Mumbai: Y.V. Reddy, former Reserve Bank of India (RBI) governor, and widely seen as the saviour of the Indian financial system from the impact of the global meltdown, strongly feels that the Indian recovery should happen sooner than that in most other countries because of the country’s inherent strengths such as stable rural demand and relatively less dependence on exports. However, he added that the underlying inflationary pressure in India is very high.
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In his opinion, one should take into account the Consumer Price Index (CPI) and not the Wholesale Price Index (WPI) while taking monetary and fiscal measures.
In contrast to WPI, the country’s most widely tracked weekly inflation index, CPI reflects the price of goods at the retail level. For the week ended 25 April, WPI inflation was 0.70%, but CPI for industrial workers continued to be high at 9.63%, for February 2009 (the latest available number).
“Whenever we are thinking of taking a coordinated action, we are talking of countries which are talking of fiscal stimulus and monetary stimulus at a time when there is a very low level of inflationary or deflationary situation… To assess the underlying inflationary pressure, and compare the policy actions taken by other countries, we should recognize that CPI of India is still on the high side,” Reddy told Mint in an interview, ahead of the release of his book, India and the Global Financial Crisis: Managing Money and Finance.
Warning note: Former RBI governor Reddy says the challenge before governments would be to see the implementation of stimulus packages. Abhijit Bhatlekar / Mint
The monetary and fiscal packages announced by RBI and the government, according to him, are “on track”, but the challenge before the authorities is unwinding the packages in due course. “Otherwise, vested interests (will) develop in some stimulus packages” and that will add to the inflationary pressures, he said.
“You pre-commit yourself to a reasonable exit than have an open-ended commitment to do whatever it is to get the recovery. You cannot do recovery at any cost. Your recovery has to be at an appropriate price.”
Since mid-September 2008, after the collapse of Wall Street investment bank Lehman Brothers Holdings Inc. that led to an unprecedented credit crunch, the Indian government has announced three fiscal stimulus packages worth 3% of the country’s Rs54 trillion gross domestic product (GDP). RBI has brought down its policy rate from 9% to 3.25% and released at least Rs3.9 trillion worth of liquidity into the system through various measures.
As a result of all these measures, the combined fiscal deficit of India, including subsidies in oil and fertilizer sectors, will be at least 11% of GDP for fiscal 2009. But Reddy is not unduly worried about the widening fiscal deficit even though it will put pressure on the interest rates, because RBI can manage it. “Fiscal deficit is indeed in bit of a pressure and it could put pressure on the interest rates when the turnaround comes... But it will still be manageable because the Reserve Bank has quite an array of instruments,” he said.
In a no-holds-barred interview, Reddy spoke on a range of subjects, including the fledgling signs of recovery, pressure points in the economy and times when the central bank and finance ministry did not see eye to eye during his five-year stint as governor that ended in September 2008. Edited excerpts:
Your introduction to the speeches that the book carries sets the context and makes it abundantly clear that there were many issues on which the finance ministry and RBI did not see eye to eye. There was tremendous pressure on you. How did you cope with that?
I think we should take a more balanced view. I don’t know whether I didn’t represent the truth in the book, but there are many areas where we have been able to bring about changes. We were able to eliminate virtually all weak banks and put some standards of governance. There are a lot of areas on the developmental side. There has been significant coordinated efforts for strengthening the institutional regulations.
You are right that there are a couple of areas in which there has been difference in the pace—both in regard to external sector liberalization and the financial market liberalization.
On these two, the judgement was that RBI preferred a cautionary approach because of inherent suspicion that there are infirmities in the global module. And, secondly, a conviction that in Indian circumstances, caution is important. These were the two considerations.
This is the origin (of differences). There is no difference except in terms of the judgement about the veracity of any of the model and its appropriateness in India at this stage of institutional and fiscal developments. It has been a continuous dialogue. So, I won’t say it is a pressure as such. You can call it creative tension (laughs) and the outcome is good, I suppose, by and large. So, both can take credit.
North Block vs RBI: creative tension
Could you tell us the issues on which there was maximum “creative tension”?
Basically, a major issue was on the capital account liberalization. But I think we arrived at reasonable balance. (The) second (issue) was the extent of the derivatives and other elements of financial market development. We (RBI) were more on the cautious side in these two areas.
What about participatory notes?
That’s one element. The basic issue was that the RBI, within its jurisdiction, took action to control overseas corporate bodies. It has banned overseas corporate bodies and, therefore, in some senses it is possible to do it and enhance the ‘know your investor’ norm. RBI believed that the same rule should apply to participatory notes also.
And the use of foreign exchange reserves for infrastructure creation? Wasn’t that a huge issue?
I won’t say it was a huge issue. The limited point is as long as it’s part of the forex reserves, its utilization should confirm to the letter and spirit of the law. I think basically the issue was, as I understand, the government wanted to use it, but then it would go to fiscal domain… So, in some ways, the Reserve Bank’s preference was to maintain the integrity of its balance sheet.
Was there any occasion where you felt that the governor’s authority was being eroded?
There is no question of authority. In general, of course, the central bank has to be accountable and in the Indian situation, the way the RBI Act is structured, there is no question of authority. It’s a question of harmonization and coordination at operational points.
I believe there were occasions where you contemplated resigning and even actually offered to do so…
There was no question of offering to resign as such. But, as you know, when you undergo some tensions, you almost contemplate...you almost spill out your contemplation. But there is no question of any offer of resignation.
And I think if you just see that the number of things that we have done together in a close, coordinated fashion, that infinitely outweigh the few differences.
If the central bank always agrees with the government, it is superfluous; and if it disagrees, it is obnoxious.
How ministry forced RBI to hike rates
There were differences on macro issues, too. For instance, the government has all been pushing for high growth and it refused to see the first sign of overheating in certain pockets of the economy. It was impatient with the first sign of rising inflation and at least on one occasion last June it forced RBI to hike rates even though you were not in favour of that. How do you defend the central bank’s credibility in such cases?
I think we must make a distinction between the monetary policy issue and the communications issue. More generally, as far as the monetary policy issue is concerned, it is recognized globally also that the government has a slightly shorter-term perspective and the central banks have a medium-term perspective. And this difference in emphasis persists in all countries.
But what is relevance is the issue of communication. If the government creates some expectations through communications, it necessarily constraints the freedom and the communication capabilities of the Reserve Bank. This is a general observation. In terms of monetary policy, the stance taken was typical of almost all central banks vis-a-vis all governments.
You seemed to have fought the battle with the government single-handedly. Was there any support from any quarter?
First, I should clarify that I have not approached my job with any pre-conceived notion. I don’t have pre-conceived ideologies. I am aware of theories, but I don’t have pre-conceived ideologies. Therefore, whatever policies that have been adopted by RBI, they have been adopted after intensive internal analysis of the global practices, internal understanding of the theory and internal assessment of Indian conditions. It represents the collective wisdom of RBI. It also represents the guidance that we got from the board of directors—a very very eminent board of directors.
I will be very candid to say that there was no individual opinion. But, yes, I believe that we encouraged pretty much of independent analysis, independent thinking and a group discussion, which threw up this type of approaches.
Whether it is credit or debit, I don’t want to monopolize anything. I would like to share it fully with my institution, including my board and all the professionals.
There were occasions when the finance ministry wanted to divide the board…
I don’t think that’s appropriate. I think our board is eminent, quite independent and they members are not subject to any influence. None of them.
You have said the “light touch” regulations in global financial centres such as New York and London played a major role in the meltdown. What’s your view in building Mumbai as a global financial centre?
I think now the whole idea of international financial centres, the tax havens, the model for regulation, etc. are all under review. So, in any case, not only what you are contemplating as a new centre, but also your existing centres are trying to review their own thinking. I don’t know what type of animal will arise after the review.
After the crisis, nobody can envisage the new animal. We will have to see how it works out. But definitely there has to be new logic and new approach and we just can’t afford to fall back upon the wisdom of yesterday.
Between financial stability and price stability, you seem to prefer financial stability.
On the contrary, I would say the emphasis has been very much on the price stability. The difference is some other central banks in other countries felt that their only focus should be on price stability but in our case we took both price stability and financial stability into consideration. As our financial sector developed and as it was getting integrated with the global economy, the concerns about financial stability were flagged.
You are worried about the possible fallout of the monetary expansion and the fiscal stimulus packages as they have the potential to trigger inflationary pressures and create liquidity trap. What should be done to avoid that?
It’s not a question of what is to be done. I was trying to be analytical. Analytically, there are two issues. Globally, there is something like saying that all countries should try to do some fiscal stimulus. But each country starts with a different base of fiscal stimulus. And the international financial market responds differently to the fiscal deficit of different countries.
The fiscal deficit of England and America and couple of others are at a level where the financial m arkets are not uncomfortable. But in case of some other countries, they are more uncomfortable. So, the limited point is that while there is a global urge of taking fiscal stimulus, if everybody tries to take the same extent of fiscal stimulus, then some countries will suffer more.
There should be appropriate fiscal stimulus packages for different countries.
And, you have to look at the exits. If you are trying to do something only for the sake of stimulus, when the system does not need stimulus, then you should be able to withdraw it. The actions should be time-bound…
The exit should be in a way that the intention is expressed in advance by the policymakers. So that they are buying themselves towards a respectable exit and the market knows that there is some exit. Otherwise, sometimes vested interests develop in some stimulus packages. And when the vested interests develop, it adds to inflationary pressures.
I guess this is easier said than done
It is. But you should be conscious, like a general who goes into the battle. The general always plans how he will withdraw before the battle is over. Otherwise, sometimes he will lose the battle.
The idea is that when everybody is worried how to handle the crisis, I think a good and responsible policymaker simultaneously looks and says, “Okay this is the crisis, these are the steps I have taken…now when do I step back?”
If you explain this to the system, then the system is more confident. You pre-commit yourself to a reasonable exit than have an open-ended commitment to do whatever it is to get the recovery. You cannot do recovery at any cost. Your recovery has to be at an appropriate price.
State & market
After the collapse of capitalism, what’s your view on markets vis-a-vis states? You were never market-friendly. Have you become more unfriendly now?
I will invite your attention to what you wrote when I was a deputy governor… You wrote that I was very market-friendly. For about five-six years everybody gave me credit of being market-friendly…
But that changed after you became the governor.
No, the point is very simple. The markets are very happy when the regulator and the market happen to be on the same wavelength, which helps the market make profits. But if the regulator felt that the markets are taking excessive risks and tries to stop (the markets), then there’s a problem. Let me give you an example of Mr (Alan) Greenspan. When Mr Greenspan said that productivity increases (were behind the market’s rise), then the markets were very happy with the productivity increases explanation because of high liquidity. But when he said irrational exuberance (was behind the rise), the markets simply ignored (it).
The market’s perception depends very much on the market’s interest and not the system’s interest. We should recognize that. That’s all. Let me (be) very frank. Whether a regulator is market-friendly or market-unfriendly are all contextual and the state of the mind of the market, rather than the appropriateness of the policy.
In terms of the overall balance between the state and the markets, there are three things I would say.
First, there is a feeling that there has been excessive faith put on the market to self-correct itself, without creating a problem. There is a doubt about that.
Second, the financial sector is very important for development. It reached a stage where the financial sector development became an end in itself. Now, there is a better recognition that financial sector became a means to an end.
Then, there is a third point—the banking system. Now there is a better appreciation that the banking system is almost like a public utility and it has to be publicly owned or significantly public sector-dominated or intensely regulated.
In fact, if I can add the fourth factor it should be global finance—the financialization of the whole world. I think it is now recognized that the global financial integration is different from the global trade integration. So, there is a lot of rebalancing.
Will you give a straight answer?
I think that basically the fundamental of the market logic will continue to operate. But earlier the perception was that markets are always right. Now the perception will be that markets may be right, but you keep watching them.
You blamed the dollar’s monopoly as one of the reasons behind the crisis. Would you recommend a currency for the Saarc (South Asian Association for Regional Cooperation) region, on the line of euro, to counterbalance this?
No, no… There are risks in one country’s currency being the international reserve currency. Because the country itself has a problem of doing what is good for its domestic economy and that has serious impact on the rest of the world. Sometimes, the rest of the world will benefit when there is a convergence between the interest of the domestic economy and the global economy. But when there is divergence, there is a lot of price to be paid.
In the last few years, because of global financial imbalances, there is a bit of a divergence. Is this a risk worth taking? It may be not worth taking is the consensus now. At the same time, it’s not easy to replace. This is a subject on which there has been a lot of debate, but there is no compulsion to act to find a solution. However, difficult it is, we will have to find a solution. Now many countries, particularly China, are flagging this issue. We have to see how it will resolve. I expect that there will be lot more on the table for discussion.
The Indian recovery and concerns
What’s your take on recovery of the Indian economy? You seem to be reasonably bullish on faster recovery.
Sometimes positive sentiments may be backed by mutual consent to add to the confidence. I am not talking about that kind of thing. I am talking about the inherent strengths. Though the banking sector may be affected due to the impact of deteriorating asset quality, it is reasonably strong. Except for a few days or weeks, the financial market functioned pretty normally. This is one important strength that we have.
Secondly, the rural demand is fairly stable by all indications. Your dependence on the export sector is very important and socially it is very important in terms of employment, but you don’t have the huge dependence on exports like some other Asian countries. So, all in all, the Indian recovery should be earlier than most other countries.
Any particular concern?
I think we have to revert back to our fundamental issue of improving the physical infrastructure. We will have to concentrate on that.
As far as recovery package is concerned, I think by and large—one cannot go to the detail—both the fiscal and monetary sides are good and I expect that they have been thought out well. So once that is taken care of, things are reasonably on track.
What about the rising fiscal deficit?
Fiscal deficit is indeed in bit of a pressure and it could put pressure on the interest rates when the turnaround comes. It could put pressure on the external sector, but it will still be manageable, because RBI has quite an array of instruments. It has the skills and the capacity
But I would still say that one should keep in view that the underlying inflationary pressure in India is very high. Whenever we are thinking of taking a coordinated action, we are talking of countries which are talking of fiscal stimulus and monetary stimulus at a time when there is a very low level of inflationary or deflationary situation. And you have to compare the Consumer Price Index. In our case, it happens to be WPI.
But to asses the underlying inflationary pressure, and in order to compare the policy actions taken by other countries, we should recognize that the CPI of India is still on a high side and that should be an important input. Very often the financial markets may not give attention to that.
Do you also see any scope for further downward movement of interest rates?
I do not want to take any view on any contextual issue, because I am not a party to information.
In the “creative tension” between the finance ministry and RBI, you always stood by the decisions that you took. Now, do you feel vindicated?
Sometimes you get undeserved blame and sometime you get undeserved praise. That is part of life (laughs).
Finally, when is your next book coming? I believe Columbia University wants you to write…
No such thing at all. There is nothing actively on my mind, but, of course, people keep on saying why don’t you write a book? I don’t think there is much to write about. I have no serious thoughts about it. Maybe I should write a joke book so that we get out of ‘creative tension’ and we create some creative cheer and jokes.
Is there anything else that I should have asked you?
No. You have asked more than what you should have asked (laughs).
Shall we end with a joke?
There is one joke I used in the book itself. A cynic remarks—“Under socialism, the governments took over the banks and under capitalism, the banks took over the governments.”