For the Year July 1, 2002 to June 30, 2003*

VII - Assessment and Prospects

Assessment of 2002-03

7.1 The Indian economy performed reasonably well in 2002-03, in spite of the simultaneous impact of several adverse developments. Border tensions in the early months of the year were followed by the worst drought in fifteen years. The estimated fall of 29 million tonnes in foodgrains production was the largest since Independence. Furthermore, the global economy was characterised by an environment of generalised uncertainty and low growth in the period leading up to the war in Iraq. During this period, there was also considerable hardening of international crude prices.

7.2 It is important to note that in the past, the occurrence of any one of the shocks experienced in 2002-03 in isolation had produced a sharp loss of growth, higher inflation, balance of payments difficulties, and even financial instability in the economy. Seen in this context, the performance of the economy during 2002-03 demonstrates the developing resilience of the Indian economy. This suggests that perseverance with structural reforms, despite the drag of slower growth in the second half of the 1990s, has helped to relatively shock-proof the economy and sustain a stable macro-economic environment.

7.3 The growth of the Indian economy in 2002-03, although significantly lower than expected, was still among the highest in the world. Timely and coordinated supply management strategies were effective in containing potential inflationary pressures, with headline inflation remaining benign over the greater part of the year. The strategy of accumulating food stocks and international reserves served the economy well by cushioning the impact of the shocks and by providing domestic and international confidence in the presence of considerable adversity. A heartening feature of the performance of the economy in 2002-03 was the revival of industrial activity, driven mainly by the strength of export demand that indicates the growing international competitiveness of Indian industry.

7.4 The comfortable state of India’s balance of payments reflected the high growth of merchandise exports at 19.2 per cent and buoyant invisibles. Consequently, the current account was in surplus for the second year in succession. International confidence in the fundamentals of the economy was further reflected in sustained capital inflows which in combination with the surplus in the current account led to an unprecedented accumulation of foreign exchange reserves in 2002-03. Recognition of the growing strength of the reserves has also led to the designation of India as a creditor country by the International Monetary Fund (IMF) under its Financial Transaction Plan (FTP). In recognition of the increasingly comfortable balance of payments situation, further progress was made during 2002-03 in liberalising external current and capital transactions covering overseas investments and remittances abroad by banks, corporates and resident individuals.

7.5 Monetary policy was effective in ensuring stability and orderliness in the domestic money, debt and foreign exchange markets. The expansionary impact of large capital flows was managed through timely action in the form of open market sales and LAF operations, supported by a sequenced liberalisation of outward international transactions. Interest rates declined in all segments of the market spectrum in response to the monetary policy stance of facilitating a softer interest rate regime that would support the revival of investment demand. The active management of liquidity conditions enabled the successful completion of the market borrowing programme of the Centre and States. Public debt management was strengthened through prepayment of external debt, debt swaps between the Centre and the States and a comprehensive restructuring of the scheme of ways and means advances and overdrafts for the States.

7.6 Ensuring financial stability continued to be a dominant objective underlying the intensification of financial sector reforms during 2002-03. Prudential norms were strengthened, consistent with the strategy to bring about greater convergence with international best practices. Significant initiatives were put in place to clean up and strengthen the balance sheets of banks. Management of non performing assets (NPA) was fortified by the operationalisation of the Corporate Debt Restructuring (CDR) mechanism and the enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act, 2002 which provides statutory support for the enforcement of creditors’ rights and, inter alia, paves the way for the establishment of Asset Reconstruction Companies (ARCs). The supervisory function was improved considerably through the institution of Prompt Corrective Action as an early warning tool. The development of financial markets was carried forward by putting in place the infrastructure for the retailing of government securities by order-driven, screen based trading in stock exchanges and the introduction of exchange traded interest rate derivatives. These developments will enable market participants to manage market risk better. The impact of financial sector reforms was reflected in an improvement in profitability of banks and in the overall efficiency of the financial sector.

7.7 The industrial recovery was well-diversified, particularly in manufacturing. The resurgence of industrial exports had a salutary effect across a wide spectrum of industry groups. In particular, exports of automobiles and components, chemicals, basic metals, food products, beverages and tobacco were robust. In terms of the demand composition, the revival of industrial activity in 2002-03 was led by consumer non-durables. The pick up in demand from the retail segment was also evident in the upturn in construction activity which was mirrored in the substantial increase in demand for bank credit from housing and cement industries. There was overall improvement in production conditions in the infrastructure industries, despite some shortfalls from targets. A significant development was the strong revival in the production of capital goods, heralding an improvement in the investment outlook. The financial performance of the corporate sector improved steadily in every quarter. A healthy expansion in sales and reduction in interest costs enabled a surge in post-tax profits, especially in the second half of the year.

7.8 There has been an active and continuous attempt at bringing about reforms in the infrastructure sector. The government is slowly moving away from its traditional role as a ‘provider’ of services to one of ‘facilitator’ by ensuring that infrastructure services are delivered in a desirable manner. The government has made rapid progress in the implementation of the National Highway Development Project (NHDP). There have been some efficiency gains in ports through the privatisation of ports services and berths. The telecom sector has perhaps seen the most significant development. Tariffs in the telecom sector have declined sharply in response to deregulation, competition and technology. Consequently, there has been a sharp increase in the growth of telephone lines, particularly in mobile services.

7.9 Although there have been some slippages in fiscal consolidation on account of the counter-drought stance of fiscal policy and the slack in economic activity, there was a renewal of the commitment to improve the quality of fiscal adjustment through monitorable reform programmes, debt consolidation and measures designed to bring back buoyancy to the tax-GDP ratio. With the passage of the revised Fiscal Responsibility and Budget Management (FRBM) Bill in the Parliament, the institutional architecture is being put in place for a much greater transparency in respect of the fiscal position and a phased decline in the Centre’s borrowings to meet its capital and revenue expenditure. Some States have also enacted fiscal responsibility legislations.

7.10 The outlook for the global economy turned even more uncertain than a year ago. Despite positive developments such as the cessation of hostilities in Iraq, retreat of the Severe Acute Respiratory Syndrome (SARS) epidemic and reversal of persistent sell-offs in major equity markets, signs of recovery in major industrial economies are still not clear. Interest rate cuts by the Federal Reserve and the European Central Bank (ECB) in June 2003 have taken key international rates to all-time lows, reflecting a growing concern about possibility of deflationary trends emerging. The hesitant recovery of growth in the emerging market economies of Asia has been accompanied by the return of capital flows with falling bond spreads and a modest regaining of access to international capital markets. There are some concerns that higher capital flows reflect prospects of low returns in developed countries rather than strong fundamentals of emerging market economies. In spite of large cross-currency movements, misalignments continue to persist in the face of the continued global imbalances, particularly the high current account deficit in the US, which entail a downside risk for the prospects of recovery.

Outlook for 2003-04

7.11 The year 2003-04 has begun on a strong, positive note. Excess rainfall vis-a-vis the long period average in July 2003 - the sowing month for the kharif season - and revised projections of a normal monsoon have brightened the prospects for agriculture considerably. The satisfactory spread of the SouthWest monsoon so far is expected to compensate for the delay in sowing on account of the late arrival of the rains. A precise assessment of the anticipated levels of output under various crops would await more information on the intensity and distribution of the monsoon. Nevertheless, comfortable food stocks and the progressive improvement in reservoir levels provide sufficient protection against any unexpected developments.

7.12 The momentum of industrial growth has been sustained, with manufacturing output rising strongly in the first quarter. A heartening feature of the emerging industrial sector profile is the turnaround in the consumer durables sector after twelve successive months of decline. The outlook for the industrial sector is expected to be reinforced by the renewal of agricultural activity, the abiding strength of export demand and the improved environment for new investments indicated by a surge in the production of capital goods and non-oil imports, low interest rates and improved all round corporate profitability. Business confidence remains positive with expectations of increase in capacity utilisation, no major changes in employment and inventory levels and higher export orders.

7.13 Notwithstanding the unfavourable international environment, India’s external sector continues to post gain, with merchandise export growth in April-June, 2003 adhering to the target growth path set for the year. Capital flows continue to be buoyant with significant increase in non-resident rupee deposits and portfolio investment by foreign institutional investors in the first quarter of the fiscal year. Reflecting these developments, accretions to foreign exchange reserves have continued, taking their level to US $ 85.4 billion on August 15, 2003 – up by US $ 10.0 billion over the end-March level on top of an increase of US $ 21.3 billion in 2002-03.

7.14 The substantial expansion in net foreign assets of the Reserve Bank has engendered easy liquidity conditions so far. Net Reserve Bank credit to the Centre, on the other hand, declined sharply on account of Liquidity Adjustment Facility (LAF) repos and open market sales. Broad money expansion was also lower on account of slowing deposit growth, and a slack in currency demand. Lower procurement operations resulted in a weak off-take of food credit. Non-food credit expansion has been broadly maintained.

7.15 Financial markets exhibited stability and ample liquidity. Call rates softened to sub-repo levels since May 2003. Despite the launch of the Centre’s borrowing programme for 2003-04, the gilt market has been range-bound by expectations of a further decline in yields. In the foreign exchange market, the Indian rupee appreciated against the US dollar on the back of strong supplies. Forward premia hovered between 1-3 per cent in April, 2003 before increasing mildly thereafter. The capital market experienced increased activity in the current year with significant buying interest in Public Sector Unit (PSU) and bank scrips.

7.16 Monetary policy for 2003-04 retains its stance of maintaining adequate liquidity in the system to meet credit growth and support investment demand in the economy while continuing a vigil on movements in the price level. Accordingly, the preference for a soft and flexible interest rate environment within the framework of macroeconomic stability is being continued. The endeavour of monetary policy would continue to be the development and smooth functioning of the financial markets, enhancing the allocative efficiency of the financial sector, preserving financial stability and improving the transmission mechanism of monetary policy.

7.17 By early-July, 2003, inflation retreated from a temporary spike during the last fortnight of June on account of spurts in prices of vegetables, processed tea and iron and steel. In the beginning of July, vegetable and fruits prices declined. Oilseeds prices have been ebbing since the beginning of June on the prospects of a good monsoon. The decline in the prices of mineral oil and man-made fibres continues to restrain overall inflation. By early August 2003, wholesale price inflation fell below 4 per cent. Internationally, inflation remains weak in the US, the UK and the Euro Area. The Fed and the Bank of England reduced their key policy rates by another 25 basis points each as the possibility of deflation continues to be a cause for concern. Although the international inflation scenario remains benign, a close watch will have to be kept on commodity prices of key items, such as, iron and steel, POL, edible oils and cotton, which exhibit some possibilities of firming up.

7.18 The fiscal deficit of the Centre was somewhat lower in April-June, 2003 than in the previous year. The revenue deficit and primary deficit were, however, higher during the first quarter of 2003-04 as a result of a substantial decline in proceeds from corporation tax, income tax and union excise duties. Custom duties, on the other hand, benefited from the surge in import growth and registered an increase. Aggregate expenditure during April-June 2003 registered a moderate growth. As the Tenth Plan document has noted, the key to sustaining growth of 8 per cent per annum is prudent fiscal management based on increased public investment financed by higher government saving and internal resource mobilisation by the public sector. States would have to play a predominant role in making investment decisions, particularly in infrastructure development. Priority needs to be accorded to arresting the declining trend in government saving. The revenue deficit must be contained and has to be reduced to 2.4 per cent of GDP by the end of the Tenth Plan period. This would also help in ensuring sustainability of public debt, inclusive of contingent liabilities. The large size of contingent liabilities has implications for the sustainability of Government finances. The contingent liabilities in case of State Governments essentially reflect the practice of setting up special purpose vehicles (SPVs) to borrow from the market. Given the low user charges and inefficient operations of PSUs, these contingent liabilities are a potential threat to the stability and sustainability of the financial system. In view of these systemic risks associated with any possible default of State Government guaranteed paper, there have been ongoing discussions between the Reserve Bank and the State Governments. States have now become sensitised to the risk inherent in committing support to unsustainable contingent liabilities and various mechanisms are being considered to limit them.

7.19 A number of initiatives have been taken to ensure adequate credit to the agricultural sector. There are broadly three categories of institutions which deliver credit to rural areas, i.e., commercial banks, Regional Rural Banks (RRBs) and co-operative banks. Although public sector banks as a group have achieved the targets for lending to the priority sector, the flow of credit to rural areas by other segments of the banking system has not been buoyant. The non-performing assets of RRBs have been declining in recent years largely due to an increase in the share of assets in the standard category. This augurs well for the credit delivery mechanisms of the RRBs in the context of their specialised function. The rural co-operative sector remains dependant on flow of finance from the National Bank for Agriculture and Rural Development (NABARD). The Government of India has introduced an amendment to the NABARD Act, 1981 to enable it to provide refinance facilities directly to District Central Co-operative Banks (DCCBs), in addition to State Cooperative Banks (StCBs) and Regional Rural Banks (RRBs) to which NABARD is already providing refinance. This would enable the system to reduce the rate of interest charged to the ultimate borrower. There is a continuing need to improve the delivery of rural credit so that farmers receive timely and adequate credit at a reasonable cost in an institutional manner.

7.20 The scheme of micro-finance has made rapid strides in India, both in terms of Self-Help Groups (SHGs) linked with banks and the number of beneficiaries covered. The progress of micro-finance across the States has, however, been uneven. Micro- finance forms an integral part of priority sector lending with banks allowed to classify their credit under the SHG-bank linkage programme as advances to weaker sections. Banks are being encouraged to mainstream micro-credit and enhance the outreach of micro-credit providers. The Reserve Bank has been placing emphasis on the flow of bank credit to micro-enterprises in rural and semi-urban areas. This programme is also of benefit to the banks by externalising the credit delivery process and ensuring more than 95 per cent recoveries, besides being cost effective.

7.21 Real GDP growth in 2003-04 was projected at about 6.0 per cent in the Statement on Monetary and Credit Policy for the year 2003-04, issued in April, 2003, based on the assumption of somewhat below normal rainfall forecast by the Meteorological Department at that time. As per the latest assessment of rainfall conditions, a strong recovery in agricultural output is likely during the year. Along with the continuance of the upturn in the industrial and the services sectors, the expected growth for 2003-04 may significantly exceed the earlier projection, if output growth in agriculture shows a sizeable increase over the low base of 2002-03. Based on current assessment, the inflation rate in 2003-04 on a point-to-point basis, is placed in the range of 5.0 to 5.5 per cent. Consistent with the expected GDP growth and inflation, the projected expansion in broad money (M₃) for 2003- 04 is placed at 14.0 per cent. As the projected expansion of money supply is on a higher base including the mergers that took place in the banking industry, the volume of liquidity would be adequate to meet the credit needs of the productive sectors of the economy. Consistent with this order of growth in M₃, an increase in aggregate deposits of scheduled commercial banks is set at Rs.1,79,000 crore. Non-food bank credit including investments in commercial paper, shares/ debentures/bonds of PSUs and private corporate sector is projected to increase by 15.5-16.0 per cent, which should be adequate to facilitate the sustenance of growth in industrial activity during 2003-04. A re-assessment of the projected growth rate for the current year will be attempted in the mid-term review of the Monetary and Credit Policy in October 2003, by which time reliable information on the progress of the monsoon and the spread of the industrial upturn would be available.

7.22 Achieving the growth projections related to overall economic performance will be dependent on a significant increase in investment, both public and private. Such a change in expenditure composition towards higher investment could lead to the re-emergence of a current account deficit that would then enable better absorption of capital inflows for investment purposes.

MEDIUM-TERM ISSUES

Real Sector

7.23 The higher growth trajectory envisaged under the Tenth Five Year Plan would combine increased investment with improvement in efficiency. This would require shifts in the growth strategy to improve saving and investment rates, and reduce the high fiscal deficit. Raising the domestic saving rate to about 27 per cent per annum to finance the required investment effort is a daunting task at the current levels of income and this, in itself, underscores the imperatives for stepping up the growth rate of the economy. A key issue in this regard would be the intensification of reforms in social security, insurance and other conduits of long-term savings as well as the development of markets and instruments with a view to bringing about a convergence between the time preference of savers and the risk-return profiles of investors. At the same time, institutional mechanisms need to be put in place to draw the saving of the unorganised sector into formal channels.

7.24 Arresting the dissaving in the public sector and halting the preemption of private saving by burgeoning public sector revenue deficits is critical to the drive for mobilising finances for growth. As fiscal consolidation improves and the draft on domestic resources from the budget diminishes progressively, a larger volume of resources would be available for private investment also. This transformation would also stem the continuous erosion in public investment that has occurred in the new millennium, empowering it to anchor aggregate demand, build new productive capacities and create the enabling conditions for private investment. Reduction in the revenue deficit would also enable greater public investment for the provision of public goods that are necessary to catalyse a high rate of efficiency of private investment.

7.25 The Indian growth experience has been marked by a high correlation between domestic saving and investment. Globalisation and internationally mobile capital have tended to weaken this correlation elsewhere as developing countries have undertaken financial liberalisation to harness the growth-financing potential of foreign saving, especially when efforts to mobilise resources domestically have run up against hard constraints. The investment requirement of the Tenth Plan strategy relies on external financing to the extent of about 1.6 per cent per annum, on average. Given the past experience and the evolving openness of the economy, the order of external saving envisaged in the Tenth Plan seems reasonable.

7.26 As the Tenth Plan document notes, the key to the growth strategy is efficiency "based on unlocking of hidden capacities in the economy, unleashing repressed productive forces and entrepreneurial energies and upgrading technology in all sectors". This will require acceleration of the process of dismantling policy constraints, procedural rigidities and price distortions. It will also require that the essential institutional structure necessary for the orderly operation of the economy is strengthened significantly.

7.27 An issue of concern as highlighted by the Tenth Five Year Plan is the decline in the employment growth rate from above 2 per cent per annum during the 1980s and the early part of 1990s to 1.1 per cent in the latter part of 1990s. With the growth rate of working age population exceeding the overall population growth rate, the unemployment rate could worsen further if the economic growth envisaged does not give rise to new activities that are appropriately labour intensive.

Agriculture

7.28 The drought of 2002-03 has renewed concerns relating to the high variability of agricultural output and the adverse ramifications for overall economic activity. The monsoon dependency of kharif production – the main agricultural season – and the indirect dependence of the rabi agricultural season on storage in reservoirs has become more pronounced in recent years. Furthermore, in a country of sub-continental proportions, there are always some regions which experience drought even though at the national level moisture stress is not there. Localised droughts have a severe region-specific impact, often repetitively, as in the case of Western India which suffered three droughts during 1999-2000 to 2002-03 leading to large losses of national oilseeds production. This underscores the urgent need for water harvesting and watershed development alongside water conservation. Classification of land capability in terms of inherent characteristics, external land features and environmental factors is a key issue from the point of view of preserving fertility and planning watershed development. Crop selection should be related to the availability of water. Programmes promoting greater afforestation in the uplands would help in better water management for increasing the availability of water in currently water scarce areas. Effective social and legal institutions for management of community resources are crucial for watershed development programmes including strategies to educate, encourage and operationalise the collective participation of watershed communities.

7.29 An area of vulnerability of Indian agriculture to weather shocks is the concentration in the cropping pattern, which constrains the flexibility of supply response. Agricultural pricing policies are at a crossroad. There is considerable debate in the country today assessing their benefits in terms of ensuring food security versus the distortions in cropping patterns and input usage that have stemmed from a skewed incentive structure. The Minimum Support Price (MSP) system has changed the cropping pattern in favour of rice and wheat at the cost of other important components of the average consumption basket such as other cereals, oilseeds and pulses, and other foodstuff such as fruits, vegetables, poultry and the like. Moreover, the irrigation intensive rice-wheat cropping pattern in North-Western India is increasingly being recognised as unsustainable environmentally. Water logging and the disproportionate application of fertilisers has led to decline in soil fertility and an alarming drop in the underground water table. Intensive input usage is causing salinity with adverse implications in terms of long-term desertification of soil.

7.30 As the Tenth Plan document has recorded, despite the declining share of agriculture in GDP, employment in agriculture has remained virtually unchanged at around 190 million people over the last decade. With growing incidence of fragmentation, the consequent decline in the average size of land holding and subdued growth in yields, any further improvement in agricultural incomes will have to come from value addition through agro-processing or agro-based industries rather than agricultural production per se. Demand based agricultural production may necessitate moving away from fiscal price supports in a phased manner towards greater exposure to international terms of trade and the development of alternatives such as futures trading which result in better price discovery and risk management. A crucial prerequisite is the removal of restrictions on the physical movement of major agricultural commodities and the integration of domestic agricultural markets.

7.31 The low growth of yields during the post-reform period highlights the need for upgradation of technology. Agricultural research and development must be geared to a re-prioritisation of investment on new technologies so as to balance or supplement the traditional technologies with new advances in biotechnology. Here, public investment in agricultural research is critical. The Indian agriculture research system performed well in supporting the green revolution. Now attention needs to be given to re-focussing the research system so that agricultural diversification can be accelerated for achieving new productivity levels. Effective adoption of new technologies also requires an efficient extension system for technology dissemination. The task of extension becomes more challenging with the signing of the Agreement of Agriculture under the World Trade Organisation (WTO). This requires a flexible approach allowing specific information to be customised for different farmer-groups.

7.32 If India is to approach the growth target of the Tenth Plan, it is essential to step up the growth of agriculture significantly. Higher agricultural growth will now have to come from a much more diversified agriculture as has been the experience in other fast growing Asian countries. Agricultural diversification and accelerated agricultural growth will require much greater investment in rural infrastructure such as roads, storage facilities, telecommunications, power, and the like. Diversified agriculture will need much more complex commercial linkages between the farm and market. A key challenge will be the financing of rural infrastructure. New approaches to public private partnerships, participation of local governments, funds sourced from dedicated levies such as the fuel cess will have to be explored.

7.33 Despite India being the second largest producer of fruits and vegetables in the world, the production of these commercial crops has been hampered by the relatively low priority given to the food processing industry and inadequate market infrastructure. This has become increasingly important in view of the WTO bindings on tariffs. Concerted measures have to be taken to promote agro-based industries with export orientation as these are comparatively labour intensive and would exploit the comparative advantage India should have in food processing. In this regard, the vital function of efficient agricultural marketing should be recognised. This underscores the need to move to a situation where an alternate system of market intermediaries is created in agricultural marketing along with the existing ones. A thorough review of adequacy of institutional arrangements in quality control, certification and trading in agriculture sector should be a national priority to take advantage of global opportunities. Under the Agricultural Produce Marketing Regulation Act, State Governments alone are empowered to initiate the process of setting up of markets for agricultural products within a defined area. In order to encourage private sector participation and investments required for development of alternative marketing infrastructure and supporting services, provisions of the corresponding State Acts would need modification.

Industry

7.34 Since the second half of the 1990s, the industrial sector has been undergoing deep-seated restructuring in order to cope with the rigours of the changing environment. There has been heightened activity in the form of mergers and acquisitions as also in the shedding of non-core operations. The significant acceleration of growth envisaged for industry in the Tenth Plan period - from 4.5 per cent in the Ninth Plan period to 10 per cent in 2002-07 - is a major challenge, given that this expansion would have to occur in a fiercely competitive environment created by the progressive removal of barriers to entry and exit, trade liberalisation, a congenial policy regime for foreign direct investment (FDI) and a progressive extension of the process of industrial liberalisation to the State level. Issues in corporate governance have assumed increasing significance with a view to avoiding/minimising corporate failures and financial irregularities as well as to strengthen management accountability. In consonance, amendments to the Companies Act, 1956, Chartered Accountants Act, 1949, Cost and Works Accountants Act, 1959 and Companies Secretaries Act, 1980 are currently underway. Indian corporate entities are increasingly faced with the need to benchmark their corporate governance practices with the best international practices.

7.35 In order to achieve the significant step-up in industrial growth, it is vital now to expand the ambit of reforms to the difficult areas concerning land laws, the labour market, bankruptcy and exit procedures. In this context, the recent amendment to the Companies Act in 2002 ushering in the National Company Law Tribunal as a single forum for winding up of companies is a noteworthy measure. The associated repeal of the Sick Industrial Companies Act (SICA) and consequent abolition of the Board for Industrial and Financial Reconstruction (BIFR) is yet to be passed. Furthermore, the Competition Act, 2002 which replaces the Monopolies and Restrictive Trade Practices (MRTP) Act recognises the need for businesses to grow and secure the advantages/economies of scale to compete with MNCs in the global market place. Another amendment to the Companies Act has allowed for primary producers/co-operatives to produce and market industrial products in a modern and professional manner at par with other companies. This is expected to enhance the competitiveness of co-operatives.

7.36 Inadequate project appraisal and persistent time and cost overruns have been identified as major impediments to improving the international competitiveness of Indian industry. While there has been some recent improvement in the implementation of Central Sector Projects (CSPs), the proportion of delayed projects has also increased. Delays in the completion of major CSPs has led to the huge cost escalation, which currently accounts for 59 per cent (around Rs.26,000 crore) of the actual cost of delayed projects. According to the Ministry of Statistics and Programme Implementation, control on time overruns may reduce the cost overruns by 75 per cent. Time overruns in the completion of projects are mainly on account of problems relating to funds and land, apart from absence of feasibility studies before commencement of the projects, problems relating to award of contracts, equipment supply and civil works. Currently, the Railways have the largest number of projects that were delayed by more than five years. The power sector accounts for the predominant share (52 per cent) of cost overruns in respect of delayed projects. The implementation of projects in the road sector have started showing delays since February 2003, leading to the postponement of the scheduled date of completion of Golden Quadrilateral project to December 2005. The fiscal implications of delays in CSPs underscore the importance of the Tenth Plan strategy of placing full emphasis on the completion of partially completed or on-going projects as well as upgradation of existing capital assets before initiating new projects.

7.37 The significance of the Small Scale Industry (SSI) sector in terms of the objectives of nurturing new entrepreneurship, regional industrial growth and promotion of employment has been well recognised. In this regard, priority needs to be accorded to enhancement of investment limits, greater ancillarisation, and larger and quick credit flow to the SSI. There is a continuing need to undertake radical changes in the policy of reservation of certain products for the SSI sector which has impacted adversely upon growth and exports. Quantitative restrictions need to be replaced by an incentive structure which enables a greater market orientation of SSIs. The recent de-reservation of further 75 items for the SSI sector as well as the hike in investment limits for 51 items in the area of garments, hand tools, stationery items and drugs are steps in the right direction. The future of SSIs in India critically hinges on modernisation, technical up-gradation, and competitiveness in terms of quality and price. The flow of credit to SSIs has slowed down in the second half of the 1990s. Banks and other financial intermediaries need to support emerging SSIs more actively so that new entrepreneurship is encouraged to flourish.

7.38 Inflexibilities in the labour market have posed a serious problem for industrial restructuring and have also deterred new investment in labour using industries where India has a potential comparative advantage. There has been some progress in reforming the product markets; however, factor markets for labour and land have considerable structural rigidities. While Special Economic Zones (SEZs) may provide flexible labour markets, there is an urgent need to address the issue on a nation-wide scale so that employment intensive activities are encouraged. In the corporate sector, successful labour restructuring has brought modest successes and these initiatives are worthy of wider emulation.

Services

7.39 The services sector is emerging as the mainstay of the Indian growth process in recent years. The improvement in the performance in ‘financing, insurance, real estate and business services’ and ‘community, social and personal services’ has more than offset the deceleration recorded by ‘trade, hotels, transport and communication’ in 2002-03. The major contributory factors to services growth could be traced to the resurgence in financial services and housing finance, growing demand for transport and communication services and booming export demand particularly for software. An input-output analysis of the Indian economy reveals that 70 per cent of industrial activities (particularly, machinery, food processing, textiles, cement, leather, tobacco, steel, drugs, paper and rubber) are directly services-intensive. Thus, services are expected to continue leading the economy into the higher reaches of the growth potential of the economy, drawing from the strengthening linkages with manufacturing and the expansion of markets enabled by international commerce.

Fiscal Policy Issues

7.40 The progress of fiscal consolidation in the medium-term would need to hinge around a correction of the structural weaknesses in resource mobilisation as well as in expenditure management. Increasingly, the content of fiscal policy is being assessed by the quality of the adjustment. An improvement in the quality of fiscal adjustment would require cutting down consumption expenditure while maintaining or increasing the investment expenditure. At present, revenue expenditure accounts for nearly 85 per cent of Centre’s aggregate expenditure and only 15 per cent goes for investment purposes. Further, of the total revenue expenditure nearly one third is accounted for by interest payments, other major items being defence and subsidies. Given the composition of Government expenditure with large proportion of committed expenditure, compression of expenditure is very difficult. Subsidies are perhaps one area where considerable scope for reduction exists. During the year 2002-03, however, expenditure on subsidies as a proportion to GDP has gone up to 1.8 per cent from 1.4 per cent in the preceding year. Thus, given such rigidities in the composition of expenditure, significant fiscal improvement will hinge increasingly on improvement in revenue collections. Deterioration in the tax-GDP ratio at the Central level that has occurred over the past decade has to be reversed. The improvement in tax administration and use of information technology should help greatly in curbing tax evasion, and hence in enhancement of revenues.

7.41 On the expenditure front, the deteriorating State finances have led to compression of social and economic overheads. This has severely limited the ability of the States to improve the physical and social infrastructure. Accordingly, developmental expenditure needs to be earmarked sector/area-wise and monitored through targets to judge the progress of reforms. This should form an integral part of the Medium-Term Fiscal Reforms Programme (MTFRP) which already encompasses fiscal consolidation, public sector enterprises reform, power sector reforms and fiscal transparency. While there is greater monitoring of the overall debt from all sources at the State level and increasing co-ordination between regulatory bodies, MTFRP should involve strict adherence to the monitorable targets.

7.42 Another important factor constraining the States’ ability to undertake developmental activities is that of increasing pension payments, which rose from less than three per cent of revenue receipts in the early 1980s to about 10 per cent of the revenue receipts in 2001-02. Increasing pension liabilities of the State Governments have become an area of concern since they are not backed by any funding arrangements and have to be met through budgetary resources causing heavy drag on the State exchequer. There is a clear need for pension reform at the State-level.

7.43 Recognising that the mobilisation of adequate revenue is crucial to fiscal reforms, the Tenth Plan document envisages a rise in the Centre’s tax/GDP ratio from 9.0 per cent in 2002-03 to 10.3 per cent by 2007-08. Continuous efforts to improve tax administration, including IT enablement and expansion of the tax base to include the services sector are expected to enhance the buoyancy of both direct and indirect taxes. Indirect tax reforms would be based on rationalisation of rates and withdrawal of exemptions. States’ own tax revenue collections would also need to rise from 5.8 per cent in 2002-03 to 6.6 per cent of GDP by the terminal year of the Tenth Plan. In this context, the move to a unified VAT covering all goods and services assumes importance. The objective is to create a single market space and a transparent and harmonious indirect tax system which eschews distortions such as tax cascades and tax exportation. The VAT requires integration of various stages of commodity taxation between the Centre and the States. It also involves managing the problems in transition from the existing structure, including the long run effects of State VAT on the economy and on public revenue. Consensus among all the States on the principle and rates is essential so that exemptions and escape clauses in VAT rate structures and anomalies in legislation are limited.

7.44 States also need to explore alternative taxes and the scope for improvement of the tax regime and administration in the areas of stamp duties, registration fees, and motor vehicle tax, particularly with a view to preventing interstate diversions. Certain States like Andhra Pradesh have in-built buoyancy in stamp duty by relating the duty to valuation of the property. With the increasing importance of urban infrastructure and efficiency of cities for overall economic efficiency, focussed attention has to be given by States to the improvement of city finances. This will need reforms to augment the urban tax base, particularly, through the levy and collection of property taxes and more efficient assessment procedures.

Infrastructure

7.45 The composition of expenditure as well as the stock of infrastructure assets has deteriorated with the neglect of cost recovery. The principal issue is the levy and collection of appropriate user charges on the array of social and economic services which the States provide (e.g., water supply, sanitation, sewerage, transportation, education, and medical facilities). Provision for public goods has to be made from tax resources whereas private goods and services should be financed by the levy of appropriate user charges. User charges need to be indexed to input costs and the process of periodic revision should become automatic, along with appropriate provision for productivity improvements. At the same time acceptability of higher charges for such services will not be feasible unless there is greater efficiency in the delivery of these services. This requires widespread reform in the public sector - MOUs for 100 per cent metering to avoid transmission and distributional losses, setting up State Electricity Regulatory Commissions (SERC), unbundling of generation, transmission and distribution under deadlines. The issue of user charges may well be the most important in the canvas of fiscal reforms.

7.46 Key to the envisaged industrial expansion in the medium-term is the modernisation and deepening of the physical infrastructure. In the power sector, the Electricity Act, 2003 envisages liberalisation over a wide area providing for greater freedom for private investment. In the process, consumers would eventually be free to choose their suppliers of electricity in a competitive market. The Act also envisages phasing out of cross subsidies and outlines a strategy to address the poor financial health of the SEBs. The Tenth Plan also highlights the need to restore the balance between hydro (which presently accounts for only 25 per cent of total power generation) and thermal power as well as provide a thrust to nuclear power generation.

7.47 Financing the growth of infrastructure remains a major concern. Public sector resources can be effectively leveraged through greater reliance on the execution of infrastructure projects through public-private partnerships as has been recently proposed in the Union Budget. Although the demand for funds by the corporate sector reflects the dampened investment climate in the current phase of the business cycle, the supply and the tapping of these funds for infrastructure and industrial activity in general is likely to become critical as impulses of new investment gather strength. Cross-country experiences suggest that external sources play a predominant role in financing infrastructure, at least in the early and intermediate stages. The capital market, in particular, provides an efficient conduit, enabling the channelling of saving to investors of varied risk-return profiles.

7.48 The capital markets have witnessed a drastic slowdown over the last decade, mainly due to depressed primary market activity, low investor confidence and stringent norms for public issues. In the years ahead, strengthening of the role of the capital market is essential for maintaining the flow of funds through this channel. The role of the corporate bond market in this context can hardly be overemphasised. The corporate bond market in India is marked by a low investor base, lack of a variety of instruments and an illiquid secondary market. In the primary segment, corporates are innovating new arrangements to circumvent the barriers in access to markets. These off-market financing arrangements have, however, come in the way of market development, impeding price discovery and obscuring transparency, disclosure and market discipline.

7.49 The integral part of the process of market evolution is the tapping of new savings to meet the envisaged surge that is expected in investment demand over the medium-term. Contractual savings constitute the natural sources of funds that can be deployed productively in medium and long-term investments. Pension and provident funds, and insurance companies are the natural holders of such long-term funds along with the traditional instruments of small savings such as post office savings accounts. At present, such contractual savings are largely deployed in government securities for regulatory reasons or because of the perceived absence of productive opportunities for remunerative medium and long-term investments. A similar gilt bias is observed in the behaviour of banks, despite the change in regulatory environment that has blurred the boundaries between the banks and non-banks. There is need for greater innovation in risk management by all these institutions so that they can exploit better the emerging opportunities in both industrial and infrastructure financing. Financial intermediaries must also seek new arrangements to provide opportunities for the unorganised sector to deploy their savings for productive purposes. This would need improved marketing of new saving schemes along with innovative expansion of the distribution network, including the use of traditional outlets such as post offices and other retail outlets that offer synergies with other financial products. The proposed pension scheme that has been announced for the unorganised sector constitutes an appropriate step in this direction.

External Sector Issues

7.50 Over the years ahead, the progressive correction of the anti-export bias in India’s trade policies would need to be carried forward with the complete elimination of quantitative restrictions and non-tariff barriers, accelerated reduction and rationalisation of tariffs, liberalisation in the trade and payments regime and improved access to export incentives. The attainment of a current account surplus would suggest that tariff reductions could be carried out faster than envisaged earlier, without posing any significant risk to the balance of payments. In the context of the strategic export promotion policies being designed to guide an aggressive export effort, it is necessary to broaden coverage to a large number of non-traditional items and markets which are expanding above the world average. Measures introduced to ensure timely delivery of credit to exporters and to remove procedural hassles should be strengthened. The Medium Term Export Strategy announced by the Government in January 2002 involves a comprehensive plan, taking into account the contemporary global scenario, to achieve a quantum increase in exports in the medium-term coinciding with the Tenth Plan period (2002-07). This would need to be buttressed with sector-specific strategies based on demonstrated or perceived export potential. The introduction of a comprehensive system to make tax rebates to exporters transparent and comprehensive, upgradation of export infrastructure, trading agreements (free trade agreements and preferential trade agreements), improved access to bank credit and marketing infrastructure are other elements of the strategic export policy of the medium-term.

7.51 The export led growth experience of South-East Asian countries provides valuable lessons for countries like India where export performance is regarded as the key to the health of the balance of payments. This experience suggests that it is technology intensive items that will provide momentum to the export drive. In particular, it is important to seize the opportunities afforded by the progressive vacation of technology exports by Japan, East Asia and China. So far India’s export promotion policy has been broadly neutral in respect of technology upgradation, rather than focused on specific areas of technological advantage. Moreover, some elements of industrial policy such as emphasis on indigenisation, thrust on adaptation rather than innovation considerably restrict technology intensification in exports. In this context, a conscious choice between a ‘leapfrog’ from low technology to high technology exports or a more "gradualist" approach has to be made, given that India is a late entrant in the race for export markets.

7.52 Export promotion policy needs to utilise the natural complementarity of Foreign Direct Investment (FDI) with export activity. In the final analysis, it needs to be recognised that definitional issues notwithstanding, it is administrative and procedural hurdles which are the biggest impediments to larger flows of FDI into India. The time lag involved in converting investment intentions to actual flows of foreign exchange, technology and know-how must be reduced to compare favourably with investment destinations which have proven attractiveness on account of the ease in investing. The global reach and marketing abilities of FDI could be effectively utilised to provide a cutting edge to the export effort. The thrust on attracting higher FDI inflows in infrastructure sector should be dovetailed into the regulatory and pricing reforms in major infrastructure services such as power and transportation.

Financial Sector Issues

7.53 The monetary policy framework is changing in response to reforms in the financial sector. The Reserve Bank’s endeavour is to enhance the allocative efficiency of the financial sector and preserve price and financial stability. Striving for price stability and financial stability usually requires complementary and reinforcing policies; nevertheless the two objectives may occasionally be in conflict with each other. While internationally, economies have stabilised in terms of inflation and growth, financial cycles have become more pronounced. Besides the use of interest rates, the Reserve Bank is supporting financial stability by implementing policies to make the financial system more resilient. Through its monitoring mechanism, the Reserve Bank is not only striving to assess the potential problems but is also continuously monitoring risks at the macro level.

7.54 Recent domestic and international experience in the role of central banks as lenders of the last resort has highlighted some important issues. First, while the central bank’s role in providing liquidity support instills confidence to the financial system, the actual action requires the central bank to distinguish between solvency and liquidity problems. For this, the regular availability of comprehensive information is a prerequisite. Secondly, in a deregulated financial system with progressive diversification of bank ownership, shocks tend to get transmitted more rapidly across financial institutions, especially if they do not have the comfort of the backing of sovereign ownership. While the contagion can adversely affect even strong institutions, the weaker and the more fragile institutions become relatively more vulnerable to shocks. It is, therefore, imperative that banks increase their intrinsic strengths. Thirdly, as the financial system opens up, it is vital for the central bank to be more proactive in monitoring macro risks arising out of any potential fragility in the financial system. Mechanisms that throw up early warning signals so that prompt corrective actions can be undertaken would help in preventing a crisis. Recent experience has also brought to the fore the possibility of a technology risk translating into a liquidity risk. This underscores the importance of appropriate liquidity management systems in banks that are attuned to providing enhanced services to customers through technological innovations.

7.55 In the recent period, there have been significant improvements in the financial health of the banking system as reflected in the performance of certain key parameters. Banks have shown improved profitability, reduction in the net NPA ratio and improvement in capital adequacy ratio. The balance sheets of banks are looking healthier and the institutional infrastructure mounted in the financial system, including the Negotiated Dealing System (NDS), Credit Corporation of India Ltd. (CCIL) and screen based trading system for interest rate derivatives is poised to enable banks to manage their risks more efficiently. These actions would get a further boost with the operationalisation of the real time gross settlement (RTGS) system.

7.56 The Reserve Bank is also committed to the implementation of the "Core Principles for Effective Banking Supervision" drawn up by the Basel Committee on Banking Supervision. In order to achieve full compliance with these principles, steps have been taken in a phased manner to move towards a system of consolidated supervision, for enhancing the role of external auditors, strengthening corporate governance and increasing transparency and disclosure in the balance sheets of banks. In this process, monitoring the financial system by the Reserve Bank in an increasingly deregulated financial system is better facilitated.

7.57 While the overall policy environment has fostered a significant degree of financial soundness and banks have recorded higher profitability, mainly due to large investments in gilts, this should not lull them into a state of complacency. Banks need to recognise the potential interest rate risks and resort to larger provisioning and build-up of reserves including investment fluctuation reserves. Globally, the best managed banks are proactive in building up reserves when the profits are on the upswing. Timely write off and provisioning in respect of problem assets characterise the operation of many of the banks.

7.58 In line with international best practices, the Reserve Bank announced a timetable to move to the 90-day norm for loan impairment, effective end-March 2004. Since banks were provided a sufficient time frame to graduate to these new norms, it is expected that they would have built-in adequate levels of provisioning. Nevertheless, banks need to be on guard against any upsurge in the measured NPAs consequent upon the movement to the 90-day norm.

7.59 Recent trends in exchange rate and interest rate movements have fuelled greater demand by corporates for foreign currency loans from Indian banks. Considerable flexibility has been given to the corporates over a period of years to hedge their foreign exchange exposure in the market. A significant portion of the corporate foreign currency commitments remain unhedged on the basis of perceptions of the market and these could potentially have an impact on their overall financial position in case of unexpected developments. Accordingly, banks need to exercise caution in "unhedged" lending in foreign currency since exchange risk could turn easily into credit risk if exchange rate movements turn adverse. Banks also need to put in place a system for monitoring such unhedged external liabilities.

7.60 While the financial sector reforms have focused on improving the efficiency of the banking system, as the Tenth Plan has observed, it is important to finance activities that are of crucial importance for growth. It has been the endeavour of the Reserve Bank to improve the credit delivery mechanism by simplifying procedures, encouraging decentralised decision making and enhancing competition. Improving the flow of bank credit to the agricultural sector is a dominant objective of monetary policy by removing procedural impediments, upgrading institutional mechanisms for delivery and creating an environment where small and marginal farmers reap the full benefits of softer interest rate regime. In this regard, the recent lowering of public sector banks lending rates for agriculture to a ceiling of 9.0 per cent is expected to improve the channeling of bank credit to the farm sector. The cooperative banking sector has been playing an important role in the delivery of rural credit. In order to further improve the credit delivery, co-operative banking is being sensitised to the changing context of the financial regulation through enhanced standards of disclosure and governance.

7.61 With the gradual liberalisation of the Indian financial system and the growing integration among markets, the risks associated with banks’ operations have become increasingly complex, requiring strategic management. In keeping with the spirit of the guidelines on Asset-Liability Management (ALM) systems and on integrated risk management systems, banks need to design their risk management architecture, taking into consideration the size, complexity of business, risk philosophy, market perception and the level of capital. Banks are also being prepared for fine-tuning the risk management systems to deal with credit and market risk. Derivatives have been introduced in the Indian financial markets for management and hedging of market risk. The menu of derivative products has been recently expanded. Guidelines on credit derivatives for management and hedging of credit risk are being framed in consultation with banks. In pursuance of the Core Principles for Effective Banking Supervision guidelines on policies and procedures in banks for identifying/ monitoring/ controlling country risk exposures are already in place. The developments in the financial markets also emphasise the need for enhancing the scope and extent of disclosures by banks with a view to rationalising the existing disclosure requirements and make these instruments effective for ensuring market discipline.

7.62 The repeated bouts of international financial crises in the 1990s, including the recent spate of corporate accounting irregularities, have increasingly brought to the fore the multiple linkages between financial liberalisation, supervision and corporate governance. Prevention of financial fragility can come only through synergistic efforts of all stakeholders, viz., management, depositors, debtors and owners. Corporate governance assumes importance in this context in specifying the rights and responsibilities of various stakeholders and ensuring accountability within the decision making and implementation processes. Irrespective of the choice of the model for corporate governance, the key elements have to be timely and reliable public disclosures, independence of audit committees and obligations, strengthening of criminal penalties and addressing issues raising conflict of interest.

7.63 In consonance with the emerging financial environment, there is a conscious move away from micro-supervision towards off-site surveillance and risk-based supervision in India. The impetus for this has come from two sources: the need to infuse flexibility into the regime in the context of financial liberalisation, and to minimise the costs of the regulatory and supervisory function. Country experiences, including India’s own, suggest that a mix of a risk-based supervisory framework (with effective prompt corrective action), detailed disclosure norms and conscious corporate governance could minimise the costs of supervision.

7.64 In recent years, there has been a significant transformation in the operating environment of development finance institutions (DFIs). Leading DFIs are in the process of getting converted into banks and in this context, a gap is emerging in the market continuum at the long end. DFIs have played a prominent role in providing industrial finance in India, particularly during the 1980s. Until the mid-1990s they complemented rather than competed with commercial banks in providing finance to Indian corporates. Commercial banks are now expected to play a greater role in bridging the gap in demand and supply of long-term funds faced by Indian corporates. In this context, the cross-country experience yields valuable lessons and banks are already in the process of introducing structured products, largely off-market, which adapt to the risk-return profiles of corporates. In this regard, banks have to contend with institutional, operational and regulatory issues such as (i) time consuming, costly and inadequate legal infrastructure for recovery of loans, especially long-term loans, (ii) difficulties in cash management for longer-term loans under a cash credit based system, (iii) significantly higher capital charges for providing funds to corporates as opposed to investment in government securities, (iv) lack of past expertise of banks in long-term lending and the lack of information base on term lending, (v) regulatory requirement for priority sector obligation linked to bank credit rather than total assets of banks, (vi) relatively higher liquidity of long-term investments in corporate securities compared to long-term loans to corporates and greater concern for credit risk as compared to market risk. Nevertheless, banks in India are poised to enhance their role into provision of long-term financing of corporates, including in the form of multi-agency approaches.

7.65 With the process of registration of NBFCs almost over, this sector is moving towards consolidation. The mushroom growth of NBFCs has been curtailed and with the weaker units weeded out, the NBFC sector is expected to become strong and vibrant and participate in the financing of higher growth. It is, therefore, important to preserve their integrity and financial soundness so that they emerge as viable financial intermediaries in India. Towards this goal, the Reserve Bank is refining its supervisory framework based on a four pronged mechanism consisting of on-site inspections based on the CAMELS rating system, a state-of-the art technology for effective scrutiny and monitoring of the returns (COSMOS) submitted electronically, market intelligence and exception reports from Statutory Auditors.

7.66 There is a progressive diffusion of computerisation and IT in the Indian financial system. Banks are increasingly integrating their own electronic funds transfer facilities with the Reserve Bank’s Electronic Funds Transfer Scheme in order to offer innovative products to their customers. Major public sector banks are moving towards Core Banking Solutions, thus paving the way for ‘anywhere banking’ for a growing section of the banking public. Usage of the Structured Financial Messaging Solution (SFMS) by banks would help to speed up inter-bank financial communication in a secure mode, and result in quick flow of funds and financial information across branches and even amongst different banks. The payment systems in India are in the process of integration and technological upgradation, especially in large value payments. Currently foreign exchange transactions are being cleared domestically, resulting in a marked saving in terms of transaction costs. Retail payments are also being made faster and more efficient, including in debt and equity markets. The commencement of operations in the RTGS would have a positive impact on the efficiency and speed of the payment and settlement system.

Monetary Policy Issues

7.67 Since 1997, in addition to maintaining low inflation, the revival of investment demand has been an important concern in the setting of monetary policy in India. Accordingly, ensuring adequate liquidity and a preference for soft and flexible interest rates have characterised monetary policy formulation. This monetary policy stance has been signaled through cuts in the Bank Rate, LAF rates and the CRR. The pace and magnitude of easing has, however, been conditioned by the need to ensure macroeconomic and financial stability, particularly in the context of continuing large external capital flows. The full impact of the monetary policy stance on economic activity has been constrained by the structural rigidities in the financial system, especially on account of the downward inflexibility in the interest rate structure and operating costs of financial intermediaries. The conduct of monetary policy is faced with the dilemma of surplus liquidity in financial markets together with inadequate credit demand in the context of financing sustained growth in the real sector. Banks have improved their profitability by passively investing largely in government securities, reaping trading gains with the declining yields and rising prices. In this context, the improvement in banks’ post-tax profits, while welcome, does not provide much room for comfort in the medium-term.

7.68 Further refinements in operating procedures have to be carried forward, both for day-to-day liquidity management and for equitable delivery of credit. This becomes necessary in the context of the soft interest rate stance and the need to maintain adequate liquidity in financial markets, while narrowing operating spreads in policy rates as well as market related rates. With the progressive integration of different segments in the financial market, it should be possible in the medium-term to fine-tune monetary policy operations to manage market conditions through a narrow interest rate corridor. With capital flows expected to remain strong, a key issue in the future would be greater innovation in the use of available instruments to deal with the expected strong capital flows. In this regard, it needs to be recognised that sterilisation is a first stage response for ongoing liquidity management until more durable policies can be put in place to absorb capital flows for the expansion of productive capacity. Furthermore, sterilisation has in-built costs and limitations. The growing internationalisation of monetary policy arising from the cross-border integration of financial markets also emerges as an important issue. In this context the exercise of discretion in the conduct of domestic monetary policy becomes challenging. There needs to be better clarity in the rules and responsibilities of monetary policy for ensuring effective macroeconomic policy co-ordination.

7.69 The Fiscal Responsibility and Budget Management Legislation provides a framework for the appropriate ‘assignment’ of fiscal and monetary policies. The Bill prohibits the Reserve Bank from subscribing to primary issues of Central Government securities, effective 2006-07. The Reserve Bank will continue, however, to purchase and sell government paper in the secondary market depending upon evolving liquidity and monetary conditions, consistent with the price situation. This would work towards strengthening the pursuit of growth in an environment of low and stable inflation. Recognising the possibility of unforeseen or special circumstances that could disturb financial stability, the Bill provides for some flexibility in these arrangements. Under well defined exceptional circumstances, the Reserve Bank will be enabled to subscribe to primary issues in consultation with the Government of India if considered necessary for providing stability.

7.70 In recent years, valuable lessons have been emerging for conducting monetary policy from the experience with managing the external sector during periods of external and domestic uncertainties - the need to keep a continuous vigil on market developments, the importance of building adequate safety nets that can withstand the effects of unexpected shocks and market uncertainties. In this context, India’s exchange rate policy seems to have stood the test of time. It has focused on the management of volatility without a fixed rate target or a pre-announced target or a band and the underlying demand and supply conditions are allowed to determine the exchange rate movements over a period in an orderly way. The Reserve Bank will continue to follow the approach of watchfulness, caution and flexibility by closely monitoring the developments in the financial markets at home and abroad. It will co-ordinate its market operations carefully with appropriate monetary, regulatory and other measures as considered necessary from time to time.

Concluding Observations

7.71 To sum up, the macroeconomic fundamentals of the Indian economy are strong and have acquired a distinct resilience in the face of the periodic crises that characterised the previous decades. The overall policy environment has fostered macroeconomic stability, complementing financial stability, and this has generated optimism regarding the medium-term. As regards the financial sector, progress has been made in several areas, including enhancing accountability, improving management practices and corporate governance, and managing the pressures of structural changes. Considerable headway has been made in refining the regulatory and supervisory function, and fine-tuning it to the country-specific circumstances.

7.72 The main challenge that requires constant vigil in the macroeconomic management is that of reducing high fiscal deficits. Whereas expenditure containment must remain a continuing quest, particular attention must also be given to raising the tax/ GDP ratio along with concerted action to levy and collect appropriate charges for infrastructure and other services at both the Central and State levels. These actions are essential to correct and reverse the trend of increasing public sector dissavings that have emerged in recent years. Positive public sector savings are necessary to finance essential physical and social sector investments that will "crowd in" private sector investments for the achievement of self-sustaining, accelerated growth.

VIII - Monetary and Credit Policy

8.1 Monetary and Credit Policy for the year 2002-03 was formulated against the backdrop of comfortable liquidity conditions, a benign inflation environment and growing strength in the balance of payments and international reserves. The objective of revitalising investment demand dominated the conduct of monetary policy even while maintaining a continuous vigil on inflation. Accordingly, the policy stance remained accommodative with a commitment to ensure adequate liquidity to meet credit demand. A preference for softening of interest rates and greater flexibility in the interest rate structure in the medium-term was retained with changes in policy rates envisaged in response to the evolving liquidity and credit situation. Despite a modest recovery in industrial activity nurtured by the co-movement of non-food bank credit, the drastic shift in macroeconomic conditions due to the onset of the drought necessitated a preemptive easing in the monetary policy setting. Mitigating the deleterious effects of the drought on farm output and rural incomes emerged as a dominant concern. Amidst excess supply conditions in the financial markets, a decisive easing of monetary policy was signalled through cuts in the repo rate (June and October, 2002 and March 2003), in the Bank Rate (October, 2002) and in the CRR (June and November, 2002). Interest liabilities on farm loans were deferred and agricultural loans were rescheduled to provide a measure of financial relief to the drought affected areas. Improvements in the channels of bank credit flow to various sectors were facilitated by providing greater flexibility to banks in meeting allocations of lending to the priority sector, housing, the small scale sector, micro finance vehicles and rural infrastructure. Contending with large capital inflows engaged monetary policy throughout 2002-03. Efforts to sterilise the expansionary impact of the capital flows took the form of large open market sales and continuous repo operations under the LAF.

MONETARY POLICY OPERATIONS

8.2 The Bank Rate was reduced in stages to 6.25 per cent in October 2002, the lowest rate since May 1973, and by a further 25 basis points in April 2003. The Bank Rate has been reduced by 500 basis points in the last five years. This is the sharpest reduction in the Bank Rate since Independence. With the institution of the Liquidity Adjustment Facility (LAF), the repo rate has functioned as an informal floor for money market rates, providing a powerful signal to the market about the policy preference on interest rates. Ample liquidity conditions drove down money market rates frequently below the repo rate during 2002-03 prompting a 25 basis point reduction in the repo rate in June 2002, followed by another 25 basis point paring in October 2002 and a 50 basis point cut in March 2003. The repo rate has been adjusted downwards from 8.0 per cent in March 1999 to 5.0 per cent in March 2003. With a view to encouraging competition among banks and also to increase flow of credit to the export sector, interest rates on rupee denominated export credit were liberalised.

8.3 In April 2002, the ceiling rates on FCNR(B) deposits were revised downwards from LIBOR to LIBOR/SWAP rates of corresponding maturities minus 25 basis points. In April 2003, the minimum maturity period of fresh NRE deposits was raised from 6 months to 1 year in alignment with the maturity structure of FCNR(B) deposits. Effective July 17, 2003, the interest rates on fresh NRE deposits for one to three years should not exceed 250 basis points above the LIBOR/ SWAP rates for US dollar of corresponding maturity.

8.4 On a review of developments in the international and domestic financial markets, a 75 basis point reduction in the CRR during June to November, 2002 was followed by a further 25 basis points cut from June 14, 2003 taking the level of the CRR down to 4.5 per cent. The minimum daily maintenance of CRR was raised to 80 per cent of the average daily requirement for all the days of the reporting fortnight with effect from the fortnight beginning November 16, 2002. This was subsequently lowered to 70 per cent with effect from the fortnight beginning December 28, 2002. The payment of interest on eligible CRR balances maintained by banks was changed from quarterly basis to monthly basis from April 2003. The CRR has been almost halved since April 2000 resulting in cumulative release of first round resources of over Rs.33,500 crore.

8.5 From April 1, 2003, all scheduled UCBs have to maintain the entire SLR holdings of 25 per cent of NDTL in government and other approved securities only. Similarly, regional rural banks (RRBs) were required to maintain their entire SLR holdings in government and other approved securities by March 31, 2003 with SLR holdings of RRBs in the form of deposits with sponsor banks maturing beyond March 31, 2003 being reckoned for the SLR till maturity. The maturity proceeds of such deposits would have to be converted into government securities for RRBs not reaching the 25 per cent minimum level of SLR in Government securities by that time.

8.6 The medium-term objective of monetary policy is to move away from sector-specific refinance facility. Of the two standing facilities, viz., export credit refinance (ECR) and collateralised lending facility (CLF) available to scheduled banks from the Reserve Bank, the latter was withdrawn with effect from October 5, 2002.

8.7 The LAF was actively used during 2002-03 to manage the injections of liquidity due to large capital inflows. Easy liquidity conditions in the market were reflected in the large repo bids received. The average daily repo bid amount received at overnight repo auctions was significantly higher at Rs.10,315 crore as against only Rs.162 crore for reverse repos. Net open market sales were higher during 2002-03 than in the previous year and in excess of the Reserve Bank's net subscription to primary issuance of government securities.

8.8 The conduct of monetary policy during 2002-03 was reasonably successful in the context of its objectives. There was a reduction in the deposit rates across all maturities. Longer-term deposit rates of commercial banks declined more sharply than the short-term rates. PLRs of public sector banks fell modestly to 9.0 - 12.25 per cent in March 2003. Sub-PLR lending of the banking system (excluding exports, the bulk of which is at sub-PLR rates) constituted over one-third of their total lending. Notwithstanding these reductions, the effective lending rates of commercial banks reflected high spreads.

Monetary Policy Stance for 2003-04

8.9 The increasing integration of the domestic markets and the sensitivity to impulses from the international financial markets pose new challenges for the conduct of monetary policy especially to the commitment to maintain adequate liquidity in the market with a preference for soft and flexible interest rates to the extent the evolving situation warrants.

8.10 Monetary policy for the year 2003-04 is set in conditions characterised by large accretion to foreign exchange reserves and improving prospects for agriculture with the revised expectations of a normal monsoon. Accordingly, considerable optimism characterises the prospects of real GDP growth, which was initially projected at 6.0 per cent. Inflation is expected to be in the range of 5.0 to 5.5 per cent. Non-food bank credit adjusted for investments in commercial paper, shares/ debentures/ bonds of public sector units (PSUs) and the private corporate sector is projected to increase by about 15.5-16.0 per cent in order to facilitate the sustenance of growth in industrial activity.

8.11 The overall monetary and macroeconomic conditions are, at present, satisfactory and in line with policy expectations. Nevertheless, the Reserve Bank would continue to keep a constant watch on the domestic and external situation. Monetary policy for 2003-04 is guided by the objective of provision of adequate liquidity to meet credit growth and support investment demand in the economy while monitoring carefully the movements in the price level. The policy stance continues to be one of preference for a soft and flexible interest rate environment within the framework of macroeconomic stability.

IX - Development and Regulation of Financial Markets

9.1 Adequate liquidity and orderly financial conditions facilitated the progress of reforms in the money, government securities and foreign exchange markets during 2002-03. In order to promote balanced development of the various segments of the money market, and to preserve its integrity and transparency, prudential limits on exposure of banks and primary dealers to call/notice money market were applied. This was accompanied by the infusion of vibrancy into the repo, commercial paper (CP), certificates of deposit (CD) and derivatives segments by easing entry conditions and providing flexibility in issuance. The deepening of the government securities market was carried forward with stricter regulation and surveillance. In the foreign exchange market, the prime objective has been to manage volatility, while there is no fixed target for the exchange rate which is determined by market forces. Liberalisation in current and capital account transactions was continued apace with a view to augment activity in the foreign exchange market, consistent with the growing openness of the economy, and to prepare market participants for greater sensitivity to volume-driven market movements. Priority was accorded during the year to modernising the technological infrastructure for markets in the form of automated screen-based trading under the Negotiated Dealing System (NDS) and risk minimising mechanism for efficient clearing and settlement under the Clearing Corporation of India Limited (CCIL).

MONEY MARKET

9.2 The basic objective of money market reforms continues to be the development of a proper short-term rupee yield curve with sufficient liquidity in all segments. The Reserve Bank has been following a four-fold strategy. First, with a view to transforming the call/notice money market into a pure inter-bank market, a phased exit of non-banks from the call/ notice money market was started in May 2001. As the implementation of Stage I did not cause any strain in the call/notice money market and in view of the encouraging progress in NDS/CCIL, the process of moving towards a pure inter-bank call money market was accelerated with the implementation of the Stage II in June 2003. Secondly, prudential limits were assigned on call exposure during 2002-03. The objective is to ensure that banks use the call/notice money market to finance only temporary mismatches. Thirdly, with the liquidity adjustment facility (LAF) emerging as a primary instrument for modulating day-to-day liquidity conditions and providing a corridor for market play, the sector-specific standing liquidity support to the banks and primary dealers was rationalised. Fourthly, measures (discussed below) were taken to make other money market instruments freely accessible to non-bank participants. These measures were intended to improve depth, efficiency and transparency in money market operations.

9.3 The limit on maximum daily call/ notice money borrowings at two per cent of aggregate deposits at the end of March of the previous financial year, that had been placed on Urban Co-operative Banks (UCBs) was extended to State Cooperative Banks (StCBs) and District Central Co-operative Banks (DCCBs) on April 29, 2002. Furthermore, prudential limits on borrowing and lending in call/ notice money market were stipulated for scheduled commercial banks (SCBs) with a view to preserving the integrity of the financial system and facilitating the development of the repo market. A two-fold strategy was adopted in order to ensure that these banks do not face any disruption in their asset-liability management (ALM). Borrowers and lenders were allowed to unwind their positions by October 4, 2002. Second, the application of caps on banks in the call/notice money market was undertaken in two stages, commencing from the fortnights beginning October 5, 2002 and December 14, 2002, respectively. Any bank facing mismatches was allowed to approach the Reserve Bank for temporary access to the call/notice money market in excess of the stipulated limit. An increased access over stipulated norms was also permitted for a longer period for banks with fully functional and satisfactory ALM systems.

9.4 In view of the encouraging results from the functioning of NDS and CCIL and to facilitate further deepening of repo/term money market, the Stage II of the transition was made effective from the fortnight beginning June 14, 2003. Non-bank participants were allowed to lend, on an average in a reporting fortnight, only up to 75 per cent of their average daily lending in the call/notice money market during 2000-01. The Reserve Bank may consider providing temporary permission to lend higher amounts in the call/notice money market for a specific period on a case-by-case basis.

9.5 In pursuance of the recommendations of the Working Group on Rupee Derivatives (Chairman : Shri Jaspal Bindra), banks and primary dealers were permitted to undertake transactions in exchange traded interest rate derivatives in June 2003. Trading in futures contracts in notional 10-year Government of India bonds, notional 91-day Treasury Bills and 10-year zero coupon bonds commenced at the National Stock Exchange on June 24, 2003.

9.6 Collateralised Borrowing and Lending Obligation (CBLO) was operationalised as a money market instrument through the Clearing Corporation of India Ltd. (CCIL) on January 20, 2003. The CBLO has original maturity between one day and up to one year. In order to develop CBLO as a money market instrument, it has been exempted from CRR subject to banks maintaining minimum CRR of three per cent. As on July 31, 2003, 52 members were admitted in CCIL’s CBLO segment. The total turnover in CBLO during January 20, 2003 – July 31, 2003 stood at Rs.7,925 crore amounting to a daily average turnover of Rs.74 crore.

9.7 The eligibility to participate in the repo market was expanded with effect from March 3, 2003 to include non-SGL account holders like non-banking financial companies, mutual funds, housing finance companies and insurance companies. These entities were permitted to access the repo market through their "gilt accounts" maintained with the custodians. Since they do not maintain current and SGL accounts with the Reserve Bank, necessary precautions were built in to ensure "Delivery versus Payment" (DvP) and transparency while restricting the repos to government securities only. Repos between a custodian and its own clients as well as between clients of the same custodian are not permitted as DvP cannot be ensured for these transactions.

GOVERNMENT SECURITIES MARKET

9.8 Since the early 1990s, the Reserve Bank has been engaged in the deepening and widening of the primary and secondary segments of the government securities market in order to obviate the need for monetisation of fiscal deficits, as part of reforms in monetary-fiscal coordination. Significant steps taken by the Reserve Bank in the recent period include elongation of maturity, development of new benchmark government securities by consolidating new issuances in key maturities, enhancing fungibility and liquidity by reissuances of existing loans, promoting retailing of government securities, introduction of floating rate bonds, announcement of a core calendar and enhanced transparency of the Central Government’s borrowing programme.

9.9 The Negotiated Dealing System (NDS) has stabilised since its inception on February 15, 2002. Almost all market participants have joined NDS and Subsidiary General Ledger (SGL) transactions at the Public Debt Office (PDO), Mumbai are now on electronic mode through NDS.

9.10 Clearing Corporation of India (CCIL) commenced operations with transactions in government securities as well as Rupee/US dollar foreign exchange spot and forward deals since November 12, 2002. Effective April 1, 2003 all transactions in government securities in the Public Debt Office (PDO), Mumbai are now being settled through CCIL which has resulted in significantly reduced funding requirement for every member and mitigation of liquidity risk.

9.11 Buying and selling of government securities through the stock exchanges (National Stock Exchange (NSE), Stock Exchange Mumbai (BSE) and Over the Counter Exchange of India (OTCEI) was allowed with effect from January 16, 2003 on an anonymous screen-based order-driven basis to facilitate countrywide access and wider participation in the government securities markets.

FOREIGN EXCHANGE MARKET

9.12 Reforms in the foreign exchange market were carried forward to deepen various segments of the market and impart sophistication to its functioning. Market participants were allowed greater flexibility of operations in both spot and forward segments, especially in managing risks. Alongside the introduction of new instruments, significant liberalisation was effected in international current and capital transactions. These efforts are intended to prepare the market for equilibrating significantly higher volumes, and for improving the process of price discovery, supported by the ongoing modernisation of the technological infrastructure. The development of the foreign exchange market in India has been facilitated by the stance of exchange rate policy –underlying demand and supply conditions are allowed to determine exchange rate movements in an orderly manner.

Outlook

9.13 The Reserve Bank has pursued a process of consultation with market participants in its endeavour to deepen and widen the financial markets so as to enhance allocative efficiency, preserve financial stability and improve the transmission of monetary policy. The objective is to ensure balanced development of various segments of the financial market as also to preserve integrity and transparency of market operations. The operationalisation of the CCIL, NDS and CFMS combined with the advanced stage of implementation of centralised PDO and the RTGS system would contribute to efficient functioning of the markets. Simultaneously, efforts are underway to reduce market overlap and to develop segments which cater exclusively to specific classes of instruments and participants. This will enhance efficiency and contain risk in a systemic sense.

9.14 The progress of money market reforms so far has been satisfactory and without undue strains on market conditions. The transformation of the call/notice money market into a pure inter-bank market is progressing and the accessibility of non-banks would be further reduced before being eventually phased out. The implementation of borrowing restrictions on primary dealers in call/notice money market is contingent on further developments in the repo market. A wider array of hedging instruments have been made available to the market as banks and PDs have been permitted to undertake exchange traded futures and foreign currency-rupee OTC options with suitable safeguards.

9.15 In the government securities market, various measures are being undertaken to widen the base of repo transactions by extending coverage to CSGL account holders, and to allow rollover of repo contracts using the same securities between the same counter-parties. Allowing sale of securities purchased under repo, widening of the repo market to all entities including corporates and extending the eligibility to all debt instruments including rated corporate bonds are some of the measures under active consideration. Furthermore, a "when issued" market for government securities would help efficient price discovery in the primary auctions. Widening of the instrument base through introduction of inflation indexed bonds and STRIPS in the government securities market is in progress. Measures to further develop the retail market for government securities using PDs and banks are being considered. The scheme of trading of government securities on stock exchanges through order-matching screen-based trading has been introduced and ways of enhancing investor interest are being examined. The implementation of the next phase of the PDO-NDS project involving integration with security settlement system and primary markets operations, automation and inter-connectivity of PDOs, electronic maintenance of record of ownership will represent a step forward in improving the government securities market.

9.16 With regard to the foreign exchange market, the Reserve Bank will continue to follow the approach of preparing the market for transacting rising volumes of international transactions. A key priority is to avoid disruptive shifts in volatility and market sentiment. Accordingly, the Reserve Bank will continue its stance of watchfulness, caution and flexibility by closely monitoring the developments in the markets at home and abroad, with appropriate monetary, regulatory and other measures as considered necessary from time to time.

X Financial Regulation and Supervision

10.1 In India, progressive strengthening of the regulatory and supervisory framework has been a key element of financial sector reforms. There has been significant progress in achieving international best practices in banking regulation and supervision. Within the process of convergence with best practices, fine-tuning is undertaken keeping in view the country-specific circumstances. The process of refining the crucial functions of regulation and supervision of the financial system in India gathered further momentum in 2002-03 in the context of dramatic shifts in the macroeconomic and financial environment. The focus of policy initiatives during the year was on streamlining banking operations, upgrading risk management systems, enhancing the level of compliance by banks with the Accounting Standards and operationalising consolidated accounting practices. A major development in the evolving institutional infrastructure for financial regulation was the enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 which is expected to improve the recovery of non-performing loans. Policies for regulation and oversight of the financial system were guided by the objectives of increasing operational efficacy of monetary policy, redefining the regulatory role of the Reserve Bank, strengthening prudential norms and developing the technological and institutional infrastructure.

THE BOARD FOR FINANCIAL SUPERVISION (BFS)

10.2 The Board for Financial Supervision (BFS), formed in November 1994 under the aegis of the Reserve Bank, is responsible for an integrated system of supervision of banks, financial institutions (FIs) and non-banking financial companies (NBFCs) regulated by the Reserve Bank.

10.3 During 2002-03 (July-June), the BFS held 11 meetings. It reviewed the performance of regulated financial entities on the basis of 101 Inspection reports of banks/FIs. The Board also reviewed the monitoring of bank frauds, house-keeping in PSBs, including reconciliation of entries in inter-branch accounts, inter-bank accounts (including Nostro accounts) and balancing of the books of accounts. The performance of Primary Dealers (PDs) as a group was reviewed by the BFS. Besides delineating the course of action to be pursued in respect of institution-specific supervisory concerns, the BFS provided guidance on several regulatory and supervisory policy decisions.

10.4 At the initiative of the BFS, studies were also conducted on the impact on capital adequacy of converting excess SLR holdings into loan assets, capital market exposures of banks and the differences in the provisioning norms being followed by Indian banks and those applicable to banks in the US under their Generally Accepted Accounting Principles (GAAP). Another important study conducted under the direction of the BFS was the analysis of slippages of NPA accounts from sub-standard to doubtful/loss category.

10.5 Keeping in view the emerging supervisory concerns, six banks in the old private sector group and five banks in the new private sector group were placed under monthly monitoring. The scope of monthly monitoring is being expanded to include the progress in recovery of NPAs.

SCHEDULED COMMERCIAL BANKS

10.6 Subsequent to the introduction of the SARFAESI Act, 2002, the Reserve Bank issued fresh guidelines for onetime settlement scheme in January 2003 for compromise settlement of chronic NPAs up to Rs.10 crore in PSBs. These guidelines cover: (a) all NPAs in all sectors, irrespective of the nature of business, which have become doubtful or loss assets as on March 31, 2000 with outstanding balance of Rs.10 crore and below on the cut-off date; (b) NPAs classified as sub-standard as on March 31, 2000, which have subsequently become 'doubtful' or 'loss' assets; and (c) cases in which the banks have initiated action under the SARFAESI Act, 2002 and also cases pending before Courts/ Debt Recovery Tribunals (DRTs)/Board for Industrial and Financial Reconstruction (BIFR), subject to consent decree being obtained from the Courts/DRTs/BIFR. The last date for receipt of applications from borrowers under the scheme is September 30, 2003.

10.7 Guidelines for the special OneTime Settlement (OTS) scheme for loans up to Rs.50,000 to small and marginal farmers by PSBs were operative up to December 31, 2002. They were extended up to March 2003 in view of requests received from banks and the drought/ flood situation in various parts of the country.

10.8 The Reserve Bank issued guidelines to commercial banks and FIs to enable them to make increasing use of Lok Adalats. They were advised to participate in the Lok Adalats convened by various DRTs/DRATs for resolving cases involving Rs.10 lakh and above to reduce the stock of NPAs.

10.9 The Debt Recovery Tribunal (Procedure) Rules 2003 were amended substantially regarding application fee and plural remedies for better administration of the Recovery of Debts due to Banks and Financial Institutions Act, 2002. The passage of the SARFAESI Act, 2002 has provided the necessary impetus for banks and FIs to hasten the recovery of the dues.

10.10 Off-site monitoring and surveillance (OSMOS) function was established in 1995 with the primary objective of analysing the financial position of banks in between on-site inspections. A comprehensive OSMOS became fully operational in 1997. Since then, the scope and coverage of the off-site returns have been enhanced significantly. In view of the recent initiatives on consolidated supervision, country risk management and risk-based supervision, certain additional data needed to be collected through the off-site returns. Accordingly, an upgraded OSMOS system, including new returns as well as enhancing the coverage of the existing ones, has been implemented from the quarter ended June 2003.

10.11 Guidelines on consolidated supervision were issued to banks for implementation with effect from the year ended March 2003. Banks were advised to ensure strict compliance commencing from the year ended March 31, 2003. This would enable the Reserve Bank in adhering to the Core Principles for Effective Banking Supervision.

10.12 The scheme of prompt corrective action (PCA) was developed for preemptive adjustments by troubled banks to early signs of financial vulnerability. The scheme is in operation, initially for a period of one year from December 2002. Continuation or otherwise of the PCA framework as well as modification in the trigger levels or actions to be taken will be reviewed in December 2003.

10.13 To ensure a smooth transition to Risk Based Supervision (RBS) and to facilitate the requisite preparation, commercial banks were involved in a consultative process to identify the support required by them in this regard. The Risk Profile Template (RPT) has been tried by banks for undertaking self-assessment of risks and found suitable. Training of commercial bank officers as well as the Reserve Bank supervisory staff at the training colleges of the Reserve Bank has made considerable progress. On-location and dedicated programmes on risk based supervision and risk management have also been conducted for banks. The RBS Manual has been prepared for use by the Reserve Bank supervisory staff. The pilot run of risk-based supervision of select banks was initiated during the quarter April-June 2003.

10.14 Several countries, including India, have undertaken efforts towards developing macro-prudential indicators (MPIs) for monitoring the health of the financial system. Accordingly, a pilot review of MPIs was prepared for the half-year ended March 2000, followed by regular half-yearly reviews from September 2000 onwards for internal circulation. The scope and coverage of MPIs were enhanced in the review for the half-year ended March 2002.

10.15 The Government of India introduced Special Economic Zones (SEZs) with a view to providing an internationally competitive and a hassle-free environment for export production. For the first time, Offshore Banking Units (OBUs) were permitted to be set up in SEZs. These units would be virtually foreign branches of Indian banks but located in India. These OBUs, inter alia, would be exempted from cash reserve requirements and would be able to provide finance to SEZ units and SEZ developers at international rates of interest.

10.16 The Reserve Bank has been continuously making efforts to ensure convergence of its supervisory norms and practices with the international best practices. In regard to accounting standards issued by the Institute of Chartered Accountants of India (ICAI), banks in India are generally complying with most of these standards.

10.17 Scheduled commercial banks (SCBs) improved their profitability in 2002-03. Net profits (as a ratio of total assets) increased from 0.8 per cent during 2001-02 to 1.0 per cent during 2002-03, largely due to higher non-interest income and lower interest expenses. Non-interest income increased from 1.6 per cent of total assets in 2001-02 to 1.9 per cent in 2002-03 on account of treasury operations. Reflecting the soft interest rate environment, interest income as well as interest expenses (both as a ratio to total assets) moderated during the year to 8.4 per cent and 5.6 per cent, respectively. The reduction in the interest expenses ratio (around 22 basis points) was relatively sharper than that on the income side (around four basis points) suggesting that decline in lending rates was not commensurate with that in deposit rates. Banks were able to contain their operating expenses at 2.3 per cent of their total assets. At the end of March 2003, almost all SCBs (92 out of a total of 93) complied with the regulatory requirement of CRAR of nine per cent. There was a further improvement in the NPAs position of banks, both in relation to assets and advances. This reflected, inter alia, recent initiatives at improving recovery. The number of banks with net NPAs (as a proportion of net advances) above 10 per cent fell from 23 during 2001-02 to 12 during 2002-03.

CO-OPERATIVE BANKING

10.18 Since 2001-02, the Reserve Bank has undertaken a series of measures directed towards strengthening the financial position of the UCBs, such as applying capital adequacy standards, prescribing an asset-liability management framework, enhancing the proportion of holding of Government and other approved securities for the purpose of SLR, restriction on bank finance against the security of corporate shares and debentures. During 2002-03, these efforts were reinforced. Deposits and advances of scheduled UCBs increased marginally during the year, and their growth was significantly lower than that of the commercial banking system. A positive aspect of the performance of the UCBs was a reduction in net NPAs, both in absolute terms as well as a proportion to net advances, reflecting the recent supervisory initiatives.

FINANCIAL INSTITUTIONS

10.19 During 2002-03, the main focus of policy initiatives of the Reserve Bank for select all-India financial institutions¹ (FIs) was on imparting operational flexibility, strengthening the prudential regulatory and supervisory framework, and improving accounting and auditing standards. The Government undertook restructuring packages for some of the FIs, taking into account their financial performance, rising NPAs, adverse market conditions for raising resources, and challenges posed by commercial banks under a competitive environment. All FIs, except IFCI Ltd. and IIBI Ltd., had a CRAR much above the norm of nine per cent as at end-March 2003. The net NPAs of all-India FIs increased during 2002-03 due to slow economic recovery, sectoral bottlenecks and adverse domestic/international market conditions. IDFC Ltd., NHB and NABARD continued to maintain nil or negligible NPAs. The Corporate Debt Restructuring (CDR) mechanism became operational from March 2002 with the execution of the Inter-Creditor Agreement (ICA) on February 25, 2002 by 47 institutions/ banks. The CDR Empowered Group approved final schemes in respect of 41 cases in which aggregate assistance by financial system amounted to Rs.38,638 crore; 18 cases were rejected and the remaining 12 cases are being processed.

NON-BANKING FINANCIAL COMPANIES

10.20 At end-June 2003, a total of 37,859 applications were received by the Reserve Bank for grant of Certificate of Registration (CoR). Of these, approval was granted to 13,863 applications, including 725 applications of companies authorised to accept/hold public deposits. At the end of September 2002, almost 94 per cent of the NBFCs reported a CRAR equal to or in excess of the stipulated minimum of 12 per cent with as many as 74 per cent reporting a CRAR above 30 per cent. The gross and net NPAs of reporting companies have been showing a declining trend. The gross NPAs, which formed 12.0 per cent of the credit exposure in September 2001, came down to 9.7 per cent in September 2002. Over the same period, the net NPAs came down from 5.8 per cent to 4.3 per cent of credit exposure.

Outlook

10.21 Over the medium-term, the conduct of financial regulation and surveillance in India would progress from micro-regulation to macro-management, supported by a tightening of prudential norms and improvements in the functioning of the financial markets. A clearer definition of the regulatory role of the Reserve Bank is emerging within the broader debate on the conflict of interest between ownership and regulation. Co-operative banking is being sensitised to the changing context of financial regulation through enhanced standards of disclosure and governance, and a disentangling of the existing regulatory overlap.

10.22 The supervisory strategy of the Board for Financial Supervision would increasingly blend on-site inspection, off-site surveillance, enhanced role of external auditors and strengthening of corporate governance. Banks need to prepare for switching fully to risk-based supervision by 2003 by identifying information gaps in the compilation of risk profiles and training of personnel. The supervisory follow-up process will then involve a monitorable action plan including remedial actions and timely corrective steps.

10.23 Banks are being encouraged to improve the reliability and robustness of their risk management, management information and supervisory reporting systems. A scheme of prompt corrective action based on early warning triggers is evolving as a supervisory tool and would increasingly be adapted to country-specific circumstances. In addition to macro-prudential indicators of financial vulnerability being reviewed in India, financial soundness indicators have been proposed as early warning signals. The Reserve Bank and the Government have initiated a wide range of legal reforms to enable the regulatory and supervisory regime to keep pace with advancements in information and communication technology.

XI - Public Debt Management

11.1 Debt management in 2002-03 continued to be directed at minimising cost, keeping in view the rollover risk, within the overall objectives of monetary policy. The borrowing programmes of the Central and State Governments were completed successfully with gross market borrowings of Rs.1,81,979 crore. The Central Government mobilised market borrowings to the tune of Rs.1,51,126 crore (net Rs.1,04,118 crore) during 2002-03 as against Rs. 1,33,801 crore (net Rs.92,302 crore) in the preceding year. The gross and net borrowings through dated securities amounted to Rs.1,25,000 crore and Rs.97,580 crore, respectively while Rs.26,126 crore (gross) and Rs.6,538 crore (net) were raised through 364-day Treasury Bills. The gross and net market borrowings of the State Governments amounted to Rs.30,853 crore and Rs.29,064 crore in 2002-03 as compared with Rs.18,707 crore and Rs.17,261 crore in the preceding year, respectively. Comfortable liquidity conditions due to increased capital flows, absence of pressures on account of credit off-take, and reductions in CRR combined with appropriate private placements, facilitated the smooth completion of a large market borrowing programme. The weighted average cost of borrowings declined significantly during the year, benefiting from falling yields due to easy liquidity conditions and low inflation.

11.2 The Reserve Bank continued to combine private placements with open market operations to meet the twin objectives of managing liquidity in the system and containing volatility in the secondary market. New initiatives in debt management included pre-payment of external debt against issue of domestic debt, a debt-swap scheme for the State Governments and a debt buy-back scheme which involved buying back of high cost and illiquid securities issued in the past in exchange of new securities at the prevailing market yield. Comprehensive restructuring of the scheme of Ways and Means Advances (WMA) and overdraft (OD) for States was also undertaken during 2002-03.

CENTRAL GOVERNMENT

11.3 The Ways and Means Advance (WMA) limits of the Centre were maintained at Rs.10,000 crore for the first half (April-September) and Rs.6,000 crore for the second half (October-March) of 2002-03. The daily average utilisation of WMA and overdraft (OD) was, however, significantly lower.

11.4 The gross amounts raised through 91-day and 364-day Treasury Bills were higher during 2002-03. There was no devolvement on the Reserve Bank in any auction of the Treasury Bills during 2002-03. During the current year so far (up to August 6, 2003) the primary yield of 91-day and 364-day Treasury Bills declined by 97 and 94 basis points, respectively, from their March-end levels. Since April 23, 2003, the primary yields of both 91-day and 364-day Treasury Bills fell below the repo rate, mainly due to abundant liquidity. The notified amount of 91-day Treasury Bills was enhanced from Rs. 500 crore to Rs. 1,500 crore for eight auctions from August 6, 2003 to September 24, 2003 keeping in view the prevailing liquidity conditions in the system.

11.5 The Central Government raised a gross amount of Rs.1,25,000 crore and a net amount of Rs.97,580 crore during 2002-03 through issuance of dated securities. The gross and net market borrowings increased by 9 per cent and 11 per cent, respectively, over the preceding year. The ratio of net market borrowing through dated securities to the gross fiscal deficit moved up to 67.1 per cent in 2002-03 from 62.2 per cent in 2001-02. The policy of elongation of maturity of government securities was persevered with. The maximum maturity of securities issued was extended to 30 years in 2002-03 as compared with 25 years in 2001-02. There was a marginal fall in the weighted average maturity of securities issued during the year. This occurred mainly because of the issuance of securities for prepayment of foreign debt on maturity matched basis for an average tenor of 9.3 years. The scheme of non-competitive bidding, which was introduced in January 2002 to facilitate investment by retail and mid-segment investors in Central Government securities, was made an integral part of the borrowing programme since October 2002. During 2002-03, out of a total reserved amount of Rs.4,050 crore, the non-competitive bidders were allotted Rs.1,302 crore, amounting to 32.2 per cent of the reserved amount. In the individual auctions, the response of non-competitive bidders varied from 8 per cent to 88 per cent of the reserved amount.

11.6 In line with the policy of ensuring sufficient securities in the portfolio of the Reserve Bank to conduct open market operations (OMO), the Government of India converted Rs.40,000 crore of 4.6 per cent Special Securities held in the Reserve Bank's portfolio into marketable securities of various maturities (3 to 18 years) at the prevailing yields in 2002-03. The outstanding balance of the Special Securities has accordingly diminished.

11.7 The budget estimate of the net market borrowing of the Central Government through dated securities for the year 2003-04 is placed at Rs.1,07,320 crore. Including repayments of Rs.32,910 crore, the gross market borrowing through dated securities amounts to Rs.1,40,230 crore, an increase of 12.2 per cent over the previous year's level. The calendar for the first half covering 50.6 per cent of the market borrowing programme was announced on March 31, 2003.

11.8 During the current year so far (up to August 7, 2003), the Central Government raised gross amount of Rs.88,434 crore (net Rs.61,316 crore), including Rs.14,434 crore raised on account of buy-back of Government securities; and Rs.5,000 crore was through private placement. On May 19, 2003, a Floating Rate Bond 2014 was issued for the notified amount of Rs.5,000 crore. The maximum amount for non-competitive bidding was raised from Rs. 1 crore to Rs. 2 crore from this auction onwards. The cut-off yield was at 5.09 per cent, 14 basis points above the variable base rate. Under the modified design of floating rate bonds, the variable base rate is determined on the basis of average cut-off yield emerging in the preceding three auctions of 364-day Treasury Bills instead of preceding six auctions earlier. It also provides for annual reset of variable base rate for fixation of coupon as against half yearly reset earlier. The coupon payment, however, continue to remain semi-annual.

STATE GOVERNMENTS

11.9 The Reserve Bank provides WMA to States with a view to help them tide over temporary mismatches in cash flow. The WMA limits are fixed by the Reserve Bank from time to time. Drawing from the recommendations of the Ramachandran Committee (2002) and consultations with the State Governments, the Reserve Bank revised the Scheme of Ways and Means Advances for the States, effective March 3, 2003 to give them the benefit of higher limits in the last month of the fiscal year. The revised normal WMA limits have been computed by taking into account the average of revenue receipts for the three fiscal years 1999-2000, 2000-01 and 2001-02 and then applying a multiplication factor of 3.19 for the non-special category States and 3.84 for the special category States. The total normal WMA limits effective from March 3, 2003 at Rs.7,170 crore was 18.8 per cent higher than the earlier limit of Rs.6,035 crore.

11.10 States resorted to large volumes of market borrowings in 2002-03. States raised Rs.30,853 crore (Rs.27,880 crore through tap issuances and Rs.2,973 crore through auctions), an increase of 65 per cent over Rs.18,707 crore (Rs.15,942 crore through tap issuances and Rs.2,765 crore through auctions) during 2001-02. The interest rates on tap issues ranged between 6.60-7.80 per cent with a spread fixed in the range between 38-52 basis points over the corresponding secondary market yield of Government of India dated securities. The cut-off yields on auctions ranged between 6.67-8.00 per cent with a spread ranging between 20-76 basis points over the corresponding secondary market yield of Government of India dated securities. Of the States that used the auction method, some were able to mobilise loans at competitive rates (Punjab and Andhra Pradesh) while others had to pay higher rates (Kerala and Jammu and Kashmir).

11.11 The Union Budget for 2003-04 has envisaged measures for debt restructuring as a part of fiscal consolidation. They encompass pre-payment of external debt, buy-back of loans by the Government from the banks on voluntary basis and restructuring of State Governments' debt to the Centre through a debt swap scheme. The Central Government prepaid foreign currency loans to these institutions amounting to US $ 3.0 billion. The possibility of further repayments of external debt is being explored.

11.12 The buy-back of high coupon loans by the Central Government from banks and debt-swap by the State Governments are the two schemes aimed at restructuring the domestic debt.

Outlook

11.13 The conduct of debt management continues to be driven by the objectives of reducing costs and elongating maturities while ensuring the smooth completion of the Centre's and States' borrowing programmes. The process of debt consolidation and efforts at enhancing the benchmarking of securities would be persevered with. Undue elongation of the maturity profile could increase interest rate risks. Accordingly, the issue of capital indexed and more floating rate bonds are under active consideration. It is expected that stripping of government securities will be operationalised after the Government Securities Act is passed in the Parliament. In the case of Treasury Bills, as in the past, the amounts offered in the auctions would be modulated keeping in view the liquidity conditions. In the secondary market, measures like rollover of repo and operationalisation of DVP III settlement system, measures to further develop the retail market for government securities using the PD network and banks would be accelerated. The Reserve Bank would develop the debt markets further through over the counter (OTC) as well as exchange traded interest rate derivatives (interest rate futures trading has commenced since June 24, 2003). Efforts are underway to introduce interest rate options on exchanges, broaden the eligible underlying to other items in the balance sheet for hedging through derivatives and permit market making to those banks that have the required risk management capabilities. Initiatives are being taken to harmonise regulations in respect of OTC derivatives with exchange traded interest rate derivatives.

XII - Currency Management

12.1 The core central banking function of note issue and management of currency in circulation is performed by the Reserve Bank with the objectives of ensuring adequate availability of notes and coins in the economy and maintaining the quality of notes in circulation. This is done through its 18 regional Issue Offices/sub-offices and a wide network of currency chests, repositories and small coin depots spread across the country. In 2002-03, the sub-offices of the Issue Department at Bhopal and Chandigarh and the currency chest at Jammu were converted into full-fledged Issue Offices. Sixty-four additional currency chests and 46 additional small coin depots were opened during the year. The demand for notes and coins was addressed by sending remittances to currency chests and by issue of notes and coins over the counters of Issue Offices. With improvements in the supply position of fresh notes and coins, efforts were directed towards improving the quality of notes in circulation through a number of measures. Adequate supply of fresh notes to bank branches during episode of liquidity stress was ensured by keeping the vaults of Issue Offices open beyond office hours and also on sundays/public holidays.

Clean Note Policy - Quality of Notes in Circulation

12.2 In pursuance of the Clean Note Policy, efforts for improving the quality of notes in circulation were directed towards replacing soiled notes in circulation by fresh or reasonably good quality notes. Key measures in this regard included mechanisation of note processing-cum-verification and eco-friendly destruction of soiled notes, widening of the currency chest network, non-stapling of note packets, speeding up handing over and taking over of remittances by the chests, and continuation of anti-counterfeit steps.

12.3 Tracking of new type of forgeries and scrutiny in association with the Security Paper Mill and Note Printing Presses is an important step. The Reserve Bank's main thrust continues to be on dissemination of security features of bank notes to the public and other agencies like banks, Government departments, police and intelligence agencies. Enhanced security features in the form of improved public features and machine-readable features in bank notes are being incorporated in consultation with the Government of India. The notes in the Ashoka Pillar Series, i.e., Ashoka Pillar in watermark window, are being phased out from circulation as they do not contain adequate anti-counterfeit security features as compared with the Mahatma Gandhi series notes which were introduced in 1996.

12.4 The Reserve Bank would pursue its objective of meeting the currency demand of the economy and improving the quality of notes. Installation of additional Currency Verification and Processing Systems would be undertaken to ease the accumulation of soiled notes in the Issue Circles. Constant surveillance over the system of distribution of notes and coins would be strengthened with a view to enlarging/improving the distribution of fresh notes and coins. Innovative measures like distribution of coins through post offices would be expanded. Customer service would be upgraded through mobile issue of coins and introduction of Rs.10 coins. Enhanced security features in the form of improved public features in bank notes are being devised to prevent counterfeiting. These features will be complementary to the process of mechanisation of currency operations.

XIII - Payment and Settlement Systems

13.1 The information technology revolution has thrown up powerful synergies with banking and finance. In particular, there are four key areas in which the financial system has experienced the benefits of the technology revolution: product development, market infrastructure, risk control and market reach. In the process, technology has changed the contours of three major functions of financial intermediaries: access to liquidity, transformation of assets and monitoring of risks.

13.2 In recent years, the Reserve Bank has assigned priority to upgrading the technological infrastructure of the Indian financial system. Efforts have been made to modernise clearing and payment through Magnetic Ink Character Recognition (MICR) based cheque clearing, Electronic Clearing Services and Electronic Funds Transfer (ECS and EFT) and the Centralised Funds Management System (CFMS). A key prerequisite for the development of the financial system is a modern, efficient, integrated and secure payment and settlement system. The goal is to put in place systems which conform to international standards and best practices.

13.3 At present, key large value payment systems such as the Negotiated Dealing System (NDS) and foreign exchange clearing adhere fully to the Core Principles for Systemically Important Systems of the Bank for International Settlements (BIS). Retail payment systems comply partially with the Core Principles. Efforts are on to make these systems also fully compliant to the Core Principles by providing a legal basis for netting and provision of risk reduction measures for netting systems.

13.4 The Reserve Bank is in the process of implementing the National Electronic Funds Transfer (NEFT) System - a nation-wide electronic funds transfer system - to provide for transfer of funds electronically across a large number of bank branches in the country. As a first step, a Special Electronic Funds Transfer (SEFT) System was implemented with effect from April 1, 2003. The System is designed to provide for same day inter-bank transfer of funds between accounts maintained in any of the designated participating branches which are networked so that SEFT messages could be transmitted electronically. SEFT provides for multiple daily settlements, with three settlement cycles on weekdays (at 12:00 noon, 2:00 p.m. and 4:00 p.m.) and two settlements on Saturday (at 12:00 noon and 2:00 p.m.). The System also facilitates timely funds settlement for the T+2 based rolling settlement introduced for settlement of securities at the stock exchanges.

Settlement Systems

13.5 The imperative for ensuring the integrity of settlement systems stems from the need to minimise risks inherent in payments. The settlement of foreign exchange clearing operations, which commenced from November 2002, is guaranteed by the Clearing Corporation of India Ltd. (CCIL). Effective May 1, 2003, all inter-institutional over-the-counter (OTC) transactions in Government securities, whether outright or repo, are traded through the NDS only.

Information Technology (IT) in the Reserve Bank

13.6 All activities of the Reserve Bank are getting increasingly IT-enabled. The implementation of IT in the Reserve Bank is based on the mission "IT for Overall Efficiency and Excellence". The Reserve Bank aims to bring in transaction processing and analytical capabilities at the desk top of each official in order to equip the functionaries to complete transactions in a timely and accurate manner and to make informed decisions. This will also usher in a Less-Paper Office. Furthermore, the Reserve Bank is committed to providing efficient customer service to the Governments, banks, financial institutions and general public, using the tools and solutions offered by information and communication technology.

13.7 In order to address each constituent of the INFINET/SFMS system uniquely, a system of Indian Financial System Codes (IFSC) was designed during 2002-03, similar in approach to that of SWIFT.

Outlook

13.8 The Reserve Bank will continue with its efforts to establish a modern, robust, efficient, secure, and integrated payment and settlement system for the country. Significant milestones in this path are the Negotiated Dealing System for transactions in Government securities and the Clearing Corporation of India. The INFINET would emerge as the communication backbone of the financial system. The operationalisation of RTGS System would enable real time funds transfers across different banks and thereby provide for optimal utilisation of funds.

13.9 The future of banking and finance hinges around the exploitation of opportunities thrown up by the technology explosion. This requires the combined efforts of all participants in the financial system. In December 2001 the Reserve Bank set out its vision of the road ahead in the document entitled "Payments System in India", to share this vision with all participants and the nature and direction of reforms needed to achieve it. The collective goal should be to make use of synergies between technology and finance to maximise the benefits to society.

XIV - Human Resource Development and Organisational Matters

14.1 The response of the Reserve Bank to the challenges imposed by the changing economic and business environment has been reflected in its approach to human resource management, notwithstanding the rigidities confronting it. The traditional institutional structure and culture has sometimes operated as a drag on human resource development, particularly in skill development, management change and career planning. This has been counteracted by recruiting skilled manpower from the open market to a certain extent, including some lateral induction of experts and redeployment of existing staff in new activities after suitable training. A major challenge is to develop the special competencies and skills for an environment of deregulation and openness driven by growing sophistication of operations and ever-expanding frontiers of information technology. In this milieu, building and reinforcing a corporate vision and culture that fosters creativity and recognises talent and merit is critical.

XV - The Reserve Bank's Accounts for 2002-03

Appropriation of Net Disposable Income

15.1 The net disposable income of the Reserve Bank for the year 2002-03 amounted to Rs.8,838.00 crore.

15.2 The surplus transferable to the Central Government for the year 2002-03 amounted to Rs.8,834.00 crore, inclusive of Rs.1,717.00 crore towards interest differential on special securities converted into marketable securities. The transfer on account of interest differential is intended to compensate the Government for the difference in interest expenditure, which the Government had to bear consequent on the conversion.

INCOME

15.3 The gross income of the Reserve Bank for the year 2002-03 (July-June), was Rs.23,185.64 crore which was lower by Rs.1,504.70 crore (6.1 per cent) as compared to the previous year's total income of Rs.24,690.34 crore. The fall in income from domestic sources was due to fall in domestic assets and lower interest rates. The fall in income from foreign sources was due to reduction in international interest rates.

15.4 During the year 2002-03, the return on foreign currency assets excluding capital gains less depreciation decreased to 2.8 per cent from 4.1 per cent during 2001-02 because of lower interest rates abroad. However, taking into account the capital gain on securities, the net earnings went up from 2.8 per cent to 3.1 per cent during 2002-03. The foreign securities held in the Reserve Bank's portfolio are valued at the end of every month at the lower of book value or market rate. If the market rate is lower than the book value, depreciation to the same extent is provided for. Appreciation is neither taken to profit and loss account nor to the reserves.

15.5 Domestic income decreased by Rs.1,344.89 crore (9.1 per cent) from Rs.14,703.88 crore in 2001-02 to Rs.13,358.99 crore in 2002-03.

15.6 Profits booked on sale of securities amounted to Rs. 4,798.03 crore in 2002-03 representing an increase of Rs. 1,737.99 crore over the previous year. The net open market operations sales amounted to Rs.53,780 crore in 2002-03 as compared to Rs.30,335 crore in 2001-02. The interest income on ways and means advances showed decrease of Rs.339.98 crore during 2002-03 from Rs.952.48 crore in 2001-02 to Rs.612.50 crore in 2002-03, reflecting decreased recourse by the Central Government to this facility and also lower bank rate. Interest earnings from loans and advances to banks/financial institutions declined by Rs.769.31 crore from Rs.1,170.44 crore in 2001-02 to Rs.401.13 crore in 2002-03, due to lower utilisation of refinance facility by Primary Dealers/Scheduled Commercial Banks combined with lower interest rates applicable on these advances.

EXPENDITURE

15.7 Total expenditure of the Reserve Bank increased by Rs.181.02 crore (2.8 per cent) from Rs.6,542.39 crore in 2001-02 to Rs.6,723.41 crore in 2002-03.

Interest Payment

15.8 Interest payment decreased by Rs.344.90 crore (14.8 per cent) from Rs.2,334.99 crore in 2001-02 to Rs.1,990.09 crore in 2002-03 due to reduction in rate of CRR and lower interest rates payable on eligible CRR balances.

Establishment Expenditure

15.9 Establishment expenditure increased by Rs.184.50 crore (14.1 per cent) from Rs.1,304.36 crore in 2001-02 to Rs.1,488.86 crore in 2002-03 as a result of increased provisioning with respect to gratuity and pension funds. As per the actuarial valuation the provisioning in this regard was to the extent of Rs.616.67 crore during 2002-03 as against Rs.440.80 crore during the previous year.

Non-Establishment Expenditure

15.10 Expenditure on security printing, comprising cost of printing of currency notes, cheque forms etc., increased by Rs.128.60 crore (9.9 per cent) from Rs.1,304.49 crore in 2001-02 to Rs.1,433.09 crore in 2002-03, mainly due to upward revision in rates of printing currency notes, increase in quantum of notes printed and larger component of higher denomination notes of Rs.100 and above consistent with the clean note policy.

BALANCE SHEET

Liabilities

National Industrial Credit (Long Term Operations) Fund

15.11 There were no operations in the National Industrial Credit (Long Term Operations) Fund (established under Section 46-C of the RBI Act, 1934) during 2002-03 except the credit of Rs.1.0 crore to the Fund out of Reserve Bank's income.

National Housing Credit (Long Term Operations) Fund

15.12 The National Housing Credit (Long Term Operations) Fund was established by the Reserve Bank in terms of Section 46D(1) of the Reserve Bank of India Act, 1934 in January 1989. A token contribution of Rs.1.0 crore was made to the Fund out of Reserve Bank's income during 2002-03.

Other Liabilities

15.13 'Other Liabilities' include the internal reserves and provisions of the Reserve Bank and net credit balance in the RBI General Account. These liabilities have increased by Rs.9,112.06 crore (8.3 per cent) from Rs.1,09,243.95 crore as on June 30, 2002 to Rs.1,18,356.01 crore as on June 30, 2003 mainly on account of increase in the levels of internal reserves.

15.14 The reserves, viz., Contingency Reserve, Asset Development Reserve, Currency & Gold Revaluation Account and Exchange Equalisation Account reflected in 'Other Liabilities' are in addition to the 'Reserve Fund' of Rs.6,500 crore held by the Reserve Bank as a distinct balance sheet head.

Currency and Gold Revaluation Account and Exchange Equalisation Account

15.15 Gains/losses on valuation of foreign currency assets due to movements in the exchange rates and/or prices of gold are not booked in profit and loss account but in a separate account called Currency and Gold Revaluation Account (CGRA), the balance in which represents accumulated net gain on valuation of foreign currency assets and gold. During 2002-03, there was an accretion of Rs.265.64 crore to the CGRA, thus increasing the balance to Rs.51,276.41 crore as on June 30, 2003 from Rs.51,010.77 crore as on June 30, 2002. The CGRA at the end of June 2003 was equivalent to 13.4 per cent of foreign currency assets and gold holdings of the Reserve Bank, as against 18.0 per cent at the end of June 2002. This was mainly on account of increase in the foreign currency assets and also appreciation of the rupee against the US dollar. The balances in Exchange Equalisation Account (EEA) represents provision made for exchange losses arising out of forward commitments. The balance in the EEA as on June 30, 2003 stood at Rs.567.25 crore.

Contingency Reserve and Asset Development Reserve

15.16 The Reserve Bank maintains a Contingency Reserve (CR) to enable it to absorb unexpected and unforeseen contingencies. The Reserve Bank has set an indicative target of 12 per cent of the Reserve Bank's total assets to be achieved in phases by the year 2005, subject to review, if considered necessary. The balance in CR has gone up from Rs.48,434.17 crore as on June 30, 2002 to Rs.55,249.29 crore as on June 30, 2003. A sum of Rs.81.20 crore representing unresolved items of credit, which was included under Other Liabilities - Miscellaneous was credited to CR during 2002-03. A transfer of Rs.6733.92 crore was made to CR during 2002-03 from Reserve Bank's income. The balance in CR was sufficient to meet the contingent liabilities.

15.17 In order to meet the internal capital expenditure and make investments in its subsidiaries and associate institutions, the Reserve Bank had created, in 1997-98, a separate Asset Development Reserve (ADR) with the aim of reaching one per cent of the Reserve Bank's total assets within the overall target of 12 per cent set for CR. In the year 2002-03, an amount of Rs.890.31 crore was transferred from income to ADR raising its level from Rs.4,700.54 crore as on June 30, 2002 to Rs.5,590.85 crore as on June 30, 2003. CR and ADR together constituted 11.7 per cent of total assets of the Reserve Bank as on June 30, 2003.

ASSETS

Foreign Currency Assets

15.18 The foreign currency assets comprise foreign securities held in Issue Department, balances held abroad and investments in foreign securities held in Banking Department. Such assets rose from Rs.2,67,333.18 crore as on June 30, 2002 to Rs.3,65,000.98 crore as on June 30, 2003. The increase in the level of foreign currency assets was mainly on account of market purchases, interest & discount and revaluation gains.

Investment in Government of India Rupee Securities

15.19 Investment in Government of India Rupee Securities which stood at Rs.1,35,067.86 crore as on June 30, 2002 decreased by Rs.29,923.82 crore (22.2 per cent) to Rs.1,05,144.04 crore as on June 30, 2003 mainly on account of substantial open market operations sales during the year.

Investments in Shares of Subsidiaries and Associate Institutions

15.20 The Reserve Bank's investments in the shares of its subsidiaries and associate institutions have increased by Rs.100.00 crore during 2002-03 on account of an additional investment in capital of the National Housing Bank.