The Hindu Business Line : Reddy’s warning legacy

Dr Y. V. Reddy’s tenure at the RBI coincided with the best years of the economy to date and ended with a more complex legacy than ever before, says ASHOAK UPADHYAY.

The RBI Governor, Dr Y. V. Reddy, can take satisfaction from the contribution that the central bank has made in easing the passage of the Indian corporate sector into global finance and manufacturing.

The Annual Reports of the Reserve Bank of India are often so routine that sometimes they escape public attention as did the latest one for 2007-08. But this time it has been different because it seems to contain Dr Y. V. Reddy’s last hurrah, a warning legacy for his successor.

The Centre’s finances, the RBI notes, “may come under pressure” with the 6th Pay Commission award, loss of revenue with the reduction of duties on petroleum products, increase in fertiliser subsidies and the farm waiver. The government’s additional issuances of oil and fertiliser bonds will impact the level of public debt. Interest expenditure on account of bonds would increase revenue expenditure and widen revenue and fiscal deficits. The RBI notes that conventionally measured fiscal deficit may not be affected. But, here comes the denouement; such liabilities will have the same effects as “expansion of fiscal deficit” by “crowding out of resource availability to the private sector”.

In another part of the report, the RBI’s language is loaded with hidden reprimands. The increasing recourse to extra budgetary fiscal liabilities is not merely an issue of “transparency in fiscal operations or a de facto larger government borrowing programme than admitted” (emphasis added) but for debt and monetary management. A couple of sentences later, the RBI makes clear what it suggests: de facto borrowings create apprehensions about the quality of the fiscal consolidation process… and poses challenges for fiscal, external and monetary management.”

Eventful five years

These incisive comments on the return of fiscal profligacy or the backdoor entry of deficit financing are a fitting coda to an eventful five-year term that Dr Reddy enjoyed. They were not just dramatic. Mr S. Venkitaramanan, at the start of the 1990s, had enough drama on his hands with the foreign exchange reserves down to a billion, the sale of reserve gold for the first time and the eventful joint World Bank and IMF meeting at Bangkok that earned India the IMF’s structural adjustment programme bailout. Dr Reddy’s term was eventful because it had an auspicious beginning that presaged India’s rapid drive onto the highest growth trajectory ever with a sustained 8-9 per cent GDP. Between 2003, when he took over the reins from Dr Bimal Jalan, and the present, the organised economy posted some of the most outstanding growth indices in manufacturing, savings and investment, foreign exchange reserves, remittances and, of course, the emergence of the Indian global enterprise.

Looking back with a glow

When Dr Reddy leaves the RBI after formally handing over charge to Dr Duvvuri Subbarao today, he can take satisfaction from the contribution that the central bank has made in easing the passage of the Indian corporate sector into global finance and manufacturing. That may not have looked possible in 2003 when he assumed charge. In retrospect, it is possible to see that year as a watershed, the cusp between the promise of the reforms that had preceded it and their realisation.

In 2003, it seemed right for the RBI to reverse the end of the 1990s trend for hardening interest rates. That process came on the back of a series of critical reforms: Deregulation of interest rates, auctions of government securities, and reductions in the statutory pre-emption of institutional resources by the government and, most important of all, the phasing out of automatic monetisation of the fiscal deficit by 1997-98.

In 2003, the then government introduced the Fiscal Responsibility and Budget Management (FRBM) Act that began the long overdue process of fiscal compression and prudence that was to pay off in more legroom for the private sector at a time when the global capital markets had not quite opened up for it. The FRBM had an instant success; the gross fiscal deficit that had hovered round 6 per cent the previous two years fell to 4.5 per cent of GDP in 2003-04 also because of buoyant revenues from an economy in flight.

The watershed year: 2003-04

That year gave a foretaste of how the economy would move and the policy responses required to facilitate those movements. The RBI’s annual report, the first after Dr Reddy took over in September 2003, mentioned sterilisation of dollars as a temporary expedient — “buying time till macro-economic policies can be put in place to nurture a durable absorption of the capital flows into productive investments and augmentation of capacity…”

Five years later, that temporary measure still mops up the excess dollars even as its flip side, sale of government securities to skim the excess rupee liquidity has been augmented by frequent hikes in CRR and repo rates.

The RBI did not wait for those durable policies to emanate from Delhi. Decisively and systematically, it raised the ceiling on foreign exchange limits for companies and individuals to set in motion the biggest mergers and acquisitions spree ever. That movement towards fuller capital account convertibility, abetted by rising foreign exchange reserves, proved to be Dr Reddy’s answer to the contentious issue of an optimal use of the country’s growing reserves.

Permitting the private sector more access to foreign exchange allowed it to raise its productive investments and augment capacity increased role of Indian enterprise in the advanced economies. If India counts as the UK’s third largest investor today, the RBI’s increasing liberalisation of foreign exchange rules helped significantly.

Cautiously taking risks

But the RBI’s calculated risk taking by which it permitted the private sector greater access to increasingly complex global financial markets and brand acquisitions was accompanied by caution that has left many issues unanswered. The idea of an Indian Sovereign Wealth Fund spluttered briefly, with some assuming a $5 billion could get India access to Wall Street firms. Silence from Mint Street simply killed it. The more active notion of using forex reserves to finance infrastructure gained some legitimacy with the Deepak Parekh committee; a special purpose vehicle is in place. But that’s about it.

Caution also marked the central bank’s approach to the participation of Indian funds in the innovative and increasingly complex financial architecture that built up after 2003 on the back of systemic deregulation, initiated by Alan Greenspan and other western central banks.

Once again, voices clamoured for liberalisation to allow the Indian banking system participate in the hugely profitable and arcane financial world built after 2000. Those voices died with the sub-prime crisis, as did the cries for greater financial de-regulation, as western central banks struggle with increasing losses, and the collapse of the theories of self-regulation. If India escaped the contagion that still stalks western societies, the RBI’s prudent approach to capital outflows helped in no small measure.

The present crisis of monetary policy

From July 2007, when the RBI began tightening repo and CRR rates to fight relentless inflation, monetary policy’s unintended consequences have served to underscore the futility of the central bank’s actions.

Those demand pressures, it so often highlighted over the years, are now no longer the result of excess consumer demand or even high credit growth but those government borrowing and liabilities that create excess liquidity and as the latest report mentions, render difficult monetary management. But Dr Reddy’s legacy of cheap currency has contributed no less to excess liquidity despite sterilisation. Indian interest rates attract capital, force companies abroad for cheaper funds and the central bank is stuck with a problem of plenty. Some time ago, the Prime Minister’s Economic Advisory Council suggested a cap on annual inflows.

A better way to control its pernicious effects on inflation would be to let the rupee appreciate; exports would suffer temporarily in a slipping trade environment but the import bill would fall too with positive effects on the deepening trade deficit

Dr Reddy’s signing off tune about government finances, queering the pitch for monetary policy, is a recognition that most policymakers hover between fulfilment and futility. The problem is that never before has the RBI moved down the road from one to another so rapidly, while combating inflation.

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