The spectacular implosion of financial systems in the West created a rather unlikely hero?the doughty former RBI governor, Yaga Venugopal Reddy. Just as previously celebrated regulators and central bankers, most notably Alan Greenspan, lost their sheen for their failure to predict and prevent such a major crisis, Reddy found fame as the man who shrewdly (and in the face of mainstream opinion to the contrary) kept the worst of the crisis away from India.
Few would dispute Reddy?s intellectual prowess and integrity. And for a career civil servant, his grasp of macroeconomics and his instinct towards liberalisation and reform were noteworthy. He was a key member of Manmohan Singh?s reform team in the early 1990s, when he served as joint secretary, capital markets in the ministry of finance. In 1996, he moved on to RBI as deputy governor in charge of monetary policy and economic analysis, a position he occupied for six years. Along with Bimal Jalan, Reddy?s boss for most of his time at RBI, he steered India through the difficult period of the Asian crisis in 1997-98 and the slowdown that followed. It was perhaps this period that cultivated his caution about financial liberalisation, which found expression during his tenure on top.
Not that it was at all obvious that he would graduate to the top job. In fact, he may have given up that ambition when he was packed off to the IMF in 2002 (for a 3-year term) as India?s executive director. Then, when Bimal Jalan prematurely quit as Governor to move to Parliament in 2003, there was a rush for the top job on Mint Street. Reddy wasn?t the favourite to come out on top against S Narayan (then advisor to PM) and Vijay Kelkar (then advisor to FM, and who had earlier beaten Reddy to become finance secretary in 1998). What may have swung it for Reddy, according to some, was the influence exerted by Chandrababu Naidu (then extremely influential in the NDA) in favour of his fellow Andhraite.
So, how should one judge his legacy as RBI chief here in India? On regulation and supervision, he has proved his detractors wrong. There are three key areas in which he took strong, and in hindsight, wise stands: first, his decision not to allow complex securitisation that, after all, induced excessive risk in, and finally felled, what were considered sound and well developed financial systems. Second, he took a strong stand against a potential bank-fuelled real estate bubble by raising the risk-weightage assigned to bank loans for this sector. Third, he resisted the extensive opening of the banking sector to foreign banks. While one may disagree with some of the reasons behind his caution, one can hardly argue against his policy stance now, when the world?s biggest and most powerful banks are on life support from governments.
Where Reddy?s record is more ambiguous and where history may not be as kind as it has been on his stand on regulation, is his conduct of monetary policy and exchange rate management.
For critics on the right, exchange rates should be market-determined. But, Reddy?s RBI chose to repeatedly intervene to manage the exchange rate. In most cases, the intervention was in the form of purchasing dollars to prevent appreciation of the rupee, which was facing upward pressure because of the huge quantity of capital inflows in the period between 2003 and early 2008. The problem with this, apart from its subversion of market forces and bias towards exporters, is that it leads to a sharp increase in domestic money supply, which forces a looser monetary policy in a time of boom?this exacerbates the boom and fuels inflation.
To fight this problem, RBI resorted to sterilisation. But existing government securities were in limited supply to support the scale of sterilisation needed. RBI, in 2004, came up with the market stabilisation scheme under which it would have the authority to issue g-secs and T-bills, money from which would not accrue to the government fiscal account (that would lead to inflationary monetisation), but for which the government would still pay interest.
This last point drew the ire of left wing economists. Why, according to them, was the government paying interest of a few thousand crore a year to tinker with the exchange rate when there were calls to cut subsidies for food and fertilisers? For the left, the solution lay in curbing the inflows themselves, something Reddy once suggested be discussed, only to withdraw his suggestion under pressure from the government.
In essence, Reddy?s RBI tried to achieve the impossible trinity of macroeconomics: pegged exchange rate (within a range ), open capital flows and an independent monetary policy. It could not have lasted as textbook macro tells us that only two of the three are possible simultaneously.
RBI?s almost singular focus on a stable exchange rate may have led Reddy to miss a trick during the period of high inflation in the summer of 2008. Since the inflation was induced by an international commodity price boom, the sensible option would have been to cushion the impact on India by letting the exchange rate appreciate (making imports cheaper). Unfortunately, RBI decided instead to raise interest rates, which had no impact on inflation but which began the long choke on the real economy.
RBI?s exchange rate management (and the impossible trinity act) did finally come apart with D Subbarao at the helm, when massive capital outflows in the post-Lehman world put severe downward pressure on the rupee. RBI was unable (and fortunately unwilling) to stop a sharp depreciation (rupee went from 40 to 50 to a dollar). Any intervention would have squeezed the domestic economy. Monetary policy autonomy was paramount.
So, his monetary policy record doesn?t shine as brightly as his regulatory record. The real economy, which Reddy has an express preference for compared with the financial sector, took two hits in 2008 as a result of Reddy?s decisions?a lot of firms hadn?t hedged foreign currency risk because of an implicit peg (and suffered in the move down to Rs 50), and the rise in interest rates choked borrowing. It may, therefore, be a while before the real sector in India warms up to him like public policy circles and the media in the West have.