Role of RBI in a liberalised economy

In 1994, the finance minister said that if the government fails to keep control over its deficit the

Reserve Bank would be free to dump adhoc treasury bills on the market at the going rate of interest and making the government pay the market related interest on the outstanding debt. This means a rise in interest expenditure and a further rise in the fiscal deficit. But this does not mean that the Reserve bank of India is fully free in formulating and implementing monetary policy. There are two reasons for this. In the first place, the banking system has to adhere to the policy of mandated lending and the structure of administered interest rates; in the second place, there is not yet legislative backing for guaranteeing the independence of the Reserve Bank as in the case with the US Federal Reserve Board [the FED] and the West German Budes Bank [BUBA].

                        

After decades of resistance to international economic integration, India has recently made significant progress in liberalizing trade and access to foreign investment, beginning in 1993. These policy changes reflect widespread concern that Indians past inward orientation inhibited economic growth, especially in comparison with the developing countries of East Asia. The acceptance of economic liberalization and reform has allowed the relaxation of restrictions on foreign direct investment and inward portfolio capital flows. India retains tight controls on outward portfolio capital flows, restricting the access of residents to foreign capital markets and domestic markets in foreign currency-denominated securities. The relaxation of these controls and further liberalization of the capital account remain controversial policy issues for India. For convenience the role of RBI on the economy of India has been dealt under the three areas:

 

(i)RBI on Forex Reserves

 

(ii)RBI on Banking

 

(iii)RBI on Corporate Debt Restructuring

 

 

 

RBI on Forex Reserves

Foreign exchange reserves play an irreplaceable role in many emerging economies. The central, or reserve, bank creates and then uses domestic money to buy foreign exchange. If a central bank creates more domestic money, it can buy more foreign exchange. It does not have to pump iron to build reserves. It does not have to sweat it out. It has to merely pump domestic money into the domestic economy and coolly build foreign exchange reserves. The creation of foreign exchange reserves is wholly a white-collar job.

 

The Reserve Bank of India (RBI) undertook a review of the main policy and operational matters relating to management of the reserves, including transparency and disclosure and decided to compile and make public half-yearly reports on management of foreign exchange reserves for bringing about more transparency and also for enhancing the level

of disclosure in this regard. These reports are being prepared with reference to positions as of 31st March and 30th September each year, with a time lag of about 3 months. The reports talk about the report is a compilation of quantitative information with regard to external reserves, such as, level of foreign exchange reserves, sources of accretion to foreign exchange reserves, external liabilities vis-à-vis foreign exchange reserves, prepayment/repayment of external debt, Financial Transaction Plan (FTP) of IMF, adequacy of reserves, etc.

 

Adequacy of reserves

 

 

Adequacy of reserves has emerged as an important parameter in gauging its ability to absorb external shocks. With the changing profile of capital flows, the traditional approach of assessing reserve adequacy in terms of import cover has been broadened to include a number of parameters which take into account the size, composition and risk profiles of various types of capital flows as well as the types of external shocks to which the economy is vulnerable. The High Level Committee on Balance of Payments, which was chaired by Dr. C. Rangarajan, erstwhile Governor of Reserve Bank of India, had suggested that, while determining the adequacy of reserves, due attention should be paid to payment obligations, in addition to the traditional measure of import cover of 3 to 4 months.

 

In 1997, the Report of Committee on Capital Account Convertibility under the chairmanship of Shri S.S.Tarapore suggested four alternative measures of adequacy of reserves which, in addition to trade- based indicators, also included money-based and debt-based indicators. Similar views have been held by the Committee on Fuller Capital Account Convertibility (Chairman: Shri S.S.Tarapore, July 2006). In the recent period, assessment of reserve adequacy has been influenced by the introduction of new measures. One such measure requires that the usable foreign exchange reserves should exceed scheduled amortisation of foreign currency debts (assuming no rollovers) during the following year. The other one is based on a “Liquidity at Risk” rule that takes into account the foreseeable risks that a country could face. This approach requires that a country’s foreign exchange liquidity position could be calculated under a range of possible outcomes for relevant financial variables, such as, exchange rates, commodity prices, credit spreads etc. Reserve Bank of India has done exercises based on intuition and risk models in order to estimate “Liquidity at Risk (LAR)” of the reserves. The traditional trade-based indicator of reserve adequacy, viz, import cover of reserves, which fell to a low of 3 weeks of imports at end-December 1990, rose to 11.5 months of imports at end-March 2002 and increased further to 14.2 months of imports or about five years of debt servicing at end-March 2003. At end-March 2004, the import cover of reserves was 16.9 months, which came down to 14.3 months as at end-March 2005 and further to 11.6 months as at end- March 2006. The import cover for reserves was 12.4 months at end-March 2007. The ratio of short-term debt to foreign exchange reserves declined from 146.5 per cent at end-March 1991 to 5.3 per cent as at end-March 2005, but increased slightly to 5.7 per cent as at end-March 2006 and further to 6.0 per cent at end-March 2007. The ratio of volatile capital flows (defined to include cumulative portfolio inflows and short-term debt) to reserves declined from 146.6 per cent as at end-March 1991 to 35.2 per cent as at end-March 2004. However, this ratio increased moderately to 36.9 per cent as at end-March 2005 and further to 43.4 per cent as at end-March 2006 and decreased to 38.2 per cent as at end March 2007.

 

 

Investment Pattern and Earnings from Foreign Exchange Reserves

 

The foreign exchange reserves are invested in multi-currency, multi-asset portfolios as per the existing norms, which are similar to international practices in this regard. As at end-March, 2007, out of the total foreign currency assets of US$ 191.9 billion, US$ 53.0 billion was invested in securities, US $ 92.2 billion was deposited with other central banks, BIS & IMF and US$ 46.8 billion was in the form of deposits with foreign commercial banks.

 

 

 

RBI on corporate debt restructuring

The objective of the Corporate Debt Restructuring (CDR) framework is to ensure timely and transparent mechanism for restructuring of the corporate debts of viable entities facing problems, outside the purview of BIFR, DRT and other legal proceedings, for the benefit of all concerned. In particular, the framework will aim at preserving viable corporates that are affected by certain internal and external factors and minimize the losses to the creditors and other stakeholders through an orderly and coordinated restructuring programme.

 

A Special Group was constituted in September 2004 with Smt.S.Gopinath, Deputy

Governor, Reserve Bank of India to undertake a review of the Scheme. The Special Group had suggested certain changes / improvements in the existing Scheme for enhancing its scope and making it more efficient. Based on the recommendations made by the Special Group revised draft guidelines on Corporate Debt Restructuring were prepared and circulated among banks for comments. On the basis of the feedback received the draft guidelines have been reviewed and the revised guidelines on CDR mechanism

 

The major modifications made in the existing CDR mechanism relate to

 

(a) Extension of the scheme to entities with outstanding exposure of Rs.10 crore or more

 

(b) Requirement of support of 60% of creditors by number in addition to the support of 75% of creditors by value with a view to make the decision making more equitable

 

(c) Discretion to the core group in dealing with wilful defaulters in certain cases other than cases involving frauds or diversion of funds with malafide intentions.

 

(d) Linking the restoration of asset classification prevailing on the date of reference to the CDR Cell to implementation of the CDR package within four months from the date of approval of the package.

 

(e) Restricting the regulatory concession in asset classification and provisioning to the first restructuring where the package also has to meet norms relating to turn-around period and minimum sacrifice and funds infusion by promoters.

 

(f) Convergence in the methodology for computation of economic sacrifice among banks and FIs

 

(g) Limiting RBI’s role to providing broad guidelines for CDR mechanism

 

(h) Enhancing disclosures in the balance sheet for providing greater transparency

 

(i) Pro-rata sharing of additional finance requirement by both term lenders and working capital lenders

 

(j) Allowing OTS as a part of the CDR mechanism to make the exit option more flexible

and

 

(k) Regulatory treatment of non-SLR instruments acquired while funding interest or in lieu of outstanding principal and valuation of such instruments.

 

 

RBI on Banking

Though the RBI, as part of its monetary management mandate, had, from the very beginning, been vested with the powers, under the RBI Act, 1934, to regulate the volume and cost of bank credit in the economy through the instruments of general credit control, it was not until 1949 that a comprehensive enactment, applicable only to the banking sector, came into existence. The Banking Regulation Act from March 1966. The Act vested in the Reserve Bank the responsibility relating to licensing of banks, branch expansion, and liquidity of their assets, management and methods of working, amalgamation, reconstruction and liquidation. Important changes in several provisions of the Act were made from time to time, designed to enlarge or amplify the responsibilities of the RBI or to impart flexibility to the relative provisions, commensurate with the imperatives of the banking sector developments.

 

 

Branch Authorisation Policy

 

 The RBI announced a new Branch Authorisation Policy in September 2005 under which certain changes were brought about in the authorisation process adopted by the RBI for the bank branches in the country. As against the earlier system, where the banks approached the RBI, piece meal, through out the year for branch authorisation, the revised system provides for a holistic and streamlined approach for the purpose, by granting a bank-wise, annual aggregated authorisation, in consultation and interaction with each applicant bank. The objective is to ensure that the banks take an integrated view of their branch- network needs, including branch relocations, mergers, conversions and closures as well as setting up of the ATMs, over a one-year time horizon, in tune with their own business strategy, and then approach the RBI for consolidated annual authorisations accordingly

 

Operations of Foreign Banks in India

 

At present, there are 29 foreign banks operating in India with a network of 273 branches and 871 off-site ATMs. Among some circles, a doubt is sometimes expressed as to whether the regulatory environment in India is liberal in regard to the functioning of the foreign banks and whether the regulatory approach towards foreign participation in the Indian banking system is consistent with liberalized environment. Undoubtedly, the facts indicate that regulatory regime followed by the Reserve Bank in respect of foreign banks is non-discriminatory, and is, in fact, very liberal by global standards. Here are a few facts which bear out the contention;

 

India issues a single class of banking licence to foreign banks and does not require them to graduate from a lower to a higher category of banking licence over a number of years, as is the practice followed in certain other jurisdictions. This single class of licence places them virtually on the same footing as an Indian bank and does not place any restrictions on the scope of their operations. Thus, a foreign bank can undertake, from the very first day of its operations, any or all of the activities permitted to an Indian bank and all foreign banks can carry on both retail as well as wholesale banking business. This is in contrast with practices in many other countries.

 

No restrictions have been placed on establishment of non-banking financial subsidiaries in India by the foreign banks or of their group companies. Deposit insurance cover is uniformly available to all foreign banks at a non-discriminatory rate of premium. In many other countries there is a discriminatory regime. The prudential norms applicable to the foreign banks for capital adequacy, income recognition and asset classification, etc., are, by and large, the same as for the Indian banks. Other prudential norms such as those for the exposure limits, investment valuation, etc., are the same as those applicable to the Indian banks. Unlike some of the countries where overall exposure limits have been placed on the foreign-country related business, India has not placed any restriction on the kind of business that can be routed through the branches of foreign banks. This has been advantageous to the foreign bank branches as the entire home-country business is generally routed through these branches.

 

Substantial FII business is also handled exclusively by the foreign banks. In fact, some Indian banks contend that certain amount of positive discrimination exists in favour of foreign banks by way of lower Priority Sector lending requirement at 32 per cent of the adjusted net bank credit as against a level of 40 per cent required for the Indian banks. Unlike in the case of Indian banks, the sub-ceiling in respect of agricultural advances is also not applicable to foreign banks whereas export credit granted by the foreign banks can be reckoned towards priority sector lending obligation, which is not permitted for the Indian banks.

 

Notably, in terms of our WTO commitment, licences for new foreign banks may be denied when the share of foreign banks’ assets in India, including both on- as well as off-balance-sheet items, in the total assets (including both on- and off-balance-sheet items) of the banking system exceeds 15 per cent. However, we have autonomously not invoked this limitation so far to deny licences to the new foreign banks even though the actual share of foreign banks in the total assets of the banking system, including both on- and off-balance-sheet items (on Notional Principal basis), has been far above the limit. This share of foreign banks stood at 49 per cent, as at end-January 2007, as mentioned in the India’s Trade Policy Review, 2007

 

Securitisation Guidelines of the RBI

 

The RBI had first issued the draft guidelines for securitisation of standard assets in April 2005, for public comments and after an extensive consultative process; the final guidelines were issued in February 2006, in order to facilitate an orderly development of this market. In certain quarters, however, a view has been expressed that these guidelines, tend to negate the benefits envisaged in the very concept of securitisation, and thus, are hindering the growth of securitisation market in the country. Let me attempt to briefly present today the international perspective vis-à-vis RBI guidelines and the thinking and rationale underlying our formulation.

 

The independence of the Reserve Bank holds the key to effective monetary control. An independent Reserve Bank can hold out threat of a high rate of interest on Government borrowing if the Government indulges in fiscal excesses. As the high rate interests retard the rate of economic growth and adversely affect the chances of the politicians’ re-election they behave more responsibly than they otherwise would.