India : RBI : Progress On The Five Pillars Of Reform

British Deputy High Commission Mumbai

January 2014



Rajan committed to five pillars of reform on taking office.  Five months on, there has been progress on all fronts. Most recently, two key committees reported their recommendations.  Urjit Patel  proposed strengthening monetary policy through inflation targeting. On financial inclusion, Nachiket Mor revisited priority sector lending (PSL) targets, suggesting a higher target but with sectoral and regional weights based on difficulty. The requirements are still  significant, but trade in PSL certificates and participation in securitised assets provides some respite.






India currently follows a multiple indicator approach in determining monetary policy and final decision is taken by the Governor.  The Urjit Patel  committee recommends


  1. Targeting CPI inflation with a base target of 4% (+/-2%).  Headline CPI inflation closely reflects the cost of living and influences inflation expectations. In view of the elevated level of current CPI, a transition bringing down inflation from 10% to 8%  over the next 12 months and  6% over the next 24 months is proposed, before formally adopting the recommended target of 4%.

  1. An accountable Monetary Policy Committee (MPC), similar to the UK system.    A five member MPC, with two external members appointed by the Governor. Each member will have one vote and the MPC will be accountable for failure, defined as the inability to achieve the target over three successive quarters. This will require the MPC to issue a public statement, signed by each member, stating the reasons for failure, remedial actions proposed and the likely period over which inflation will return to the centre of the target zone.

  1. An operating rule based on a real policy rate.  When inflation is above the nominal anchor, the real policy rate is expected to be positive. The MPC can decide the extent to which it is positive, with due consideration to the state of the output gap (actual output growth relative to potential) and financial stability. Moving the operating rate from the overnight repo to the 14 day repo is recommended.

  1. Macroeconomic reform.  The Central Government should reduce the fiscal deficit to GDP to 3% by 2016-17 (its existing commitment). It also requires a commitment to eliminate administered prices, wages and interest rates.  Establishment of a separate Debt Management Office is recommended and it deters the RBI from using open market operations to manage yields on government securities. 

  1. A flexible approach, in a global context. To address excessive inflows, RBI should build a sterilization reserve out of its portfolio of GoI securities across the range of maturities, with capability to rapidly intervene at the short end and introduce a remunerated standing deposit facility, which will effectively ensure unlimited sterilization capability. To guard against outflows, the RBI is required to build an adequate buffer of foreign reserves.  Establishing regional swap lines is recommended as a second line of defence.         




The Nachiket Mor Committee recommends mobile payment systems to give every Indian adult access to banking and insurance products by January 1, 2016.  This would be linked to India’s Unique Identification Document (UID) scheme. The establishment of payment banks, accepting deposits below Rs.50,000 (£500), and wholesale banks, accepting deposits only above Rs. 50m (£0.5m), is recommended.


The main recommendations of the report which impact UK interests relate to PRIORITY SECTOR LENDING.  They are as below


  1. A PSL target of 50%, up from 40%. Some UK banks will be impacted by this move as full PSL targets are applicable to foreign banks with over 20 branches. Other foreign  banks have a PSL target of 32%.

  1. This 50% target to be the sum of weighted or adjusted PSL. More difficult sectors such as agriculture and  “weaker sections” (small and marginal farmers, women, scheduled caste/tribes etc), will now receive a higher weighting.  Rs.1 lent to direct agriculture will qualify for adjusted PSL achievement equal to Rs.1.25 and  Rs.1 lent to weaker sections will qualify for APSL achievement equal to Rs. 1.10.  Similarly, lending in a district  which scores 5.5% on financial inclusion will qualify for a weight of 1.245 while a district which scores 97% will not qualify for any additional weight. . 

  1. No sectoral targets within the PSL target.  Of the current PSL target of 40%, 18.5% must go to agriculture and 10% to “weaker sections”. The rest can be allocated to micro and small enterprises, education and housing.  This offers significantly greater flexibility for banks, including the option to specialise in areas of strength.

  1. Securitisation of PSL assets. Credit facilities documented as bonds or Pass-Through Certificates (PTC) can be held against PSL targets.  The Government of India should restore the tax-free status of securitisation SPVs to allow Wholesale Banks to provide liquidity to other Banks and Financial Institutions directly originating assets in priority sectors.  Risk-free PSL Certificates should be used as a means to achieving PSL compliance amongst banks that wish to do so.

  1. Indirect investment to count towards PSL targets.  Equity investments in rural infrastructure such as water stations, rural warehouses, and non-bank financial companies in low financial depth districts will contribute to overall priority sector lending targets. They carry a multiplier of four, to reflect their higher risk and the illiquid character.  Investment in bonds of institutions will qualify where wholesale lending to the institution already qualifies under PSL, for instance lending to micro finance companies.  




DEEPENING FINANCIAL MARKETS: The ceiling on foreign investment in the debt market has been progressively raised. Discussions to list India on one of the international bond indices are in progress. Interest rate futures on 10 year government bonds have been introduced and a proposal to allow foreign portfolio investors in the currency futures markets is under consideration. Rajan has made an explicit commitment to internationalisation of the rupee.


BANKING STRUCTURE REFORM:  The RBI is considering a proposal for differentiated bank licenses.  The norms of setting up local subsidiaries for foreign banks have been laid out. It is voluntary for UK banks since they have been present in India before 2010. 

STRENGTHENING ASSET RECOVERY:  With non-performing assets on the rise, the RBI has released a discussion paper which seeks to ensure early recognition of stressed assets, penal rates for uncooperative borrowers, and easier norms for the sale of stressed assets. Promoting asset reconstruction companies, private equity and leveraged buyouts presents opportunities for UK financial services. 



The reform agenda is not without critics.  Arvind Mayaram , Economic Affairs Secretary noted that it may be premature for India to use CPI as an anchor for inflation targeting, arguing that food inflation, which has a large weighting in CPI, cannot be controlled through interest rates.  Meanwhile, several of the banks represented on the Nachiket Mor Committee have spoken out against its recommendations, in particular claiming that the timelines proposed are unrealistic. 


Some recommendations differ in detail from other reform initiatives.  For instance the Urjit Patel Committee has recommended a five member MPC with two external members to be appointed by the Governor. The FSLRC recommended a eight member  MPC, with five external members, two appointed by the Government in consultation with the RBI, and three by the Government without RBI consent.




Some reform momentum was there before Rajan took office, but he has undoubtedly driven the agenda forward. Reforms at the RBI withstand election cycles, though some of the recommendations of Urjit Patel Committee will require legislative amendments. Ultimately, this agenda will bring India closer to global practices and provide the structural and institutional underpinnings necessary for financial market liberalisation. At the same time the lines of defence built up by the RBI will guard against global volatility.  


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