The Hindu Business Line : ‘It is all a matter of judgment’

Governments generally prefer to give greater emphasis on growth when inflation is low, hoping that inflation will not rise or that the central banks will take care of it. This is a universal phenomenon.

DR Y. V. REDDY, FORMER RBI GOVERNOR

K. R. Srivats

In these turbulent times, the stewardship of a central bank may be more of an art than a science. This is the impression one gets after an interaction with former RBI Governor, Dr Y.V. Reddy, who was in Delhi to launch his new book India and the Global Financial Crisis: Managing Money and Finance. The book is a compilation of 23 select speeches delivered by Dr Reddy during his tenure as RBI Governor between September 2003 and 2008. It provides insights into the challenges faced in the management of India’s calibrated integration with the global economy. The causes and consequences of the global financial crisis have been dealt with in the Epilogue.

The book also delves into the relationship between the Government and the central bank, the complexities involved in their interface and the need for close coordination to bring about structural and systemic changes in the economy. Hedging, Dr Reddy told Business Line that he would only elaborate on what he had said in the book and not respond to independent questions on monetary policy, state of the economy, etc. “No predictions, no forecasts,” he quipped. All the same, he came out with some gems, especially on how the “degrees of freedom” of a central bank often get constrained if there was a communication from the Government and that communication had a different wavelength from that of the RBI on the same subject.

Excerpts from the interview:

Does your book address the inflation-growth trade-off and the resultant challenges for a central bank?

It is all a question of judgment. Governments generally prefer to give greater emphasis on growth when inflation is low, hoping that inflation will not rise or that the central banks will take care of it. This is a universal phenomenon. A similar thing has happened in India also. When inflation rises, the public authorities react strongly.

In India, there is a fixation about double-digit inflation. The central bank generally looks at underlying inflationary pressures and lagged effects. The public policy authorities look at inflation perceptions and inflation expectations. The central bank also takes into account inflation expectations. But it takes into account inflation expectations and assesses its capacity to convince the people that there are lagged effects to influence expectations. That’s the type of judgments that come in.

If there is a strong communication from the public authorities and a strong communication from the financial markets in one direction, then to some extent the central bank is constrained both in its actions and sometimes in its judgments. It is a fairly complex situation. I have tried to explain to some extent the context in my introduction to the book. When there are communications from the Government, the degrees of freedom available for the central bank get constrained.

What about ‘financial protectionism’ in developed countries in the wake of the global financial crisis?

The book has “very clearly” addressed this topic. The global wisdom on the financial sector is changing and the global rules of the game are likely to change. Financial institutions in advanced economies are now being heavily subsidised. The earlier rules of the game were based on the assumption that there was a level playing field and government should not interfere.

Now you have a situation where it is quite possible that reasonably healthy banks in developed economies will also be taken over. The level-playing field argument has been removed.

This also applies to free trade agreements where there are financial services agreements. All of them were based on the ground that markets were operating normally with a level-playing ground. This may no longer be the case.

Where do you see inflation heading this fiscal?

I will stick my neck out. My own hunch is the WPI and the CPI will converge at about 5 per cent by the end of this fiscal. The CPI will start coming down. The basis for this prediction is the lagged effect of the various price changes, like that of petroleum, that have happened.

This is without reference to the spillover consequences of monetary and fiscal measures. The WPI and the CPI should be looked at together and you should look at them for the next 12-18 months. One should recognise that convergence is possible.

Any comment on inflation expectations?

Given our history, it is very difficult to convince people that in India there is a deflation threat or that inflation is coming down. I agree that there is an exit problem for fiscal and monetary policies.

What about fiscal stimulus vis-À-vis monetary stimulus?

On fiscal stimulus, we should take into account where we are starting. What is the headroom available for fiscal stimulus? If the financial sector has a big problem, then you have to take more risks. If the financial sector is not that much of a problem, you need not take so many risks. You can somehow provide fiscal stimulus.

Fiscal stimulus is slightly different from fiscal actions for bailout. Any fiscal action in a crisis is not fiscal stimulus. When a fiscal stimulus is required, there will be lot of claimants. Which claimants are you pitching up and which package are you pushing? Is the reduction in aggregate demand due to extraneous circumstances?

Suppose there is bubble somewhere and, in the name of fiscal stimulus, you are not allowing the adjustment that is required. It is quite possible that there may be some autonomous thing that has nothing to do with export demand but that the domestic area requires some adjustment.

Even China has come out in the open that when you have a crisis and a fiscal stimulus, your structural reforms get postponed. At the same time, if you take structural actions in the name of fiscal stimulus, you get into problems. This is on the fiscal side.

And the monetary side?

On the monetary side, one of the things you have to consider is inflation. There’s the US, which can afford a huge fiscal deficit. Emerging market economies are always worried about their ratings. They can’t afford very high fiscal deficits. So we have to worry about that also...

Among the emerging market economies that have current account deficits and fiscal deficits, they have to approach the fiscal deficit in a different way.

Similarly, on monetary actions, different countries have different positions with regard to inflation. It is all fairly complex and depends on the judgment made by the public authorities at the time.

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