RAGHUNATH SHANKAR KELKAR Vs. UNION OF INDIA

JUDGEMENT

(1.) A working group was constituted by the Reserve Bank of India the "Internal Working Group on the Instruments of Sterilization" to examine a range of issues arising out of increasing foreign currency assets of the bank and depleting stock of Government securities in its portfolio, which limit the capacity of the Bank to sterilize the monetary impart of sustained forex capital inflows. The report of the Working Group was submitted on 2nd December, 2003. The Working Group noted that a developing economy is liable to attract high forex inflows whether through capital investments or current account transactions or otherwise by the net surpluses of the two. Such inflows have implications for domestic monetary policy and exchange rate management. In a fully floating exchange rate regime, the exchange rate would adjust itself in accordance with demand and supply conditions in the forex market, obviating the need for intervention by the central bank. However, when huge forex inflows are expected, such as in an emerging economy like India, it may well happen that the exchange rate may appreciate significantly, though an appreciation may not automatically restore equilibrium in the balance of payments. While as a matter of practice, central banks in all countries intervene in the forex market, in emerging economies, a more intensive approach is warranted in the context of large inflows. Such an intervention is founded on shared experience because in emerging markets like in India, capital inflows are relatively more volatile; driven by sentiment and not necessarily related to fundamentals of markets. Volatile inflows are liable to pose a substantial risk to the economy. Whenever the Central Bank intervenes in the forex market, domestic liquidity is created. The market based approach which is aimed at neutralizing a part or the whole of the liquidity impact of forex market intervention is called 'sterilization'. The Central Bank has to determine the extent of forex market intervention; a consequent build up of reserves; whether to sterilize and, if so, to what extent. A policy response has to be viewed as a package encompassing exchange rate policy, level of reserves, interest rate policy and considerations relating to domestic liquidity, financial market conditions and the degree of openness of the economy. The report of the Working Group concluded with a recommendation that the Government of India may issue Market Stabilization Bills / Bonds (MSBs) for mopping up liquidity from the system. The amounts so raised should, the Group recommended, be credited to a fund created in the Public Account and the fund should be maintained and operated by the Reserve Bank in consultation with Government.

(2.) The recommendations were examined by the Ministry of Finance in the Government of India which decided that the Reserve Bank may use existing instruments or dated securities for the purpose of absorbing of liquidity under the Market Stabilization Scheme.

(3.) On 25th March, 2004 a Memorandum of Understanding was entered into between the Government of India in the Ministry of Finance and the Reserve Bank for the introduction of the Market Stabilization Scheme (MSS). The Scheme essentially constitutes an instrument of sterilization and follows a market based approach. Clause 1 of the Scheme provides as follows: