The spotlight will clearly be focused on New Delhi between the formation of the new government and its first budget a few weeks later.
But it is also time to ask what role the Reserve Bank of India (RBI) and its monetary policy should play in stabilizing the economy and nurturing its long-term growth. Two issues are worth bringing up right now—one long-term and the other short-term.
One area of heated debate will be on financial sector reform. The central bank during Y.V. Reddy’s watch had opposed pressure from the finance ministry to speed up financial sector reform. Reddy did not win too many brownie points from either the finance ministry or influential special interest groups that wanted the financial sector opened up right away. Mint was one of the few newspapers that defended Reddy on this point. After the implosion of large parts of the Western financial system in 2008, there is thankfully greater appreciation of what Reddy did.
Illustration: Jayachandran / Mint
But the battle is not over. Fresh pressure is likely to be mounted soon, as the new government draws up its agenda for the next few years. RBI will have to take guard once again.
This newspaper has no issues with financial sector reform in itself. There are clear areas where work is needed. Too few Indians have access to the modern banking system. A vibrant corporate debt market is a must. Simple derivatives—though not the exotic stuff that almost pulled down the Western financial system in 2008—are needed so that economic agents are able to manage risks better. A lively money market with a well-defined yield curve will help monetary transmission, or the process by which interest rate changes by RBI ripple out into the real economy.
But there has always been enough empirical evidence that reforms have to be sequenced properly and that hasty financial sector reforms can wreck an economy. The obvious negative externalities from financial instability need no repetition in these times. Short-term capital inflows usually accentuate the peaks and troughs of the business cycle and are an obstacle to counter-cyclical monetary and fiscal policy. And there is also ample evidence now of how powerful financial institutions succeeded in regulatory capture, in effect dominating the regulators which were set up to control their activities.
We continue to stress the need for caution on this front.
That’s the long-term issue.
A more immediate one is what RBI should do to stimulate the economy. The central bank has been quite correct in reducing interest rates to support economic activity. But it should be vigilant against pressures to begin aggressive quantitative easing (QE), which essentially means expanding its balance sheet and printing new money.
This has been popular in several Western economies of late, but those who advise RBI to follow suit do not realize that India is not in the same position as the US or the UK. The International Monetary Fund has struck a cautionary note in a recent position note on the policy options in emerging markets. “QE seems less appropriate for (emerging market economies), where deflationary expectations are unlikely to be present (and even in advanced countries, evidence on its effectiveness is limited). If anything, there is a risk that markets misinterpret QE as a return to inflationary policies—particularly if there is little commercial paper and QE takes the form of purchases of government securities. Therefore, except in extreme situations (for example, the policy rate is already set to zero), QE should only be attempted by countries with a history of low inflation and macroeconomic stability, with central bank independence and credibility.”
We agree with this view. The 1997 agreement between RBI and the finance ministry to phase out the so-called ad hoc treasury bills and then the rule in the Fiscal Responsibility and Budget Management (FRBM) Act that prevents RBI from buying government debt in the primary market have cut the umbilical cord that joined fiscal and monetary policy in India—and which reduced the potency of the latter. In that sense, QE is a step back towards the bad old days.
RBI governor D. Subbarao will have to stand up to these pressures, just as his predecessor did.
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