Monetary Policy: The Malhotra Era -I

Mr Malhotra was governor of the Reserve Bank of India (RBI) from February 1985 to December 1990. His coming to the RBI was as sudden as his departure. When the definitive history of the RBI for that period is written, I am sure that a documented account of Mr Malhotras governorship would provide a proper assessment of his era. What I propose to do is to refer to select highlights of monetary policy in the Malhotra era.

Governor Malhotra unfolded his first major monetary policy in early April 1985. It may be recalled that the Chakravarty Committee on the Working of the Monetary System, of which the then deputy governor, C Rangarajan, was a key member, submitted its report formally two days after the monetary policy announcement and as such the report would no doubt have had a strong bearing on the thrust of the policy.

 

While selective credit controls (SCC) had already become less relevant any relaxation of SCC was then taboo. The SCC had become an unbelievable maze, not even understood by the RBI and despite suggestions for rationalisation, the Bank steadfastly refused to even consider any change in the system. In his characteristic meticulous manner, Governor Malhotra worked through the night between returning to Mumbai on the last flight from Delhi and the next day early morning flight to Ahmedabad to cut through the chaotic maze of SCC and put in place a beautifully, handwritten note which rationalised the entire SCC which then could be summarised into one small table to date it is the Malhotra rationalisation which still governs the SCC. With this, the aura surrounding it, SCC disappeared and appropriately became a minor instrument relating to a very small segment of overall lending.

The April 1985 policy announcement also made a bold attempt at deposit interest rate rationalisation for maturities less than one year. It is in this policy that one sees the pioneering attempt at interest rate deregulation. The Chakravarty report had stressed the need for short-term interest rates to reflect atleast a marginal positive real rate of return, and Dr Rangarajan and Mr Malhotra recognised the benefits of rationalising these short-term deposit rates. But this significant step was thwarted by considerable controversy as banks failed to understand the purport of the policy change. At that time there were, unbelievably nine deposit rate prescriptions for different maturities, of which five prescriptions related to periods below one year. As a first step towards deregulation, the five prescriptions below one year were replaced by a single prescription under which banks had the discretion to fix their own deposit rates for 15 days to less than one year within a ceiling rate of not exceeding 8.0 per

cent. In todays context the measure would seem innocuous, but in 1985 the banks were taken by surprise and were aghast that in effect within the ceiling, deposit rates had been deregulated a dirty word!

In the aftermath, the banks failed to use the limited discretion and as they offered 8 per cent for a 15-day maturity, major shifts took place from current and savings bank accounts to fixed deposits as 15-day deposits were being treated as current accounts. The deposit rate war was started by a small private sector bank viz. the Bank of Madurai, and the foreign banks joined in vigorously. The nervous public sector banks, sensing an exodus of deposits, jumped onto the bandwagon and also offered 8 per cent for 15-day deposits and then realised the large losses they would incur. The public sector banks appealed for reimposition of deposit rate control and this appeal had the strong support of the finance ministry. Towards the end of May 1985, the RBI had to retract, and the single prescription for maturities less than one year was replaced by four fixed rate prescriptions.

The RBI was pilloried for thoughtless deregulation, but I am convinced that history will give due credit to the RBI management for being in the avant garde of deregulation. The thoughtless implementation of this measure by banks and the support for reimposition of deposit interest rate control by the finance ministry put a seven-year setback to deposit interest rate deregulation in India. Far bolder measures in the interest rate area were taken subsequently, as would be discussed later, but the saga of the first limited attempt at deposit rate deregulation ending in failure was a major setback to reform. The scars of the 1985 deposit rate episode were deep and for a period of two years deposit rates remained untouched. Although the number of maturities were gradually reduced between March 1987 and March 1989, discretion to banks to fix deposit rates had to wait till April 1992 when a single ceiling rate was prescribed and banks were given the discretion to fix the rates on intermediate maturities.

I refer to the deposit rate episode in some detail as in historical context Mr Malhotra and deputy governor, C Rangarajan, will come out as those who initiated interest rate liberalisation and yet it was they who carried the cross. In retrospect, it would appear that after serving life imprisonment under controls banks did not wish to have freedom. The April-May 1985 deposit rate episode proved very costly in that in this area the RBI had to move cautiously for the next four years and even then could not provide for discretion to banks. Yet in a number of other areas far greater liberalisation could be undertaken.

Governor Malhotra felt intensely about the April 1985 deposit rate experiment and on his last day in the Bank in 1990 he told me that though the episode was a painful one for him, he was convinced that the RBIs action was in the right direction and that, had it succeeded, we could have moved much faster in liberalisation. It was the sterling quality of the man that despite the setback of April-May 1985, and knowing that touching this area again could be dangerous, he persevered on the hard road and ultimately paved the way for deposit rate deregulation.

The release of the Chakravarty report brought about a greater awareness of the need for reform and with Dr Rangarajan, the key author of the report, as deputy governor, the RBI changed its strategy and gave time for public debate and a conditioning of banks and institutions to change. Significant action in the area of deregulation had, however, to wait till the latter part of Mr Malhotras term.