“Banking Sector Reforms-Looking Ahead”-Background Papers

While opinions vary on the date of commencement of Economic Reforms- whether it started with the incremental reforms and liberalization policies of Rajiv Gandhi in the eighties or with the Narasimha Rao – Manmohan Singh initiatives of gradually opening up of the Indian economy to the global forces in the nineties, there is consensus that the financial and banking sector reforms commenced in the nineties.

The Philosophical Base
The philosophical basis of the economic reforms programme was set out in 1992 by Sri.P.V.Narasimha Rao in his preface to the Eighth Five Year Plan “The Eighth Plan is being launched at a time of momentous changes in the world and in India. The international political and economic order is being restructured everyday and as the Twentieth Century draws to a close, many of its distinguishing philosophies and features have been swept away. In this turbulent world, our policies must also deal with changing realities. Our basic policies have stood us in very good stead and now provide the opportunity to respond with flexibility to the new situation, so that we can work uninterruptedly towards our basic aim of providing a rich and just life for our people.” The then Prime Minister proceeded to point out that, “there is today recognition that in many areas of activity, development can be best ensured by freeing them of unnecessary controls and regulations and with drawing state intervention. At the same time, we believe that the growth and development of the country cannot be left entirely to the market mechanism. The market can be expected to bring about “equilibrium” between “demand” backed by purchasing power and “supply”, but it will not be able to ensure a balance between “need” and “Supply”. Planning is necessary to overcome such limitations of the market mechanism. Planning is essential for macro economic management, for taking care of the poor and the downtrodden, who are mostly outside the market system and have little asset management. It is thus not a choice between the market mechanism and Planning: the challenges are to effectively dovetail the two so that they are complementary to each other.”

Dwelling on state and market interface, by Dr.C.Rangarajan explained in his Convocation Address at the University of Hyderabad , that “In the 1950s  and 1960s  , the dominant view in economic literature was that Government must play a role in correcting ‘market failures’ in the area of  allocation of resources over time, because of the ‘myopic’ nature of market participant , four decades of development experience world over has shown that there can be “government failures” as well , resulting not only in economic losses due to misallocations of resources arising from faulty investment decisions but also from diversion  of resources to rent seeking activities because of the very regulations themselves. Dr.Rangarajan further has observed that , “ if there is a lesson to be drawn from the development record of the last four decades, it is that there can be both “ government failure “ and market failure “ and the critical issue is not so much the presence or absence of the state intervention but the extent and quality of that intervention.” (Asian Economic Review Volume 42 Issue No. 1, April 2000). We may have to keep in view, the philosophic basis and historical experience while assessing the outcome of the financial and banking sector reforms, which enabled the Indian Economy to regain a measure of strength and stability.

Banking Sector Reforms
Of the various sectoral packages in the Economic Reforms Agenda covering fiscal reform, Industrial Policy Reform, Trade Policy Reform and Financial and Banking Sector Reform, by far the most far reaching changes impacting on the economy have been in the financial and banking sectors. The road maps for financial and banking sector reforms were laid by the Reports of the Committee on Financial Systems (1991), and the Committee on Banking Sector Reform (1998)  both chaired by Sri M.Narasimham , a financial administrator with deep domestic experience and vast international exposure. The High level committee on Balance of Payment headed by Dr. C.Rangarajan and a number of committees set up by the RBI made valuable recommendations on the changes in the financial sector and the banking system. Reforms were designed to ensure that the changes  were calibrated and secquenced  to meet the specific requirements of the various subsectors of the Indian Economy and could be carried out without affecting continuity of operations of the institutions in these vital sectors. The introduction of prudential regulations and prescription of norms for Capital Adequacy, Asset Quality, Management Earnings, Liquidity and Systems Control (CAMELS) for the banks reinfused a degree of discipline in the banking system. Issues of organization and management, systems improvement, human resources development and autonomy of operations were also covered in the report.It must however be noted that while not all the recommendations of the Committees were acted upon by the Government of India, there was a significant measure of political consensus in implementing the recommendation with emphasis on change with continuity and complementarity of measures taken in different sub-sectors of the economy.

The calibrated change in the Indian financial and banking sectors came at a time when  emerging market economies allowed themselves to be rapidly drawn into the fast changing global financial systems, and even paid a high price. That the Indian economy was saved the pains of a crisis like those faced by the East Asian Economies is largely attributable to the circumspection, foresight and measured response displayed by Sri.Narasimham and other experts though some influential quarters were indeed impatient about the pace of change advocated and witnessed in the nineties. The Indian Economy was successfully steered out of the turbulent waters of the nineties.
 

A decade and more later we now have the opportunity to not only assess the outcome of the earlier reforms, but also look ahead and prepare the nation and the economy for further changes.
Data published by the RBI indicate the dimensional growth of banking services during the seventies and the eighties and highlight the continuing tempo of deposit growth even in the nineties.  Between 1969 and 1991, the number of bank officers increased from 8187 to 61724, the deposits of scheduled commercial banks from  Rs.4822 crores to Rs.200568 crores and credit from Rs.3467 crores to Rs. 124203 crores. The nineties witnessed a slow down in branch expansion particularly after 1995-96, taking the number of bank officers to 67221 by September 2004.  The period witnessed phenomenal growth in deposits further to Rs.1567251 crores and in credit to Rs. 939145 crores. The credit deposit ratios of 71.9 in 1969, 61.9 in 1991 and 59.9 in 2004 called for a closer look at the trends in the banking sector. This revealed  re-emergence of urban centric nature of banking, persisting regional disparities in distribution of bank credit, sharp reduction in the credit shares of agriculture and small scale industries and inadequate credit to informal sectors. The changing profiles of various bank group-Public Sector Private Sector and Foreign Banks provide clues to the nature of changes following banking sector reforms.

The Economic and Political Weekly  described the recent developments as ‘metamorphic changes in the financial system.’ and has observed that “the Indian Financial System and its structure consisting of institutions, instruments, markets and public policies guiding and regulating them are expanding at a phenomenal pace nursing rapid diversification and undergoing metamorphic changes.” (EPW, March 19th, 2005).

Recent Performance
The aggregate deposits of scheduled commercial banks grew by 13.4 % in 2002-03 17.5 % in 2003-04 and 14.1% in 2004-05 and bank credit increased by 16.1 % in 2002-03  15.3 % in 2003-04 and 26% in 2004-05, and investments have also increased. Though the prevalent low interest rates resulted in lower income growth for the banks, there is a decline in gross and net non-performing assets. The gross NPAs declined from 4 % of total assets in 2002-03 to 3.3 % in 2003-04 and net NPAs from 1.9 % to 1.2 %. There are sector-wise variations in NPA improvements. Capital adequacy ratios also showed improvement. The ratio of capital to assets stood at 13.2 % (March -2004) as compared to 12.6 %.in March 2003.The Ministry of Finance’s Economic Survey (2004-05) while reporting the improvements in financial performance and investments of banks, draws attention to the fact that the investments by scheduled commercial banks in Government and other securities stood at 41.5 % of net demand and time liabilities in March 2003 and 41.3 % in March 2004 well above the stipulated SLR ratio of 25%. The slight decline in 2003-04 was on account of higher growth of bank credit to the commercial sector and lower level of market borrowings by the Central Government. The relatively high investments in risk free government securities have led to the criticism that the commercial banks are seeking returns from safer sources, while depriving the productive sector of its much needed credit.

The need is therefore as much of for deepening and widening the channels of credit flow in the domestic economy as for complying with international standards and regulations.

The annual credit policy statement for 2005-06 made by Governor, RBI, indicated improvement in credit flow to various sectors of economy in 2004-05 – increase of 23.1% in agriculture, 12.6% in industrial credit 38.6% in credit for infrastructure sector, all higher than the levels of increase in 2003-04. The Governor has pointed out that the impetus to credit growth has emanated from non-agriculture, on-industrial sectors particularly housing small transport operators and retail loans and that while credit flow to these sectors continues to remain buoyant, more raising indications are that credit agriculture and industry has also picked up.

The investments by banks also need a review. In his address “Emerging Challenges before the Indian Banks – The Road Ahead” Sri. V.Leeladhar, Dy. Governor, RBI has observed “Aided by a good macro economic environment banks’ bottom line has improved significantly over the last three years. However let us not forget that a major contributor to the windfall gains has been treasury profits fuelled by a secular decline in interest rates during the three years from 2001 to 04 and the consequent profit booking on sale of government securities. From the current year with the hardening of interest rates, this trading component of profits is no longer going to shore up banks’ profitability. On the contrary most banks have been required to provide for the decline in the market value of their investment portfolio. Thankfully one off setting factor has been the strong pickup in the credit off take due to buoyant demand in the economy and revival of industrial activity which have resulted in substantial increase in banks’ core interest income.”
Managing capital adequacy and profitability even while meeting the multi-sectoral demands is an important challenge for the scheduled commercial banks.

Basel-II
Reserve Bank of India has drawn up the time schedule for commercial banks to reach global standards and adopt international best practices with country specific adaptations. While the banks have to improve their technological and management skills, the need to rise to the demands of Basel-II norms bring in different set of challenges particularly in the prospect of higher capital allocation on account of operational risks, estimated by some to be in the range of 12 to 15 % of banks gross incomes. It is quite possible that this may build pressures on the banks’ current capital adequacy ratio and oblige the banks to seek the capital market support for funds to comply with Basel-II norms. Whether this will set off an inter-bank competition for the funds and whether all the banks can bear the costs of complying with higher capital requirements needs to be assessed in the light of the rules governing capital weighting for various entities. The expert view is that the new system will be far more complex than what the Indian Banks have so far been accustomed to and the demands for superior information technology and supervisory skills may need to be addressed and met within the time frame envisaged by the Reserve Bank of India to make the system Basel-II compliant.

We have to note the observation of Mr. Nicholas Le Pan, Chairman of Basel Accord Implementation Group, that “ Base-II is much more than a compliance exercise. Simply enacting new rules and checking periodically to ensure that they are respected is not enough. Basel-II puts onus on Banks’ Boards and management to focus more on the measurement and management of risks and to better relate risks to capital. It is very important that they incorporate this approach into their governance and actively manage their institutions with this risk focus.” (Speech at 6th Annual Global Association of Risk Professionals 1st February 2005)
 

Proposed Changes in Banking Regulations

of view, inter-relationships between activities of financial intermediaries and areas of conflict of interests need to be considered.  Third, in order to protect the integrity of the financial system by reducing the likelihood of their becoming conduits for money laundering, terrorist financing and other unlawful activities and also to ensure audit trail, greater accent needs to be laid on the adoption of an effective consolidated know your customer (KYC) system, on both assets and liabilities, in all financial intermediaries regulated by RBI.  At the same time, it is essential that banks do not seek intrusive details from their customers and do not resort to sharing of information regarding the customer except with the written consent of the customer.  Fourth, while the stability and efficiency imparted to the large commercial banking system is universally recognised, there are some segments which warrant restructuring."   
            The annual policy statement for the current year reiterates the concern for common person, while enunciating a medium term framework, for development of money, forex and government securities markets;  for enhancing credit flow to agriculture and small industry; for action points in technology and payments systems; for institutional reform in co-operative banking, non-banking financial companies and regional rural banks; and, for ensuring availability of quality services to all sections of the population.  The most distinguishing feature of the policy statement relates to the availability of banking services to the common person, especially depositors. 
            The statement reiterates that depositors’ interests form the focal point of the regulatory framework for banking in India, and elaborates the theme as follows:
“A licence to do banking business provides the entity, the ability to accept deposits and access to deposit insurance for small depositors.  Similarly, regulation and supervision by RBI enables these entities to access funds from a wider investor base and the payment and settlement systems provides efficient payments and funds transfer services.  All these services, which are in the nature of public good, involve significant costs and are being made available only to ensure availability of banking and payment services to the entire population without discrimination”.
            The policy draws attention to the divergence in treatment of depositors compared to borrowers as:
“ … while policies relating to credit allocation, credit pricing and credit restructuring should continue to receive attention, it is inappropriate to ignore the mandate relating to depositors’ interests.  Further, in our country, the socio-economic profile for a typical depositor who seeks safe avenues for his savings deserves special attention relative to other stakeholders in the banks”.

            Another significant area of concern has been the possible exclusion of a large section of population from the provision of services and the Statement pleads for financial inclusion.  It states:
“There has been expansion, greater competition and diversification of ownership of banks leading to both enhanced efficiency and systemic resilience in the banking sector.  However, there are legitimate concerns in regard to the banking practices that tend to exclude rather than attract vast sections of population, in particular pensioners, self-employed and those employed in unorganised sector.  While commercial considerations are no doubt important, the banks have been bestowed with several privileges, especially of seeking public deposits on a highly leveraged basis, and consequently they should be obliged to provide banking services to all segments of the population, on equitable basis.”   

Operationally, it has been made clear that RBI will implement policies to encourage banks which provide extensive services while disincentivising those which are not responsive to the banking needs of the community, including the underprivileged.
            The quality of services rendered has also invited attention in the current policy. I quote further,
“Liberalisation and enhanced competition accord immense benefits, but experience has shown that consumers’ interests are not necessarily accorded full protection and their grievances are not properly attended to.  Several representations are being received in regard to recent trends of levying unreasonably high service/user charges and enhancement of user charges without proper and prior intimation. Taking account of all these considerations, it has been decided by RBI  to set up an independent Banking Codes and Standards Board of India on the model of the mechanism in the UK in order to ensure that comprehensive code of conduct for fair treatment of customers are evolved and adhered to”.
            It is essential to recognise that, while these constitute contextual nuanced responses to changing circumstances within the country, the overwhelming compulsion to be in harmony with global developments must be respected and that essentially relates to Basel II.
Basel II and India
RBI’s association with the Basel Committee on Banking Supervision dates back to 1997 as India was among the 16 non-member countries that were consulted in the drafting of the Basel Core Principles. Reserve Bank of India became a member of the Core Principles Liaison Group in 1998 and subsequently became a member of the Core Principles Working Group on Capital. Within the Working Group, RBI has been actively participating in the deliberations on the New Accord and had the privilege to lead a group of six major non-G-10 supervisors which presented a proposal on a simplified approach for Basel II to the Committee.
Commercial banks in India will start implementing Basel II with effect from March 31, 2007. They will adopt Standardised Approach for credit risk and Basic Indicator Approach for operational risk, initially. After adequate skills are developed, both at the banks and also at supervisory levels, some banks may be allowed to migrate to the Internal Rating Based (IRB) Approach.
Let me briefly review the steps taken for implementation of Basel II and the emerging issues. The RBI had announced in its annual policy statement in May 2004 that banks in India should examine in depth the options available under Basel II and draw a road-map by end-December 2004 for migration to Basel II and review the progress made at quarterly intervals. The Reserve Bank organized a two-day seminar in July 2004 mainly to sensitise the Chief Executive Officers of banks to the opportunities and challenges emerging from the Basel II norms. Soon thereafter all banks were advised in August 2004 to undertake a self-assessment of the various risk management systems in place, with specific reference to the three major risks covered under the Basel II and initiate necessary remedial measures to update the systems to match up to the minimum standards prescribed under the New Framework. Banks have also been advised to formulate and operationalise the Capital Adequacy Assessment Process (CAAP) within the banks as required under Pillar II of the New Framework.
It is appropriate to list some of the other regulatory initiatives taken by the Reserve Bank of India, relevant for Basel II. First, we have tried to ensure that the banks have suitable risk management framework oriented towards their requirements dictated by the size and complexity of business, risk philosophy, market perceptions and the expected level of capital. Second, Risk Based Supervision (RBS) in 23 banks has been introduced on a pilot basis. Third, we have been encouraging banks to formalize their capital adequacy assessment process (CAAP) in alignment with their business plan and performance budgeting system.  This, together with the adoption of RBS would aid in factoring the Pillar II requirements under Basel II.   Fourth, we have been expanding the area of disclosures (Pillar III), so as to have greater transparency in the financial position and risk profile of banks.  Finally, we have tried to build capacity for ensuring the regulator’s ability for identifying and permitting eligible banks to adopt IRB / Advanced Measurement approaches.
As per normal practice, and with a view to ensuring migration to Basel II in a non-disruptive manner, a consultative and participative approach has been adopted for both designing and implementing Basel II. A Steering Committee comprising senior officials from 14 banks (public, private and foreign) has been constituted wherein representation from the Indian Banks’ Association and the RBI has also been ensured. The Steering Committee had formed sub-groups to address specific issues. On the basis of recommendations of the Steering Committee, draft guidelines to the banks on implementation of the New Capital Adequacy Framework have been issued.
            Implementation of Basel II will require more capital for banks in India due to the fact that operational risk is not captured under Basel I, and the capital charge for market risk was not prescribed until recently. Though last year has not been a very good year for banks, they are exploring all avenues for meeting the capital requirements under Basel II. The cushion available in the system, which has a CRAR of over 12 per cent now, is, however, comforting.

India has four rating agencies of which three are owned partly/wholly by international rating agencies. Compared to developing countries, the extent of rating penetration has been increasing every year and a large number of capital issues of companies has been rated.  However, since rating is of issues and not of issuers, it is likely to result, in effect, in application of only Basel I standards for credit risks in respect of non-retail exposures. While Basel II provides some scope to extend the rating of issues to issuers, this would only be an approximation and it would be necessary for the system to move to rating of issuers. Encouraging rating of issuers would be essential in this regard.  In this context, current non-availability of acceptable and qualitative historical data relevant to ratings, along with the related costs involved in building up and maintaining the requisite database, does influence the pace of migration to the advanced approaches available under Basel  II.
Above all, capacity building, both in banks and the regulatory bodies is a serious challenge, especially with regard to adoption of the advanced approaches. We in India have initiated supervisory capacity-building measures to identify the gaps and to assess as well as quantify the extent of additional capital which may be required to be maintained by such banks. The magnitude of this task, which is scheduled to be completed by December 2006, appears daunting since we have as many as 90 scheduled commercial banks in India.

Concluding Observations
In the current scenario, banks are constantly pushing the frontiers of risk management. Compulsions arising out of increasing competition, as well as agency problems between management, owners and other stakeholders are inducing banks to look at newer avenues to augment revenues, while trimming costs. Consolidation, competition and risk management are no doubt critical to the future of banking but I believe that governance and financial inclusion would also emerge as the key issues for a country like India, at this stage of socio-economic development.

Financial Sector Reforms in India: Policies and Performance Analysis*
Rakesh  Mohan

I. INTRODUCTION
As the economy grows and becomes more sophisticated, the banking sector has to develop pari pasu in a manner that it supports and stimulates such growth. With increasing global integration, the Indian banking system and financial system has as a whole had to be strengthened so as to be able to compete. India has had more than a decade of financial sector reforms during which there has been substantial transformation and liberalisation of the whole financial system. It is, therefore, an appropriate time to take stock and assess the efficacy of our approach. It is useful to evaluate how the financial system has performed in an objective quantitative manner. This is important because India’s path of reforms has been different from most other emerging market economies: it has been a measured, gradual, cautious, and steady process, devoid of many flourishes that could be observed in other countries.
Until the beginning of the 1990s, the state of the financial sector in India could be described as a classic example of “financial repression” a la MacKinnon and Shaw. The sector was characterised, inter alia,by administered interest rates, large pre-emption of resources by the authorities and extensive micro-regulations directing the major portion of the flow of funds to and from financial intermediaries. While the true health of financial intermediaries, most of them public sector entities, was masked by relatively opaque accounting norms and limited disclosure, there were general concerns about their viability. Insurance companies – both life and non-life - were all publicly owned and offered very little product choice. In the securities market, new equity issues were governed by a plethora of complex regulations and extensive restrictions. There was very little transparency and depth in the secondary market trading of such securities. Interest rates on government securities, the predominant segment of fixed-income securities, were decided through administered fiat. The market for such securities was a captive one where the players were mainly financial intermediaries, who had to invest in government securities to fulfill high statutory reserve requirements. There was little depth in the foreign exchange market as most such transactions were governed by inflexible and low limits and also prior approval requirements.

Compartmentalisation of activities of different types of financial intermediaries eliminated the scope for competition among existing financial intermediaries. In addition, strong entry barriers thwarted competition from new entrants. The end result was low levels of competition, efficiency and productivity in the financial sector, on the one hand, and severe credit constraints for the productive entities, on the other, especially for those in the private sector. The other major drawback of this regime was the scant attention that was placed on the financial health of the intermediaries. Their capitalisation levels were low. The lack of commercial considerations in credit planning and weak recovery culture resulted in large accumulation of non-performing loans. This had no impact on the confidence of depositors, however, because of government ownership of banks and financial intermediaries.

The predominance of Government securities in the fixed-income securities market of India mainly reflects the captive nature of this market as most financial intermediaries need to invest a sizeable portion of funds mobilised by them in such securities. While such norms were originally devised as a prudential measure, during certain periods, such statutory norms pre-empted increasing proportions of financial resources from intermediaries to finance high Government borrowings.

The interest rate on Government debt was administered and the rate of interest charged by the Reserve Bank of India (RBI) for financing Government deficit was concessional. On top of this, there were limited external capital flows. Such a closed-economy set-up kept debt markets underdeveloped and devoid of any competitive forces. In addition, there was hardly any secondary market for Government securities, and such transactions were highly opaque and operated through over-the-telephone deals. The provision of fiscal accommodation through ad hoc treasury bills led to high levels of monetisation of fiscal deficit during the major part of the 1980s.

The phase of nationalisation and ‘social control’ of financial intermediaries, however, was not without considerable positive implications as well. The sharp increase in rural branches of banks increased deposit and savings growth considerably. There was a marked rise in credit flow towards economically important but hitherto neglected activities, most notably agriculture and small-scale industries. The urban-bias and marked preference of banks to lend to the industrial sector, especially large industrial houses, was contained. The implicit guarantee emanating from public ownership created an impression of infallibility of these institutions and the expectation was self-fulfilling – there was no major episode of failure of financial intermediaries in this period.

Starting from such a position, it is widely recognised that the Indian financial sector over the last decade has been transformed into a reasonably sophisticated, diverse and resilient system. However, this transformation has been the culmination of extensive, well-sequenced and coordinated policy measures aimed at making the Indian financial sector efficient, competitive and stable.
The main objectives, therefore, of the financial sector reform process in India initiated in the early 1990s have been to :

• Remove financial repression that existed earlier;
• Create an efficient, productive and profitable financial sector industry;
• Enable price discovery, particularly, by the market determination of interest rates that then helps in efficient allocation    of resources;
• Provide operational and functional autonomy to institutions;
• Prepare the financial system for increasing international competition;
• Open the external sector in a calibrated fashion;
• Promote the maintenance of financial stability even in the face of domestic and external shocks.

Since there is a rich array of literature analysing the anthology of the reform process per se, the story of policy reforms in the India financial sector since the early 1990s is quite well known.1 What is less probed, however, is the outcome. In fact, from the vantage point of 2004, one of the successes of the Indian financial sector reform has been the maintenance of financial stability and avoidance of any major financial crisis during the reform period - a period that has been turbulent for the financial sector in most emerging market countries. The domain of analysis of the paper is, however, somewhat limited. Specifically, this paper limits itself to the impact analysis of financial sector reforms in the areas where the Reserve Bank of India has had a dominant role. These include the banking sector, foreign exchange and government securities markets and also the conduct of monetary policy.
The rest of the paper is organised as follows. Section II provides the rationale of financial sector reforms in India. While policy reforms in the financial sector are dealt with in section III, section IV is devoted to reforms in the monetary policy framework. Against this brief chronicle of the financial sector reforms process, I shall look into the outcomes of the financial sector reform process in section V in some detail. Instead of presenting any concluding observations, I shall raise some issues in the last section.

II. FINANCIAL SECTOR REFORMS: THE APPROACH
The initiation of financial reforms in the country during the early 1990s was to a large extent conditioned by the analysis and recommendations of various Committees/Working Groups set-up to address specific issues. The process has been marked by ‘gradualism’ with measures being undertaken after extensive consultations with experts and market participants. From the beginning of financial reforms, India has resolved to attain standards of international best practices but to fine tune the process keeping in view the underlying institutional and operational considerations (Reddy, 2002 a). Reform measures introduced across sectors as well as within each sector were planned in such a way so as to reinforce each other. Attempts were made to simultaneously strengthen the institutional framework while enhancing the scope for commercial decision making and market forces in an increasingly competitive framework. At the same time, the process did not lose sight of the social responsibilities of the financial sector. However, for fulfilling such objectives, rather than using administrative fiat or coercion, attempts were made to provide operational flexibility and incentives so that the desired ends are attended through broad interplay of market forces.
The major aim of the reforms in the early phase of reforms, known as first generation of reforms, was to create an efficient, productive and profitable financial service industry operating within the environment of operating flexibility and functional autonomy. While these reforms were being implemented, the world economy also witnessed significant changes, ‘coinciding with the movement towards global integration of financial services’ [Government of India (GoI), 1998]. The focus of the second phase of financial sector reforms starting from the second-half of the 1990s, therefore, has been the strengthening of the financial system and introduction of structural improvements.
Two brief points need to be mentioned here. First, financial reforms in the early 1990s were preceded by measures aimed at lessening the extent of financial repression. However, unlike in the latter period, the earlier efforts were not part of a well-thought out and comprehensive agenda for extensive reforms. Second, financial sector reform in India was an important component of the comprehensive economic reform process initiated in the early 1990s. Whereas economic reforms in India were also initiated following an external sector crisis, unlike many other emerging market economies where economic reforms were driven by crisis followed by a boom-bust pattern of policy liberalisation, in India, reforms followed a consensus driven pattern of sequenced liberalisation across the sectors (Ahluwalia, 2002). That is why despite several changes in government there has not been any reversal of direction in the financial sector reform process over the last 15 years.
As pointed out by Dr.Y.V.Reddy (Reddy, 2002 a), the approach towards financial sector reforms in India is based on panchasutra or five principles:
1.   Cautious and appropriate sequencing of reform measures.
2.   Introduction of norms that are mutually reinforcing.
3.   Introduction of complementary reforms across sectors (most importantly, monetary, fiscal and external sector).
4.   Development of financial institutions.
5.   Development of financial markets.
An important salient feature of the move towards globalisation of the Indian financial system has been the intent of the authorities to more towards international best practices. This is illustrated by the appointment of several advisory groups designed to benchmark Indian practices with international standards in several crucial areas of importance like monetary policy, banking supervision, data dissemination, corporate governance and the like. Towards this end, a Standing Committee on International Financial Standards and Codes (Chairman: Dr. Y. V. Reddy) was constituted and the recommendations contained therein have either been implemented or are in the process of implementation.Having delineated the broad philosophy, let me now turn to specifics of reform. I will paint the story of Indian reform with a broad brush so as to provide a context of the impact analysis that follows.

III. POLICY REFORMS IN THE FINANCIAL SECTOR
BANKING REFORMS
Commercial banking constitutes the largest segment of the Indian financial system. Despite the general approach of the financial sector reform process to establish regulatory convergence among institutions involved in broadly similar activities, given the large systemic implications of the commercial banks, many of the regulatory and supervisory norms were initiated first for commercial banks and were later extended to other types of financial intermediaries.
After the nationalisation of major banks in two waves, starting in 1969, the Indian banking system became predominantly government owned by the early 1990s. Banking sector reform essentially consisted of a two pronged approach. While nudging the Indian banking system to better health through the introduction of international best practices in prudential regulation and supervision early in the reform cycle, the idea was to increase competition in the system gradually. The implementation periods for such norms were, however, chosen to suit the Indian situation. Special emphasis was placed on building up the risk management capabilities of the Indian banks. Measures were also initiated to ensure flexibility, operational autonomy and competition in the banking sector. Active steps have been taken to improve the institutional arrangements including the legal framework and technological system within which the financial institutions and markets operate. Keeping in view the crucial role of effective supervision in the creation of an efficient and stable banking system, the supervisory system has been revamped. Stylised features of the banking sector reforms have been given in Box I.
Unlike in other emerging market countries, many of which had the presence of government owned banks and financial institutions, banking reform has not involved large scale privatisation of such banks. The approach, instead, first involved recapitalisation of banks from government resources to bring them up to appropriate capitalisation standards. In the second phase, instead of privatisation, increase in capitalisation has been done through diversification of ownership to private investors up to a limit of 49 per cent, thereby keeping majority ownership and control with the government. With such widening of ownership most of these banks have been publicly listed; this was designed to introduce greater market discipline in bank management, and greater transparency through enhanced disclosure norms. The phased introduction of new private sector banks, and expansion in the number of foreign bank branches, provided for new competition. Meanwhile, increasingly tight capital adequacy, prudential and supervision norms were applied equally to all banks, regardless of ownership.

DEBT MARKET REFORMS
Major reforms have been carried out in the government securities (G-Sec) debt market. In fact, it is probably correct to say that a functioning G-Sec debt market was really initiated in the 1990s. The system had to essentially move from a strategy of pre-emption of resources from banks at administered interest rates and through monetisation to a more market oriented system. Prescription of a “statutory liquidity ratio” (SLR), i.e., the ratio at which banks are required to invest in approved securities, though originally devised as a prudential measure, was used as the main instrument of pre-emption of bank resources in the pre-reform period. The high SLR requirement created a captive market for government securities, which were issued at low administered interest rates. After the initiation of reforms, this ratio has been reduced in phases to the statutory minimum level of 25 per cent. Over the past few years numerous steps have been taken to broaden and deepen the Government securities market and to raise the levels of transparency. Automatic monetisation of the Government’s deficit has been phased out and the market borrowings of the Central Government are presently undertaken through a system of auctions at market-related rates. Major facets of the reforms in the government securities are provided in Box II.
The key lesson learned through this debt market reform process is that setting up such a market is not easy and needs a great deal of proactive work by the relevant authorities. An appropriate institutional framework has to be created for such a market to be built and operated in a sustained manner. Legislative provisions, technology development, market infrastructure such as settlement systems, trading systems, and the like have all to be developed.

FOREIGN EXCHANGE MARKET REFORMS
The Indian forex exchange market had been heavily controlled since the 1950s, along with increasing trade controls designed to foster import substitution. Consequently, both the current and capital accounts were closed and foreign exchange was made available by the Reserve Bank of India through a complex licensing system. The task facing India in the early 1990s was therefore to gradually move from total control to a functioning foreign exchange market. The move towards a market-based exchange rate regime in 1993 and the subsequent adoption of current account convertibility were the key measures in reforming the Indian foreign exchange market. Reforms in the foreign exchange market focused on market development with prudential safeguards without destabilising the market (Reddy, 2002 a). Authorised Dealers of foreign exchange have been allowed to carry on a large range of activities. Banks have been given large autonomy to undertake foreign exchange operations. In order to deepen the foreign exchange market, a large number of products have been introduced and entry of newer players has been allowed in the market. Highlights of reforms in the foreign exchange market have been given in Box III.

The Indian approach to opening the external sector and developing the foreign exchange market in a phased manner from current account convertibility to the ongoing process of capital account opening is perhaps the most striking success relative to other emerging market economies. There have been no accidents in this process, the exchange rate has been market determined and flexible and the process has been carefully calibrated. The capital account is effectively convertible for non-residents, but has some way to go for residents. The Indian approach has perhaps gained greater international respectability after the enthusiasm for rapid capital account opening has been dimmed since the Asian crisis.

REFORMS IN OTHER SEGMENTS OF THE FINANCIAL SECTOR
Measures aimed at establishing prudential regulation and supervision and also competition and efficiency enhancing measures have also been introduced for non-bank financial intermediaries as well. Towards this end, non-banking financial companies (NBFCs), especially those involved in public deposit taking activities, have been brought under the regulation of RBI. Development Finance Institutions (DFIs), specialised term-lending institutions, NBFCs, Urban Cooperative Banks and Primary Dealers have all been brought under the supervision of the Board for Financial Supervision (BFS). With the aim of regulatory convergence for entities involved in similar activities, prudential regulation and supervision norms were also introduced in phases for DFIs, NBFCs and cooperative banks.

The insurance business remained within the confines of public ownership until the late 1990s. Subsequent to the passage of the Insurance Regulation and Development Act in 1999, several changes were initiated, including allowing newer players/joint ventures to undertake insurance business on risk-sharing/commission basis. The Insurance Regulatory and Development Agency (IRDA) has been established to regulate and supervise the insurance sector.

With the objective of improving market efficiency, increasing transparency, integration of national markets and prevention of unfair practices regarding trading, a package of reforms comprising measures to liberalise, regulate and develop capital market was introduced. An important step has been the establishment of the Securities and Exchange Board of India (SEBI) as the regulator for equity markets. Since 1992, reform measures in the equity market have focused mainly on regulatory effectiveness, enhancing competitive conditions, reducing information asymmetries, developing modern technological infrastructure, mitigating transaction costs and controlling of speculation in the securities market. Another important development under the reform process has been the opening up of mutual funds to the private sector in 1992, which ended the monopoly of Unit Trust of India (UTI), a public sector entity. These steps have been buttressed by measures to promote market integrity.

The Indian capital market was opened up for foreign institutional investors (FIIs) in 1992. The Indian corporate sector has been allowed to tap international capital markets through American Depository Receipts (ADRs), Global Depository Receipts (GDRs), Foreign Currency Convertible Bonds (FCCBs) and External Commercial Borrowings (ECBs). Similarly, Overseas Corporate Bodies (OCBs) and non-resident Indians (NRIs) have been allowed to invest in Indian companies. FIIs have been permitted in all types of securities including Government securities and they enjoy full capital convertibility. Mutual funds have been allowed to open offshore funds to invest in equities abroad.

IV. REFORM IN THE MONETARY POLICY FRAMEWORK
What has been the change in monetary policy in the wake of these changes in different market segments as well as sectors? The transition of economic policies in general, and financial sector policies in particular, from a control oriented regime to a liberalised but regulated regime has also been reflected in changes in the nature of monetary management. While the basic objectives of monetary policy, namely price stability and ensuring adequate credit flow to support growth, have remained unchanged, the underlying operating environment for monetary policy has undergone a significant transformation. An increasing concern is the maintenance of financial stability. The basic emphasis of monetary policy since the initiation of reforms has been to reduce market segmentation in the financial sector through increase in the linkage between various segments of the financial market including money, government securities and forex market. Major features of the reforms in the monetary policy framework have been provided in Box IV.
The key policy development that has enabled a more independent monetary policy environment was the discontinuation of automatic monetisation of the government’s fiscal deficit through an agreement between the Government and the Reserve Bank of India in 1997. The enactment of the Fiscal Responsibility and Budget Management Act has strengthened this further : from 2006, the Reserve Bank will no longer be permitted to subscribe to government securities in the primary market. The development of the monetary policy framework has also involved a great deal of institutional initiatives to enable efficient functioning of the money market: development of appropriate trading, payments and settlement systems along with technological infrastructure.
Box I: Reforms in the Banking Sector

• Prudential Measures     
• Introduction and phased implementation of international best practices  and norms on risk-weighted capital adequacy requirement, accounting, income recognition, provisioning and exposure.
• Measures to strengthen risk management through recognition of different components of risk, assignment of risk-weights to various asset classes, norms on connected lending, risk concentration, application of marked-to-market principle for investment portfolio and limits on deployment of fund in sensitive activities.

B. Competition Enhancing Measures

• Granting of operational autonomy to public sector banks, reduction of public ownership in public sector banks by allowing them to raise capital from equity market up to 49 per cent of paid-up capital.
• Transparent norms for entry of Indian private sector, foreign and joint-venture banks and insurance companies, permission for foreign investment in the financial sector in the form of Foreign Direct Investment (FDI) as well as portfolio investment, permission to banks to diversify product portfolio and business activities.

C. Measures Enhancing Role of Market Forces

• Sharp reduction in pre-emption through reserve requirement, market determined pricing for government securities, disbanding of administered interest rates with a few exceptions and enhanced transparency and disclosure norms to facilitate market discipline.
• Introduction of pure inter-bank call money market, auction-based repos-reverse repos for short-term liquidity management, facilitation of improved payments and settlement mechanism.

D. Institutional and Legal Measures

• Settling up of Lok Adalats (people’s courts), debt recovery tribunals, asset reconstruction companies, settlement advisory committees, corporate debt restructuring mechanism, etc. for quicker recovery/ restructuring. Promulgation of Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI), Act and its subsequent amendment to ensure creditor rights.
• Setting up of Credit Information Bureau for information sharing on defaulters as also other borrowers.
• Setting up of Clearing Corporation of India Limited (CCIL) to act as central counter party for facilitating payments and settlement system relating to fixed income securities and money market instruments.

E. Supervisory Measures

• Establishment of the Board for Financial Supervision as the apex supervisory authority for commercial banks, financial institutions and non-banking financial companies.
• Introduction of CAMELS supervisory rating system, move towards risk-based supervision, consolidated supervision of financial conglomerates, strengthening of off-site surveillance through control returns.
• Recasting of the role of statutory auditors, increased internal control through strengthening of internal audit.
• Strengthening corporate governance, enhanced due diligence on important shareholders, fit and proper tests for directors.

Technology Related Measures

• Setting up of INFINET as the communication backbone for the financial sector, introduction of Negotiated Dealing System (NDS) for screen-based trading in government securities and Real Time Gross Settlement (RTGS) System.

Box II: Reforms in the Government Securities Market

Institutional Measures

• Administered interest rates on government securities were replaced by an auction system for price discovery.
• Automatic monetisation of fiscal deficit through the issue of ad hoc Treasury Bills was phased out.
• Primary Dealers (PD) were introduced as market makers in the government securities market.
• For ensuring transparency in the trading of government securities, Delivery versus Payment (DvP) settlement system was introduced.
• Repurchase agreement (repo) was introduced as a tool of short-term liquidity adjustment. Subsequently, the Liquidity Adjustment Facility (LAF) was introduced. LAF operates through repo and reverse repo auctions to set up a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also signalling device for interest rates in the overnight market.
• Market Stabilisation Scheme (MSS) has been introduced, which has expanded the instruments available to the Reserve Bank for managing the surplus liquidity in the system.

Increase in Instruments in the Government Securities Market

• 91-day Treasury bill was introduced for managing liquidity and benchmarking. Zero Coupon Bonds, Floating Rate Bonds, Capital Indexed Bonds were issued and exchange traded interest rate futures were introduced. OTC interest rate derivatives like IRS/ FRAs were introduced.

Enabling Measures

• Foreign Institutional Investors (FIIs) were allowed to invest in government securities subject to certain limits.
• Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS). Setting up of risk-free payments and settlement system in government securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time Gross Settlement System (RTGS). Introduction of trading of government securities on stock exchanges for promoting retailing in such securities, permitting non-banks to participate in repo market.

Box III: Reforms in the Foreign Exchange Market

Exchange Rate Regime

• Evolution of exchange rate regime from a single-currency fixed-exchange rate system to fixing the value of rupee against a basket of currencies and further to market-determined floating exchange rate regime.
• Adoption of convertibility of rupee for current account transactions with acceptance of Article VIII of the Articles of Agreement of the IMF. De facto full capital account convertibility for non residents and calibrated liberalisation of transactions undertaken for capital account purposes in the case of residents.

Institutional Framework

• Replacement of the earlier Foreign Exchange Regulation Act (FERA), 1973 by the market friendly Foreign Exchange Management Act, 1999. Delegation of considerable powers by RBI to Authorised Dealers to release foreign exchange for a variety of purposes.

Increase in Instruments in the Foreign Exchange Market

• Development of rupee-foreign currency swap market.
• Introduction of additional hedging instruments, such as, foreign currency-rupee options. Authorised dealers permitted to use innovative products like cross- currency options, interest rate and currency swaps, caps/collars and forward rate agreements (FRAs) in the international forex market.

Liberalisation Measures

• Authorised dealers permitted to initiate trading positions, borrow and invest in overseas market subject to certain specifications and ratification by respective Banks’ Boards. Banks are also permitted to fix interest rates on non-resident deposits, subject to certain specifications, use derivative products for asset-liability management and fix overnight open position limits and gap limits in the foreign exchange market, subject to ratification by RBI.
• Permission to various participants in the foreign exchange market, including exporters, Indians investing abroad, FIIs, to avail forward cover and enter into swap transactions without any limit subject to genuine underlying exposure.
• FIIs and NRIs permitted to trade in exchange-traded derivative contracts subject to certain conditions.
• Foreign exchange earners permitted to maintain foreign currency accounts. Residents are permitted to open such accounts within the general limit of US $ 25,000 per year.

Box IV: Reforms in the Monetary Policy Framework

Objectives

• Twin objectives of “maintaining price stability” and “ensuring availability of adequate credit to productive sectors of the economy to support growth” continue to govern the stance of monetary policy, though the relative emphasis on these objectives has varied depending on the importance of maintaining an appropriate balance.
• Reflecting development of financial market and liberalisation, use of broad money as an intermediate target has been de-emphasised and a multiple indicator approach has been adopted.
• Emphasis has been put on development of multiple instruments to transmit liquidity and interest rate signals in the short-term in a flexible and bi-directional manner.
• Increase of the linkage between various segments of the financial market including money, government security and forex markets.

Instruments

• Move from direct instruments (such as, administered interest rates, reserve requirements, selective credit control) to indirect instruments (such as, open market operations, purchase and repurchase of government securities) for the conduct of monetary policy.
• Introduction of Liquidity Adjustment Facility (LAF), which operates through repo and reverse repo auctions to set up a corridor for short-term interest rate. LAF has emerged as the tool for both liquidity management and also as a signalling devise for interest rate in the overnight market. Use of open market operations to deal with overall market liquidity situation especially those emanating from capital flows.
• Introduction of Market Stabilisation Scheme (MSS) as an additional instrument to deal with capital inflows without affecting short-term liquidity management role of LAF.

Developmental Measures

• Discontinuation of automatic monetisation through an agreement between the Government and the Central Bank. Rationalisation of Treasury Bill market.
• Introduction of delivery versus payment system and deepening of inter-bank repo market.
• Introduction of Primary Dealers in the government securities market to play the role of market maker. Amendment of Securities Contracts Regulation Act to create the regulatory framework.
• Deepening of government securities market by making the interest rates on such securities market related.
• Introduction of auction of government securities. Development of a risk-free credible yield curve in the government securities market as a benchmark for related markets.
•  Development of pure inter-bank call money market.
• Non-bank participants to participate in other money market instruments. Introduction of automated screen-based trading in government securities through Negotiated Dealing System (NDS). Setting up of risk-free payments and system in government securities through Clearing Corporation of India Limited (CCIL). Phased introduction of Real Time Gross Settlement (RTGS) System.
• Deepening of forex market and increased autonomy of Authorised Dealers.

V. PERFORMANCE OF THE FINANCIAL SECTOR UNDER THE REFORM PROCESS
BANKING SECTOR
Banking sector reform has established a competitive system driven by market forces. The process, however, has not resulted in disregard of social objectives such as maintenance of the wide reach of the banking system or channelisation of credit towards disadvantaged but socially important sectors. At the same time, the reform period experienced strong balance sheet growth of the banks in an environment of operational flexibility. A key achievement of the banking sector reform has been the sharp improvement in the financial health of banks, reflected in significant improvement in capital adequacy and improved asset quality. This has been achieved despite convergence of the prudential norms with the international best practices.2 There have also been substantial improvements in the competitiveness of the Indian banking sector reflected in the changing composition of assets and liabilities of the banking sector across bank groups. In line with increased competitiveness, there has been improvement in efficiency of the banking system reflected inter alia in the reduction in interest spread, operating expenditure and cost of intermediation in general. Contemporaneously there have been improvements in other areas as well including technological deepening and flexible human resource management. A more detailed discussion on the performance analysis of the banking sector under the reform process is given below.

Social Objectives and Balance Sheet Management
The Indian banking system has acquired a wide reach, judged in terms of expansion of branches and the growth of credit and deposits (Tables 1 and 2). The expansion of branch network peaked in the phase of social banking during the 1970s and 1980s. Despite the slowdown in branch expansion since the 1990s, the population per bank branch, however, has not changed much since the 1980s, and has remained at around 15,000. It is often asserted that the Indian banking sector is saddled with too many branches, adding to its high intermediation costs. In fact, at about 8-10,000, the population per branch in developed countries is lower than that in India. Therefore, the reform process has maintained the gains in terms of the outreach of bank branches achieved in the phase of social banking.

Despite a decline, direct lending to disadvantaged segments of the economy under the priority sector advances remained high during the reform period. The decline in priority sector lending since the initiation of reforms in fact reflects greater flexibility provided to banks to meet such targets. Currently, in the event a bank fails to meet the priority sector lending target through direct lending, the bank can invest the shortfall amount with the apex organisations dealing with flow of funds towards agriculture and small-scale industries. While adherence of banks to the norms on direct lending towards the priority sector still remains desirable, the current arrangement reflects how the reform process has provided operational flexibility to banks even while meeting social objectives.

The discernible increase in the proportion of bank deposits to national income is reflective of the enhanced deepening of the Indian financial system during the period. Simultaneously, there have been considerable increases in per capita deposits and credit. This also implies an increase in the average business per bank branch, which is likely to have improved the viability of individual bank branches including those in the rural and semi-urban centres.

In the post-reform period, banks have consistently maintained high rates of growth in their assets and liabilities. This is particularly credible given the low inflationary situation that prevailed in this period compared to the earlier periods, most notably in the 1980s. On the liability side, there has not been much compositional change since the initiation of reforms whereby deposits continue to account for about 80 per cent of the total liabilities. On the asset side, however, there is a definite increase in the share of investments. While the share of loans and advances did decline in the 1990s, it has recovered in recent years.
Despite the large decline in SLR in the 1990s,3 the sharp increase in investments by banks is reflective of their attempt to evolve treasury operations into profit centres. The reduction in cash reserve ratio and improved inter-office adjustments in a substantially computerised and networked environment, inter alia, did free up substantial amounts of bank resources, which enabled banks to concentrate on investment operations with greater vigour.

Interestingly, despite the reduced regulatory requirement to invest in government and other securities approved for SLR investment, the major increase in investment operations by Indian banks since the mid 1990s has been on account of their investment in government securities. This reflects the sustenance of high fiscal deficits of both central and state governments, particularly after the Pay Commission award leading to increase in the government salary bill in 1997. Furthermore, subdued industrial growth since 1997 also led to lower credit demand, providing banks further incentive to place their resources in risk-free government securities. It is also possible that, in a declining interest rate scenario in the presence of a developing debt market, this was a rational profit maximising strategy. Banks’ investment in non-SLR securities as a proportion of total assets has in fact declined since 1999-2000. While in the 1990s, greater orientation towards investment activities and aversion to credit risk exposure may have deterred banks from undertaking their ‘core function’ of providing loans and advances, banks seem to have struck a greater balance between investment and loans and advances in recent years. Improved atmosphere for recovery created in the recent years coupled with greater awareness about market risks associated with large holding of securities portfolio seem to have induced banks to put greater efforts in extending loans.

Capital Position and Asset Quality

ensuring safety and soundness in order to fix ‘the true position of bank’s balance sheet and…to arrest its deterioration’ (Rangarajan, 1998). With regard to prudential requirements, norms for income recognition and asset classification (IRAC), introduced in 1992, have been strengthened over the years in line with international best practices. A strategy to attain CRAR of 8 per cent in a phased manner was put in place and subsequently the level was raised to 9 per cent with effect from 1999-2000.
The overall capital position of commercial sector banks has witnessed a marked improvement during the reform period (Table 3). Illustratively, as at end-March 2003, 91 out of the 93 commercial banks operating in India maintained CRAR at or above 9 per cent. The corresponding figure for 1995-96 was 54 out of 92 banks.4 Improved capitalisation of public sector banks was initially brought through substantial infusion of funds by government to recapitalise these banks. On a cumulative basis, infusion of funds by government into the public sector banks since the initiation of reforms for the purpose of recapitalisation amounted to less than 1 per cent of India’s GDP, a figure much lower than that for some other countries.
Subsequently, in order to reduce pressure on the budget and to introduce market discipline, public sector banks have been allowed to raise funds through issue of equity in the market subject to the maintenance of 51 per cent public ownership. 20 out of the 27 public sector banks have raised capital from the market (Table 4). In order to improve their price-earning ratios, many public sector banks have also returned part of government’s equity subscription. Another important factor in the improvement in capital position of banks operating in India stemmed from deployment of retained earnings out of increased profits.
The reform period also witnessed considerable improvements in the asset quality of banks. Non-performing loans (NPLs) as ratios of both total advances and assets declined substantially and consistently since the mid-1990s. Moreover, for the first time since the initiation of reforms, in 2002-03, the absolute amount of NPLs in both gross and net terms witnessed declines (Table 5). This improved recovery performance raises a few interesting issues. First, from the pattern of NPLs over the years, it can be argued that to a large extent the NPL problems faced by Indian banks are legacy problems emanating from credit decisions taken before the full implementation of the banking sector reforms. Second, there has been a distinct improvement in the credit appraisal process in the Indian banking system under the reform process whereby incremental NPLs have been low despite the fact that Indian industry has gone through a relatively low-growth phase since the mid-1990s. Finally, in recent years, the recovery performance of public sector banks has been better than private sector banks – both old and new – in terms of net NPL (i.e. net of provisioning). Foreign banks, however, exhibited the best recovery performance and lowest NPL levels among the all bank-groups. This raises a question mark on the applicability of the argument that links performance of banks with ownership pattern in the context of Indian banking.

Another interesting point that merits mention is that despite India’s transition to a 90-day NPL recognition norm (from 180-day norm) since 2004, both gross and net NPLs as a percentage of total advances declined between end-March 2003 and end-March 2004. This reflects the success of new initiatives for resolution of NPLs including promulgation of the SARFAESI5 Act in containing NPLs. Greater provisioning and write-off of NPLs in the face of greater profitability also helped keeping the NPLs low during 2003-04.

Competition and Efficiency
One of the major objectives of banking sector reforms has been to enhance efficiency and productivity through enhanced competition. Such policies have led to considerable and consistent reduction in the shares of public sector banks in the total income, expenditure and assets of the commercial banking system (Table 6). Shares of Indian private sector banks, especially new private sector banks established in the 1990s, in the total income and assets of the banking system have improved considerably since the mid-1990s. A number of new private sector banks have emerged as dynamic components of the Indian banking system, reducing not only the market share of public sector banks but also those of foreign banks. The reduction in the asset share of foreign banks, however, is partially due to their increased focus on off-balance sheet non-fund based business.
Notwithstanding such transformation, the position of public sector banks in the Indian banking system continues to be predominant as these banks account for nearly three-fourths of assets and income. It is important to note that public sector banks have responded to the new challenges of competition, which is reflected in the increase in share of these banks in the overall profit of the banking sector. From the position of net loss in the mid-1990s, in recent years the share of public sector banks in the profit of the commercial banking system has become broadly commensurate with their share of assets, indicating a broad convergence of profitability across various bank groups. This is yet another example that, with operational flexibility, public sector banks are competing effectively with private sector and foreign banks. The market discipline imposed by the listing of most public sector banks has also probably contributed to this improved performance. Public sector bank managements are now probably more attuned to the market consequences of their activities.
Since the mid-1990s, profitability levels of commercial banks have hovered in the range of 0.7-0.8 per cent, except during certain exceptional years (Table 7). Clearly this is an improvement over the profitability prior to the initiation of the reform process. Moreover, there is a general improvement in the profitability situation in the recent years across bank groups. Since the mid-1990s, consistent with soft interest rate policies, both interest income and interest expenditure of banks as proportions of total assets have declined. However, interest expenditure declined faster than interest income, resulting in an increase in net interest income (Table 7).
Reflecting the greater emphasis on income and expenditure management, there has been a general reduction in the operating expenditure as a proportion of total assets (Table 7). This is also reflective of efficiency gain of the Indian banking under the reform process. This has been achieved in spite of large expenditures incurred by Indian banks in installation and upgradation of information technology. Moreover, in order to address manpower redundancies, public sector banks also incurred large expenditures under voluntary pre-mature retirement of nearly 12 per cent of their total staff strength. The process, however, resulted in reduced operating expenditure in the medium-term.
Another reflection of greater competition and efficiency of the Indian banking system can be captured from the considerable reduction in interest spread over the reform period. Once again, this reduction has been across the bank-groups. In fact, the spread is the highest for foreign banks and lowest for new private sector banks (Table 8).
A major impact of the reform process on the Indian banking has been in terms of change in business strategy of the banks. When banking sector reforms were introduced, over 90 per cent of the income of commercial banks in India was in the form of interest income, this proportion has gone down substantially to about 80 per cent in recent years. This reflects greater diversification of banks into non-fund based business and also emergence of treasury and foreign exchange business as profit centres for Indian banks.
Inflexibility of the Indian labour market is often identified as one of the weak points of the Indian reform process. It is, however, important to note that as a part of financial sector reforms, 26 out of the 27 public sector financial intermediaries have been successful in restructuring their workforce, which involved downsizing of the labour force by 12 per cent. Such steps have resulted in decline in staff cost and increase in business per employee.
This brief quantitative review of the performance of the Indian banking sector documents the very significant improvements that have occurred over the decade of reforms. The performance parameters of Indian banks are now approaching international standards and they are among the better performers in the emerging market group (Table 9). As both domestic and international competition intensifies, it will be essential for Indian banks to further improve their efficiency and also deploy better their resources as fiscal dominance declines.

Debt Market
In nominal terms, fiscal deficit of the central government has increased substantially since the early 1990s and as a proportion of GDP it has hovered around 6 per cent. However, more importantly, the dependence of government on market borrowings has increased sharply in this period. The outstanding stocks of both Centre and State Government debt each increased by about 10 times since the initiation of reforms (Table 10). From around 20 per cent in the early 1990s, share of net market borrowing in financing fiscal deficit of the central government has increased to 80 per cent in recent years (Table 11).
Despite such rapid increase in market borrowing and continued dominance of financial intermediaries, especially banks, in the government securities market, there has been substantial reduction in the yield as well as cost of borrowing of the Government (Tables 12 and 13). While a major part of such reductions are in line with the high liquidity phase of the global financial market witnessed in the past few years, the reduction in yield and interest rate started much earlier, indicating efficiency gains in the government securities market.
Between the mid- and late-1990s, there has been a substantial widening of maturity profile of government securities, which has reduced the roll-over risk of government debt. Apart from reduction in yield, the dispersion of yield rate on different types of government securities has also declined considerably. These positive developments, to a large extent, reflect the improved market structure for the government securities since the initiation of reforms. Reflecting the buoyancy of the fixed-income securities market in India, despite almost secular decline in yield rate across the maturity spectrum, the turnover in the market has increased over ten-times between 1998-99 and 2003-04 (Table 14) (Mohan, 2004).

Foreign Exchange Market
The reforms measures in the foreign exchange market have resulted in significant deepening of the market in terms of both instruments and variety of players. Despite certain fluctuations, daily average turnover in the Indian foreign exchange market has shown a general increase. A survey by the Bank for International Settlements on the foreign exchange market turnover during 2001 in which 43 countries including India participated reveals that while foreign exchange market turnover declined the world over considerably as compared to 1998, it increased in India. The turnover has increased particularly in recent years (Table 15).
In recent years, the turnover in the foreign exchange market has been nearly 6 times higher than the aggregate size of India’s balance of payments. While inter-bank transactions accounted for about 80 per cent of the turnover in the foreign exchange market, merchant transactions registered high growth rates in recent years. The increased turnover can be taken as an indicator of the extent of liberalisation of the Indian foreign exchange market and the consequent deepening of the foreign exchange market. Full convertibility on the current account and extensive liberalisation of the capital account transactions have facilitated not only transactions in foreign currency, these have enabled the corporates to hedge various types of risks associated with foreign currency transactions.
Authorised Dealers (ADs) are the leading agencies in the transmission of the liberalisation measures in the context of foreign exchange market as well as widening and deepening of such markets. ADs also facilitate corporates in hedging foreign currency risk exposures. With the deepening of foreign exchange market and increased turnover, income of commercial banks through such transactions increased considerably. In recent years, profit from foreign exchange transactions accounted for 20-30 per cent of the total profit of the public sector banks.
Despite liberalisation of the capital account and introduction of a market determined exchange rate, the foreign exchange market in India remained stable barring a few episodes of mild volatility (Table 16). Therefore, India’s current exchange rate policy of managing volatility without fixed target levels has yielded satisfactory results. It is, however, important to point out that RBI intervention in the foreign exchange market has been relatively small in terms of volume. During 2002-03, a year considered to be characterised by considerable intervention by the Reserve Bank, gross intervention by the Reserve Bank of India accounted for less than 3 per cent of the turnover in the foreign exchange market. This shows the predominant role of market forces in determination of the external value of the rupee.
Reflecting the resilience of the Indian economy, in particular the financial sector, there has been a large inflow of funds towards the country in recent years. This has reflected in large accumulation of foreign exchange reserves (Table 17). An analysis of the sources of reserve accretion indicates that buoyancy in services exports, large unilateral private transfers reflecting mainly remittance from Diaspora, and various types of non-debt creating capital inflows have been the major source for the accumulation of foreign exchange reserves. It is interesting to note that while financial sector reforms started at the backdrop of external sector crisis, India’s foreign exchange reserves reached historical peaks when the country has substantially liberalised norms governing flows of foreign exchange. Accumulation of foreign exchange reserves also reflects monetary policy response in face of large capital inflows. The process has been successful in maintaining price stability. Available indicators of reserve adequacy suggest that India’s current level of foreign exchange reserves can be considered adequate as a cushion against potential disruptions to trade and current transactions as well as external debt servicing obligations. In the absence of an international lender of last resort, the reserves also provide the country a level of self-insurance against destabilising and costly financial crisis.

Other Financial Intermediaries
In line with banks, there has been an almost across-the-board improvement in the financial health of other financial intermediaries as well in terms of improvements in capital position and reduction in NPLs. Among the cooperative banks, there have been improvements in capital position, reduction in spread and operating expenses. Despite the decline in NPLs as a proportion of total assets for a majority of the cooperative banks, the ratio for some of the large cooperative banks increased significantly, mainly on account of inappropriate risk-management and corporate governance practices. Measures have been put in place to guard against repetition of such episodes, but this remains a burden.

Capital adequacy levels of most of the major DFIs have improved while NPL levels declined since the mid-1990s. Moreover, reflecting the adaptability of DFIs to changed business environment under the reform process, the share of para-banking activities such as underwriting, direct subscription and guarantees has increased from 10 per cent in the early-1990s to over 30 per cent in recent years. Some of the DFIs, however, have not been able to adjust as well as the others in the new environment mainly because of their past investment behaviours. Moreover, a few of the large DFIs felt that they could perform better as banks under the new environment. ICICI has already transformed itself into a bank and similar moves are underway for the Industrial Development Bank of India (IDBI). There has also been a large transformation in the NBFC sector, whereby a large number of NBFCs have discontinued their public deposit taking activities.

Under the strategy of sequenced reform, such measures in the insurance sector were introduced later than the banking sector. Despite this relatively late start, the insurance sector has witnessed considerable changes over the past few years. A large number of private insurance companies, generally with foreign capital participation, have entered the sector. The current profile of the Indian insurance industry reflects that, notwithstanding the entry of private sector players, in terms of both assets and liabilities, insurance companies from the public sector continue to dominate the industry. Despite this, given the fast pace of growth in the insurance industry, private players have been able to market their products (IRDA, 2002).
Perhaps more importantly, liberalisation of entry norms in insurance segment has brought about a sea change in product composition. While in the past, tax incentives were the major driving force of the insurance industry, particularly life insurance industry, in the emerging situation the normal driving force of an insurance industry is taking important roles (IRDA, 2002). Driven by competitive forces and also the emerging socioeconomic changes including increased wealth, education and awareness about insurance products have resulted in introduction of various novel products in the Indian market. Along with the changing product profile, there have also been salutary improvements in consumer service in recent years, driven largely by the impact of new technology usage, better technical know-how consequent upon foreign collaboration and focused product targeting, dovetailed to specific segments of the populace as well as cross-selling of products through bancassurance. Insurance companies are also taking active steps to venture into innovative distribution channels for their products over and above creating strong agency network.

Equity Market
The 1990s have been good for the Indian equity market. The market has grown exponentially in terms of resource mobilisation, number of stock exchanges, number of listed stocks, market capitalisation, trading volumes, turnover and investors’ base (Table 18). Along with this growth, the profile of the investors, issuers and intermediaries has changed significantly. The market has witnessed a fundamental institutional change resulting in drastic reduction in transaction costs and significant improvement in efficiency, transparency and safety (NSE, 2003). In the 1990s, reform measures initiated by SEBI such as, market determined allocation of resources, rolling settlement, sophisticated risk management and derivatives trading have greatly improved the framework and efficiency of trading and settlement. Almost all equity settlements take place at the depository. As a result, the Indian capital market has become qualitatively comparable to many developed and emerging markets.
The liberalisation and consequent reform measures have drawn the attention of foreign investors leading to a rise in portfolio investment in the Indian capital market. During the first half of the 1990s, India accounted for a larger volume of international equity issues than any other emerging market (IMF, 1995). Over the recent years, India has emerged as a major recipient of portfolio investment among the emerging market economies. Apart from such large inflows, reflecting the confidence of cross-border investors on the prospects of Indian securities market, since 1993, when entry of FII was permitted for the first time, except for one year, India received positive portfolio inflows in each year. The stability of portfolio flows towards India is in contrast with large volatility of portfolio flows in most emerging market economies.

VI. ISSUES
As the foregoing analysis suggests, there has been a structural transformation in almost all segments of the Indian financial sector since the initiation of reforms. The reform process has strengthened the health of financial intermediaries, deepened financial markets and enhanced the instruments available in the financial system. At the level of individual institutions as well as at the systemic level, there has been considerable reinforcement of the framework for stability. There have also been discernible improvements in the competitiveness, efficiency and productivity of the Indian financial system. What then are important issues facing the Indian financial system now?

have become close to 40 per cent. It is also important to recall that this paper has shown that since the initiation of reforms, financial health as well as efficiency of the public sector banks closely matched and some times surpassed those of the private sector including foreign banks. Therefore, there is no definite observed link between efficiency and ownership in the contemporary Indian banking system. The competition induced by the new private sector banks has clearly re-energised the Indian banking sector as a whole: new technology is now the norm, new products are being introduced continuously, and new business practices have become common place.
India’s approach towards treatment of insolvent banks is yet another interesting issue. Rather than closing them down, policymakers in India have shown a preference to merge such banks with healthy public sector banks. It has been felt in certain circles that such an approach may give rise to a moral hazard problem. However, two issues need consideration in this context. First, commercial banks are the most dominant and systemically important segment of the financial system. Second, over 70 per cent of the bank depositors in India are small depositors. Therefore, systemic concerns coupled with the necessity to safeguard the interest of small depositors have been paramount in the minds of policy makers while dealing with insolvent banks. This issue had not received much attention in the context of a predominantly government owned banking system. As the weight of private banks increases further thinking will need to be done on this subject, both in terms of prevention of insolvency through advance regulatory supervision and action, and post insolvency measures that discourage moral hazard and eventual fiscal cost.
Certain banking sector and related indicators on select emerging market economies (EMEs) have been presented in Annex I. Some broad points can be drawn from these data. First, while almost all EMEs have been successful in reducing domestic inflation rates since the 1990s, most of them experienced occasional inflationary spikes in this period. Reversing the situation, in the new millennium, countries such as China and Singapore experienced deflationary situations. Along with sustained reduction in inflation during the reform period, India has been able to avoid both the extreme situations. This can be taken as an indicator of the quality of financial sector reforms and monetary management in the country. Second, though lower than most of the East Asian EMEs, India maintained reasonably high and generally rising savings and investment rates since the 1990s. Stability in the financial market under the reform process has facilitated this process. Third, compared to most other EMEs, India maintained a stable real interest rate situation under the reform process. The generally increasing trend of the real rate, however, is an issue that needs greater attention of the authorities. Various steps have already been initiated in this context. Fourth, while banks in India needed to keep high proportions of their assets as liquid assets at the start of reform process, such requirements have been relaxed in a sequenced manner. Currently, these requirements in India are on the lower side among the EMEs. Lastly, despite substantial deepening of the Indian financial system as measured by the domestic bank credit to GDP ratio and domestic credit to private sector to GDP ratio, such processes are yet to catch-up the levels of the East Asian EMEs. This is yet another area where the Indian financial sector needs to make significant strides in the coming years.
Judged by the conventional measures such as share of foreign holdings in the Indian financial market, the extent of globalisation of Indian financial sector may look quite limited as compared to many other EMEs. Moreover, association of the authorities in the financial system either in the form of government ownership of financial intermediaries or intervention in the financial market may appear to be high. The conduct of the Indian financial sector in the face of various uncertainties and crises in various parts of the world, however, drives home the point that “On balance, there appears to be a great advantage in well-managed and appropriate integration into the global process … markets do not and cannot exist in a vacuum, i.e., without some externally imposed rules and such order is a result of public policy” (Reddy, 2003). Similar views have been expressed in the influential work of Prasad and others (Prasad et al, 2003), “The empirical evidence has not established a definitive proof that financial integration has enhanced growth for developing countries.
Furthermore, it may be associated with higher consumption volatility. … (I)mproving governance, in addition to sound macroeconomic frameworks and the development of domestic financial markets, should be an important element of such strategies”. It is important to point out that despite the earlier apprehensions about the outcome of India’s approach of sequenced implementation of international best practices in the financial sector and gradual opening up of the sector to international competition, such measures have enabled the country to avoid major financial sector crisis experienced by many emerging market economies since the 1990s. A list of such crises is given in the Annex II and the country experiences show that premature globalisation financial market and lack of prudential framework for financial regulation and supervision have been two major reasons for financial crises in emerging market economies. Indian policy makers have been conscious of the fact that international financial market acts in a strongly pro-cyclical manner in the case of EMEs. At the same time, these countries, especially disadvantaged strata within these economies, are seriously constrained in managing the impact of such volatility. Therefore, maintenance of stability becomes a part of public policy in the emerging market countries (Reddy, 2003). Accordingly, concern for stability has been a major plank of the financial sector reforms in India. Available indicators reinforce India’s resolve for the continuance of this approach.
Despite the considerable progress in terms of both efficiency and stability of the financial sector under the reform process, it needs to be reiterated that India has miles to go in deepening the process. Despite considerable improvements, the current level of efficiency of the Indian financial sector is far from satisfactory. Reduction in transaction costs and improving the credit delivery mechanism are two areas, which require focused attention at the current stage of reforms. There are needs for the consolidation of the banking system in India and at present there are still various institutional and legal reforms that still need attention.
Effective implementation of corporate governance practices in financial intermediaries has been a longstanding concern of the regulators and supervisors across the world. In India too, instances of inadequacies in the implementation of corporate governance norms and disregard to prudential practices on internal control have come to light. Such instances have seriously compromised the financial health of a few private sector commercial banks and cooperative banks. Prompt corrective actions including criminal proceedings against the errant individuals have been initiated by the authorities in such cases. In order to guard against recurrence of such practices the Reserve Bank has taken various measures including implementation of important facets of international best practices in corporate governance and internal control, strengthening of the role of statutory auditors, recasting of the supervisory framework and increased disclosure to strengthen the role of market discipline. In the cooperative banking sector, continuation of multiple regulators has been identified as a major challenge before the authorities in effective regulation and supervision including implementation of corporate governance and internal control norms. The Reserve Bank has suggested jurisdiction of a single regulator to deal with this banking segment.
Despite decline, continuation of considerable stock of NPLs in the banking system continues to be a cause for concern. Improved institutional and legal arrangements and strengthening of risk management practices by banks is likely to keep incremental NPLs low. Initiatives such as setting up of Asset Reconstruction Companies and greater emphasis on compromise settlements are likely to deal with the stock problem for NPLs. Banks may need to adopt a more pro-active approach in dealing with these issues.
Enforcement of creditors rights will need continuous strengthening. The implementation of recent legislation will progressively be subject to judicial testing as it gets more accepted and as problems occur in its application. The legal provisions and practice in bankruptcy of the real sector are still inadequate and need further reform.
Another area of concern relates to the decline in direct bank credit towards disadvantaged but socially important sectors such as agriculture and small-scale industries. It is felt that in the past inadequate risk management practices constrained banks to more vigorously pursue financing of such sectors. With improved risk management, it is likely that banks would deploy larger portions of their funds in these sectors. As this assessment and risk management practices improve, banks should be able to distinguish the risk quality of individual borrowers, rather than treating borrowers of a particular class as equally risky. The introduction of credit information bureau is in its infancy: the large scale availability of credit histories of borrowers at low cost is essential for better credit delivery, particularly for smaller borrowers.

Debt Market
The Indian debt market ranks third in Asia, after Japan and South Korea, in terms of issued amount. Outstanding size of the debt floatation as a proportion of GDP, however, is not very high in India. Moreover, although in terms of the primary issues Indian debt market is quite large, the Government continues to be the large borrower, unlike in South Korea where the private sector is the main borrower. The corporate debt market in the country is still at a nascent stage. Factors such as lack of good quality issuers, institutional investors, supporting infrastructure and high cost of issuance, market fragmentation, etc. have been identified as the reason for lack of depth of the corporate debt market in India (Mohan, 2004). However, to place India on a high and sustained growth trajectory and particularly to meet the huge financing needs of the infrastructure projects, it is necessary to develop the corporate bond market.
As the debt market becomes larger, both for government securities and for corporate debt, its efficient functioning will depend a great deal on deepening of liquidity in the market so that trading becomes easier and more efficient. The government securities market needs to be widened much more to non-bank participants such as insurance companies, pension and provident funds, and many real sector participants who need fixed instruments for their treasury management. This will need greater trading of debt in the stock exchanges and better price discovery through anonymous, screen based, order matching systems. With increasing interest rate movement, in both directions, the efficient functioning of the debt market will also be aided by further development of the derivatives market. However, this has to be done in a careful manner, while ensuring that market participants have adequate risk management systems.
Financial sector reforms in India were initiated early in the reform cycle. Complementary measures in other areas including fiscal and external sector provided the crucial support to the financial sector reform process. In order to deepen the financial sector reforms further, it is essential that significant reform measures are initiated in other segments of the economy including real sectors. Since the early 1990s, India as well as the world economy have undergone a structural transformation. An enduring development has been the changed perception about India – both internally and from the rest-of-the-world. While India assumes a more pivotal role in the global arena, internally the country needs to reassess the future course of restructuring process. Managing heightened expectations is going to be the major challenge of future public policy in India since, this, on the one hand, provides the country to take a quantum jump in terms of development, but, on the other hand, even a small slippage in the policy framework may prove to be the undoing of the past painstaking reform efforts. As envisaged by the 10th Plan, India is posed to attain 8 per cent per annum growth rate on a consistent basis. This was even outside the realm of wishful thinking a few years back. Appropriate sequencing and repackaging of reform measures with changed emphasis and relative speed of reforms at various sectoral levels would ultimately determine whether India would be able to leapfrog into the new growth trajectory.

References
Ahluwalia, M. S. (2002). “Economic Reforms in India since 1991: Has Gradualism Worked?” Journal of Economic Perspectives, 16, (3), 67-88.

Government of India (GoI) (1998). Report of the Committee on Banking Sector Reforms (Chairman: Shri M. Narasimham), Government of India, New Delhi. Hanson, J. A. and S. Kathuria, (1999). India: A Financial Sector for the Twenty-First Century, New Delhi, Insurance Regulatory and Development Authority (IRDA) (2002). Annual Report, IRDA, Mumbai.

International Monetary Fund (IMF) (1995). IMF Survey, IMF, Washington, D.C. Mohan, R. (2002). “Transforming Indian Banking: In Search of a Better Tomorrow”, Valedictory address at the Twenty-Fourth Bank Economists’ Conference, Bangalore, printed in Reserve Bank of India Bulletin, January 2003.

 — (2004). “A Decade of Reforms in the Government Securities Market and Agenda for the Future”, Keynote Address at FIMMDA-PDAI Conference, Dubai.

National Stock Exchange (NSE) (2003). Indian Securities Market Review, NSE, Mumbai.

Prasad, Eswar, Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose (2003). “Effects of Financial Globalisation on Developing Countries: Some Empirical Evidence”, mimeo, International Monetary Fund.
Rangarajan, C. (1998). “Banking Sector Reforms: Rationale and Relevance”, SICOM Silver Jubilee Memorial Lecture, Mumbai.

Reddy, Y. V. (2002). “Public Sector Banks and the Governance Challenge: Indian Experience” Paper presented at World Bank, International Monetary Fund, and Brookings Institution Conference on Financial Sector Governance: The Roles of the Public and Private Sectors, New York, USA.

— (2002 a). “Monetary and Financial Sector Reforms in India: A Practitioner’s Perspective”, Presentation at the Indian Economy Conference, Cornell University, USA. — (2003). “Towards Globalisation in the Financial Sector in India”, Inaugural address at the Twenty-Fifth Bank Economists’ Conference, Mumbai.

Reserve Bank of India (1991). Report of the Committee on the Financial System (Chairman: Shri M. Narasimham), Reserve Bank of India, Mumbai.

Annex I : Banking Sector Indicators of Select  Emerging Market Economies

Notes
1    See, for example, Hanson and Kathuria (1999) and Reddy (2002a).
2    In fact, in some cases, prudential norms in India have surpassed the international best practices and many of the proposals of Basel II are already under the process of phased implementation.
3    In the early 1990s through the use of SLR and cash reserve ratio (CRR) as much as 63.5 per cent of the bank resources were pre-empted. Since the introduction of financial sector reforms these rates have been cut considerably in a sequenced manner. SLR has been reduced to the statutory minimum of 25 per cent, while CRR is currently at 5.0 per cent.
4    Distribution of banks according to CRAR for 1995-96 given in Table 3 follows a slightly different classification where by banks have been grouped in terms of CRAR into groups of 4 to 8 per cent and 8 to 10 per cent.
5    Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.

The Pursuit of Financial Stability *

Kishori .J.Udeshi,
Issues related to monetary policy and financial sector continue to attract a lot of research interest all over the world and this is all the more true for emerging economies like India which are gradually integrating with the rest of the world.

With growing financial openness, globalisation and liberalisation, financial stability issues have come to the forefront. These issues have ranged from discussions on basic issues of the definition of financial stability itself to issues of measurement, issues of choice of instruments to achieve the objective of financial stability and even issues on the degree of activism that central banks should adopt in pursuing this objective.

Traditionally, it has been believed that monetary stability leads to financial stability. However, as the events of the 1990s show, it need not necessarily be the case. While there are complementarities between these two objectives, especially in the long run, the same need not hold in the short-run. A stable macroeconomic environment - low and stable inflation, sustained growth and low interest rates - can generate excessive optimism about the future economic prospects and often the risks are downplayed. Accordingly, episodes of financial instability often have their origins in environment of macroeconomic stability. Thus, macro economic stability need not necessarily always place an economy in financial stability in the medium/long term and central banks, therefore, now bestow a more focussed attention to the objective of maintaining financial stability. Historically, central banks have been concerned with both price stability and financial stability, albeit not at the same time (Crockett, 2004). What is rather unique since the 1990s has been a simultaneous pursuit of price and financial stability by central banks.

Forces affecting financial stability

The basic forces affecting financial stability are the quickening pace of technological innovation and the growing acceptance of market processes as basic determinant of resource allocation. Due to sectoral distinctions getting blurred, financial intermediaries have the ability to effectively compete in sectors beyond their domain by deconstructing and recombining risks. Further, the source of financial disturbances has become more unpredictable mainly due to integration of financial markets. Financial liberalisation has led to the emergence of financial conglomerates, cutting across not only various financial sectors such as banking and insurance, but also a number of countries. Therefore, a contagion means the problems of distant economies can become problems of our own.  The progressive opening up of the economies to external flows since 1990s has led to massive cross-border capital flows and volatile exchange rates. Sharp movements in exchange rates can have an adverse impact upon the balance sheets of both financial and non-financial entities. This is especially true for emerging economies as they usually need to resort to borrowing in foreign currencies.
If we recall the banking crisis and the resultant financial crisis of Latin America (IMF 2004), we can broadly categorise the trigger points as: 

Deficiencies in the following areas have detracted from good banking practices and increased vulnerability to crisis in some Latin American countries:

Financial markets are different from other markets and therefore, greater liberalisation goes along with deeper supervision and higher degree of regulation.  This is because in financial markets the herd mentality catches up fast making markets volatile.  Any destabilisation in financial markets affects even those who are not in financial markets.  On the other hand, financial markets can drive the real economy.   Central banks, therefore, need to pursue a multifaceted approach towards ensuring financial stability through (i) payments system oversight, (ii) contingency planning against market disruption, (iii) lender of last resort (LOLR), (iv) share in procedures for financial regulation and (v) analysis and communication through reports such as Financial Stability Reviews (FSRs) (Goodhart, 2004). The importance assigned by central banks nowadays to the objective of financial stability is evident from the fact that a number of central banks have started publishing FSRs, giving their assessment of the health of the financial sector and its ability to withstand various shocks. The European Central Bank is a recent addition to this growing list of central banks that come out with regular FSR-type reports.
At the global level, crisis prevention initiatives have prominently centred around strengthened IMF surveillance and include a number of aspects: data dissemination, greater transparency, development of standards and codes, constructive involvement of the private sector, Sovereign Debt Restructuring Mechanism (SDRM) and introduction of facilities like Contingent Credit Line (CCL).

Financial Stability: An Indian Perspective

In India too, financial stability has emerged as a key consideration in the conduct of monetary policy since the 1990s, consequent to the structural reforms initiated in the early 1990s, the gradual opening up of the Indian economy and the transformation of the financial system from a planned and administered regime to a market-oriented financial system.  As observed by Governor Dr. Reddy, contextually,  financial stability in India would mean (a) ensuring uninterrupted settlements of financial transactions (both internal and external), (b) maintenance of a level of confidence in the financial system amongst all the participants and stakeholders and (c) absence of excess volatility that unduly and adversely affects real economic activity (Reddy, 2004b). 

The overall approach of the Reserve Bank to maintain financial stability is three-pronged: maintenance of overall macroeconomic balance; improvement in the macro-prudential functioning of institutions and markets; and strengthening micro-prudential institutional soundness through regulation and supervision. Monetary stability is an important precondition for financial stability and, therefore, the most significant contribution that monetary policy can make to financial stability is through maintaining low and stable inflation. Since the second half of the 1990s, inflation has been brought down to an average of five per cent per annum compared to an average of around 8-9 per cent per annum in the preceding two and a half decades. The reduction in inflation since the early 1990s has also enabled inflation expectations to stabilise. Low and stable inflation expectations increase confidence in the domestic financial system and, thereby contribute in an important way to the stability of the domestic financial system.

Second, a number of measures have been taken to widen, deepen and integrate various segments of the financial markets in order to strengthen price discovery mechanism, lower the transaction costs and enhance the liquidity in the markets. At the same time, it is recognised that the capacity of economic agents in developing economies to manage volatility in all prices, goods or foreign exchange is highly constrained and there is a legitimate role for non-volatility as a public good (Reddy, 2004a). Accordingly, ensuring orderly conditions in the financial markets is an important aspect of the Reserve Bank's approach towards maintaining financial stability. Operating procedures and instruments of monetary policy have evolved over time to meet these objectives. For instance, with persistent capital flows, a new facility in the form of Market Stabilisation Scheme (MSS) was put in place effective April 2004. The MSS has provided the Reserve Bank greater flexibility in its market operations. Similarly, India's exchange rate policy of focusing on managing volatility with no fixed rate target, while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way has stood the test of time. Prudent external sector management with a cautious approach to capital account liberalisation has been an important component of macroeconomic policies to ensure financial stability. Overall, the Reserve Bank's approach is to minimise volatility in the financial markets and minimise knee-jerk reactions, while focusing on price stability and the underlying inflation. The objective has been to ensure that there are no avoidable uncertainties in policy, while mitigating undue pressures on the functioning of markets without undermining market efficiency.

A robust financial system is often characterised by smooth and secure payment systems and a word here about the several initiatives undertaken by RBI towards lifting the Indian payment system to global standards would be in order. While clearing houses were strengthened with MICR clearing processes, electronic clearing initiatives were undertaken through promotion of Electronic Clearing Services (ECS), Electronic Funds Transfer (EFT), establishment of an exclusive secured private network (INFINET) which serves as private geteway to the Indian financial system.  A Real Time Gross Settlement System (RTGS) has been operationalised as an effective, quick and secure system for inter bank funds transfers. Introduction of Negotiated Dealing System (NDS), a Centralised Funds Management System (CFMS) and the Structured Financial Messaging System (SFMS) are other key components that were put into the payment system. All these measures have quickened the settlement processes,  reduced risks in settlements and built confidence in the payment and settlement systems.  

In the pursuit of financial stability, effective regulatory and supervisory initiatives along with a calibrated approach to financial sector liberalisation have a critical role to play. The Indian approach towards financial sector reforms has been based on pancha sutra or five principles (Reddy, 1998): (a) cautious and appropriate sequencing of reform measures; (b) introduction of norms that are mutually reinforcing; (c) introduction of complementary reforms across sectors (most importantly, monetary, fiscal and external sector); (d) development of financial institutions; and, (e) development of financial markets. The reforms have aimed at enhancing productivity and efficiency of the financial sector, improving the transparency of operations and ensuring that it is capable of withstanding idiosyncratic shocks.

Regulatory measures:
Keeping in pace with times, various regulatory prescriptions were being issued by the central bank from time to time. These steps are taken to basically ensure banking stability vis-à-vis exposures and risks. I shall outline some of the key measures:

As a result of improvements in the regulatory and supervisory framework, the degree of compliance with Basel Core Principles has generally been high, and observed areas of weaknesses, primarily with respect to country risk guidelines have been addressed. Consolidated accounting for banks has been introduced along with a system of Risk-Based Supervision (RBS) for intensified monitoring of vulnerabilities. A scheme of Prompt Corrective Action (PCA) was introduced effective December 2002 to undertake 'structured' and 'discretionary' actions against banks exhibiting vulnerabilities in certain prudential/financial parameters. With liberalisation, financial conglomerates are emerging. Banks have accordingly been advised to prepare and disclose consolidated financial statements and prepare consolidated prudential reports. The inter-regulatory coordination has also been streamlined with the establishment of a monitoring system in respect of Systemically Important Financial Intermediaries (SIFIs), coupled with the establishment of three Standing Technical Committees constituted by the High Level Coordination Committee on Financial and Capital Markets (HLCCFCM) to provide a more focused inter-agency forum for sharing of information and intelligence.

A major initiative towards preventing crisis has been the strengthening of the effectiveness of surveillance and incorporating a fresh perspective to its analysis and policy recommendations. To identify the strengths and vulnerabilities of the financial system (which includes banks, financial institutions, NBFCs, Primary dealers, and markets – forex, debt, money/call, and capital), a half yearly review based on financial soundness indicators (also known as macro-prudential indicators MPI) is undertaken. The MPI review comprises both aggregated micro-prudential indicators (AMPIs) of the health of individual financial institutions and macroeconomic indicators (MEIs) associated with financial system soundness. 

This macro approach to financial supervision has helped the policy makers to refine their regulatory stance so as to achieve the fine balance between growth and financial stability. For instance, thanks to exhaustive data being collected under off-site surveillance, Reserve Bank could closely monitor the ratio of gross non-performing loans (NPL) to total loans which was at a high of 15.7 per cent for schedule commercial banks (SCBs) at end-March 1997. This ratio witnessed a marked decline to 7.2 per cent at end-March 2004. Net NPLs also witnessed a significant decline, driven by the improvements in loan loss provisioning, which comprises over half of the total provisions and contingencies. Also, based on the data on the maturity patterns of banks’ assets and liabilities and on the unrealised gains on the investment portfolios, RBI could regularly gauge the impact of rising bond yields on the banks’ balance sheets after taking into account the cushion available, both for the system as a whole and for the individual banks. We thus identified the outliers in the system on the basis of their capacity to withstand interest rate shock and sensitized them to take corrective steps.
 
From financial stability perspective, issues of ownership, size and governance in banks are extremely relevant. In view of the importance of corporate governance in banks, we issued guidelines for effective corporate governance and also identified the criteria for determining the fit and proper status of owners and directors. It was also considered necessary to lay down a comprehensive framework of policy on ownership and governance in banks in a transparent manner.  Accordingly, we have placed in public domain a draft paper on ‘A comprehensive policy framework for ownership and governance in private sector banks’. The Reserve Bank has adopted a consultative approach, encouraging a debate on this issue and the draft is being reviewed on the basis of the feedback received from various quarters. 

The stability of a financial system can be achieved only when institutions and markets function on the basis of informed decisions. In India, the banking system has witnessed greater levels of transparency and standards of disclosure. The range of disclosures have gradually been expanded over the years and presently includes a host of indicators relating to capital adequacy (Tier I and Tier II capital separately), NPAs, Government shareholding, movements in NPAs, exposure to sensitive sectors (capital market, real estate and commodities), movements in provisions for NPAs and investments as also information on corporate debt restructuring. These are being further enhanced to incorporate asset-liability management, risk management policies, concentrations, connected lending, evaluation of investment in subsidiaries, various performance measures and indicators thereof. Banks are providing information on various indicators in the form of notes to accounts and schedules in their balance sheets. Guidelines in regard to Fair Practices Code for Lenders were framed and the banks/all-India FIs have been advised to adopt these guidelines. The Reserve Bank has been taking several steps from time to time to enhance the transparency in banks’ operations by prescribing comprehensive requirements for disclosure in tune with the international best practices. In view of the added emphasis on the role of market discipline under Basel II and with a view to enhancing further transparency, banks have been advised on October 19, 2004 that all cases of penalty imposed by the Reserve Bank as also strictures/directions on specific matters including those arising out of inspection will be placed in the public domain with effect from November 1, 2004.

Conclusion

To conclude, ensuring an acceptable degree of financial stability is a never-ending process.

Looking ahead, the vulnerability to real sector shocks has the potential to significantly affect financial stability in India. The major sources of shocks in India are very sharp increases in oil prices and extraordinary monsoon failures and other natural calamities with consequent impact on the agricultural sector, spilling over to other sectors of the economy. Therefore, the weight to financial stability in India is higher than in many other countries.

Financial stability has moved to centre-stage nationally as well as in discussions relating to the future of the global monetary and financial system. Several factors have brought this about: the disturbing intensity and frequency of financial crises in the decade gone, the move to strengthen domestic financial systems under Basel II and the unfinished quest for the appropriate international financial architecture for crisis prevention and management.  Unlike in some countries where the responsibility for financial stability has been located in an independent authority, our approach has been to exploit the synergies that exist between the conduct of monetary policy and the function of financial regulation. Accordingly, financial stability in India is an integral responsibility of the Reserve Bank. Appropriate governance has enabled us to mitigate areas of conflict of interest even as we have reaped the benefits of (i) a deep understanding of the dynamics of India’s financial sector – which, in essence, has evolved around the Reserve Bank over the years – (ii) oversight of money, debt and foreign exchange markets and (iii) the accumulation of the technical skills associated with regulation and supervision. The experience with the tumultuous 1990s has shown that our approach has stood the test of time in ensuring a stable, vibrant and well-functioning financial system in the country. We have a well-capitalised financial system even by international standards, with low levels of loan delinquency despite our prudential standards being set tighter than international standards. Our financial markets are orderly and smoothly functioning and the ability of our financial intermediaries to deal in various segments of the financial market spectrum is improving almost continuously. Periodic monitoring and self-assessment of the quality of financial supervision is buttressed by external audits, including by the IMF. In the years ahead, we will continue to vigorously pursue the objective of financial stability by developing and refining our approach, modulating the pace and sequencing of regulatory function with the financial dynamics and benchmarking ourselves against international best practices so that our financial institutions emerge as global players and India becomes the international financial centre of the new millennium.

References

Crockett, A. “The Interaction of Monetary and Financial Stability”, Monetary Bulletin, Central Bank of Iceland, 2004/3.
Goodhart, C.A.E. “Some New Directions for Financial Stability”. Per Jacobsson Foundation Lecture at Zurich, June 2004.
Reddy, Y.V. “Financial Sector Reforms: Review and Prospects”. RBI Bulletin, December 1998.
-------.  “Towards Globalisation of the Financial Sector in India”. RBI Bulletin, January 2004a.
--------. “Financial Stability: Indian Experience”. RBI Bulletin, July 2004b.
Finance & Development, IMF, September 2004
Banking Sector Reforms- Achievements
SHYAMALA GOPINATH*

The role of the RBI in maintaining an environment conducive to investment and growth essentially relates to maintaining monetary and financial stability which can be achieved through an appropriate monetary policy framework, sound financial sector policies and strong external sector.

Monetary Policy
Structural reforms in the Indian economy since the early 1990s impacted upon the various aspects of monetary policy - its objectives, strategies and tactics. Price stability and ensuring adequate credit to productive sectors of the economy have been the twin objectives of monetary policy since Independence. The relative emphasis between these two objectives depends on the underlying economic conditions and is spelt out from time to time. Although with the introduction of the structural reforms, there has been a shift in the policy from a planned and administered interest rate regime to a market-oriented financial system, credit availability remains an important objective of monetary policy in India.
At the same time, with the opening up of the economy since the early 1990s, financial stability has now emerged as a key consideration in the conduct of monetary policy. Monetary management has now to contend with vicissitudes of capital flows and the resultant volatility in exchange rates. A related difficulty is that whereas the distinction between short term and long term flows is conceptually clear, in practice, however, it is not always easy to distinguish between the two for operational purposes. Moreover, at any given time, some flows could be of an enduring nature whereas others could be temporary and, hence, reversible. More importantly, what appears to be short-term could tend to last longer and vice versa, imparting a dynamic dimension to judgment about their relative composition? In a scenario of uncertainty facing the authorities in determining temporary or permanent nature of inflows, it is prudent to presume that such flows are temporary till such time that they are firmly established to be of a permanent nature. The instruments and operating procedures of monetary policy have, therefore, to be constantly refined to meet the challenges thrown up by such capital flows and a market-determined exchange rate. This necessitated a complete recast of the monetary policy operating procedure by moving away from statutory preemptions and direct controls to an array of indirect instruments to modulate liquidity conditions in tune with the process of price discovery. The Reserve Bank is now able to influence the quantum of liquidity through a policy mix of open market (including repo) operations alongside changes in reserve requirements and standing facilities, reinforced by interest rate signals, through changes in the policy rates which impact the price of primary liquidity. Illustratively, in India, existing arrangements to modulate liquidity had to be supplemented with innovations such as the Market Stabilisation Scheme.

Banking Sector Reforms
As the economy grows and becomes more sophisticated, the banking sector has to develop pari passu in a manner so that it supports and stimulates such growth. With increasing global integration, the Indian banking system and financial system as a whole had to be strengthened so as to be able to compete.
Until the beginning of the 1990s, the state of the financial sector in India could be described as a classic example of “financial repression”, a la MacKinnon and Shaw. While the true health of financial intermediaries, most of them public sector entities, was masked by relatively opaque accounting norms and limited disclosure, there were general concerns about their viability. Scant attention was placed on the financial health of the intermediaries. Their capitalisation levels were low. The lack of commercial considerations in credit planning and weak recovery culture resulted in a large accumulation of non-performing loans.
Starting from such a position, it is widely recognised that the Indian financial sector over the last decade has been transformed into a reasonably sophisticated, diverse and resilient system. However, this transformation has been the culmination of extensive, well-sequenced and coordinated policy measures aimed at making the Indian financial sector efficient, competitive and stable. These measures covered prudential, competition enhancing institutional and legal and supervisory measures.
An important feature of the move towards globalisation of the Indian financial system has been the intent of the authorities to move towards international best practices. This is illustrated by the appointment of several advisory groups designed to benchmark Indian practices with international standards in several crucial areas of importance like monetary policy, banking supervision, data dissemination, corporate governance and the like. Towards this end, a Standing Committee on International Financial Standards and Codes (Chairman: Dr. Y. V. Reddy) was constituted and the recommendations contained therein have either been implemented or are in the process of implementation. The RBI has recently prepared a Report that reviews the progress, provides the current status on the implementation and captures new developments in the field of international financial standards and codes.

External Sector Management
The overall objective of external sector reforms was to achieve higher growth and efficiency without exposing the system to greater vulnerability. The position of the external sector today is in marked contrast to the balance of payments crisis of 1991, when default was perceived as a real threat. As is well known even in these circumstances India did not default on any of its obligations and maintained its excellent track record of debt service. At that time reserves were down to less than US$ 1 billion and external debt was around US$ 85 billion as against the current position where reserves are more than external debt. We Indians can be proud of the fact that even during the worst currency crisis India did not reschedule, roll over or default on its obligations which is unparalleled.

The process of opening up the Indian economy has proceeded in steady steps.

What Have We Achieved ?
How did these measures get translated into tangible economic results? While assessing the conduct of policies in recent years, one needs to take cognisance of the fact that the Indian economy witnessed a large number of shocks, both global and domestic. These shocks included a series of financial crises in Asia, Brazil and Russia besides September 11 terrorist attacks in the US, border tensions, sanctions imposed in the aftermath of nuclear tests and political uncertainties. From the vantage point of 2005, it seems that our strategy worked and worked reasonably well.

There was a sharp fall in the average inflation rate to 5.8 per cent during 1994-95 to 2003-04, which is far below the long-run average of about 8.0 per cent during the 1970s-90s. While year-to-year inflation may vary depending upon the intensity of supply shocks, monetary policy can stabilise inflation expectations at low levels. It is necessary to underscore that the moderation in inflation has been wrought in an atmosphere of multiple challenges.

What had been the impact on the banking sector? The banking sector had been able to withstand various shocks and provided the foundation for a safe and sound financial infrastructure. Among various indicators, let me highlight three basic indicators:

No discussion on the achievement of financial sector reforms is complete without a discussion on financial stability in Indian context. Following Governor Reddy, financial stability in the Indian context could be interpreted to embrace: (a) ensuring uninterrupted financial transactions, (b) maintenance of a level of confidence in the financial system amongst all the participants and stakeholders, and (c) absence of excess volatility that unduly and adversely affects real economic activity.1 The stability of the Indian financial system has been tested on certain occasions and the financial system has proved its resilience.
The management of the external sector is seen as another success story. Before I delve into the details of the impact of reform in external sector, consider the following broad indicators:

It is now well recognised that the Indian approach to exchange rate management with a focus on managing volatility has stood the test of time. The Indian approach to exchange rate management has been even described as an ideal for Asia.
The merits of our cautious approach to capital account convertibility are now well appreciated. Gradualism in liberalisation implies that the mix between controlled, regulated and liberalised capital transactions keeps changing gradually in favour of the latter. We did not have to reverse policies towards the capital account as was the case with some emerging market economies that had followed a relatively rapid liberalisation without entrenching the necessary preconditions. We have repeatedly emphasised that our approach to capital account convertibility is a process rather than an event, contingent on achieving certain preconditions related to health and strength of the financial sector, sustainability in the fiscal sector and containment of inflation. Over the years, the policy regime in regard to capital account inflows and outflows in India has witnessed a significant liberalisation. There are, however, two areas where extreme caution continues to be exercised, viz., (i) unlimited access to short-term external commercial borrowing; and (ii) providing unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets (such as, real estate).

Avenues For Investment in India
Having talked of the success story of reforms let me now turn to the avenues of investment in India. Several such options are available, depending on the risk and return profile of the investment in mind. Instead of providing a shopping list, let me give a quick rundown of the menu available.

One of the oldest avenues is the NRI deposit. Since the early 1970s, when the Non-Resident (External) Deposit Scheme was introduced, the Reserve Bank has offered various facilities for non-resident Indians in the form of deposit schemes. Since the 1990s, the Reserve Bank’s policy in this regard has been aimed at attracting a stable pool of NRI deposits for providing a support to balance of payments. NRI deposits, at US$ 33.3 billion as at end-March 2004, emerged as a major source of capital inflows during the 1990s. Apart from the size, the success of the policy is also reflected in an increase in the proportion of local currency denominated deposits from around one-fourth in 1991 to almost two-third by 2002. This has been accompanied by a rationalisation of interest rates on rupee-denominated NRI deposits. This apart, we are now linking interest rates on foreign currency denominated deposits to LIBOR. The Reserve Bank has been de-emphasising short-term (up to 12 months) foreign currency denominated deposits in view of its attendant implications. These measures have been counterbalanced by several incentives to accord NRIs operational flexibility. Funds of US$ one million can be remitted through authorised dealers after payment of taxes subject to certain limits in case of property. Authorised dealers (ADs) are now permitted to grant rupee loans to NRIs. Earlier, housing loans availed by NRIs/Persons of Indian Origin (PIOs) could be repaid by borrowers either by way of inward remittances through normal banking channels or by debit to NRE/ FCNR(B)/NRO/NRNR/NRSR accounts or out of rental incomes derived from the property. Since May 2004, borrowers’ close relatives in India are allowed to repay the instalment of such loans, interest and other charges directly to the concerned ADs/ housing finance institutions through their bank accounts.

A second avenue is foreign portfolio investment. We now provide an operating environment which is now much more congenial because of procedural changes for investment and facilities for investment in equity securities as well as in debt securities. NRIs and PIOs are also permitted to invest in shares and debentures of Indian companies, government securities, commercial papers, company deposits and mutual funds. An NRI is permitted to purchase/sell shares and/or convertible debentures of an Indian company through a registered broker on a recognised stock exchange provided his/her transactions are routed through designated branch of an AD in India subject to prescribed limits. Although the aggregate paid-up value of shares of the company purchased by NRIs should not exceed 10 per cent of the total paid-up capital and convertible debentures, respectively, the ceiling can be raised to 24 per cent if a Special Resolution to that effect is passed by the concerned company. NRIs are allowed to invest in exchange traded derivative contracts approved by the SEBI out of rupee funds held in India on a non-repatriable basis.

Yet another avenue is foreign direct investment. It will be recalled that a major policy thrust towards attracting foreign direct investment (FDI) was outlined in the New Industrial Policy Statement of 1991. Since then, continuous efforts have been made to liberalise and simplify the norms and procedures pertaining to FDI. At present, FDI is permitted under the automatic route subject to specific guidelines except for a small negative list. To put this in perspective, let me mention the so-called negative list: There are just six sectors where investments are prohibited. These are: Retail trading, atomic energy, lottery business, gambling and betting, housing and real estate business and agriculture (excluding floriculture, horticulture, development of seeds, animal husbandry, pisiculture and cultivation of vegetables) and plantations (excluding tea plantations).
There are twelve  sectors where investments require prior approval of the Government. These are:
Domestic airlines, petroleum sector, investing companies in infrastructure and services sector, defence and strategic industries, atomic minerals, print media, broadcasting, postal services, courier services, establishment and operation of satellite, development of integrated township and tea sector.
Further, under the automatic route, investments only in six sectors are subject to sectoral caps. These are: Private sector banking, insurance, telecommunications, trading, exploration and mining of diamonds and precious stones and airports. (Since the speech was made in January 2005, changes have been announced by the Union Finance Minister in February and March 2005.)

Until recently, acquisition of shares from residents by non-residents through private arrangement required Government approval. Such acquisition of shares, except in financial services sector, by private arrangement no longer requires Government approval. This implies that FDI is virtually welcome in a number of sectors without any prior approval. Non-residents are permitted to enter into forward sale contracts with ADs in India to hedge the currency risk arising out of their proposed FDI in India. Non-resident shareholders were allowed to apply for issue of additional equity shares or preference shares or convertible debentures over and above their rights entitlements. Allotment is subject to the condition that the overall issue of shares to non-residents in the total paid-up capital of the company does not exceed the sectoral cap. FDI by NRIs, however, continues to be negligible.

So far I have not mentioned about the role of remittances. During 2003-04, remittances amounted to around US$ 22.8 billion. In fact, of the Asian countries, apart from India it is only the Philippines that is receiving remittances in excess of 3 per cent of GDP. I compliment the Indian Diaspora for being such a source of resilience to the Indian economy. This apart, in view of demographic challenge facing the Western countries, remittances have an additional dimension. To the extent that they are essentially in the nature of family maintenance transfers they are surely funding a non-trivial population of the aged. For the recipient countries, remittances have the potential of reducing the pressure of dependency ratios and increasing growth. It is also good for the remitting countries, facing the old-age challenge, through augmentation of their work force.

Concluding Observations
India has come a long way from the days of crisis of the early 1990s. Our pragmatic and gradual approach to reform seemed to have paid reasonably well. We emerged almost unscathed from various crises like East Asian crisis, drought or sanction-like situation. While I am not being complacent, there are reasons to believe that India would be on a higher growth trajectory in the coming decades. This is echoed in the assessment of international agencies as well.
What are the opportunities and challenges? There are business opportunities in the traditional sector – such as power generation and roadways – as well as in the sunrise sector – such as information technology. The Tenth Five Year Plan targets, among others, agriculture, and construction for high growth in view of their potential for employment generation with relatively low capital intensity. It also plans to fill the existing shortfalls in investment in power generation and communication by a significant improvement in private investment, and by removing fiscal constraints as well as generation of internal resources by the public sector. There is a particular accent on developing infrastructure which is often recognised as a major constraint on growth. Power sector reforms are energising power generation to meet the rising demand for electricity.

The aggregate of remittances and non-resident deposits is quite significant. We now look for greater contribution in this national metamorphosis for mutual benefit. There is no doubt that the emergence of the Indian economy on a high growth path provides ample scope for the entrepreneurial abilities of the NRIs. It is only appropriate to conclude that this session will be very fruitful in discussing investment opportunities available in the Indian economy.

1     Reddy, Y. V (2004): “Financial Stability: Indian Experience”, Lecture at Zurich University, Zurich, Switzerland, RBI Bulletin, July.

From RBI to Finance Ministry: Memoirs of Finance Manager!
Review by Shri.S.Venkitaramanan.*

Mr.M.Narasimham’s recent book From Reserve Bank to Finance Ministry and beyond some Reminiscences is extremely interesting and instructive too. It is an inestimable contribution to the economic history of India. Written in his usual limpid style, he translates dry as dust economic subject matters into fascinating memoirs. His skills as a raconteur are fully in evidence in these brief too brief - reminiscences.
Mr. Narasimham was in a position to interact directly with the Governor and other senior RBI officials. He recalls how, in a report on the Bank of France that he prepared for the Governor at the latter’s instance, he commented on the independence of that institution. He commented on the independence of that institution. He noted that Napoleon himself had said that he wanted it to be” independent, but not too much”.
Mr Narasimham notes how the US Congressional Committee - the Douglas Committee – had also recommended that the Federal Reserve should have autonomy within the Government. This concept of autonomy of central banks, but within the Government structure, continues to be part of current conventional wisdom. There cannot be two centres of economic power in a society.
During his time in the RBI, Mr Narasimham contributed a number of ideas, some of which later blossomed into full institutions. He played a role in the evolution of the IDBI. In a paper produced at Governor Rama Rau’s instance on the utilization of the so-called Cooley funds generated as a result of PL-480 operation, he suggested to the Governor that these funds might be utilized to set up a refinancing agency, which led to the setting up of the Refinancing Corporation, whose functions subsequently got merged with the Industrial Development Bank of India.
Following a trip to France in 1955, Mr Narasimham seems to have also laid the foundation for the close involvement of the RBI with the national Plan objectives. His study of the French system led to the credit authorization scheme, under which the RBI started approving all loans issued by commercial banks over certain limit. This scheme has since been discontinued.
Mr.Narasimham admits that subsequent developments showed that this system of authorization lent itself to abuse and bureaucratic delays. The National Credit Council was another idea that Mr Narasimham initiated and which has disappeared over time. It may well be that such a Council consisting of leading economists, industrialists and representatives of States can play a useful role even today.
While working in the RBI, Mr Narasimham interacted closely with the Government of India. Naturally, his abilities attracted the attention of the higher authorities and soon he was drafted to work in the Government. In 1972, he became an Additional Secretary in the Ministry of Finance, Department of Economic Affairs. He gives a graphic description of his engrossing work in this critical position, which in involve close interactions with his Ministers, including Mr Pranab Mukherji and the late Mr C.Subramaniam as also the then Prime Minister, Indira Gandhi.
One of his contributions during this period as Additional Secretary/Finance, which evolved from a discussion with Mr.C.Subramaniam, was the suggestion to set up Regional Rural Banks, combining as they do the resources of commercial banks with local equity, regional initiative and locally available personnel. The Regional Rural Banks have not been as successful as he hoped. But the defect may proved to be pioneers, but the general impact has not been as revolutionary as it architect expected.
In his tenure as Additional Secretary, Mr Narasimham seems to have generated even more radical changes. It is thus that we owe to Mr Narasimham the introduction of a trade-weighted basket of currencies to determine the exchange rate. This scheme, which held sway till the reforms of 1992, marked a step in the move of the country from exchange rate pegged to the sterling to its current state of being determined by the market.
One of the unrealized suggestions of Mr Narasimham, which again arose from a query of the late Mr.C.Subramaniam, was regarding the establishment of a National Development Bank, which would draw funds from the Budget as well as from the Market and approve proposals for infrastructure projects based on a professional evaluation of viability.
The then Deputy Chairman of thee Planning Commission, Mr.P.N.Haksar, was indeed, perspicacious when he responded to Mr Narasimham’s proposal stating that his Cartesian logic had little scope  for success in the “ real world of CMs”. These difficulties in the real world of Chief Ministers and State politicians is amply borne out by the difficulties faced by the Infrastructure Development Finance Corporation which, in sense, is a reincarnation of Mr. Narasimham’s National Development Bank.
It may be recalled that as Chairman of the two Committees on the financ