‘We’re seeing...early signs of overheating’

‘We’re seeing...early signs of overheating’

Mumbai: Reserve Bank of India (RBI) governor Y.V. Reddy spoke to Mint hours after he announced his mid-term review of the annual monetary policy for 2007-08. In his policy, Reddy left interest rates untouched and hiked the cash reserve ratio (CRR) by 50 basis points in a bid to reduce excess liquidity that has come into the system because of strong capital inflows in recent months.

Reddy said in the interview that he is more concerned with global risks than domestic ones, and how there are concerns about the quality of some of the capital that is flowing into India. The RBI governor also hinted that the Indian economy could be seeing early signs of overheating and that it is at greater risk than many other emerging markets because of its fiscal and current account deficits. Edited excerpts:

Dr Reddy, we get the feeling after reading your policy statement that you are more concerned about exogenous risks to the economy than about the purely domestic risks.

That’s true. Domestically, nothing major needs to be fixed other than the overhang of liquidity. But we are keeping a close watch on what is happening in the global economy. I would say that the approach as far as the domestic economy goes is to wait and watch. But for the global economy, our approach is heightened enhanced vigilance.

You have said in your policy speech that your biggest challenge has been the management of capital flows. And you have spoken both in the policy as well as on other occasions in recent weeks on the need to focus on financial stability. Would it be correct to say that RBI is now operating in a completely new monetary policy environment?

That’s an interesting question. We have managed the crisis of 1991, set the framework for reform till 1996, and then managed the problems arising after Kargil, the US sanctions and the Asian crisis. This is the first time in history when we are seeing huge growth and early signs of overheating.

The textbook response to capital flows is to reduce interest rate differentials between India and the US. You have not done this, preferring to leave interest rates where they are despite lower US interest rates. Why?

I am not sure the textbook case is that simple. If you cut interest rates, what happens to domestic savings? Also, the expectations on currency are so strong right now that the interest rate differential will have to be so large that it is unsustainable. So, the response has to be contextual.

Then again, there is an argument that capital flows are coming in because of fundamentals. But is it conceivable that the fundamentals multiplied by 50% to 70% in two years? It is difficult to establish a correlation between economic fundamentals and capital inflows. There is an element of fundamentals, but the question is how much.

Now, the fashionable word is carry trade. You don’t call it currency speculation.

Are you saying that capital inflows are greater than that justified by fundamentals?

No, I am not taking a view. All I am saying is that there is no easy correlation. From a macroeconomic management point of view, there is a limited absorption capacity.

So, how does India compare with other emerging markets in its ability to manage global financial volatility, given our economic fundamentals?

Most of the other emerging markets have current account surpluses. We have a current account deficit. Still we are attractive. Second, our trade deficit is 7% of GDP (gross domestic product). Third, our fiscal deficit is the highest among peers. These are not signs of strength.

Tomorrow, when the global system is under stress, how will we manage?

Some people say we should improve our ability to absorb capital inflows. But to what extent can we absorb capital flows amounting to 4% to 5% of GDP in the long term?

You have raised certain concerns in the policy about the quality of capital flows. First, that some of the money coming into equities is actually for currency bets. Second, that a lot of private equity and venture capital money is going into real estate. Will RBI consider some mechanism to monitor these inflows?

It’s not a question of mechanism.

The stability and volatility component (of the capital coming in) is one area of concern for us. The second area of concern is the type or sources of funds. Our type of capital flows has different characteristics as compared to the other emerging markets and we are only saying that we have to recognize it for the sake of stability.

You have opened up the currency derivatives market. What is the trigger for this and what could be the impact?

Derivatives should be encouraged as hedging mechanisms. Just as we are committed to the development of the corporate bond market, we want to encourage the use of derivatives for the development of the foreign exchange market.