Why India should listen to Steve Forbes

Steve Forbes, the editor of Forbes magazine, says in an important message to “ambitious countries” (Brazil, India, Indonesia, South Africa and Turkey): “Clean up your money messes” ( Forbes June 29, 2015). He feels these countries have overlooked a crucial requirement of economic greatness, that is, a stable currency. The irrefutable fact is that economies with sound monetary policies always outpace and outperform countries with chronically unstable money.

Steve Forbes and Elizabeth Ames in their book, Money: How Destruction of the Dollar Threatens the Global Economy — And What We Can Do About It (2014), bemoan the fact that today’s “wrong-headed” monetary policies are setting the stage for a new global economic and social catastrophe.

Forbes asserts that India could learn from Britain which, in the 1600s, at the behest of Sir Isaac Newton, fixed the pound to gold, which then set the stage for Britain to become a globe-girdling empire.

He recognises that this would require a number of stages, such as pegging to a strong currency or a currency board.

While India did not have a 100 per cent currency board system, the Reserve Bank of India (RBI) Act, 1934, provided under Section 33 for an inflexible domestic currency system based on a proportional reserve under which two-fifths of the assets of the RBI’s Issue Department were required to be held in gold or foreign securities.

With the Second Plan on the anvil in the mid-1950s, there was a strong policy preference to use the instrument of deficit financing. The government, in 1955, felt that the provision in the RBI Act would impose “a very sharp limit” to deficit financing. The alternatives considered were first, to reduce the stipulation in the proportional reserve system; second, a fiduciary system; and third, to altogether abrogate the provision in the Act.

The RBI’s towering economist BK Madan rejected the very idea that a restriction on note issue was an “effective safeguard against the misuse of political power”. He went on to argue that a formal restriction would be of little use when the government was “unmindful of its responsibility to the country”. Madan, therefore, advocated a “cut in the Gordian Knot once and for all” by abrogating the clause from the RBI Act.

The RBI, in sending its response to the government, opted for the less radical suggestion of Deputy Governor KG Ambegaokar that there should be an absolute minimum currency reserve of ₹300 or 400 crore.

In the event, the minimum absolute reserve was fixed at ₹200 crore of which the gold portion was ₹115 crore. This opened up the floodgates as, along with this measure, there was an agreement between the RBI and the government that whenever the government balance fell below ₹50 crore, there would be an automatic monetisation via creation of ad hoc treasury bills. It took almost 40 years to rectify automatic monetisation of the budget deficit and in 1994 there was a supplemental agreement to phase out ad hoc treasury bills.

In March 1995, this writer as deputy governor of the RBI, delivered the first CN Vakil Birth Centenary Lecture, in which he advocated that with the progressive integration of the Indian economy into the global economy there would be increased two-way movement of capital flows; this would need to be handled without disruption of the economy. It was suggested that there should be a clause in the RBI Act stipulating a minimum net foreign assets (NFA)-Currency (C) ratio of 40 per cent.

In March 1991, at the time of the foreign exchange crisis, the NFA-C ratio fell to 14 per cent, but in March 1995, the ratio had risen to 67 per cent. The recommendation in the lecture elicited questions in Parliament but the top policymakers were not in favour of reintroducing a stringent mechanistic clause. It was, therefore, left to the writer to prepare a draft reply saying that it was merely a suggestion which would be examined along with a host of other alternatives!

The NFA-C ratio in the middle of June 2015 was 147 per cent. Given that the economy is a lot more integrated with the global economy, the present time is apposite to introduce, through amendment of the RBI Act, a minimum NFA-C ratio of 100 per cent. This would imply that policy action would be mandatory if the ratio veered towards 100 per cent.

In effect, this would ensure against a repetition of the 1990-91 foreign exchange crisis. India would have a modified currency board arrangement which would be aligned with the Steve Forbes recommendation. What could be considered is a combination of the NFA-C stipulation with an exchange rate based on a revamped six-country Real Effective Exchange Rate (REER).

The best intellectual policymakers both in India and in the international community have miserably failed to produce a safe and sound monetary system. We need to be humble enough to accept this fact. To protect India in any future international monetary turbulence, which is bound to take place, India would do well to legislate a 100 per cent minimum NFA-C ratio which would be the safest protection for India.

The RBI should rapidly raise its present gold component of reserves from its present very low level of 5.5 per cent. If India dreams of being effective in the international monetary system, it must raise its gold component of total reserves towards the 100 per cent mark. When India attains such pre-eminence it should thank Steve Forbes for his seminal thoughts.

The writer is a Mumbai-based economist