Recently the Reserve Bank of India (RBI) celebrated 90 years of its establishment. The RBI was set up under the Reserve Bank of India Act, 1934 and it started its operations from 1st April 1935. It was nationalised in the year 1949.
At the time of its foundation its head office was located in Calcutta (now Kolkata) and moved to Bombay (now Mumbai) in 1937. It was primarily formed as an institution for better monetary management. Today, RBI has unmatched credibility among Central Banks of developing countries. By the standards of the major central banks of the World, RBI despite being 90 years old is actually quite young.
The world’s first central bank is Sweden’s Riksbank established in 1668 and in 1694 the Bank of England was established. Both these, just like RBI, were established as joint stock companies to purchase government debt. In 1800, Napoleon established the central bank of France, Banque de France with the twin objective of stabilising the currency due to hyperinflation and to aid the government raise debt. The US Federal Reserve is a much later addition and came up in the Twentieth Century.
In the present day, Central banks are mostly tasked with effective monetary policy management, currency and banking operations and to serve as the lender of last resort. Most Central Banks including the US Federal Reserve and RBI have the twin objective of monetary stability and economic growth – objectives that are very often difficult to balance, especially in modern times and after the dismantling of the Gold Standard.
Challenge of Inflation
In simple terms and as a generalisation, for the central banker, life was much easier when the gold standard which prevailed until 1914 because banking and world trade were less complex. In the more advanced countries and in those days, a decline in gold reserves led to the weakening of a country’s currency and that often led to an increase in interest rates by the central banks which in turn usually led to the flow of gold back into the country from other parts in order to take advantage of higher interest rates.
Of course, in countries such as India which were ruled by other countries the fate of the local currency was linked to the mother colony (in the case of India to Great Britain). Like most other central banks, at the time of its foundation, the RBI too was incorporated as a joint-stock company with shareholders. In India, before the establishment of the RBI, the banking landscape was dominated by the three Presidency Banks (Bank of Bengal, Bank of Madras and Bank of Bombay) which were merged in 1935 to form the Imperial Bank of India which was later nationalised and came to be known as the State Bank of India.
Till its formation, currency management was directly undertaken by the British Indian Government with the Presidency Banks/Imperial Bank given the task of borrowing on behalf of the government and to undertake banking operations on behalf of the government. In the early decades, the most important tasks for the RBI was to keep a watchful eye on the prices of agricultural commodities which formed the most important items of trade.
In the years up to the liberalisation of the economy in 1991, the most important task of the RBI was to control inflation and see to it that sufficient amounts of capital was available to agriculture and industry. This task was undertaken along with the Union of India as part of the larger planned economic model under the Five Year Plans.
A major problem that RBI had to grapple with in the run-up to liberalization was the difficulty in raising resources due to the constantly rising fiscal deficit and the low level of foreign investments due to the controlled and restricted nature of the economy. This is reflected in the combined fiscal deficit of the Centre and the States which increased from 8.8 per cent of GDP in 1984-85 to 9.4 per cent of GDP in 1990-91. The rise in oil prices during the Gulf War pressurised the balance of payments which ultimately required the pledging of Gold with the IMF to overcome the shortage of foreign exchange and the subsequent liberalisation of the economy. In the aftermath of liberalisation and with in-flow of money fighting inflation and protection of depositors was an important task for the RBI.
New Challenges
Any monetary policy that focuses on stabilising the currency requires close monitoring of trade and foreign exchange inflows and outflows. In the case of India, RBI has always has an issue of managing foreign exchange resources since the biggest import item is oil and it is denominated in dollars.
Moreover, oil has the reputation of being one of the most volatile item and international trade in oil is settled in US dollars. On an average, since 2011, India has imported about Rs.10 lakh crores of oil a year. In the past two years, it was about Rs 12 lakhs and Rs 16 lakh crores respectively.
Russian invasion of Ukraine and subsequent US sanctions have made these imports and their payments even more complex. The other important challenge is for the RBI to manage increased foreign portfolio inflows (FPI). This is important since FPI, unlike foreign Direct Investment (FDI) is considered to be "hot money" which enters and exists rapidly. Little wonder for the last nearly 15 years, RBI and the Union Government have tried their best to encourage settlement of international trade in Rupees.
For a short period of time, in the 1960s, Rupee was legal tender in some Gulf countries such as Kuwait, Qatar, Bahrain and UAE. The devaluation of the Indian Currency in 1966 led to its withdrawal. Before the collapse of the Soviet Union, India and the USSR had a large Rupee – Rouble Trade where items sold by both countries were settled in the respective currencies and fixed prices as computed by mutual agreement.
However, this avenue closed with the collapse of the Soviet Union. In the past, these efforts did not bear fruit due to the global financial crisis and the resultant complexities that it created in global trade. The attempts to increase the focus on the settlement of international trade in Rupees gained traction in the aftermath of COVID and especially after 2022.
The increased geo-political tension and the focus on de-dollarisation apart from the increased tendency of global central banks to diversify their foreign currency holdings has also helped. In August 2023, RBI allowed banks from 22 foreign countries including the UK, Germany, Bangladesh, Russia, Israel, and Sri Lanka to open Special Rupee Vostro accounts (SPVA).
Vostro accounts were first allowed in 2016 and it is a special facility wherein a foreign bank is permitted to hold foreign currency in Indian Rupees so that it can be used for the clients of foreign banks without a foreign bank actually having a presence in the country. The term "Vostro" is a Latin term meaning "yours".
It is operated by the foreign bank instructing the Indian bank to settle the account and pay the counter-party within the country. It is indicated that nearly 64 countries have evinced interest in opening such SPVA to trade in Rupees since these offer the benefit of repatriation in foreign currency. The benefit for India is that while saving precious foreign currency, it offers the possibility of laying the foundation for the internationalisation of the Rupee and the long-term goal of the Indian Rupee emerging as an important currency in the basket of currencies used in global trade.
As of now, the most important currencies used in international trade are dominated by the US Dollar which is most widely used followed by the Euro, British Pound and Japanese Yen; these are often referred to as the “big four currencies”. These Big Four are also used as Foreign Exchange Reserves by all the other nations.
However, since the global financial crisis and especially after 2013, there has been a conscious attempt by countries to diversify their currency reserves by including other more liquid and acceptable currencies. This is borne out from statistics that indicate that show that the use of non-big 4 currencies which was just 2 per cent of the total global currency reserves in 1999 has by 2023 increased to 12 per cent meaning that countries are increasingly looking at de-dollarisation (i.e., looking to hold currency reserves in currencies other than US Dollar). It is here that India’s attempt to come to a bilateral trade agreement in local currencies has important implications for countries. For India, trade in local currencies can also help reduce the pressure on foreign exchange reserves and thereby help in the larger fight against inflation.
The other important issue that RBI is now having to grapple with is the increased importance of technology and the need to deal with cross border flow of money that is now easy due to technology. Dealing with Crypto Currencies and digital currencies is bound to emerge as the biggest challenge for RBI. Cryptocurrency issue clearly showed the risks of rapid cross-border outflow of money in the era of internet when money can move across continents in a matter of seconds or minutes. This raises issues and challenges of stopping money laundering and other illegal flows.
Digital Currency is another area which RBI has announced it is experimenting. Digital Currency may emerge as the single biggest challenge for the banking sector because RBI will have to face the issue and challenge of digital currency. The twin issue is to convince citizens that their money will be safe and that the government will not appropriate or seize it due to political or other considerations and on the other hand the implications that it will have on the banking system.
This is because digital currency if it is parked with a scheduled commercial bank does not practically become any different from physical money that is deposited with a bank branch. But, the attraction of digital money will be its safety, especially if the banking system becomes unstable due to larger economic issues or panics. In such a case, invariably people would like to keep their digital money safe and there will be nothing safer than keeping it with the RBI. But if all the digital money moves to the Central Bank it creates a self-fulfilling cascade by creating a run since deposits will move to the central bank. If such a safety is not available to citizens because RBI by law not in the business of customer service or keeping customers’ deposits but is rather a bankers bank and a lender of the last resort for a bank.
Hence, the policy challenges that RBI faces at 90 have now become more complex rather than at any time since the 1970s. The challenges include the rise of China, increased geo-political conflicts and the pressures that it creates on financial flows, currency challenges with the possible re-emergence of a multi-polar world and growing conflicts.
These new set of challenges have emerged just as the older generation of policymakers at the RBI have retired or faded into the twilight taking with them the institutional memory on how to deal with currency issues in a multi-polar world and conflicts which were the norm from the period 1939 to 2010.
