Former RBI governor YV Reddy, in an exclusive interview with CNBC-TV18, said that neither growth nor inflation should drive interest rate policy. The correct rate is one that promotes savings.
Former Reserve Bank of India YV Reddy, in an exclusive interview to CNBC-TV18, said that neither growth nor inflation should drive interest rate policy. Reddy, who recently collaborated with economist Deena Khatkhate on the book 'Of Economics, Policy, and Development: An Intellectual Journey by IG Patel', believes the correct rate is one that promotes savings.
The book was launched by current RBI governor Subbarao at the RBI headquarters on Wednesday evening and is published by the Oxford University Press.
Indraprasad Gordhanbhai Patel (November 11, 1924-July 17, 2005) was the 14th RBI governor and served a five-year tenure from December 1977 to 1982.
Below is an edited transcript of the interview on CNBC-TV18.
Q: What motivated you to bring out this book? What guided you when choosing the chapters? What should we as students of economics try to glean from this book?
A: I have been an admirer of IG Patel even when I was in the university. He impressed me as somebody who has very good grasp of theory and policy and so I read his papers.
And then I found that he has expressed opinion over a period of half a century in different capacities. It is rare and he has spoken after leaving the government for about 20 years and was the director of the London School of Economics.
So, here is an extraordinarily rich source of thought processes from different angles spread over 50 years. It's rare and I thought I should bring it together. Then we had to select carefully and in selecting we made a combination.
For instance, there is one section with three excerpts. All three were after 1991 and they are on reforms. It is absolutely fascinating to read his opinion in 1991, in 1998 and in 2003 when he flagged the question of unease regarding economic reforms.
He warned that reform was not something like a laundry list. Second, real reform cannot happen if you don't take care of the fisc. Even in 1991, in the essay included in the book, he says that even import liberalisation should be considered after fiscal consolidation and he was uncomfortable with the extent of fiscal consolidation.
Third, he was concerned about the increased focus on macro whereas the real problems were at the micro-level. Going sector by sector, reforms should improve the competitive efficiency.
In 2003, he made three general points. One, he felt that though reform was supposed to reduce the scope for corruption, it had not been sufficiently attended to. Second, he felt that the gains in higher education were being lost and third, that civil society had not been fully taken on board in the reform process.
So, in some ways I thought that these were the types of observations made on reform that were vital.
Q: How should we approach the whole growth-inflation dynamics? Should we get prepared for a slightly higher inflation because growth is going to pieces? How would you position this discussion now?
A: There are two points from what I could gather from Patel's essays. One, those who expect a long-term growth for 2-3 decades at 9-10% are not fully aware of either history or the performance of other countries. He adds that the target was too ambitious. His impression was that it has to be lower and that was an over-expectation and over confidence
In order to manage inflation, monetary management alone is not important, there are several sectoral policies. In the fight agaoinst inflation, he considers supply side factors being equally important if not more. He explains that the reform process would be effective only if it focused at the sectoral and micro levels.
Q: What would be your own position on that?
A: My own position is that in using interest rates to fight inflation or promote growth, you are forgetting savers. In the ultimate analysis, investment comes from domestic savings plus foreign savings.
In the history of India and in inevitably for the future of India, more than 90% of the investment has to come from domestic savings and therefore your interest rate should be so set that it ensures a reasonably high level of savings that will finance a high level of investment and there should be incentives for efficiency and enhancement.
Ultimately, growth depends on savings, investment and productivity. I believe today's problem is that the savings are going down. If you don't tackle that then your trade-off will be at a lower level of growth.
Q: In that context, what are the new paradigms that might emerge as pillars of economic-policy thinking? In the decade 2002 to 2010 or maybe even from 1991 to 2010, our first goal was to improve the rate of growth and in the previous decade it was very clear that we wanted to get to the 8-9% growth, that was the first goal and subservient to it was trying to manage an inflation of 5% and the current account deficit of 2%. Do you think these numbers have to change now?
A: First, we must be observe the global environment and form an estimate of its state for the future. The global environment is likely to be very uncertain in the shorter term. In the medium-to-long term too, there is a general feeling that the growth globally may not reach the pre-crisis level.
So, globally, growth is likely to a little less and inflation a little more. Therefore the Indian economy has to reckon with this. To add to this, the demands on global capital is going to be very different. In future, advanced economies are likely to demand more and more of global capital because of the demography and because of huge debt incurred.
Therefore any developing country which wants to depend on foreign capital has to compete with advanced economies. Therefore whatever growth strategies you are thinking of, have to take into account this possible global scenario.
Q: So the comfort zone of the Reserve Bank from 1991 to 2010 atleast, just taking the latest period., was that 3% current account deficit is the outer limit. Should that now be revised as capital is hard to come by?
A: The formulation for more than 10 years was 2%. Then at some stage, we thought it could be little more than 2% and more recently I think the deputy chairman of the Planning Commission referred to 3% and the RBI governor agreed to 3%. The question is - was 3% a ceiling or was 3% an average?
If I look at the context when it was touching 3%, it was crossing 3% they said 3% is sustainable so I presume that they meant 3% not as an average, that’s the point, is it? Because if the markets are getting jittery when it crossed 3%, obviously it is not the average.
So I think we have to now look at the new parameters. There is going to be lot more export of capital and import of capital.
Q: Should we should now begin to accept 2% as the ceiling and maybe the average balance?
A: That's question I am raising. The experience of the last one or two years and the future uncertainties of the global economy would warrant a review of our assumptions about the sustainable current account deficit both in terms of the medium-term average and the maximum that can be afforded.
Q: The recent burst we saw surge in gold import was related to the relentless rise in inflation, therefore, an unspoken dependence on gold, which is always a traditional favourite in India?
A: The work of Professor Vaidyanathan relates it with the performance of Sensex. Gold investment is more when there are uncertainties in Sensex. In India, gold is both an investment and consumption good. The consumption good demand is a function of price and income.
But the investment good will depend on alternate investment opportunities. Now, we have to analyse whether the larger import of gold is a reflection of the fact that the domestic savers are not finding avenues of investment in financial instruments in India.
If you put money in the banks, and getting negative rate of return and if the Sensex is uncertain and if you have money, you will go to real estate, which itself is in problems. So, you have to look at alternate investment opportunities. Whereas now we have more or less given up the idea that you can really control the import of gold, but more importantly, there is a value judgement involved.
If you can permit import of, for example, after shave lotion or luxury cars, which are pure consumption goods and you don’t consider them as wasteful imports, so that is a prejudice.
Q: There is a renewed effort to push new bank licenses forward. It had become a little slow in its progress. As we get closer to the inevitable granting of such licenses any initial fears or hopes?
A: The idea of giving more licenses started before the crisis, but after the crisis the banks, how they should be and who should be running the banks is a new debate. So, therefore we have to take a view whether we should approach the question of licensing in the light of the new realities of the global financial sector.
The regulatory framework should take into account what is the experience of other countries. Further, several years ago, the Reserve Bank itself suggested strengthening its own regulatory framework even according to pre-crisis standards.
And that legislation has not yet been passed. Therefore given these experiences, it is important to go in three directions. One, regulatory framework should be strengthened. There should be satisfactory evidence of the standards of governance. And then we should consider the issue of licences in a transparent manner.
Q: Are you worried that governance in public sector banks is getting clouded?
A: We should allow operational freedom to public sector banks. That is the objective of reform. If that is objective of reform, the actual policies if they are restricting the operational freedom of the banks then it is very difficult to reconcile between the intention to reform and actions to undermine even the existing freedom. I think there is a bit of a disconnect.
Q: Are we reaching a worrisome stage as far as quality of assets is concerned?
A: Media reports say that there seems to be some increase in non-performing assets. I am not worried about the systemic strength, capital requirements and conservative accounting standards of the banks. However, it is not a good sign. It's the beginnings of less than prudent banking which we should be curbed immediately.
Q: Is there any number or ratio that you will be comfortable for forex reserves?
A: The reserve level should be such that the markets are convinced that you have enough reserves to absorb the shocks. So reserve is one element of the overall macro-economic management.
Assessment for the potential for current account shocks, assessment of the nature of your capital stock not only flows, recognising that if they are vulnerable for current account shocks then capital account shocks will automatically follow at the same time. They reinforce each other. So you have to get a fix, it’s not a number that is important, you should get a fix.
Q: Currently, market, economic and business sentiment are at their lowest ebb. If you have to pick up one important policy measure that the government should concentrate on to restore either sentiment or even economic health which one it would be?
A: I think the markets are definitely worried about the fisc. And I would share basic point that IG Patel made in his several speeches that if you don't have a good convincing fix on fiscal, further reform is dangerous.
You become more vulnerable if you go in for further reform. I think the biggest constraint either admitted or not admitted for India is constraint on taking up reform is the fisc. Fisc should be number one in terms of priority for reforms and the rest should follow, which means more pain.
So, the only way we can convince everyone including ourselves is that, if there is pain we should take the pain. If you don’t accept the pain then we are not having an era of credibility. So, I think we should attend to the painful fiscal adjustment.