S. Venkitaramanan

THE first quarter review of monetary policy by the RBI Governor, Dr Y. V. Reddy, released on July 26, had the merit of letting things remain unchanged. The impression, however, is that the RBI's own analysis may have been inclined in favour of a tightening of rates, but the Governor may have been persuaded to stay his hand, keeping in view the need to maintain the growth impulse.

The Governor's statement succinctly summarises the dilemma as follows: "Factors, such as increased global uncertainties, high and volatile international prices of oil, incomplete pass-through of oil prices domestically, upward trajectory of policy rate in the US, overhang of liquidity, high credit growth, sustained industrial growth and possible capacity pressures, enlargement of trade deficit, infrastructural constraints and delayed monsoon could prompt a change in the stance of policy".

He goes on to say: "In favour of continuation of the stance (that is to say, no change in rates, etc.), it could be argued that the oil price has been managed well with a combination of fiscal and monetary measures, overhang of liquidity has reduced with increase in the absorptive capacity of economy, excess liquidity remains sterilised, money supply growth is within the projected trajectory, credit flow is getting broad-based, industrial growth has revived after a long period of stagnation, pick-up in investment demand is evident, investment climate remains favourable, inflation remains moderate, both at the wholesale and the retail levels globally, monetary policy continues to be somewhat accommodative and global inflation during 2005 is projected to be moderate."

The Governor has stated his dilemma elegantly. But the argument in favour of doing nothing is not too strongly defined. Surely, inflation hawks must have been pressing Dr Reddy to do something. Indeed, the current stock market boom and the fear of irrational expectations driving asset prices may lead the Governor to slam the brakes on sooner than later. It is his privilege to surprise, but we should be prepared, nonetheless.

The Governor's statement cites the CSO's latest estimates for the fourth quarter of last year as indicative of a reaffirmation of real GDP growth for the full year at 6.9 per cent. This is good news, also reinforced by the latest report on the first quarter of this year.

The Governor's report derives support from the progress of the monsoon so far and from the real activity in agriculture and allied sectors. The report has a robust story to tell regarding the growth of credit, especially the private business. The rate of growth of credit during the last year has been substantially higher than previous years, and the same trend continues this year.

The various measures of the Business Confidence Index, cited by the Governor, go to confirm that the economy is doing really well and deserves to be nurtured. The problem, of course, continues to be that while the real sector is doing well, the fiscal situation is still bad.

While the Governor's statement does not analyse the causes for this problem, it is obvious that a great deal has to be attributed to the failure to take decisions on cutting subsidies, such as those on petroleum prices. While there is need to control inflation by keeping taxes low on petroleum products, it cannot be at the expense of the oil producing sector whose bottom-line is being badly hurt in the form of lower dividend to the Government.

By and large, the Governor's statement steers clear of any form of hectoring to the Government in regard to fiscal matters. This is appropriately left to the political masters to decide, while the Governor has deemed it fit to concentrate on the monetary side of the equation.

The latest monetary policy statement is significant, not only for its indications on domestic policy stance, but also for its disclosures on various other developments, in particular external environment. The statement has brought out clearly that we are getting into a current account deficit, after a gap of three years.

The current account deficit in 2004-05 has been of the order of $6.4 billion. A trade deficit of $38 billion, bridged partly by invisibles of the magnitude of $31.6 billion, makes up the current account deficit. That is, we are running up larger import bills than can be managed by our exports of goods. It is our so-called invisibles — the remittances and other service exports — that are helping to bridge the gap in the trade account.

The overall balance of payments is in surplus, thanks to capital receipts both in the form of FII inflows and FDI inflows. As a result, the reserves did increase in the last year by $26 billion. The data on BoP is not being given to scare the public, but the facts are important that we are living beyond our means. We are sustained essentially by capital inflows, which means we are increasing our forex liabilities in exchange for being able to import more goods, mostly for consumption.

As the Governor's statement points out, import payments increased by 48 per cent during 2004-05. Non-oil import payment growth, led by import of capital goods and industrial inputs, was even higher, at 49.5 per cent. Suffice it to say that the trade deficit reached a historical peak of $38.1 billion during 2004-05 — 5.5 per cent of GDP, up from an average of a little below 3 per cent of GDP during 1990-2004.

It is easy to dismiss concerns over the increasing trade gap as "mercantilist" — in terms of keeping Indian imports low. Indeed, there is even an argument that high current account surpluses simply imply a transfer of our savings to richer countries and, from that point of view, current account deficits are a more healthy sign of growth.

I would not quarrel with this argument so long as current account deficits are incurred mainly for purposes of increasing the productive capacity of the nation. But, to the extent that the current account deficit is accounted for by increased imports of petroleum and other such fuels, which are not exclusively utilised for increasing productive capacity, there is reason for concern.

The need for a national policy focus on energy conservation is all the more urgent, considering the fragile state of our energy security programme.

While we rightly plan for greater access to global energy sources, such as oil and gas, we have simultaneously to impress on industry and the general consuming public the need to have greater efficiency in energy use. This would mean a clearly defined national policy that encourages increased efficiency in energy use by industry, apart from generally increasing energy use efficiency in automotive and other sectors.

The Governor's statement makes it clear that we are comfortably situated so far as the external environment is concerned. He has produced detailed data to show how our high exchange reserves are a robust safeguard against any instability on the external front. The Table shows how we stand in terms of the indicators of reserve adequacy, in relation to other countries.

All in all, the adequacy question seems to be fairly satisfactorily answered. But the question still remains whether keeping high reserves is the best form of utilisation of the nation's productive capacity. After all, they are investments in the low-yielding securities of advanced countries and not in our development.

The Governor's statement refers briefly to China's revaluation decision. He does not seem to be bothered overmuch as to its implications. He rightly restates the RBI's policy in regard to exchange rate management as defined in earlier policy announcements.

The Governor's statement seems to show an overall feeling of complacency, at least so far as the external sector is concerned. Hopefully, this feeling is justified by the actual turnout of events so far. But the Sheiks of Arabia and OPEC may puncture this feeling of "all is well with Mint Street and the world".

Is our complacency in regard to external position fully justified given the rapidly increasing oil prices and our rising dependence on imports of energy?

It is time our external payments situation is looked at holistically from the point of view of sustainability of our BoP in the face of rising crude prices, even if we tie up our external sources of gas and oil, be they from Iran or Kazakhstan.

Ultimately, we have to pay for these imports in the form of exports. Are we doing enough to keep up the inflow of forex from our exports of goods and services?

The Governor has done his bit to focus his attention, albeit ever so subtly, on the critical issues that face us.

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