The Hindu Business Line : Challenges before the new RBI Governor

The most crucial task before the new RBI Governor, Dr D. Subbarao, is to shield India from global financial and economic turbulence. Dr Reddy’s legacy may be worth continuing at a time of general instability, say C. SHIVKUMAR and A. SRINIVAS.

Dr D. Subbarao, RBI Governor.

Dr D. Subbarao has taken over from Dr Y. V. Reddy as the Reserve Bank of India’s Governor at a time of uncertainty on various counts: a slowdown in the world economy in the wake of the sub-prime crisis, rising tensions in Central Asia on control over oil supplies and a global rethink on monetary policy options in a financially integrated global economy.

Dr Subbarao has said that controlling inflation is his priority. However, the most crucial task before him is to shield India as much as possible from financial and economic turbulence — a particularly difficult task at a time when India is far more integrated with the world economy than in 1997, when the East Asian crisis broke out.

Domestic savings will hold the key to sustaining India’s medium-term growth and insulating it against external shocks. The Report on Currency and Finance strikes a note of caution on further capital account convertibility.

It says: “The banking system in a freer capital account regime would be exposed to enhanced risk in terms of currency risk, counterparty credit risk, transfer risk, legal risk, risk of regulatory arbitrage, risk in derivatives transactions and reputation risk… A freer capital regime would require improvement in the liquidity management and disclosure practices by financial institutions.”

Dr Reddy’s legacy — of managed float and calibrated capital account convertibility — may be worth continuing at a time of general instability. In the light of the experiences over the last decade, it is best to approach financial reforms with caution.

Fallout of US conditions

It appears that the US will make the world pay for its laxity. The bailing out of the Freddie Macs and Fannie Maes will not prevent a long, shallow recession.

According to the International Monetary Fund, world economic growth is expected to decline from 4.9 per cent in 2007 to 3.7 per cent in 2008 and 3.8 per cent in 2009.

India’s exports could be hit as demand from its largest trading partners — the US, the EU and China — falls. Even if oil prices continue to fall gradually, India may still end up a current account deficit much larger than the present level of 1.5 per cent of GDP.

To enable capital flows to bridge the gap at a time of sagging equity markets, India will have to keep its interest rates high to invite debt flows. But that approach is problematic for two reasons: it will increase India’s debt burden and slow down the economy.

Besides, debt flows may still not be forthcoming if foreign institutional investors, whose net outflows (equity and debt) between April 2008 and August end were $155 million, continue to cover their sub-prime losses.

The silver lining is the growth of foreign direct investment, but whether this marks the return of money earlier parked in overseas equity and debt, or fresh inflows into projects is hard to say.

Meanwhile, foreign currency reserve balances of the RBI are below $300 billion. Liquidity expansion in the banking system from foreign exchange flows has decelerated drastically since the beginning of this month.

Evidence of this deceleration comes from the sustained recourse to the repurchase window. (In repurchase operations, banks borrow from the RBI using SLR-eligible securities as collateral.) This implied that the liquidity in the financial markets had contracted. The equity market, propped up by FII flows, crashed. ECB and NRI flows are also yet to pick up.

Uncertain outlook

Therefore, the outlook on the capital account front is uncertain. In view of this, the RBI seems to have decided to focus on the current account deficit by trying to drive down the rupee and promote exports.

Perhaps it feels that the chances of getting a grip on the BoP situation through the current account appear brighter.

However, what is revealing about this move is that RBI seems reconciled to an inflation rate of 5-6 per cent.

This is implicit in the nominal growth assumptions in the Union Budget 2008-09. The reversal of the rupee appreciation policy has largely escaped notice.

The RBI’s August bulletin points out that the real effective exchange rate is currently at 104.39 as against 109.94 (1993-94=100) during the same period last year — a drop of 5 percentage points on a year-on-year basis.

A drop in the REER implies that the rupee has depreciated against its determined trade-weighted basket of currencies.

However, recent trends in the market stabilisation scheme (MSS) are noteworthy. The MSS was introduced in April 2004, at a time when surging foreign inflows had become a headache. F

oreign exchange reserves rose by $35 billion between 2002-03 and 2003-04. The RBI mopped up dollars to keep the rupee rise in check and, in turn, floated long-term MSS bonds to check the growth of reserve money. But MSS operations continue to this day, despite the fact that foreign inflows have dried up (see chart).

MSS bonds are not treated as government borrowings, although the interest payout is treated as revenue expenditure.

Along with oil bonds and fertiliser bonds, it can be counted as another off-budget liability of the Centre. Interest payments on MSS securities, amounted to Rs 8,351.34 crore in 2007-08 — almost 2.3 times the budgeted estimates.

For the next year, the interest servicing on outstanding MSS securities are estimated at Rs 13,958.14 crore — a 67 per cent increase.

The options

At a time when there is no upward pressure on the rupee, one option before the RBI is premature redemption of these bonds to take the pressure off tight liquidity and high interest rates.

The result of this liquidity squeeze is evident in the yields on the Treasury Bills that are faced with an escalation. At the last 91-day Treasury Bill auction, the cut-off yields were 9.06 per cent.

Between April and now, yields on the T-Bills have risen by over 200 basis points. Since the beginning of this year, the benchmark prime lending rate has been hiked to 14 per cent, or an increase of 200 basis points from April this year.

High interest rates will not so much control inflation — more a result of cost-push and endemic supply-side factors — as push industry into slowdown mode.

There is another issue on which the RBI might have to take an early decision — whether India should continue to park its foreign currency assets in US treasuries at a time when the dollar is decidedly weak. In a situation of financial fragility, this may be the right time to boost gold reserves and explore other options.

A policy option before the new RBI Governor to focus on the trade deficit, as the risks underlying imports and exports are easier to foresee.

Exports may not respond to a weaker currency, if world demand takes a beating. On the import front, the movement of oil prices over the next year is anyone’s guess, given the simmering tensions on the world stage.

In the event of an escalation of tension in the Gulf region — a possibility that cannot be ruled out, with Presidential elections round the corner in the US — there could be a disruption in oil supplies and a rise in prices.

Yet, it is possible to prepare for these eventualities and work towards a manageable current account deficit. Capital flows have a habit of proving forecasters wrong.