Responsive rather than reserved

The Governor of the Reserve Bank of India (RBI), in his Annual Policy Statement released last week, has set out a strategic and numerical framework which corresponds to one that is principally about consolidating the gains made by the Indian economy over the past several years. First, it is structured around the urgency of maintaining price stability at around 5%, while sustaining growth at 8.5%?a little lower than in 2005-06 and 2006-07, but fairly high nevertheless.

Second, it seeks to take inflation and inflationary expectations to levels that are closer to 4%, a prerequisite for greater financial and hence the necessary currency integration with regional economies and with the world at large. It is simply untenable to trade away all, or perhaps more than all, of the domestic productivity gains on account of higher domestic inflation that in the normal course results in real currency appreciation. Equally so, in the medium to long term, it is not tenable to offset this outcome through large-scale intervention by the central bank in the foreign exchange markets.

Third, it emphasises a focus on credit quality. Given the enormous expansion of bank credit in the past few years, and the extent of variable-interest retail lending, it is extremely important that lenders re-examine their assets, especially variable interest loans, and assess the impact of higher interest rates on both asset quality and the broader implications of a lengthening of tenor (longer repayment periods). Banks have successfully improved their balance sheets in the first part of this decade; now they need to make sure that they are strong enough to bear the burden of further expansion.

Fourth, the RBI has initiated steps towards the development of an interest rate and currency futures market, a necessary precondition for both the further development of the domestic financial market and its closer financial integration with the rest of the world. Hopefully, the combined initiatives of the central bank and players in the financial market will rapidly put in place the basis of active markets in a relatively short while?given the competencies that domestic players have already put together in this area.

Fifth, the statement has appropriately focused on controlling liquidity, while at the same time not ruling out further changes on rates and reserve requirements (as may be read into its promise of a ?swift response with all appropriate measures to all situations impinging on inflation expectations and the growth momentum?). To be read into this, I would suggest, is that the central bank feels reasonably comfortable in its present position, but is prepared to move in either direction if conditions warrant it. In the jargon of the market, it is neither ?ahead? nor ?behind? the curve.

Finally, it has taken some measures to reduce the weight of excess capital inflows. It has cut the maximum deposit rate that may be offered on non-resident bank deposits by 50 basis points?though it could go further in that direction, given that established banks in overseas western markets are mostly offering term rates that are much below Libor. Overseas investment limits have been raised for companies and mutual funds, and individuals can send out more money than earlier.

However, there needs to be some restriction on the use of external commercial borrowings (ECBs) to finance rupee assets?otherwise, the effectiveness of the monetary policy framework will be undermined. A simple non-discretionary approach would be an embargo on the conversion of ECB proceeds into rupees.

What would happen to infrastructure investment, some may ask. The answer is simple: use the ECB proceeds to import equipment and services. With our infrastructure deficit, it ought to be obvious ?import as much equipment that can be realistically installed. Combine that with acquiring overseas private assets?companies, coal mines, and oil & gas fields?and you, incidentally, also have the answer to the non-problem that has been frequently raised: how to use foreign currency reserves to boost infrastructure.

?The author is economic advisor, Icra. These are his personal views