Central Banking and Monetary Policy Regimes: The Indian Experience

From the mid-1970s, estimates of money demand relationships began to break down, vitiating projections by predicting faster money growth than was actually observed. This breakdown, dubbed "the case of the missing money," significantly complicated the conduct of monetary policy. The rapid pace of financial innovation, deregulation of financial markets, institutions and financial prices, technological progress and modern payment and settlement practices blurred ‘moneyness’ and the relationship between money and its determinants. 

Monetary policy based on targeting the monetary aggregates was virtually given up by the 1980s. As the then Governor of the Bank of Canada, Gerald Bouey, remarked, “We didn’t abandon monetary aggregates, they abandoned us.” Once again, monetary policy lost its anchor and was awash in the twilight of uncertainty in search of a new regime.

India’s Tryst with Exchange Rate as Nominal Anchor

Monetary policy regime shifts in India mirrored the global experience strikingly. The earliest formal framework for monetary policy was established by the gold exchange standard from 1893 to 1931, when the rupee was pegged to the pound sterling after Britain abandoned the gold standard. Under the gold exchange standard, the exchange rate became the nominal anchor, with the value of the rupee fixed at 1 shilling and 4 pence.

At that time, India was a rich country, and it ran a trade surplus with the rest of the world. It received gold in exchange for its net exports, which was kept in England and invested in sterling securities. An importer of Indian goods had to exchange gold for pound sterling, with which council bills could be bought from the Secretary of State for India in London. The council bills would be sent to India by telegraphic transfer and exchanged at the Treasury or designated banks here for rupees, which would then be paid to the exporter. By selling more or less council bills in England and expanding/contracting the supply of rupees in India, the sterling parity of the rupee was kept constant or at least prevented from appreciating.

In reality, it was a mechanism for draining India’s wealth and accumulating it in England as sterling balances, which were used for England’s benefit. John Maynard Keynes praised it as “the ideal monetary system of the future” because it economised on the use of gold. It was the subject of his first book, titled Indian Currency and Finance, in 1913. In later life, it became the source of many of his recommendations on international monetary systems. The Bretton Woods system was a de facto gold exchange standard.

Credit Allocation: The Indian Way

During the time of the first five-year plan in the mid-1950s, the case for credit allocation or planning was being made strongly. The plan document observed that in India’s developmental strategy, “Judicious credit creation somewhat in anticipation of the increase in production and availability of genuine savings has also a part to play.” The instruments took various forms, such as directed credit or priority sector lending and statutory pre-emptions like the cash reserve ratio and the statutory liquidity ratio. Other instruments were administered interest rates, with different rates for different sectors; selective credit controls, which involved restrictions on lending to sensitive commodities, and the credit authorisation scheme under which the RBI’s approval was required for large loans (₹10 million and above). It failed in a familiar way. The allocations were not optimal since they were directed by state policy. Credit was mispriced. Administered interest rates led to inefficiencies. Private enterprise was choked.

Monetary Targeting With Feedback

Based on the recommendations of the Sukhomoy Chakravarty Committee that was appointed by Governor Dr Manmohan Singh and submitted its report in the tenure of Governor Shri R.N. Malhotra, India transitioned to a regime of monetary targeting with feedback in 1985. This approach targeted a projected growth in broad money or M3 but allowed for mid-year adjustments based on macroeconomic conditions. It was an elegant approach based on strong intellectual foundations and was steered by Dr C. Rangarajan, first as Deputy Governor and member of the Committee, and then as Governor. Under his stewardship, India moved away from direct controls and credit allocation towards balancing price stability with economic growth through the lens of explicit targets for money supply. Dr Rangarajan remains an ardent proponent of this approach. He continues to hold that monetary aggregates can convey important information about future aggregate demand. Monetary base control can be the only instrument available to a central bank in the eventuality of short-term rates approaching the zero lower bound. Monetary aggregates can serve as an additional communication tool for central banks via forward guidance. In the final analysis, in his view, monetary policy without money is like Hamlet without the Prince of Denmark. 

The performance record of this regime was poor, though. The targeted rate of money growth was achieved only in one year; more often than not, money supply growth stayed high despite adjustments to the cash reserve ratio, ultimately fuelling inflation. In 1998, a working group on money supply observed that money demand estimates had lost predictive stability. After 1998, money targets were not announced.

The Multiple Indicator Approach

Once again, monetary policy entered a twilight zone with the perceived breakdown of the relationship between money, output and prices. In this milieu, Dr Bimal Jalan, as Governor, advocated a pragmatic approach in which a host of indicators should be monitored for policy purposes. It has been called the checklist approach – like a pilot in a cockpit checking pressure, fuel, temperature, etc., before a flight. Articulating its contours in the RBI’s monetary policy statements of 1998, he observed: “The objective is to widen the range of variables… rather than rely solely on a single instrument variable, such as, growth in broad money (M3)…money market rates of interest, exchange rates, foreign exchange reserves, credit to Government and commercial sector and fiscal position …have been closely monitored and utilised for policy actions.” It needs to be noted that Dr Bimal Jalan’s approach was with regard to the operating, intermediate and final indicators/instruments of monetary policy.

The multiple indicator approach was refined further by Dr Y.V. Reddy, who succeeded Dr Jalan as Governor, and also by his successor, Dr D. Subbarao. Under their guardianship, the multiple indicator approach acquired a distinct preference for discretion over rules, albeit bounded by the requirement of explicit communication. Its conduct went beyond just the indicators to encompass even the goals of monetary policy. Dr Reddy formulated the concept of a hierarchy of objectives. In his view, “In essence, monetary policy aims to maintain a judicious balance between price stability and economic growth. The relative emphasis between price stability and growth is governed by the prevailing circumstances at a particular time and is spelt out from time to time in the policy announcements of the Reserve Bank. Financial stability, subsumed in monetary stability, has gained in importance since the second half of the 1990s.” Dr Reddy would often deliver ‘surprises’, shaping and re-shaping market expectations. ‘Markets swoon to Reddy’s tune’, stated one newspaper headline during his time.

Dr Subbarao was more explicit in his choice of discretion over Tinbergen’s assignment rule and in mainstreaming the objective of financial stability. In his words, “In contrast to the minimalist formula of single objective, single instrument, the conduct of monetary policy by the Reserve Bank has been guided by multiple objectives and multiple instruments. In general, our three main objectives have been price stability, growth and financial stability, with the inter se priority among the objectives shifting from time to time depending on the macroeconomic circumstances.” Dr Subbarao was known for his meticulous finesse and penchant for detail, which he brought to monetary policy making.

The problems with this approach arose because people were confused about the specific manner in which the RBI conducted monetary policy. It also led to the criticism of shifting goalposts opportunistically. The moment of reckoning was cataclysmic. It arrived in the fateful summer of 2013.

Loss of Faith in Multiple Indicators

India was among the first nations to bounce back from the global financial crisis (GFC) on the wings of a fiscal stimulus of 3.5% of GDP, a cumulative monetary policy rate reduction of 425 basis points, and assured liquidity of 10% of GDP. The rebound took India’s growth in 2009-10 to higher than in the pre-GFC year of 2007-08 even as the global economy contracted in 2009. The momentum provided by the unprecedented stimulus measures pushed growth even higher in 2010-11. Aspirations of India’s underlying potential seemed within reach, exemplified in official expectations: the 12th five-year plan envisaged average growth of 8% for the period 2012-17 on the back of a massive push to build a world-class infrastructure, with the banking sector intermediating its financial requirements.

Destiny would, however, ordain otherwise – 2009-10 would turn out to be a decisive year in the recent history of the conduct of monetary policy in India. First, the large monetary stimulus was not unwound in a timely manner. The RBI’s Annual Report for the year acknowledged that exit was debated in the light of the build-up of domestic inflationary pressures and inflation expectations. Clairvoyantly, it noted that the lag with which monetary policy operates pointed to a case for tightening sooner rather than later as the large overhang of liquidity could engender inflation expectations and an unsustainable asset price build-up, especially as capital inflows had resumed. Eventually, however, arguments for deferring the unwinding won on the grounds of nurturing nascent growth impulses and also the facile view that inflationary pressures were driven by supply-side constraints, particularly food prices, which lie outside the remit of monetary policy.

Exit did begin in October 2009, but it consisted of terminating some sector-specific liquidity facilities which were largely unutilised, restoring the statutory liquidity ratio to its pre-crisis level, and restoring provisioning requirements for advances to the commercial real estate sector. Substantive liquidity withdrawal commenced from January 2010 when the cash reserve ratio was raised by 75 basis points, but by then inflation was about to break out into double digits and race out of control.

In hindsight, the RBI was carried away by the nationwide robust optimism about growth aspirations that characterised those exuberant days and refrained from acting counter-cyclically. This would prove to be a costly policy error. Between March 2010 and October 2011, the RBI raised its policy rate by 375 basis points in 13 consecutive actions, backed up by another cash reserve ratio increase in April 2010, and the unwinding of all the extraordinary GFC liquidity measures in 2010. But inflation had checked in to stay.

It surged from 3.8% in 2009-10 to 9.6% in 2010-11. Rates of return on bank deposits adjusted for inflation turned negative (-1%). Meanwhile, real rates of return on alternative assets such as housing (about 10%), equity (about 10%) and gold (12.5%) looked lucrative and induced a portfolio shift from financial assets to physical assets. Households’ financial savings declined from a recent peak of 10.9% of GDP in 2009-10 to 7.4% by 2011-12, with a corresponding increase in their physical assets from 14.0% to 16.3%. The rate of India’s gross domestic saving in which households are the prime movers, was at 36.9% of GDP in 2010-11, but it underwent a prolonged decline that took it down to 30.6% by 2018-19.

India’s gross domestic investment rate held up through these troubled times at around 39% of GDP. With public investment declining from 9.0% of GDP in 2008-09 to 7.2% in 2012-13 as the GFC fiscal stimulus was unwound, the burden of sustaining the investment was entirely financed by foreign saving as reflected in the current account deficit rising from 0.1% in fourth quarter of 2008-09 to a peak of 6.8% of GDP in October-December of 2012-13 as people pulled out deposits from banks and bought gold. This reflected capital flight since India mines only around 1% of its gold consumption domestically. An annual level of gold imports of 750-850 tonnes surged to over 1,000 tonnes in 2011-12. The RBI’s warnings on the current account deficit went unheeded in the flush of large capital inflows.

The Taper Tantrum

In 2013, an announcement of the US Fed’s inclination to reduce the size of its balance sheet, bloated by the GFC stimulus, set global financial markets on fire in what has gone down in recent history as the taper tantrum. As financial markets reeled under high turbulence and risk-off sentiment became pervasive, capital flows stampeded towards safe havens, exiting EMEs as an asset class. India was one of the worst hit, with the rupee depreciating the most among peers during May 22-August 30, 2013. At that time, the foreign exchange reserves were close to $300 billion, but markets discounted that completely. India joined Brazil, Indonesia, South Africa and Turkey in what was termed the ‘fragile five’.

An unconventional crisis defence had to be mounted. Facing risks of currency turmoil due to the taper tantrum, the RBI judged that spillovers could endanger financial stability and growth and gave priority to stabilisation of the rupee in the conduct of monetary policy. In July 2013, a rare data point was formed – monetary policy was employed in defence of the exchange rate for the second time in recent history, the first being in the GFC. Liquidity operations ensured that the money market rates were tightened sharply. Although the exchange rate stabilised in the ensuing months, inflationary pressures persisted, warranting a more conventional monetary policy response in the form of policy rate increases in September and October 2013, even as the unconventional measures began to be wound down. Foreign exchange reserves were augmented by overseas borrowings and swaps, and gold imports were restricted through both tariffs and end-use constraints. Although the crisis was seen off and the situation stabilised thereafter, inflation had taken a heavy toll on macroeconomic conditions.

With public credibility in monetary policy eroded, the time for a regime overhaul was upon the RBI and India.

(The masterclass continues in the next part, where Michael Patra examines how the RBI operationalises monetary policy through liquidity management, transmission, market operations and communication, and why implementation matters as much as the policy rate itself.)

Masterclass with Michael Patra: Previous Sessions

Part 1
Origins, Ideas and Institutions
Michael Patra begins the masterclass by tracing how central banks evolved from fragile monetary experiments into institutions entrusted with preserving trust, stability and confidence.

Part 2
RBI and the Safeguarding of Confidence
The series then turns to the RBI’s evolution, its expanding institutional role, and the balance between autonomy, growth and price stability.

Part 3
The Rise and Fall of Monetary Policy Regimes
From Bretton Woods to monetary targeting, the masterclass examines how central banks repeatedly reinvented monetary policy frameworks when old anchors collapsed.

Part 4
When Monetary Anchors Collapse
As monetary targeting broke down globally, central banks were pushed again into uncertainty, instability and regime change.