Title of the Paper

Monetary Policy making: Challenges in an open economy

The Indian Experience

Author

Ms. Radhika Pandey

Lecturer (Economics)
National Law University, Jodhpur
NH 65, Nagaur Road, Mandore, Jodhpur (Rajasthan)
PIN 342304
Tel: 0291-5121595; 2013999; 9828122466
Fax: 0291-2577540
Email: radhika78in@yahoo.com

Abstract
Monetary Policy Making: Challenges in an Open Economy
The Indian Experience
Radhika Malhotra
Whether Central Bank should habitually intervene or should not intervene at all with the
exchange rate movements is a burgeoning question. If we accept intervention, the
question arises as to what should be the extent of Reserve Bank of Indias intervention
to contain the expansionary impact of global capital inflows? The ramifications of RBIs
intervention has given rise to many complexities which need exploration. This will help
to delineate the possible mechanisms to overcome the trade-off between the various
objectives of monetary policy.
Indian experience reveals that the large inflows of foreign capital put upward pressure on
exchange rate; monetary expansion resulting from intervention tends to exert upward
pressure on domestic price level. This raises the issue of an appropriate exchange rate
policy and price policy. There is, thus, an imperative to study the various monetary policy
instruments, goals and policy variables in the wake of the changed scenario. The research
paper inter alia would focus on the following:
Reasons involved towards changing character of reserve money;
Emerging challenges in terms of exchange rate management and domestic price
stability;
An analysis of the efficacy of the existing instruments used to tackle the
challenges;
To suggest alternative policy options for tackling challenges.

Monetary Policy making: Challenges in an open economy

The Indian Experience

Introduction
The conduct of monetary policy has become increasingly complex in a globalized
environment. Globalization has considerably expanded the level of economic
interterdepence and interaction among countries. At the same time the evolution of a
globalized economy has brought to the forefront new challenges faced by the monetary
authority. Monetary policy decisions have to be made in an environment characterised by
increased risk and uncertainity. Globalization, as understood in the present context refers
to integration of the financial markets.Financial markets ,driven by massive capital flows
immediately transfer the valuation of risks thus having considerable implications for
exchange rate stability. Thus the formulation of monetary policy has to take into account
not only the domestic macroeconomic policy environment but also impact of crossborder capital flows and their implication for the macroeconmic variables.
The present paper is divided into five sections. Section I deals with an overview of the
monetary policy during the 1980s and changes in the institutional environment affecting
the conduct of monetary policy in the post reform period. Section II deals with capital
flows; one of the most important component of external sector reforms, their components,
nature, determinants and their impact on monetary management. Section III elaborates

the challenges faced by the monetary policy in its attempt to avoid a trade-off between
price stability and exchange rate stability; their implications and possible alternative
strategies to manage the trade-off. Section IV decsribes the current state of the economy
characterised by acute inflation and the pressure faced by the monetary authority to bring
about an interest hike. Section V concludes the paper.

Section I

Monetary Policy during 1980s:

The conduct of any macroeconomic policy is greatly influenced by the prevailing
institutional environment. The institutional setting during the 1980s was governed by a
strong monetary-fiscal policy interface. The strong monetary-fiscal policy nexus is
measured by the amount of net RBI credit to the Government. The net RBI credit to the
Government constituted 96% of the reserve money growth during the 1980s. The Central
monetary authority financed an increasing portion of the governmnets budget deficit.
The fiscal pressure on monetary tergetting had its roots in the practice of automatic
monetisation of Central Government fiscal deficit. An agreement was made between the
officials of the RBI and the Finance Ministry in early 1955 by which the fall in the
balances of the Central Government with the RBI below Rs 50 crore must be replenished
by accepting adhoc treasury bills1. Thus the issue of adhoc treasury bills became a

M.Ramachandran, Fiscal Deficit, RBI Autonomy and Monetary Management, Economic and Political
Weekly, August 26 September 2, 2000 PP. 3266-72, available at,
<http://www.epw.org.in/showArticles.php?root=2000&leaf=08&filename=1701&filetype=pdf> visited on
12.09.2004

convenient means of meeting any temporary mismatch between the receipts and
expenditure of the Central Government budget. In course of time it became a regular
practice to finance the deficit through the issue of adhoc Treasury Bills and consequently
an overwhelmingly large portion of governments fiscal deficit was automatically
monetised.
The 80s decade was characterised by high rates of economic growth. The economy was
able to cross the barrier of the Hindu Rate of Growth of 3.5% and consequently the
economy grew at an annual average rate of growth of 5.6 percent. On the flip side it was
also a period characterised by high fiscal deficits; a significant amount of which was
being financed through the issue of adhoc treasury bills. The monetisation of budgetary
deficit is an important source of inflation. This raised important issues related to the fiscal
impact of monetary expansion. Recognising the dangerous implications of automatic
monetisation on the flexibility and efficacy of monetary policy as an instrument of
economic growth; the RBI appointed a committee under the Chairmanship of Professor
Sukhamoy Chakravarty to suggest measures to improve the effectiveness of monetary
policy. The Chakravarty Committee recommended attaining price stability as the core
objective of monetary policy. Emphasizing monetary policy target, the Committee
suggested that the monetary target must be linked with the rate of growth of output and
prices. In order to achieve the desired monetary expansion, the growth of reserve money
has to be regulated in line with the targeted monetary expansion2. Recognising the fact
that the government borrowing from the Reserve bank has been an important

Alok Kumar Mishra (March 2004), Revisiting Monetary Policy Perspectives in India during 1990s, Vol.
III No. 2 Journal of Applied Economics, March 2004, ICFAI University, PP.66-67

contributory factor in reserve money growth and hence in money supply, the committee
wanted an agreement between the Central Government and the RBI on the level of
monetary expansion and the extent of monetisation of fiscal deficit3.

Money Supply Determination

The determination of money supply is a process of determination of the sources of
variation in reserve money and money multiplier. The Reserve Bank of India shows that
there are five sources which contribute to the growth of money supply in India. They are:
a) Net Bank Credit to the Government
b) Bank credit to the commercial sector
c) Net foreign exchange assets of the banking sector
d) Governments currency liabilities to the public
e) Non-monetary liabilities of the banking sector.
These factors affect money supply by causing variations in the growth of reserve money.
Till the early 90s, the most important component affecting reserve money was the
Reserve Bank credit to the Government. The supply of broad money is related to reserve
money through the following equation:
M3 = mRM
Where m is money multiplier and RM is reserve money. Money Multiplier is related to
behavioural factors, such as currency to deposits ratio, and a policy variable i.e, the cash
reserve ratio.
3

C. Rangarajan, Some critical Issues in Monetary Policy, EPW Special Aricle, June 16 2001, Available
at<http://www.epw.org.in/showArticles.php?root=2001&leaf=06&filename=3129&filetype=html> visited
on 20th September 2004

Table: 1

Sources of Money Supply

Source: Handbook of Statistics on Indian Economy, RBI

Table: 2

Sources of Money Stock: Current Position

Source
2000-01
1
1.

2.

2001-02

2002-03

2003-04
5
7,44,616

Mar. 7,
2003
6
6,68,037

Mar. 21,
2003
7
6,62,382

2
3
4
Net Bank Credit to 5,11,955 5,89,565 6,74,430
Government (A+B)
A. RBIs net credit to 1,53,877 1,52,178 1,20,679
Government (i-ii)
(i) Claims
on 1,56,696 1,57,323 1,24,210
Government
(a+b)
(a)
Central 1,49,353 1,46,528 1,16,515
Government (1)
(b)
State 7,343
10,794
7,695
Governments
(ii)
Government 2,819
5,145
3,531
deposits with RBI
(a+b)
(a)
Central 2,819
5,145
3,531
Government
(b)
State

Governments
B. Other Banks Credit 3,58,078 4,37,387 5,53,750
to Government
Bank
Credit
to 6,79,218 7,59,647 8,92,088
Commercial
Sector
(A+B)
A. RBIs
credit
to 13,286
5,929
3,048
commercial sector
(2)
B. Other banks credit 6,65,932 7,53,718 8,89,040
to
commercial
sector (i+ii+iii)
(i) Bank credit by 5,11,434 5,89,723 7,29,215
commercial
banks
(ii) Bank credit by 1,19,170 1,32,081 1,31,109
co-operative
banks
(iii) Investments by 35,328
31,915
28,716
commercial and
co-operative
banks in other

47,555

1,19,749

1,09,456

48,097

1,19,891

1,09,598

44,307

1,13,821

1,06,393

3,790

6,070

3,205

542

142

142

501

101

101

41

41

41

6,97,061

5,48,288

5,52,925

10,11,074 8,75,645

8,88,638

2,061

2,972

3,223

10,09,013 8,72,422

8,85,665

8,35,382

7,16,012

7,29,215

1,42,963

1,28,026

1,27,915

30,668

28,383

28,535

3.

4.

5.

securities
Net Foreign Exchange 2,49,819
Assets of Banking
Sector (A+B)
A. RBIs net foreign 1,97,175
exchange assets (iii) (3)
(i) Gross
foreign 1,97,192
assets
(ii) Foreign
17
liabilities
B. Other banks net 52,644
foreign
exchange
assets
Governments
5,354
Currency Liabilities to
the Public
Banking Sectors net
Non-monetary
Liabilities Other than 1,33,126
Time Deposits (A+B)
A. Net non-monetary 79,345
liabilities of RBI (3)
B. Net non-monetary 53,781
liabilities of other
banks (residual)
(1+2+3+4-5)
13,13,220

3,11,035 3,93,715 5,15,304

3,92,475

3,87,550

2,63,969 3,58,244 4,84,413

3,51,484

3,52,079

2,63,986 3,58,261 4,84,431

3,51,501

3,52,097

17

17

17

17

17

47,066

35,471

30,891

40,991

35,471

6,366

7,071

7,291

7,036

7,071

1,68,258 2,48,101 2,77,936

2,26,644

2,26,899

1,01,220 1,27,141 1,10,310

1,29,056

1,24,372

67,038

97,588

1,02,527

1,20,960 1,67,626

14,98,355 17,19,203 20,00,349 17,16,550 17,18,742

3
16,89,532 (19,83,088) (16,86,605) (16,89,071)

Source: RBI Bulletin No.11 Sources of Money Stock M3.

Recognising the dangers of strong monetary fiscal policy nexus, there was a conscious
effort to devise a mechanism by which budget deficit and monetisation could be delinked.
This had been formalised by an agreement between the Government of India and the RBI
signed on September 9 1994, by which automatic monetisation of treasury bills could be
phased out over a period of three years and from 1997-98 this instrument could be

10

abolished. The issue of adhoc treasury bills was discontiued with effect from April 1,
1997, and a system of Ways and Means Advances (WMA) was advanced to meet the
temporary mismatch in the receipts and expenditure of the Central Government.
Thus automatic monetisation of overnments deficit through RBI financing has been done
away with.4
Changes in the Institutional Environment: An overview of the External Sector
Policies
It is useful to outline the major developments in the external sector policies introduced
since the beginning of the 90s decade as the conduct of monetary policy is closely linked
with the broad framework of the external sector environment.
During the first three decades of planned economic development, our development
strategy focussed on self reliance based on import substitution and heavyindustrialization first strategy. The loopholes of this closed , restrictive policy regime
ultimately culminated into a serious Balance of payments Crisis.
In the aftermath of the Balance of payments Crisis, policy actions were initiated as a part
of the overall macroeconomic management coordinated to simultaneously achieve
stabilisation and structural change. External sector policies designed to open up the
economy formed a major plank of the overall reforms strategy. The external sector
reforms were based on the recommendations of a High level Committee on Balance of
payments( Dr. Rangarajan Committee, 1993) The Committee recommended:

Improvement in exports

Supra Note 1

11

Modulation of import demand on the basis of the availability of current receipts to

ensure a level of current account deficit consistent with normal capital flows.

Enhancement of non-debt creating flows to limit the debt service burden

Adoption of market-determined exchange rate

Adequate build up of foreign exchange reserves to avoid liquidity crisis and to

eliminate the dependence on short term debt.

The external sector reforms paid rich dividends in terms of sustainability of the current
account deficit and resilience to a series of external and domestic shocks.
These external sector reforms played their part in further global economic integration in
terms of reduced barriers on the inflows and ouflows of capital in response to interest
differentials. This emphasises the need for a closer coordination between monetary and
exchange rate policy to maintain monetary and exchange rate stability.

Section II

The Changing nature of capital flows and their determinants

One of the most significant developments in the global economy has been the spectacular
surge in international capital flows. These flows emanate from a greater financial
liberalisation, emergence and proliferation of institutional investors such as mutual and

12

pension funds and a spate of financial innovations.5. It is widely recognised that financial
liberalization can contribute significantly to growth in developing economies through
augmenting domstic savings, enhancing competitive pressures,reducing cost of capital
and transferring technology. In the endogeneous growth framework, the contributions to
growth attributed to capital flows comprise the spillovers associated with foreign capital
in the form of technology, skills and introduction of new products as well as positive
externalities in terms of higher efficiency of domestic financial market resulting in
improved resource allocation. At the same time it is also recognised that surges in capital
flows cause several concerns. Large capital flows create inflationary tendencies,
destabilise the exchange rates. Moreover there is a risk of domestic macroeconomic
instability arising from volatility of short-term capital flows and from the export of
domestic savings. In extereme cases premature capital account liberalization can lead to
currency substituion, capital flight and balance of payments crisis.
Before analysing the implications of capital flows on domestic monetary management it
is important to trace the changes in the composition of capital flows. An important
feature of the enhanced capital flows to developing economies in the nineties decade is
that private (debt and equity) as opposed to official flows have become an important
source of financing large current account imbalances. Another change has been a shift
away from debt flows towards equity flows especially foreign direct investment and
foreign portfolio investment. If we analyse the trends of capital flows to developing
countries as a whole we find that foreign direct investment flows to developing countries

Reserve Bank of India, Report: Report on Currency and Finance, Management of Capital Flows,
(Government of India, 2003)

13

started picking up in the early 1980s, however they were only one-eighth of the total
flows to developed economies even till the end of 1980s. The net FDI inflows towards
developing countries started picking up from 1987 and grew at a sustained pace between
1987 and 1997. From 1997 onwards capital flows to developing economies have been
facing severe shocks- in the form of the Asian crisis of 1997, the collapse of the
Argentine Currency Board Peg in 2001 and more recently by the disturbing economic
parameters of the US economy in terms of high fiscal and current account deficit.
Chart: 1

Capital Flows to Developing Economies

Examining specifically Indias case; external aid was the major component of Indias
Balance of payments. In recent years, however aid is replaced by flows in the form of
foreign direct investment, portfolio investment, external commercial borrowings and

14

special deposit schemes like India Development Bond, Resurgent India Bond and India
Millenium deposits.
Table: 3

Composition of Capital Inflows to India

Variable

1990- 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03

91

10

Total Capital Inflows (Net)

(US $ billion):

7.1

4.1

12.0

9.8

8.4

10.4

10.0

10.6

12.1

Composition of Capital flows

(Per cent to total)
1.
Non-debt
Creating 1.5
117.5
51.3
54.8
28.6
49.7
67.8
77.1
46.6
Inflows
52.4
23.7
36.2
29.4
20.7
40.2
58.0
38.5
a) Foreign
Direct 1.4
Investment
b) Portfolio Investment 0.1
65.1
27.6
18.6
-0.8
29.0
27.6
19.1
8.1
2.
Debt Creating Inflows
83.3 57.7
61.7
52.4
54.4
23.1
59.4
9.2
-10.6
9.2
9.2
9.7
8.6
4.3
11.4
-20.0
a) External Assistance 31.3 21.6
b) External Commercial
Borrowings #
31.9 31.2
23.7
40.6
51.7
3.0
37.2
-14.9
-19.4
c) Short- term Credits
15.2 1.2
7.0
-1.0
-8.9
3.6
1.0
-8.4
8.1
d) NRI Deposits
21.8 27.0
27.9
11.4
11.4
14.7
23.1
26.0
24.6
-6.1
-7.8
-9.5
-6.8
-6.2
-4.9
-3.9
e) Rupee Debt Service -16.9 -23.3
3.
Other Capital @
15.2 -75.2
-13.0
-7.2
17.0
27.2
-27.2
13.7
64.0
4.
Total (1 to 3)
100.0 100.0
100.0
100.0
100.0
100.0
100.0
100.0
100.0
Memo:
Stable flows*
84.7 33.7
65.4
82.4
109.7
67.4
71.4
89.3
83.8
#
: Refers to medium and long-term
borrowings
@
: Includes leads and lags in exports (difference between the custom and the banking channel data), banking
capital (assets and liabilities
of banks excluding NRI deposits), loans to non-residents by residents, Indian investment abroad, Indias
subscription to international
institutions and quota payment to IMF.
*
: Stable flows are defined to represent all capital flows excluding portfolio flows and shortterm credits
Note
: Data on FDI have been revised since 2000-01 with expanded coverage to approach international best
practices. FDI data for previous
years would not be comparable with those
figures.
Source: Reserve Bank of India.

What are the determinants of capital flows to a country? The determinants can be broadly
grouped into country specific pull factors or global push factors. The pull factors
are more intrinsic to a country like the nature of macroeconomic policies, fiscal regime,
Political risk perception, regulatory regime etc. The push factors are more in the nature

15

of a stimulus provided by some external factor. For example a decline in US interest rates
or recessionary trends in the US economy may push capital flows out of US to India.
The jump in the foreign inward capital that India experienced after liberalisation as well
as the composition of these inflows upholds the role of internal or pull factors such as
credible economic reforms, improved macroeconomic performance and domestic policies
that encouraged investor confidence and attracted foreign investors. The push factors
are equally important as the relatively high rates of return on Indian assets also attract
capital inflows.

Capital Flows and their Macroeconomic Impact:

An inflow of foreign capital exerts an upward pressure on the real exchange rate. The
transmission channel of the real exchange rate depends upon the exchange rate regime
being followed in the recipient country. If a country follows a freely floating exchange
rate with no Central Bank intervention, the appreciation will take place through a nominal
appreciation6 leading to a current account deficit with profound implications for external
competitiveness.Alternatively if the exchange rate regime is fixed and the Central Bank
intervenes to counter appreciation pressures, then capital inflows would be visible in
increases in foreign exchange reserves.
The implications of the two alternative exchange rate regimes can be plotted against time
to find out what strategy India had been adopting to counter the expansionary impact of
6

Renu Kohli, Capital Account Liberalisation Empirical Evidence and Policy Issues I, EPW, Special
Article, April 14, 2001 P. 1199 available at
<http://www.epw.org.in/showArticles.php?root=2001&leaf=04&filename=2377&filetype=pdf> visited on
12. 09.2004

16

capital flows. The two implications being the current account deficit as a percent of GDP
( resulting from freely floating exchange rate regime) and the accumulation of foreign
exchange reserves (resulting from fixed exchange rate regime). The following two graphs
trace the trend of foreign exchange reserves and current account balance from 1970 to
1998. The graphs can give us an idea of the behaviour of these two variables in the pre
and post reform period.
Chart: 2A

Foreign Exchange Reserves (excluding Gold and SDR)

Source: see bibliography (Renu Kohli, 2001)

17

Chart: 2B

Current Account Balance

Source: see bibliography (Renu Kohli,2001)

The current account deficit has shown a narrowing trend after touching the peak of 3.2
percent of GDP in 1991, the crisis year. The steep increase in foreign exchange reserves
is synchronous with this trend, suggesting absorption of foreign currency inflows by the
central bank. In 1993, almost entire increase in foreign exchange inflows were absorbed
as foreign exchange reserves. Since then a substantial portion of capital inflows has been
absorbed by the Reserve Bank thus resulting in adequate build-up of foreign exchange
reserves. The accumulation of international reserves with the RBI represents an increase
in the net foreign exchange assets of the central bank and directly affects the monetary
base. What has been the impact of capital inflows on money supply and how monetary
poliy has responded to these inflows?

18

Though India has had a market-determined exchange rate since 1993; flexibility in the
true sense has never been adopted by the central monetary authority. The degree of
intervention by the central bank has substantially increased and the foreign exchange
reserve build-up has been substantial. Before examining the monetary implications of
reserve build-up it would be worthwhile to examine the major sources of reserve
accretion since 1991.

Movement of reserves with the RBI- a disaggregative analysis

The level of reserves with the RBI has substantially increased from US$ 5.8 billion as at
end March 1991 to US$ 113 billion by end- March 2004. The increase in foreign
exchange reserves has been on account of capital and other flows. In the recent period the
major sources of accretion to foreign exchange reserves has been the items both under the
current account and the capital account of the Balance of payments. The current account
account has been witnessing a surplus due to increase in invisble earnings. Current
account posted a surplus of 1.4% of GDP in the fiscal year 2003-04. Under the capital
account the major components responsible for reserve accretion are a) foreign investment
b) banking capital c) short term capital d) valuation changes in reserves 7.
Table: 4

Sources of Accretion to Foreign Exchange Reserves since 1991

(US$ million)
1991-92 to 2003-04

Items
A

Reserve Outstanding as on end-March 1991

5.8

B.I.

Current Account Balance

-23.9

B.II.

Capital Account (net) (a to e)

124.1

a. Foreign Investment
7

65.5

Report on Foreign Exchange Reserves, Reserve Bank of India, (Government of India, 2003-04)

19

B.III.

Chart: 3

b. NRI Deposit

23.4

c. External Assistance

9.3

d. External Commercial Borrowings

13.5

e. Other items in capital account

12.4

Valuation change

6.9

Total (A+BI+BII+BIII)

107.1

Trend in Movement of Foreign Exchange Reserves

Movements in Foreign Exchange

Reserves
120
100
US$
billion 80

60
40
20

Table: 5

91 92

93 94 95

96 97 98

99 00 01 02 03 04

Sources of Accretion to Foreign Exchange Reserves

(US $ billion)
Items

2003-04

2002-03

I.

Current Account Balance

8.7

4.1

II.

Capital Account (net) (a to e)

22.7

12.8

a. Foreign Investment

14.5

4.6

b. Banking Capital

6.2

8.4

3.6

3.0

c. Short-term Credit

1.6

1.0

d. External Assistance

-2.7

-2.5

Of which: NRI Deposits

20

III.

e. External Commercial Borrowings

-1.9*

-2.3

f.

Other items in Capital Account

5.0

3.6

Valuation Change

5.4

4.4

Total (I+II+III)

36.8

21.3

The changing monetary policy paradigm

In the changed scenario, with a massive reserve build-up of reserves with the RBI; the
central bank has the added responsibility of countering the expansionary impact of capital
flows and maintaining a stable exchange rate apart from pursuing an independent
monetary policy. The question is whether the central bank can manage all these
responsibilities with the existing monetary instruments?
The theoretical understanding of the interrelationship amonst the various macroeconomic
aggregates as well as the working of the the Reserve bank reveals that the trinity of
desirable objectives, viz., a fixed/managed exchange rate, an independent monetary
policy and an open capital account cannot be achieved simultaneously. For example if the
domestic macroeconomic conditions necessitate that the domestic interest rates should
be higher than the international rates, this would attract capital flows from the rest of the
world. Persistent capital flows would exert an upward appreciation pressure on the
exchange rate with implications for external competitiveness. Alternatively, the monetary
authorities may attempt to moderate the appreciation pressure through absorption of these
flows; this would, however, have an expansionary impact on money supply, (as has been
happening in Indias case) which over time, could create inflationary tendencies. Thus
only two of the three objectives are mutually consistent With an open capital account the
policy makers can either pursue an independent monetary authority or a fixed /managed

21

exchange rate. If the policy makers follow a fixed/managed exchange rate it has to forego
its objcetive of price stability. These inherent trade-offs among the policy objectives have
been described as Macroeconomic Policy Trilemma

Section III

Challenges to monetary policy- What needs to be done

A reflection on the monetary and exchange rate dynamics reveals that the possibility of
having a fixed rate mechanism is no longer feasible and the dominant view is that, for
most countries floating or flexible rates is the most sustainable way of having a less
crisis- prone exchange rate regime. Opinions also vary on the extent and degree of
flexibility in exchange rates. But a completely free float without intervention is clearly
out of favour. Studies by the IMF and other experts have showed that most countries have
adopted intermediate regimes of various types, such as, managed floats with no preannounced path, and independent floats with foreign exchange intervention moderating
the rate of change and preventing undue fluctuations.
Another argument put forth against free float is that a freely floating regime does not
attach any importance to maintaining an adequate level of foreign exchange reserves. If
demand for foreign exchange is higher than supply, domestic currency will depreciate
and if supply exceeded demand, domestic currency will appreciate thus equilibrating
demand and supply over time. However in the light of volatility induced by capital flows,
there is now a growing consensus that emerging market economies, as a policy must

22

maintain adequate level of reserves.8 Earlier the adequacy of reserves was defined in
terms of months of imports; now an additional indicator of the adequacy is that reserves
should be atleast sufficient to cover likely variations in capital flows or liquidity at risk
Thus the above discussion can be converged into the following three points

Exchange rate should be flexible and not fixed or pegged

Countries should be able to manage or intervene or manage exchange rate to

atleast some degree if the movements are believed to be destabilising in the short
run

Reserves should be adequate to take care of variations in capital flows and

liquidity at risk

With a massive build-up of foreign exchange reserves with the RBI; it is imperative to
devise mechanisms to check the inflationary pressures arising from increased intervention
in the face of a surge in capital flows. The basic relationship is:
Change in M3 =m( change in NFA + change in RCG)
Where M3 is broad money, m is the money multiplier, NFA is the net foreign assets and
RCG is the reserve bank credit to the Government. When RBI purchases foreign currency
to stabilise the value of rupee, NFA goes up. This relationship suggests two ways of
mounting a response:

Dr. Bimal Jalan, Governor, Reserve Bank of India, speech delivered on August 14 2003 at the 14th
National Assembly of Forex Association of India in Mumbai on Exchange Rate Management: An
Emerging Consensus?

23

Impact on reserve money: The rise in NFA can be sterilized by reducing the central
banks credit to the Government. If the rise in NFA is completely offset by a reduction in
Reserve Bank credit to the Government; there is no change in money supply (M3).
Another channel for sterilization is the repo operations conducted by the RBI wherein the
Government bonds are pledged to banks when borrowing from them.
Another channel is the outright sale of government securities through open market
operations.
Impact on money multiplier: The second strategy which the Central bank can adopt is to
follow monetary tightening mechanisms which would reduce the value of money
multiplier m. This would involve policy initiatives such as raising CRR, forcing public
sector entities to directly hold accounts with the RBI etc.9

Two major episodes of surges in capital flows can be identified to examine RBIs
policy response towards them and their implications for monetary and exchange
rate parameters. Episode I can be identified as running from March 1993 to April
1995. As Virmani observes, in dealing with the surge in capital flows a threepronged startegy was suggested:

a) to partially sterilize the reserve build-up and to watch the situation on the inflation
front carefully.

Ila Patnaiak (2003), The Consequences of Currency Intervention in India, ICRIER Working . Paper. No.
114

24

b) Not to sterilize the permanent increase in reserve-build-up, so that it could

increase capital available in the economy, reduce the interest rate and promote
investment.
c) To accelerate the opening up of the current account and capital account to
improve the efficiency of the economy .
Thus we can infer that the policy makers were not in favour of complete sterilization
of capital flows as they thought it would throttle monetary expansion in the early
stages of an investment boom. Thus the policy response was tilted in favour of a nonsterilized intervention. There was a sharp increase in net foreign assets as a
consequence of currency intervention. Hence money supply grew sharply. M3 grew
by over 20% in the second half of 1994. This led to a sharp increase in the inflation
rate to over 15%.
Chart: 4 Money Supply & Inflation in episode I

Source: Ila Patnaik (oct 2003)

25

This led to attempts by RBI to control the growth in money supply through containing
the money multiplier by raising the reserve requirements. Thus we find that there
were consistent increase in the Cash Reserve ratio from June 1994 to July 1995
Table: 6 Monetary Tightening in episode I

We identify Episode II as having commenced from April 2002 and is still continuing. In
sharp contrst to Episode I, the intervention by the RBI in Episode II was motivated by a
current account surplus rather than by a capial surge. The capital surge only took place
from 2002-03 onwards whereas foreign exchange reserves with the RBI grew sharply in
2001-02, that is before the increase in capital flows in the following year. The figure on
currency intervention in episode II shows that the policy response of RBI was governed
by sterilized intervention. Sterilization was conducted through open market operations i.e
sale of government securities. In the figure we see a striking relation where months with
high purchases of USD were months where substantial sale of GOI securities took place.
Since sterilization was adopted as a monetary tightening mechanism; the need to reduce
money supply throgh reserve requirements was not required. On the contrary, cash

26

reserve ratio was reduced as apart of the broader monetary policy objective of avoiding
burden on the banking sector to maintain reserves.
Chart: 5

Currency Intervention in episode II

Source: Ila Patnaik (Oct 2003)

Chart: 6

Drop in CRR in Recent Years

Source: Ila Patnaik (Oct 2003)

27

As money multiplier is based on behavioural ratio like cash reserve ratio, currencydeposit ratio; any change in these ratios bring about a change in the value of multiplier.
Thus we find that the multiplier has been showing an increasingly upward trend as shown
in the Chart.
Chart: 7

Money Multiplier in recent years

Source: Ila Patnaik (Oct 2003)

Despite the cuts in CRR and increase in the value of the multiplier, the growth of money
supply remained under control due to open market operations by the RBI. Hence till
recently there was no need to increase the rate of interest as measure on the demand side
to curb inflation. The present situation in the face of high inflation rate calls for a relook
at the entire monetary-excahnge rate dynamics which would be elaborated later in the
article.

28

Chart: 8

Money Supply and inflation in Episode II

Source: Ila Patnaik (Oct 2003)

Consequences of Sterilised Intervention:

The consequences of sterilised intervention can be analysed in terms of its quasi-fiscal
cost and interest implications. Quasi-fiscal cost arises from the substitution of domestic
assets by foreign assets on the Central Banks balance sheet. In order to assess the impact
of quasi-fiscal cost of sterilisd intervention we compare the interest differential between
the returns on domestic government bonds and foreign interest rate times the amount of
foreign exchange reserves held by the Central bank. According to RBI estimates the
sterilized intervention by the RBI between April 2001 and March 2002 cost an estimated
Rs 2813.3 crores as QFC. This was about 0.56% of GDP in both 2001-02 and 2002-03.

29

Another implication of sterilized intervention is that when RBI sells bonds, this tends to
drive up the domestic interest rate and invite further capital inflows.
Moreover the availability of sufficient government marketable government securities
with the RBI could also constrain the extent of sterilization operations. There has been a
consistent decline in the share of domestic assets in the Reserve Money through out the
1990s. In particular the stock of the Government of India securities- the main instrument
of sterilization- declined from 1,46,534 crore at end March 2001 to rs 36,919 crore by
January 16, 200410.
Suggestions of the RBI Working Group
The depleting stock of government securities with the RBI has brought into a sharp focus
the limitations on the RBI to sterilise capital flows in future. Keeping this in mind RBI
constituted an Internal working Group on the Instruments of Sterilization to review the
working of various instuments with their associated costs and benefits and their
applicability. The Group suggests a two pronged approach a) strengthening the existing
instruments b) exploring new instruments applicable in the Indian context.
The Group examined the option of sterilisation of inflows by using/refining the existing
instrument without changing the legal framework. These instruments included: (i)
Liquidity Adjustment Facility (LAF); (ii) Open Market Operations (OMO); (iii) Balances
of the Government of India with the Reserve Bank; (iv) Forex Swaps; and, (v) Cash
Reserve Requirements. The Group also considered the introduction of cer tain new
instruments which would involve amendments to the RBI Act: (i) Interest Bearing
Deposits by Commercial Banks; and (ii) Issuance of Central Bank Securities. Moreover,
10

Report on Currency and Finance, Chapter VI, Reserve Bank of India, 2003

30

the Group explored the possibility whether the Government could issue Market
Stabilisation Bills / Bonds for sterilisation purposes if the existing instruments are found
to be inadequate to meet the size of operations in future.11 In pursuance of the
recommendation of the working group, a Market Stabilisation Scheme was introduced on
April 1,2004 under a Memorandum of Understanding between the Government of India
and the Reserve Bank. Under the MSS, treasury bills and dated securities of the Central
Government are issued for conducting sterilisation operations.
The Reserve Bank notifies the amount, tenure and timing of issuances under the MSS
under a calendar of issuances. The ceiling on the outstanding obligations of the
Government for the year 2004-05 under the MSS was fixed at Rs.60,000 crore, which is
now revised to Rs 80,000 crore. Through the Market Stabilisation Scheme, any increase
in the Reserve Banks net foreign assets would be matched by an accretion in
Government balances under the MSS driving down the net Reserve Bank credit to the
Government. The decline in Reserve Money nullifies the monetary impact of the increase
in Reserve Banks NFA.12. In August, 2004 the Central Government raised Rs 5000 crore
from MSS.

11
12

Ibid
Annual Report 2003-04, Reserve Bank of India

31

Section IV

Monetary Policy in the Current Inflationary Scenario

The rise in the annual inflation rate from 5.5 percent on June5 to 7.87% for the week
ended Setember 11 has raised serious concerns about the conduct of monetary policy.
The Reserve Bank is under pressure to curb inflation which is showing no signs of
abating. Government started its inflation control programme on the fiscal front through a
reduction in customs and excise duties on petroleum products. It was followed by RBIs
decision to increase the cash reserve ratio by 50 basis points to 5 % in stages. So far RBI
has refrained from raising any of the interest rate under its control-the bank rate or the
repo rate as a part of its preference for soft interest policy stance which yielded
favourable results for the economy; industrial investment and output have begun to look
up. But there are apprehensions that the prevailing macroeconomic situation may place
pressure on the RBI to raise the rate of interest. The mid term review of the Annual
Policy Statement to be announced on October 26 also signals a hike in the interest rate.
Notwithstanding these pressures, the balance of considerations suggest that the RBI
should resist them so that the incipient recovery that is now discernable after a long
period of recession, particularly in the manufacturing sector is not throttled.
Monetary Policy also faces the challenge of managing the rupee-dollar exchange rate
which is continually oscillating between appreciation and depreciation in response to

32

factors like rising inflation rate, surges in oil prices, slow down in foreign exchange
inflows etc13.

Section V

Conclusion
Monetary policy through plethora of its instruments both direct and indirect attempts to
manage the inherent conflicts between exchange rate stability and price stability.
Monetary policy has been responsive to the developments in the external sector and has
been able to fine tune itself in the changed operational environment. The major challenge
is in the form of high order of capital inflows and the swelling foreign exchange reserves
which has raised doubts about the sustainability of sterilization operations which are
currently underway to curb the expansionary impact of capital inflows. The thrust of the
monetary policy is therefore to explore new and more effective instruments of
sterilization. A positive step in this direction is the introduction of the Market
Stabilization Scheme introduced since April 1 2004 to absorb the excess liquidity in the
market. Besides Sterilization operations are also conducted through repos under the
Liquidity Adjustment Facility (LAF).
Another aspect which is a cause of serious concern and requires serious thinking is the
conduct of monetary policy in a situation characterised by rising inflation triggered by
external developments in the form of oil price hike. A serious consideration is thus
13

EPW Research Foundation, Interest Rates: Case against a Hike, Economic and Political Weekly, Vol.
XXXIX No. 38 September 18, 2004. PP. 4202-4204

33

required into the effectiveness of various direct and indirect instruments of monetary
control because their implication is not limited to price control but affects the overall
prospects of investment growth in the country.
Thus in short the monetary policy transmission mechanism has to be carefully examined
to minimise the negative externalities arising from its conduct to make it more
meaningful for the attainment of our broad objective of economic growth.

****

Bibliography
Alok Kumar Mishra, Revisiting Monetary Policy Perspectives in India during 1990s,
Vol. III No. 2 Journal of Applied Economics, March 2004, ICFAI University, PP.66-67,
March 2004

Annual Report 2003-04, Reserve Bank of India

C. Rangarajan, Select Essays on Indian Economy, Vol. I, edited by R. Kannan, Academic

Foundation, New Delhi, 2004.

34

C. Rangarajan, Some critical Issues in Monetary Policy, EPW Special Aricle, June 16
2001,

Dr. Bimal Jalan, Governor, Reserve Bank of India, speech delivered on August 14 2003
at the 14th National Assembly of Forex Association of India in Mumbai on Exchange
Rate Management: An Emerging Consensus?

EPW Research Foundation, Interest Rates: Case against a Hike, Economic and Political
Weekly, Vol. XXXIX No. 38 September 18, 2004. PP. 4202-4204

Ila Patnaiak, The Consequences of Currency Intervention in India, ICRIER Working .

Paper. No. 114, 2003

M. S. Ahluwalia, et al, (eds), Macroeconomics and Monetary Policy: Issues for a

Reforming Economy, Oxford University Press, New Delhi, 2002

M.Ramachandran, Fiscal Deficit, RBI Autonomy and Monetary Management, Economic

and Political Weekly, August 26 September 2, 2000 PP. 3266-72,

Renu Kohli, Capital Account Liberalisation Empirical Evidence and Policy Issues I,
EPW, Special Article, April 14, 2001 P. 1199

Report on Currency and Finance, Chapter VI, Reserve Bank of India, 2003

35

Report on Foreign Exchange Reserves, Reserve Bank of India, (Government of India,

2003-04)

Reserve Bank of India, Report: Report on Currency and Finance, Management of Capital
Flows, (Government of India, 2003)

Y. V. Reddy, Lectures on Economic and Financial Sectors Reforms in India, Oxford

University Press, New Delhi, 2002

Tables and Charts

Table: 1

Sources of Money Supply

Table: 2

Sources of Money Stock: Current Position

Table: 3

Composition of Capital Inflows to India

Table: 4

Sources of Accretion to Foreign Exchange Reserves since 1991

Table: 5

Sources of Accretion to Foreign Exchange Reserves

Table: 6

Monetary Tightening in episode I

Chart: 1

Capital Flows to Developing Economies

Chart: 2A

Foreign Exchange Reserves (excluding Gold and SDR)

Chart: 2B

Current Account Balance

36

Chart: 3

Trend in Movement of Foreign Exchange Reserves

Chart: 4

Money Supply & Inflation in episode I

Chart: 5

Currency Intervention in episode II

Chart: 6

Drop in CRR in Recent Years

Chart: 7

Money Multiplier in recent years

Chart: 8

Money Supply and inflation in Episode II

37