Annual Report

1.1 During the year 1999-2000, the Indian economy exhibited a good degree of resilience. Economic growth continued to be in line with the trend in the post 1991 period, notwithstanding deceleration in agricultural output (Appendix Table I.1). Industry showed recovery while the services sector surged ahead, led by some of the fast rising segments such as construction and software. Monetary conditions were supportive of growth. Interest rates softened. The combined gross fiscal deficit of both the Central and State governments increased particularly due to a sharp rise in the fiscal deficit position of State governments. The monetary policy efforts in ensuring availability of sufficient credit at reasonable interest rates were facilitated by the general absence of inflationary pressures in the economy, although towards the close of the year, the inflation rate moved up due to revisions in certain administered prices. The external sector gained in strength with the enlargement of the invisible surplus and capital inflows. Foreign exchange reserves increased by about US $ 5.5 billion in 1999-2000.

1.2 A significant aspect of recent economic developments is the increasing influence of economic and financial market conditions in industrial economies on external payment and growth prospects in emerging market economies, including India. During 1999-2000, with the global growth and trade prospects improving significantly, almost all crisis affected South-East Asian economies and economies in other parts of Asia posted higher economic growth and experienced relatively stable financial market conditions.

1.3 In respect of India, however, there were three distinct developments that had a bearing on the domestic economic situation and policy evolution during 1999-2000. First, the border conflict in Kargil, which began in the first week of May 1999 and lasted for about two months, placed considerable pressure on government finances and created uncertainty in the financial markets. The additional defence expenditure had to be absorbed in the government budget, resulting in an adverse impact on the fiscal position. Secondly, the economic sanctions imposed by a number of western countries including the US and Japan on India, following the nuclear tests in May 1998, continued to cast their shadow in 1999-2000, notwithstanding some relaxations in November 1998 and October 1999. The Indian economy, however, could cope with the sanctions without much of adverse consequences, mainly because of heightened investor confidence as reflected in the increase in capital flows. Thirdly, the increase in international oil prices inflated the oil import bill.

1.4 It is against this difficult external environment that monetary and exchange rate policies and structural and institutional measures were framed during the year. The current account deficit was contained at a moderate level of 0.9 per cent of GDP during 1999-2000, notwithstanding the hardening of international petroleum prices and the consequent spurt in the oil import bill. The sharp increase in oil imports was partly offset by a turnaround in the export performance, which largely reflected higher export demand. Invisible receipts increased, partly owing to a rise in remittances and partly due to large exports of software products. There were strong capital inflows for the larger part of the year, leading to the accumulation of foreign currency reserves.

1.5 The Reserve Bank proceeded with the policy of cautious liberalisation of the external sector. Several measures were undertaken to facilitate capital flows. First, the cut-off date for forward exchange cover to foreign institutional investors (FIIs) in respect of their equity investments was changed from June 11, 1998 to March 31, 1999 and authorised dealers (ADs) were permitted to provide forward exchange cover to FIIs to the extent of 15.0 per cent of their outstanding equity investments as at the close of business on March 31, 1999 and the entire amount of investments undertaken thereafter. Secondly, Indian companies were permitted to issue rights/bonus shares and non-convertible debentures to non-residents subject to certain conditions. Moreover, Indian mutual funds were allowed to issue units and similar instruments under schemes approved by the Securities and Exchange Board of India (SEBI) to FIIs with repatriation benefits. Foreign corporates and high net worth individuals were permitted to invest in Indian markets through SEBI registered FIIs. Thirdly, policies in respect of external commercial borrowings (ECBs) were substantially liberalised (for details, refer to Section VI). Fourthly, foreign direct investments in all sectors, except for a small negative list, were placed under the automatic route. Fifthly, Indian companies engaged in knowledge based sectors like information technology, pharmaceuticals, bio-technology and entertainment software were permitted to acquire overseas companies engaged in the same line of activity through stock swap options up to US $ 100 million or 10 times the export earnings during the preceding financial year on an automatic basis. Investments up to US$50 million subject to certain conditions can be made by Indian parties in joint ventures abroad/wholly owned subsidiaries without prior approval of the Reserve Bank/Government of India and those proposals of investment involving amounts in excess of US $ 50 million will be considered for approval by the Special Committee on Overseas Investment. Finally, the minimum maturity of FCNR(B) deposits was raised to one year from six months with a view to elongating the maturity profile of external debt.

1.6 The Export Import (EXIM) Policy for 1997-2002 had attempted to liberalise the trade regime with a view to improving the national export performance. In continuation of this process, modifications announced on March 31, 2000 introduced a number of important fresh initiatives and also significant changes in some of the existing policies/procedures. These include export promotion measures such as extension of the hitherto sector-specific Export Promotion Capital Goods (EPCG) Scheme to all sectors and to all capital goods without any threshold limit, several sector-specific measures, e.g., for gems and jewellery, silk, leather, handicrafts and garments, drugs, pharmaceuticals, agro-chemicals and bio-technology along with a scheme for granting assistance to States for the development of export related infrastructure on the basis of their export performance. Reflecting India's international commitments, 714 out of 1,429 restricted items have been shifted from the Special Import Licence (SIL) list to the Open General Licence (OGL) list. The remaining items would be moved to the OGL list by March 31, 2001 by which time the SIL list would be abolished. Pharmaceutical and biotech firms would be able to import R&D equipment and goods duty-free up to 1 per cent of free on board (fob) value of their exports. The EXIM policy proposes to set up special economic zones (SEZs) in different parts of the country, which would be able to access capital goods and raw materials duty-free from abroad and from the domestic tariff area (DTA) without payment of terminal excise duty on the condition of achieving positive net foreign exchange earning as a percentage of exports annually and cumulatively for a period of five years from the commencement of commercial production. Sales to DTA would, however, be permitted on payment of full applicable customs duty. The EXIM policy also places emphasis on e-commerce - electronic data interchange including filing, processing and disposal of application forms.

1.7 The gross fiscal deficit (GFD) of the Central Government increased to 5.6 per cent of GDP in the revised estimates from 4.0 per cent in the budget estimates, partly reflecting cyclical, unforeseen and security related factors. The combined state government fiscal deficit also increased sharply. In this context, issues relating to devolution of finances between the Centre and the States and specified aspects of Centre-State fiscal relations have been examined by the Eleventh Finance Commission (EFC), which submitted its final report in July 2000 (Box I.1).

1.8 Monetary management has increasingly focussed on multiple indicators in order to influence domestic liquidity conditions. The strategy followed here was one of offsetting autonomous liquidity flows with discretionary flows. Given the thinness of the Indian foreign exchange market, the Reserve Bank had to ensure orderly conditions through pre-emptive and remedial measures. Pressures in the foreign exchange market emerged in May/June and end-August 1999. During this period, liquidity was appropriately tuned. Once normalcy was restored, the Reserve Bank could ease monetary conditions by reducing reserve requirements and rates consistent with the domestic credit demand.

1.9 One of the important characteristics of 1999-2000 is the softening of the interest rate structure, despite an increase in the fiscal deficit (Appendix Table I.2). The key interest rates decided by the Reserve Bank, such as the Bank Rate, the repo rate and the interest rate on savings deposits, have come down substantially. The Reserve Bank has also reduced reserve requirements in order to reduce the implicit tax imposed on banks by such statutory pre-emptions and cut down banks' borrowing costs. The other domestic interest rates are left to the banks to decide except in the cases of credit extended under the DRI scheme and of credits of up to Rs.2 lakh. However, a number of structural factors prevent financial entities, especially banks, from quickly responding to changes in the inflation rate while deciding on the nominal interest rates they charge on their lending or offer on deposits. For example, the post-tax return on bank deposits remains lower than those on contractual savings such as the Provident Fund and the National Saving Scheme. The higher fixed rate on long-term deposits raised in the past when interest rates were ruling high as also the high level of non-performing assets (NPAs), besides the high administrative costs of the banking system have limited the flexible use of the interest rate as an instrument of financial intermediation.

1.10 The experience of the past year suggested that flexibility should be the guiding principle in respect of both deposit and lending rates as also in regard to the maturity structures. This was, to an extent, addressed in the Monetary and Credit Policy announcement for the year 2000-01. Nonetheless in 2000-01, there are several challenges to be faced, and dilemmas resolved. Among these, the significant ones are: managing the large Government borrowing programme, meeting the increasing credit needs of the growing economy, maintaining reasonable interest rates and financing the continuing high oil import bill.

1.11 The course of monetary management in 1999-2000 could be categorised into three phases, viz., Phase I (April-May 1999), Phase II (June-October 1999) and Phase III (November 1999-March 2000).

1.12 The Reserve Bank was able to ease monetary conditions following the turnaround of capital flows in March 1999. The Reserve Bank reduced the Bank Rate by one percentage point to 8.0 per cent at the close of business on March 1, 1999 and the fixed repo rate by two percentage points to 6.0 per cent, effective March 2, 1999. The Reserve Bank reduced the cash reserve ratio (CRR) by 0.5 percentage point, effective the fortnight beginning March 13, 1999 releasing, in the process, Rs.3,100 crore in terms of lendable resources to the banking system. In response, major public sector banks reduced their deposit rates and prime lending rates. The Reserve Bank continued to ease monetary conditions by reducing the CRR by a further 0.5 percentage point, effective the fortnight beginning May 8, 1999.

1.13 The situation changed during the second phase as capital flows dried up in end-May 1999. The resultant volatility in the foreign exchange market, was, however, quickly contained as a result of the Reserve Bank's operations in the foreign exchange market and the money market coupled with the reiteration of its intention to meet demand and supply mismatches. There was a second bout of volatility in the foreign exchange market in end-August 1999. The Reserve Bank was again able to restore orderly conditions in the foreign exchange market with a similar mix of foreign exchange and money market operations and announcement effects. The Reserve Bank continued to align short-term interest rates with the interest rates implied in in the forward market premia in order to pre-empt funds from flowing into the foreign exchange market, in view of the prevailing excess demand conditions. This was achieved by modulating discretionary liquidity through export credit refinance to commercial banks and liquidity support to primary dealers (PDs), which resulted in the firming up of call rates. The Reserve Bank also continued with its policy of accepting private placements/devolvements of government paper when the domestic conditions were tight and offloading them in the market when the situation eased. Thus the Reserve Bank was able to modulate monetary and interest rate conditions using an array of mostly indirect monetary policy instruments such as open market operations and money market support to banks and primary dealers.

1.14 The third phase saw the return of excess supply conditions in the foreign exchange market with the turnaround in capital flows. This, in turn, allowed the Bank to ease monetary conditions further. The cash reserve ratio was reduced by one percentage point in two stages of 50 basis points each, effective the fortnights beginning November 6 and November 20, 1999, respectively. This augmented commercial banks' lendable resources by about Rs.7,000 crore. Effective the fortnight beginning November 6, 1999, the liabilities under the FCNR(B) scheme were exempted from incremental CRR requirements of 10.0 per cent (over the April 11, 1997 level). The supply of discretionary liquidity through the reduction in reserve requirements allowed banks to retire their borrowings from the Reserve Bank. Call rates thus eased below the Bank Rate. Further, as a result of the return of stability in the foreign exchange market, the Bank withdrew the stipulation of a minimum interest rate of 20.0 per cent per annum on overdue export bills and the interest rate surcharge of 30.0 per cent on import finance imposed in January 1998.

1.15 The Reserve Bank introduced a ';Special Liquidity Support'; facility for the period December 1, 1999 to January 31, 2000 with a view to enabling banks to meet any unanticipated additional demand for liquidity in the context of the century date change. Banks were allowed to avail of liquidity to the extent of their excess holdings of Central Government dated securities/Treasury Bills over the required statutory liquidity ratio (SLR) at the rate of 2.5 percentage points over and above the Bank Rate. Further, with a view to enabling the banks to meet any unanticipated surge in currency demand on account of the century date change, cash in hand, amounting to about Rs.4,500 crore, with banks was allowed to be included for compliance of CRR requirements during the same period.

1.16 The Reserve Bank continued to ease monetary conditions in April 2000 through a package of measures. The CRR was reduced by one percentage point to 8.0 per cent in two equal stages, effective April 8 and April 22, 2000, augmenting the lendable resources with commercial banks by about Rs.7,200 crore. The Reserve Bank reduced the Bank Rate by one percentage point to 7.0 per cent, effective the close of business on April 1, 2000. The fixed rate repo rate was reduced by one percentage point to 5.0 per cent, effective April 3, 2000. The Reserve Bank cut the savings deposit rate of scheduled commercial banks by 0.5 percentage point to 4.0 per cent, effective April 3, 2000. Comfortable liquidity conditions allowed commercial banks and primary dealers to redeem their borrowings (Rs.11,172 crore) from the Reserve Bank by April 21, 2000, thereby easing call rates below the Bank Rate. There was a general softening of interest rates across the maturity spectrum.

1.17 May 2000 saw a return of excess demand conditions in the foreign exchange market, mainly on account of large oil import payments and a slowdown in capital inflows. The Reserve Bank undertook net sales of US $ 1,948 million during May-June 2000 to meet temporary demand-supply mismatches. The resultant gap put pressure on money market conditions, driving up banks' and PDs' recourse to the Reserve Bank by Rs.7,236 crore by June 30, and thereby nudging up call rates above the Bank Rate especially during the second half of May and June 2000. The Reserve Bank accepted private placements/devolvements amounting to Rs.6,961 crore. The Centre's ways and means advances (WMA) declined by Rs.6,859 crore.

1.18 In order to reduce the uncertainty in the foreign exchange market, the Reserve Bank undertook the following policy actions on May 25, 2000: (i) an interest rate surcharge of 50 per cent of the lending rate on import finance was imposed with effect from May 26, 2000, as a temporary measure, on all non-essential imports; (ii) it was indicated that the Reserve Bank would meet, partially or fully, the Government debt service payments directly as considered necessary; (iii) arrangements would be made to meet, partially or fully, the foreign exchange requirements for import of crude oil by the Indian Oil Corporation; (iv) the Reserve Bank would continue to sell US dollars through the State Bank of India in order to augment supply in the market or intervene directly as considered necessary to meet any temporary demand-supply imbalances; (v) banks would charge interest at 25 per cent per annum (minimum) from the date the bill falls due for payment in respect of overdue export bills in order to discourage any delay in realisation of export proceeds; (vi) ADs acting on behalf of FIIs could approach the Reserve Bank to procure foreign exchange at the prevailing market rate and the Reserve Bank would, depending on market conditions, either sell the foreign exchange directly or advise the concerned bank to buy it in the market; and (vii) banks were advised to enter into transactions in the foreign exchange market only on the basis of genuine requirements and not for the purpose of building up speculative positions. In response to these measures, the rupee regained stability and traded within a narrow range of Rs.44.57-Rs.44.79 per US dollar during June 2000.

1.19 The introduction of the Liquidity Adjustment Facility (LAF) effective June 5, 2000, allowed the Reserve Bank an additional lever for influencing short-term liquidity conditions. With the persistence of pressures in the foreign exchange market, the Reserve Bank conducted reverse repo auctions, averaging about Rs.3,000 crore, at interest rates which increased from 9.05 per cent as on June 9 to 10.85 per cent as on June 14. The Reserve Bank rejected all bids in the June 16, 2000 auction. Reacting to this, inter-bank call rates went up to 28.0 per cent. The Reserve Bank accepted reverse repos (Rs.1,350 crore) at 13.5 per cent as on June 19, 2000 and gradually scaled down the reverse repo rate to 12.25 per cent as on June 28, 2000 with the return of stability in the foreign exchange market.

1.20 The exchange rate of the rupee, which was bound in the range of Rs. 44.68-Rs. 44.74 per US dollar during the first half of July 2000, depreciated to Rs. 45.02 per US dollar on July 21, 2000. On a review of developments in the international and domestic financial markets, including the foreign exchange market, the Reserve Bank took the following measures on July 21, 2000: (i) the Bank Rate was increased by 1 percentage point from 7 per cent to 8 per cent as at the close of business on July 21, 2000; (ii) CRR was increased by 0.5 percentage point from 8 per cent to 8.5 per cent in two stages by 0.25 percentage point each, effective July 29, 2000 and August 12, 2000, respectively; and (iii) the limits available to banks for refinance facilities including the collateralised lending facility (CLF) were reduced temporarily to the extent of 50 per cent of the eligible limits under two equal stages effective from July 29, 2000 and August 12, 2000. In early August, the Reserve Bank also introduced special repo auctions of more than one day maturity to absorb excess liquidity.

1.21 The Reserve Bank continued to play a major role in the development of financial markets and improvement of credit delivery systems. In order to provide greater flexibility, the Reserve Bank has attempted to move gradually towards provision of a daily liquidity adjustment facility in the Indian money markets. The Interim Liquidity Adjustment Facility (ILAF) introduced in April 1999 was replaced in June 2000 by a full fledged liquidity adjustment facility in which liquidity would be injected through reverse repo auctions and liquidity would be sucked out through repo auctions. This is being introduced in stages (Box I.2).

1.22 The Reserve Bank has, in addition, introduced several measures to facilitate short-term liquidity management. First, in order to facilitate cash management banks were advised to maintain CRR during a fortnight on the basis of net demand and time liabilities (NDTL) as on the last Friday of the second preceding (instead of the first as hitherto) fortnight with effect from November 6, 1999. Further, the minimum daily requirement of CRR balances was reduced from 85.0 per cent to 65.0 per cent with effect from May 6, 2000. Secondly, the Reserve Bank allowed cheque writing facilities to money market mutual funds (MMMFs), gilt funds and Liquid Income Schemes of mutual funds, which invest not less than 80.0 per cent of their corpus in money market instruments through tie-ups with banks. Further, it has been decided that MMMFs need to be set up as separate entities instead of operating through money market deposit accounts (MMDAs). Finally, the Reserve Bank attempted to further widen the scope of money market instruments. The minimum maturity period of certificates of deposit (CDs) has been reduced to 15 days in order to bring it at par with other instruments such as commercial paper (CP) and term deposits.

1.23 The measures to develop money markets continue to be well supported by reforms in the government securities market. First, the repo market has been gradually developed with the introduction of proper regulatory safeguards. The Reserve Bank clarified that there are no restrictions on the tenor of repos. All non-bank entities maintaining SGL accounts and current accounts with the Reserve Bank, which could so far undertake only reverse repos, have been permitted to borrow money through repos on par with banks and PDs, so that the permission presently given to such entities to only lend in the call money market could be eventually withdrawn. Secondly, several steps were undertaken with a view to imparting depth and liquidity to the Treasury Bill market. It was decided to announce a calendar for the issuance of Treasury Bill auctions for the entire year. Effective May 26, 1999, 182-day Treasury Bills have been re-introduced. The Reserve Bank initiated two-way operations in Treasury Bills in February 2000, based on the recommendations of an internal working group. Thirdly, the Reserve Bank continued to increase the PD network by adding six more PDs, taking the total number to 15. The system of underwriting has been replaced by a system of minimum bidding commitments at the beginning of each year in respect of Treasury Bill auctions, with the minimum bidding commitments of all PDs absorbing more than 100 per cent of the issuance of Treasury Bills. The liquidity support to PDs would now be based on bidding commitments and other parameters. It was further modified during April 2000 to take into account not only the bidding commitment but also the performance in both primary and secondary markets. At the same time, the payment of commissions for Treasury Bills was withdrawn with effect from June 5, 2000, as PDs are no longer required to take devolvements. In case of dated securities, it was decided to accept underwriting from PDs up to 100 per cent of the notified amounts (as against 50.0 per cent so far). PDs were advised to evolve reasonable leverage ratios with the consent of their boards of directors. In view of the differences in the regulations on bank/financial institution (FI)-subsidiary PDs and others, detailed guidelines on internal control systems relating to securities transactions on uniform basis were issued to PDs. Capital adequacy standards are also proposed to be introduced for PDs. The payment date for 14-day Treasury Bills and 91-day Treasury Bill auctions (normally held on Fridays) was changed from Saturday to the next working day as there is no large value clearing on Saturday.

1.24 The Reserve Bank undertook several measures to further facilitate the deregulation and flexibility in interest rates. First, the Reserve Bank allowed banks the freedom to prescribe different prime lending rates (PLRs) for different maturities. Banks were accorded the freedom to charge interest rates without reference to the PLR in case of certain specified loans. Banks may also offer fixed rate term-loans in conformity with the ALM guidelines. Secondly, scheduled commercial banks (excluding regional rural banks), PDs and all-India financial institutions were allowed to undertake forward rate agreements (FRAs)/ interest rate swaps (IRS) for hedging and market making. Corporates and mutual funds were allowed to undertake these transactions for hedging balance sheet exposures. The Reserve Bank would also consider requests for hedging commodity price exposures from Indian corporates in specified products, such as over-the-counter (OTC) futures contracts, based on average prices, categories of options contracts, etc. Thirdly, the Reserve Bank allowed the interest rates that are implied in the foreign forward exchange market to be used as an additional benchmark to price rupee interest rate derivatives and facilitate integration between money and foreign exchange markets.

1.25 A Working Group was constituted by the Reserve Bank to explore the possibilities of setting up a Credit Information Bureau in India (Chairman: Shri N.H.Siddiqui). Based on its recommendations and realising the need for development of better institutional mechanisms for sharing of credit related information, the Union Budget 2000-01 announced the establishment of a Credit Information Bureau. The Reserve Bank advised banks and FIs in April 2000 to make necessary in-house arrangements for transmittal of the appropriate information to the Bureau.

1.26 With the passing of the Insurance Regulatory and Development Authority (IRDA) Act, 1999, banks and non-banking financial companies (NBFCs) have been permitted to enter the insurance business. The Reserve Bank issued guidelines in this regard (Box I.3). These are felt necessary in view of the fact that the insurance business does not break-even during the initial years of operation and that the banks and NBFCs do not have adequate actuarial and technical expertise in undertaking insurance business.

1.27 The Reserve Bank issued guidelines to banks for operation of gold deposit schemes. The Reserve Bank also granted in-principle approval for an assaying and hallmarking venture to be set up by the State Bank of India (SBI) as its subsidiary, with equity participation from Allahabad Bank, Corporation Bank, Canara Bank and Credit Suisse Financial Products, London.

1.28 In view of the need for promoting and sustaining financial stability and in the light of the international discussions on transparency practices and standards in different financial sector activities, the Reserve Bank appointed a Standing Committee on International Financial Standards and Codes (Chairman: Dr. Y.V. Reddy) in order to identify and monitor developments in global standards and codes being evolved and consider the applicability of these standards and codes to the Indian financial system and chalk out a road map for aligning India's standards and practices with international best practices (Box VI.8). The Reserve Bank has already initiated several measures in order to achieve greater transparency in banking operations by closely complying with the Core Principles for effective banking supervision prescribed by the Basel Committee on Banking Supervision. The Reserve Bank issued a self-assessment of the Core Principles in operation in Indian banking.

1.29 In line with the recommendations of the second Narasimham Committee, the Mid-Term Review of the Monetary and Credit Policy of October 1999 announced a gamut of measures to strengthen the banking system. Important measures on strengthening the health of banks included: (i) assigning of risk weight of 2.5 per cent to cover market risk in respect of investments in securities outside the SLR by March 31, 2001 (over and above the existing 100 per cent risk weight) in addition to a similar prescription for Government and other approved securities by March 31, 2000, and (ii) lowering of the exposure ceiling in respect of an individual borrower from 25 per cent of the bank's capital fund to 20 per cent, effective April 1, 2000.

1.30 Out of the 27 public sector banks (PSBs), 26 PSBs achieved the minimum capital to risk assets ratio (CRAR) of 9 per cent by March 2000. Of this, 22 PSBs had CRAR exceeding 10 per cent. To enable the PSBs to operate in a more competitive manner, the Government adopted a policy of providing autonomous status to these banks, subject to certain benchmarks. As at end-March 1999, 17 PSBs became eligible for autonomous status.

1.31 While nationalised banks need to augment their capital base to deal with the changing operational environment, the Government preferred that banks raise capital from the market. To facilitate this, the Government decided to reduce its minimum shareholding to 33 per cent, whilst at the same time, keeping the public sector character of these banks unchanged as well as ensuring that the fresh issues of shares are widely held by the public. The Government also proposed to bring about necessary changes in the legislative provisions to accord flexibility and autonomy to the boards of banks.

1.32 While the Government did not provide any amount towards recapitalisation of PSBs in 1999-2000, it nonetheless provided a sum of Rs.297 crore towards writing down of its investments in the capital base of Vijaya Bank for adjustment of its losses. With this, the cumulative losses written off against capital amounted to Rs.6,334 crore. The reduction in the Government's investments cleans up the balance sheets of the banks concerned and enables them to go for public issues.

1.33 As a move towards consolidated reporting, the Reserve Bank advised banks in April 2000 to voluntarily build-in the risk weighted components of their subsidiaries into their own balance sheets on a notional basis, at par with the risk weights applicable to banks' own assets. Banks are to earmark additional capital in their books over a period of time so as to obviate the possibility of impairment of their net worth when the switch over to a uniform balance sheet for the group as a whole is adopted. The additional capital required may be provided in the banks' books in phases beginning with the year 2000-01.

1.34 The Reserve Bank persevered with the on-going process of strengthening prudential accounting norms with the objective of improving the financial soundness of banks and to bring them at par with international standards. The Reserve Bank advised PSBs to set up Settlement Advisory Committees (SACs) for timely and speedier settlement of NPAs in the small scale sector, viz., small scale industries, small business including trading and personal segment and the agricultural sector. The guidelines on SACs were aimed at reducing the stock of NPAs by encouraging the banks to go in for compromise settlements in a transparent manner. Since the progress in the recovery of NPAs has not been encouraging, a review of the scheme was undertaken and revised guidelines were issued to PSBs in July 2000 to provide a simplified, non-discriminatory and non-discretionary mechanism for the recovery of the stock of NPAs in all sectors. The guidelines will remain operative till March 2001. Recognising that the high level of NPAs in the PSBs can endanger financial system stability, the Union Budget 2000-01 announced the setting up of seven more Debt Recovery Tribunals (DRTs) for speedy recovery of bad loans. An amendment in the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, was effected to expedite the recovery process.

1.35 Further progress was made in respect of the market valuation of investments in SLR securities by raising the proportion of current investments by 5 percentage points to a minimum of 75 per cent for the year ended March 31, 2000. The proportion has been retained unchanged for the year 2000-01.

1.36 The Reserve Bank advised banks in February 1999 to put in place an ALM system, effective April 1, 1999 and set up internal asset liability management committees (ALCOs) at the top management level to oversee its implementation. Banks were expected to cover at least 60 per cent of their liabilities and assets in the interim and 100 per cent of their business by April 1, 2000. The Reserve Bank also released ALM system guidelines in January 2000 for all-India term-lending and refinancing institutions, effective April 1, 2000. As per the guidelines, banks and such institutions were required to prepare statements on liquidity gaps and interest rate sensitivity at specified periodic intervals.

1.37 The Reserve Bank issued detailed guidelines for risk management systems in banks in October 1999, encompassing credit, market and operational risks (Box I.4). Banks would put in place loan policies, approved by their boards of directors, covering the methodologies for measurement, monitoring and control of credit risk. The guidelines also require banks to evaluate their portfolios on an on-going basis, rather than at a time close to the balance sheet date. As regards off-balance sheet exposures, the current and potential credit exposures may be measured on a daily basis. Banks were also asked to fix a definite time-frame for moving over to the Value-at-Risk (VaR) and duration approaches for the measurement of interest rate risk. The banks were also advised to evolve detailed policy and operative framework for operational risk management. These guidelines together with ALM guidelines would serve as a benchmark for banks which are yet to establish an integrated risk management system.

Financial liberalisation has ushered in a sea change in the desired role, functions, operations, competitiveness, rules and regulations and external environment faced by financial entities. For example, the removal of market imperfections through the entry of new players resulting in increased competition limits arbitrage opportunities, exerts pressure on margins and reduces the cushion for absorbing losses even as the potential for business losses increases due to higher market volatility. In India, the interest rate spread exhibited a narrowing trend following the deregulation of interest rates since October 1994 with some convergence by 1998-99 (Chart I.1). Simultaneously, an entire spectrum of financial market risks has emerged in day-to-day operations of banks in India, viz., price risks like interest rate risks, liquidity risks like local and cross-currency funding risks, counter-party risks like pre-settlement and settlement risks, in addition to credit risks, posing a threat to banks' operations in the new deregulated environment.

1. Reserve Bank of India, (1999), Risk Management Systems in Banks: Guidelines.

1.38 As a move towards greater transparency, banks were directed to disclose the following additional information in the 'Notes to Accounts' in the balance sheets from the accounting year ended March 31, 2000: (i) maturity pattern of loans and advances, investment securities, deposits and borrowings, (ii) foreign currency assets and liabilities, (iii) movements in NPAs and (iv) lending to sensitive sectors as defined by the Reserve Bank from time to time.

1.39 In the Union Budget Speech 1998-99, the Finance Minister had proposed to set up an expert group to suggest amendments in the key laws governing banking and financial practices. Accordingly, the Government set up an Expert Committee (Chairman: Shri T.R.Andhyarujina) to suggest appropriate amendments in the legal framework affecting the banking sector such as the Transfer of Property Act, foreclosure laws, Stamp Act, Contract Act, Debt Recovery Tribunal Act, etc. The Committee has recently submitted its report to the Government. The Reserve Bank is also finalising its views on amendments with regard to certain important issues, such as penal provisions against directors indulging in connected and related lending, foreclosure and bankruptcy, besides broadbasing of certain provisions designed to plug existing lacunae as well as to achieve greater clarity in bank related Acts.

1.40 In India, banks as well as other financial entities have entered the domain of information technology and computer networking. A satellite-based Wide Area Network (WAN) would provide a reliable communication framework for the financial sector. The Indian Financial Network (INFINET) was inaugurated in June 1999. It is based on satellite communication using VSAT technology and would enable faster connectivity within the financial sector. The INFINET would serve as the communication backbone of the proposed Integrated Payment and Settlement System (IPSS). The Reserve Bank constituted a National Payments Council (Chairman: Shri S. P. Talwar) in 1999-2000 to focus on the policy parameters for developing an IPSS with a real time gross settlement (RTGS) system as the core.

1.41 With the ultimate goal of designing and developing multiple deferred/discrete net settlement systems and RTGS, facilitating efficient funds management, house-keeping and customer service, the Reserve Bank took a number of steps to improve the infrastructure which include developing a Payments System Generic Architecture Model for both domestic and cross-border payments. The model conceives networking of computerised bank branches, with their controlling offices, central treasury departments and head offices with the provision for introducing standardisation of operating systems and networking platforms within the bank and a bank-level standardised gateway to the INFINET. Progress has also been made towards developing standards for newer payments instruments such as SMART cards.

1.42 The Committee on Technology Upgradation in the Banking Sector (Chairman: Dr. A. Vasudevan), which submitted its report to the Reserve Bank in July 1999, recommended, inter alia, a new legislation on the Electronic Funds Transfer (EFT) system to facilitate multiple payment systems to be set up by banks and FIs. Technological upgradation in payments and settlements systems has implications for the conduct of monetary policy. The demand for liquidity at the short end of the market itself depends on the type of settlement system that is in operation. The pricing of resources at the short end of the market also depends on the payments and settlement system in place. The intra-day liquidity requirements would be substantial if the RTGS mechanism is made operational.

1.43 The Reserve Bank had set up a Working Group (Chairman: Shri M. S. Verma) to suggest measures for the revival of weak PSBs in February 1999. The Working Group, in its report submitted in October 1999, suggested that an analysis of the performance based on a combination of seven parameters covering three major areas of i) solvency (capital adequacy ratio and coverage ratio), ii) earnings capacity (return on assets and net interest margin) and iii) profitability (operating profit to average working funds, cost to income and staff cost to net interest income plus all other income) could serve as the framework for identifying the weakness of banks. PSBs were, accordingly, classified into three categories depending on whether none, all or some of the seven parameters were met. The Group primarily focussed on restructuring of three banks, viz., Indian Bank, UCO Bank and United Bank of India, identified as weak as they did not satisfy any (or most) of the seven parameters. The Group also suggested a two-stage restructuring process, whereby focus would be on restoring competitive efficiency in stage one, with the options of privatisation and/or merger assuming relevance only in stage two.

1.44 The Union Budget 2000-01 announced the setting up of a Financial Restructuring Authority (FRA) in a modified form from the model suggested by the Working Group in respect of any bank which is considered potentially weak. The FRA, comprising experts and professionals, would be given powers to supersede the board of directors on the basis of recommendations of the Reserve Bank. It was announced in the Budget that the Government would consider recapitalisation of weak banks to achieve the prescribed capital adequacy norms, provided a viable restructuring programme acceptable to the Government as the owner and the Reserve Bank as the regulator is made available by the banks concerned. The restructuring plans of the three weak banks are under active consideration.

1.45 Reforming the deposit insurance system, as observed by the Narasimham Committee (1998), is a crucial component of the present phase of financial sector reforms in India. The Reserve Bank constituted a Working Group (Chairman: Shri Jagdish Capoor) to examine the issue of deposit insurance which submitted its report in October 1999. Some of the major recommendations of the Group are : (i) fixing the capital of the Deposit Insurance and Credit Guarantee Corporation (DICGC) at Rs.500 crore, contributed fully by the Reserve Bank, (ii) withdrawing the function of credit guarantee on loans from DICGC and (iii) risk-based pricing of the deposit insurance premium in lieu of the present flat rate system. A new law, in supercession of the existing enactment, is required to be passed in order to implement the recommendations. The task of preparing the new draft law has been taken up. The relevant proposals in this respect would be forwarded to the Government for consideration.

1.46 The Reserve Bank advised public sector banks to prepare Special Agricultural Credit Plans (SACPs) on an annual basis. For the financial year 1999-2000, the disbursement to agriculture under the SACPs amounted to Rs.21,913 crore against the projection of Rs.21,308 crore. In response to the Union Budget 1998-99, all scheduled commercial banks were advised in August 1998 to introduce the scheme, formulated by NABARD, for issuance of Kisan Credit Cards (KCCs) to farmers to enable them to readily purchase agricultural inputs and draw cash for their production needs. As on March 31, 2000, 27 PSBs had issued 13.7 lakh KCCs as against the target of 20 lakh KCCs fixed for the year. It is proposed to extend the coverage of KCCs to 75 lakh in 2000-01 as announced in the Union Budget.

1.47 The policy to channelise the shortfall in the priority sector lending by banks into rural infrastructure investment continued during 1999-2000. A Rural Infrastructure Development Fund (RIDF) with a corpus of Rs.2,000 crore was constituted at NABARD in April 1995 for advancing loans to State governments and state owned corporations for quick completion of ongoing projects relating to medium and minor irrigation, soil conservation, watershed management and other forms of rural infrastructure. Subsequently, RIDF - II-V were established between 1996-97 and 1999-2000 (Table 1.1). The Union Budget 2000-01 announced the establishment of RIDF - VI with a corpus of Rs.4,500 crore at NABARD and a reduction in the interest rate by 0.5 percentage point. The repayment period for loans under RIDF-V and VI has been extended to 7 years from 5 years earlier with the scope also widened to include lending to gram panchayats, self-help groups and other eligible organisations for implementing village level infrastructure projects. The order of disbursal of RIDF funds, as at end-March 2000, however, continued to remain low reflecting the difficulties associated with the identification of appropriate projects by some of the State governments, lack of budgetary support where only part-funding from RIDF was visualised, delays in finalisation of formalities for drawal of funds and in completing the necessary spade work for irrigation projects involving land acquisition and tendering procedures. The state-wise utilisation was uneven. Three States, Uttar Pradesh, Andhra Pradesh and Maharashtra accounted for 37.6 per cent of total disbursements as at end-March 2000. No State had utilised their RIDF sanctions in full.

1.48 A sum of Rs.152.65 crore was expended by the Central Government during 1998-99 to strengthen the capital base of regional rural banks (RRBs). Besides, a budgeted sum of Rs.168 crore was released by the Central Government for restructuring the capital base of select RRBs during 1999-2000. For the year 1999-2000 (July-June), the Reserve Bank renewed a credit limit of Rs.5,700 crore, sanctioned in the previous year, to the National Bank for Agriculture and Rural Development (NABARD) consisting of Rs.4,850 crore under GLC I (for seasonal agricultural operations) and Rs.850 crore under GLC II (for various other approved short-term purposes). In view of the increase in the sanction of credit limit by NABARD to co-operatives and RRBs in general and for meeting the additional requirements of funds on account of the recent cyclone/floods, in Orissa in particular, an additional limit of Rs.400 crore under GLC I was sanctioned in December 1999, at the request of NABARD.

1.49 The Micro-credit Special Cell, set up in the Reserve Bank pursuant to the Monetary and Credit Policy announcement in April 1999, submitted its report in January 2000. Meanwhile, the Task Force on Supportive Policy and Regulatory Framework for Micro Finance, set up by NABARD, had also submitted its report. Taking into consideration the broad thrust of these two reports, the Reserve Bank advised banks in February 2000 to mainstream micro-credit and extend the outreach of micro-credit providers. Micro-credit extended either directly or through any intermediary is reckoned as part of banks' priority sector lending. Banks are now free to prescribe their own lending norms. Micro-credit would form an integral part of their corporate credit plan and would be reviewed at the highest level every quarter. In view of its potential in the alleviation of poverty, banks have been advised to make all out efforts for provision of micro-credit.

1.50 The Union Budget 2000-01 announced an additional coverage of one lakh self-help groups (SHGs) during the year by NABARD and SIDBI. To give a further boost to this programme, the Union Budget 2000-01 has also announced the creation of a Micro-Finance Development Fund in NABARD with a startup capital of Rs.100 crore from the Reserve Bank, NABARD, banks and others. This Fund will provide start-up funds to micro-finance institutions and infrastructure support for training and systems management and data building.

1.51 The process of registration of NBFCs is a continuous one. The Reserve Bank (Amendment) Act 1997 had allowed a period of three years to NBFCs which did not have the statutory minimum net owned funds (NoF) of Rs.25 lakh at the commencement of the Act to attain the minimum NoF and thus become eligible for registration. The three-year time period expired on January 9, 2000. Out of 26,938 NBFCs whose NoF was less than Rs.25 lakh as on January 9, 2000, as many as 8,070 NBFCs have reported to have stepped up their NoF to Rs.25 lakh or more, thus becoming eligible for registration. In addition, the Reserve Bank received 2,211 applications for extension of time. As per the provisions in the Act and NBFC Acceptance of Public Deposits (Reserve Bank) Directions, 1998, NBFCs with NoF less than Rs.25 lakh are not entitled to accept fresh public deposits. In the case of new NBFCs, which commence the business of a non-bank financial institution as on or after April 21, 1999, and which seek registration with the Reserve Bank, the requirement of minimum NoF was raised to Rs.2 crore. As on June 30, 2000, the Reserve Bank has granted certificates of registration to 679 companies permitting them to accept public deposits and to 8,451 companies without authorisation for acceptance of public deposits.

1.52 The Monetary and Credit Policy of April 2000 announced a number of measures in respect of the NBFC segment. These include, among others, prescription of guidelines on ALM and risk management, guidelines for their entry into the insurance business and procedures for fixing of interest rates. Considering the heterogeneous size and geographical spread of NBFCs, the Reserve Bank is exploring the possibility of promoting the concept of self regulatory organisations (SRO), particularly among smaller NBFCs, and further improving the disclosure requirements in order to instill confidence in their functioning. The Union Budget 2000-01 proposed to introduce a new bill, which would strengthen the hands of depositors in situations of malafide or fraudulent actions of NBFCs.

1.53 The traditional division between banks (as providers of working capital) and FIs (as providers of project finance) is increasingly getting blurred with the deepening of financial reforms and integration of financial markets. There is a need to gradually put in place a regulatory framework which will facilitate eventually the transition to universal banking. The Reserve Bank undertook a number of policy measures during 1999-2000, relating to the prudential regulation and supervision of all India term-lending and refinancing institutions. Effective March 31, 2000, a risk weight of 2.5 per cent was assigned to all securities to cover the market risk over and above the existing 20-100 per cent credit risk weight assigned to different types of securities. The Reserve Bank issued prudential norms relating to the assignment of risk weight, asset classification and provisioning in respect of such take-out financing by FIs. With a view to moving towards the international standards of 15 per cent, the exposure ceiling in respect of all-India term-lending institutions for individual borrowers was reduced from the present level of 25 per cent to 20 per cent of their capital funds, effective April 1, 2000. However, the exposures in excess of 20 per cent existing as on October 31, 1999 are required to be brought down to 20 per cent by end-October 2001. On the resource raising front, all-India financial institutions have also been recently accorded the freedom to determine interest rates on term-deposits. On June 21, 2000, the Reserve Bank also issued a new set of guidelines providing FIs with greater flexibility in resource mobilisation through bond issues.

1.54 The process of reform in the capital market was carried forward during 1999-2000. In order to ensure better investor protection and transparency in corporate affairs, SEBI accepted the recommendations of the Committee on Corporate Governance (Chairman: Shri K.M. Birla) (Box II.6). A beginning in establishing a code of corporate governance was made by changing the listing norms at the stock exchanges while other recommendations of the Committee are under consideration of various regulatory agencies. Regulations for rating agencies have been framed. In order to promote new entrepreneurs and knowledge-based industries through venture capital route, the SEBI has been made the single point nodal agency in the Union Budget for 2000-01. The SEBI has accepted the recommendations of the Committee on Venture Capital Fund (Chairman: Shri K.B. Chandrasekhar) and is reviewing its existing guidelines on venture capital (Box V.3). Legal restrictions in respect of derivative trading were removed by enacting the Securities (Amendment) Act, 1999. Two major stock exchanges viz., the Stock Exchange, Mumbai (BSE) and the National Stock Exchange (NSE), commenced trading in stock index futures in June 2000. To protect investor interest, the SEBI framed regulations for collective investment schemes (CIS) as suggested by the Dave Committee. The guidelines stipulate, inter alia, higher net worth for collective investment management companies (CIMC), compulsory rating for CISs and prohibit assured return schemes. The SEBI served notices to 23 CISs, which failed to comply with the SEBI guidelines to wind up their operations and repay investors' money.

1.55 The SEBI reduced the minimum public offering of equity for the purpose of initial public offering (IPO) from 25.0 per cent to 10.0 per cent of the post-issue capital for companies in the information technology (IT) sector in August 1999 and, subsequently, for those in the media, telecommunications and entertainment sectors. The companies will be required to make a public offer for at least Rs.50 crore and offer at least 20 lakh securities. In order to ensure that companies do not take undue advantage of relaxed norms for IPOs, it was stipulated that companies in the IT, media, telecommunications and entertainment sectors making IPOs must have track record of distributable profits in three out of five years in these businesses/from these activities. In June 2000, the SEBI decided to tighten the IPO norms by stipulating that companies making IPOs of size up to five times of the pre-issue net worth should either satisfy the track record of profitability and net worth criterion or should adopt the book-building route. Further, any issue size beyond five times the pre-issue net worth would have to take the book-building route. The SEBI also modified the guidelines for the book-building method of floating new capital issues, allowing the issuer to choose either the existing or the modified mode of book-building. The modified guidelines impart greater flexibility in terms of display of demands, price disclosures, allotment to small investors, etc. It has resulted in an increasing number of issuers adopting the book-building route in order to reduce transaction costs and for a better price discovery.

1.56 The SEBI allowed Internet trading through the order routing system, which allows routing of orders from clients to brokers for trade execution on the recognised stock exchanges. In order to shorten the settlement period, the SEBI introduced the rolling settlement system by bringing initially 10 scrips under the compulsory rolling settlement on a T+5 basis with effect from January 10, 2000. Subsequently, more scrips were brought under rolling settlement. Stock exchanges were also permitted to open trading terminals anywhere in the country. In order to improve liquidity in the secondary market, the SEBI accepted the recommendations of Committee on Market Making (Chairman: Shri G.P. Gupta). Market makers would be required to offer two-way quotes in specified shares. The SEBI prescribed eligibility criteria and risk containment measures for automatic lending and borrowing mechanism (ALBM), a quasi-derivative instrument, in line with the carry forward system.

1.57 The SEBI modified the investment guidelines for mutual funds (MFs). The new guidelines restrict MFs from investing more than 10 per cent of the net asset value (NAV) of a scheme in shares or share-related instruments of a single entity. The MFs' investments in rated debt instruments of a single issuer was restricted to 15 per cent (up to 20 per cent with prior approval of Board of Trustees and AMC). Restrictions were also put in place in respect of investments in unrated debt instruments and in shares of unlisted companies. The new norms also specified a maximum limit of 25 per cent of NAV of any scheme for investment in listed group companies as against an umbrella limit of 25 per cent of NAV for all schemes taken together earlier. The SEBI also issued a code of conduct restricting MFs from making assurance or claims that could mislead the public.