The tradition-bound RBI is nervous

Written by S Narayan | Updated: Jan 19 2005, 05:30am hrs
Theres been considerable media comment after the recent speech of the RBI governor, in which he expressed anxiety over the quality and quantity of foreign exchange flows. He suggested that flows to the secondary market contributed a significant volatility to the flows, and that a view needs to be taken on the capping of these flows into the market, and that price-based measures such as taxes could be considered. Rejecting these views, the finance minister clarified there was no proposal to tax FII flows.

The RBI policy has been of intervention in the exchange rate, which, without any predetermination on the exchange rate as such, enables it to intervene to smoothen the volatility in the currency markets. This moving peg policy has served it very well in the past. Whenever the RBI has been intervening in the market to purchase dollars, the excess liquidity it generates in the system has been mopped up through sale from the stock of government bonds that it holds. Coupled with restrictions on capital account convertibility, it has, until now, given the RBI a fairly close control over flows and rates of foreign exchange. It has, therefore, been able to guide monetary policy largely independent of external exchange considerations.

It seems clear the United States is ready to accept a weaker dollar, and as a consequence, the US dollar is expected to drop further. Though there are different scenarios about the eventual adjustment, it appears we are only about halfway through the fall. This leaves the RBI with the unenviable task of smoothening the effects of this fall through repeated interventions. After a major intervention in April 2004, net intervention was low for several months. But increased flows have necessitated RBI action again in recent months. A steep adjustment would affect exports adversely, and no one is quite sure of the effects of such steep adjustments in the short term. The RBI is also constrained by the fact that it would soon be running out of government bonds to sterilise the market. It is concerned that if there were no sterilisation, it would only add to inflationary pressures.

In the last budget, RBI came up with the novel idea of market stabilisation bonds, which are off-Budget documents to be used only for the purpose of mopping up excess liquidity caused by intervention, and the interest charges for these bonds would be borne by government. Since the interest is a debit on the Budget, the government has, till now, provided Rs 60,000 crore in the fund. There may be need for more, which may impact on the fiscal deficit through additional interest payments.

RBI is constrained by the fact that it will be running out of government bonds
Quick changes have never been the central banks strong point
Debate, among other things, capital account convertibility vs controls
Then there is concern over the flows themselves. In the last decade, the government has put in place several initiatives to facilitate foreign investmentby relaxing or removing foreign equity caps in several sectors in the hope of seeing multinational and global firms set up manufacturing facilities in India. There is a committee to assist investment competitiveness, and another to attract investment. There is a ministry to persuade the diaspora to invest in India. The argument is that these FDI flows will ramp up the manufacturing sector, bring in world-class technology and provide employment. But this hasnt happened. Rather, we see increasing activity in the financial markets that do not facilitate this objective. They are short-term investments, primarily to make money for the contributors of the funds that are active in the market. There has also been the problem of the ownership of these funds. Quite recently, the issue of participatory notes has been agitated, until Sebi, in a halfway measure, directed that only participatory notes subject to regulatory controls in their parent countries would be permitted, leaving the question of tax-havens inadequately addressed.

The RBIs concern is, therefore, that it may not be in a position to discharge its duties of capital account control and currency control satisfactorily in the coming year. And that, in a year GDP growth is already slowing, has significant repercussions. Finally, there is also the unstated worry that there are too many balloons up in the air about the use of the foreign exchange reserves-financing infrastructure, issues of capital account convertibility and the like. The RBI is necessarily nervous. Further, the RBI is a tradition-bound organisation, and fast changes have never been its forte.

The comments in the media have all had to do with whether the RBI should have given vent to its nervousness in the manner that it did, and not about the fundamental issues themselves. The general consensus is that these issues should not be debated between RBI and the finance ministry in public and that it leads to nervousness in the markets. It is equally important to note that there has been no clear articulation of the problems or the alternatives available, in any forum, leading to the worry that they are perhaps not being addressed at all. One would like to see a debate on capital account convertibility versus controls, on exchange rate management versus a free-floating exchange rate and on the limits to monetary policy in the present state of the economy. Finally, it is important that policy pronouncements on these issues are available soon, so the road ahead is clear.

The India plate moving to a new position under the Burma plate caused the recent tsunami. The India plate moves continuously and is one of the best greased tectonic movements. But a portion of the plate usually sticks until the pressure of the plates that have moved ahead pull the sticking portion with a jerk of catastrophic consequences. One would not like to see RBI as the sticking portion in the movement towards economic liberalisation.

The author is a former finance secretary and economic advisor to the PM