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EVOLUTION OF MONETARY, FISCAL AND EXCHANGE RATE POLICY OF INDIA
Venkatesh Ramamoorthy
EC 230 – International Finance
QUICK FACTS
2nd largest population
7th largest country by area
Mainly agricultural but declining, services > manufacturing
Currently enjoying demographic dividend
6th largest economy
World’s fastest growing economy in 2015, 2018
Ease of doing business index
STYLIZED FACTS
Labor share – 60%
Capital share – 34% (mildly volatile)
Hours worked – 40% of time endowment
Investment to Capital ratio – 8 percent (fairly stable)
Depreciation – 9 percent (mildly volatile)
Return to capital – 4 percent
Capital-Output ratio is fairly constant
Difference between Income and TFP
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IMPORTS USD MILLION
Oil Non-Oil Total
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EXPORTS USD MILLION
EVOLUTION OF MONETARY POLICY OF INDIA
SIX PHASES
Sterling parity (1935-1949)
Developmental years (1949-1969)
Credit planning (1969-1985)
Monetary targeting (1985-1998)
Multiple indicators (1998-2015)
Flexible inflation targeting (2015- present)
STERLING PARITY (1935-1949)
Fixed Exchange rate
Low to high inflation due to war
Bank rate – 3.00 % -> 3.50 %
DEVELOPMENTAL YEARS (1949-1969)
Nationalised in 1949
SLR was introduced (Statutory Liquidity Ratio)
Rupee devaluation in 1966
‘Planned’ economy, fiscal deficit, agri failure, war
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CA deficit/GDP
CREDIT PLANNING (1969-1985)
‘Romance with Socialism’
- Bank nationalisation, Fiscal > Monetary
Drought, Oil shock, High inflation
IMF loan, SLR, CRR, Bank rate increased
MONETARY TARGETING (1985-1998)
Inflation -> money supply
‘Deposit financing’ – 53.50%
Depreciation – Gulf war
Liberalization – CRR, SLR, Inflation
MULTIPLE INDICATORS (1998-2015)
Broad money, inflation, interest rate, bank credit, exchange rate
Forward looking surveys – Capacity utilization, Industrial outlook, professional forecasters, inflation expectations
BPLR, LAF, MSS
FLEXIBLE INFLATION TARGETING (2015- PRESENT)
CPI target 4 +/- 2 % -successfully met
Financial stability –HLCCFM, FSDC
TOOLS OF MONETARY POLICY
Tools
Quantitative measures
Qualitative measures
TOOLS OF MONETARY POLICY
Quantitative
OMO Bank rate CRRSLR,
Repo/Reverse Repo
OPEN MARKET OPERATIONS - OMO
Sells government securities - reduces liquidity
Buys government securities - increases liquidity
Limitations
If banks possess excess liquidity then it’s not effective
Popularity of G-Sec maters - not so popular due to low rate of return
Won’t work in countries where banking system is not well-developed
If market is unstable due to lack of demand for credit then it won’t work
BANK RATE
Minimum rate at which RBI provides loans to banks
Fall in Bank Rate – expansionary
Rise in Bank Rate – contractionary
Limitations
Banks have to approach RBI instead of capital markets
Banks usually hold on to interest rates than change
CASH RESERVE RATIO (CRR)
Certain percentage of their NDTL to RBI
To prevent cash shortage
To control money supply
Decrease CRR - expansionary
Increase CRR – contractionary
STATUTORY LIQUIDITY RATIO (SLR), REPO/REVERSE REPO RATE
CRR - Percentage of bank NDTL to be maintained as liquid assets – Cash, G-Sec, Gold etc.
SLR - Stopback measure to control banks from selling liquid assets when CRR is increased
Repo rate – Rate at which banks borrow from RBI
Reverse Repo rate – Rate at which banks can park excess cash with RBI
Both are short-term instruments
TOOLS OF MONETARY POLICY
Qualitative
Credit rationing
Lending margin
Moral suasion
Direct control
QUALITATIVE MEASURES
Credit rationing - Priority sector lending targets for banks
Lending margin – RBI can dictate LTV cap – Loan-to-Value ratio
Moral suasion – Psychological instrument
Directing banks through policy guidelines
Affirming markets about their intention without action
Indicating policy direction without action
Warn banks in public statements without any direct action
Example – Yes Bank case, ICICI Bank case etc.
Direct control – Gives direct order to banks, presence on board
UNIQUE FEATURES OF RESERVE BANK OF INDIA
Statutory Liquidity Ratio
Base rate – MCLR rate
Developmental role
EVOLUTION OF EXCHANGE RATE REGIME OF INDIA
PHASES OF EXCHANGE RATE REGIME
Socialistic phase
FERA phase
FEMA phase
SOCIALISTIC PHASE
1947-1971
Par value of Rupee – 4.15 grams of gold, +/- 1% with pound sterling as intervention currency
Devaluation of Rupee in September 1949 and June 1966
Post Brettenwoods collapse, FERA was introduced.
Rupee was linked to Sterling in turn linked with Dollar
From 1975, Rupee was linked to a basket of currencies instead of Sterling. The weights of currencies were kept confidential to avoid speculation
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Import cover in months
FERA PHASE
BoP crisis, Forex covered only 2 week of imports, high inflation and low output
No default, IMF lent $1.8 billion and India underwent structural reforms
Pegged exchange rate system was abandoned in 1991 after depreciating twice in 1991 and Liberalized exchange rate system was introduced
60-40 duality – Authorized dealers convert at market rate, RBI converts at its official rate
Unified system was introduced in 1993 and current account was fully convertible
Huge inflow of foreign capital
FEMA PHASE
FEMA was introduced in 2000 triggering structural changes
Highly stable and robust economy
67 tonnes of gold was pawned to IMF in 1991
Current forex reserves was thrice that amount
TRILEMMA SITUATION
Exchange rate index =0.01/(0.01 + 𝑠𝑑(∆(log(𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒)
Monetary independence index = 1 − 𝑐𝑜𝑟𝑟 𝑖ℎ, 𝑖𝑓
Capital openness index = (FI investment outflow + inflow)/GDP
TRILEMMA SITUATION
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Axis T
itle
Axis Title
Gold (USD million)
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