Banker’s Trust | RBI’s Reddy wages lonely battle on capital flows

Banker’s Trust | RBI’s Reddy wages lonely battle on capital flows

South African Reserve Bank governor T.T. Mboweni was in Mumbai as a guest of the Indian central bank to deliver a lecture on monetary policy early this month, a few days after the Reserve Bank of India’s (RBI) mid-week review of the Indian monetary policy.

Ahead of his lecture, in a private chat with senior RBI executives, Mboweni explained his philosophy of central banking. He said he had agreed to take on the job of South Africa’s chief money man with some conditions.

First, he told the South African President that he could be shown the door if he fails to achieve the inflation target. Then he must be given a clear target and the government must stay away from taking any populist measure that raises the level of inflation. And no government official should have any interaction with the governor a few days before and after the announcement of the monetary policy. During this time, if there are occasions when the central bank governor and the president of the country or the finance minister are attending government functions, they should avoid talking to each other. And, finally, the government should not talk about interest rates.

One central banker who would surely envy Mboweni is RBI governor Yaga Venugopal Reddy. A couple of days after the mid-year review of the monetary policy, finance minister P. Chidambaram told reporters that RBI had factored in a possible rate cut by the US Federal Reserve (Fed) while announcing its policy—a classic case of a minister being aware of the making of the monetary policy more intimately than the governor himself. Reddy never claimed that RBI measures had taken into account the future move of the Fed. In fact, he insisted that the RBI policy was based on all available data at the time of announcing it. A day after the RBI policy, the Fed cut its discount rate by a quarter percentage point.

Reddy’s is one of the rare cases when an RBI governor has been given a five-year term at one go. But, as he enters the fifth year in his office on Mint Road, Reddy’s isolation is now clearly increasing.

It started in January 2005. While releasing the India Development Report 2004-05 of the Indira Gandhi Institute of Development Research one evening, Reddy had said that a view needs to be taken on capping foreign institutional investors’ (FII) inflows into the market. He expressed his concerns about the “quality and quantity" of FII flows and drew the attention of the authorities (read the government) to examine the efficacy of “price-based measures such as taxes" (on FII flows). He, however, admitted that their effectiveness was arguable and quotas or ceilings on FII flows, as practised by certain countries, might not be desirable at this stage.

Chidambaram immediately appeared on TV channels to clarify that the government had no proposal to cap FII inflows or tax them. Late that evening, Reddy, too, called reporters to say that personally he was not in favour of a ceiling on foreign fund inflows. Since then, the government and the governor appear to have been unable to bury their serious differences on tackling capital flows, the sole influencing factor for the monetary policy in India.

If persons familiar with the matter are to be believed, at the last board meeting of the Securities and Exchange Board of India (Sebi), the capital market regulator that took the decision to partially block investment in Indian market through participatory notes (PNs), the RBI nominee put in a dissent note. The note clearly says RBI wants a complete ban on PNs as it strongly feels the quality of money flowing through this route is suspect. But there was no taker for the RBI argument among other board members, including the government nominee. PNs are securities linked to equities used by investors who cannot trade directly in the Indian market. Similarly, Reddy also wants to block the flow of foreign money into the booming real estate sector. He wants a ban on overseas venture funds’ investment in this segment, but Sebi, which controls this segment, possibly does not see any merit in the RBI argument.

So, Reddy is left to fight a lone battle against the never-ending capital flow in the world’s second fastest growing economy. And he does not have too many weapons in his arsenal to tackle the surfeit of liquidity. Over the last one year, India’s foreign exchange assets have risen by close to $93 billion (Rs3.65 trillion) as RBI has continuously been buying dollars from the market. It is doing so to rein in the runaway appreciation of the local currency as a rising rupee brings down the real income of exporters. But, it will not be easy to continue with this strategy as its intervention in foreign exchange market is losing its effectiveness.

Reddy’s monetary policy is also becoming highly predictable. This is also because he does not have too many monetary tools to use. For instance, in July, he had raised banks’ cash reserve, or CRR, kept with RBI by half a percentage point to drain liquidity from the system. He repeated the measure end-October. And, on both occasions, the hike in cash reserve was followed by a raise in the government’s monetary stabilization scheme (MSS), at the instance of the central bank.

Under this scheme, the government issues bonds to soak liquidity from the system. With the government unwilling to allow Reddy any other measure to control the capital flow as that will derail India’s growth story, the governor has no choice but to continue to use CRR and MSS to maintain stability. Nobody should be surprised if banks’ CRR goes up further from the current level of 7.7% and the Rs2.5 trillion ceiling on MSS is raised again in coming days.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Please email comments to