Evolution of the Reserve Bank of India

The origins of the Reserve Bank of India (RBI) can be traced to 1926, when
the Royal Commission on Indian Currency and Finance – also known as the
Hilton- Young Commission – recommended the creation of a central bank for
India to separate the control of currency and credit from the Government and
to augment banking facilities throughout the country. The Reserve Bank of
India Act of 1934 established the Reserve Bank and set in motion a series of
actions culminating in the start of operations in 1935. Since then, the Reserve
Bank's role and functions have evolved, as the nature of the Indian economy
and financial sector changed. Though started as a private shareholders' bank,
the Reserve Bank was nationalised in 1949.
The Preamble to the Reserve Bank of India Act, 1934, under which it was
constituted, specifies its objective as “to regulate the issue of Bank notes and
the keeping of reserves with a view to securing monetary stability in India and
generally to operate the currency and credit system of the country to its
advantage”. The primary role of the RBI, as the Act suggests, is monetary
stability, that is, to sustain confidence in the value of the country's money or
preserve the purchasing power of the currency. Ultimately, this means low
and stable expectations of inflation, whether that inflation stems from
domestic sources or from changes in the value of the currency, from supply
constraints or demand pressures. In addition, the RBI has two other important
mandates; inclusive growth and development, as well as financial stability.
India's financial system is dominated by banks. Their regulation and
supervision is therefore important both from the viewpoint of protecting the
depositors' interest and preserving financial stability. The RBI, deriving
powers from the Banking Regulation Act, 1949, designs and implements the
regulatory policy framework for banks operating in India. Over the years, the
purview of regulation and supervision has been expanded to include non-
banking entities also.
Central banks are at the heart of a country's payment and settlement system.
“One of the principal functions of central banks is to be the guardian of public
confidence in money, and this confidence depends crucially on the ability of
economic agents to transmit money and financial instruments smoothly and
securely through payment and settlement systems”1. The RBI has, over the
years, taken several initiatives in building a robust and state-of-the-art
payment

Functions of the Reserve Bank

The functions of the Reserve Bank today can be categorised as follows:
(i) Monetary policy
(ii)Regulation and supervision of the banking and non-banking financial
institutions, including credit information companies
(iii)Regulation of money, forex and government securities markets as also
certain financial derivatives
(iv)Debt and cash management for Central and State Governments
(v)Management of foreign exchange reserves
(vi)Foreign exchange management—current and capital account
management
(vii)Banker to banks
(viii)Banker to the Central and State Governments
(ix) Oversight of the payment and settlement systems
(x) Currency management
(xi)Developmental role
(xii)Research and statistics

Aims and Objectives

i) to regulate the issue of banknotes and the keeping of reserves with a view
to securing monetary stability in India and generally to operate the currency
and credit system of the country to its advantage; and
ii) that it is essential to have a modern monetary policy framework to meet the
challenge of an increasingly complex economy and the primary objective of
the monetary policy is to maintain price stability while keeping in mind the
objective of growth.

Monetary Policy Making in India

Central banks derive their objectives from their respective mandates.
Monetary Policy could have either a single objective of price stability or
multiple objectives of the policy. In the literature and in practice, price stability
is considered as the dominant objective of monetary policy. For countries,
which have adopted inflation targeting framework, price stability is the core
objective. Monetary Policy refers to the use of monetary instruments under
the control of the central bank to influence variables, such as interest rates,
money supply and availability of credit, with a view to achieving the objectives
of the policy.
After the amendment to RBI Act, 1934, in May 2016, the primary objective of
monetary policy is to maintaining price stability while keeping in mind the
objective of growth.
There are various direct and indirect instruments used for implementing
monetary policy including Repo Rate, Reverse Repo Rate, Liquidity
Adjustment Facility (LAF), Marginal Standing Facility (MSF), Corridor, Bank
Rate, Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), Open
Market Operations (OMOs) and Market Stabilisation Scheme (MSS). They
are briefly explained below
Repo Rate : The (fixed) interest rate at which the Reserve Bank provides
overnight liquidity to banks against the collateral of government and other
approved securities under the Liquidity Adjustment Facility (LAF).
Reverse Repo Rate : The (fixed) interest rate at which the Reserve Bank
absorbs liquidity, on an overnight basis, from banks against the collateral of
eligible government securities under the LAF.
Liquidity Adjustment Facility (LAF) : The LAF consists of overnight as well
as term repo auctions. Progressively, the Reserve Bank has increased the
proportion of liquidity injected under variable rate repo auctions across the
range of tenors. The aim of term-repo is to help develop the inter-bank term-
money market, which in turn can set market-based benchmarks for pricing of
loans and deposits, and hence improve transmission of monetary policy. The
RBI also conducts variable interest-rate reverse-repo auctions, as
necessitated under market conditions.
Marginal Standing Facility (MSF) : A facility under which scheduled
commercial banks can borrow additional amount of overnight money from the
Reserve Bank by dipping into their Statutory Liquidity Ratio (SLR) portfolio up
to a limit at a penal rate of interest. This provides a safety valve against
unanticipated liquidity shocks to the banking system.
Corridor : The MSF rate and reverse repo rate determine the corridor for the
daily movement in the weighted average call money rate.
Bank Rate : It is the rate at which the Reserve Bank is ready to buy or
rediscount bills of exchange or other commercial papers. The Bank Rate is
published under Section 49 of the Reserve Bank of India Act, 1934. This rate
has been aligned to the MSF rate and, therefore, changes automatically as
and when the MSF rate changes alongside policy repo rate changes.
Cash Reserve Ratio (CRR) : The average daily balance that a bank is
required to maintain with the Reserve Bank as a share of such per cent of its
Net demand and time liabilities (NDTL) that the Reserve Bank may notify
from time to time in the Gazette of India.
Statutory Liquidity Ratio (SLR) : The share of NDTL that a bank is required
to maintain in safe and liquid assets, such as, unencumbered government
securities, cash and gold. Changes in SLR often influence the availability of
resources in the banking system for lending to the private sector.
Open Market Operations (OMOs): These include both, outright purchase
and sale of government securities, for injection and absorption of durable
liquidity, respectively.
Market Stabilisation Scheme (MSS): This instrument for monetary
management was introduced in 2004. Surplus liquidity of a more enduring
nature arising from large capital inflows is absorbed through sale of short-
dated government securities and treasury bills. The cash so mobilised is held
in a separate government account with the Reserve Bank.

Evolution of Monetary Policy Framework in India

In order to attain the objectives of monetary policy, it is necessary to have a
consistent policy framework.
Objectives are the aims of the monetary policy, which are goal variables or
nominal anchors and long-term in scope but are not directly under the control
of the central bank. As a result, central banks strive to achieve these
objectives only indirectly by targeting intermediate and operating targets,
which bear a stable relationship with the ultimate objectives, through
instruments which are under its direct control. The choice of the operating
target is crucial as this variable is at the beginning of the monetary
transmission mechanism. Similarly, the selection of intermediate targets is
conditional upon the channels of transmission – the process through which
monetary policy actions impact the ultimate objectives.
Operating procedure essentially deals with how the central bank intends to
influence the operating target and thereby the intermediate target with the use
of monetary policy instruments at its disposal and attain the end- objectives of
monetary policy. Therefore, the operating procedure is essentially the day-to-
day management of monetary conditions consistent with the overall stance of
the monetary policy. In other words, operating procedure is also called the
nuts and bolts of monetary policy.

Governance arrangements primarily deal with the process of decision making

and focus on responsibilities, powers and accountability of the monetary
authority

Monetary Targeting Framework

Under this framework, broad money became the intermediate target while
reserve money was one of the main operating instruments for achieving
control on broad money growth. Accordingly, monetary (M3) projection was
made consistent with the expected real GDP growth and a tolerable level of
inflation. Technically, in a simple form, if expected real GDP growth was 6 per
cent, the income elasticity of demand for money was 1.5 and a tolerable
inflation was 5 per cent, the M3 expansion target was set at 14 per cent (M3
growth = 1.5(6) +5 =14 percent). This framework was in operation during
mid-1980s to 1997-98. Analysis of the money growth outcomes during the
monetary targeting regime indicates that targets were rarely met. The biggest
impediment to monetary targeting was lack of control over RBI's credit to the
central government, which accounted for the bulk of reserve money creation.
With economic and financial sector reforms in the 1990s, there was shift in
financing government and the commercial sector with increasing reliance on
market-determined interest rates and exchange rate. RBI was able to move
away from direct instruments to indirect market-based instruments. The SLR
and CRR were gradually brought down to 25 per cent and 9.5 per cent,
respectively by 1997. Further, as the pace of trade and financial liberalisation
gained momentum in the 1990s, the efficacy of broad money as an
intermediate target was re-assessed. Financial innovations and external
shocks emanating from swings in capital flows, volatility in the exchange rate
and global business cycles imparted instability to the demand for money.
There was also increasing evidence of changes in the underlying
transmission mechanism of monetary policy with interest rate and the
exchange rate gaining importance vis-à-vis quantity variables. Against this
backdrop, in India, the search for an alternative monetary framework ended in
switching over to Multiple Indicator Approach in 1998-99.

Monetary Policy Operations

The objective of monetary policy operations is to enable the transmission of
monetary policy to the financial system. The MPC determines the policy
interest rate, and the policy stance to achieve the inflation target. The
operating target of the monetary policy is the weighted average call rate
(WACR), which is the volume weighted rate of the overnight transactions
undertaken in Call money market (uncollateralised) segment of the money
market with banks and primary dealers as participants). By conducting the
market operations as per the liquidity management framework designed by it,
the RBI ensures that the operating target, i.e., the WACR is aligned to the
policy rate on a daily basis.

The liquidity management framework of RBI comprises of the Liquidity

Adjustment Facility (LAF) and Marginal Standing Facility (MSF) for
management of transient liquidity, i.e., liquidity surplus or deficit of temporary
nature. LAF includes various types of repos and reverse repos conducted by
the RBI. MSF is an additional facility in which banks can borrow rupee funds
from RBI by using the collateral from dipping into SLR securities up to a
specified limit at penal rate. For managing liquidity of enduring nature, i.e.,
liquidity surplus or deficit, which is persisting due to various factors, Open
Market Operations (OMO) by outright purchase and sale of government
securities, changes in CRR and Market Stabilisation Scheme (MSS) are
used.
The Cash Reserve Ratio (CRR) is a direct instrument which immediately
impacts the system liquidity. If CRR is increased, banks have to maintain
higher balances in their current account with RBI, thereby creating liquidity
deficit in the banking system. Similarly decrease in CRR has the immediate
impact of creating liquidity surplus in the banking system.

Monetary Policy Framework Agreement (MPFA)

With the signing of the MPFA between the Government of India and the
Reserve Bank on February 20, 2015, flexible inflation targeting (FIT) has
been formally adopted in India. Under the MPFA, the objective of monetary
policy is to primarily maintain price stability while keeping in view the objective
of growth. The Reserve Bank was to bring CPI inflation below 6 per cent by
January 2016. The target for 2016-17 and all subsequent years was set at 4
per cent with a band of +/- 2 per cent. The MPFA also requires the Reserve
Bank to establish an operating target and an operating procedure for
monetary policy through which the operating target is to be achieved. The
Reserve Bank shall be seen to have failed to meet the target if inflation
remains above 6 per cent or below 2 per cent for three consecutive quarters.
In such circumstances, the Reserve Bank is required to provide the reasons
for the failure, and propose remedial measures and the expected time to
return inflation to the target. The Reserve Bank shall publish a document
explaining the sources of inflation as well as forecasts of inflation for the next
six to eighteen months.
The Reserve Bank has been publishing a bi-annual Monetary Policy Report
(MPR) since September 2014, which provides forecasts of inflation and
growth as well as an assessment of the overall macroeconomic conditions.
The MPR also sets out the operating target and gives details of the operating
procedure of monetary policy and any changes thereto.
With the amendment to the RBI Act on May 14, 2016, several provisions of
MPFA were subsumed in the amended Act. The Central Government, in
consultation with the Reserve Bank, has notified the inflation target of 4.0 per
cent (with 6.0 per cent and 2.0 per cent as the upper and lower tolerance
levels, respectively) in the Official Gazette on August 5, 2016. This inflation
target is applicable for the period from August 5, 2016 to March 31, 2021.
Moreover, factors that constitute a failure to achieve the inflation target – i.e.,
if the average inflation is more/less than the upper/lower tolerance level for
three consecutive quarters – have also been defined and notified in the
Official Gazette on June 27, 2016.