‘We need institutions that can be market makers for corporate bonds’

Prime Minister?s Economic Advisory Council chairman C Rangarajan discusses high current account deficit, persistence of high inflation and corporate bond market reforms, in an interview with MK Venu and KG Narendranath.

India is running a huge deficit on the balance of trade on goods owing to the near-flat (month-on-month) growth in exports for several months in a row coupled with surging imports. Despite the remittances and positive balance on services trade, the high merchandise trade deficit also keeps the current account deficit high. What should be the policy paradigm to address this issue?

India?s merchandise trade deficit stood at $13 billion in August this year, as against $10 billion in April owing to the fragile recovery of the world economy. Services exports are not growing very fast either. Remittances are also expected to grow at a lower rate this fiscal as compared to the pre-crisis period.

With imports into the fast-growing, largely domestic-demand-driven economy consistently outpacing the growth in exports, the current account deficit for the whole fiscal year could be higher than 3% of the GDP as against 2.4% we (the PMEAC) had projected earlier. So, the deficit on the current account is reflective of the fact that the world economy is not recovering fast enough.

As far as capital inflows are concerned, they were such that until the end of August, accretion to RBI?s foreign exchange reserves had been nil. The inflows were fully required to cover the current account deficit. Portfolio inflows picked up in September leading to fresh addition to the reserves. There is every indication that capital flows have resumed. RBI will have to watch the situation and if necessary, buy more dollars from the market and accumulate the reserves.

Since the rest of the world is not recovering fast enough, wouldn?t it be the right policy to depreciate the currency to give some boost to exports?

Until the end of August, there wasn?t any nominal appreciation of the rupee against the dollar. Only in September did the rupee begin to rise in nominal terms. The real appreciation of the rupee remains high due to high domestic inflation. Our projection is that wholesale price inflation according to new series would come down to 6.5% by this December and 5.5% by March 2011. When inflation rate comes down, there will automatically be a reduction in the rupee?s real appreciation.

In nominal terms, we should not let the rupee appreciate. To the extent which capital flows are responsible for such appreciation, RBI can intervene in the market and add to the reserves.

There is the question of quality of flows. What we have seen of late are largely FII inflows.

Contrary to what many think, FII inflows into the country have not been that volatile and unsettling. The worst outflow of FII money was seen in 2008-09, when $13 billion were taken out, self-evidently due to the global crisis. Post-Lehman, while some FIIs sold their assets in India, some others purchased new shares. So, clearly, all FIIs don?t behave in an identical manner.

In a way, FII inflows also facilitate capital absorption in the economy. Of course, FII money doesn?t contribute to the expansion of real capital in the same way as FDI, but it also contributes, one step removed. FII funds help unlock value for the operators. To the extent FIIs are successful in IPOs, the relevant company will be able to expand its capital base.

The India story continues to stimulate foreign capital inflows, But there is a fear that due to the absence of certain structural reforms on the part of the fiscal authorities, the economy has not fully acquired the capacity to absorb such capital without precipitating any asset bubbles.

If the capital inflows are largely FIIs? buying of shares and FDI in manufacturing sector, then their ability to cause asset bubbles will be minimal. Such bubbles can occur when the funds are flown to real estate or property. That is one thing regulators need to watch out for.

As far as FIIs? purchase of shares is concerned, it is not difficult to figure out where the money goes. There are mechanisms to find out what kind of shares they are buying. The experience so far has been that the pattern that FII flow when it comes to buying shares is very different from some of the well-known mutual funds. FII money does not flow into the real estate directly.

Doesn?t the government need to look at some of the pending reform measures with a sense of urgency?

Any reform that requires legislative action would be rather difficult to do at this point of time. Short of such measures, whatever measures in the executive domain can be undertaken. Some amount of disinvestment which was thought of should indeed go through. As far as financial-sector reforms are concerned, some measures have already been taken. For instance, the SBI Act was amended to bring government holding in the country?s largest public sector bank on a par with other public sector banks at 51%.

Bigger changes like allowing higher FDI limits in insurance sector will have to wait.

I think by and large the necessary reforms in a wide area has been undertaken. The real issue now is that of governance and implementation.

Look at the power sector for instance. In the first three years of the current Five Year Plan, the generation capacity addition was falling below target. If the target is to be met, some 50,000 mw has to be added in the last two years of the Plan (2010-11 and 11-12). We really need to put in place good governance systems for faster execution of projects. There are areas where governance reforms would make a real difference.

Economic decisions will now be incremental in nature, rather than giant sweeping measures. The objective of these decisions will have to be to accelerate growth. Some action o is also required to bring down the inflation rate. Market intervention by the government should not only be through PDS but also through open market sales.

With inflationary expectations more or less dampening, is there a need to tighten money further?

Until the inflation rate comes down to 6-6.5%, we need to continue to take action. Repo rate is now 6%, still negative in real terms. Average inflation is high even according to the latest data.

Of course, it is the year-on-year inflation, the momentum is actually flat?build-up from the end of March 2010 has been just 3.3%. Conventionally, November-December has shown some seasonal decline in inflation. Therefore I don?t think by March 2011, the rate can be higher than 5.5%. My optimism also stems from the fact that monsoon has been good. Benefits of good rains in terms of increased farm output would be soon evident. While shortage of pulses were a major problem last year, pulses production would be much higher this year. So there is a configuration of several factors that would rein in inflation.

What is your take on the level of money supply in the economy?

There has been a slow down in the growth of broad money supply from the beginning of the year. The build-up since March this year has been just 4.7% as against 6.2% in the corresponding period last year.

The actions taken by RBI to regulate money supply has been in the right direction. Whether further action is called for would depend on the behaviour of inflation. Unless inflation begins to drop very strongly by November when RBI?s next action is due, I would suggest that it could look at one more round of (rate) hike.

As I said earlier, our expectation is that inflation rate would come down to 6.5% only by December. Inflation at 7-8% level would, in my view, warrant one more dose of monetary policy action.

Over a lakh crore from telecom spectrum auction has helped the government to cut its borrowing plan for this fiscal. But this is a one-time gain. Going forward, the year 2011-12 itself could see substantial fresh expenditure commitments on social-sector programmes ? food security law for instance with an estimated bill of Rs 1.9 lakh crore.

It is true that spectrum revenue is a one-time gain. While this would allow the government to reduce its fiscal deficit even beyond the budgeted level, it will be difficult next year to bring it down further. I mean it would be a real effort to stick to the medium-term fiscal consolidation plan.

Some of the expenditure commitments that are now being contemplated will impose a burden (on the fisc). They could be introduced in a calibrated way.

We could also look more carefully at some of the subsidies like fertiliser subsidy. I doubt if the order of fertiliser subsidy currently being maintained is really warranted. Pruning of such subsidies is necessary to make available money for the socially relevant projects being mulled.

Also, disinvestment (of PSUs) should be made regular pattern. There is already greater acceptance to the idea of disinvestment. We may be in a position to augment disinvestment in the coming years and use the funds raised from it for the expansion of these enterprises.

How useful would be the proposed new bank licences in furthering financial inclusion?

The plan to issue new bank licenes should not be seen from the angle of financial inclusion alone. In fact, existing banks would have a much greater role in pushing the financial inclusion agenda. Licensing of new banks must be seen from the overall point of view of imparting a greater amount of competition in the system and also the the needs of a growing economy.

In terms of reaching out to the unbanked population and the underprivileged, major efforts have to necessarily come from existing banks.

Microfinance institutions, due to their think capital base, can?t be contenders for the new bank licences where minimum capital need is being mulled at Rs 500-1000 crore. I think local area banks (LABs), with their smaller capital base and restricted geographical coverage, would be able to play a meaningful role in financial inclusion. Since LABs? capital base is thin, they would also have lighter and manageable asset bases.

Debt market reforms continue to be an unfinished agenda.

For the corporate bond market to develop, we need to set up institutions that will perform the function of buying/ selling bonds. Institutions like the Discount and Finance House of India and Securities Trading Corporation has been instrumental in creating markets for money-market instruments and government securities. Similarly, we need institutions which will be market makers for corporate bonds. I have already floated the idea in the appropriate forums. The high-level committee on capital market is also looking at it.

One sees a kind of a caste system in operation in the bond market with someone just below AAA tag being unable to raise funds. There is also the issue of tax treatment.

There needs to be trade-off between risk and return. Unless there are different varieties of bonds and varying risk perceptions, the markets won?t develop. Bonds that carry high risk and very high return do have a reason to exist.

In tax treatment, the debt is treated differently from equity because interest payments made on debt instruments is part of the allowable expenditure.