It’s true, I, so to speak, presided./But all — and none of us — decided./That is the doctrine, don’t you see,/Of joint responsibility. (From The Elephant and the Tragopan, by Vikram Seth.)
RBI governor Y.V. Reddy. Ashesh Shah / Mint
Today is an apt occasion to discuss the economy’s performance during Y.V. Reddy’s term. A tribute first. My interaction with him began in 1999, when I started working with RBI researchers on a project about India’s debt and interest rates. From questions to suggestions, Reddy’s involvement in the project was substantial. Last, but not the least, like many others, I can testify to his legendary warmth and hospitality — very real, not nominal, in economics terminology.
A central bank’s activities cover a very wide domain — banking and financial sector regulation being a critical one. Given space limits and my own comparative expertise, I shall look at the macro economy. Reddy intuitively and fully understood the most important economic idea that any good central banker knows — an easy money policy leads to high interest rates over time. The same cannot be said of some of his predecessors, nor of some current high-level policymakers.
Unfortunately, many economists in India, such as Surjit Bhalla, still do not grasp this, as his repeated diatribes against RBI and the “monetarist” European Central Bank reveal. He mixes up the outmoded quantity theory (which predicts inflation based on stable money demand) with the robust fact that a tight money policy will ensure low interest rates, without hurting long-run growth. A part of my RBI debt study was geared to explaining this difference.
Understanding a concept is one thing; implementing it is another. How has the governor fared in this regard? When he took over in September 2003, the cash reserve ratio (CRR), the most important policy tool of RBI, was 4.75%. As he leaves, after repeated recent hikes, it is now almost double — 9%. The Consumer Price Index for Industrial Workers, which was 108 in September 2003, has reached 134 for June 2008. Extrapolating up to September, the Reddy rupee worth 100 paise back then is worth 65 paise now, an inflation of about 6%. High, and a bit above target.
Rising inflation since early 2007 has been partly due to a global surge in food and oil prices. However, well before that, there have been numerous indications that the economy was overheating — credit and money growth, real estate and equity prices, etc. The worst effects of the lax monetary policy are yet to come, despite doubling of CRR and raising interest rates.
To what extent is Reddy responsible for the lax monetary policy? The Vikram Seth quote above says it all, or most of it. RBI does not have adequate autonomy despite the 1994 and 1997 agreements with the finance ministry, which is dominant. On specific decisions, while the governor, “so to speak, presided”, quite likely someone else decided. He has repeatedly and correctly resisted the endless pressures for more demand stimulus.
At critical times, on crucial matters, Reddy and his team took the right call, in my opinion. As forex reserves were building up hugely from 2004 onwards, to control inflation, the policy dilemma was clear-cut. Should RBI stop intervening and let the rupee float, or should it restrict capital inflows to prevent a sharp rupee rise? In contrast to the finance ministry’s preference for full floating, RBI took the latter stance of curbing inflows.
The Mistry committee last April was pushing for a full float with complete hedging facilities, and no curbs on inflows. The finance ministry stance embodied in this report showed no awareness of the severe macroeconomic difficulties encountered across the world, over two decades of full floating, despite developed currency derivative markets in many cases. By contrast, RBI under Reddy was against a sharp rupee rise. RBI accordingly dissented from the Lahiri committee recommendations on participatory notes. Last year, it worked to re-establish limits on external commercial borrowing.
Ajay Shah and others have characterized RBI’s curbs on capital flows as bureaucratic moves to augment its power, bringing back the licence control raj. This is needless paranoia. Indeed, from the first committee on capital account convertibility (1997) onwards, RBI has played a major role in moving vigorously to dismantle all current account controls and greatly reduce capital controls. It would not have dismantled so many controls had it been so keen on retaining power.
If anything, RBI was not stringent enough in this regard. A case can be made that Reddy and his team did not think enough, in advance, about the real possibility that the textbook “impossible trinity” constraints could seriously damage the economy. The controls that were imposed in 2007 were firefighting responses. Indeed, the composition of the second committee on fuller capital account convertibility in October 2006, in which RBI under Reddy presumably played a part, is noteworthy. Some members from the first 1997 committee, who forcefully advocated more inflows and then asserted that the inflows could be easily sterilized the Chinese way, were reappointed (no prizes for guessing who). Was it all the finance ministry’s doing? Perhaps not. In short, two-and-a-half cheers for Yaga Venugopal Reddy and welcome to the new governor, Duvvuri Subbarao.
Vivek Moorthy is professor of economics at IIM-Bangalore. Comment at theirview@livemint