The Hindu Business Line : Temptations to resist, challenge to meet

As the Budget-making gathers momentum, the Finance Minister must not announce actions or policy intentions on areas that do not strictly fall under the category of fiscal policy. It must also avoid sundry other temptations. Equally, it faces the challenge of building infrastructure, says A. Vasudevan, who suggests a bond model wherein the instrument is SDR, rather than dollar, denominated.

The Finance Minister, Mr P. Chidambaram, should in the Budget leave issues such as debt waivers, direction of credit flows and regulation of financial sector to the central bank and the banking sector. — Shanker Chakravarty

THE Finance Minister, Mr P. Chidambaram, would be now busy preparing the details of the Budget with the help of his technocrats, of course keeping in view the compulsions of the Indian polity. Two aspects, however, need to be placed on view at this stage, since everyone knows that changes can be introduced in the Budget, even at the last minute.

First is the need to ensure that the Budget does not announce actions or policy intentions on areas that do not strictly fall under the category of fiscal policy. For instance, the issues relating to the central bank. Finance Ministers have often in the past touched upon issues concerning the cost of credit, debt cancellations, sectors that need to be focused for credit flows, and institutional issues concerning regulation of the financial sector including the banking sector.

This practice should be eschewed as it gives the impression that the central bank has no face of its own and would have to merely follow the centralised commands.

Let us deal with specificities here. Announcements of hikes in interest rates or elimination of frictions relating to early redemptions of certain government-controlled saving instruments or about interest rates on certain categories of borrowers or sectors would be tempting. While some of the announcements contribute to higher market absorption of the said instruments, and are perceived as populist, they tend to influence market expectations about other interest rates as well.

Changes in interest rates — the relative price of capital — would affect portfolios of economic units and asset prices. Interest rate is a forward-looking variable in open market economies and along with state variables forms an integral part of the process of formulation of monetary policy.

The Budget should also avoid the temptation of announcing waivers of debt owed to public sector banks and other financial institutions by certain groups of individuals pertaining to an activity area. This would pose a fiscal burden and generate more pressures for waivers of debt on a large scale. It would, therefore, be best to leave debt restructuring issues to financial institutions including banks.

The ultimate moral hazard in debt waivers could severely damage the financial soundness of public sector financial institutions and place the institutions at a disadvantage in competing in the market vis-à-vis private sector financial institutions.

Announcements about changes in the extent of credit flows to certain sectors other than those already in existence by way of targets within or outside the priority sector lending framework for all banks should be shunned since they would be an invitation for potential `adverse selection'. Besides, they militate against the portfolio choices that bankers should make within the extant risk management guidelines.

There is also a speculation that the Finance Ministry favours a super supervisor and regulator for the entire financial sector. The British example is cited but this is not enough. Such a super organisation would be a monopoly in the government sector and would be subject to pressures of coalition politics. The UK example is unfortunate since we know that its super authority is under considerable stress and is not a known success story. There is very little evidence of support for such a super authority in other highly industrialised countries.

If the Finance Ministry heeds to the logic and rationale of our arguments, then the Reserve Bank of India has to prepare itself to meet the challenge. The RBI has to discard the practice of policy announcements almost eight weeks after the Budget presentation as this does not do any good to influence the market expectations.

It should advance the date of the annual policy announcement latest to end March. No doubt the announcement would contain estimates of state variables and of forecasts of both the state and forward-looking variables for the year ahead, but they are sufficient for monetary policy to influence market expectations. The second aspect relates to the problem of financing the expected large outlays on infrastructure. The Planning Commission Deputy Chairman, Dr Montek Singh Ahluwalia, seems to have favoured an annual disbursement of $5 billion on infrastructure imports to eliminate the bottlenecks in expanding economic activity.

The idea of placing government securities with the RBI for drawing dollar resources has not been favoured by a number of economists mainly in view of the inflationary implications and the pressures that such an arrangement would place on the government to have similar arrangements for financing a number of projects including those in the social sector. Against this context, let us explore the possibility of resolving the problem on hand in a different manner.

It is well known that a number of countries, especially those in Asia, have large foreign exchange reserves and would like to invest them in safe and relatively high-yielding securities. The US securities market has so far been the main attraction for such investments. The US, however, has large twin deficits — very large external current account deficit and high fiscal deficit — and is more sharply subject to uncertainties about the international economic and political environment than ever before.

The Government of India should, therefore, explore the possibility of issuing special medium-term infrastructure bonds in favour of other countries' central banks/governments at attractive yield rates. The bonds could, if necessary, be guaranteed by the RBI at a fee for providing comfort about the safety. These bonds could have maturity period of three years.

Maturity periods of more than three years could give rise to unnecessary speculation that the infrastructure projects would not be completed within the medium term. The bonds would be issued subject to a maximum realisation amount, somewhat similar to Dr Montek Singh Ahluwalia's suggested figure.

This would give a signal that the external liabilities of the government would be incurred for specific purpose and determined after taking into account sustainability conditions.

Since the dollar value has been somewhat volatile, it is worthwhile expressing the amounts in terms of SDR (special drawing right) — a more stable `unit of account'. The resources raised by such issues could be kept in a separate special SDR security account of the Government for use strictly for importing items for infrastructure.

Temporary lags in use, however, would have to be codified and addressed by investing the amounts in foreign exchange or security markets abroad through the Reserve Bank acting as the agent of the Government. Alternatively, the Government could temporarily supply the foreign exchange resources in the Indian foreign exchange market again through the RBI. Such temporary parking of resources would be guided both by safety and yield considerations.

To make investments in such bonds attractive, a liquidity strip up to 20 per cent of the face value of the bond could be attached with a qualification. If the investing foreign central bank/government has a liquidity problem, it could raise the eligible amount by issuing a derivative instrument such as a repo for a maximum maturity period of 30 days. The rate on such a repurchase agreement could be determined on the basis of the trends in the international foreign exchange market. To enhance the credibility of the intentions of the Government regarding infrastructure financing through foreign exchange resources, the special SDR security account and the transactions relating to it could be subjected to a special audit.

(The author, a former Executive Director of the Reserve Bank of India, can be accessed at asurivasudevan@hotmail.com)

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