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RESERVE BANK OF INDIA www.rbi.org.in www.rbi.org.in\hindi e-mail: helpprd@rbi.org.in

March 18, 2006 REPORT ON CURRENCY AND FINANCE 2004-05 The Evolution of Central Banking in India This Report documents the evolution of central banking in India over its seventy year existence. The functions of the Reserve Bank of India have been changing over time as it has responded to the emerging requirements of the macro economy and continuously diversifying financial system. The efforts to constitute a central bank for India can be traced back to Warren Hastings proposal for a General Bank of Bengal and Bahar in 1773. The initiatives with regard to central banking in the colonial era had to face stiff resistance. Many such proposals faced failures. The amalgamation of the three Presidency Banks and emergence of the Imperial Bank of India in 1921 was the first concrete step in this direction. A sequence of events subsequently led to introduction of the Reserve Bank Bill (1933) and the Reserve Bank of India Act came into force on January 1, 1935. The Reserve Bank commenced operations on April 1, 1935. It was nationalised on January 1, 1949 in terms of the Reserve Bank of India (Transfer to Public Ownership) Act, 1948. Functional Evolution of Central Banking The primary impulses for establishing central banks in many parts of the world in the twentieth century emanated from exigency of financing wars. The necessity to finance wars also led to nationalisation of many of the early central banks, which were functioning as private entities. Central banking efforts in India after independence were geared towards mobilising resources for planned economic development and ensuring price stability. Central bank mandates in developing countries such as India have gone well beyond typical central banking functions to encompass a wide range of developmental pursuits in order to promote economic growth. Central banking was initially practiced with a large number of informal norms, conventions and self-imposed codes of conduct. Instituting a medium of exchange and currency management alongwith monetary policy had been globally in focus till the Great Depression. With the passage of time, however, central banks took over a whole range of functions, becoming multi-tasking institutions that conduct monetary policy, regulate and supervise the banking system and perform a crucial role in the payment system. Crisis situations that emerged from time to time led to redefining of central bank mandates. The role of the lender of last resort evolved overtime and enlarged into that of the regulator and supervisor, as also the custodian of financial stability. This gained credence in the face of danger of contagion as economies got integrated. The necessity to manage government debt emanated from the historic reasons of financing wars. The hazards of financing the persistent government deficits were, however, well recognised and such financing is being increasingly avoided. In the wake of SouthEast Asian crisis of 1997, many central banks in developing countries initiated financial reforms. In this direction, central banks also played a vital role in development of the financial markets to strengthen the monetary policy transmission channels. Institutional development has been one of the major objectives of central banks in developing economies in order to spread the umbrella of organised credit in such economies.

The issue of inflation targeting has been addressed by the central banks across the world. While some of the traditional central banking functions have been effectively hived off, the objective of achieving price stability and financial stability has assumed greater emphasis with the adoption of inflation targeting and promotion of financial markets development. Central banks around the world have been vested with a variety of additional responsibilities such as preparing macroeconomic data-bases, data dissemination, putting in place advanced clearing systems, coordinating with the international agencies, undertaking policy-oriented research activities and bridging gaps in information. Central Banking in India The primary functions of the Reserve Bank in the foundation phase (1935-1950) were : (a) issue of currency; (b) banker to the government; and (c) banker to other banks. Except in the sphere of agriculture, the Bank was not entrusted with any great promotional role in this period. In the realm of monetary policy, except for maintaining exchange rate stability, other functions such as the management of money supply or inflation were not so important due to low levels of economic activity. As the bankers bank, the Reserve Bank was meeting seasonal requirements apart from being lender of last resort. The emphasis in these years was essentially on protecting depositors interests rather than on credit regulation. During the war and post-war years, the major preoccupation of the Bank was facilitation of war finance, repatriation of sterling debt and planning and administration of exchange control. The issues relating to regulation and supervision of banks came to occupy centre-stage in the backdrop of a number of bank failures. The Banking Companies Act was enacted in 1949 to empower the Reserve Bank with supervisory control over banks in order to ensure their establishment and operation along sound lines. The Reserve Bank of India was nationalised on January 1, 1949. With the launch of Five-Year Plans in 1951, the Reserve Banks functions became more diversified in terms of Plan financing, establishment of specialised institutions to promote savings and investment in the Indian economy and to meet credit requirements of the priority sectors. This was a novel feature for any central bank at that point of time. The Agricultural Refinance Corporation was set up in 1963 for extending medium and long-term finance to agriculture. Other institutional developments included setting up of the Industrial Finance Corporation of India (1948), the Industrial Development Bank of India (1964) and Unit Trust of India (1964). The role of monetary and credit policy in maintaining price stability was explicitly emphasised for the first time in the First Five Year Plan. Plan financing by the Reserve Bank evolved as deficit financing which took the form of system of issuance of ad hoc Treasury Bills. This arrangement of financing the Government was intended to be temporary but acquired a permanent character over time. Devaluation of the rupee in June 1966 and nationalisation of fourteen private sector banks in July 1969 multiplied the responsibilities of the Reserve Bank. The move helped to bridge the gaps in credit availability in many rural and urban areas and ensured sufficient funds availability to the preferred sectors. In terms of the outcome, this phase succeeded in mobilising private savings through the banks and paved the way for nationalisation of six more private sector banks in 1980. The breakdown of the Bretton Woods system of stable exchange rates got exacerbated by the oil shock of 1973-1974 and posed serious challenges for exchange rate management while creating balance of payments difficulties for India. For conserving foreign exchange reserves, the Government reexamined the provisions of the Foreign Exchange Regulation Act, (FERA) 1947 and introduced changes in 1973 which incorporated necessary changes for effective implementation of Government policy and removing difficulties in the working of the existing legislation. In the light of concerns about capital outflows, reinforced by repeated stress on balance of payments due to drought, war and oil shocks, the emphasis was placed on utilising domestic savings for domestic investment, while continuing to preserve foreign exchange reserves.

During the 1980s, monetary policy assumed a new focus. The period was also marked by introduction of a formal monetary policy framework emerging out of the necessity for striking a balance between the developmental functions and price stability. With the collapse of the Bretton Woods system, there was a paradigm shift in the approach of monetary policy as also the foreign exchange management around the world. Influenced by this line of thinking, the concern about ever increasing fiscal deficit coupled with large scale increase in the money supply, led the Reserve Bank of India to appoint a Committee to Review the Working of Monetary System (Chairman: Sukhamoy Chakravarty). The Committee suggested that the monetary authority should embark on monetary targeting in a more formal manner. Accordingly, the Reserve Bank, for the first time evolved a formal framework of monetary policy by the mid-1980s with M3 as a nominal anchor to be targeted, a policy framework that continued until recently. Further, the estimated expected level of bank credit was to be used for developing appropriate sectoral allocation in the light of the Plan priorities. This was closely followed by setting up of a Working Group on Money Market (Chairman: N. Vaghul). Based on its recommendations, a number of money market instruments were introduced such as 182-day Treasury Bills, inter-bank participation certificates (IBPC), certificates of deposit (CDs) and commercial paper (CP). The Discount and Finance House of India (DFHI) was set up in 1988 for promoting a secondary market in various money market instruments. The Banks efforts towards financing the credit needs of agriculture were strengthened with the setting up of NABARD in 1982. The expansionary banking network in terms of geographical coverage and heightened controls affected the quality of bank assets and strained their profitability. In the mid-1980s, a number of consolidation measures were initiated to strengthen the bank structures. A health code system was introduced for the banks in 1985. A set of measures to provide greater operational flexibility to the banks were also put in place. Liberalisation and globalisation of the Indian economy initiated since 1991 (reform phase 1991-2005) added several new dimensions to the responsibilities of the Reserve Bank. Alongwith the financial sector reforms, the monetary policy framework has been fine-tuned and conventional central banking functions of currency management and payment and settlement systems have been revamped in tandem with the global trends and domestic needs. Increasing globalisation of the Indian economy necessitated integration of domestic markets with international financial markets for full realisation of the benefits of globalisation. The first phase of reforms, guided by recommendations of the Committee on Financial Systems (Narasimham Committee I) focused on deregulation of the banking industry, including permitting entry to new private sector banks; strengthening of the institutional framework for banking, non-banking financial companies (NBFCs) and financial institutions through prudential norms, capital adequacy stipulations, improvements in payments and settlement systems, and strengthening of the supervisory framework. The enforcement of complementary institutional measures included setting up of the Board for Financial Supervision (BFS) for strengthening the supervisory mechanism, recapitalisation of banks and improvements in debt recovery. The second phase of reforms (recommended by Narasimham Committee II) lays emphasis on improvement in prudential norms in a gradual move towards meeting the international standards. NBFCs, especially those involved in public deposit taking activities, have been brought under the regulation of the Reserve Bank of India. For regulatory convergence of entities involved in similar activities, prudential regulation and supervision norms have been introduced for development finance institutions and cooperative banks. The Insurance Regulatory and Development Authority (IRDA) was established to regulate and supervise the insurance sector. The capital markets reform measures focused on improving market efficiency, increasing transparency, prevention of unfair practices, enhancing competitive conditions, minimising information asymmetries, developing modern technological infrastructure, reducing transaction costs and containing speculation in the securities market. Securities and Exchange Board of India (SEBI) was established in 1992 as the regulator for equity markets. Further, Indian capital market was integrated with global markets by allowing Foreign Institutional Investors in 1992 and allowing Indian corporate sector to tap international capital markets through ADRs, GDRs, FCCBs and ECBs.

In the debt market, the ad hoc Treasury Bills were phased out effective April 1, 1997 in terms of a historic agreement between the Reserve Bank and the Government. Interest rates on Government paper have been made market related and the maturity periods changed to reflect market preferences through auctions enabling market based price discovery. Open market operations (OMO), hitherto ineffective, gained considerable momentum. Collateralised borrowing and lending obligations (CBLOs) were operationalised as a money market instrument through the Clearing Corporation of India Limited (CCIL) set up in 2003. A repo market outside the liquidity adjustment facility (LAF) has been assiduously developed by the Reserve Bank to provide an avenue for bank and non-bank participants to trade funds after the conversion of the call/notice money market into a pure inter-bank market. On the external front, rupee value has been linked to the market forces. Current account convertibility was achieved in August 1994. FERA was repealed and replaced by a new legislation - Foreign Exchange Management Act (FEMA), in 1999. Further, the Exchange Control Department of the Reserve Bank was renamed as Foreign Exchange Department. Besides, a large number of innovative products and newer players have come to play active role and new hedging instruments have been introduced, viz., foreign currency-rupee options, etc. Authorised dealers could use cross-currency options, interest rate and currency swaps, caps/collars and forward rate agreements (FRAs) in the international forex market. In the context of monetary policy framework, there has been a greater focus on liquidity management engendered by the growing integration of financial markets, domestically and internationally. With the near total deregulation of interest rates, the Bank Rate has been reactivated since April 1997 as a reference rate and as a signaling device to reflect the stance of monetary policy. Following the recommendations of the Working Group on Money Supply: Analytics and Methodology of Compilation (Chairman: Y. V. Reddy), the Reserve Bank has commenced compilation and publication of four monetary aggregates [M0 (monetary base), M1 (narrow money), M2 and M3 (broad money)]; and introduced three new liquidity aggregates (L1, L2 and L3) by incorporating deposits with post- office savings banks, term deposits, term borrowings and certificates of deposits of term lending and refinancing institutions and public deposits of non-banking financial institutions; broadening of the definition of credit by including items not reflected in the conventional bank credit; redefining the net foreign assets of the banking system to comprise banks holdings of foreign currency assets net of (a) their holdings of FCNR(B) deposits and (b) foreign currency borrowings. With the liberalisation of the external sector, the monetary targeting framework came under stress due to increasing liquidity mainly on account of increased capital inflows, necessitating a review of the monetary policy framework and the Reserve Bank switched over to a more broad-based multiple indicators approach since 1998 in monetary policy formulation. The informal monetary policy strategy meetings review the monetary and liquidity conditions and the process has been made consultative. The Financial Markets Committee (FMC) monitors the developments in financial markets on a daily basis. The Committee makes quick assessment of the liquidity conditions and recommends strategies for intervention in the money and securities markets. The open market operations, repo and reverse repo operations have emerged as important liquidity management tools. Further, Liquidity Adjustment Facility (LAF), which was introduced in June 2000, has emerged as the principal operating instrument of monetary policy, enabling the Reserve Bank to modulate short-term liquidity under varied financial market conditions. In order to fine-tune the management of liquidity and in response to suggestions from market participants, the Reserve Bank has introduced a Second Liquidity Adjustment Facility (SLAF) from November 28, 2005. Further, to address the dilemma of keeping a balance between the twin objectives of containing exchange rate volatility and maintenance of domestic price stability in the face of surging capital inflows, the Market Stabilisation Scheme (MSS) was introduced in April 2004 to provide the Reserve Bank with an additional instrument of liquidity management. Under the MSS, the cost of sterilisation is borne by the Government. As part of management of the demand for currency, it has been the endeavour of the Reserve Bank to contain the volume of notes in circulation by coinising the lower denomination notes and conscious shift towards higher

denomination notes in circulation. Major developments in this regard include following a clean note policy, mechanisation of note counting operations by the commercial banks, outsourcing of coin distribution to the private operators to ease pressure on distribution channels, regular reviews of security features of bank notes and mechanisation of destruction of soiled notes, etc. These operations are aimed at ensuring the optimal level of customer service through adequate supply of good quality and secure notes and coins in the country. Information Technology With the increasing globalisation and advances in technology, the payment and settlement systems, that form the backbone of economic activity in any modern society, need to be safe, sound and secure. The Reserve Bank has endeavoured to ensure full compliance with the core principles of the BIS in this area. The significant move in this direction is the introduction of Real Time Gross Settlement (RTGS) system aimed at reducing risks especially settlement and systemic risks. New MICR based cheque processing centres have been set up at the commercial bank level, even as the settlement function continues to rest with the Reserve Bank. Further, the IT based initiatives have focussed on meeting the three pronged objective of better house keeping, improved customer service and overall systemic efficiency. The Reserve Bank has released a Financial Sector Technology Vision Document outlining the approach to be followed for IT implementation in the medium-term of about three years. Regulation and Supervision The regulation and supervision of the financial system in India is carried out by different regulatory authorities. The Reserve Bank regulates and supervises the major part of the financial system. The supervisory role of the Reserve Bank covers commercial banks, urban cooperative banks (UCBs), some financial institutions and nonbanking finance companies (NBFCs). Some of the financial institutions, in turn, regulate or supervise other institutions in the financial sector, for instance, Regional Rural Banks, and the cooperative banks are supervised by National Bank for Agriculture and Rural Development (NABARD); and housing finance companies by National Housing Bank (NHB). Department of Company Affairs (DCA), Government of India regulates deposit taking activities of corporates, other than NBFCs, registered under companies Act, but not those which are under separate statutes. The Registrar of Cooperatives (ROC) of different States in the case of single state cooperatives and the Central Government in the case of multi-state cooperatives are joint regulators, with the Reserve Bank for UCBs, and with NABARD for rural cooperatives. Whereas RBI and NABARD are concerned with the banking function of the cooperatives, management control rests with the State/Central Governments. This dual control impacts the supervision and regulation of the cooperative banks. The Insurance Regulatory and Development Authority (IRDA) regulates the insurance sector; and the capital market, mutual funds, and other capital market intermediaries are regulated by Securities and Exchange Board of India (SEBI). With regard to the banking system of the country, the primary role of the Reserve Bank at inception was conceived as that of the lender of last resort. The bank failures of the mid-1930s brought forth the necessity of regulation of banking system. It, however, took the Reserve Bank of India and the Government a decade to put in place a comprehensive system of regulation and the Banking Companies Act, 1949 was enacted for the purpose. Further, in February 1950, it was decided that all banking companies would be inspected, irrespective of their size and standing. In 1961, the Reserve Bank reorganised and strengthened its inspection arrangements to cover many more branches than in the past. Between 1960 and 1968, the thrust of the regulatory and supervisory function of the Reserve Bank continued to be on ensuring soundness of operations of banks, consolidation and protection of the interests of the small depositors. The nationalisation of fourteen major commercial banks in 1969 was a turning point in the Indian banking system with the entry of the public sector. To strengthen the supervisory mechanism further, it was decided to institute a new type of inspection during 1977-78, viz., Annual Appraisal of banks in addition to the Financial Appraisal. The system of inspection of banks has been subjected to continuous scrutiny to ensure that the exercise serves the desired objectives.

The massive expansion of the banking system had resulted in certain stresses and strains and in the middle of the 1980s the system entered into a phase of consolidation. Notwithstanding the remarkable progress made by the Indian banking system in achieving social goals during the 1980s, it experienced certain problems that led to decline in efficiency and productivity, and erosion of profitability. The decade of the 1990s was a watershed in the history of the Indian financial system in general and the banking system in particular. The urgency of reforms in the financial system was addressed by the Committee on the Financial System (Narasimham Committee, 1991) which looked into various issues with a view to initiating wide ranging financial sector reforms. Following the Report of the Committee, the Reserve Bank adopted a comprehensive approach on the reforms of the financial sector. Over the years, the regulatory and supervisory polices in India have transformed significantly in tandem with the global developments and the changing pace of the Indian financial system. Apart from on-site inspections, the Reserve Bank has adopted other three supervisory approaches, viz., off-site monitoring, internal control system in banks and use of external auditors. The Reserve Bank also initiated measures to implement Risk Based Supervision (RBS). The RBS process has been recently revisited by revising the risk profiling templates and introducing a new rating framework with a view to make the RBS process more risk-sensitive, objective and user-friendly. The Reserve Bank has initiated half-yearly discussion meetings with the Chief Executive Officers of the financial conglomerates (FCs) in association with other principal regulators to address outstanding issues/supervisory concerns, which would further strengthen the system of monitoring the FCs. In November 2004, the Reserve Bank revised the guidelines on Know Your Customer (KYC) principles in line with the recommendations made by the Financial Action Task Force (FATF) on standards for Anti-Money Laundering (AML) and Combating Financing of Terrorism (CFT). Further, the Indian banks are preparing to adopt the Basel II norms from March 2007, as directed by the Reserve Bank. Further, a Standing Technical Advisory Committee on Financial Regulation was constituted in November 2003 to strengthen the consultative process among banks, market participants and regulators of financial markets in the context of carrying forward Indias prudential regulatory system. The Reserve Bank h also constituted a Working Group on Conflict of Interest in ad the Indian Financial Services Sector to identify the sources and nature of potential conflicts, and suggest possible measures/ actions to be taken for mitigating them. The Task Force to address the issue of duality of control over the cooperative institutions suggested to draw an Action Plan to redefine the roles and responsibilities and areas of regulation through delegation of powers in respect of all the players in the field. In view of the weaknesses persisting in the cooperative banks, a system of preparation of institution specific development action plans and execution of Memorandum of Understanding have been initiated since 2003-04. Further, a Task Force (Chairman: A. Vaidyanathan) was appointed in August 2004 to examine, inter alia, the issues relating to an appropriate regulatory framework for rural cooperative banking institutions. The recommendations of the Task Force have been accepted in principle by the Government. As a prudent step towards aligning the UCBs within the financial system, a Draft Vision Document (2005) of the Reserve Bank seeks to rationalise the existing regulatory and supervisory system; facilitate a focused system of supervision through enhancement of technology; and to evolve mechanism to address the dual control. For effective spervision of the NBFCs, a four-pronged mechanism comprising on-site inspection on the CAMELS pattern, viz., capital adequacy, assets management, earnings, liquidity, systems and procedures; off-site monitoring through periodic control returns using state-of-the-art information technology; an effective market intelligence network; and a system of submission of exception reports by statutory auditors of NBFCs were instituted in order to buttress the regulatory and supervisory framework for NBFCs. In order to bring the functioning of the NBFCs in line with international practices, the Reserve Bank initiated a consultative process with the NBFCs with regard to their plan of action for voluntarily phasing out of their acceptance of public deposits as prescribed in the mid-term review of Annual Policy 2004-05. Recently, the Reserve Bank has laid down a road map for Residuary Non-Banking Companies (RNBCs) with a view to ensure that the process of transition of these institutions complies with the Reserve Banks directions.

In April 1995, select all-India financial institutions were brought under the supervisory purview of the BFS. All India financial institutions are being covered by an on-site supervisory process (CAMELS standards) since 1995 on the lines of commercial banks. On-site and off-site surveillance system has been instituted for DFIs more or less on the lines of commercial banks. A major restructuring in the financial sector is evident in the recent conversion of ICICI and IDBI into banks. In sum, the changing role of financial regulation and supervision of the Reserve Bank focuses on prudential supervision, while emphasising the creation of an environment in which the banks think freely and innovate. More importance is being given to principles and greater attention to risk assessment and risk containment. In future, the regulatory and supervisory role would not only be friendly and frank, but also prompt and firm. The changing face of regulation and supervision would accord importance to intensified use of technology in supervisory processes and substantially enhance the skills and capacities of the supervisors. While fully meeting the socio-economic objectives, it would continue to maintain stable and orderly conditions in the financial system. Financial Market Development A review of financial market development in India during the past seven decades reveals that the Reserve Bank has been successful in creating deep and vibrant money, Government securities and foreign exchange markets. Financial market development in India has, apart from improving monetary policy transmission mechanism, facilitated changes in monetary policy strategies: from emphasis on credit allocation to monetary targeting and the subsequent multiple indicator approach. The success of deregulation of the interest rate regime in India owes significantly to the simultaneous development of financial markets. Financial markets have enabled banks and institutions to better manage their liquidity and treasury operations and thereby strengthen their fund-based income and profitability. Further, the growth of financial markets in the 1990s contributed towards improved asset and liability management by banks and other financial entities. At the same time, there was a significant shift in the financing pattern of larger companies, which moved away from the banking system to raise resources from the financial markets. Though the various initiatives taken by the Reserve Bank have resulted in deep and wide money, Government securities and forex markets, the reform process continues. In the money market, the policy thrust of the Reserve Bank continues to be to encourage the development of collateralised market, broad-base the pool of securities to act as collateral for repo and CBLO markets and provide avenues for better risk management with further improvements in the ALM framework. In the Government securities market, in the FRBM environment, shortselling with appropriate safeguards, developing When Issued market, active consolidation and ensuring effective debt management are likely to be some of the challenges facing the Reserve Bank. In the forex market, further liberalisation of the capital account in line with CACs recommendations could pose fresh challenges to the Reserve Bank. In the context of integration of the Indian financial markets with the global markets, the Reserve Bank has been constantly refining and fine-tuning its regulatory mechanism to align with the global standards. Notwithstanding the significant changes in financial markets, there are several imponderables which could have a bearing on monetary policy formulation. Some of the developments that are likely to have a bearing on the size and evolution of the money and Government securities markets in the coming years are implementation of the FRBM Act, 2003 (which will put an end to Reserve Banks participation in primary auctions of Central Government securities from April 1, 2006). While this would lead to functional separation of debt management from monetary operations thereby enabling the Reserve Bank to have greater control over the composition of its balance-sheet and flexibility in monetary operations, it would also call for greater coordination between the Reserve Bank and the Government for ensuring stability in the financial markets. In the context of the changed monetary and debt management scenario, the Reserve Bank has to take steps to fine-tune its open market operations and LAF. Greater accuracy in forecasting market liquidity over the short to medium-term has also become very crucial.

Another challenge confronting the Reserve Bank in the medium-term is the increasing openness of the Indian economy and the management of liquidity following strong capital inflows. As there is a trade-off between the excessive volatility in financial markets, exchange rates and interest rates which are likely to result in erosion in the competitiveness of the economy on the one hand, and financial cost of sterilisation (measured as outgo of coupon on the sterilised amount over and above the earnings from deployment of foreign exchange reserves) on the other, the Reserve Bank has to properly balance its sterilisation operations. This would also call for fine-tuning of its policy instruments by the Reserve Bank so as to keep call money rates range bound (within the corridor of the repo and reverse repo rates). The liberalised financial system necessitates greater transparency, fostering strong institutions and developing better risk analysis systems. Improvements in market discipline also call for greater coordination between banks, major players in the financial markets and regulators. In order to have greater transparency in the financial position and risk profile of banks, India has been expanding the area of disclosures. Adoption of Basel II would improve risk management systems and enhance the competitiveness of Indian banks, thereby enabling them to play a more active role in global financial markets. In the area of monetary policy, the low and stable inflation coupled with very strong central banks have changed the monetary dynamics. Consequently, while rising inflation is no longer a major concern, excessive increase in asset prices and credit have emerged as major challenges facing the central banks as this can lead to financial instability. In the context of financial stability, besides improved transparency, better analysis of trends in major sectors of the economy and banks to detect stress, policies which better affect inflation expectations and cautious liberalisation of international capital movements have assumed significance. The Reserve Bank and other central banks have to pursue market driven strategies and policies that are stable and forward looking to anchor expectations. Fiscal discipline and deep and well functioning financial markets are necessary for the success of central banks policy strategy. Monetary and Fiscal Interface The Reserve Banks experience over the past seven decades on the issue of monetary and fiscal interface offers some useful insights. The Reserve Bank had to cope with the challenges thrown up by the changing phases of fiscal policy from fiscal neutrality to fiscal dominance and further to fiscal consolidation - by suitably adapting the operating procedures of monetary policy and making institutional arrangements so as to foster monetary and financial stability. This was facilitated through a mutual agreement between the Reserve Bank and the Government to phase out automatic monetisation of fiscal deficit. Despite some improvement in the monetary fiscal interface, fiscal dominance persisted with growing market borrowings, necessitating the adoption of a strategy of appropriately combining devolvement/private placements with open market operations in order to contain the cost of Government borrowings. The opening up of the economy posed new challenges in the conduct of monetary policy. While the Reserve Bank has been empowered with greater instrument autonomy, the exchange rate adjustment has essentially been market-driven with episodic interventions to counter self-fulfilling speculative activities. However, the opening up of the capital account has been calibrated sequentially which, as evident from the East Asian Crisis, has turned out to be prudent. The Reserve Bank, being at the helm of money, Government securities and foreign exchange markets, could balance diverse considerations of interest rate and exchange rate stability through appropriate market interventions and interest rate signals. The Reserve Bank could carefully craft its debt management policy so as to simultaneously meet the objectives of minimising cost as well as reducing rollover risks of Government borrowings through elongation of maturity of Government paper. Thus, the Reserve Bank has been successful in meeting the challenges of debt management, while ensuring orderly financial market conditions. As per the FRBM stipulations, the Reserve Bank would not be participating in the primary market auctions effective April 1, 2006. This would be in tune with the traditional argument that the power to spend money should be separated from the power to create money (Reddy, 2001). While the withdrawal of the Reserve Bank will

impart greater functional autonomy to monetary policy, the Reserve Bank will have to keep a vigil on interest rate uncertainties and create alternate financing mechanism for ensuring successful completion of the Governments market borrowing programme. With high levels of public debt in India, the case for a separation of monetary and debt management seems to be gaining ground. Given the complexities in separating the function of monetary and debt management, a minimum requirement should be that their relationships and transactions be reported as transparently as possible (Reddy, 2001). In the event of a functional separation, greater explicit coordination between the monetary and the debt authorities would be required to resolve policy dilemmas of simultaneously undertaking exchange rate, monetary and debt management, which the Reserve Bank has hitherto addressed by virtue of being vested with all three responsibilities. The key to successful monetary fiscal coordination is the realisation by the fiscal authorities that the control over deficits reins inflation expectations thereby facilitating the conduct of monetary policy. Thus, if inflation expectations are anchored at low levels, a proactive monetary policy can ensure a stable and low interest rate regime that is conducive to maintaining the momentum of economic growth, while facilitating the task of public debt management. Reserve Bank Balance Sheet Analysis of the Reserve Banks balance sheet over the last seven decades reveals the correlation of its evolution to shifts in the policy regime as well as changes in the macroeconomic environment. The balance sheet of the Bank has undergone considerable changes from the primacy of the note issuance function during the formative years, to slow but steady fiscal ascendancy during the early phase of planning which culminated into a period of fiscal dominance (and higher pre-emption of the resources of the banking system) coupled with strong developmental role. Further, there is a structural transformation in the 1990s with dominance of foreign assets, market determination of public debt management and reduction in reserve requirements. With the recent compositional shift in the Reserve Banks balance sheet towards foreign currency assets and the resultant shift in the risk-return profile of the Bank, the concerns of the balace sheet being exposed to interest and exchange rate risks with attendant valuation implications assume greater significance.With the change in asset composition of the Reserve Banks balance sheet, relatively lower rate of return on foreign currency assets, volatility in exchange and interest rates in the global markets and adoption of mark to market valuation norms with asymmetric treatment for appreciation gains, various risks, viz., market risk, credit risk, liquidity risk, risks arising out of intervention operations, operational risk and lender of last resort risk, have assumed greater significance in the context of the health of the Reserve Banks balance sheet and have intensified the need for adoption of effective and adequate risk management measures. The volatility in financial asset prices during the deregulation phase has had a bearing on the balance sheet of the Reserve Bank to the extent that it is asymmetric in terms of its impact on assets and liabilities. In the wake of these developments, the Bank has initiated several measures to ensure revaluation of both domestic and foreign assets on a prudent basis and also build up adequate cushion in the form of contingency reserves so as to impart policy flexibility in a liberalised environment. The issue of sterilised intervention is relevant in the context of the Reserve Bank because it manages foreign exchange reserves and absorbs the valuation impact of exchange and interest rate movements in the international market. While per se sterilised intervention involves adjustment within the assets side of the Reserve Banks balance sheet (in terms of substitution of domestic assets by foreign assets), recent instruments such as market stabilisation bonds, though innovative, cause an expansion of the balance sheet. Such an expansion of the balance sheet may necessitate corresponding increase in contingency reserves. Thus, in times to come, a contextual analysis of transfer of surplus and provision of contingency reserves would be needed in the wake of appropriate risk management strategy on the part of the Reserve Bank. While the Reserve Bank has continued to conduct banking business of the Government, the view that has gained prominence is that the Reserve Bank should assign the retail banking business of the Government in favour of the agency banks with a view to ensuring that in the long run, the Bank will maintain only the principal accounts of

the Government, leaving the day to day banking business to commercial banks functioning as its agents (Reddy, 2002). Another issue under consideration relates to the cost of conducting State Government business. Under the existing arrangement, the Bank is not entitled to receive any remuneration for the conduct of ordinary banking business of the Government other than such advantage that may accrue to it from holding of cash balances free of obligation to pay interest thereof. Furthermore, the Reserve Bank incurs expenditure in terms of reimbursement of costs incurred by agency banks for conducting Government business. Country practices also reveal that the cost of conducting Government business in most countries is borne by the respective Governments and not the central banks. A rationalisation measure being contemplated in respect of remuneration payment to agency banks is to shift from the present cost based system to a system of bidding for Government business by agency banks. Finally, the balance sheet of a central bank needs to adhere to the principles of sound central banking ensuring price and financial stability on the one hand, and its developmental role on the other. Transparency is a necessary precondition in this regard. A transparent central bank balance sheet would go a long way to enhance the credibility of the central bank and efficiency of monetary policy. The evolution of balance sheet of the Reserve Bank over seven decades bears testimony to these principles. Organisational Evolution and Strategic Planning The organisational evolution of the Reserve Bank of India took place in response to the functions which devolved on the Bank as the socioeconomic conditions unfolded. The focus on rural finance, development of cooperatives, necessity of credit allocation to the preferred sectors, need for economic research in the post-war period and weak bank failures, etc., facilitated creation of a diversified edifice to respond to the changing environment. Financial stability, though not an explicit element in the Preamble to the RBI Act, 1934, always remained a core objective underpinning policy actions of the Reserve Bank from time to time. The organisational restructuring was undertaken in view of the evolving socioeconomic conditions. The Board for Financial Supervision (BFS) was set up to put in place an integrated supervisory mechanism. To cope with the financial markets dynamism, a number of Departments were created such as the Department of External Investments and Operations, Internal Debt Management Department, Monetary Policy Department, and more recently, the Financial Markets Department. The thrust through the changing phases has been to move alongwith the emerging macroeconomic scenario and to cope with the crisis situations in a pragmatic manner. Although the Reserve Bank did not adopt any systematic strategic planning process, it could undertake the transformation from time to time on account of its ability to leverage the skills of its staff. The adoption of Strategic Action Plan (SAP) that is under consideration for implementation, however, poses the dilemma of either to be bound by a set model of planning or adapt to the changes as they come in the backdrop of rapid economic transformation that calls for far quicker responses than ever before. Communication Policy Transparency has assumed renewed focus with a clear communication policy of the Reserve Bank, which enables it to disseminate a wide range of information regularly to the public. In recent years, the Reserve Bank has been laying emphasis on a well-designed communication policy with three main features - transparency, timeliness and credibility. The objective of the communication policy is achieved through extensive dissemination of information on the policy and the processes of its formation. The Reserve Bank extensively uses its website for dissemination of information. The publications of the Reserve Bank, also available on the website, containing data, research studies and speeches of top-management of the Reserve Bank provide rationale and explanations behind the policy decisions. In an interesting development in recent years, the Reserve Bank regularly solicits feedback on important issues placed on its website. In sum, the evolution of central banking, not only in India but also globally, indicates that the central banks have continued to adapt to the changing economic environment. In the interaction between the financial intermediaries

and the central bank, the focus has been the welfare of the general public. The central banks carefully watch the market trends and monitor numerous variables, both quantity and rates, in the domestic and global economy. The information contained in these indicators and the direct feedback from the market participants helps in calibrating and crafting an appropriate monetary policy to ensure financial stability. In the last hundred years, a period of time when most central banks were established, the markets, the objectives and instruments of monetary policy have changed. Despite these changes, the central banks have established themselves as necessary and permanent part of the financial system. The Reserve Bank has had a fair degree of success in achieving the twin objectives of growth with stability, especially in the post-reform period. The well calibrated strategies of the Reserve Bank in refining monetary policy operating procedures, managing the capital flows, ensuring evolution of competitive markets and sustaining a healthy financial system, while also performing the developmental role have yielded visible results. While successfully facing the challenges of globalisation, the Reserve Bank has earned international credibility in terms of efficacy of its policies. The Reserve Bank has achieved transparency in its operations, especially in terms of evolving communication policy aimed at addressing a wide range of audiences. Notwithstanding the changing challenges of different regimes, the Reserve Bank has managed to evolve constructively on a continuous basis to cope with demands for stable macroeconomic management and financial stability, while meeting the objectives of economic growth and development. As the economy becomes increasingly open and global, the role of the Reserve Bank will undergo further change and it will need to equip itself for coping with these emerging challenges on a continuous basis.

Alpana Killawala Chief General Manager Press Release: 2005-2006/1184