Mumbai: Former Reserve Bank of India (RBI) governor Y.V.Reddy, who many believe saved the Indian financial system from the fallout of global financial crisis, says the monetary policy transmission will take time and one has to be careful whether any further tightening is required at this stage. RBI has raised its policy rates 10 times to 7.5% since March 2010 to tame a persistently high inflation.
In an interview, Reddy said “The interest rate already has increased and, therefore, we have to see how much more monetary action is required or is it required at all. I will put this as a question mark.”
“On the fiscal side, there is a problem of credibility—whether the fiscal consolidation is likely to be as per the expectations or assurances. The credibility of the fiscal numbers that has come up in the budget is a big issue,” he said. Edited excerpts:
You stepped down in the first week of September 2008, just a week before the collapse of Lehman Brothers Holdings Inc. Almost three years have passed since then. Has the world addressed the root causes of the crisis?
There is no full agreement on what have been the root causes of the crisis. That’s the first problem.
Everybody agrees that there are two basic elements—one is the macro economic imbalances and the second is the financial sector regulations.
As far as macro economic imbalances are concerned, the major forum where these things are discussed is the G-20. There is some sort of an agreement on possible indicators but nothing beyond that. One is not sure whether there is a reasonable agreement that something will be done.
When it comes to financial sector regulations, there is some movement—particularly in the US, the UK, and to some extent in Europe, which have been the epicentres. After the initial framework, there is considerable discussion and fear that the regulatory regime is likely to be significantly diluted.
The US and the UK are trying to have soft regulation because the financial industry is threatening that they will run away to some other sector. So, the same problem is coming up again.
Finally, the dominance of the financial sector in the political process is all too evident and the real progress in terms of financial sector regulation is not significant. Even when the financial markets are doing well, the recovery in the real economy is uneven, fragile and uncertain. At least for the next two to three years, there will be considerable uncertainties in the macro economic outlook and significant volatility in the financial markets.
Are you seeing euro zone disintegrating?
The euro zone is not going to disintegrate. There is political commitment at the highest level and they are determined to save the euro zone. Within that framework, there is a lot of bargaining going on. The major issue is how to distribute the burden between the banks which indulge in irresponsible lending and the countries which indulged in irresponsible borrowing and large financial intermediates who helped these countries to cover up their sins by a fat fee. This has to be resolved.
That’s a huge political process because the countries in which the banks are located are different from the countries where the debt is high. So, it’s a question of bargaining and postponing the way in which this can be resolved. It can be harsh but it doesn’t lead to a break-up.
We have seen 10 rate hikes in the past 16 months and yet inflation continues to be very high.
We are not giving sufficient attention in our debates on what is the potential output growth of the country. In other words, what is the rate of growth of the economy, consistent with its inherent strengths. This is determined by the real factor, productivity growth and savings-investment ratios.
Perhaps the analysts and the policy makers overestimated the potential for growth. There is a view that growth could have been higher than it could inherently be. I would revisit that fundamentally. Secondly, there are some supply bottlenecks and, more importantly, is the fiscal situation.
The situation is complex and it is difficult for the monetary policy to bear the burden or deliver the goods. Overall, more should be done to manage the expectations.
More rate hikes?
More analysis and communication. Now the expectation is that the inflation is entrenched.... First, analyse the real economy. Second, be sure what the reality is and then relate expectation to reality. That way, you are credible in creating expectation.
What else can RBI do?
There are short-term actions and not-so-short-term actions. In terms of short-term action, RBI has acted pretty well. The monetary policy transmission will take time and hence one has to be careful whether any further tightening is required at this stage. That will depend on the assessment of the transmission that has happened so far. But definitely some more transmission has to take place.
The interest rate already has increased and, therefore, we have to see how much more monetary action is required or is it required at all. I will put this as a question mark. On the fiscal side, there is a problem of credibility—whether the fiscal consolidation is likely to be as per the expectations or assurances. The credibility of the fiscal numbers that has come up in the budget is a big issue.
Would you recommend inflation targeting as a mandate for RBI?
When there is a fiscal dominance, what will just inflation targeting do? Post-crisis, the supporters for inflation targeting are becoming less. The wisdom is not in favour of inflation targeting and the Indian conditions haven’t been changed.
The first decade of the century was a decade of high growth and low inflation. Do you see a reversal of theme in the second decade?
The first issue comes from our thinking that 9% is the normal growth. If you recall, when it hit 9%, I used the word ‘overheating’. Everybody was unhappy with it and I stopped using the word. But I took whatever action was required.
So one has to be clear.
You hiked rates aggressively.
I didn’t have the pleasure of reducing it at all in five years. If you say that we were 9% and we came down to 8.2-8.5% and, therefore, growth is decelerating, it may be a wrong way of looking at it. The right way of looking at it may be that we should be growing only at 8.5% and since we allowed us to grow at 9% we are suffering from inflation now.
We have to recognize what is the potential output on the growth side. On the inflation side, we must recognize the fact that the global situation has changed. Though there is an immediate deflationary trend, many emerging market economies are facing inflation. Secondly, over the longer term also I think the level of inflation that is likely to be prevalent globally may be slightly more than it was in the past. So don’t think that there is such a deceleration in growth; may be we are closer to normal than before. As far as inflation is concerned, perhaps we are higher than what it should be but what is normal may not be what it was before.
In the medium term, where do you see growth and inflation?
I recall at that time I said 5%. Every year we tried to contain inflation within 5%. In a way, it operated as informal inflation targeting and all expectations were built around that. As an academic if I have to build inflation expectation, I would expect global inflation be up between 100 and 200 basis points more and, therefore, it makes sense now to say that 5-6% is realistic for medium term in India.
And 7.5% growth?
No. The growth definitely is 8%-plus and it is not 10%.
It seems there will be credit crunch. Do you see a replay of what happened in mid ’90s?
Both these are very different worlds altogether. We are now a lot more open, resilient, dynamic economy. I don’t see any credit crunch.
What is the biggest challenge before the Indian banking system?
The real challenge for the banking industry is to ensure that the real economy grows in a stable manner. Its own balance sheet is fairly strong. Yes, there are some NPAs (non-performing assets) but there is enough capital. One of the greatest trends of Indian banking system is that it is a diversified system while other countries believe in one model.
We have public sector banks with its own culture, concentration in retail deposits. Foreign and private banks are different. The diversity itself lends certain amount of stability to the system.
It will be difficult to say in India that the financial sector is holding back growth. The growth is not giving opportunities for financial sector to serve it. Most of the household savings go to finance fiscal deficit. What are we playing around? In the final analysis, household savings have to finance the fiscal deficit and the private sector demand. To expect that you have to fix financial sector and banking sector to enable growth is not right—you need to fix something else which is difficult.
So, you are not worried about the health of the banking system.
No. I agree that there has been some restructuring of loans, particularly some banks are still over-exposed to realty and infrastructure projects. This can create problem but overall their capital base is high, leverage is low and the off-balance sheet exposures are not that great. I would not worry about the vulnerability of the banking system. Of course, the credit quality of the banking system should improve and it will happen with the improvement in the real economy.
What is the challenge before the regulator?
Attention of banking system is diverted from its core function of providing working capital to agriculture, SMEs (small and medium enterprises) and the total economic activity. Everybody encourages banks to do everything other than the core function. There is a hollowing of banking in India. Everybody wants you to give loans to infrastructure or contribute to some bonds which will in turn finance infrastructure or develop debt markets.
So, from lazy banking to hollow banking?
In fact, lazy banking was about to become crazy banking and we contained that. Now, I have a fear that it is becoming hollow banking and that’s not good for the economy.
Are you also seeing that the regulators are compromising on their autonomy?
I think one has to be careful in coming to the conclusions but let me generalize one. There is an issue of operational autonomy. In actual operation, the regulators should be permitted to exercise their autonomy. If it is not done, it is not very good for the system. As far as structural changes or significant policy changes are concerned, I think coordination is better than simple assertion of independence. Coordination does not mean subordination. Coordination should be consultation so that the actions are not contradictory to each other. It depends on the context. Simply because RBI is consulting government on a matter, it doesn’t mean that it is losing its autonomy. But there is a structural problem with regard to the other regulators. One has to examine whether the other regulators are really independent structurally because they have ministry of finance representatives on the board.
Are you referring to Sebi and Irda?
Yes. They have government representatives on the board. How do you ensure independence as one representative from the government is enough to influence the decision? There is lot of discomfort (in the government) about RBI because such facilities are not available in RBI. The finance secretary is on the RBI board and he can only discuss but cannot vote. He is more or less like an adviser. So, the government’s say in the decision making in RBI is limited. The level of independence for the regulators other than RBI is different from the level of independence the RBI has.
This is an edited transcript of an interview that was first telecast on Bloomberg UTV on Thursday.