What is Governor Reddy signalling?

Reserve Bank Governor Y V Reddy deserves sympathy for the situation he faced when preparing last month's Annual Monetary Policy Statement.

In the Budget Speech at the end of February, the finance minister had announced a "pause" in the trajectory of fiscal adjustment under the Fiscal Responsibility and Budget Management (FRBM) Act.

As this took place less than a year after the Act had been notified (by the same minister), it called seriously into question the government's commitment to fiscal consolidation.

Thereafter, the minister predicted a continuation of a "benign" interest rate environment, in advance of the monetary policy.

Against this backdrop any central bank concerned about protecting its anti-inflation credentials and institutional independence would be inclined to tighten monetary policy, even if only symbolically.

That is what the Governor did late last month, when he raised the reverse repo rate by 25 basis points, from 4.75 per cent to 5 per cent.

The reverse repo rate is the rate at which banks can place their surplus cash with the Reserve Bank of India (RBI), and provides an anchor to the structure of short-term rates, including the inter-bank call money rate.

This increase followed upon a similar increase of 25 basis points at the October review. The financial markets promptly took fright, with bank stocks in particular being heavily marked down, presumably because of their still significant exposure to capital losses on their bond portfolios.

While symbolism is important, the real question is whether this increase was warranted, given the current domestic and international monetary conditions, and what it presages for the future.

In the view of some analysts, the boom of the first half of the early 1990s came to an end because of the excessive tightening of monetary policy in 1996.

As indicated in Chart 1 of the RBI's excellent companion document to the Governor's policy statement (Macroeconomic and Monetary Developments in 2004-05), that slowdown persisted for six long years, from 1997-98 till 2002-03, despite the fact that the world economy was booming for the first part of that period.

The recent recovery has clearly been greatly assisted by an easing of domestic monetary policy, symbolised by the dramatic drop in yields on the benchmark 10-year bond from around 12 per cent in July 2000 to as low as 5.32 per cent in February 2004 (Chart 16 in the same document).

It was this phase of domestic easing that came to an end last October, largely because of the pick-up in domestic inflation.

The wholesale price index (WPI) peaked in August at 8.7 per cent before diminishing to 5 per cent at end-March 2005 (both on a 12-month point-to-point basis).

Over the last six months, the RBI's touch on the brakes has had its effect. The 10-year bond yield hardened to 7.31 per cent last November, and remains in that territory at present.

According to data published in Business Standard on April 30, the spread between one-year and ten-year gilt-edged paper is now 184 basis points, as versus 96 basis points a year ago.

Thus, the markets are apparently pricing in a collision between the fiscal stance of the government and the financing needs of a reviving economy.

The Governor's justification for the more recent tightening is set out in Part II of the Annual Statement, and amplified in his various media interactions since the policy.

As with the initial move last October, the essential argument is the need to contain inflationary expectations in an environment of strong credit growth, incomplete pass-through of the oil price shock, continued strong capital inflows, and a move of the current account into deficit after a period of surpluses.

Yet, as the text itself acknowledges, inflation in 2004-05 largely reflected the sharp increase in prices of a handful of commodities: iron ore; iron and steel; mineral oils; and coal mining.

Excluding these four categories, the WPI inflation rate is calculated at 2 per cent (on a point-to-point basis), lower than the 3.3 per cent a year earlier.

The paper concedes that "if the impact of mineral oil prices on WPI is isolated, the underlying inflationary pressures appear moderate" (para. 50).

Since October, as the statement notes, growth is up while inflation is down.

While acknowledging that the inflationary pressures originate primarily from the supply side, the Statement points to the "liquidity overhang" as one reason it needs to worry about a wage-price spiral.

Yet the monetary numbers for 2004-05 are truly extraordinary.

Notwithstanding a consolidated government deficit estimated at around 8 per cent of GDP, the RBI reduced its financing of the government by Rs 57,000 crore (Rs 570 billion); even the commercial banks increased their exposure by only 9 per cent as commercial lending opportunities opened up and as the market risks embedded in their investment portfolios became more apparent.

As far as one can tell from the RBI documents, the central government was able to minimise recourse to the banking system on account of the prepayment of old high-cost debt by the states under the debt-swap scheme.

In turn the states have met their incremental financing requirements through an even more massive recourse to small savings than before.

Accordingly, the main autonomous source of the "liquidity overhang" that the RBI so bemoans, and which it is trying to neutralise through its interest rate policy, is not the fiscal deficit, but the banking system's accumulation of foreign assets, almost wholly represented by the RBI's own accumulation of foreign exchange reserves.

The presentation in the documents is somewhat disingenuous in that it treats this accumulation as a spontaneous, natural event, rather than as the result of the RBI's intervention in the foreign exchange market.

Stripped to its bare bones therefore, the story is the same one that has been recounted in earlier columns. The economy would benefit from an enlarged, though sustainable, current account deficit so as to absorb more foreign savings.

In turn this entails an appreciation of the real exchange rate (i.e. an increase in the prices of things non-tradeable relative to those tradeable). There are three methods of adjustment available: appreciation of the nominal effective exchange rate; trade liberalisation; or domestic inflation higher than international.

Such inflation is part of the equilibration process and should not be resisted. If none of these is palatable, the alternative will be to squeeze economic growth so that the current account deficit is contained.

This is where the international dimension becomes relevant. In a recent article in this newspaper ("Imbalances need global solutions"), Martin Wolf of the Financial Times has argued that, as part of a global solution to the problem of the US current account deficit, recipients of long-term capital inflows need to move into current account deficit.

While this prescription is meant to apply substantially to China, it has its relevance for India as well. Fortunately, our growth of non-oil imports has finally built up momentum, with non-oil, non-gold and silver imports increasing by 33.8 per cent between April 2004 and January 2005.

So India is doing its part in the global adjustment process, and benefiting accordingly.

Central banking is the art of decision-making under uncertainty. The main contribution of monetary policy to growth over the long haul is to provide an environment of price stability; increasingly this requires operating on inflationary expectations.

All this is well accepted. But there are also real costs associated with tightening too soon or too hard. Given the state of both the Indian and the world economies, and the inflation numbers presented in the RBI documents, my own inclination is to let the party run a little longer before taking away the punch-bowl.