The Hindu Business Line : Inflation target is only a `self-imposed, informal mandate'

It is not like we are aiming for the moon, it is something we have achieved on an average in the last four years. Now, what I am trying to do is remind ourselves not to be content with 5 per cent this year. — DR Y. V. REDDY, RBI GOVERNOR

Inflation has been ruling at around 6 per cent the past few weeks. The Reserve Bank of India, in its latest Annual Policy Statement, has revised its inflation target from 5-5.5 per cent to 5 per cent for the current fiscal and 4-4.5 per cent for the medium term. Shortly after announcing the Annual Policy, the RBI Governor, Dr Y. V. Reddy, spoke to Business Line on the rationale of RBI's revised inflation targets and the policy on the exchange rate and External Commercial Borrowings.

Excepts from the interview:

In the last two policy reviews you indicated that the economy is overheating and that the measures taken were intended to contain inflation. This time you have left all the key rates unchanged and focused more on measures to manage capital inflows. Do you see any signs of cooling of the economy?

About three years back itself, there was a hint that we had to withdraw the monetary policy accommodation. This was partly because of the global developments and partly to address the issue of oil price shocks as they emerged. As we moved along to 2006, there was an additional factor, which came in with the type of money and credit growth that was happening combined with consumer and investment demand. Demand was accelerating but supply invariably responded with a lag. So, this is an additional dimension to macro-economic developments warranting the attention of the monetary policy.

We had to show that supply side management is very important to ensure supply elasticities to meet that accelerating demand. And the time lag between supply response and demand emergence should be minimised. And demand also has to be managed so that prices do not go up to such an extent that they add to inflation expectations and complicate the growth process and make the global integration more difficult. This can also have an impact on the sentiment of the financial market. That is the background in which we flagged this problem. Then we sensitised all the policymakers to this issue. The RBI quickly moved and took the necessary measures to demonstrate the determination to manage the demand appropriately rather than allow it go out of control.

I think these actions should be viewed with reference to the actions initiated. So that is why we say cumulatively the lagged effect of all the monetary policy measures should now be seen and we believe they have started operating.

We have to observe, as we go along, how the effect of our measures will be on the demand side, the supply management and on the liquidity conditions emanating out of the capital flows. Because capital flows are not within the RBI's jurisdiction, nor are the supply factors. These are exogenous and so we have to observe how they will move.

Don't you think the 5 per cent inflation target for this year and the 4-4.5 per cent for the medium term is too ambitious given that inflation has been ruling at much higher levels?

In many countries there is an inflation target but we don't have one. But the RBI feels it is better that public opinion and policy should have some idea of what is the range of inflation, which is appropriate. That is why we have called it a self-imposed, informal mandate of inflation ceiling of 5 per cent. It is an objective. Actually the average of headline inflation of the last five years was close to 5 per cent. It is not like we are aiming for the moon, it is something we achieved on an average in the last four years.

Now, what I am trying to do is remind ourselves that don't be content with 5 per cent this year. In the next stage we are trying to prepare public opinion and the policy sensitivities as well as the RBI's own functioning to a range of 4-4.5 per cent which we believe is achievable in the medium term and which will be consistent with the societal preference as well as the global inflation scenario.

Do you think without addressing the supply-side constraints, you will be able to achieve the 5 per cent inflation target?

The whole issue is that you have to handle the supply side. And if the supply side is handled better, the burden on the monetary policy would be less.

Personally, are you in favour of the policy of inflation targeting?

It is not very well established whether formal inflation targeting is necessarily good or not. Actually targeting was particularly advocated in emerging countries, which had hyper-inflation. In our country, because of democracy, it was always moderate so there is no compulsion to look at inflation targeting. In our view, public opinion and democracy are ensuring that inflation does not go out of control.

The rupee had been moving both ways but of late it has been appreciating to an extent that exporters are crying. Are you comfortable with the situation?

Two things: As far as our policy is concerned, we don't have an exchange rate band. It is basically market determined but we would certainly like to avoid excess volatility. But having stated that, if you see what has happened in the last four years, the exchange rate has moved both ways, and the movement has been more than before, month after month. Now, again, it is heartening to know that for the last four years, until the last few weeks, the exchange rate was not an issue. The exchange rate was moving both ways, exporters and importers were comfortable. So, to that extent, I would reinforce that the RBI's exchange rate policy has served its purpose well. And therefore there is no particular reason to revisit that policy.

The concern of exporters is something about which policy-makers cannot be insensitive. But when you analyse, you don't look at exporters' interest as such or importers' interest, but you have to be objective. And objectively, if you analyse it, the phenomena is fairly complex. One is, what is the role of exchange rate in the context of inflation? One way of looking at it is that if the exchange rate appreciates then the prices will come down because the prices of imported goods will be cheaper. There is another way of looking at it. If there is inflation, there is excess demand. And if you (rupee) appreciate, then the price of imports will be cheaper. That may add to demand pressures. It is not possible to conclude that that is the way of handling inflation. The second issue is that the exchange rate transmission through inflation is not automatic or short term. Because there are many long-term contracts — inter-corporate issues, the services contracts, the quality of goods... So, it is not that it is that elastic as prices change. So the transmission mechanism is questionable in the short run. But definitely it will have an impact on the demand-supply balance over a period.

The third situation is the relationship among trade deficit, exchange rate, output and employment. Now take China, which has a trade surplus. People will advocate that you allow it (the Chinese currency) to appreciate. But they are resisting on the ground that for them output and employment are important. But then some East Asian countries can argue that `if China is resisting appreciation, our domestic industry is competing with China, therefore we should also resist appreciation. If we don't resist appreciation, our domestic industry will lose out'. Then, if you have financial flows, how will you handle them? So these are the complex issues. There are no readymade answers.

External Commercial Borrowings constitute a major portion of forex inflows. Concern has been expressed on the arbitrage opportunity provided by this route. What is the RBI view?

The overall ECB policy is part of the public policy. We basically administer, and to some extent we also have some say in the matter. Essentially there are interest differentials depending on the exchange rate expectations. You can take a position, but you can also hedge. But in a given situation, you are right, ECBs will appear more attractive, and this is one of the factors that has to be taken into account in capital account management. But the ECB is only one part of the larger movement of capital. And, second, purely in terms of "arbitrage", there are many ways in which it can happen.

The major thing that we are trying to ensure is that there is better link between the ECB and the real sector. That is why we say only to the corporate sector. If it is a real user, then it is not pure arbitrage. Basically the difference between what I may call arbitrage and real use, in a crude way, is that if you have an underlying exposure and borrow, then it is not pure arbitrage. That is exactly why we have been very cautious in restricting the ECB to the real sector and not to the financial sector

The latest policy mentions differentiated bank licences. What is this concept? Does this mean that there would be a new licensing policy for foreign banks?

It goes back to a few years ago. We were finalising priority sector guidelines and we wanted to take into account a lot of off-balance-sheet items. Some foreign banks said `we have got only a few branches, we are doing a lot of other activities, foreign exchange or bond markets, and this priority sector is complicating matters'.

We also found that a few years ago IDBI wanted a limited banking licence only to do the forex business. Also, Exim Bank. So we found that some domestic entities wanted to do one part of the banking business and not the others. So also some foreign banks. When we checked up, there exists what are called limited banks licences

Because these requests are there and now with the diversified, and more advanced financial sector, we decided that we will have to examine these requests on the basis of a careful study. We thought we would do a study so that we are in a position to give different categories of licences. Is financial exposure to real-estate still a concern?

As you know, we are trying to moderate the exposure of the banking sector to real estate by asking them to have higher risk weightage, so that the banks moderate their exposure.

We are not saying do not do it. But over a period now we find that the growth in the exposure to real-estate has moderated. So all we are trying to say is if some people have their own money, they want to go and buy it is fine. But at the moment looking at the experience of Japan or Mexico, if the real-estate prices go up, if the credit goes up too fast and the equities market too, if all the three are growing too rapidly, and in a short period, that has very often resulted in some sort of a crisis. And also it impacts the banking system. We wanted to make sure that in our banking system, which is very important for our economy, such impact is moderated. And from evidence that we have, there is some beginning of deceleration or [at least] reduction in the acceleration of exposure to real-estate.

What policy changes would be required to turn Mumbai into an international financial centre? The High Powered Expert Committee has suggested fuller capital account convertibility in 18-24 months. Do you see this happening?

We have a very comprehensive report. And it covers quite a broad spectrum, from high schools on the one hand to high finance on the other. From urban development to international acquisitions... And the number of institutions involved in bringing this about are huge. The legal changes that are required are huge. There are so many agencies.

But what I thought we should do, as the RBI, since it is a finance centre proposal is that a group should look into the suggestions that are relevant if this legal structure is given, because we cannot assume the legal structure changes. If this institutional structure is given, if this government policy is given, are there are suggestions that the committee has made that the RBI should and can do.

What about capital account convertibility in 18 to 24 months as suggested by the report?

Capital account convertibility is a national policy issue. The financial centre is one element of it. But what drives CAC has to be the national policy considerations. Our approach to capital account liberalisation again has been well tested.

Many banks have still not complied with the RBI's directives on introducing passbooks, accepting cheques for credit-card payments at the counter, and such other issues. What is the RBI doing about this?

Very valid point. To be frank some banks felt that it is too much of a hassle and that they are not prepared, etc. But we tried to tell them that what we are saying is that if a customer wants it, it is your duty to give it to the customer. And especially for the older generation, many people would like to have the comfort. Naturally it requires some investment in machinery and processes. There was some resistance. We had a series of discussions, and we have been informed that in public sector banks, which cover most of the deposit base (about 75 per cent), this system is in place. It is the private sector banks and in particular some of the new private sector banks whic developed their computer systems and work processes without this requirement. These banks are now reworking these processes. They have assured us that they will re-engineer their work processes for this facility. We are encouraging them to do that.

We don't want to micro manage, but we believe it is a desirable and a necessary service that has to be rendered by the bank. And after all the RBI has given a licence and these are some of the things that banks are expected to do.

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