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Carrying the imprimatur of the Central Board of Directors, the Annual Report of the Reserve Bank of India (RBI) is perhaps its most authentic statement on the state of the economy and the possible solutions to the various problems faced in almost every sector.
Two outstanding features, as in the past, are the high standard of analysis backing the diagnosis of what ails the economy, and transparency in not mincing words in advising the Government. It would need another report to offer critical comments on the wide canvas of the issues covered in the document. Hence, only a few observations are made here.
About transparency, let me quote the clear-cut statement in para VII.1 (page 119) : “The Reserve Bank conducted the market borrowing programme with the objective of minimising the cost of borrowing for the government while pursuing debt maturity profiles that posed a low rollover risk” (emphasis added).
It is now official that the debt buybacks under the so-called Open Market Operations (OMO) are really Debt Management Operations (DMO), as contended in my earlier columns.
OMO has a monetary objective, DMO a fiscal one. There should be no more prevarication on the part of the authorities in this matter. The RBI need not feel apologetic even though it violates the non-justiciable Fiscal Responsibility and Budget Management Act in spirit. After all, as a banker to government, it is its duty to get the best terms for its client in borrowing. The basic question is, whether there will be a change in the situation once the so-called independent public debt agency is set up.
Demand for Money
The econometric exercise included in the report on page 46 (Box.II.9) is of interest due to my past work in this area in the RBI. The central bank needs to know the factors that determine the demand for money in the economy so that it can estimate the money supply required that will accommodate it in order to preserve equilibrium in the market.
Money demand is defined as the average M(3) for the year and is influenced by real income (nominal income minus inflation ) in terms of GDP at constant market prices and the price level as captured by the Wholesale Price Index (WPI).
Every percentage increase in the WPI results in a rise in demand for money by almost one per cent. It means the absence of ‘money illusion’ (MI).
Since the time of Keynes, macro-economic literature has dealt with MI or its absence among the public as one of the determinants for policy making in such areas as wages.
MI implies people are concerned more with their nominal incomes, i.e., what they receive as pay packets or wages, than real incomes that indicate the purchasing power of money.
To give a simple example, MI prevails if all incomes increase by 100 per cent but the general price level also goes up by the same percentage and people still think they are better off than before, even though in terms of the purchasing power of money it is not true.
According to Leontief, Keynes assumes that workers suffer from MI. They do not understand the effect of prices on real wages. So they willingly supply labour when real wages fall because of a rise in prices.
In the context of the organised sector in India, workers are well aware of the importance of real wages as evident from contracts relating dearness allowance to price changes.
In the agricultural sector too, farmers agitate for a rise in minimum support prices for their crops whenever the costs of inputs increase. It is clear on the basis of the results that there is no MI in India.
The income elasticity of demand for money (IEDM) is estimated to be 1.3. It means that for every percentage increase in real GDP, the demand for money rises by 1.3 per cent. In estimating the growth in money supply required vis-a-vis demand in recent years to preserve equilibrium in markets, the RBI has been utilising IEDM as an input in recent times at a level above 1.3, resulting in excess money supply.
It also accommodates inflation further by adding 4 to 5 per cent to the estimated amount. As a result, we have seen a fantastic price rise over the years. RBI researchers should carry forward the work, taking into account the recent studies on the subject in professional journals.
Foreign Direct Investment
There is an assumption that foreign direct investment (FDI) comes without a cost and is a better route than borrowing from abroad from the point of view of servicing.
We need to keep in mind that there could be pressures on the current account due to FDI, on account of dividends.
The trends in this variable are clear. In 2002-03 the credit, debit and net figures for investment income in the balance of payments were $3.4 billion, $6.8 billion and -$3.4 billion, respectively.
In 2010-11 they were $7.9 billion, $21.8 billion and $13.9 billion, respectively. The annual compound growth rate of net outflows is around 17 per cent.
Offshore banking units (OBUs) were introduced in Special Economic Zones in 2002. As of now, there is no information available on their working. Still, in the context of black money generation, money-laundering, etc, OBUs are systemically important, even if their role in the total situation is not significant.
(The author is a Mumbai-based economic consultant >blfeedback@thehindu.co.in )
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