I. Review of Macro-economic and Monetary Developments: 1999-2000

Domestic Developments

2. According to the estimates of the Central Statistical Organisation (CSO), the GDP growth in 1999-2000 is likely to be 5.9 per cent as compared with 6.8 per cent in 1998-99 and 5.0 per cent in 1997-98. (It may be noted that the CSO figures for 1998-99 have been substantially revised upwards because of increase in the growth rate of agriculture and allied activities to 7.2 per cent during that year.) A welcome feature of macro-economic developments last year was a substantial acceleration in the growth of industrial output, particularly manufacturing output. Recovery in industrial production, witnessed during the first six months of the year was further consolidated during the second half of the year. During April 1999-February 2000, industrial growth was 7.9 per cent, with manufacturing output showing a growth of 8.8 per cent.

3. The annual rate of inflation as reflected in the movements in the wholesale price index (1981-82=100) during the year was 3.74 per cent (on a point-to-point basis) and was 2.97 per cent (on an average basis). The inflation rates were significantly lower than in the preceding year⁺. The reduction in the rate of inflation was also reflected in the Consumer Price Index (CPI). The CPI for the month of February 2000 showed an increase of 3.61 per cent over the previous year (as compared with 8.64 per cent in February 1999). A relatively high growth of output, fuelled by sustained industrial recovery, combined with low inflation and high reserves, provided a positive environment for monetary management in 1999-2000.

4. During 1999-2000, the annual growth in M₃, on a point to point basis, was 13.6 per cent (provisional) as against 19.2 per cent in 1998-99. The aggregate deposits of the scheduled commercial banks increased by 13.5 per cent as against 19.3 per cent in the previous year. It may be mentioned that a substantial part of the increase in the aggregate deposits was due to increase in time deposits (of over Rs.87,187 crore). This is a continuation of the pattern observed in 1998-99 when almost the entire increase in the aggregate deposits was accounted for by increase in time deposits.

5. Non-food credit showed an expansion of 16.0 per cent as against an increase of 13.0 per cent in the previous year. The total flow of funds from scheduled commercial banks to the commercial sector, including banks' investments in bonds/debentures/shares issued by public sector undertakings (PSUs) and private corporate sector and commercial paper, etc., is estimated at Rs.69,380 crore as against Rs.56,558 crore in the corresponding period of the previous year. Total resource flow to the commercial sector, including capital issues, Global Depository Receipts (GDRs) and borrowings from financial institutions, is placed at Rs.1,34,013 crore as compared with Rs.1,13,488 crore in the previous year. The faster growth in bank credit to the commercial sector despite a lower growth in deposits was facilitated by substantial reduction in cash reserve ratio (CRR) and increase in non-deposit sources of funds, such as bills payable, operating surplus, etc.

6. Partly as a result of tax concessions extended to mutual funds in the last year's Budget, there was a substantial increase in resources flowing to such funds during 1999-2000. Preliminary figures indicate that mutual funds have mobilised net resources of Rs.17,966 crore during the year as compared with a net outflow of Rs.1,204 crore in the previous year. Further growth and development of mutual funds, provided they are able to compete for household and corporate savings without special concessions, could contribute to the development and stability of the financial system in the long run. A developed financial infrastructure, with multiple intermediaries operating in different asset markets with varying risk profiles, is likely to be less vulnerable to unanticipated developments, including external shocks.

7. Food credit expansion during the year was of the order of Rs.8,875 crore as against Rs.4,331 crore in the previous year. Investment by scheduled commercial banks in government securities increased by Rs.54,612 crore during the year as against Rs.36,261 crore in the previous year. The share of lending to government in the overall deployment of resources by the scheduled commercial banks during the year was substantially larger than in the previous year.

8. As per the Revised Estimates in the Union Budget, the fiscal deficit of the Central Government (excluding small savings) for 1999-2000 was higher at 5.6 per cent of GDP as against budgeted figure of 4.0 per cent. As a result, gross market borrowings exceeded the budgeted level by Rs. 15,616 crore. In addition, State Governments' gross market borrowings amounted to Rs. 13,706 crore as against Rs.12,114 crore in the previous year

9. Due to favourable macro-economic environment, the Reserve Bank was able to meet the large market borrowing requirements of government without too much stress and without causing upward pressure on interest rates. In fact, secondary market yields on government securities of 7-year and 10-year maturity were nearly 110-120 basis points lower at end-March 2000 than those prevailing a year ago. Since 1998-99, a conscious attempt has been made to elongate the maturity structure of marketable debt of the Government to avoid bunching of redemption with consequent pressure on sustainability of the gross market borrowing programme. During 1999-2000, there was no issue of dated securities up to 5 years. Furthermore, about 65 per cent (Rs.56,630 crore) of the total dated securities (Rs.86,630 crore) issued during the year was above 10-year maturity.

10. An important monetary development during the year has been the negative growth in the monetised deficit of the Government (i.e., net Reserve Bank credit to Government), and low growth of reserve money, despite large borrowing requirements. As on April 24, 2000, i.e., a day before the final closing of government accounts, the monetised deficit of the Government was negative by as much as Rs.5,584 crore, reflecting the success achieved by Reserve Bank in activating its Open Market Operations (OMO). This compares with an increase in the monetised deficit by Rs.11,800 crore in 1998-99 and by Rs.12,915 crore in 1997-98. So far as reserve money is concerned, the increase during the year was only 8.1 per cent as compared with 14.6 per cent in the previous year.

11. The relatively low growth of M₃ of 13.6 per cent (as compared with 19.2 per cent last year) was possible because of a lower expansion in reserve money. Particularly significant was the decline in the monetised deficit of the government which contributed to this favourable outcome. It is interesting to note that if the reserve money growth and monetised deficit were of the same order in 1999-2000 as in the previous year, on the basis of the normal relationship among these variables, M₃ expansion could have actually been even higher than last year, which would have had an unfavourable effect on the inflationary outlook for the current year.

12. While some comfort can be drawn from the fact that we have been able to manage a large government borrowing programme without undue strain on interest rates or the overall liquidity environment, it is also clear that such high levels of fiscal deficits are not sustainable over the medium term. The continuing large fiscal deficits year after year have already led to sharp increase in repayment obligations on outstanding public debt in the nineties. In 1990-91, the gross and net borrowing of the Central Government stood respectively at Rs.8,988 crore and Rs.8,001 crore in a ratio of 1:0.89. Thus, for every rupee of fresh borrowing, the government received 89 paise in net terms. In 2000-01, the gross and net borrowings of the government are projected at Rs.1,17,704 crore and Rs.76,383 crore respectively. Thus, in the current year, the net receipt for every rupee of borrowing will be only 65 paise. Yet another consequence of larger borrowings is the substantial increase in interest payments which will touch Rs.1,01,266 crore in 2000-01. Interest payments in 1990-91 were only Rs.21,498 crore.

13. The large borrowing programmes of Government year after year have also put pressure on the absorptive capacity of the market. The banking system now holds government securities of around 34.3 per cent of its net demand and time liabilities as against a minimum statutory requirement of 25 per cent. In terms of volume, the holdings above the Statutory Liquidity Ratio (SLR) amounted to about Rs.85,000 crore, which is higher than the last year's net borrowings.

14. The overall monetary management has also become much more complex now than was the case a few years ago. The last year's positive outcome was partly due to the fact that the economy was in a phase of business cycle when there was no problem of excess demand or emerging inflationary pressures. If the economy were characterised by excess demand and liquidity pressures, it would have been difficult to meet the large borrowing requirements of government without a sharp increase in interest rates and some crowding out of private investments. Under those circumstances, the economy could have slipped into a vicious circle of tight liquidity and high interest rates. It is of utmost importance that such an eventuality is avoided by taking credible fiscal action urgently. A national consensus on an effective and time bound programme of fiscal correction is, therefore, essential so that efforts made in this direction in the Union Budget for 2000-01 can be further intensified.

External Developments

15. A notable development affecting India's balance of payments during the year was the sharp increase in prices of crude oil and petroleum products. In the last 16 months, crude oil prices increased by around 150 per cent from US $ 10-11 per barrel during January 1999 to about US $ 25 per barrel during most part of March 2000. Following the recent decision of OPEC to increase production, oil prices have declined to around US $ 20-21 per barrel in April 2000.

16. The impact on oil import bill, due to increase in the prices of oil, is estimated to be US $ 12 billion during the year 1999-2000. Fortunately, the increase in oil import bill was absorbed without an undue pressure in the overall current account deficit. The current account deficit is likely to be around 1.0 per cent of the GDP in 1999-2000, i.e., the same level as in the previous year. The relatively low current account deficit was made possible by a turnaround in exports, lower growth of non-oil imports and continued buoyancy in invisible receipts. After taking into account the recent changes in oil prices as well as changes in EXIM policy, the current account deficit in the year 2000-2001 is still expected to be well below 2 per cent of GDP.

17. Developments in respect of both the exchange rate of the rupee as well as movements in foreign exchange reserves were also satisfactory. At the end of March 2000, the foreign currency assets of the country were higher by US $5.54 billion compared with a year ago, and reached the highest level of US $ 35.06 billion. Foreign exchange reserves, including gold and SDRs, were also at their highest (US $ 38.04 billion), and showed an increase of US $ 5.55 billion during the course of the year. Net reserves, after taking into account forward liabilities, increased by US $ 5.67 billion over the year.

18. Following the East-Asian crisis and subsequent developments in certain other countries, an appropriate policy for management of foreign exchange reserves in emerging economies has figured prominently on the international agenda. India is a member of various international groups where discussions on the international financial architecture and related issues are currently in progress (e.g., the International Monetary and Financial Committee at the IMF, the Bank for International Settlements, the Group of 20, and Working Groups set up by the Financial Stability Forum, etc.). It is now widely agreed that in judging the adequacy of reserves in emerging economies, it is not enough to relate the size of reserves to the quantum of merchandise imports or the size of the current account deficit. In view of the importance of capital flows, and associated volatility of such flows, it has become increasingly important to take into account the composition of capital flows, particularly short-term external liabilities, in judging the adequacy or otherwise of foreign exchange reserves. An additional factor which has to be built into this assessment is the need to take into account certain contingencies, such as, unanticipated increase in commodity/asset prices.

19. The recent international experience, particularly during the period of the East Asian crisis, also highlighted the fact that the emerging economies have to largely rely on their own resources during external exigencies as there is no "lender of the last resort" to provide additional liquidity at short notice. While the International Monetary Fund and the World Bank did their best to arrange rescue packages and provided financial assistance to the affected economies, the agreement on conditionality packages necessarily took some time and their implementation posed further difficult challenges for the policy makers. The content, size and the speed with which these programmes could be approved also varied from country to country depending on the strength of political support by industrialised countries, which are the major shareholders of the international financial institutions.

20. The overall approach to the management of India's foreign exchange reserves has reflected the changing composition of balance of payments, and has endeavoured to reflect the "liquidity risks" associated with different types of flows and other requirements. The policy for reserve management is thus judiciously built upon a host of identifiable factors and other contingencies. Such factors inter alia include: the size of the current account deficit; the size of short-term liabilities (including current repayment obligations on long-term loans); the possible variability in portfolio investments and other types of capital flows; the unanticipated pressures on the balance of payments arising out of external shocks (such as, the impact of the East Asian crisis in 1997-98 or increase in oil prices in 1999-2000); and movements in the repatriable foreign currency deposits of Non-Resident Indians.

21. The movements in India's foreign exchange reserves in recent years has kept pace with our requirements on trade as well as capital account. The strength of the foreign exchange reserves has also been a positive factor in facilitating flow of portfolio investments by FIIs and in reducing the 'risk' premium on foreign borrowings and Global Depository Receipts (GDR)/American Depository Receipts (ADR) issued by Indian corporates. However, there can be no room for complacency. Unanticipated domestic or external developments, including undue volatility in asset prices in equity/bond markets, can create disproportionate pressures in the foreign exchange market in emerging economies. It is, therefore, essential to continue with the pursuit of realistic and credible exchange rate policies, in addition to vigorous implementation of domestic and external sector reforms to further strengthen the balance of payments position over the medium term. It is also necessary to ensure that, leaving aside short term variations in levels, the quantum of reserves in the long run is in line with the growth in the economy and the size of risk-adjusted capital flows. This will provide us with necessary security against unfavourable or unanticipated developments.

22. The day-to-day movements in exchange rates are market determined. The primary objective of the Reserve Bank in regard to the management of the exchange rate continues to be the maintenance of orderly conditions in the foreign exchange market, meeting temporary supply-demand gaps which may arise due to uncertainties or other reasons, and curbing destabilising and self-fulfilling speculative activities. To this end, as in the past, the Reserve Bank will continue to monitor closely the developments in the financial markets at home and abroad, and take such measures as it considers necessary from time to time.

23. Exports, particularly software exports (which technically form part of the invisible receipts in the balance of payments statistics) have done well during the year. In the interest of balance of payments viability, this momentum must be kept up. In the past 18 months, several measures were introduced to ensure timely delivery of credit to exporters and remove procedural hassles. These measures included provision of 'On Line credit' to exporters, extension of 'Line of Credit' for longer duration for exporters with good track record, peak/non-peak credit facilities to exporters, permission for interchangeability of pre-shipment and post-shipment credit and meeting the term loan requirements of exporters for expansion of capacity and modernisation of machinery and upgradation of technology. Improvements were also made in the procedure for handling of export documents and fast track clearance of export credit at specialised branches of banks. Similarly, new simplified guidelines were issued for sanction of credit facilities for software services, project services and software products and packages.

24. In order to ensure that the above procedural and other improvements in the credit delivery system are actually reaching the exporters, the Reserve Bank had also set up a Bankers' Group at the operational level (comprising senior officials from commercial banks and the Reserve Bank). The Group has held a number of inter-active sessions with exporters as also base-level officials of the commercial banks at 21 major export centres in the country in addition to discussions with industry associations. So far, the feedback received from this exercise is highly positive. In order to further improve the credit delivery system, the Reserve Bank would now like to invite exporters, particularly those who are located in non-metropolitan centres, to send their reactions on whether the new systems are working satisfactorily. They may also send their suggestions for improvement in procedures, particularly those which are designed to reduce paper work without diluting accountability. Exporters' responses can be sent directly to the RBI by post or by e-mail at exportsreview@rbi.org.in by end of June 2000. On the basis of responses received, the Bankers' Group will be advised to formulate a programme of action to further improve the credit delivery system.

25. Over the past two years, the Reserve Bank has also introduced several new facilities for Non-resident Indians (NRIs). The overall objective is to make financial transactions in and out of India by NRIs as flexible and easy as possible, and to reduce the need for seeking individual or specific permission from the Reserve Bank. Thus, general permission has already been issued for opening of different types of bank accounts, transactions in shares, securities and debentures, and portfolio and direct investments, etc. As in the case of exporters, NRIs are also requested to send in their responses on whether the facilities and procedures are working satisfactorily. They may also send their further suggestions for improvement in these facilities. Their views/suggestions may also be sent by e-mail at nrireview@rbi.org.in by the end of June 2000. Further action to improve the facilities will be taken by the Reserve Bank, in consultation with the Government, wherever necessary.

26. Recently, the Government has substantially expanded the automatic route for Foreign Direct Investment (FDI). RBI has already granted general permission to the Indian companies to receive funds and issue shares to their foreign collaborators. No specific approval of Reserve Bank is required for such investments. The same benefit has also been extended to all cases of foreign investment approved by the Foreign Investment Promotion Board (FIPB). The above facilities are subject to filing a post-facto report by the recipient company with the Regional Offices of the RBI within 30 days of the issue of shares to foreign collaborators. All companies are requested to comply with this requirement.

27. In January, 2000 general permission was granted to Indian companies for issue of ADRs and GDRs without any value limits. Accordingly, Indian corporates can now freely utilise up to 50 per cent of such ADRs/GDRs for overseas investments subject only to post facto reporting to the Reserve Bank. In addition, companies in IT & entertainment software and certain other knowledge-based sectors have been granted further facilities for overseas acquisition without requiring prior permission of the Government or the Reserve Bank. These facilities provide for acquisitions allowed by issue of ADRs/GDRs on stock swap basis up to a value limit of 10 times the export earnings of the Indian company in the previous year, or up to U.S. $ 100 million (without reference to the level of actual exports). It is also open to Indian companies to apply to the Reserve Bank for approval of any overseas investment or acquisition proposals which do not fall within the above parameters. It is hoped that these facilities would provide sufficient scope for expansion of internationally competitive Indian enterprises at the global level.

II. Stance of Monetary Policy for 2000-2001

28. Against the background of the developments in the economy last year and economic prospects during 2000-2001 an important objective of monetary policy in the current year is to provide sufficient credit for growth while ensuring that there is no emergence of inflationary pressures on this account. On current assessment, the prospects for achieving these objectives look reasonably promising. Notwithstanding the sharp increase in oil prices, the international inflationary environment continues to be reasonably benign. A freer trade regime, combined with a high level of food stocks and a high level of foreign exchange reserves, should provide sufficient scope for effective supply management during the year. On the demand side, the budget stance of reining in the overall fiscal deficit is welcome. Some allowance, however, has to be made for the fact that there has been considerable delay in the adjustment of important administered prices, including prices of petroleum products. However, such adjustments cannot be avoided if fiscal deficit has to be kept under reasonable control in order to keep potential inflationary pressures under check and future expectations favourable.

29. Keeping the above considerations in view, the Reserve Bank proposes to continue the current stance of monetary policy and ensure that all legitimate requirements for bank credit are met while guarding against any emergence of inflationary pressures due to excess demand. Towards this objective, the Reserve Bank will continue its policy of active management of liquidity through OMO, including two-way sale/purchase of treasury bills, and reduction in cash reserve ratio as and when required.

30. In line with the continuing overall stance of policy, at the beginning of the new financial year on April 1, 2000, the RBI announced a number of measures to enhance liquidity and reduce the cost of funds to banks. These measures were :

1. A reduction in the Bank Rate by 1.0 percentage point;
2. A reduction in CRR by 1.0 percentage point in two stages;
3. A reduction in Repo Rate by 1.0 percentage point; and
4. A reduction in savings deposit rate of scheduled commercial banks from 4.5 per cent to 4.0 per cent.

Following the above measures most public sector banks have also announced a reduction in their lending and deposit rates. For major banks, deposit rates have been reduced by 0.50 to 1.00 percentage point depending on maturity and prime lending rates have been reduced by 0.50 to 0.75 percentage point. In March 1999 also, banks had effected similar reductions in the PLR. Taking these changes in the PLR into account, the prime lending rate of the largest bank (i.e., the State Bank of India) was lower by 1.75 percentage point on April 3, 2000 compared with end-February, 1999.

31. For purposes of monetary policy formulation on the basis of current trends, growth in real GDP may be placed at 6.5 to 7.0 per cent in 2000-2001, assuming a normal agricultural crop and continued improvement in industrial performance. Assuming the rate of inflation to be around 4.5 per cent (i.e., close to the average of last two years), the projected expansion in M₃ for 2000-2001 is about 15.0 per cent. This order of growth in M₃ should lead to an increase in aggregate deposits of scheduled commercial banks by about 15.5 per cent (or Rs.1,25,000 crore). Non-food bank credit adjusted for investments in commercial paper, shares/debentures/bonds to PSUs and private corporate sector is projected to increase by around 16.0 per cent. This is expected to be adequate to meet the credit needs of the productive sectors of the economy.

32. However, it cannot be over-emphasised that the above outlook can change dramatically within a relatively short period of time in the event of unanticipated domestic or international events. Several unfavourable events that affected the outlook for the economy during the years 1997 through 1999 point to the need to respond quickly and to change course, if and when required. In the past 3 weeks, even after eliminating the effect of the change in the base year of the Wholesale Price Index, the inflation rate has been somewhat rising. Some States have also been affected by severe droughts. On the inflation front, therefore, there is need for continuous vigilance and caution. The Reserve Bank will continue to monitor domestic monetary and external developments, and tighten monetary policy through the use of instruments at its disposal, when necessary and unavoidable. Banks and other financial institutions should make adequate allowances for unforeseen contingencies in their business operational plans, and take into account the implications of changes in the monetary and external environment on their operations.

33. Based on the experience of some industrialised countries, there is a view that, in India also, monetary policy, to be transparent and credible, should have an explicit narrowly defined objective like an inflation mandate or target. While technically this appears to be a sound proposition, there are several constraints in the Indian context in pursuing a single objective. First, there is still fiscal dominance and the debt management function gets inextricably linked with the monetary management function while steering the interest rates. If the two functions, (i.e., monetary management and debt management) were to be separated as has also been suggested by some experts, it is almost certain that the prevailing interest rates in the market would be substantially higher than considered desirable from monetary stability and/or growth points of view. The last year's experience in our ability to maintain a softer interest rate environment, during a period of low inflation, while at the same time meeting large government borrowing requirements, confirms this view. Secondly, in the absence of fully integrated financial markets, which remain still imperfect and segmented, the transmission channel of policy is rather weak and yet to evolve fully. Thirdly, the high frequency data requirements including those on a fully dependable inflation rate for targeting purposes are yet to be met. Under these circumstances, it is necessary to carefully measure and balance between possible outcomes, after taking into account movements in a variety of monetary and other indicators.

34. It may be recalled that during the last 2 ½ years, the Bank Rate, Repo Rate and CRR have been used in conjunction with OMO and other operations bearing on liquidity to meet short-term monetary policy objectives in the light of emerging domestic and external situations. The Bank Rate and short-term repo rate announced by the RBI have been perceived by the markets as signals for direction in market rates of interest, in particular the call money rates. The active debt management, combining private placements and distribution of securities through open market sales at convenient intervals and activating the OMO window for Treasury bills, has helped in keeping the short-term liquidity situation reasonably comfortable during the year without causing undue pressure on security prices.

35. While there has been a significant softening of interest rates in the last 13 months, the decline in nominal interest rates has not kept pace with the decline in the rate of inflation. Under the circumstances, there has been some debate in the country on the need to bring nominal interest rates down sharply so that real interest rates would move down correspondingly. If this happens, it is argued, industrial growth could be accelerated further and India's competitiveness abroad would improve. At the same time, it has to be recognised that there are several structural factors which constrain downward flexibility in the interest rate structure in India. The mid-term review of the Monetary and Credit Policy in October 1999 had dealt with some of these structural rigidities. In view of the interest in the subject, and also significant decisions taken recently to reduce some of the administered interest rates and abolish the interest tax, it may be useful to revisit this matter again.

36. It needs to be reiterated that the prime lending rates of banks for commercial credit are entirely within the purview of the banks and are not set by the Reserve Bank. The domestic interest rates which are subject to regulation are only the rate of interest on savings accounts and rates of interest on export credit and credit for small and tiny sectors, including DRI schemes, up to an amount of Rs.2 lakh. It is interesting to note that several key rates fixed by RBI, i.e., the Bank Rate, Repo Rate and the rate on savings account have already come down substantially (to 7.0 per cent, 5.0 per cent and 4.0 per cent, respectively). At the present levels, these rates are not too out of line with ruling international rates.

37. Decisions in regard to interest rates on bank credit have to be taken by banks themselves in the light of various factors, including their own cost of funds, their transaction costs, and interest rates ruling in the non-banking sector. It is interesting to note that, even after reduction in several administered rates, the post tax return on deposits being provided by banks is considerably lower than the prevailing rates on contractual savings like Provident Fund, as well as National Savings Scheme. The interest rate, subject to tax, on 3-yearly deposits is currently 9.5 per cent as compared with 11 per cent for National Savings Scheme and Provident Fund (which, of course, have longer maturity and are also less liquid).

38. Banks have been given freedom to offer variable interest rates on longer-term deposits. However, partly due to historical reasons and partly due to strong preference of depositors (for example, fixed-income groups and retirees), banks have continued to offer fixed interest rates on relatively long-term deposits. The effect of this practice is to reduce the flexibility that banks have in lowering their lending rates since the rates on the existing stock of deposits cannot be lowered. (For example, in respect of one of the large public sector banks, it is estimated that 80 per cent of time deposits are longer than 1 year. Even though the rates of interest for maturities of one year and above are currently in the range of 8.00 to 9.50 per cent, the effective rate of interest for the outstanding deposits of maturities above one year is as high as 11 per cent.)

39. Another factor affecting the interest rate structure in India is the high level of non-interest operating expenses of public sector banks. These work out to 2.5 to 3 per cent of total assets. The high transaction costs which generally reflect high staff costs, combined with relatively high levels of Non-Performing Assets (NPAs), further constrain the manoeuvrability in respect of lending rates.

40. Against the above background, it is clear that, while much greater flexibility in the structure of interest rates in tune with changes in the inflationary environment is desirable, there is no "quick fix" solution to engineer a sharp fall in nominal deposit and lending rates of banks. Vigorous action has to be taken by banks to reduce their transaction costs and the volume of NPAs, and improve risk management. This requires action in a number of areas, including legal reforms for recovery of dues and restructuring of weak banks. Concerted action is also required to move forward with financial reforms in a competitive environment coupled with a reduction in Government's fiscal deficit and wider public acceptance of the need for flexibility in administered interest rates.

III. Financial Sector Reforms and Monetary Policy Measures

41. The recent annual Monetary and Credit Policy Statements in April, as well as mid-term reviews in October, have focused on 'structural measures' to strengthen the financial system and to improve the functioning of the various segments of financial markets. The main objectives of these measures have been five-fold: (a) to increase operational effectiveness of monetary policy by broadening and deepening money market and bond market, especially the government securities market; (b) to redefine the regulatory role of the Reserve Bank; an attempt has been made to reduce RBI's direct role in fixing interest rates, margins and credit allocations, while simultaneously strengthening its role in the development of financial markets and the management of overall liquidity in the system; (c) to strengthen prudential and supervisory norms, while at the same time providing banks and financial institutions maximum autonomy in operational matters; (d) to improve the credit delivery system, particularly for agriculture, exports, services, small-scale industries, self-help groups and micro-credit institutions; and (e) to develop the technological and institutional infrastructure for an efficient financial sector.

42. While there has been substantial progress in achieving some of these objectives, the pace of progress has been relatively slow in certain areas. Thus, for example, considerable success has been achieved in redefining the role of the Reserve Bank in financial markets and in actively associating financial experts and intermediaries in policy formulation and its implementation. Substantial progress has also been made in the area of deregulation and providing much greater autonomy to banks in operational matters. Money market is functioning reasonably satisfactorily with substantial volume of transactions, although it still continues to be dominated by a few operators. The secondary market for government securities has been strengthened with the emergence of a large number of Primary Dealers (PDs) as active participants. Technological infrastructure in the form of Indian Financial Network (INFINET) has been put in place, and preparatory work for Real Time Gross Settlement System (RTGS) and Centralised Data Base Management has been completed. However, so far, very little progress has been made in making the secondary market for securities and bonds sufficiently liquid and accessible to individuals and small investors. Prudential and supervisory norms have been strengthened, but there is considerable scope for further improvement in risk management and internal control procedures of banks and other institutions. The NPA levels remain unduly high, and there is still a long way to go in making the loan recovery/settlement procedures timely and efficient. A large number of measures have been introduced to make the credit delivery system less cumbersome and hassle free, but progress on the ground is slow.

43. In this year's policy also, it is proposed to review the present position and carry forward the direction of financial reforms initiated in recent years, keeping in view the actual experience in implementation and other relevant developments.

Introduction of Liquidity Adjustment Facility (LAF) replacing Interim Liquidity Adjustment Facility (ILAF)

44. Pursuant to the recommendations of the Narasimham Committee Report on Banking Reforms (Narasimham Committee II), it was decided in principle, to introduce a Liquidity Adjustment Facility (LAF) operated through repo and reverse repos in order to set a corridor for money market interest rates. To begin with, in April 1999, an Interim Liquidity Adjustment Facility (ILAF) was introduced pending further upgradation in technology and legal/procedural changes to facilitate electronic transfer and settlement.

45. The ILAF was operated through a combination of repo, export credit refinance, collateralised lending facilities and OMO. ILAF provided a mechanism for injection and absorption of liquidity available to banks and PDs to overcome mismatches in supply and demand from time to time. The fortnightly average utilisation of CLF/ACLF and export credit refinance facilities by banks ranged between Rs.3,180 crore and Rs.10,122 crore during the year 1999-2000. Liquidity support availed of by PDs was in the range of Rs.814 crore and Rs.7,406 crore during the above period.

46. The ILAF has served its purpose as a transitional measure for providing reasonable access to liquid funds at set rates of interest. In view of the experience gained in operating the interim scheme last year, an Internal Group was set up by RBI to consider further steps to be taken. Following the recommendation of the Internal Group, it has now been decided to proceed with the implementation of a full-fledged LAF. The new scheme will be introduced progressively in convenient stages in order to ensure smooth transition.

• In the first stage, with effect from June 5, 2000, the Additional CLF and level II support to PDs will be replaced by variable rate repo auctions with same day settlement.

• In the second stage, the effective date for which will be decided in consultation with banks and PDs, CLF and level I liquidity support will also be replaced by variable rate repo auctions. Some minimum liquidity support to PDs will be continued but at interest rate linked to variable rate in the daily repos auctions as determined by RBI from time to time.

• With full computerisation of Public Debt Office (PDO) and introduction of RTGS expected to be in place by the end of the current year, in the third stage, repo operations through electronic transfers will be introduced. In the final stage, it will be possible to operate LAF at different timings of the same day.

47. In the proposed LAF, the quantum of adjustment as also the rates would be flexible, responding immediately to the needs of the system. At the same time, funds made available by the RBI through this facility would meet primarily the day-to-day liquidity mismatches in the system and not the normal financing requirements of eligible institutions. It is expected that the LAF would also help the short-term money market interest rates to move within a corridor and impart greater stability, facilitating emergence of a short-term rupee yield curve. Both the time-table and the scope of proposed changes are, however, subject to review in the light of actual experience.

48. There will be no change in the export credit refinance scheme. This will continue as before and as such banks will be entitled to automatic access for export refinance as per present policy. Ideally, it would also be desirable for export credit refinance to be subsumed in the LAF for effectiveness of monetary policy. However, under the present circumstances, given certain domestic rigidities in the interest rate structure and the desirability of giving maximum support to exporters, there is a case for the scheme of export credit refinance to continue for some more time. It would be possible to do away with sector-specific refinance, like export credit refinance facility, when domestic interest rates in nominal and real terms converge with international rates on a sustainable basis.

For features of the proposed scheme of Liquidity Adjustment Facility please click here.

Development of Financial Markets

49. In an effort to carry forward the reforms towards widening and deepening of the financial markets, the following measures are being introduced for further development of the markets :

(a) Money Market

• Forward Rate Agreements and Interest Rate Swaps were formally introduced in 1999. The guidelines had indicated that the rate on any domestic money or debt market instrument can be used as the benchmark. In order to provide more flexibility for pricing of rupee interest rate derivatives and to facilitate some integration between money and foreign exchange markets, the use of 'interest rates implied in the foreign exchange forward market' as a benchmark would be permitted in addition to the existing domestic money and debt market rates.

• At present, the minimum maturity for Certificates of Deposit (CDs) is 3 months. To bring it on par with other instruments such as CP and term deposits, the minimum maturity of CDs is being reduced to 15 days. Incidentally, the minimum period of transferability for CDs has already been reduced to 15 days.