Near to Medium-term Challenges for the Reserve Bank

Monetary Policy Response to Supply Shocks

* Repeated supply shocks pose a constant challenge to ensuring a low inflation regime in India, which is necessary for achieving inclusive high growth. A medium-term approach is required to augment the supply by addressing structural supply constraints, particularly in items of mass consumption.

Improving Monetary Policy Transmission

* In India, since the financial system did not face a crisis, the damage to the transmission channel was minimal, even though the pre-global crisis time structural rigidities continued to limit the effectiveness of Reserve Bank’s monetary policy actions. The recent switch over to the new “base rate” system is expected to help in improving and enhancing the visibility of the transmission of monetary policy signals to credit markets.

Fiscal Space for Increasing the Flexibility of Monetary Policy

* Persistence of fiscal imbalances over extended periods tends to increase risks to inflation through money-financed pressures on aggregate demand, interest rates through crowding-out pressures, and exchange rate through the twin deficit channel. The fiscal space in India is critical not only for the usual output stabilisation requirements around a high growth path, but also for limiting the impact of temporary but large supply shocks on headline inflation.

Capital Flows – Managing Surges and Sudden Stops

* Volatile capital flows have been a potential source of instability for Emerging Market Economies. Costs could magnify for an economy during periods of both too little and too much of capital flows, unless they are managed judiciously. India, in recent years, had to manage phases characterised by large net inflows as well as sudden outflows in the midst of a global crisis.
*A judicious mix of flexible exchange rate, sterilisation of the impact of inflows on domestic liquidity, cautious approach to liberalisation of the capital account, and the cushion of foreign exchange reserves has been used to deal with the adverse ramifications of capital flows.

Financing of Infrastructure

*The infrastructure gap of India, both in relation to other major countries and its own growing demand, has been a key factor affecting the overall productivity of investments. The requirement of high initial capital outlay, that too over longer terms, necessitates measures to address the financing constraint to capacity expansion in infrastructure.
*Bank credit to the infrastructure sector witnessed significant growth during last ten years, taking the share of bank finance to infrastructure in gross bank credit from about 2 per cent to more than 12 per cent. While banks continue to be a prime source of financing for infrastructure projects, alternative non-banking financing has to be attracted with appropriate policies to be able to address the financing constraint to growth in infrastructure.

Financial Inclusion – Strengthening the Contribution of Finance to Sustainable Growth

* The potential of the financial system has not been harnessed fully due to the extent of financial exclusion prevailing today. The Reserve Bank has significantly scaled up its efforts aimed at increasing the level of penetration of bank financing in the economy. Financial inclusion represents a critical component of the policy process that intends to make the financial system serve the needs of the real economy.

Financial Sector Reforms – What Next?

*Since the global crisis, there has been a decisive shift in trend towards assigning increased responsibility to the central banks for both “systemic oversight” and “macro-prudential regulation”. This greater responsibility is driven by the capability of the central banks among regulators and public institutions to perform the intended task. In order for the Reserve Bank to effectively discharge such responsibilities, the issue of institutional independence and autonomy becomes important.
*Going forward, three areas will continue to be important in policy debates, i.e., development of long-term corporate bond markets, derivative markets to facilitate better price discovery and risk transfers, and more competition by allowing greater foreign participation.

Systemic Stability Risks – The New Regulatory Architecture for the Financial System

*Much of the challenges in the domain of financial stability regulation would arise from complexities surrounding the assessment of systemic risk, interconnectedness, common exposures, risk concentrations in complex innovative products and use of models to manage and price risks which at times mask information.
*Countries like India are yet to fully benefit from the financial system in harnessing the growth potential and achieving various developmental objectives. Any regulatory actions that may limit the flow of credit to the productive sectors of the economy would clearly bring to the fore the trade-off between stability and growth.

Globalisation-induced Challenges to Monetary and Financial Sector Policies

*The global crisis revealed how countries are interlinked beyond the conventional channels of trade and capital flows. Globalisation will continue to be a source of opportunity to maximise the country’s growth potential, but there would be increasing pressures on current comparative advantages of India, besides raising the scope for faster transmission of shocks from the global economy to the domestic economy.
*Sound domestic policy environment is increasingly more important to minimise the impact of global shocks on domestic real economy. Past experience shows that some of the global shocks will emerge suddenly as black swans, and hence, policy space must be created and preserved at every stage to deal with such shocks.