The year 1991 was an important landmark in India?s post-independent economic history. The country faced a serious economic crisis triggered mainly by an acute balance of payments problem. India?s policymakers adroitly responded to the crisis by putting in place a set of policies meant for stabilisation and structured reforms. Stabilisation policies were aimed at correcting the weaknesses in the balance of payments and fiscal spheres. Structural reforms looked at correcting certain rigidities that have crept into the economy. The Reserve Bank of India was closely associated with the government in the design and implementation of both the stabilisation and structural reform policies. A brief analysis of the role of RBI in the reform process is attempted here.

In the area of stabilisation, the major step that was taken by the new government that came into power in 1991 was to devalue the rupee in two steps. It was an important corrective step. RBI was deeply involved in this decision. A two-step devaluation was attempted in order to gauge the impact of the first step before taking the second step. One interesting thing about the devaluation decision was that this was not announced by the government. Rather, RBI took the step as part of its normal function of fixing the exchange rate. Of course, this policy action was preceded by extensive consultations between RBI and the new government. As far as fiscal correction was concerned, it remained mainly the responsibility of the government. However, RBI too played an important part in the effort to bring down the fiscal deficit and to reduce the borrowing programme to a level that was considered manageable.

Structural reforms initiated by the new government in mid-1991 covered a wide spectrum. However, there are three areas in which initiation of reforms was done in active consultation with RBI. These three areas were the external sector, the monetary sector and the financial sector. The country opted to adopt a more open economy. Quantitative controls on imports were dismantled. Import duties were brought down steeply. The objective was to take the import duties to a level comparable to those prevailing in the fast-growing economies in the developing world.

But the reform of the trade sector was accompanied by a far-reaching change in the exchange rate regime. Previously, the exchange rate was determined by RBI on a day-to-day basis. In 1991, a dual exchange rate system was introduced for the first time. But very soon, by the beginning of 1993 to be precise, the country moved to a unified market-determined exchange rate system. This is a fundamental change with far-reaching implications. It was a decision in which RBI and I, as the governor, were intimately involved. Looking back, it was a bold step that has stood the country in good stead. India?s balance of payments situation has never been stronger than in the period following 1992-93. The current account deficit was low and the accretion of reserves was significant. Of course, over the years, the accretion of reserves became so large that this had its own problems. Nevertheless, this was a problem of plenty rather than scarcity.

The second area of reform RBI was closely associated with was the monetary one that, of course, is its primary area of concern. I would like to refer to two important decisions in this area that have had a lasting effect on the conduct of monetary policy in our country.

The first action was to dismantle the administered structure of interest rates. This also meant that the government had to go to the market to borrow on market-determined rates of interest. Interest rates were determined through auctions. This helped the government securities market to function independently and eventually facilitated the activisation of open market operations as an instrument of credit control. The repo and reverse repo operations that have become common these days would not have been possible had the decision not been taken to compel the government to go to the market and to borrow at rates determined by the market.

The second important decision was to bring an end to the system of issuing ad hoc Treasury Bills. This put an end to the automatic monetisation of the fiscal deficit. A further step in this direction was taken later when under the FRBM Act it was decided that the government would not enter the primary government securities market. These decisions helped RBI to pursue an independent monetary policy. In the absence of these measures, monetary policy would have been an appendage of fiscal policy. This doesn?t mean monetary policy would have worked at cross-purposes with fiscal policy. There is, no doubt, a need for coordination between the two policies. But the measures mentioned did give the Central bank of the country at least the operational autonomy it required.

The third area of reform was in the sphere of banking. By mid-1991, it became very clear that the nationalised banking system in India, despite its wide geographical coverage, was weakly capitalised. Profitability was low and there were no well-accepted norms of income recognition uniformly adopted by all banks. In the light of the recommendations of the Narasimham Committee, the banking sector underwent a number of changes. Capital adequacy norms were introduced. Prudential norms of various types were also enforced. Again, the introduction of these reforms required close coordination between RBI and the government.

Emphasis on capital adequacy norms would not have mattered much, if the government had not come forward to provide additional capital. So, the policy initiatives of the government and RBI were complementing each other. Needless to say, the objective of financial sector reforms in India has been to improve the safety and soundness of the banking system. I believe that as a result of the policies taken then, the banking system today is much stronger than that it was two decades ago. The process of introducing banking reforms was not easy. The banks found it difficult initially to show loss on the balance sheets. It was really hard on them. However, over a period of time, the banks were enabled to strengthen their capital base and function more effectively.

Reforms are a continuous process and in the financial sector, they need to be introduced as circumstances change. The international financial crisis has taught us many lessons.

Because of the precautionary measures taken earlier, the Indian banking system has been able to stand up to the challenge and come out of the crisis with very little damage.

As far as regulation is concerned, there are a few important lessons to be learnt from the crisis. First, it is necessary to ensure that all segments of the financial markets are brought under the regulatory control. At least in the West, the philosophy of ?light touch? allowed some segments of the market such as investment banks, hedge funds and the rating agencies to be outside regulatory oversight. It is recognised now that all these segments must also be brought under regulatory control. The rigours of regulation must be uniform across all segments so that there is no ?regulatory arbitrage?.

Second, systemically important institutions must attract greater scrutiny on the part of the regulators. A more stringent regulation may have to be enforced in relation to these institutions. This will help to avoid the dilemma of ?too big to fail?. It is also important in this context to note that financial innovations are also extremely important and that there should be a balance between the need for financial innovations and the need for regulation to ensure financial stability. Even as we make the regulatory system in our country more rigourous, we should also engage ourselves in bringing about the necessary changes in the financial system. The financial system has to become more responsive to the needs of a growing diversified economy. For example, new initiatives in the area of creating strong bond markets may have to be taken. In the area of infrastructure, innovative ways for meeting the long-term fund requirements will have to be evolved. These are some directions in which financial sector reforms may have to move in the coming years.

The new exchange rate regime has become well established. The market-determined exchange rate arrangement has given us reasonable stability. The country moved to current account convertibility in the early 1990s. The capital account has been substantially liberalised. However, the capital account liberalisation cannot be treated as a discreet step. It is a process. We need to widen the ambit of capital account liberalisation as the financial system gets strengthened and the fiscal deficits come under greater control. In short, capital account liberalisation must happen pari passu with the strengthening of the financial and fiscal system.

The autonomy of the Central bank is a much debated issue. As mentioned earlier, there is a need for close coordination between monetary policy and fiscal policy. A lax fiscal policy will put too much strain on monetary policy. While recognising the need for coordination, it must also be emphasised that monetary policy has specific concerns and these must take predominance while formulating monetary policy.

The impact of capital flows on the economy has, on occasions, given rise to a conflict of views between RBI and the government. This is because of differing emphasis on the objectives to be achieved. Maintaining price stability and controlling inflation is a major concern of monetary policy and that has to remain its dominant objective. This does not mean that financial stability or exchange rate stabilisation are not concerns of monetary policy. This only means that in the hierarchy of objectives, price stability ranks higher as far as monetary authorities are concerned.

The author is chairman of the PM’s Economic Advisory Council and former RBI governor