The Hindu Business Line : Pitching for fiscal prudence

The RBI's latest Annual Report yields a wealth of data and is rich in analyses. It stresses that maintaining macroeconomic and financial stability would depend critically on policies relating to oil prices, diversification of agriculture and improvement in urban infrastructure. But, says S. Venkitaramanan, its strictures on the Government's lack of fiscal prudence are all-too-mild.

UNDER the Reserve Bank of India Act 1934, RBI is required to submit an annual report to Government of India, its sole shareholder. The report is accompanied by the usual statement of accounts and balance-sheet.

Usually, the RBI uses the occasion for yet another analysis of economic developments, particularly referring to the year under review. The annual report is usually looked forward to as a repository of the central bank's accumulated analysis and is, indeed, a treasure house of information on the economy.

It appears that the bank cannot help complimenting itself on what it calls its "continuous rebalancing of the weights assigned to growth and macroeconomic stability". It points out how a judicious mix of supply management, fiscal measures to contain pass-through of imported inflation and monetary measures to stabilise inflationary expectations helped contain inflation.

This is a rather elegant way of masking the RBI's discomfiture at the Government's fiscal misdemeanour, vis-à-vis oil prices and other issues. The delayed price adjustment meant higher deficit. The RBI does not mention specifically the role of the appreciating rupee, which kept nominal prices lower than they would have otherwise been.

The economic costs of recent policy measures are, however, much higher than the financial costs. Cheaper petro-products tend to encourage their consumption and hence a higher import bill.

News has just come in that Government of India has at least decided to bite the bullet of oil prices and increase the prices of most petro-products. There remain LPG and kerosene on the subsidised list. Hopefully, there will be no rollback.

But the fatal fascination with the idea of keeping petro-products low-priced irrespective of rising crude prices remains. It also means higher fiscal deficit and higher inflation, which will ultimately hit the common man with no productive investment being created.

I must confess that although at the time of publication of the annual report a few days back, analysts went to town noting the RBI's "strong" critique of the Government on its oil pricing policy or lack of policy, searching for the RBI's comment was like looking for a needle in a haystack.

Hidden away on page 104 of the report, in the last paragraph of a review of assessment and prospects, the report says, rather sotto voce: "In sum, it is clear that prospects for economic growth are strong, while inflation has been contained. Maintaining macroeconomic and financial stability in an environment of sustained high growth of the economy in the future would, however, depend critically on policies relating to oil prices, diversification of agriculture and improvement in urban infrastructure".

Too oblique a plea

This is as oblique a plea as can be for fiscal prudence, especially in oil pricing policies. Surely, the RBI's mild strictures will be treated as water off a duck's back. Willing to hurt, but afraid to wound seems to be RBI's stance!

In contrast to this, Mr Alan Greenspan, the Federal Reserve Chairman, in his monetary policy report to the Congress was more categorical in his statement warning his Government, albeit also tucked away in a footnote: "Large deficits could result in rising interest rates and ever-growing interest payments on the accumulated stock of debt, which in turn would augment deficits in future years. That process could result in deficit as a percentage of gross domestic product rising without limit. Unless such a development was headed off, it could cause the economy to stagnate at some point over the next couple of decades".

Even Mr Greenspan has been more direct than Dr Y. V. Reddy when it comes to pointing out the adverse consequences of fiscal deficit.

The RBI's annual report is usually looked forward to by observers for hints on future interest rate and exchange rate movements. While the analysis is comprehensive, it is rather economical on indications of interest rate stability or exchange rate movements.

Obviously, we have to read between the lines to infer what the RBI's policy will be on either of these fronts. Inflation management is the key determinant that seems to rank high on RBI's list of objectives. We can, therefore, expect the rising trend in interest rates to continue, and the exchange rate to keep appreciating.

On the external front, the RBI has a credible and creditable story to tell. It has incorporated a workmanlike analysis of the external economy, the growth of exports and invisible receipts, the rising current account deficit financed by capital receipts on FDI and portfolio investments.

Is current account deficit inevitable?

The fact that India has gone into current account deficit after three years of surplus is a sign of increased openness of the economy and higher industrial growth with increasing capital outlays. The inference by the central bank that this reversal is a healthy sign that our savings are not being exported has, however, to be taken with a pinch of salt.

Even if we concede that the current account deficits are good in the long run as they import other country's savings for our economy, they do come at a cost. We are incurring external liabilities, either as debt or as equity — debt in the form of external commercial borrowing or equity in FDI or FII investments.

The critical issue is whether the current account deficit is inevitable and whether we can increase our exports of goods and services further. While the RBI report is complacent on this aspect, it is worth reflecting that its exchange rate policy and the appreciating rupee do cause an impediment to exports.

It is time we took a holistic, long-term view of our external environment, our exchange rate policies and export promotion.

To argue that a reduced current account surplus means more foreign savings finance our development and hence justify deficits is to ignore the costs of such financing.

As usual, the annual report presents the accounts and balance sheet of RBI for the latest period. The income and expenditure statement of RBI shows that on the whole RBI has been a "profitable" undertaking when taken into account an equity investment of Rs 5 crore by the Government.

`Profitable' undertaking

In the latest year 2004-2005, its gross income was Rs 19,000 crore (roundly) made up of Rs 17,000 crore from the interest on foreign assets, the balance earned on domestic assets. The income from both sources has declined over the last few years due to lower interest rate environment abroad and lower availing of ways and means advances by Centre and States.

Of the total income of nearly Rs 19,000 crore, the RBI transfers Rs 6,100 crore to contingency reserve and Rs 700 crore to asset development reserves, leaving a net income of about Rs 12,000 crore. After deducting expenditure of nearly Rs 7,000 crore, we have a balance of Rs 5,400 crore, which is transferred to the government.

What is interesting is that whatever the level of gross income, the RBI effectively reduces the amount transferable to the Centre by correspondingly increasing transfers to the two designated funds. While a contingency reserve and asset development fund are, no doubt, essential for the integrity of the apex bank's balance sheet, the principles governing the contribution from year to year to these funds seem rather flexible.

Incidentally, there seems to be no specific legal provision for such reserves as per the RBI Act, although it takes refuge under an enabling Section of the Act. The RBI appears to adjust the amount of transfers to the funds in such a way that whatever the size of the total revenue, the surplus for transfer to the government remains the same, at around Rs 5,000 crore.

It seems desirable to revisit the issue to clarify on what basis the contingency reserve should be built up and for what purpose it can be drawn upon. The objective should be not to reduce the surplus transferred to the government.

Another alternative is to create other funds, such as the long-term operation fund, which used to finance IDBI and other development finance institutions in the old days.

On the question of returns on reserves, the RBI's report is laconic. It shows that the returns have been relatively low - 3.2 per cent in 2004-05, against 2.8 per cent in 2003-04. Surely, this is rather low, compared to the figures of returns on FDI and portfolio investments. There has to be a re-examination of policy, which at present governs the deployment of the RBI's foreign currency assets.

The deployment of the RBI's reserves in securities abroad is at a net cost — in the sense it earns less than we pay at the margin for the forex we get.

Whether we cannot borrow from the successful example of Temasek, the Singapore government investment vehicle, which earns a significantly higher return of 8-10 per cent on its assets, deserves to be explored. Surely, the RBI is not short of experts in investment. As it is, Temasek has many non-resident Indian experts advising it on how to earn its high yields.

Overall, the RBI's latest annual report yields a wealth of data and is rich in analyses. It is essentially lucid and as free from jargon as a central bank report can be.

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Summit's hits and misses

Denmark's success formula: No fairy tale

The household sector: Super-savers, not star-shoppers

Pitching for fiscal prudence

RBI's difficult prescription for economy

Beefing up regulators

Fuelling the oil crisis

Disaster wave