Daring to be right

Tarapore?s book on India?s recent financial policies is impressive in its sweep, depth and contemporary relevance, writes YV Reddy

At the outset, I should declare my long standing association with the author of this book. I had known Mr Tarapore as one of the key players in managing the balance of payments crisis of 1991 and subsequent reforms when I was in the ministry of finance. We worked together closely in 1995-96 when I was secretary (banking) in the ministry. As deputy governor, he was my immediate predecessor in the Reserve Bank of India and partly instrumental in encouraging me to move to his position. From my close professional association with him, I can vouch for his mastery over theory and practice in the area of money and finance, which is amply reflected in this collection of recent essays.

The issues flagged in the book and the intellectual position of the author on each of them is of fundamental importance and contextual relevance in the present state of the Indian economy. The book contributes to a better understanding of money and finance in India and, more importantly, suggests some steps on the way forward.

Divided into 12 parts, the book is a collection of 84 essays. Each part devotes itself to a broad theme and the essays are arranged in the chronological order in which they were originally presented. The themes of the essays are of lasting and immense significance to policy makers and participants in financial markets, though a few of them are merely informative.

Part I is on Macro Economic issues and Global Crisis. Chapter 1 titled ?We all fall down? focuses on the importance of managing the impossible trinity of an independent monetary policy, open capital account and a managed exchange rate. It explores the appropriate mix for managing it well in the Indian context. The essay ends with the following caution: ?There is considerable ecstasy that the centre of economic power is moving to India and China. What this implies is that these countries would have to bear the brunt of international adjustment. Are we ready to take on this additional burden? The world is poised on a precipice and we need to remember the nursery rhyme, ?Ring-a, ring-a roses? that ends: ??We all fall down?. And we need to ensure that in the process we do not break the spinal column of the Indian economy.? The issues are: (a) whether, in going forward, there is a possibility that India will have to take on a greater burden of international adjustment than it has done so far, since normalcy in the global economy is yet to be restored and (b) what are the measures that are needed to ensure that we do not damage the ?spinal column??

The second essay invites attention to the Hayekian approach to macro-economic management. Mr Tarapore visits the issues of growth and inflation, as well as their trade-off from that perspective, as distinct from the dominant Keynesian one. Of particular interest is his suggestion that there is a need to review the literature of bygone years, including the seminal article by VKRV Rao in 1952 and PR Brahmananda?s comments relevant to current dilemmas before the Indian economy.

Chapter 3 pursues the Hayekian approach and holds that Indian economy does not reflect a glut in savings relative to investment opportunities and that, therefore, the Keynesian theory of pump-priming is inappropriate. By insisting that this is no time for adventurism, he prefers prudent macro policies and, in his view, ?it would be best if Puritans are in-charge of the punchbowl?. He warns that artificially low interest rates could cause ?mal-investment and misallocation of resources, which would take many years to rectify?. It may be interesting to consider whether the recent bout of reduction in financial savings in India and large import of gold validate this contention?

In part I, the author comes across as a prophet of doom or a wise counsel, depending on one?s ideological inclinations. ?We need to avoid the prevailing macho euphoria that we can, quite easily, get back to a nine per cent growth rate. The slow-down is attributive to the global meltdown as well as overheating of the Indian economy (the concept of overheating is anathema to the Indian authorities).? Referring to the combined effect of monetary and fiscal policy and headroom available to the RBI in the given institutional conditions, he was, perhaps, prophetic when he said: ?in the emerging situation, there could be a sharp upsurge in inflation or a sharp increase in interest rates or heavy financial repression. There is no way that we can get away from all these unpleasant consequences?.

The important issue that cuts across most essays is whether, in India, there has been sufficient awareness of the trade-offs involved in the use of a range of mix of fiscal and monetary policies. The author?s contention is that, ?if the government needs more resources, however legitimate the need, the non-government sector will have to make do with less.? Accordingly, if the non-government sector also cannot do with less, the spillover will clearly be evident in the current account deficit. In other words, it is implicit in the arguments of Mr Tarapore that there are laws of money which involve distribution of resources between the government and the non-government sectors within the country and the extent of dependence on the rest of the world for resources. If these constitute the laws of money and, if they are ignored, presumably the author implies that there would be a spillover on inflation. In this regard, the related issue of inflation expectations cannot be ignored and his contention is capsuled in his essay titled ?An Epistle to the Prime Minister?. The reader may, legitimately, hold that the author has not given adequate attention to the quality or nature of fiscal management (which may reinforce the author?s conclusion) and the

trade-offs between short and medium term (which may add complexities to the author?s conclusions), while considering trade-offs between growth and inflation.

In part II, dealing with Monetary Policy and the Global Crisis, writing about the relationship between the government and RBI, he suggests, ?In 1982, there was public outcry on monetary policy tightening and there was a Calling Attention Motion in the Rajya Sabha. The then Finance Minister, Mr. Pranab Mukherjee, defended the RBI with great panache and skill and the document on the proceedings is a locus classicus.? He suggests that ?the proceedings should be mandatory reading for policy makers in the RBI and government?.

It is interesting to consider whether this line of thinking is critical to strengthen the hands of the RBI in managing inflation. If the RBI always agrees with the government, it is superfluous. If it persists in disagreeing, it is obnoxious. The differences between the two should, ideally, be considered as constructive disagreements. The author has a valid point when he favours the government rendering support to RBI in the public domain to enhance its policy effectiveness. The government has the options of convincing the RBI or exercising its power of giving directions. The governor also should have opportunities to interact closely with the government. However, on occasions, differences expressed in public may reflect posturing, addressed to multiple constituencies. Overall, however, the contention that RBI?s effectiveness will be enhanced by support from the government and vice-versa appears wise.

The second suggestion, which finds place several times, is the establishment of an ?inflation commission?. Mr Tarapore says, ?In this context, there is an urgent need to set up a High-powered Inflation Commission, with clearly defined terms of reference and powers, headed by an eminent and well respected person with vast experience, such as a former governor of the Reserve Bank of India?. He elaborates on this issue in Chapter 39. ?Serious commitment by the government to set up such a Commission would be the best barometer to judge whether the government is serious in its commitment to usher in a just society.?

An important issue currently under debate is whether the RBI should be given an inflation target. There are genuine doubts about the ability of RBI to deliver an inflation target on its own given the fiscal stress for a prolonged period, supply shocks and bottlenecks. There may be considerable merit in considering unique institutional mechanisms for working out an inflation target and assigning responsibilities to the government and the RBI, respectively, keeping in view the unique characteristics of the Indian economy. This approach will also be consistent with the post-global crisis economic thinking, away from the exclusive focus of central banks on price stability and towards flexibility in inflation targeting.

There are some analysts who argue that India can afford higher inflation to facilitate higher growth. Mr Tarapore appears to differ with this on grounds of equity. He states, ?Finally, what would be the trade-off between inflation and growth? For the masses there can be no greater punishment than inflation. Advocates of higher growth must recognise that a combination of high growth and high inflation is a lethal cocktail for the lower income groups. Such a configuration is always skewed against the weaker sections of the society.?

In the context of conduct of monetary policy, he makes laudatory reference to the performance of D Subbarao. In an essay ?A Superb Juggler?s Act? the author says ?As Dr. Montek Singh Ahluwalia said, the art of monetary policy is to keep a number of balls in the air. Dr. Subbarao deserves to be complimented for performing a juggler?s act to perfection?. The essay titled ?Finely Modulated Policy? holds that ?the RBI Governor, Dr. D. Subbarao and the top management of the RBI deserve to be commended for dealing with a very difficult situation with statesman-like maturity and judgment?. Coming from a distinguished central banker, these assessments should be respected in terms of their implications for the on-going debate. The suggestion for an inflation commission may also need to be viewed in this context.

In the context of the need for monetary exit and the government?s unwillingness to put through fiscal measures, Mr Tarapore makes a reference to the need for the government to pay attention to certain structural issues. One such issue is participatory notes (PNs). He holds, ?The current official line is that PNs serve a legitimate purpose. A contrary view is that that PNs are opaque, pose a national security risk and that a ban on PNs would bring about a qualitative improvement in capital inflows.? He concludes: ?Hence, there is great merit in imposing a ban on PNs. It would be sad if we were to sacrifice our national security at the altar of a few more dollars?. Yes ?n? how many deaths will it take till he knows that too many people have died??

Part IV is devoted to the nitty-gritty of ?Clawing Back Monetary Easing?, which may be of special interest to the banking community. While it is easy to agree with the statement, ?the longer the measures are delayed, the larger would be the problem?, it is extremely difficult for any central bank to get the timing of measures exactly right. Operationally, the issue is whether the balance of risks lies in advancing action or delaying action. Even if there is an agreement on the direction of policy measures, timing and magnitude are extremely critical and involve considerable elements of judgment about trade-offs, particularly in an uncertain global environment. The author gives an impression that he favours monetary tightening at all costs, unless one assumes that he was responding to measures warranted in a given macro environment in India.

In Part V, the message from the essay ?Terrorism, Meltdown and Fiscal Chastity? is that there should be no compromise on items like the financial costs of war on terrorism. A great merit in this proposal is the consciousness that it will develop among influential tax payers. In regard to fiscal policy, the author?s commitment to credibility, be it in monetary or fiscal policies, is evident when he concludes Chapter 36 with a quote from Dr Isher Ahluwalia, ?The FRBM is like a chastity belt, don?t loosen it without a better alternative?.

In part VI, dealing with Financial Stability, of particular interest is a warning in the essay ?Cracks in the Financial Edifice?. ?As Liaquat Ahmad, the author of Lords of Finance said during a recent visit to India, India will be faced with a financial crisis in the future, though he could not say precisely when. The Indian authorities have been forewarned and should take heed well before a financial crisis hits India?. Recent events do point to the importance of avoiding complacency, though the prospects of a crisis may appear to be far-fetched.

In part VII, it is very clear that the author is in favour of significant and comprehensive changes in the legislative framework governing money and finances. There are several references to the Financial Sector Legislative Reforms Commission. However, Mr Tarapore contemplates greater autonomy to RBI than now and preserving the unique status of RBI in the Indian economy. He states that ?It is unfortunate that the present legislative framework is still tilted totally against the RBI. The present Act sanctifies the RBI being a vassal state of the government.?

The author adds, ?The separation of debt management from monetary policy is highly desirable, but there are certain prerequisites to be met. The RBI should first have total autonomy in the area of monetary policy. Furthermore, the fiscal deficit should be within manageable limits.? The author fails to mention what is a manageable deficit. Perhaps, in the Indian context, a manageable deficit is one when governments are able to issue debt without the stipulation of large statutory liquidity ratio. However, the final recommendation of the FSLRC seems to be out of alignment with what Mr Tarapore was contemplating in terms of comprehensive reforms. The Reforms Commission also had several dissenting notes, some of which support the author?s approach.

On bank mergers in part VIII, the author feels they are desirable only when ?one plus one is greater than two? and is not comfortable with the reported approach of the government to appoint foreign consultants to assist larger public sector banks (PSBs). He cautions that mergers involve blood-letting and are often ugly and advocates a totally different track, given the complexity of the task. He suggests that the government should set up a high-level banking consolidation commission with special powers on mergers. Undoubtedly, there is a broad consensus that the public sector banking system requires considerable reform to finance rapid development. Mergers in PSBs may not, perhaps, comprise the most important element of urgently needed reforms in this sector. There is a view that the current relationship between the government (as dominant owner) and banks may not be entirely consistent with sound governance or effective regulatory standards. The issue is whether there is a willingness to undertake a comprehensive examination, as well as commitment to a clear roadmap to strengthen the public sector component of the banking system, in which the public sector continues to be dominant.

Several proposals regarding reduction of public ownership in public sector banks have been held up in the process of legislation. Admittedly there are difficulties in allocating fiscal resources necessary for recapitalisation. This is an important area because the financial sector, including the comprehensive legislative changes, under contemplation in the financial sector, will not yield the desired results, as long as more than two-thirds of the assets of the banking system are in the public sector, with no clear idea of its objectives or future. The book provides an interesting starting point on this and suggests ?setting up a high level Banking Consolidation Commission with specified powers to merge strong public sector banks?. Perhaps, such a commission cannot ignore the legislative framework, on which he says: ?The legislative framework for banking is indeed stultifying. There are different clauses governing private foreign and public

sector banks. What is even more glaring is that even within the public sector banks, there is a proliferation of

legislation. There should be a single legislative framework?.

Chapters 58-60 examine the ongoing debates on private sector banks. While much water has flown under the bridge since these pieces were written, they do raise important issues that still remain valid in processing applications for new licences. A noteworthy observation is the importance of providing an appropriate exit mechanism for a bank that does not serve the purpose for which it was licensed. Perhaps there is a policy vacuum in this regard. A regulatory system which provides a procedure only for entry, without providing an effective procedure for exit, is likely to choke the banking system, introducing inefficiency in operations and distortion in outcomes. Mr Tarapore refers to this but does not carry it further. ?Death and birth are part of the law of nature but in India we do not accept that banks should be allowed to die and, as such, how are banks to be born??

One of the most interesting essays is on the need for reforms in mutual funds (chapter 64). Many wonder why mutual funds, which are meant essentially for individual investors, are being allowed to accept funds from banks and corporates. There have been reports that in India, often individual banks and corporates contribute more to MFs than individuals. It is also argued that this has resulted in the MF industry being an instrument of the interests of banks and corporates, rather than serving individuals, for whom it was primarily meant. There are issues of potential conflicts of interests in the operations of mutual funds when they depend heavily on resources from banks and corporates. Mr Tarapore has an interesting story about the origin of this state of affairs, where a somewhat casual approach was taken in making decisions at high levels. He makes several practical suggestions for improvement, but is realistic enough not to underestimate the hurdles ahead when he says, ?I am appreciative of the fact that the Mutual Fund industry will fight tooth and nail to oppose these suggestions. The SEBI has its task cut out for it and should be firm in its resolve to put through measures of reform. I am afraid I have lost my friends in the Mutual Fund industry ? they are good folks!?. This essay should be compulsory for anyone interested in improving the trust and confidence of households in financial markets in India.

In part IX, three essays address the risks of allowing the rupee to appreciate more than what may be good for the health of the Indian economy. Advocating the importance of resisting pressures towards a strong rupee exchange rate, he has a pithy comment to make: ?While we can always aspire to have a strong rupee exchange rate, this has to be earned.? In this regard, he recognises that there are divergent views and ?it is best to go back to first principles?. It is obvious that recent developments do warrant a careful assessment of both ? the first principles and the way forward ? in the Indian context.

Part XI deals with the importance of gold. He pleads for revival of the gold bank proposal which was mooted in 1992, soon after the economic crisis, but quickly given up. In view of the current debate about reviewing the gold policy in the context of large CAD, the proposal deserves to be revisited, along with a review of the gold policy in India. Further, Mr Tarapore has been a strong advocate of the RBI increasing its share of gold reserves and has been averse to the idea of passive management of gold in the reserves with the RBI. Recent events have proven his stand to be right. The RBI has gained immensely by purchasing gold from the IMF in recent years. The advanced economies, which have a large proportion of gold in their reserves, had, a few years ago, undertaken sale of gold but have virtually stopped selling it with the onset of the crisis, while the developing countries continue to accumulate gold in their reserves. However, it may be difficult to readily agree with him when he advocates that policy makers should build on the Zoellick (former president of the World Bank) proposal on the modified gold standard. In any case, analysts and policy makers could debate on the three issues flagged by him, namely, policy with regard to gold in the Indian economy; policy with regard to gold in the forex reserves of RBI and the prospects for a greater role for gold in the international monetary system in future.

This book is most valuable in generating debates on a wide range of issues relating to financial policies, which should be of great interest to policy makers, analysts and financial market participants. Without doubt, this book is impressive in its sweep; depth and contemporary relevance to India?s financial policies. In conclusion, I cannot, as a former central banker, resist the temptation of reproducing the following extract from the book: ?Dr Manmohan Singh, as governor, in the early 1980s, would say that the governor of RBI performs the loneliest job in the country?. Mr Tarapore dares to say what he thinks to be right, and that attribute, by itself, warrants a reading of this book.

YV Reddy is chairman, 14th Finance Commission & a former RBI governor

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First published on: 11-08-2013 at 00:56 IST