ANSWER 8 The main objective of the financial sector reforms in India initiated in the early 1990s was

to create an efficient, competitive and stable financial sector that could then contribute in greater
measure to stimulate growth. Concomitantly, the monetary policy framework made a phased shift
from direct instruments of monetary management to an increasing reliance on indirect instruments..
Reforms in the various segments had to be coordinated. In this process, growing integration of the
Indian economy with the rest of the world also had to be recognised and provided for. Financial
Sector and Monetary Policy: Objectives and Reforms Till the early 1990s Monetary policy was
subservient/subordinate to the fiscal policy. The financial system was characterised by extensive
regulations such as weak banking structure, lack of proper accounting and risk management systems
and lack of transparency in operations of major financial market participants. Such a system
hindered efficient allocation of resources. Financial sector reforms initiated in the early 1990s have
attempted to overcome these weaknesses in order to enhance efficiency of resource allocation in
the economy. Simultaneously, the Reserve Bank took a keen interest in the development of financial
markets, (especially the money, government securities and forex markets).. The Reserve Bank had,
in fact, been making efforts since 1986 to develop institutions and infrastructure for these markets
to facilitate price discovery. These efforts by the Reserve Bank to develop efficient, stable and
healthy financial markets accelerated after 1991. There has been close co-ordination between the
Central Government and the Reserve Bank, as also between different regulators, which helped in
orderly and smooth development of the financial markets in India. What have been the major
contours of the financial sector reforms in India?

• Removal of the erstwhile existing financial repression

• Creation of an efficient, productive and profitable financial sector

• Enabling the process of price discovery by the market determination of interest rates that
improves allocative efficiency of resources

• Providing operational and functional autonomy to institutions

• Preparing the financial system for increasing international competition

• Opening the external sector in a calibrated manner; and

• Promoting financial stability in the wake of domestic and external shocks.

The financial sector reforms since the early 1990s could be analytically classified into two phases.

1. The first phase - or the first generation of reforms - was aimed at creating an efficient, productive
and profitable financial sector which would function in an environment of operational flexibility and
functional autonomy.

2. In the second phase, or the second generation reforms, which started in the mid-1990s, the
emphasis of reforms has been on strengthening the financial system and introducing structural
improvements. Against this brief overview of the philosophy of financial sector reforms, let me
briefly touch upon reforms in various sectors and segments of the financial sector.
ANSWER 9 OBJECTIVE BEHIND MONETARY POLICY REFORM

The three objectives are:

(1) Price Stability or Control of Inflation,
(2) Economic Growth
(3) Exchange Rate Stability.

Objective 1# Price Stability or Control of Inflation:

price stability can be pursued most effectively by monetary policy.
Achieving price stability has remained the dominant objective of
monetary policy of Reserve Bank of India. It may however be noted
that price stability does not mean absolutely no change in price at
all. In a developing economy like ours where structural changes take
place during the process of economic growth some changes in
relative prices do occur that generally put upward pressure on
prices.

Therefore, some changes in price level or, in other words, a certain

rate of inflation is inevitable/compulsory in a developing economy.
Thus, price stability means reasonable rate of inflation. A high
degree of inflation has adverse effects on the economy. First,
inflation raises the cost of living of the people and hurts the poor
most. Therefore, inflation has been described as enemy No. 1 of the
poor.

Inflation sends many people below the poverty line. Secondly,

inflation makes exports costlier and, therefore, discourages them.
On the other hand, due to higher prices at home people are induced
to import goods to a large extent. Thus, inflation has an adverse
effect on the balance of payments.

Thirdly, when due to a higher rate of inflation value of money is

rapidly falling, people do not have much incentives to save. This
lowers the rate of saving on which investment and economic growth
depend. Fourthly, a high rate of inflation encourages people to
invest in the unproductive assets such as gold, jewellery, real estate
etc.

Objective 2# Economic Growth:

Promoting economic growth is another important objective of the
monetary policy. In the past Reserve Bank has often been criticised
that it pursued the objective of controlling inflation and achieving
price stability and neglected the objective of promoting economic
growth. Monetary policy can promote economic growth
through ensuring adequate availability of credit and lower
cost of credit.

There are two types of credit requirements of businesses. First, they

have to finance their requirements of working capital and for
importing needed raw materials and machines from abroad.
Secondly, they need credit for financing investment in projects for
building fixed capital. Easy availability of credit at low interest rate
stimulates investment and thereby quickens economic growth.

However, during the periods of high inflation, Reserve Bank

followed a tight monetary policy under which Cash Reserve Ratio
(CRR) and Statutory Liquidity Ratio (SLR) were raised to restrict
the availability of credit for private sector. Besides, by raising bank
rate and repo rate at which banks borrow from Reserve Bank of
India lending rates of interest of banks were kept at high levels
which discouraged private investment.

This tight monetary policy worked against promoting growth.

However, in the opinion of Prof. Rangarajan, there is no conflict
between the objectives of price stability and growth. Price stability,
according to him, is a means to ensure economic growth.

To ensure higher economic growth the adequate expansion of

money supply and greater availability of credit at a lower rate of
interest is needed. But large expansion in money supply and bank
credit leads to the increase in aggregate demand which tends to
cause a higher rate of inflation. This raises the issue of what is
acceptable trade off between growth and inflation, that is, what rate
of inflation is acceptable to promote growth through appropriate
monetary policy.

Expert Committee on monetary policy headed by Late Prof.

Chakravarty suggested a target of 4 per cent as “the acceptable rise
in prices”. According to it, the growth of money supply and
availability of credit should be so regulated that rate of inflation
does not exceed 4 per cent per annum.

However, C. Rangarajan, former Governor of Reserve Bank, fixed a

higher target, namely, 5 to 6 per cent rate of inflation in the context
of objective of achieving 6 to 7 per cent rate of economic growth. To
quote him, “keeping the price and growth objectives in view the
money supply growth should be so regulated that inflation rate
comes down, eventually to 5 to 6 per cent. That indeed must be the
goal of monetary policy.”

Objective 3# Exchange Rate Stability::

Until 1991, India followed fixed exchange rate system and only
occasionally devalued the rupee with the permission of IMF. The
policies of floating exchange rate and increasing openness and
globalisation of the Indian economy, adopted since 1991, have made
the exchange rate of rupee quite volatile/uncertain.

The changes in capital inflows and capital outflows and changes in

demand for and supply of foreign exchange, particularly US dollar,
arising from the imports and exports cause great fluctuations in the
foreign exchange rate of rupee. In order to prevent large
depreciation and appreciation of foreign exchange rate Reserve
Bank has to take suitable monetary measures to ensure foreign
exchange rate stability.

Owing to the fixed exchange rate system prior to 1991 the concern
about foreign exchange rate had not played a significant role in the
formulation of monetary policy.

This is too high current account deficit which is putting downward

pressure on the exchange rate of rupee. The depreciation of rupee
raises the costs of imports which adds to the inflationary pressures
in the Indian economy. Therefore, reducing current account deficit
(CAD) to the comfortable level is not only essential for exchange
rate stability but also for controlling inflation and achieving price
stability.
To arrest the fall in value of rupee Reserve Bank raises the bank rate
and repo rate and thus send signals to the banks to raise their
lending rates. It also raises cash reserve ratio (CRR) to reduce the
liquidity in the banking system and thus reducing lendable
resources of the banks.

Thus, through rise in the cost of credit and reduction in the

availability of credit, borrowing from the banks are discouraged
which is expected to reduce the demand for dollars. The higher
interest rates in India would also discourage foreign institutional
investors and Indian corporates to invest abroad. This will also
work to reduce the demand for dollars which will prevent the fall in
the value of the rupee.