The Hindu Business Line : Achieving growth and stability

Speculation is rife about whether the RBI will further tighten credit and increase rates in its forthcoming policy review. The political apparatus, on the contrary, would not like to risk a slowdown in credit disbursement or its cost. Hopefully, Dr Reddy and Mr Chidambaram will resolve this conundrum without treading on each other's toes, says S. VENKITARAMANAN.

The 1990s saw the emergence of central bank independence as a recipe given by financial sector reforms, particularly to developing countries. It was taken as given that central banks in developed countries were independent of their governments. It was believed by financial sector reformers that ensuring the apex bank's autonomy and placing at its head professionals with integrity and inflation-fighting credentials was the only way to go. Various developing countries accepted this advice in the right spirit and enshrined independence in the fiscal responsibility and central banking legislation they enacted in the period. But the tension between the independent central banker and the all-powerful political executive, who placed him at the top of the central bank, was always alive.

The enactment that enshrined the Federal Reserve of the US listed both growth and stability as the tasks of the Fed. The independent Federal Reserve had to operate within these circumscribed limitations. There were, however, episodes when the Fed went far out to squeeze out inflation, as it did under the famous banker Paul Volcker. This led to an incipient recession, although it effectively squeezed out inflation, partly by contracting demands.

We are currently going through a phase in which certain economies, both developed and developing, face a difficult choice. The central bankers instinctively try to squeeze money supply, and raise rates of interest and reserve ratios, while the political executive watches with great concern and tries to nudge the central bank to hold its hand.

Pressure on Bank of Japan

The latest such instance in a developed economy was reported in the media last week, when the Japanese Government expressed its displeasure over the Bank of Japan's reported decision on a rate rise. The fact that Bank of Japan had held its hand for quite a while was not an argument. Government circles were concerned that the Bank's action may snuff out the growth impulses, which were just surfacing. Incipient deflation was considered a greater threat by the politicos. The Financial Times of London of January 18, 2007, carried a front-page story headlined "Bank of Japan under pressure to backtrack on rate rise". This happened even when its policy board began its meeting to consider the interest rate rise. The report noted that, in recent days, Bank of Japan officials, through speeches and background comments, prepared the ground for a possible rise in the overnight call rates from 0.25 per cent to 0.5 per cent.

There was a counter-statement from the office of the Prime Minister, Mr Shinzo Abe, that it is premature to raise rates before Japan has definitely escaped deflation. The Bank itself could not comment on this since it was in a blackout period, forbidden to make any comments.

Spectators went on a rampage, betting on whether Bank of Japan would succeed or the Government. Some economists disapproved of Bank of Japan caving in to Government pressure and giving control of monetary policy to the politicians. The judgment was that Bank of Japan has lost control over policy-making. The participants in the debate included the powerful Secretary-General of the ruling party. He called for a showdown with Bank of Japan, asking the Government's observers at the policy board meeting formally to request a postponement of the rate increase.

Mr Abe has reiterated his formula that while the Bank has independent decision-making authority, it is also committed to support his economic growth strategy.

The debate appears familiar to us in India. Government circles are locked in a dilemma. They have to allow the central bank to independently pursue its inflation-fighting policy, especially now that inflation has reached 6 per cent. At the same time, there is a need to sustain the growth impulses. Growth, however, demands financial provisions in terms of credit for agriculture, infrastructure and industry. I had referred in my piece last week to the EAC's pithy summary of this dilemma. The problem is acute as our Plan strategy depends on credit for the various producing sectors and their growth is needed to fight inflation.

Speculation is rife about whether the RBI will further tighten credit and increase rates in its forthcoming monetary policy announcement. The danger signals are already there. The higher WPI inflation, which is above the targeted percentage rise and the tolerance limit of 5 per cent characterise India's response to inflation.

The political apparatus, on the contrary, would not like to risk a slowdown in credit disbursement or its cost, especially with the background of coming polls in crucial States. The more material point is whether monetary tightening can reduce the price pressures, which come about due to petroleum price rise or commodities' boom, or monsoon variations.

Negotiate with RBI

It seems there is a need for the political apparatus to negotiate with the RBI and reach a workable alternative. It is difficult to realise a sustainable growth pattern if the central bank sticks to slowing down credit disbursements or raising their costs. Supply-side actions are indicated as the better way to handle inflation consistent with growth.

My own surmise is that both Dr Y.V. Reddy, the RBI Governor, and the Finance Ministry are too sophisticated at the game to allow the wrangle to deepen into dissent. I believe the Ministry of Finance will try to reach an agreement with the RBI about possible alternative strategies to depress the inflation numbers, including tax actions and imports.

Cooling the economy can be accomplished in a controlled manner, growth not being sacrificed. Maybe, selective credit controls are needed. But that is not the best of all possible options. In a second best world, it is better than stifling growth in pursuit of inflation management.

Earlier dissent

India has had episodes of dissent between North Block and Mint Street before. One famous, or infamous, incident was when the then Finance Minister, T.T. Krishnamachari had a spat with the then central bank Governor, B. Rama Rau, on interest rate announcement.

The RBI historian is quite clear in his judgment that the Governor was within his rights and TTK was obviously wrong. But Governor Rau resigned in protest at his being not understood, or misunderstood. The mechanism of periodic consultation between the RBI top brass and the Finance Ministry normally works smoothly. But the cracks appear when the two approach the problem from totally different points of view. It is time to correct the rift, if one exists. Turning to the current situation, the omens are not good, if we go by the inflation figures. The solution has necessarily to be a test of the willingness of both sides of the debate to compromise.

The central bank is, of course, independent. But, as the episode between Prime Minister Abe and Bank of Japan indicates, the independence is subject to overall imperatives of growth. Hopefully, Dr Reddy and Mr Chidambaram will resolve this debate. After all, they have a wise leader in Dr Manmohan Singh, who has been a central banker, a Finance Minister, a Deputy Chairman of the Planning Commission and a reformer par excellence.

I am sure his wise words of advice will guide both Dr Reddy and Mr Chidambaram in squaring the circle and solving the conundrum of growth with stability with no decline in central bank independence.

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