View from a central banker

S S Tarapore takes a balanced view: he gives the RBI credit where it's due and criticises the central bank where necessary

This book is by a quintessential central banker with experience both in India and abroad. It reproduces articles written by him between 2008 and 2011, when he was free to give expression to his thoughts - having retired from the Reserve Bank of India (RBI) 16 years earlier. The book contains 12 parts, which are divided into 84 chapters that span a wide gamut of monetary and fiscal policies, gold, financial stability, banking, exchange rate management and the author's views on some recent official reports as well as a few personalities in RBI management.

The author takes a balanced view: he gives the RBI credit where it's due and criticises the central bank where necessary. In general, I am on the same page as Mr Tarapore when he discusses monetary and fiscal policies and calls for tightening in the context of rising prices. His criticism of the extensive liberalisation of policies in the light of the 2008 crisis is justified. I called that response a panicky overreaction to the crisis and expected the chickens to come home to roost - and they did. However, his suggestion to abolish the foreign currency-denominated FCNR (B) deposits, although in a different context, is shocking - especially in the current state of steep currency depreciation. I have argued elsewhere that it is time this deposit scheme was freed from interest rate restrictions, and that fresh accruals to this and other deposit schemes for non-resident Indians should not be subject to the statutory liquidity ratio requirement. It will result in welcome flows to the account, thereby relieving pressure on the rupee.

Also, the author objects to open-market operations in secondary markets since they violate the spirit of the Fiscal Responsibility and Budget Management Act. This is in line with what I have called debt management operations. I wish he had pointed out, at an appropriate place in his writings, two more violations of the spirit of the Act. These are the purchase by the RBI of oil bonds from oil marketing companies against the payment of foreign exchange, which could not be termed a secondary market activity; and the overnight transfer of the sequestered balance in the market stabilisation scheme to the government's cash account in the RBI. Of course, the government cannot be taken to court for such violations because the framers of the Act had the foresight to make the Act non-justiciable, like the Directive Principles of State Policy in the Constitution.

He also argues for changes in the RBI Act to ensure autonomy for the central bank. I feel it is time for a new Act to replace the old one, as many developed (New Zealand) and developing (the Philippines) countries have done. It will incorporate all the elements of modern central banking. The Financial Sector Legislative Reforms Commission missed this important point in its report.

However, Mr Tarapore's arguments in favour of the depreciation of the currency are not convincing. The old concept of the real effective exchange rate is no longer relevant. It was conceived at a time when the purchasing power parity theory held the field in international economic relations. So, if the inflation rate was out of alignment in comparison with other competing countries, a depreciation or an appreciation, as the case might be, would restore equilibrium. At that time, the current account dominated the balance of payments. But today, with massive capital flows across nations in search of better yields, it is the capital account that determines the exchange rate. During my travels, whether in the United States, Europe, Africa or Southeast Asia, I found in the shops that non-Indian goods of equivalent quality were priced much higher than those produced in India. My enquiries revealed that many foreign importers bought goods in India at low prices, repackaged them with their own brand names and sold them at higher prices in other countries. This is, of course, changing due to the establishment of export houses in the country.

In my earlier writings, I have made the point that the Indian rupee is undervalued in relation to the dollar purely in terms of purchasing power. The market rate is determined by a whole complex of factors, of which capital flows are the most important. A study of recent years would show that Indian exports did well at a time of rupee appreciation and badly during episodes of depreciation, as is the case now. The RBI's intervention to curb currency appreciation in the past had only a temporary effect because it was followed by sterilisation. There is enough evidence to show that intervention followed by sterilisation takes the exchange rate back to square one (The Economics of Money, Banking and Financial Markets by Frederic S Mishkin). Now the Swiss National Bank has reiterated its pledge to buy foreign currency "in unlimited quantities" to defend the SFr 1.20 floor per euro. But it is not sterilising the liquidity created in the process. It seems to be succeeding. It is actually facing the prospect of deflation by the end of the year.

A COMMENTARY ON INDIA'S RECENT FINANCIAL POLICIES
S S Tarapore
Academic Foundation; Rs 995