The best possible outcome under the circumstances actually happened last week. The architect of India?s economic reforms became the Prime Minister of the country. Some of the leading lights of the Left parties blew their gunpowder over the weekend with their antics, possibly surprised that their usual bluster could have such an enormous impact on the financial bourses and the business climate in general. Maybe for a brief moment with an army of television journalists jostling to catch their every word, some might have believed that they were like Lenin steaming into St Petersburg in April 1917; all that was left was to script a latter day April Thesis. The fireworks will continue even as this column goes to press before the swearing-in and we learn which worthies have landed which ministerial fish.
While wishing the new Prime Minister well in this most challenging task, we will leave politics to those who must live by them. But one word in closing: The lessons of all recent crises ? in East and South East Asia, Russia etc. ? have one thing in common: Lack of information. The same thing characterises the recent elections. What was construed to be reasonably dependent sources of political information has turned out to be very flawed. The lesson to be drawn from this is that, the financial world must learn to treat future elections with great circumspection and choose not to bet on any one outcome ? whatever the pundits might say in public and private, and politicians confide in private. Even when the consensus appears to be universal.
The Annual Policy Statement of the Reserve Bank of India presented last Tuesday is in many respects a lesson in transparency. Provided, that is, in this age of information overload, it is read carefully. In the background of the initiatives in managing capital inflows and the introduction of Market Stabilisation Bonds, it is but natural that several paragraphs are devoted to discussing the problem and the alternative instruments that can be conceived to deal with it. The basic issue is that when the RBI purchases foreign exchange in the market it simultaneously injects the equivalent amount of rupees in the form of incremental reserve money. Were the RBI then to absorb the same quantum of rupees by way of sale of government securities or through the repo route, it would neutralise the expansionary monetary impact of the transaction. This process is termed sterilisation, since the monetary impact of the RBI?s purchase of foreign exchange would be neutralised. To the extent that the RBI chooses not to sterilise the foreign capital inflows that it buys, it releases additional high power money that in turn raises the broader money supply by a fairly large multiple. To get a broad idea, for every rupee of additional reserve money injected into the system, broad money (M3) increased by 6 to 10 times between 1999-00 and 2002-03. In 2003-04, the factor was smaller at about 4 times.
What is the impact of unsterilised RBI purchase of capital inflows? It is similar to what happens when the central bank monetises a part of the government?s fiscal deficit ? with one distinction. When it is the latter the disposition of the additional monetary resource is known, while with unsterilised flows the disposition is not. In the popular, albeit inaccurate, phraseology this is about printing notes. Some of it works through the system stimulating economic activity, some of it ends up in inflation, and the respective proportions depend on the starting conditions. If the economy is in a recession (negative, not just low, growth rates), which generally means large unutilised capacities across the board, there is more of economic stimulus and perhaps no inflation; if that is not the case, you get more of inflation. And the outcome manifests with a lag of a year or so.
There is one caveat. An economy is a growing animal and as it grows, its need for money balances also increases. What is the safe limit for a normal economy, that is, one not in recession? A range of 1 to 2 per cent of GDP has been mentioned in the literature, but it depends on the particularity of the circumstance.
In para 11 of the Annual Policy Statement, the RBI tells us that in 2003-04 its ?foreign currency assets (adjusted for revaluation) increased by Rs. 141,428 crore on top of an increase of Rs. 82,089 crore in the previous year. The expansionary impact …. was neutralised to a large extent by substantial OMO sales including sustained repo operations.. (and in consequence) … net RBI credit to the Central Government declined by 67.3 per cent (Rs. 76,065 crore) on top of a decline of 20.1 per cent (Rs. 28,399 crore) in the previous year?. Which means that the unsterilised flows arising from RBI intervention in the foreign currency market was as high as Rs 53,690 crore in 2002-03 (65 per cent of total inflow) and Rs 65,363 crore (46 per cent of total inflow). These amount to 2.2 and 2.4 per cent of GDP for 2002-03 and 2003-04 respectively.
I have tried to reconstruct the counterpart numbers for previous years, but in the absence of equivalent clarity in regard of the data, the estimation is approximate. It would seem that unsterilised flows as a proportion of purchases of foreign exchange by the RBI amounted to as much as 68, 80 and 96 per cent in 1999-00, 2000-01 and 2001-02. As a proportion of GDP, this amounted to 1.4, 2.2 and 3.3 per cent. Further there were small amounts of monetisation of government deficits in 2000-01 and 2001-02. What were the principal effects of this fairly aggressive monetisation? How much of it spilled over to inflation and how much into growth is an issue that is unlikely to be readily resolved.
But there is one conclusion that we can incontrovertibly arrive at. That is, in the absence of these large injections of liquidity by the central bank, yields on government bonds would not have fallen in the way that it did despite an aggregate government deficit of 10 per cent of GDP. And we can also conclude that with inflation in 2004-05 strong for the third fiscal year in a row, there will be in the future full sterilisation of any net capital inflows (assuming that they transpire) and hence no liquidity relief from that quarter. The corollary ? in a world of tightening monetary conditions ? needs hardly to be spelt out.
The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)