Finance secretary D. Subbarao has been appointed the 22nd governor of the Reserve Bank of India, or RBI, at a time when the economy is growing at its slowest rate in 14 quarters and inflation is at a 16-year high.
Illustration: Jayachandran / Mint
His immediate concern will naturally be high inflation. But Subbarao’s tenure will also be judged on the basis of what he does to open up the financial sector and change the way RBI operates. And contrary to the widely held belief, it is the latter two tasks that will prove to be the more contentious ones. There is now far more agreement on how to respond to inflation than there is on the structural issues.
Outgoing governor Y.V. Reddy has been raising interest rates since 2004, when the first signs of mild overheating became evident. His hawkish policy did not win too much applause at first, especially from a finance ministry that was more focused on high growth rather than growing inflationary pressures.
But ever since wholesale price inflation moved into double digits earlier this year, there is a growing consensus among policymakers and economists that the best way to cool prices is not through price controls but with higher interest rates.
This newspaper has generally supported the way Reddy has managed interest rates. We continue to believe that monetary policy needs to be tightened further if India is to maintain a stable economy in the years ahead. Two recent statements by Subbarao as finance secretary make us believe that there will be no sudden change in the way RBI battles inflation. He said in June that monetary policy is the “first line of defence” against rising prices. And a month later he said that raising interest rates was an “obvious solution” to keep a lid on inflation.
The roots of the current round of high global inflation can be traced back to the irresponsibly loose monetary policies in the US and China since the early years of this decade. These two countries continue to hold their interest rates artificially low, in effect forcing other central banks to tighten further. Till there is better global coordination of monetary policy, central banks such as RBI will have to be more vigilant than usual.
The other — and more — contentious issue Subbarao will have to deal with is financial sector reforms. Several official committees have called for rapid and far-reaching changes in the way the Indian financial sector is managed; the one headed by former International Monetary Fund chief economist Raghuram Rajan being the most recent. Their recommendations have ranged from allowing more complex financial products to be traded in India to fewer restrictions on foreign investment in banking to getting RBI to focus on inflation as its primary goal.
Reddy has been distinctly cool towards many of these recommendations. His conservatism was unfashionable till recently; but the crisis in the Western financial system has made it less so. There is less enthusiasm right now around the world on the need for an unfettered financial system — after the government-arranged sale of Bear Stearns in the US, massive subprime losses and the bailout of Northern Rock in the UK.
RBI now finds itself in the same “I told you so” moment as it did in 1997. Then, it was hammered for preventing the rapid removal of controls on capital inflows and outflows, till the Asian financial crisis silenced its critics.
There is no doubt that India needs a far better and deeper financial system to ensure that national savings are shovelled into productive uses. The real debate is on how fast an economy such as India’s — smothered by a huge fiscal deficit and with shallow bond markets — can move to a less regulated financial sector.
RBI has already backtracked on its commitment to introduce some products such as credit derivatives but gone ahead on other products such as currency futures. Subbarao would do well to continue this policy of picking and choosing parts of the financial system that need change. Sweeping changes are uncalled for right now.
It is hard to guess what he will actually do — though this will be as important a part of his job as inflation control is. Subbarao’s first big test will come seven months from now. RBI is expected to make it easier for foreign banks to invest and expand in India after April. His decision will be closely watched.
The third challenge that Subbarao faces is dealing with the way RBI operates. Modern central banks have very clear goals and make it a point to communicate their policies very clearly. RBI still sticks to multiple indicators and goals — a policy that undoubtedly gives it flexibility, but one that also confuses the bond and currency markets.
We doubt India is ready for a central bank that concerns itself with an inflation target and nothing else. But there is still a case for Subbarao to push RBI towards greater transparency about what it is really up to.
Subbarao will also do well to roll back one thing that Reddy has done — the growing use of blunt instruments such as the cash reserve ratio, or CRR, to tame credit growth and inflation. It is a tax on the banking system and also an inefficient way to manage an economy. That could be a useful first step.
What should D. Subbarao do? Write to us at email@example.com