YV Reddy, the former governor of Reserve Bank of India (RBI) and emeritus professor at the University of Hyderabad, believes that with fiscal policy dominating currently, the headroom for monetary measures has reduced. Reddy, who has chronicled the thoughts of former governor IG Patel, says many of the fiscal measures that were introduced are not withdrawable. Speaking to Aparna Iyer, Reddy says if the currency is to be managed, excess appreciation must be avoided because that way the central bank can operate better.
Recently, Dr Rakesh Mohan said we should have a managed float as our foreign exchange policy and should not let the rupee appreciate or depreciate too much. What do you think?
Analytically, somewhere, most currencies are managed. You see that in the case of Switzerland or Japan but they manage their currencies as an exception. I think there is increasing awareness for the need for more active management than many people believed necessary before the crisis. In India, the basic policy, originally formulated by Dr Jalan is that we don?t have any fixed rate, but we don?t want volatility.
But we don?t know what is volatility, because some forex flow is permanent, part of it is temporary. It is a matter of judgement about volatility, effectiveness of intervention and also the cost of intervention. These are the three elements which make it difficult for people to assess whether management is intensive. Transactions in forex market are huge and the central bank can make a difference at the margin. More importantly, the central bank does not have infinite capacity. If you have to manage, be careful to avoid excess appreciation because that way you can operate better. Be careful and be alert when things are appreciating so that the correction is not big.
Since IG Patel till date, the difference is that India is much more integrated with the world economy. How has fiscal and monetary policy evolved and has it been able to deliver?
One thing we get from the essays, even at the beginning of the reform process, is that the fiscal problem is the biggest problem in our economic management. In fact Dr Patel says that you should not attempt import liberalisation before you get your fiscal problems in place. Now since the economy is open, what is happening is that fiscal excesses are spilling over to the external sector and, therefore, you are supposed to correct them in time and if you don?t, then you get into a problem.
The biggest challenge before 1991 was how to manage the monetisation of the deficit and how to manage the fiscal excess when the government asked RBI to print money. But, after liberalisation, external flows became a problem. So if you look at RBI balance sheet, in pre-liberalisation days, what grew the balance sheet was the demand from the government to print money whereas subsequently it is the capital flows.
But the extent of the intervention, post crisis, has risen.
In general, when there is a crisis situation, the immediate first line of defence is the monetary policy and that has been so in India and in other countries. In India, however, the fiscal stimulus happened at a time when there was a structural problem with the fisc and that?s why the downside to the excess stimulus is huge. Stimulus should at some point be withdrawn but most measures that were taken were not withdrawable. Stimulus actually resulted in a structural deterioration of the fiscal position. In China, fiscal stimulus was through investment whereas in our case it was through consumption and so doesn?t add to the productive capacity of the economy. It adds to prices unless there is a slack in demand, but you can?t say there was a slack in demand in India.
So fiscal vulnerabilities have risen?
The quantum and the quality of stimulus created the problem as the supply inelasticities, or physical infrastructural bottleknecks. So, in a way, the current problems are not a direct result of the global crisis but the type of response to the crisis and also the starting point.
Has monetary policy been sidelined?
Globally, there is a revival of fiscal dominance. In India, it is more so because at the starting point itself we had a relatively high debt-to-GDP ratio. When the outcomes of fiscal measures persist, the headroom available for further monetary policy measures is less. The returns start diminishing because policies are less effective and, therefore, in the pace of policy or headroom for further monetary policy interaction is less.
There is talk about economy being in wage spiral and stagflation. What do you think?
We are talking of low growth at 6%, so where is the question of stagnation? This is deceleration of economic growth and the word stagnation is out of question in the context of ?stagflation?. There is inflation, definitely, and the interface between wages and inflation is inevitable. I assume we could have a lagged effect because wages in some sectors have not caught up. In a way, it is not macroeconomic management that is the issue, it is the sectoral management. Unless the productive capacity and effeciency of the sectors are not addressed, you may be as well manage the macroeconomy but you cannot develop sectoral policy.