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Dr Jalan's policy stance

S. Venkitaramanan

THE RBI Governor, Dr Bimal Jalan, hit the spotlight by announcing changes in the bank rate and in the CRR ahead of schedule. One would normally have expected the Governor's slack season policy to indicate these important changes. He was perhaps persuaded to do this earlier because he wanted to set the stage for Mr Yashwant Sinha's expected actions on rates of interest on small savings.

Did Dr Jalan do what he did because the US Fed reduced its rates of interest? I think not. While it is true that India forms part of a global economy, and the reduction of rates of interest in US influences capital flows into India, this does not seem to have been the main influence on Dr Jalan. As enlightened commentators have pointed out, the compulsions behind Mr Alan Greenspan's reduction of Fed Fund rates and Dr Jalan's reduction of bank rates are different.

For one thing, the US economy has considerable slack and its productivity is at an all-time high. Mr Greenspan's actions have an eye mainly on the reactions of the stock market, which governs the growth prospects of the US economy. Further, the US Govern ment has a trillion-dollar fiscal surplus, with which it is exploring ways of spending. The argument that leads Mr Greenspan to take a decision on interest rates cannot influence Dr Jalan, faced as he is by the reality of a very high fiscal deficit. Dr J alan does not also have the same degree of freedom as Mr Greenspan.

It must be admitted, however, that the interest burden on the Government is an important factor in persuading Dr Jalan to nudge interest rates down. But it does not follow that reduction of bank rate will ipso facto translate into reduction of rates on g ilts. If the Government demands more resources than the banking system has, the rate of interest charged on Government borrowing cannot be the RBI's actions alone. All this is, however, not to deny that there is a clear relationship between bank rates, t he feedback between deposit rates and the rates banks expect on their contribution to government loans. The spread taken by the banks on the deposit rates is critical in determining the final outcome.

There is a problem here. An issue is the pressure on bank bottomlines as a result of the Governor's action, if banks are unable to reduce their deposit rates. Further, if banks reduce the rates of interest offered on deposits, the flow of funds into the banking system may itself decrease, especially in view of the competition from mutual funds. The Governor will have to keep this in mind in his follow-up decisions. This might well mean that the Governor will not be able to do a repeat performance.

The Governor's recent actions are not, in my view, a knee-jerk reaction to the Fed Reserve's decrease in interest rates. They are a reflection of the economic reality of India, which demands a lower interest burden on financial intermediation, both from the point of view of business as well as the Government. How this is to be reconciled in practice with the incentive needed for higher savings in the economy is a complex task, which the FM himself is expected to tackle in the Budget.

Interest rates have an impact on exchange rate management. Every time the rupee's exchange rate has come under pressure, the RBI has resorted to changes in interest rates and CRR. In this context, it is worth looking at Dr Jalan's recent lucid exposition on the RBI's stance on exchange rate policy.

In a talk delivered on the occasion of the 21st Century Asian Forex Congress, Dr Jalan has delineated clearly his views in the context of what he calls the central banking perspective on the development and management of the forex market. He cites, with approval, the so-called impossible trinity capital account convertibility, monetary independence and a stable currency.

According to this view, if capital account convertibility is accepted, you either have the choice of giving up monetary independence and setting up a Currency Board or give up the stable currency objective and let the exchange rate float freely. Dr Jalan obviously is not in favour of the Currency Board route. His policy stance is, thus, in favour of a float of the rupee.

India has, indeed, managed a floating currency over the last decade. But it has set no fixed rates target. To quote the Governor: ``Our markets are relatively thin and the declared policy of the RBI is to meet temporary demand-supply imbalances that aris e from time to time. For example, in the current period, because of extraordinary rise in oil prices, the RBI has been meeting the oil import requirements of Indian Oil Corporation directly as well as through debt service requirements. Our objective is t o keep market movements orderly and ensure that there is no liquidity problem or rumour of panic-induced volatility.'' The conclusion is inescapable that Dr Jalan is not in favour of full capital account convertibility in the immediate future.

A question often raised in regard to exchange rate management is whether it is desirable to allow the exchange rate to fluctuate freely according to capital flows to appreciate when they are strong and to depreciate when weak. The Governor conced es that this option is not always available to central banks because of market forces being biased in favour of long positions in foreign currencies when the indigenous currency depreciates. Dr Jalan is apparently in favour of intervent ion when necessary.

The Governor also discusses a pertinent question as to what level of foreign exchange reserves is adequate for a country. He points out that, theoretically, in a free-float regime, it can be argued that there is no need for any reserve. But, in the light of the volatility induced by capital flows, there is now a growing consensus that emerging market countries must maintain adequate reserves.

Dr Jalan quotes his approval of the `Guiadotti rule', which argues that forex reserves should be adequate to cover a year's import and capital flow requirements. This seems to be the policy now in force in the RBI. As a consequence, the RBI has added $10 billion to its reserves over the last couple of years. The Governor points out how he has recently taken action to further augment reserves to meet the cost of high oil prices.

The RBI Bulletin also reproduces another erudite and wide-ranging talk by Dr Jalan on economic policy in general. The talk is tantalisingly titled ``A new beginning or a false dawn''. Dr Jalan is in favour of a new generation of market-oriented reforms. He notes the changes in thinking in favour of market-oriented reforms in academic circles, both in India and abroad.

The Governor's statement backs the view that the global services revolution has been good for India. This is in contrast to the earlier academic view that the growth of services in relation to manufacturing is not per se good for development. An importan t aspect of the latest services revolution to which the Governor draws special attention is that the geography and levels of industrialisation are no longer the primary determinants of the location of facilities for production of services.

This is obvious from the fact that the death of distance has contributed to India being able to competitively provide services to developed countries. The integration of the world economy incidental to the new services revolution, however, implies that n ational economies have to maintain high standards of macro-economic management, disclosure, transparency and financial accountability, if they are to protect their economies from the spread effects.

What is particularly striking about Dr Jalan's comprehensive view of India's policy alternatives is the stress he lays on the importance of governance. The Governor reiterates the point of view that State qua State has not lost its importance, in spite o f the market becoming predominant. The Government has still to play an important and crucial role, particularly in areas of education, health and water supply. Law and order is, above all, a prime prerequisite,

The Governor draws special attention to a core issue with multiple dimensions, which needs to be resolved in the years to come, on the importance of governance in Government. He calls attention to the fact that the authority of Governments at both Centre and the States to enforce their decisions has been eroded over time. Governments can pass orders, but implementation is delayed, partly due to the intervention of Courts, if they run counter to the private interests of some, but at the expense of the ge neral public interest. This is a perverse consequence of the rule of law and our legal system.

While the judiciary has been rightly accorded an important place in our scheme of things, it has been misused. Public interest litigation has become the last resort of many overall interests, who use the Courts to stop progress. In this context, the Gove rnor has emphasised the importance of institutional reforms to narrow the scope of such litigation.

The current heavy load of public interest litigation on the judiciary means it is not able to devote sufficient time and attention to the wealth of cases brought before it. This cries out for institutional reform, which is important, if governance is to become effective, unimpeded by the pressures of judicial intervention. This reform is crucial for the success of the next phase of reform, with which the Governor is in full agreement.