‘Riksbank’ a joint-stock bank established in Sweden in the year 1668 is recognized as the world’s first central bank. The bank was commissioned to lend funds to the government and to act as a clearinghouse for commerce. But in the year 1897 the ‘Riksbank’ deserted commercial lending and it was granted a monopoly for issuing banknotes. Since then, several European countries like France, England, etc. set up institutions that functioned as central banks. The early central banks like the Banque de France and the Bank of England were set up through private capital. Beside engaged in banking activities these banks helped sovereigns finance their debt. Later on, countries worldwide established their Central Banks and the role of these central banks was advanced from time to time according to the changing needs of their economies and evolving financial structure.
The Reserve Bank of India (India’s Central Bank) was set up under the Reserve Bank of India Act 1934 on the basis of the recommendations of the Hilton Young Commission. Though originally privately owned, RBI was nationalized in 1949 and is fully owned by the Government of India. The Central Office of the RBI was originally established in Calcutta but later moved to Bombay in 1937. The RBI also acted as Burma’s (now Myanmar) central bank until April 1947 (except during the years of Japanese occupation (1942–45)), even though Burma seceded from the Indian Union in 1937. After the Partition of India in August 1947, the bank served as the central bank for Pakistan until June 1948 when the State Bank of Pakistan commenced operations.
The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as under.
“to regulate the issue of Banknotes and 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; to have a modern monetary policy framework to meet the challenge of an increasingly complex economy, to maintain price stability while keeping in mind the objective of growth.”
This preamble indicates the two core functions of the Reserve Bank: (i) issue of currency; and (ii) monetary authority. The Act also entrusts other major functions to the Reserve Bank including regulation of non-bank financial institutions, management of foreign exchange reserves, management of sovereign debt – by statute in respect of central government and by agreement in respect of state governments – and regulation of forex, money, and government securities markets and their derivatives
Although, the term ‘monetary stability’ used in preamble remains open to debate and interpretation. It may mean price stability, exchange rate stability and a stable payments system in equal measure. Of late the focus of financial stability has been not only confined to regulation and supervision but also extending the reach of the formal financial system to the unbanked and un-served population.
The monetary policy of the Reserve Bank of India kept on changing in line with the changing character of the economy and developments in the financial market.
Initial Phase (1935 to 1949): Prior to independence the focus was on maintaining the sterling parity by regulating liquidity through open market operations (OMOs), with additional monetary tools of bank rate and cash reserve ratio (CRR). During this period the exchange rate was the nominal anchor for monetary policy. However, due to the agrarian nature of the economy inflation often emerged as a concern owing to supply-side shocks. The Government of the time undertaken price control measures like the rationing of essential commodities. RBI on its part used selective price control and moral suasion to restrain banks from extending credit for speculative purposes.
1949 to 1968: Monetary Policy in sync with the Five-Year Plans: After independence in 1947, India had to recover from the partition and the disequilibrium in the economy due to the Second World War. In 1950, the Government headed by Prime Minister Jawaharlal Nehru set up the Planning Commission to create, develop, and execute India’s five-year plans. The First five year Plan had the objectives of rehabilitating refugees, agricultural development, and self-sufficiency in food along with controlling inflation followed by a policy of planned economic development. The above period was characterized not only by a predominant role of the state but also by a marked shift in the conduct of monetary policy. As planned expenditure was accorded a pivotal role in the process of development, there was an emphasis on credit allocation to productive sectors. The role of the monetary policy of Reserve Bank, therefore, during this phase of planned economic development revolved around the requirements of five-year plans. Though there was no formal framework, monetary policy was relied upon for administering the supply of and demand for credit in the economy. The policy instruments used in regulating the credit availability were bank rate, reserve requirements and open market operations (OMOs). With the enactment of the Banking Regulation Act in 1949, the statutory liquidity ratio (SLR) requirement prescribed for banks emerged as a secured source for government borrowings and also served as an additional instrument of monetary and liquidity management.
1969 to 1985: Credit Planning: In 1969, Prime Minister Indira Gandhi-headed government nationalised 14 major commercial banks and another six banks in 1980. The Nationalisation of major banks marked another phase in the evolution of monetary policy. The main objective of the nationalisation of banks was to ensure credit availability to a wider range of people and activities. The banks started to lend money in priority sectors, such as the loan for agricultural and allied activities, small businesses, small scale industries, etc. During this phase, the Reserve Bank faced the challenge of maintaining a balance between financing economic growth and ensuring price stability in the wake of the sharp rise in money supply emanating from credit expansion. In addition to the above worries, Indo-Pak war in 1971, drought in 1973, global oil price shocks in 1973 and 1979, and the collapse of the Bretton-woods system in 1973 also had inflationary consequences. In such an environment, traditional monetary policy instruments, viz., the Bank Rate and OMOs were found inadequate to address the implications of money supply for price stability. As banks were flushed with deposits under the impact of deficit financing, they did not need to approach RBI for funds. This undermined the efficacy of the Bank Rate as a monetary policy instrument. Similarly, due to the underdeveloped government securities market, OMOs had limited scope to be used as monetary policy instruments. During this phase, the average growth rate hovered around 4.0 percent, while wholesale price index (WPI) based inflation was around 8.8 percent.
1985 to 1999: Monetary Targeting: Together with the challenge of maintaining a balance between financing economic growth and ensuring price stability in the wake of the sharp rise in money supply emanating from credit expansion reflected in automatic monetization of budget deficit through ad hoc treasury bills and progressive increase in SLR by 1985. The familiarity of monetary policy in dealing with the objects of containing inflation and promoting growth eventually led to the adoption of monetary targeting as a formal monetary policy framework in 1985 on the recommendations of the Chakravarty Committee. As per the recommendations of Chakravarty Committee recommendation reserve money was used as an operating target and broad money as an intermediate target with the objective of controlling inflation through limiting monetary expansion. The targeted growth in the money supply was based on expected real GDP growth and a tolerable level of inflation. CRR and SLR were used as the primary instruments for monetary control. However, due to continued monetary control, both SLR and CRR reached their peak levels by 1990. In the backdrop of the Gulf war and disintegration of the USSR manifested in deterioration of external balance position and collapse in domestic growth of India in 1991-92. The Indian currency lost 18% of its value relative to the US dollar on account of devaluation of Indian currency in July 1991.
The balance of payment crisis prompted large scale structural reforms, financial sector liberalization and opening up of the economy to achieve sustainable growth with price stability. Further, RBI moved its policy of a fixed exchange rate regime to a market-determined exchange rate system in 1993. Concurrently, there was a notable shift towards market-based financing for both the government and the private sector. Further, the automatic monetisation of budget deficit through ad hoc treasury bills was abolished in 1997 and replaced with a system of ways and means advances (WMAs). The central bank deregulated bank interests and some sectors of the financial market like the trust and property markets. During this period, the average domestic growth rate was 5.6 percent and the average WPI-based inflation was 8.1 percent. In the early 1990s, RBI in pursuit of financial sector reform has decided to deregulation of interest rates. The process of deregulation of interest rates, which began in the early 1990s, was largely completed by October 1997. The Reserve Bank of India adopted multiple indicators approach in April 1998 in place of monetary targeting framework and operating procedures. Under this approach, besides monetary aggregates, a host of forward-looking indicators such as credit, output, inflation, trade, capital flows, exchange rate, returns in different markets and fiscal performance constituted the basis of information set used for monetary policy formulation
Since 2000: The Foreign Exchange Management Act, 1999 came into force in June 2000. National Electronic Funds Transfer (NEFT) and Real-Time Gross Settlement (RTGS) is an electronic funds transfer system maintained by the Reserve Bank of India (RBI). Started in November 2005, the setup was established and maintained by the Institute for Development and Research in Banking Technology (IDRBT). From December 16, 2019, there would be 48 half-hourly batches occurring in NEFT between 00.30 am to 00:00 am every day (24 x7x365) regardless of a Holiday or otherwise. (NEFT is an electronic fund transfer system in which the transactions received up to a particular time are processed in batches, whereas, in RTGS, the transactions are processed continuously on a transaction by transaction basis throughout the RTGS business hours).
The Security Printing & Minting Corporation of India Ltd., a merger of nine institutions, was founded in 2006 which produces banknotes and coins. In July 2010, a few categories of interest rates that continued to be regulated on the lending side were small loans up to Rs.2 lakh and rupee export credit deregulated when the Reserve Bank replaced the Benchmark Prime Lending Rate (BPLR) system with the Base Rate system. With this; all rupee lending rates were deregulated. On the deposit side, savings bank deposit interest rate which was not deregulated earlier was deregulated in October 2011. In 2016, the Government of India amended the RBI Act to establish the Monetary Policy Committee (MPC) to set policy rates. The MPC membership is evenly divided between members of the RBI (including the RBI governor) and independent members appointed by the government. In the event of a tie, the vote of the RBI governor is decisive.
A Monetary Policy Framework Agreement (MPFA) was signed between the Government of India and the Reserve Bank on February 20, 2015. Pursuant to this flexible inflation targeting (FIT) was formally adopted with the amendment of the RBI Act in May 2016. The role of the Reserve Bank in the area of monetary policy has been restated in the amended Act as follows “the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth”. Conferred by the above mandate by the Government, RBI adopted a flexible inflation targeting (FIT) framework under which primacy is accorded to the objective of price stability, defined numerically by a target of 4 percent for consumer price headline inflation with a tolerance band of +/- 2 percent around it, while simultaneously focusing on growth when inflation is under control. The relative emphasis on inflation and growth depends on the macroeconomic scenario, inflation and growth outlook, and signals emerging from incoming data.
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