RBI has acquired a great degree of de facto autonomy since the onset of globalisation, particularly in the post-1991 period. The enhanced freedom of the central bank to perform the functions assigned to it is in evidence not only in its central role as the monetary authority but also in other areas like financial regulation. Freeing of markets and internationalisation of regulatory norms?as in defining the capital adequacy ratio of banks?in the last couple of decades aided the process of RBI?s evolution, as much as the (resultant) growth and diversification of the Indian economy. Thanks to the laws made by the Parliament or executive orders issued by the government over the decades, RBI is now required to perform many functions other than its prime and original role of ensuring monetary stability. These additional functions include management of foreign exchange, financial market regulation and banking regulation.

It is possible to find rather distinct layers of RBI?s evolution, although there is the risk of oversimplification in attempting such stratification. RBI was established on April 1, 1935 as a private shareholders? bank and till its nationalisation in 1949, the bank used to have a largely subservient function to the Bank of England?which was the real central bank. Issue of currency was the sole function of RBI during the pre-nationalisation (pre-Independence) period. RBI was elevated to the status of a national institution from that of a company.

RBI was part and parcel of the government system during the era of centralised planning. The Planning Commission used to dictate the savings and investment policies during the period. Subsequent to the nationalisation of commercial banks in 1969, virtually all functions of RBI?including monetary and credit policies?became largely dependent on government policy. Banks were seen as instruments of government policy. The government used to take large amounts of debt to fund the Five Year Plans and monetise them.

Interest rates were administered by the government. Destitute of sound prudential counsel, banks used to function like any other PSU. Even on matters such as credit allocation, the government used to give guidance to banks.

Of course, the balance of payments crises caused by the oil shocks of 1973 and 1979 saw coordinated remedial action by the government and RBI. At a broader level, however, the government, rather than RBI, continued to be the predominant architect and conductor of public finance policies. The situation continued till about the early 1980s, when one started seeing a gradual movement towards the free market system. Then came a slow loosening of the controls on forex and monetary markets. Exchange rates became more market-determined.

By mid-1980s, the foundations of the money market were more or less built and RBI started to gradually take over its rightful regulatory role. The period between 1987 and 1991 was one of uncertainties. While an acute balance of payments crisis was staring us in the face, the problem was compounded by political instability. Rising to the occasion, RBI clearly assumed leadership in monetary policy formulation, while also broad-basing its coordination with the government.

For RBI, the Asian crisis was the most difficult problem to handle. Defying convention, RBI, in close coordination with the government, decided to have no fixed target for the exchange rate. The idea was to have a flexible but managed exchange rate. The market was given the confidence (through the Resurgent India bonds and the like) that RBI had the ability to intervene in the market when warranted?that is, to curb any self-feeding depreciation of the rupee. By 1996, the exchange rate became sufficiently flexible and interest rates became market-determined. When the global debate was about the dichotomy of full float/fixed exchange rate, RBI showed remarkable wisdom by adopting a policy favouring the flexible-but-managed exchange rate. It may be noted that there is universal acceptance of such an exchange rate policy now, although most central bankers despised it in the 1990s.

The subsequent period was witness to more meaningful interplay between fiscal and monetary policies and the resultant harmonious relationship between the government and RBI. Today, India is in a position to take advantage of the phenomenal changes in production technologies, surge in world trade and free movement of capital. With free capital flows across national borders, scarcity of domestic capital is no longer a binding constraint. Increased mobility of capital has ensured that global resources would flow to countries like India, which can show high growth and high returns.

What emerging economies like India are witnessing is a virtuous cycle of higher growth, higher external capital inflows and higher domestic incomes and savings. All these can lead to further growth. It is forecast that by the year 2025, India?s GDP would exceed that of Japan. India would then be the third largest economy in the world behind the US and China. RBI, along with the government, can play a very constructive role in spurring this growth through appropriate reform initiatives.

However, we need to be chary about the potential of excessive capital flows to create asset bubbles. Any de-link between the asset and liquidity markets should not be lost sight of. In 2007, we saw the stock market surging at a rate six times higher than the rate at which the real economy grew in the year. A self-feeding financial bubble like the one that occurred in the developed world should be guarded against. An immediate priority of RBI could be to take steps to deepen the corporate debt market. Unless there is a strong social security reason (like in the case of provident funds), all instruments of savings should be taxed evenly. Low tax rates for saving instruments are welcome, but not differential rates.

The government and RBI need to act in perfect sync with each other to not only maintain the acquired strength of India?s financial and external sectors, but also to achieve the optimum level of growth with an acceptable level of price stability.

(As told to KG Narendranath)

The author was the RBI governor from 1997 to 2003