K. Subramanian

REACTIONS to the Annual Monetary Policy Statement for 2005-06 issued by the Reserve Bank of India (RBI) range from compliments — "right emphasis on growth and liquidity"— to complaints — "more inward looking than warranted".

There are those who praise it for being a "finely balanced act" and for taking care of the credit needs of a buoyant economy. A hard-core monetarist would attack it as being "timid". But those who read the statement in its entirety would observe an elegantly orchestrated policy which is open, transparent and which responsibly takes note of the position India occupies in the global economy.

India is no longer insulated from the winds of change blowing from abroad. As yet, India is not fully open and the financial sector is being opened gradually. Again, under our conditions, it is not practical to segment fiscal and monetary policies; leaving the former to the Government and the latter to the Central Bank as is advocated in developed countries such as the US and the UK.

Notwithstanding the current fashion in monetary theory, there are reasons to doubt whether fiscal policies can operate for long without impinging on monetary policies.

At least in developing countries such as India, there is a direct and close link between the two, especially as the governments (Union or State) have heavy borrowing programmes. By the same token, it sets the modes in which the RBI may evolve its policies in due regard to the Government's economic policies. If, in the global contest, the Government does not have the freedom to pursue autonomous policies, the RBI cannot lay down credit polices in isolation.

Sadly, there is a divergence between the domestic situation and the global developments. As the RBI Governor, Dr Y.V. Reddy, explained at the press conference on April 28: "In India, the domestic factors dominate and they all point to stability. Global factors point to risks in terms of oil prices, interest rate movements and currency imbalances." Though these risks become relevant with global integration, he notes: "Our vulnerability to global risks will also be much lesser than the rest of the world." What he did not elaborate on was that the lower vulnerability of our economy is due to the gradualness in our opening of it.

It is not the "big bang" approach that reform fundamentalists favour. Some of the criticism of the current credit policy is from those who are unhappy that the RBI has not changed the interest rate or allowed freedom to banks to tinker with the Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR).

The Bank has its own reasons. It is aware of the risks to growth attached to such a policy. According to the RBI: "Risks to growth arise from current account and fiscal imbalances and excessive leveraging in some advanced economies which has necessitated current account and exchange rate adjustments. Global expansion has been largely imbalanced with hesitant recovery amid structural rigidities in some advanced economies, leaving the prospects of global growth in near term somewhat uncertain."

The International Monetary Fund (IMF) itself was rather upbeat about the global economy in its Global Financial Stability Report and it was only later, in its World Economic Outlook submitted to the Spring Meetings of the IMF/Bank, that the warning about global prospects was issued.

In its earlier assessments, it had underplayed the impact of oil prices and it is only in recent months that it has issued warnings on the impact of rising oil prices on the global economy.

The RBI takes note of several of the imponderables flowing from abroad. It takes a dim view of global expansion: "Considering that economic expansion may be at a very advanced stage of business cycle in some systemically important matured markets, it may be difficult to sustain the current high levels of corporate earnings." It forebodes that current equity prices, which look good in most markets, could slide if earnings drop. Further, if the required adjustments in current and fiscal gaps of advanced economies do not take place over the next few years, interest rates may have to rise to clear the markets.

The impact on balance sheets could be much larger than is currently anticipated. It is a recall to the policies of the US Fed, which led to financial crises in many Latin American countries such as Mexico, Argentina and Brazil.

Very pragmatically, the RBI relates the monetary policy to several factors including macroeconomic prospects, global developments and the balance of risks. The monetary policy is perceived as a vehicle that would enhance the various segments of the financial market, improve credit delivery, nurture credit culture and enhance the quality of financial services.

Along side, there is need to contain the threat of growing inflation. In the US and the UK, the only role assigned to the central banks is that of containing inflation. In countries such as ours, the RBI's role is diverse and containing inflation is only one if its roles. Inflation, again, is not a demon that it can fight on its own. The economy has to grow and the Government, in its turn, has to contain fiscal pressures within reasonable limits. The approach of the RBI is holistic and this is very different from what is being advocated by traditional monetarists. The philosophy of monetary management was explained by the Governor perspicaciously in a speech that he delivered at the Annual Conference of Andhra Pradesh Economic Association on February 12. "Conduct of monetary policy is complex. It has not only to be forward looking but also grapple with uncertain future," he explained.

There are additional complexities when an emerging country such as India which is in transition from a relatively closed economy to a progressively open one. He details the linkages between exchange rate movements and interest rates and the impact of increasing capital flows across the border. It is the same economic philosophy that informs the credit policy of the RBI.

The disappointment among some critics is that the RBI has left the Bank Rate, the CRR and the SLR requirements unheeded to. It has increased the reverse repo rate by 25 basis points, which may indirectly increase the interest on loan products. It is evident that the main concern of the RBI is to grapple with the excess liquidity in the banking system. The Governor is equally concerned about the large capital inflows adding to liquidity and the limits within which the RBI can mop it up. It was for this reason that he had suggested imposition of ceilings or tax on inflows, which was unfortunately rejected by the Finance Minister. By holding the interest rate, he is trying to reduce the interest differentials that could contain further inflows. Sadly, there are limits to such action. One hopes that soon there would an agreement between the RBI and the Government on the measures to be taken to moderate capital inflows.

(The author, a former Finance Ministry official, has extensive experience in international, financial and trade issues)

© Copyright 2000 - 2009 The Hindu Business Line