The Hindu Business Line : Macroeconomics behind the monetary policy

While inflation management does require the RBI to avoid excessive intervention and pumping in of liquidity, the external sector needs a cheaper rupee for sustainability and rising exports of goods and services. This conflict has to be resolved by a mix of fiscal and monetary actions, says S. VENKITARAMANAN.

There is a famous saying, attributed to a former US Federal Reserve Chairman, which goes thus: "Central bankers are known to remove the punchbowl just when the party gets going." This is a reference to their tendency to tighten the screws just when the markets are booming. Dr Y.V. Reddy has, however, proved himself to be a central banker with a difference when he did not spoil the party but gave it the green signal, unveiling a benign, no-change Annual Monetary Policy on April 24. The equity market was pleasantly surprised and saluted the Governor's policy with a resounding rise in the Sensex. That, however, masks an inherent contradiction in the macroeconomic mix that served as the background to Dr Reddy's policy.

Apart from handling the impossible trinity — the complexities of an almost open capital account with large inflows, monetary policy independence and exchange rate management, Dr Reddy must have spent sleepless nights over how to sustain the current macroeconomic situation.

Leave alone the inflationary pressures and fiscal imbalance, which are bad enough, there is the continuing burden of current account deficits sustained mainly by capital inflows, consisting mostly of the portfolio type. How sustainable are they in the long run? If not, what is the alternative? Can we raise our current export earnings given the appreciating rupee? That is the economic dilemma that faces India today.

I turn now to the informative document "Macroeconomic and monetary development in 2006-07", which Governor Reddy released together with the monetary policy announcement. This report is a rich storehouse of analysis and data - almost a mini economic survey but released by the RBI instead of the Government. I found much to learn from it and I hope the reader will be interested in a few significant takeaways from it. I refer partly to the dilemma on the external account. As usual, the document surveys the country's external position in an expert and lucid manner. Of particular interest is the information conveyed in it regarding the country's net investment position — that is, the difference between its external assets and liabilities. While the analysts have expectedly turned euphoric about the level of reserve assets — now in excess of $200 billion — the data discloses a disturbing datum that relates to what these assets are made up of. The net investment position — the excess of assets over liabilities on the external front — is negative and revealing.

Assets and liabilities

The Table brings out the assets and liabilities of India on the external front as of September 2006 (Provisional). This has broadly been the level of the net investment position over the last few years. That is, the assets represented mostly by foreign exchange reserves and some foreign equity holdings are to be set off against liabilities, of which foreign portfolio investment is a substantial part, especially in terms of equity portfolios and foreign direct investment flows.

In this context, the rising stock market presents a dilemma of sorts to management of the balance of payments. As equity portfolio holders participate in a booming market, they do register substantial capital gains. In this context, the recent rise in stock market indices must mean that foreign portfolio-holders of Indian stocks have already clocked a hefty return on their investments. Consider, further, that the rupee has appreciated. The foreign portfolio investor gains both ways, nominally by the market value appreciation and in real terms by exchange rate appreciation. If he brings in $100 at $ = Rs 45, he makes Rs 4,500 investment. This investment goes up by reason of market variations.

When he converts back into dollars, he gains more dollars because the rupee has appreciated in the meantime. Fewer rupees fetch a dollar. So, for the same number of rupees, there will be more dollars. The portfolio investor must be laughing all the way to the bank.

Consider how the markets have rewarded the investors in the recent period. Calculations show that the equity returns have, in a broad sense, gained more than 20-30 per cent per annum in many cases. When the portfolio investor exits the Indian market he gets a return of this high order even without taking into account the exchange rate effect.

Portfolio Investment

Obviously, when we consider portfolio investment as a means of financing our current account deficit — the import of oil, food, capital goods, and so on, it is a costly method compared to even debt, which carries at most a 10 per cent charge, and that too in depreciating dollars.

Dr Reddy and the Centre may have to consider whether it makes sense to put a cap on ECB and as a result go in for costlier portfolio flows as a means of financing the current account gap. Obviously, the answer has to lie in trying to bridge our current account gap on a sustainable basis by increasing our export of goods and services. Here, we come up against a problem posed by an appreciating rupee. True, a nominal appreciation of the rupee has to be seen against the offset of decrease in inflation and consequent real exchange rate changes.

But export sectors such as software, textiles, and so on are really facing a serious problem as a result of the rising rupee.

While inflation management does require the RBI to stay off excessive intervention and pumping in of liquidity, the external sector needs a cheaper rupee for sustainability and rising exports of goods and services. This conflict has to be resolved by a mix of fiscal and monetary actions.

Exporters' needs

It is arguable that tax-based sops to exports, although practised by many nations in spite of WTO agreements, militate against fiscal responsibility. But fiscal responsibility first presupposes as a pre-requisite a sustainable BoP. And that requires a focused agenda for handling export competitiveness. How Governor Reddy will solve this problem will determine his place in the galaxy of successful and path-breaking economic pioneers!

No less important is the role of the Finance Minister, who has to be more generous in releasing tax support for the dollar-earners of the economy.

Depending on purist tax policy experts, who are particular about reducing subsidies, can be hazardous to the economy's long-term health. So, let North Block and Mint Street beware. Ritual purity may hollow out the economy! It is better to take a holistic view of the needs of exporters in our sensitive sectors.

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