares, etc., in the 'Notes on Accounts' to their balance sheets from the year ending March 2001.

6.13 The statutory responsibility for prudential supervision of select financial institutions was assigned to the Reserve Bank from April 1995. The scope and coverage of inspection of select financial institutions has since been broadened to take into account their developmental, coordination and supervisory roles. The task of designing an enhanced off-site monitoring system for select financial institutions has been introduced effective March 1999. The position with regard to CRAR and net NPAs of select DFIs over the last five years is presented in Table 6.4.

6.14 With the exception of IFCI and IIBI, all the other financial institutions have CRAR exceeding 10.0 per cent (Chart VI.2). The IFCI, IIBI and IDBI had net NPAs exceeding 10.0 per cent of net loans in 1999-2000. A significant deterioration in loan quality was observed in the case of IFCI in 1998-99.

6.15 The Reserve Bank was vested with comprehensive legislative powers only from January 1997. Some of the significant measures initiated by the Reserve Bank in recent years for regulation and supervision of NBFCs are as follows: (i) compulsory registration; (ii) higher entry norms of Net Owned Funds (NOF) of Rs.25 lakh (enhanced to Rs.2 crore for new NBFCs which seek registration with the Reserve Bank and commence business on or after April 21, 1999); (iii) stricter prudential norms; (iv) enhanced capital adequacy standards; (v) requirement of credit rating; and (vi) commissioned audits through professional accountants at the behest of the Reserve Bank.

6.16 Under Non-Banking Financial Companies Prudential Norms (Reserve Bank) Directions, issued in January 1998, NBFCs are required to achieve a minimum 12 per cent CRAR on or before March 31, 1999. The frequency distribution of CRAR of companies with an asset size of Rs. 10 crore and above for the half-years ended September 1998, March 1999 and September 1999, respectively, is presented in Chart VI.3. Most of the companies had CRAR above the stipulated minimum. As regards NPAs, Chart VI.4 shows that the majority of the companies had NPAs within a reasonable limit.

6.17 During the first half of 1999-2000, there was a reduction in gross NPAs of NBFCs by Rs.259 crore, due mainly to reduction in sub-standard and loss assets. The ratio of gross NPAs to total credit, therefore, declined from 12.9 per cent to 12.2 per cent (Table 6.5).

6.18 A detailed self-assessment of the Core Principles for Effective Banking Supervision has been issued by the Reserve Bank in October 1999. The assessment has shown that most of the Core Principles were already enshrined in the existing legislation or current regulations. Gaps had been identified between existing practices and principles mainly in the areas of risk management in banks, inter-agency co-operation with other domestic/international regulators and consolidated supervision. Internal working groups were set up to suggest measures to bridge these gaps and their recommendations are in the process of being implemented. Guidelines on Asset Liability Management (ALM) of banks were issued in February 1999. Banks were advised to put in place an ALM system, effective April 1, 1999. These guidelines were subsequently extended to cover select financial institutions in December 1999. Detailed guidelines on risk management systems have also been issued to banks in October 1999. A beginning has been made towards consolidated supervision by advising banks to not only voluntarily build in risk-weighted components of their subsidiaries into their own balance sheets on a notional basis and earmark additional capital in their books beginning with 2000-01, but also to annex the balance sheet of the subsidiaries (for public sector banks) to their balance sheets beginning from the year ending March 31, 2001. In addition, to guard against regulatory forbearance and to ensure that regulatory intervention is consistent across institutions, the Reserve Bank has prepared a Discussion Paper delineating a framework for Prompt Corrective Action (PCA) with various trigger points for prompt responses by the supervisors.

6.19 The Union Budget 2000-01 announced the institution of a Financial Restructuring Authority (FRA) in a modified form in respect of any bank which is considered potentially weak, on the lines of the model suggested by the Working Group (Chairman: Shri M.S. Verma) for the revival of weak public sector banks. Over the period 1993-94 to 1998-99, the Government has extended recapitalisation facility to the extent of Rs.5,694.3 crore for the three weak banks as identified by the Verma Working Group. The restructuring plans of the three weak banks are under active consideration. The FRA, comprising experts and professionals, would be given powers to supercede the Board of Directors on the basis of the recommendations of the Reserve Bank.

6.20 With the objective of dealing pro-actively with the non-performing assets (NPAs) of the banking sector, a menu of options has been offered to banks to restructure bad assets through Debt Recovery Tribunals (DRTs) and Settlement Advisory Committees (SACs), as well as through explicit recapitalisation from the budgetary provisions. Till 1999-2000, an amount of Rs.20,446 crore had been expended towards recapitalisation of 19 nationalised banks. Guidelines on SACs were subsequently revised in July 2000, in order to provide a simplified, non-discriminatory and non-discretionary mechanism for the recovery of stock of NPAs of all sectors. Recognising that the high levels of NPAs in public sector banks can engender financial system instability, the Union Budget 2000-01 announced the setting up of seven more DRTs, in addition to those already established, for speedy recovery of bad loans. An amendment in the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, was effected to expedite the recovery process. Consequent upon the various measures undertaken, the gross NPA levels of public sector banks came down from 23.2 per cent of gross advances as at end-March 1993 to 14.0 per cent as at end-March 2000 (Chart VI.5).

6.21 In recognition of the increased cross-border financial integration and in respect of its obligations as a member of the IMF, the World Bank and the BIS, India has been actively participating in the deliberations on reforming the international financial architecture (IFA). While academic proposals on new international financial architecture have generated substantial theoretical debate, efforts are underway to improve the existing system through increased transparency, better governance and credible practices. India has been closely associated with the development of codes of good practices, international financial standards and codes and initiatives for improved data dissemination. Generally, standards and codes in India compare with the international best practices, especially in the financial sector.

6.22 India is a member of the Group of 20 (G-20) countries that advises the Financial Stability Forum (FSF) and the Core Principles Liaison Group set up by the Basle Committee on Banking Supervision (BCBS) to promote and monitor principles of banking supervision and the Working Group on Capital, which discusses proposals for revising the capital adequacy framework. India is also an early subscriber to the Special Data Dissemination Standards (SDDS) and one of the first countries to accept the Financial Sector Assessment Programme (FSAP) of the IMF and the World Bank.

6.23 The transparency and disclosure standards recommended in the International Accounting Standards have been implemented in a phased manner for the banking system. The formats of commercial banks' Balance Sheet and Profit and Loss Account Statements were revised in 1992 in order to bring about greater transparency. Disclosure requirements have been gradually broad-based and banks have been advised to disclose the key business ratios in the 'Notes to Accounts' from the year ended March 31, 1998. These ratios include (i) capital adequacy ratio with tier-I and tier-II capital separately; (ii) percentage of shareholding of Government of India in nationalised banks; (iii) percentage of net NPA to net advances; (iv) amount of provision made towards NPA, depreciation in the value of investments and income tax during the year; (v) amount of subordinated debt raised as tier-II capital; (vi) the gross value of investments in India and outside India, the aggregate provisions for depreciation separately on investment in India and outside India and the net value of investments in India and outside India; (vii) interest income as a percentage of average working funds; (viii) non-interest income as a percentage of average working funds; (ix) operating profits as percentage of working funds; (x) return on assets; (xi) business (deposits plus credit) per employee; and (xii) profit per employee. In order to further enhance the transparency of banks' balance sheets, banks have been advised to disclose maturity pattern of deposits, borrowings, investments and advances and foreign currency assets and liabilities, movements in NPAs and lending to sensitive sectors (e.g., capital market, real estate and commodity sector) with effect from March 31, 2000. The total exposure to sensitive sectors as on March 31, 2000 by scheduled commercial banks stood at Rs.19,669 crore, comprising 4.4 per cent of total advances as a whole. Exposure to these sensitive sectors is well diversified among commodities, real estate and capital market (Chart VI.6).

6.24 The Reserve Bank has also released its views on the New Capital Adequacy Framework in April 2000 with a view to generating a national debate. The views of the Reserve Bank can be broadly summed up as follows. First, where banks are of simple structure and have subsidiaries, the Accord could be adopted on a stand-alone basis with the full deduction of equity contribution made to subsidiaries from the total capital. Secondly, for assigning preferential risk weights for book assets (excluding claims on sovereign), preference should be given to assessments made by the domestic rating agencies as opposed to external rating agencies. The skepticism about the role of external rating agencies is based on the premise that different external rating agencies not only employ different sets of parameters, but also have varied and non-standardised mixes and weightage of objective and subjective factors. Thirdly, the risk weighting of banks should be de-linked from that of the sovereign in which they are incorporated and instead, preferential risk weights in the range of 20-50 per cent, on a graded scale could be assigned on the basis of risk assessments by the domestic agencies.

6.25 Over the last few years, sustained efforts have been made, both by the Government and the Reserve Bank, to improve data dissemination. Besides prescribing improved disclosure norms for financial institutions, the Reserve Bank, on its own part, has taken several steps to improve data quality and data dissemination. It began revaluing gold at close to international prices at the month-end and its foreign currency assets every week. The Reserve Bank also initiated disclosure of month-end data on forward liabilities. Besides, it has been publishing high frequency financial data through its many publications and at its website. With regard to scheduled commercial banks, the annual Report on Trend and Progress of Banking in India provides bank-wise details of several key ratios, including capital adequacy ratios, NPA ratios (both absolute as well as percentages to total assets as well as gross advances) and their consolidated income and expenditure statements and data on off-balance sheet activities (Table 6.6). The Statistical Tables Relating to Banks in India publishes the detailed balance sheets of scheduled commercial banks, including those of regional rural banks (RRBs). This publication has introduced data on movements in NPAs (excluding RRBs), maturity profile of selected items of liabilities and assets (excluding RRBs) as well as bank-wise details of contingent liabilities of scheduled commercial banks for the year 1999-2000.

6.26 The integrity of the data has been periodically reviewed in order to align the compilation of monetary and balance of payments (BoP) statistics in line with international standards. The BoP data are compiled in accordance with the IMF's Balance of Payments Manual (5^th edition). With a view to compiling quarterly balance of payments statistics in line with the commitments made to the SDDS, the Sub-Group on Reporting of Foreign Exchange Transactions by Authorised Dealers (Chairman: Shri S.P. Paniyadi) recommended the collection of data on purpose-wise details of foreign exchange transactions by electronic media from critical size authorised dealers. The BoP statistics are now published with a lag of just one quarter. The Technical Group on External Debt (Chairman: Shri M.R. Nair) has proposed compilation of external debt on both original and residual maturity basis in line with international norms. The Status Report on External Debt of the Ministry of Finance has published estimates of India's short-term external debt by residual maturity for December 1999. The Working Group on International Banking Statistics (Chairman: Shri N.K.Puri) has recommended the introduction of a comprehensive return that would facilitate effective monitoring of the international claims and the liabilities of the banking system as well as India's participation in the international banking statistics. The Reserve Bank's Working Group on Money Supply: Analytics and Methodology of Compilation (Chairman: Dr.Y.V. Reddy) has re-defined monetary aggregates on residency basis, introduced credit and liquidity aggregates and proposed a financial sector survey in view of financial reforms and in line with the IMF's draft Manual on Monetary and Financial Statistics. New monetary aggregates have been introduced in the October 1999 issue of the RBI Bulletin. Liquidity aggregates were introduced in the November 2000 issue of the RBI Bulletin.

6.27 International standards and codes have come to be regarded as benchmarks for national efforts to improve transparency and governance. The main recommendations as approved by FSF and subsequently endorsed by the G-20 as well as the IMF's International Monetary and Financial Committee pertain to 12 areas (Box VI.4). In general, the Reserve Bank and the Government of India have welcomed the international approach to the issue of implementing standards and codes. The Reserve Bank has appointed a Standing Committee on International Financial Standards and Codes to examine the applicability of international standards and codes to Indian conditions (Box VI.5).

6.28 Since 1993, efforts have been made to improve debt recovery by setting up special debt recovery tribunals. However, tribunals remain insufficient in number, in staffing and in other infrastructure. Progress in implementing debt recovery has also been constrained by several institutional impediments, especially the inadeqate legal system in place. The efforts to reduce NPAs would, to a large extent, depend on improving the legal infrastructure. The Expert Committee for Recommending Changes in the Legal Framework Concerning Banking System (Chairman: Shri T.R. Andhyarujina) had submitted its report to the Government in February 2000. The Committee had recommended, inter alia, the institution of a new law granting statutory power of possession and sale of security directly to banks and financial institutions and adoption of the draft Securitisation Bill. Efforts to improve debt recovery would need to be supplemented by efforts for improving credit assessment so that incremental NPAs are kept low. The proposed plan to set up Credit Information Bureau is, therefore, an important step in the efforts to reduce the sticky portfolios of financial institutions.

6.29 India is among the few countries, which has a long standing tradition of bank deposit insurance as a safety net. About 97 per cent of the deposits of scheduled commercial banks are fully protected, with the coverage amounting to over 70 per cent of the deposit amount. The extent of coverage under deposit insurance is seen to have remained more or less stable in terms of number of accounts. The insurance coverage, nevertheless, has registered some rise during the second half of the 1990s, albeit with some year-to-year fluctuations (Table 6.7). Deposit insurance has a well-found rationale in economic theory and is viewed as a means to prevent banking panics in a financial market characterised by multiple equilibria.² However, mere provision of deposit insurance is neither a necessary, nor a sufficient condition for ensuring financial stability. Deposit insurance poses moral hazard risks that could invite imprudent behaviour by bank managements or poor choices by depositors. Therefore, what is of greater importance is to ensure that deposit insurance is provided on efficient lines and does not guarantee complete insurance. Despite the low probability of banking failure in the Indian financial system with predominant presence of state-owned banks, the issue of reforming the deposit insurance system has been accorded importance. There is a certain amount of consensus that the principal objective of a deposit insurance system is to protect small depositors and to contribute to the stability of the financial system. The Reserve Bank constituted a Working Group (Chairman: Shri Jagdish Capoor) to examine the issue of deposit insurance which submitted its report in October 1999. Some of the major recommendations of the Group are: (i) fixing the capital of DICGC at Rs.500 crore, contributed fully by the Reserve Bank; (ii) withdrawing the function of credit guarantee on loans from DICGC; and (iii) risk-based pricing of the deposit insurance premium in lieu of the present flat rate system. A new law in supersession of the existing enactment is required to be passed in order to implement the new recommendations. The task of preparing the new draft law has been taken up. The relevant proposals would be forwarded to the Government for consideration.

6.30 Macroeconomic stability and financial stability reinforce each other. Therefore, macroeconomic co-ordination that ensures macroeconomic and financial stability is an important consideration in framing monetary and fiscal policies. This has become even more important with the fiscal reforms and emergence of a more liberalised financial system. There are several possible dimensions for co-ordinated response. At core of this is the persistence of fiscal imbalances that have placed burden on fiscal sustainability, with implications for financial stability.

6.31 The Government budget and the way it is financed impacts interest rates as well as inflation in the economy. Fiscal discipline is, therefore, important for financial market stability. The general trend observed in the budgetary performance of the Central Government is that, final account data, by and large, do not adhere to their original targets. Consequently, the fiscal deficit, more often than not, turns out to be far higher than the anticipated level. For instance, during 1992-99, on an average, the gross fiscal deficit in the final account, turned out to be higher by 22.4 per cent than the original budget estimates. On the receipt side, both tax revenue and total revenue receipts experienced shortfalls in the final accounts as compared to the budget estimates. This shortfall ranged between 2.1-12.6 per cent in respect of total revenue and 2.5-10.7 per cent in the case of tax revenue. As regards expenditure, the trend observed was that both revenue expenditure and aggregate expenditure exceeded the budget targets; the rise was to the extent of 2.6 to 6.2 per cent for revenue expenditure and 3.0 per cent to 8.0 per cent in respect of aggregate expenditure. While the magnitude of the impact of fiscal deficit on interest rates and inflation depends upon the size of the fiscal deficit, overruns in government deficits have adverse macroeconomic impacts. A high and growing stock of public debt, which has implications for the sustainability of the fiscal situation, puts pressure on the absorptive capacity of the market and, thus, fuels interest rate expectations. In the Indian case, it is empirically found that despite the stability in the market debt, the overall fiscal situation is precarious because of potential instability in the non-market debt and due to large unfunded liabilities of the Central and State governments³ .

6.32 A readjustment in the maturity structure of Government debt has taken place after reforms. The share of short-term maturity bonds (i.e., under five years) in total outstanding dated securities has recorded a sharp increase from 8.6 per cent to 41.0 per cent between 1991 and 1998. On the contrary, share of long-term bonds (i.e.,over ten years) declined rapidly to 18.2 per cent in 1998 from 85.8 per cent in 1991 (Chart VI.7). Shortening of maturities, however, led to some bunching of redemption of securities and the need for frequent rollovers from the market. The repayment profile witnessed steep humps in the medium-term on account of shortening of the average maturity of fresh issues of dated securities to 5.5 years in 1996-97 from 18.6 years in 1991-92. In order to impart stability to the maturity profile of internal debt, debt management operations were re-oriented towards transforming the maturity structure to longer-term. As a result, the average maturity of dated securities steadily rose to 12.6 years in 1999-2000.

6.33 The fluctuations in maturity profiles and the yield curve have attracted attention for improving treasury management skills to cope with interest rate risks. Until recently, investors in the securities market were willing to take interest rate risks by locking themselves into long maturities, on the ground that their incomes would be higher if they invested at the longer end of the spectrum without giving due cognisance to risks of depreciation⁴ . With the market orientation of interest rates, investors are required to make provisions for depreciation in their portfolio. Increased focus on asset-liability management, therefore, assumes importance. The Reserve Bank has taken several steps and provided guidelines to help market participants to initiate prudent trading activities that add to the strength and stability of the financial system.

6.34 Apart from debt accumulation, the growing size of guarantees extended by the Government affects public sector balance sheets and impacts the fiscal position. In the case of State governments, under a market-oriented borrowing system, the higher amount of guarantees without proper risk assessment has the potential of raising the risk premium on their bonds. As part of the effort for improved fiscal discipline, the outstanding guarantees for the Central Government has been brought down from 7.8 per cent of GDP as at end-March 1993 to 4.2 per cent as at end-March 1999 (Table 6.8). Such guarantees for the Centre and States (combined) also declined from 13.9 per cent as at end-March 1992 to 8.9 per cent of GDP as at end-March 1999. The reduction of such contingent liabilities has been lower in case of State governments.

6.35 In view of the budgetary imbalances, the imbalances on account of quasi-fiscal activities and the need to contain explicit and implicit Government guarantees, an institutional mechanism to support fiscal restraint would be useful. The Central Government and the Reserve Bank have been closely co-ordinating in this respect. In the Union Budget for 2000-01, the Government announced its intent to bring about Fiscal Responsibility Legislation (Box VI.6).

6.36 The Fiscal Responsibility and Budget Management Bill, 2000 was introduced in Parliament in December 2000. The Bill provides for the responsibility of the Central Government to ensure inter-generational equity in fiscal management and long-term macro-economic stability by achieving sufficient revenue surplus, eliminating fiscal deficit and removing fiscal impediments in the effective conduct of monetary policy. It also provides for prudential debt management consistent with fiscal sustainability through limits on the Central Government borrowings, debt and deficits, greater transparency in fiscal operations of the Central Government and conducting fiscal policy in a medium-term framework and for matters connected therewith or incidental thereto. The salient features of the Bill, inter alia, include laying the Medium-term Fiscal Policy Statement, Fiscal Policy Strategy Statement and Macroeconomic Framework Statement by the Central Government before the Parliament, along with the annual budget; elimination of the revenue deficit by March 31, 2006 and bringing down the fiscal deficit to 2 per cent of GDP in the same period; and prohibition of direct borrowings by the Central Government from the Reserve Bank after three years except by way of advances to meet temporary cash needs in certain circumstances.

6.37 Developing countries typically run current account deficits (CAD) to supplement their domestic savings to achieve higher levels of investment and growth without cutting their current consumption. In the borrowing countries, the accumulated current account deficits result in external debt and other liabilities that need to be serviced out of the country's current earnings. This raises the question of a sustainable level of external debt. India is classified as a less indebted country by the present value-GNP criterion and a moderately indebted country by the present value-exports criterion by the Global Development Finance (Table 6.10).

6.38 Measured in terms of conventional indicators of external debt sustainability, India's external debt position has undergone significant consolidation during the 'nineties as a part of the overall approach to external sector management (Chart VI.8). First, the current account deficit has been kept within sustainable limits, with the CAD/ GDP ratio averaging at around 1 per cent since 1991-92 in contrast to an average of 2 per cent during the 'eighties. Secondly, as a result of a distinct shift in the policy framework in favour of equity as against debt in capital inflows, non-debt creating inflows have increased from a mere 1 per cent of total capital flows in 1990-91 to more than 50 per cent of the capital inflows. Thirdly, a transparent policy on external commercial borrowings with the stated objectives of prudent debt management has helped to consolidate India's external debt. The policy aims at lengthening of maturity while keeping a ceiling on approvals. Restrictions on end-use in the form of investments in stock markets/real estate have helped to avoid the pitfalls associated with unbridled external flows. Fourthly, in the case of non-resident deposits, withdrawal of exchange guarantees, alignment of interest rates with international rates, a minimum maturity prescription of 12 months in the case of foreign currency denominated deposits and promotion of non-repatriable deposits helped in consolidating non-resident deposits and making them a stable source of external funding. Fifthly, short-term debt flows have been tightly monitored and are permitted only for trade related purposes given their volatility and the possibility of their non-renewal in times of crisis. Sixthly, the exchange rate policy, which has been market determined, helped in avoiding the excessive risk-taking that occurred in some of the South-East Asian countries that followed a policy of either a fixed exchange rate or a predictable exchange rate regime. Finally, since debt servicing has ultimately to be funded out of current earnings, the policy efforts have been aimed at achieving a commensurate growth in current receipts. It may be noted that in line with the current trend in the liability management, the Central Government has set up a high level steering committee and a technical group to work out the modalities for more active sovereign external liability management in India. The Group in collaboration with the World Bank is developing a risk management model for sovereign external liability management in India.

There is a well-documented literature on country-wise experiences relating to fiscal policy legislation (Table 6.9). The most common fiscal policy rule being followed is the budget-balance rule, that is, one relating to balance between Government revenue and expenditure. The borrowing rules are the oldest operating fiscal rules, which consist of prohibition of or limits on Government borrowing. Several advanced economies and some developing economies prohibit direct central bank financing to the Government sector and also to the rest of the non-financial public sector. The rule is not usually practiced in developing countries and transition economies on account of lack of market microstructure and infant debt markets. The debt rule consists of a limit on, or a target for, the stock of public debt as a proportion or ratio to the country's GDP. In some ways parallel to the debt rule is a rule, which may prescribe a target accretion of reserves (most probably in terms of liquid assets) for a future unforeseen event. Country experiences reveal that many countries have prescribed limits on Government access to central bank credit.

The compliance with fiscal rules may have some disadvantages, despite the generally favourable macroeconomic effects, because these may distort the composition of Government expenditure or accentuate tax increases. Secondly, fiscal rules may induce profusion of creative accounting practices and increased recourse to one-time measures. Thirdly, governments cannot eliminate fiscal stress by adhering to a set of rules, for reduction in stress levels requires that governments commit themselves to some sort of a funding constraint. Further, rules could be suspended or repealed through subsequent legislative action, hence the sanctity of rules itself depends upon the level of discipline the government is willing to impose upon itself.

The legislation in India needs to focus on rectifying the medium-term fiscal balance and complete elimination of the revenue deficit, reduction/stabilisation of public debt as well as the consistency of fiscal balance with debt target. However, in order to achieve convergence, some intra-year assessment of the financial position of the Government is necessary as budgeting is an annual exercise, and based on the assessment, the stance of fiscal policy should be modified. Depending on the chosen policy instrument, if there is significant deviation of the fiscal variables from the targets set, corrective actions should be taken to ensure adherence to targets. Instrument focus could be on the levels of borrowing and net RBI credit to Governments as these are high frequency data which are readily available.

The statutory provisions of the Act and the system of penalty in case of violation of the act also assume critical significance. In this context, the degree of flexibility granted to the fiscal authorities in the Act assumes greater importance. Putting an autonomous surveillance mechanism to monitor the fulfillment of the fiscal rule laid down in the Act would be an important pre-requisite for the success of the Act.

On the issue of the role of the Reserve Bank, the level of monetisation should always be at the initiative of the central Bank. There is the issue of imposing a borrowing rule possibly circumscribed by a debt-GDP ratio. However, that would hinge upon the separation of the debt management function from that of monetary management by the central bank. Whether the central bank should participate only in the borrowing programme of the Government in the primary market or withdraw from the primary and operate only through the secondary market is the main question to be addressed. There is also the question of the quantum of devolvement. A stringent precision rule based regime in the present Indian scenario, given the large overhang of debt and the huge borrowing programme of the Government, seems difficult to envisage. However, a corrective strategy capsulated as rules aimed at medium-term rectification of the fiscal imbalance would definitely be a responsive signal indicating and enhancing the credibility of the governments in their intent towards fiscal consolidation and facilitating macroeconomic balance.

6.39 Reflecting the above multi-pronged approach to external sector management, external debt has remained almost range-bound since 1995. The stock of external debt initially increased from US $ 83.8 billion as at end-March 1991 to US $ 99.0 billion as at end-March 1995. Subsequently, it declined to US $ 93.5 billion as at end-March 1997. As at end-March 2000, external debt at US $ 98.4 billion, was still lower than its March 1995 level. Notwithstanding the higher external debt stock as at end-Match 2000 as compared with the end-March 1992 level, the ratio of external debt-GDP has almost halved from a peak of 39 per cent as at end-March 1992 to 22 per cent as at end-March 2000 (Chart VI.8). Similarly, the debt-service ratio halved from 35 per cent in 1990-91 to 16 per cent in 1999-2000. The proportion of concessional debt in external debt declined from 46 per cent as at end-March 1991 to 39 per cent as at end-March 2000.

6.40 A more noteworthy aspect of external debt consolidation is the decline in short-term debt. Short-term debt, by original maturity, declined significantly from US $ 8.5 billion as at end-March 1991 to US $ 4.0 billion as at end-March 2000. As a result, short-term debt, as a proportion of total external debt, fell sharply from 10.2 per cent to 4.1 per cent over the same period. In view of the importance of short-term debt by residual maturity as highlighted by the recent financial crises, the Status Report by the Ministry of Finance on India's external debt has started publishing data on short-term debt by residual maturity.

6.41 Recent events have also highlighted the need to monitor external contingent liabilities of the Government. In the Indian context, the Central Government provides guarantees on a selective basis on external borrowings by public sector enterprises, DFIs and in some instances, to private sector companies. These contingent liabilities are monitored by the Government and efforts have been made to reduce the magnitude of such guarantees. For instance, Government guarantees declined from US $ 12.2 billion as at end-March 1994 to US $ 7.5 billion as at end-December 1999, mainly on account of the decline in guarantees to public sector enterprises from US $ 8.6 billion to US $ 4.6 billion. Guarantees to the financial sector declined from US $ 3.3 billion to US $ 2.6 billion over the same period, Guarantees to the private sector have been insignificant at around US $ 0.3 billion. An important point to note is that since these guarantees have been provided to residents, the invoking of guarantees would only shift liabilities from residents to the Government and would not imply any additional liability for the country as a whole.

6.42 In sum, the Indian financial system is reasonably stable. The banking system is well protected against risks with a median CRAR exceeding 11.0 per cent for the nationalised as well as the Indian private sector banks as at the end of 1999-2000. The CRAR for all-India DFIs is still higher. However, there are some weaknesses in the system that need to be addressed. These include the high level of non-performing loans in some banks and some DFIs. There are also disciplinary issues with regard to NBFCs that are being addressed by the regulators by putting in place a stricter supervision and regulatory system. There is also a need for ensuring greater transparency through disclosure norms for the mutual funds industry. Reinforcing financial stability would necessitate tackling these problems, as also problems of low asset quality through adequate recognition for impaired assets and adequate provisioning for losses. While external debt is moderate, the Governments' domestic debt and guarantees continue to be an area of concern from the viewpoint of macroeconomic stability. Although substantial progress has been made in addressing the areas of weaknesses, further improvements would be necessary.