Monetary Policy: The Malhotra Era-Ii
In retrospect, it would appear that although the Reserve Bank of India had got itself into a policy bind, against the backdrop of the Chakravarty Committee report, work progressed on evolving a sharper focus on the monetary aggregates and an overhaul of the cumbersome interest rate structure and more importantly, emphasis was put on ensuring that real rates of interest were positive. Further, it was recognised that there was a need to take measures to develop the money market. I referred to the April-May 1985 deposit rate episode in my column last week as it appeared to be that experimentation with interest rate deregulation was taboo. But with governor Malhotras own predilection and the preference of deputy governor, C Rangarajan, (a key co-author of the Chakravarty report), for a more flexible interest rate policy, the duo were determined to put through the change notwithstanding the problems of April-May 1985. The preparatory work, however, took a long time for conditioning market players to handle the
deregulation in a mature manner. This was done through a public debate on the Chakravarty report and the subsequent Vaghul working group report on the money market.
October 1988 was a landmark in monetary policy as there was a removal of the ceiling interest rate on all advances other than those that provided credit at concessional rates. This was a very bold measure at the time but the tactics this time round paid off. First, the fixed ceiling rate of 16.5 per cent was altered to a rate of 16.0 per cent minimum, which provided relief to prime borrowers. Second, banks were counselled to use the discretion judiciously and to ensure a degree of moderation. Governor Malhotra and deputy governor, C Rangarajan, counselled a number of banks on how to handle the interest rate discretion provided to banks, in the event this path-breaking change was put through successfully.
Encouraged by the successful implementation of the first major step in deregulation of the lending rates, the RBI set its sights on deregulating the money market. Although some tentative measures had been taken on the Vaghul working group report on the money markets when it was submitted in August 1987, the core recommendations remained unimplemented. After a series of discussions with banks, financial institutions, non-banking financial companies and chambers of commerce and industry, in March 1989, there was a sudden momentum in the areas of market development and deregulation. The interest rate ceilings were abolished on call and notice money, inter-bank term money, rediscounting of commercial bills and inter-bank participation without risk. New instruments of certificates of deposits (CDs), commercial paper (CP) were introduced without any interest rate regulation. The extent of deregulation was way beyond what the advocates of deregulation would have hoped for. I well recall N Vaghul telling me soon
after the announcement that he never expected the RBI to move so swiftly and so decisively.
The successful deregulation of March 1989 encouraged the RBI management to tackle a more sensitive area, viz., the structure of lending rates, which was characterised by an excessive proliferation of rates. There were not only a number of rate prescriptions for different loan amounts for each activity but also borrowers were charged vastly different rates for the same loan amount. In a sweeping rationalisation, which took considerable time to craft, a major coup was pulled off by successfully implementing in September 1990, a total rationalisation of lending rates.
The underpinning for the rationalisation was the Chakravarty report which recommended that the introduction of a minimum lending rate, one rate below that to take care of societal concerns and a general free rate. Mr Malhotra and Dr Rangarajan recognised that it would not be possible to move to such a system immediately, but it would be possible to cut across the maze of prescriptions and rationalise the lending rates. Accordingly, in September 1990, the dossier on lending rates was replaced by a single structure of six rates; these were eventually compressed into the present two lending rates.
It is fortunate that the statutory ceiling on CRR was raised to 20 per cent just before the crisis of 1990-91. Again, it was realised that raising CRR and paying higher and higher interest on CRR balances was counter-productive as monetary control was lost. In a significant policy change, the interest rate on cash balances relating to incremental liabilities after March 1990 were subject to a lower rate of interest. This was gradually lowered to zero and the RBI managed to get off the tigers tail without damage. Again, restructuring of the loss of interest to a uniform 25 per cent on the amount of the shortfall enabled the discretionary refinance interest rates to be raised during the crisis period. Thus, in an unobtrusive manner, the shutters for monetary policy tightening were built up well before the crisis hit the system in 1990-91. Thus, during the crisis, the CRR was used actively to bring about a sharp slowdown in credit expansion and banks took the signal from the default rate on the CRR, and the
discretionary refinance rate to raise the lending rates. Thus, a careful and timely crafting of policy tools well in advance enabled the RBI to evolve an effective monetary policy during the crisis period. The country owes the late Mr Malhotra a debt for foreseeing the need and preparing the monetary policy instruments for appropriate use during the crisis of 1990-91.