Reserve Bank of India, Evolution of

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RESERVE BANK OF INDIA, EVOLUTION OF

RESERVE BANK OF INDIA, EVOLUTION OF The shape of the Reserve Bank of India (RBI) which was set up in 1935 during British rule, was influenced by two different attitudes, though with agreement that it should be independent of government. The British rulers were swayed by the prevailing monetary orthodoxy, of keeping the functions of raising and using money separate from that of creating money, while the nationalists wanted independence for the RBI in order to insulate it from the interference of the alien power. Despite this general agreement, the act establishing the RBI was so drafted that it left several gray areas for interpretation of the RBI-government relationship. As a result, the executive started, from the beginning, to encroach on the autonomy of the RBI, as evidenced by the finance member of the government of India selecting the composition of the RBI Board, and also by a virtual dismissal of its first governor, Sir Osborne Smith, on the ostensible grounds of disagreement on the issue of fixing the bank rate. During World War II, the authority of the RBI was further clipped in regard to its monetary policy, when it was forced to pursue a government-initiated low interest rate policy to keep the cost of financing the war low and to expand money supply through accumulation of sterling (foreign exchange) balances.

After a brief interlude of relative autonomy experienced after independence in 1947, the RBI's monetary policy domain shriveled rapidly when planning dominated India's overall economic policy. Since 1951, the government aimed at a mixture of public and private sectors, but much greater weight was assigned to the former. This had serious consequences for the RBI's functioning, organization, and the use of its policy instruments. Its main policy instruments, such as open market operations, and cash reserve and statutory liquid assets ratios, took the character of fiscal instruments directed more toward raising resources for the government than facilitating the financing of private sector investment—the main area for the exercise of monetary policy. Even more significantly, the RBI was obliged to extend credit to government, which fueled inflationary pressures in the economy.

The erosion of the RBI's power was also reflected in its other two collateral functions, that is, the exchange rate management, and the supervision and prudential control of the banking system. Because of ill-defined provisions of the RBI and the Banking Companies Act, and the ideological dispensation of the government, the RBI was unable to efficiently discharge these functions. The five-year plans, implicitly based on the assumption of constant prices, took as axiomatic that the exchange rate—the price of Indian currency in terms of gold or other foreign currencies—should remain unchanged. As it turned out, however, the government had to devalue the rupee by force majeure in 1966—a decision in which the RBI played only a technical role. There was, however, some change in 1976, when the RBI was given greater leeway in regard to exchange rate determination. It adopted a multicurrency basket of exchange rate under which the rupee value was determined with reference to the exchange rate movements of a select number of currencies of India's trading partners.

In the area of bank supervision and inspection, the RBI's record was marred by government decree. In the beginning, the RBI discharged its prudential control policies efficiently, but with the advent of Indian official intervention, this function was increasingly politicized. In the case of Palai Central Bank of Kerala State, where the government disregarded the RBI's advice, a serious banking crisis emerged a few years later. The RBI's prudential responsibilities were further downgraded in 1969 when banks were nationalized, the government of India assuming more direct and tighter control of banks.

Back to the Basics of Central Banking

The economic context in which the RBI functioned was radically transformed in 1991, when economic rationality was given precedence over ideology and politics. The private sector was liberalized from the straight jacket of industrial licensing, trade barriers were lowered, the foreign exchange control regime was gradually transformed into a market-oriented foreign exchange management system and, most important, the financial sector was liberalized from the earlier restrictive regime, which had substantially erased the distinction between the monetary policy of the RBI and the fiscal policy of the government. Those economic and financial reforms gave primacy to markets, incentives, and prices, thereby creating ideal conditions so essential for the unhampered exercise of the RBI's monetary policy instruments.

The RBI's freedom to exercise its policies was facilitated by two important developments. First, India liberalized its current balance of payment account, almost totally by 1995, and followed that up by selectively eliminating some restrictions on the capital balance of payments account. This led to a large movement of capital across India's borders, requiring the RBI to remain alert to both the exchange rate and interest rate movements, since both of these affected capital flows. The second development was the deregulation of domestic interest rates, thereby giving greater leverage to the RBI to influence them through its various policy instruments.

The RBI regulates the cost and availability of aggregate money by controlling the determinants of reserve money, that is, currency in circulation and banks' cash on hand and bank deposits held with the RBI. The determinants of reserve money are net bank credit to the government and to banks, and its holding of net foreign exchange assets. Prior to 1991, the RBI regulated reserve money by changing the quantity of its credit to government and banks, and varying its cash reserve requirements ratio, but currently, the RBI relies more on open market operations, that is, the purchase and sale of government securities held by it, varying its lending rates on credit extended to banks as well as to the central and state governments.

Since 1994 and 1995, a concordat was entered into between the RBI and the government of India under which automatic financing of government deficit by the RBI (called monetization) was capped. Only short-term credit to government was extended, which was required to be cleared at the end of the fiscal year. Any credit beyond the limit was treated as an overdraft, permissible for not more than ten consecutive days and on which interest rate was charged at bank rate plus two percentage points. This landmark decision has strengthened the RBI as a monetary authority. In regard to the net credit to banks, the RBI made its bank rate and other refinancing rates more effective. It instituted a Liquidity Adjustment Facility for banks for meeting temporary liquidity shortages, the rates on which were linked to the bank rate, thereby reviving the bank rate as a reference rate as in many central banks.

The RBI's role in regulating net foreign exchange assets has become dominant. It now intervenes in the foreign exchange market by the purchase and sale of foreign exchange and offsets the impact of these transactions on money supply by countervailing sale and purchase of securities. During 1992 to 1993 and 1998 to 1999, when there was a large inflow of private capital in India, the RBI bought foreign exchange to maintain a stable exchange rate, but at the same time, it sold securities to absorb liquidity so as not to weaken its restrictive monetary policy.

Though the RBI has moved in the right direction of greater independence and power in formulating its policies, it has considerable ground to cover. To emerge as a central bank of truly modern mold, it has to shift, as Anand Chandavarkar (1996) emphasized, "from independent to effective central banking based on the highest professionalism and integrity."

Deena Khatkhate

See alsoMonetary Policy from 1952 to 1991 ; Monetary Policy since 1991 ; Money and Credit, 1858–1947