India: Recent Economic Developments and Selected Issues

India rebounded strongly from its 1991 balance-of-payments crisis, aided by structural reforms and other policy adjustments. The government has sought to reinvigorate the process of structural and fiscal reform. The paper examines trends in interstate differences in rural poverty; reviews India's postal saving system and possible reform issues; describes and evaluates the current system of pensions and provident funds, and discusses reform options. The paper also briefly reviews the structure of and recent developments in the Indian foreign exchange market.


India rebounded strongly from its 1991 balance-of-payments crisis, aided by structural reforms and other policy adjustments. The government has sought to reinvigorate the process of structural and fiscal reform. The paper examines trends in interstate differences in rural poverty; reviews India's postal saving system and possible reform issues; describes and evaluates the current system of pensions and provident funds, and discusses reform options. The paper also briefly reviews the structure of and recent developments in the Indian foreign exchange market.

IV. Monetary Policy and Financial Market Developments1

A. Monetary Policy and Interest Rate Developments

1. Monetary policy developments during 2000/01 occurred in roughly three phases. The year began with the Reserve Bank of India (RBI) cutting interest rates and the commercial banks’ cash reserve ratio (CRR), reflecting a continuation of the previous year’s bias toward ease. However, policy began to tighten shortly thereafter, and official interest rates were hiked in August, largely in response to pressure on the exchange rate, in turn related to increases in international interest rates and pressure on the current account due to higher world oil prices. Exchange rate pressures dissipated from November, as world oil prices moderated, foreign reserves were rebuilt with the success of the India Millennium Deposit (IMD) scheme, and global interest rates fell. Against this background, and in response to signs that domestic demand was weakening and inflation risks were contained, money market conditions were progressively eased, and the RBI cut official interest rates by the end of 2000/01.

2. In April 2000, the RBI cut its Bank rate by 100 basis points to 7 percent and reduced the repo rate by the same amount to 5 percent (Chart IV.1 and Table IV.1). The rate on saving deposits with banks was reduced from 4½ percent to 4 percent, and the CRR was cut from 9 percent to 8 percent. These measures were reinforced by the April 2000 Monetary and Credit Policy Statement, in which the RBI signaled its intention to continue its easing bias. Banks followed through almost immediately by lowering their average prime lending rates (PLR) by 100 basis points to 11½ percent.

Chart IV.1.

India: Monetary Indicators, 1996-2001

Sources: Data provided by the Indian authorities; and Reuters.
Table IV.1.

India: Selected Monetary Indicators, 1995/96-2001/02


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Source: Reserve Bank of India.

New broad money series.

Relates to five major banks

3. While yields on short-term government securities fell sharply in response to the policy moves, longer-term yields did not respond as significantly. The government’s issuance of large quantities of longer-dated securities contributed to a marked steepening of the yield curve, and the difference between the 10-year and 3-month yields jumped to 240 basis points by end-April (Chart IV.2). Easy liquidity conditions during this period kept call money rates between the fixed repo rate (5 percent) and slightly above the Bank rate (7 percent).

Chart IV.2.

India: Financial Market Developments, 1996-2001

Sources: Data provided by the Indian authorities; and Reuters.1/ Difference between 10-year secondary market yield of central government securities and 91-day Treasury bill yield. Increases indicate a steeper yield curve.2/ Prime lending rate of the State Bank of India.

4. Market sentiment weakened and pressure on the exchange rate emerged through the summer of 2000. This shift in sentiment was prompted by sharply rising oil prices, the drop in the U.S. Nasdaq, and interest rate hikes by the U.S. Federal Reserve and the European Central Bank. Through May and June, portfolio flows dried up, stock market volatility increased, balance of payments pressures resulted from oil imports, and headline inflation jumped to over 6½ percent. In response, the yield curve shifted up noticeably, with a firming of both short- and longer-term yields.

5. Against this backdrop, in July, the RBI announced an increase in the Bank Rate and CRR of 100 and 50 basis points, respectively. The RBI also raised short-term repo rates in several stages using its newly introduced Liquidity Adjustment Facility (LAF), in effect reversing its April policy move. Following the announcement, short-term rates rose to their highest levels in two years, commercial banks raised the PLR back to its pre-April level, and the yield curve continued to shift up through August (Chart IV.2).

6. Pressure on the rupee began to ease by November, This reflected declining oil prices, expectations of global interest rate cuts, and a rebuilding of foreign reserves, aided by inflows from the IMD. The rupee stabilized, and money market and securities market conditions became more favorable. An easing of repo and call rates by the RBI was paralleled by a gradual decline in yields on treasury bills and government securities. The yield curve began to flatten and shift down with falling short-term rates. Through December and January, securities markets rallied as monetary policy easing in the United States raised expectations for a rate cut in India.

7. The authorities responded to the reduction in external pressures and signs of economic weakness by announcing a series of easing steps in February and March 2001. Around the time of the 2001/02 budget, the RBI cut the Bank rate by 100 basis points in two stages and CRR by 50 basis points. In response, commercial banks lowered their PLR to 11½ percent, facilitated by the government’s announcement that the administered rates on small savings would be reduced by 100-150 basis points. At this point, the RBI expressed the view that the downside risks to growth were manageable, and the uncertainties on the inflation front combined with the need to maintain confidence in the face of the stock market turbulence argued for putting further cuts on hold in the near term.

8. However, in its April 2001 Monetary and Credit Policy Statement, the RBI suggested a bias toward further ease (Box IV.1). Subsequently, the RBI lowered its repo rate by 25 basis points each on April 26 and May 28, bringing it to 6½ percent, and lowered the CRR to 7½ percent from 8 percent on May 19. Interest rates in the Treasury Bill and securities market, after jumping temporarily in March in response to stock market and political scandals, resumed their downward path in April.

India: April 2001 Monetary and Credit Policy Statement

With rate cuts preceding the release of the statement, the RBI left the Bank rate and CRR unchanged. However, there were references to the possibility of some future softening of rates. For 2001/02, the RBI projected GDP growth of 6-6½ percent; inflation within 5 percent; broad money growth of about 14½ percent; and the external current account deficit well below 2 percent of GDP.

CRR balances: Effective April 21, the interest rate paid on eligible CRR balances was increased from 4 to 6 percent. The RBI indicated that at some point in the future interest paid on CRR balances would be adjusted to the Bank Rate.

Liquidity Adjustment Facility: The RBI announced that the standing liquidity facilities available from the RBI (collateralized lending and export refinance) were to be split into two parts: (i) a normal facility and (ii) a back-stop facility. The normal facility initially constituted two-thirds, and the backstop facility one-third, of the total credit limits. The normal facility would be provided at the Bank rate, whereas the back-stop facility will be provided at a variable daily rate (initially, at one percentage point above the reverse repo rate). With effect from the fortnight beginning May 5, 2001, the magnitude of the export refinance credit facility was increased to 15 percent of the outstanding export credit eligible for refinance.

Interest rate regulation: The ceiling rate with respect to pre-shipment credit up to 180 days was set at 1½ percentage points below the PLR; banks were also free to charge interest rates below the ceiling rate. In addition, the ceiling rate on foreign currency loans for exports by banks was revised to LIBOR plus 1 percentage point. The requirement that the PLR act as the floor rate for loans above Rs 200,000 was relaxed, and banks were allowed to offer loans at below-PLR rates to exporters or other creditworthy borrowers including public enterprises.

Inter-bank call money market: The statement announced that corporates would be cut out from the market by end-June 2001, and access to other non-bank institutions (including Financial institutions, mutual funds and insurance companies) would be gradually reduced in four stages. The minimum maturity period for term deposits was reduced to 7 days (from 15).

Prudential regulations: The RBI announced that loans would be classified as non-performing if the interest and/or installment of principal remained overdue for a period of more than 90 days, beginning from 2003/04 (from the prevailing practice of 180 days). To facilitate the transition, the RBI called on banks to begin making additional provisions for such loans. In addition, assets of Financial institutions would be treated as non-performing if interest and/or amortization of principal remained overdue for 180 days (previously 365 days).

Stock Market: The RBI’s statement proposed to revise guidelines issued in November 2000 on banks’ investments in shares, advances against shares, and other exposures. It discouraged Urban Cooperative Banks (UCBs) from lending directly or indirectly against security of shares, and urged them to unwind existing lending to stock-brokers or direct investment in shares. The statement limited the amount of funding available to institutions such as UCBs from the call-market, and imposed limits on cross exposures within the UCB sector (i.e., UCBs were advised not to increase term deposits with other UCBs and to unwind existing deposits). The proportion of the Statutory Liquidity Requirement that UCBs have to hold in the form of government and other approved securities was increased, and the statement raised the possibility of setting up a new supervisory body for UCBs.

9. Owing to increases in inflation and a general decline in benchmark nominal rates, real interest rates declined in 2000/01 (Table IV.2). Despite within-year volatility, nominal rates fell on average during 2000/01, and in real terms, the decline was magnified by rising inflation. The decrease was most striking when the WPI or its nonfood manufactured component was used to calculate real rates, as inflation figures derived from these indexes were substantially higher than the previous year.

Table IV.2.

India: Real Interest Rates

(In Percent)

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Sources: Data provided by the Indian authorities; and staff calculations.Key: WPI: Wholesale Price IndexWPIM: Manufactured subcomponent of the WPIWPIMNF: Non-food Manufactured subcomponent of WPICPI: Consumer Price Index

B. Monetary Aggregates

10. Reserve money continued to grow at a moderate rate in 2000/01, increasing by 8¼ percent (y/y) (Chart IV.3 and Table IV.3). The relatively slow rate of reserve money expansion reflected the effects of the economic weakness and the cut in the CRR. In particular, RBI credit to banks and commercial sector fell by 18 percent. Despite continued fiscal weakness, net RBI credit to government increased by 6 percent, as the RBI’s large net subscription to the government’s fresh dated securities was offset by net open market sales. Aided by IMD inflows, the RBI’s net foreign assets grew 19 percent during the year.

Chart IV.3.

India: Selected Monetary Indicators, 1996-2001

Sources: Data provided by the Indian authorities; and staff estimates.1/ Twelve-month increase in credit to the private sector as a ratio of the twelve-month increase in commercial bank deposits.
Table IV.3.

India: Reserve Money, 1997/98-2000/01 1/

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Source: Data provided by the Indian authorities

Except for March 31, all other quarters are on a last reporting Friday basis.

11. Broad money (M3) growth accelerated to 18 percent (y/y) in 2000/01 from the 14½ percent in the previous year, exceeding the RBI’s projection of 15 percent (Chart V.3 and Table IV.4). However, M3 growth was boosted by the effects of the IMD and other nonresident foreign currency deposits, and the RBI’s new monetary aggregate (NM3), which excludes these flows, slowed to a growth of 14 percent, compared to 15¼ percent in the previous year.2

Table IV.4.

India: Monetary Survey, 1997/98-2000/01 1/

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Source: Data provided by the Indian authorities.

End-year data are a consolidation of March 31 data for the RBI and the last reporting Friday data for commercial banks.

Includes RBI commercial credit, bank holdings of securities, and credit to cooperatives.

12. Despite lower agricultural activity, and the larger base in 1999/2000 on account of Y2K uncertainties, growth in currency held by the public, at 10¾ percent, was the same as the previous year’s growth rate. However, the slowing of the economy was reflected in the growth of domestic credit, which eased to 15 percent during the year, compared to 6¼ percent the year before. Both net credit to government and credit to commercial sector grew slower than in 1999/2000. Net foreign assets of the banking sector, however, were bolstered by IMD flows, and grew by 18¾ percent, 3 percentage points higher than the previous year. Although bank credit to commercial sector rose rapidly in the first part of the year, it slowed significantly by year-end, and grew by 14¾ percent in 2000/01 on average, compared to 18¼ percent in the previous year.

C. Stock Market Developments

13. In the wake of the Asia crisis and the imposition of sanctions, Indian stock prices rebounded strongly during October 1998-February 2000. The Bombay Stock Exchange index rose by over 100 percent over this period to reach an historical high, and other indices performed similarly. Contributing to the surge were the announcement in February 1999 of favorable tax treatment of dividend distributions as well as international developments, including the improved sentiment toward emerging markets and the global investor enthusiasm for information technology (IT) stocks—IT stocks represent roughly one quarter of the Indian market’s capitalization.


India. Stock Prices and Portfolio Inflows, 1908-2001

Citation: IMF Staff Country Reports 2001, 181; 10.5089/9781451818550.002.A004

Source: CEIC.

14. However, stock prices fell sharply during February 2000-April 2001, with the BSE index dropping by nearly 40 percent on a monthly average basis. In large part the decline reflected the global turnaround in sentiment toward the IT sector, but domestic factors were also significant. Notably, investor sentiment was adversely affected by concern regarding the effect of high oil prices on growth, as well as uncertainty regarding the effect of trade liberalization on competitiveness. The effects of weak investor sentiment were also felt in the secondary market—resource mobilization through Initial Public Offerings declined significantly and funds raised through public and rights issues were 26 percent lower during April-December 2000 compared to the corresponding period of 1999.

15. In March and April 2001, excessive leveraging and scandals compounded stock market volatility. In March, share prices fell sharply, reportedly owing to insider trading, which contributed to several brokerage firms being unable to settle trades. As the large exposures to brokers of some Urban Cooperative Banks (UCB) came to light, episodes of depositor runs also took place. The RBI was required to intervene in one of the UCBs, and several large commercial banks also suffered losses on their interbank lending. Charges of insider trading and lax supervision led to the resignation of the chairman and the suspension of the broker-directors of the BSE.

16. The episode revealed a number of supervisory and structural deficiencies. Risks related to leveraging and price volatility were compounded by a weekly settlement cycle for stock transactions—all transactions within a week were settled only at the end of the cycle—and the so-called “Badla” market allowed clients to carry forward positions into future cycles and defer settlement. While the overall exposure of the banking system to the stock market appears to have been limited, some UCBs appeared to have carried large indirect exposures, reflecting lax supervision.

17. The authorities acted swiftly to adopt measures to restore market confidence and address the underlying structural weaknesses. As a first step to stabilize markets, the RBI announced that liquidity support to banks would be available if necessary funding from the market could not be secured. The Securities and Exchange Board of India (SEBI) tightened margin requirements and disclosure rules, and proposed to introduce a code of conduct for market participants. The government announced plans to de-mutualize the stock exchanges and adopt rolling settlements for the 200 scrips that represented the bulk of the trading volume. The RBI also issued revised guidelines on bank exposure to the stock market, and introduced limits on borrowing by urban cooperative banks in the interbank market (Box IV.2).

D. Banking Sector Developments

18. The financial position of the commercial banking sector generally improved during 1999/2000. Operating (pre-provision) profits increased by 33½ percent and net profits increased by 62¾ percent in the fiscal year, as fee and commission revenues and profit from securities trading witnessed a large year-on-year increase. However, net interest margins continued to decline for the third consecutive year, mainly among the public sector banks. This appears to reflect the fact that these banks tend to re-price their assets more frequently than their liabilities and the decreasing interest rate environment.

Financial Sector Reform Measures

Recently, the RBI has taken a number of measures to further develop financial markets and strengthen the regulatory and supervisory framework:

  • In addition to lowering the PLR (see Box IV.1), the Monetary and Credit Policy Statement gave banks the discretion to disallow premature withdrawal of large time deposits.

  • An announcement was made with regard to setting up a clearing corporation for debt securities and foreign exchange transactions, as well as an electronic Negotiated Dealing System to facilitate transparent electronic bidding in auctions and dealing in government securities on a real time basis.

  • A new valuation norm was introduced for the investment portfolio of banks. Effective September 30, 2000, the investment portfolio of banks would be classified under three categories, viz., “held to maturity”, “available for sale” and “held for trading.” No more than 25 percent of the total investments could be classified as “held to maturity”. Those classified as “held for trading” had to be revalued at monthly or at more frequent intervals.

  • Effective March 31, 2002, revised rules on large exposure required, off-balance sheet exposures to be included in the measurement of large exposures, the limit of which was reduced from 20 percent of “capital funds” to 15 percent of the sum of Tier I and Tier II capital for single borrowers, and from 50 to 40 percent for a group of related borrowers.

  • Revised guidelines on bank exposure to the stock market kept the exposure limit at 5 percent of total advances, but the definition of “exposure” was broadened to include direct investment in shares and convertible debentures, advances against shares, and guarantees issued on behalf of brokers. To avoid the concentration of such exposures to a few stock-broking entities, a sub-ceiling of 10 percent of total exposures to a single entity, including its associates and inter-connected companies, was also imposed.

  • UCBs were prohibited from lending against security of shares and their call money market borrowing was capped. The placement of term deposits within the sector would be phased out. The proportion of Statutory Liquidity Requirement (SLR) that UCBs have to hold in the form of government and other approved securities was also increased.

19. Asset quality in the banking sector remained a concern (Table IV.5). Gross nonperforming assets (NPA) fell to 12.8 percent of gross loans in March 2000, compared to 14¾ percent in March 1999, and the ratio of net NPAs (i.e., after provisions) to net loans also declined from 7½ percent to 6¾ percent. However, this mainly resulted from loan growth rather than a drop in NPAs—indeed, gross NPAs within the public sector banks increased by 3 percent.

Table IV.5.

India: Financial Performance of Commercial Banks, 1993/94–1999/00

(As a percent of total assets)

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Source: Report on Trends and Progress of Banking in India, 1999/00, and staff estimates.Note: Average is the five-year simple average over the period 1995/96 to 1999/00.

20. Efforts to improve loan recovery in the banking sector continued. In July 2000, the RBI issued guidelines for a one-time compromise settlement scheme that allowed banks to provide concessions in accrued interest in order to facilitate repayment of NPAs by delinquent borrowers. The 2001/02 budget announced plans to set up seven more Debt Recovery Tribunals (DRTs), and proposed legislation to repeal the Sick Industrial Companies Act, to replace the Board for Industrial and Financial Restructuring (BIFR) by Company Law Tribunals, and to ensure foreclosure and enforcement of securities in cases of default.

21. Restructuring among the public sector banks was encouraged with the adoption in 2000/01 of a uniform voluntary retirement scheme (VRS). Of the 27 public sector banks, 26 opted to participate in the scheme, which provided for early retirement for employees aged 45 years and older. Two months salary was allowed for the lesser of each year of completed service or for the number of years remaining before retirement. Reports suggest that by end April 2001, 126,280 bank employees had applied for the scheme, equivalent to roughly 15 percent of the workforce.

22. Capital adequacy remained relatively stable. The average capital adequacy ratio (CAR) of the public sector banks declined marginally, whereas the CARs of most commercial banks remained well above the minimum stipulated requirement. The three weak public sector banks that had been identified by the earlier Verma Committee report as requiring restructuring submitted requests for recapitalization to the government, but approval of these plans is pending. Separately, in order to mitigate the adverse effect on capital adequacy ratios of voluntary retirement schemes, public sector banks were permitted to treat such costs as deferred expenditures to be charged against income over a period of five years.

23. Consolidation continued among the private sector banks. Following the merger between HDFC Bank with Times Bank in February 2000, ICICI Bank completed its merger with Bank of Madura in March 2001. The proposed merger between UTI Bank and Global Trust Bank, however, was called off amid charges of share price rigging prior to the merger announcement.

24. Reform among the nonbank financial sector also continues. In an effort to harmonize the roles and operations of development finance institutions (DFIs) and banks, a high-level Standing Coordination Committee was set up to coordinate the activities of DFIs and banks, including the adoption of common approaches to the operational issues in jointly-financed projects. The registration process for the Non-Bank Finance Companies (NBFCs) also was completed in 2000/01. Of the total applicants, 6 percent were permitted to accept public deposits by February 2001, and only 25 of these had deposits exceeding Rs 500 million, and the aggregate deposits of NBFCs totaled only about 2½ percent of total commercial bank deposits. The RBI has also issued guidelines that would allow NBFCs to be transformed into banks.

25. Legislation was passed to allow private sector participants to write life insurance policies, with a cap of 26 percent on foreign ownership. Twelve licenses to new entrants were issued and additional requests were in the pipeline. The Insurance Regulatory and Development Authority (IRDA), set up in April 2000, made it obligatory on new insurers to conduct certain business in rural/social sectors. For example, by their fifth year of operation, new entrants must write 15 percent of their life policies in priority sectors.

Table IV.6.

India: Indicators of Financial System Soundness, 1995/96-1999/2000

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Source: Data provided by the Indian authorities.

Loan classification and provisioning standards do not meet international standards.

Gross nonperformaing loans less provisions.

External deposits comprise foreign currency deposits and nonresident (external) rupee accounts (NRE accounts) which can be freely repatriated abroad, Several classes of deposits were reclassified as external in June 1997.

As of August 1999.

Refers only to commercial bank purchase or discount of foreign bills. No other information is available.


Prepared by Taimur Baig and Dong He.


The new broad money (NM3) series excludes nonresident repatriable foreign currency fixed liabilities, as well as pension and provident fund assets.