The Hindu Business Line : The RBI Governor's policy options

THE biannual monetary policy statements of the RBI Governor are eagerly awaited by the general public as windows on policy changes of the central bank. There is, however, a feeling that Governor's policy responses are mostly predictable, given the information on the various economic data.

The RBI has been refreshingly frank about the space it has carved out, within the constraints imposed by the fiscal stress on Governments. The Governor's policy options are obviously constrained. But it is worth the while exploring what he may try to unveil, come end April 2005.

The monetary policy statement has of late been more multidimensional than focusing merely on monetary aggregates. From the mid-1990s, the RBI has shifted to a multiple indicator based policy direction. This was a change from earlier policy stance that had focused principally on various measures of money supply. This reflected a Friedmanite view of the world, in which money supply mattered the most.

The latest view takes a more balanced position. While money matters, other factors also matter. The world is not as simple as visualised by Friedman and his disciples. The new approach includes money supply as also other variables, such as interest rates, rates of returns in different markets, along with data, such as currency credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate — these juxtaposed with output data to draw policy perspectives.

The biannual monetary policy statements of the Governor are looked forward to by the markets mostly for their indication of the RBI's stance on interest rates and cash reserve ratios, besides other directives on lending by banks. The policy statement is, no doubt, the result of a close interaction with Government as it is important to ensure that the RBI does not speak out of turn on major policy issues.

The economic history of India has a number of instances when the Finance Minister had reportedly got upset with the RBI Governor for not taking him into confidence about Credit Policy declarations by him. One of these is the famous spat between the then finance minister, T. T. Krishnamachari, and the then Governor, B. Rama Rau, which finally led to the latter's exit. This shows the potentially delicate state of the relationship between the Governor and the Government.

It is fair to add that Governor Rama Rau was very much within his right to make the policy announcement he made and the Finance Minister had taken a very rigid view of his rights over the central bank Governor's autonomy. Those days are now over. These are days of central bank independence.

I am sure that the RBI would already be in the process of assessing the various trends in the economy together with global trends before it comes up with its policy suggestions, which it discusses with the Finance Ministry. There is a suggestion afloat about setting up a Monetary Policy Committee, which will include outside experts besides Deputy Governors to advise the Governor on his credit and monetary policy stance. There is a precedent for this in Great Britain. Whether such a Committee will be set up by the Governor in his attempt to reform the governance of RBI, remains to be seen.

Turning to the forthcoming policy and its priorities, the Governor must be particularly concerned with the implications of inflation, especially on the top of the crude oil price rise in recent months. While inflation has been manageable within the 5 per cent range, it is still above the threshold, which was acceptable in India before the OPEC-inspired changes in the past few decades.

As of March 19, 2005, the RBI weekly statistical statement reports an inflation of 4.9 per cent year on year. The main elements of the contributory factors were fuel, power and lubricants at 10.4 per cent and iron and steel at 19.2 per cent. The contribution of sugar, khandsari and gur is also significant at 16.3 per cent.

Edible oils, however, show a fall at (-)7.3 per cent. The overall WPI situation is surely disturbing, but not unmanageable, given the forex reserve position and global trends, except for oil, steel and minerals

The impact of global trends has obviously been significant in determining the extent of inflation. The rising demand for steel in the Chinese market has had its impact. The Centre has done its bit to contain the rising price of oil by subsidising the consumer, but the same option would prove to be a fiscally costly one for the Left advocate in respect of steel.

The fact is that inflation is a supply-side phenomenon, which the RBI can do little to control unless it be by reducing demand in the economy by severe compression of credit and introducing higher interest rates. These alternatives are not acceptable.

While the anti-inflation hawks may be urging the bitter medicine, the Governor has many other factors to consider, including the growth imperative and the fiscal consequences of higher policy rates. I doubt whether Governor Reddy will feel inclined to raise interest rates, notwithstanding the Federal Reserve's recent steps in that direction.

That takes me to the next question. How will Governor use his monetary policy statement to signal his options on the external front? He is facing an abundance of riches — an embarrassment, albeit a pleasant one — in the form of huge reserves and continuing FII inflows.

He is right in stressing the risk on our depending too much on volatile sources of forex, like FII, which should yield place to FDI. The Governor is rightly of the view that our ratios of FII to FDI are skewed. They are the reverse of those in vogue in China, which has far more FDI than FII flows.

It is to be admitted that the FIIs do have the potential of inducing volatility, especially in the stock market. It, however, seems premature for India to consider Chilean type restrictions on such flows.

Such actions may send a wrong signal even to the potential FDI investors that India does not welcome foreign investment.

It is true that Governor Reddy had at one stage hazarded a dangerous thought suggesting a Chilean-type taxation of foreign inflows, but this idea was nipped in the bud — and rightly so — by the Finance Minister.

Hopefully, the Governor will not proceed further in this direction, although the problem he highlighted remains. It has to be handled by our innovative economic reformers, without rocking the boat too sharply.

So far as exchange rate policies are concerned, Governor Reddy seems comfortable about letting the rupee appreciate. This has, of course, certain side-benefits from the point of view of keeping import prices cheap in rupee terms and thus managing inflation apart from increasing the attractiveness of buying capital equipment from abroad.

The higher rupee is, of course, a double-edged weapon, with its adverse potential for reducing the competitiveness of our major exports, such as software and textiles, which are in the services sector and employment-intensive.

It will, of course, squeeze the margins of our BPO entrepreneurs, which will ironically be music to US' ears. However, the task of keeping the rupee weak is almost impossible, given the levels of forex inflow and rising exports.

We cannot obviously expect Governor to answer all questions in the monetary policy statement. But, it seems clear that Governor Reddy will not rock the boat with any rise in interest rate or cash reserve ratio.

The monetary policy will, in all likelihood, include an exhortation for banks to persevere with higher credit disbursements, especially to the priority sector.

To be sure, it will let the exchange rate policy stay at its current state of benign neglect — allowing the rupee to find its level in the context of higher inflows.

This might also mean the Governor's tightening access to external commercial borrowings. One of the reasons corporates are trying to access external capital markets is because of the difficulties in getting resources from the Indian banking system, partly because of exposure norms.

The RBI should think of steps that make it easier for corporates to get their resources from India's credit institutions, given the abundant liquidity. Let us not "export" India's capital market to New York and London.

Whether the Governor will have any new initiatives on FDI in banks is doubtful, given the political implications, in the current state of coalition dynamics.

There will be the well-deserved pat on the back for the financial system of India having conformed to the best international standards of disclosure and accounting. This is creditable.

The Governor's thrust to increase the bankers' lending to important sectors may not, however, be meaningful, given our weak bankruptcy laws and fragile state of bankers' rights to recover their dues — in spite of recent reforms.

All in all, India can look forward to Governor's monetary policy statement with the feeling that he will neither shock nor surprise, given the India's robust economic fundamentals today.

But, it is the central bankers' privilege to take the punchbowl away when the party gets going.

Will Governor Reddy keep the party going or take away the punchbowl?

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