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policy environment> domestic environment
Domestic Environment
The gross fiscal deficit (GFD) of the Central Government increased to 5.6 per cent of GDP in the revised estimates from 4.0 per cent in the budget estimates, partly reflecting cyclical, unforeseen and security related factors. The combined state government fiscal deficit also increased sharply. In this context, issues relating to devolution of finances between the Centre and the States and specified aspects of Centre-State fiscal relations have been examined by the Eleventh Finance Commission (EFC), which submitted its final report in July 2000.
Domestic Monetary Policy Framework
Monetary management has increasingly focussed on multiple indicators in order to influence domestic liquidity conditions. The strategy followed here was one of offsetting autonomous liquidity flows with discretionary flows. Given the thinness of the Indian foreign exchange market, the Reserve Bank had to ensure orderly conditions through pre-emptive and remedial measures. Pressures in the foreign exchange market emerged in May/ June and end-August 1999. During this period, liquidity was appropriately tuned. Once normalcy was restored, the Reserve Bank could ease monetary conditions by reducing reserve requirements and rates consistent with the domestic credit demand.
One of the important characteristics of 1999-2000 is the softening of the interest rate structure, despite an increase in the fiscal deficit. The key interest rates decided by the Reserve Bank, such as the Bank Rate, the repo rate and the interest rate on savings deposits, have come down substantially. The Reserve Bank has also reduced reserve requirements in order to reduce the implicit tax imposed on banks by such statutory preemptions and cut down banks' borrowing costs. The other domestic interest rates are left to the banks to decide except in the cases of credit extended under the DRI scheme and of credits of up to Rs.2 lakh. However, a number of structural factors prevent financial entities, especially banks, from quickly responding to changes in the inflation rate while deciding on the nominal interest rates they charge on their lending or offer on deposits. For example, the post-tax return on bank deposits remains lower than those on contractual savings such as the Provident Fund and the National Saving Scheme. The higher fixed rate on long-term deposits raised in the past when interest rates were ruling high as also the high level of non-performing assets (NPAs), besides the high administrative costs of the banking system have limited the flexible use of the interest rate as an instrument of financial intermediation.
The experience of the past year suggested that flexibility should be the guiding principle in respect of both deposit and lending rates as also in regard to the maturity structures. This was, to an extent, addressed in the Monetary and Credit Policy announcement for the year 2000-01. Nonetheless in 2000-01, there are several challenges to be faced, and dilemmas resolved. Among these, the significant ones are: managing the large Government borrowing programme, meeting the increasing credit needs of the growing economy, maintaining reasonable interest rates and financing the continuing high oil import bill.
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