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The RBI’s overall performance in maintaining financial sector stability deserves credit.

The Annual Report of the RBI comes very soon after the Annual Monetary Policy Statement. The report accompanying the monetary policy on macroeconomic development for the previous year more or less covers the same ground as the Annual Report does, except that the Annual Report also includes information on the performance of the bank as such. This, however, is definitely an important aspect and I will turn to it shortly.

So far as the macroeconomic system is concerned, the RBI’s stance remains sharply focused on price stability, especially controlling the WPI by various monetary actions. The RBI claims to have achieved some success in managing inflationary expectations of the economy. The task has been rendered difficult by the global inflation factor. But, the present received wisdom is that whatever the supply side factors may be, monetary policy has a role to play in controlling the price situation by constraining demand.

To what extent monetary policy will be effective in controlling supply side factors, such as crude, petroleum product prices, etc, which are dictated from abroad, is not clear. The RBI’s overall performance in maintaining financial sector stability deserves credit considering that in many developed economies, financial institutions have been known to fail and create problems for their own national economies as well as to the global system.

The Federal Reserve has been particularly found wanting in its regulation of activities of banks and financial institutions, which led to the collapse of institutions threatening the stability of financial systems.

It is a credit to the RBI that under its eagle eye the financial institutions of India have been saved from the likes of the sub-prime crisis and risky innovations, which flowed from the securitisation and such other developments that characterised the US and European economies.

The emphasis of the RBI on price stability is natural since the tolerance of Indians for inflation is limited. However, there may be a fatal flaw in our financial structure inasmuch as the RBI is not specifically mandated to take into account considerations of employment and growth, as is the case of the Federal Reserve of the US. It is a different matter that individual Governors, such as Dr Y. V. Reddy, had been nudged to give importance to the growth of the economy. But, his measures of monetary control, which resulted in abstractions of resources from the banking system, have contributed to a negative bias with reference to growth. It is not surprising that there has been much pain in the system as a result of the RBI’s excessive focus on price stability.

One of the observations in the RBI’s report relates to the need to have Government’s cash management proceed on considerations that take into account the expenditure cycle. The contra-cyclical phasing of Government expenditure is part of the Keynesian solution for depressed economies. Whether the Government’s phasing of expenditure management within a year can take into account such contra-cyclical factors does not seem to be clear. This requires a little bit more elaboration by the RBI.

Turning to the accounts of the RBI, standing as it does as the owner of foreign currency assets of the order of $300-plus billion, it is no wonder that the RBI derives substantial income from the deployment of these reserves in the international market. It is a different matter that, as a matter of abundant caution, it had decided to deploy its reserves primarily in the low-yielding Treasury Securities of advanced countries, particularly the US. This policy has led to rather low returns derived by the RBI.

The return, as a percentage of foreign currency assets, was 4.8 per cent in the year 2007-08 — the RBI’s report notes a marginal increase from 4.6 per cent in the previous year.

These low returns would have been sufficient to condemn the RBI as a poor portfolio manager in its League table. This low return of roughly 4.8 per cent is, indeed, considerably lower than the kind of returns Sovereign Wealth Funds at Singapore Government’s GIC derive. I recall that Mr Lee Kuan Yew had pointed to the steady and robust returns of more than 10 to 15 per cent from his investments in various types of securities, including those in the stock market. It is true that there are risks in such investments. But an asset management enterprise must be able to balance risks and rewards.

Even at these low rates of return, the total earnings of the RBI from the deployment of foreign currency assets came to Rs 51,000 crore in 2007-08 compared to Rs 35,000 crore in the previous year. The increase over 2006-07 primarily reflects the larger size of assets under management.

I now turn to a mystery in the disposition of these profits. Including the return from domestic assets, the total earnings of the RBI in 2007-08 came to Rs 57,000 crore. But it transferred out of these, large sums of money, including most importantly Rs 33,000 crore, to contingency fund reserves, leaving a balance of roughly Rs 15,000 crore for transfer to Government. It is interesting that in the previous year, the amount of transfer itself was so adjusted that the balance available for transfer was about the same order notwithstanding that the gross revenues were substantially different. The RBI seems to have adopted a policy of abstracting from the ample revenues an amount sufficient to reduce the available surplus for transfer to around Rs 15,000 crore.

Surely, an entity such as the RBI, which derives a revenue of around Rs 57,000 crore, should be called upon to transfer to Government of India, its owner, bulk of this revenue after allowing for staff expenditure, without making undue provision for contingency reserves. In any event, the justification for contingency provision deserves to be looked into with reference to the practice adopted in other countries, such as Singapore, China, Japan and Taiwan.

On inflation, the report does not concede the point that the focus should be on CPI rather than on WPI considering the practice in most other countries, both in the developed and developing world. There is, however, a reference to the practice of focusing on core inflation, which is adopted by countries such as the US.

Under this practice, the US focuses on the consumer price index, excluding items such as energy prices and food. In an elaborate table in the Report, the RBI tries to say that this exclusion of food may be applicable to the US but it is not contextually suitable for India as food accounts for a large part of the consumer expenditure. I do not know to what extent this logic applies.

Similarly, energy costs in the US are a significant part of the budget of the consumer, both directly and indirectly. The energy cost accounts for not only transportation but also cost of distribution of commodities and it does not seem to be clear whether the same argument as applied by the RBI to India would apply in the case of the US. Exclusion of energy cost and food from headline inflation indicator is justified because they are mostly supply-based and dictated by global factors.

This perhaps is the reason why the US applies the exclusion principle. A similar policy would be justified for India also. The inflation fighter’s belief in his therapy is all powerful. If the economy is stalled as a result, he cannot help it.

More Stories on : RBI & Other Central Banks | Economy | S Venkitaramanan

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