Presentation by Dr. Y.V. Reddy, Deputy Governor, RBI
at J.L. Kellogg Graduate School of Management Department
of Accounting & Information System Northwestern University,
Illinois on May 12, 1997
Financial Sector Reforms in India - Recent Trends
Professor Bala and friends,
- It was with great pleasure that I accepted the invitation
of Professor Bala to visit Kellogg School. I could not come last
month for an international seminar but Prof. Bala took a promise
that I shall do so at the earliest; and here I am. I consider
this both as a privilege and as an opportunity : a privilege to
be in this prestigious school, and an opportunity to present
recent trends in financial sector reforms in India.
- I shall begin with a brief but factual account of the perform
ance of Indian economy in the last three years to illustrate the
positive impact of economic reforms in general; and the reforms
in the financial sector in particular. This would be followed up
with a review of the financial sector reforms in terms of objectives,
ownership and control, competition, regulation and policy
environment. There would then be a detailed update of reforms
attempted this year (1997-98) through the budget as well as the
monetary and credit policy announcements. In particular, I would
focus on elements of continuity, contextual response and change
in the monetary and credit policy.
Indian Economy : Recent Trends
- The growth in real Gross Domestic Product (GDP) in the last
three years ranged from 6.8 to 7.2 per cent and current year
(1997-98) should be no exception. While growth in industry averaged
10.4 per cent in the last three years, that of agriculture
was 2.5 per cent inspite of a negative growth in 1995-96. Gross
Domestic Savings as a percentage of GDP continued to rise from
24.9 per cent in 1994-95 to 25.6 per cent by 1995-96.
- Gross Fiscal Deficit of Government of India as a percentage of
GDP has come down from 6.1 per cent to 5 per cent in the last
three years and is estimated to go down further to 4.5 per cent
this year. The internal debt of the government as a percentage
of GDP is also down correspondingly. The rate of inflation as
measured by Wholesale Price Index went down from 10.4 per cent in
1994-95 to 5.0 per cent in 1995-96 but has jumped again to 7.3
per cent in 1996-97. In the current year, we expect that it will
be down to around 6.0 per cent. Consistent with this, broad money
growth is targeted to grow only by 15 to 15.5 per cent this year.
Growth in non-food credit, however, was sluggish at 10.1 per cent
in 1996-97 but we expect it to move towards a figure of over
twenty per cent, closer to the very high actuals in 1994-95 and
- Growth of exports and imports in SDR terms averaged 13.3 per
cent and 17.5 per cent respectively in the last three years, but
the performance last year was below average at 9.6 and 10.7 per
cent. In the external sector, Current Account Deficit as a
percent of GDP has averaged at a little over one per cent. The
exchange rate has been under pressure on occasions but overall
while nominal exchange rate vis-`-vis US dollars exhibited a
steadily depreciating trend, the real effective exchange rate has
been appreciating during the last three years.
Financial Sector Reforms : A Review
- The major objectives of the financial sector reforms, as
elaborated by Dr. Rangarajan, Governor, RBI fall under the three
broad categories viz.
However, for convenience these measures can be related to
issues of ownership, competition, regulation and policy stance.
- measures aimed at removing the external
constraints bearing on the profitability of banks,
- measures aimed at improving the financial health of banks by introducing appropriate prudential norms and
- measures aimed at institutional strengthening including improving the competitiveness of the financial system.
Reforms in Ownership and Control
- The thrust of reforms in this area relates to privatization
and restructuring. Public sector banks have been permitted diversified
ownership by law subject to 51 per cent holding of Govern
ment/RBI/SBI. IFCI and IRBI were converted into public limited
companies. The Industrial Development Bank of India Act, 1964
was amended to allow IDBI to raise capital up to 49 per cent of
its paid up capital from the public. Legal amendments have been
made to induct private participation in the Board of Directors.
As a part of restructuring efforts, weak public sector banks
were recapitalised through budgetary support.
Reforms to Increase Competition
- New private sector banks have been established and Local
Area Banks have been licensed to instill a greater element of
competition in the financial system. There is a more liberal
policy of permitting branches of foreign banks. In the area of
interest rate, the administered structures were dismantled, both
on the deposit and lending side. The lending rates were rationalized
to two categories and on the deposit side, the Reserve
Bank of India (RBI) prescribes only one rate in the 30 days to
one year category and that too in the form of 'not exceeding 9.0
percent'. Further, credit norms have been liberalized and banks
now have more freedom to open new branches/upgrade existing
Reforms in Regulation
- Prudential norms have been introduced based on objective
criteria for income recognition, asset classification and provisioning.
The Basle Committee framework for capital adequacy has
been adopted. A Board for Financial Supervision has been set up
for exercising integrated supervision both, on-site and off-site
over banks, financial institutions and finance companies. Besides,
several steps have been taken to improve the audit system
in general. Non-banking financial companies have been brought
under more effective supervision of RBI.
Reforms in Policy Environment
- The Indian banking system operated on a high level of reserve
requirements for a long time. Progressive reduction has
brought down the Statutory Liquidity Ratio from 37.5 per cent to
25 per cent on an incremental basis and the Cash Reserve Ratio,
including incremental CRR from 25.0 per cent and 10.0 per cent.
As I mentioned earlier, there is near full deregulation of both
deposit and advances interest rates. The financial sector is now
operating in a more open and more market oriented environment.
Government debt is now mostly at market rates. Foreign exchange
rate is also market-determined.
Financial Sector Reforms : An Update (1997-98)
- The budget of 1997-98 and the monetary policy for the first
half of 1997-98 are considered landmarks in the process of
economic reform in India. In the budget of 1997-98, there are
some elements of great relevance to the financial sector, while
the monetary policy announcement that followed has been described
as a `big bang' in financial sector reform.
Ways and Means Advances
- A historic reform related to the financial sector was the
abolition of the system of ad hoc Treasury Bills and the introduction
of the system of the Ways and Means Advances. The ad hoc
Treasury Bills emerged as a mode of financing the Government's
deficit in the mid-1950s. The ad hoc Treasury Bills, which were
meant to be temporary, gained a permanent as well as cumulative
character. It became an attractive source of financing Government
expenditure, especially since it was available at an interest
rate pegged at 4.6 per cent per annum since 1974.
Under the new system of Ways and Means Advances (WMA),
financial limits have been fixed to accommodate the temporary
mismatches in Government receipts and payments. Interest rates on
the WMA would be at market related rates. The process of elimination
of ad hoc Treasury Bills was in three stages. In the first
stage between 1994-95 and 1996-97, limits were set for the yearly
increases in ad hoc Treasury Bills. In the second stage, i.e.,
for two years beginning April 1997-98, overdraft would be permit
ted beyond ten consecutive days, but at a cost. In the final
phase, i.e. after the transition of two years, no overdraft will
be permitted beyond ten consecutive days. The new system gives
more autonomy to the central bank to conduct its monetary policy.
- Many other measures having significant implications on the
financial sector were announced. The Budget commenced the phasing
out of interest tax. It removed the Tax deduction at source
on Government Securities, which had hitherto distorted pricing in
the secondary markets. The Government announced the launching of
Capital Indexed Bonds. A committee has been set up to draw the
road map for capital account convertibility. It also acknowledged
that in India's progress towards a more open economy, the regulations
governing foreign exchange transactions need to be modernised.
In view of this, the budget proposed to replace the exist
ing Foreign Exchange Regulation Act 1973 with a Foreign Exchange
Monetary and Credit Policy : Issues
- In the backdrop of the performance during 1996-97, four
major issues had to be addressed by the monetary policy for
First, what should be the order of increase in broad
money growth? Should M3 be targeted at all ?
Secondly, what should be the approach towards large
capital inflows in case it occurs ? If nominal exchange rate is
allowed to appreciate, what would be the impact on exports ? On
the other hand, if an interventionist policy is pursued, the
resultant expansion of money supply would need to be sterilized.
But, there are limits to sterilization; both in terms of costs
and availability of securities.
Thirdly, the prevailing level of interest rates did not
reflect the stance of monetary policy. The sizeable reduction in
the cash reserve ratio did not impart reduction in lending rates.
Under the circumstances, what measures could be taken to bring
interest rates down ?
Fourthly, on the issue of credit dispensation and credit
flows, what could be done to correct the sluggish growth in non-food
credit by banks. Can credit flow enhancement be a target at
Monetary and Credit Policy For 1997-98
- There are elements of continuity, contextual response and
more important, significant changes in the recent half yearly
monetary and credit policy.
- As Governor of the RBI, Dr. Rangarajan stated, the basic
objectives of monetary and credit policy continue to be the same.
The stance of this policy also continues to be maintaining reasonable
price stability and ensuring availability of adequate
bank credit to support growth of output in the real sector.
- Often we used to mention in the policy statement the important
measures that are kept unchanged. This time we did not: But there
are many features including CRR and SLR on domestic liabilities
which remain unchanged. The general thrust of financial sector
reforms continues and will continue over the period through
series of measures that will be announced from time to time. This
is the normal practice.
- The process of reduction in sector specific refinance has
been carried further. Over the past few years, we have been
gradually moving away from refinance to banks against export
credit, investment in Government Securities, etc.
- The increase in the proportion of loan system signifies conti
nuity. Until recently, banks were extending working capital
finance to corporates through a system of cash credits. There has
been a gradual shift from the cash credit system of financing to
the loan system.
- The general approach continues to be gradual. We have always
recognized the need for a cautious step-by-step approach rather
than a rapid deregulation.
- The rate of inflation at 7.3 per cent during 1996-97 was a
matter of concern. The current policy tries to respond by revising
the target for growth of M3 downward. As against the target
of 15.5 - 16.0 per cent for 1996-97, the actual performance was
15.6 per cent. The target for 1997-98 was scaled down to 15.0 -
15.5 per cent.
- To the extent, the slow growth of non-food credit - or credit
choke - is related to capital markets, advances against shares
have permitted. Banks have been allowed to extend loans to corporates
against shares held by them to enable such corporates to
meet the promoters' contribution to the equity of new companies
in anticipation of raising resources. Changes in the credit
delivery system were effected to give banks more autonomy and
- In the area of lending rates, measures were taken on a number
of fronts, especially through rationalization and signaling, to
reinforce the downward movement that has already taken place in
the short end of the market.
- The possibility of continued capital inflows was recognized
and as stated in the policy, would be a factor in regulating
- The policy continues to be exporter-friendly. The policy
rewards exporters who bring back their proceeds quickly. Interest
rates for usance bills up to 90 days have been prescribed at `not
exceeding 13 per cent. Previously it was fixed at 13 per cent.
Exporters can now extend trade related advances out of EEFC
accounts up to $ 3 million per account without prior approval of
Big Bang :
- The policy seeks greater market orientation in the financial
sector by empowering banks with greater operational flexibility.
RBI has moved out of microregulation. Now banks are given total
freedom on consortium arrangements and methodology of assessing
working capital requirements. No doubt, prudential guidelines
will continue to be prescribed by the RBI. These measures signify
changes in the relationship between the RBI and banks.
- Borrowers have also been empowered to reinforce marketisation.
These measures have changed the relationship between the
banker and the borrower. Borrowers can choose to go through a
single bank or multiple banks or take the syndication route.
Access to commercial paper is freer now.
- Macromanagement by the Reserve Bank has been emphasized. The
bank rate will emerge as a signal of the stance of monetary
policy and determine the rate at which funds will be available to
the system from the RBI. Interest rates on domestic term deposits
(maturity of 30 days and up to 1 year) and NRE deposits, RBI
refinance rates and the rates at which RBI provides liquidity
support to Primary Dealers have all now been linked to the bank
- Integration of money market, Government Securities market and
forex markets has commenced. Measures towards this end include
exemption of CRR/SLR on inter-bank liabilities, permission to
Authorised Dealers (ADs) to borrow from and lend in overseas
market, permission to ADs to book forward cover on the basis of
past performance, permission to undertake rupee/forex currency
swaps, allowing repos in all Government Dated Securities, reverse
repos for all SGL account holders, reducing the minimum period of
Commercial Paper (CP), etc.
The integration of the domestic and foreign exchange market
could lead to increased volatility in the domestic market as the
impact of exogenous factors could be transmitted to the domestic
market. However, the proposals for deepening and widening the
forex market such as allowing forward cover based on business
projections, development of rupee-forex swap markets have
strengthened the market participants with additional instruments
to hedge risks and reduce volatility.
- Extensive consultations with market participants were held
both formally and informally before finalising the policy. Further,
as a signal on ongoing consultations, a Committee for
Money Markets has been constituted, similar to the Technical
Advisory Committees on Forex and Government Securities Markets.
Significantly, it signals a difference in relationship between
the Reserve Bank and market participants at the informal level.
In conclusion, it would be useful to explore why the
recent policy is described as a `big bang'. After all, as in the
case of any Monetary Policy, there has been a combination of
Continuity, Contextual response and Change. But, there are some
significant features which have led observers to describe them as
institutional and structural reforms and these relate to changes
in relationships. First, the policy changes the relationship
between RBI and banks from micro regulation to macromanagement.
Second, it changes the relationship between banks and borrowers
by giving greater choice to borrowers among banks and among the
modes of financing their requirements. Third, to the extent, the
process of integration has started, it changes the relationship
between different market participants. Finally, the relationship
between the RBI and market participants is changed by expanding
and reinforcing the consultative process.
Through the various reform measures so far, we have laid
down the foundation for a more efficient financial system. Need
for further changes is recognized and for example, a Committee on
Capital Account Convertibility has been appointed. The cumulative
experience provides us with the necessary confidence to grapple
with the future challenges and our success so far makes us go
ahead with a sense of optimism.