Central Banking, Developmental Aspects of
CENTRAL BANKING, DEVELOPMENTAL ASPECTS OF
CENTRAL BANKING, DEVELOPMENTAL ASPECTS OF India, like other developing countries, has had a late start in central banking, which evolved under the influence of both international banking practices as well as the imperatives of the emerging domestic economy. Since the overriding focus has been on achieving rapid economic development, inevitably, central banks in emerging economies have had a distinct developmental orientation. Unlike several other developing economies, however, in India the central bank was established before independence from British colonial rule in 1947. The Reserve Bank of India (RBI) was established as a private shareholders' bank in 1935. After independence, the subsequent developmental orientation necessitated the conversion of the RBI from a private shareholders' bank into a nationalized central bank.
The primary developmental challenge for the RBI during the 1950s and 1960s was to build a financial network with a wide geographical spread and deep socioeconomic reach. Extending beyond the conventional objectives of central banking, the First Five-Year Plan (1951) noted that "central banking in a planned economy . . . would have to take on a direct and active role, firstly in creating or helping to create the machinery needed for financing developmental activities all over the country and secondly, ensuring that the finances available flows in the directions intended."
An important step toward this objective was the formation of the State Bank of India in 1955. In addition, the RBI promoted long-term industrial financing by establishing term-financing institutions, including the Industrial Finance Corporation of India (1948), State Financial Corporations (1952) and the Industrial Development Bank of India (IDBI; 1964), as well as a mutual fund entity, the Unit Trust of India (UTI; 1964). In accordance with its statutory mandate, the RBI also promoted an appropriate structure of policies, procedures, and institutions in rural financing, including the creation of the Agricultural Refinance and Development Corporation (1963). At the same time, efforts were made to strengthen the cooperative credit structure and to improve credit delivery at the grassroot level, with the goal of eliminating exploitative informal sources of financing. Furthermore, the RBI offered a number of sector-specific refinance facilities, including export credit and food credit, and established three national funds in order to finance long-term operations in agriculture and industry and to support agricultural stabilization. These measures were supported by the necessary legislative framework for facilitating reorganization and consolidation of the banking system, including the enactment of the Banking Regulation Act of 1949.
In the 1960s and 1970s, the challenge was to ensure that the financial system was able to channel resources from the saver to the investor, in tune with the wider objectives of developmental planning. A major step was the nationalization of fourteen large commercial banks in 1969. Banks were given "priority" sector targets for agriculture and small-scale industries in the 1970s. Special schemes were introduced for the weaker sections, such as the Differential Rate of Interest plan in 1972 and the Integrated Rural Development Programme in 1980. In continuation of the earlier phase of institution building, new specialized institutions were created for rural credit, including Regional Rural Banks (1975) and the National Bank for Agriculture and Rural Development (NABARD), as well as export financing, in the form of the Export and Import Bank of India, both in 1982.
The objective of creating a large financial, especially banking, network was satisfied by the 1980s. Following nationalization, banking in India acquired a broad mass base and emerged as an important instrument of socioeconomic change. The difficulty, however, was that the imperatives of "social control," in the form of credit controls and concessional lending, segmented financial markets and blunted the process of price discovery, thereby impinging on the efficiency of resource allocation and thus the profitability of the banking industry. At the same time, the sharp increase in the government's budgetary gap had to be funded initially by raising resources from the banking system by fiat, first by raising statutory liquidity requirements and later by monetizing the fiscal deficit. In order to neutralize the inflationary effect of deficit financing, the RBI had to raise reserve requirements, thus imposing an indirect tax on the banking system. By 1991 statutory stipulations came to account for as much as over 60 percent of the deposit mobilization by the banking system, further limiting the scope for portfolio optimization by the banking system. Furthermore, the imperative of maintaining low interest rates in order to contain the interest rate cost of public debt and to provide concessional credit to various sectors resulted in a degree of financial repression in the economy.
This repression led to the challenge of rejuvenating the process of price discovery so as to enhance the efficiency of resource allocation, without compromising social imperatives. This involved a three-pronged strategy of dismantling the regime of administered interest rates and directed credit, introducing new financial instruments and making financial markets capable of allocating resources in line with market signals, while at the same time ensuring credit delivery for the relatively disadvantaged sections of society.
A series of policy initiatives were taken in the 1980s, mainly aimed at consolidation and diversification, and to an extent, at deregulation. The consolidation measures included rationalization of branch expansion while emphasizing coverage of spatial gaps in rural areas, institution of comprehensive action plans of organizational development by individual banks, and greater focus on balance sheet strength. Banks were accorded greater operational flexibility in terms of greater discretion in portfolio allocation, especially with the abolishing of the Credit Authorisation Scheme in 1988, as well as fresh business opportunities in equipment leasing (1984) and mutual funds (1987). The process of financial liberalization in terms of rationalization of the interest rate structure and development of financial markets, especially money markets, took root in the late 1980s. The RBI also promoted the Discount and Finance House of India in 1988 to act as a market maker in the money markets. The Small Industries Development Bank of India was set up in 1990 to provide finance for small-scale industries.
The process of financial sector reforms gathered momentum in the 1990s, as a part of the overall program of reforms in the aftermath of the unprecedented balance of payments crisis in 1991. In line with the increasing market orientation of the economy, the very form of the developmental orientation experienced a dramatic change. The earlier regime of administered interest rates and credit controls was replaced by an incentive structure to channel funds in accordance with the spirit of financial liberalization and the imperatives of poverty eradication. The RBI has since spearheaded the modernization of the financial system through the development and diffusion of information technology, and improvement in trading and settlement practices, including the gradual migration to a real-time gross settlement system. At the same time, the conventional monetary policy objective of price stability, which had acquired an important dimension in developing economies, especially since inflation tends to hurt the poor the most, was no longer as relevant. By the mid-1990s, inflation had been reined in, decelerating to around 5 percent between 1995 and 2004 from over 8 percent in the 1970s and 1980s. The challenge is now to consolidate the hard-won gains against inflation by stabilizing inflationary expectations.
The RBI now accords substantial freedom to banks in optimizing their portfolios as well pricing their products, except in specific cases such as interest rates chargeable on small loans and priority sector advances. Statutory preemptions have been progressively reduced to the minimum (25% in case of statutory liquidity ratio) or close to the minimum 3 percent (in case of cash reserve ratio). The RBI is gradually divesting its investments in term-lending institutions—including phasing out concessional finance in the form of national funds—and is doing away with sector-specific refinance facilities, which have often resulted in market segmentation. At the same time, prudential norms have been instituted and supervisory framework strengthened for financial institutions to ensure financial stability. The RBI now offers incentives to banks in the areas of infrastructure financing and housing loans.
The RBI has undertaken several measures to strengthen the credit delivery system, especially to the disadvantaged sections of Indian society. Although banks are still required to earmark 40 percent of their advances for the priority sector, the definition of the priority sector has been considerably widened—and besides, the shortfall, if any, can be deposited with NABARD's Rural Infrastructure Development Fund. Another new development is the experiment of micro-finance, through self-help groups funded directly by banks or through intermediaries, such as nongovernmental organizations. The RBI is strengthening the supervisory framework of cooperative banks and nonbanking financial companies, which are able to meet localized and sometimes specialized financing requirements through their local network because of their relative flexibility.
The concept of central banking in India has thus shifted course over the years, responding to the contemporary challenges of economic development. Just as it was necessary to build institutions to monetize the economy in the 1950s, the very process of financial deepening prompted the financial institutions to function efficiently by the 1990s. The RBI thus continues to play a key role in the progress of economic development in India in tune with the changing macroeconomic environment.
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