A softer approach by Reddy would have only left a messier clean-up job for the new RBI governor.
Economic challenges and how they are dealt with are the key factors that make or break a central banker’s tenure. Indeed, the history of central banking repeatedly shows that able chiefs can sometimes mess up owing to unanticipated and unfamiliar financial and economic complexities. Conversely, less able chiefs might have uninspiring tenures but could still prompt a conclusion of having a done a “good” job, essentially owing to the absence of serious challenges.
The success or failure of a central bank chief is partly underwritten by his predecessor. Also, the good or bad done by him often comes to the surface after his tenure ends. For example, former Federal Reserve Chairman Alan Greenspan was accorded a larger-than-life status during his long tenure, but the mess beneath the surface emerged only after he stepped down, leaving the current Chairman, Ben Bernanke, to clean up the mess.
How should one judge Y V Reddy’s five-year tenure as RBI governor that ended last week? Should it be narrowly restricted to the letter of the RBI Act that sets the goals for the central bank? Or should it be a popularity contest, as it is for our politicians, many of whom are perfectly happy to fuel a mass feel-good factor even if it is at the expense of macro-management? Should the scope and pace of the financial sector reforms be the only yardstick to judge his tenure, even though it is widely acknowledged that the government has been unable to create a more enabling backdrop for engineering these reforms?
Recent Indian governments blame coalition politics for not being able to move faster on reforms. Should a similar concession be applied to Reddy since he never seemed to have the adequate — if not complete — freedom to do decide on the when and how much of monetary tightening?
Reddy became governor in September 2003, just as the economy was recovering from a severe drought in the prior year. Investment spending, which had been languishing for several years, was also beginning to show tentative signs of turning up, following a restructuring of corporate balance sheets and a greater focus on export markets owing to the multiyear near-recession-like domestic demand conditions. But little did anyone know that the next four to five years would unleash an unprecedented growth upturn in the largely supply-constrained Indian economy. The growth acceleration was meaningfully powered by a sharp increase in global risk appetite that boosted capital inflows into India, and created its own dynamics. The structural story remains intact, but we are currently experiencing the reverse of that global liquidity cycle.
With the exception of Reddy, almost everyone misread the nature and sustainability of huge capital inflows into India. For most, the misinterpretation was a result of a combination of inexperience, ignorance and innocence. The dynamics of credit and asset cycles created by these inflows, and the impact on asset quality of banks from potential reversals in capital inflows was irresponsibly ignored, except by Reddy. There was no dearth of questionable advice: I recall suggestions by some bankers to cut the statutory liquidity ratio (SLR) so that loan growth, already running over 30 per cent for some years, could rise even further! SLR undoubtedly needs to be cut but hardly at the peak of a credit cycle simmering with inflationary pressure.
Reddy began hiking rates in late 2004, probably owing to concerns over increasing cyclical strength and the need for moving early and gradually. The move was well before people even began thinking about inflation. He brought in quarterly policy reviews and economic assessment, and introduced a rudimentary form of a monetary policy committee. All of these are work-in-progress, but he has set up a decent foundation for his successors to build on.
The debate about appropriate monetary policy ignored a key consideration: Any addition to spending, including higher investment, that ultimately enhances capacity only adds to aggregate demand in the near-term, thereby worsening the relative demand-supply balance that could add to inflationary pressure. In a reforming economy, high growth and low inflation do not have to be mutually exclusive, but the onus is on the government to work toward that goal. The current government has been unable to deliver on reforms in a timely manner — that would have increased the non-inflationary speed limit on growth, and also allowed fiscal slippage.
A central bank is essentially a risk manager, and should focus on flagging risks rather than indicating what it is likely to do — that is the job for financial markets to work out. Many people think that Reddy preferred to surprise. Possibly. But a sizeable element of that surprise, in my opinion, came from the markets indirectly guessing how much freedom he would have on monetary tightening.
Reddy’s five years essentially brought out the best and the worst in Indian policymaking: They showed how individual integrity could rise above the destructive and frequent undermining, despite all parties having interest in keeping inflation low. Ironically, the current government wants financial, including banking sector, reforms, but cannot seem to wean itself away from forcing uncommercial decisions on public sector banks, some of which have only compromised the transmission of monetary policy decisions.
The most puzzling feature of Reddy’s term is how an individual with proven reformist credentials became ultra-conservative in the last few years. Perhaps the exigencies of being flooded with uncomfortably high capital inflows, still-large “true” fiscal deficit, and need for financial stability explain the shift. Still, it is surprising that Reddy could not edge forward on financial sector reforms.
With his warm and disarming style, the new governor, D Subbarao, has work cut out for him. His anticipated progress on managing inflation expectations and the reform agenda will be facilitated by Reddy having done the unpopular task of tightening. Also, Reddy has not left behind a banking system on its knees following the unprecedented surge of capital inflows into India.
There is no such thing as a perfect central bank chief. Each governor rises (or falls) owing to his responses to the unfolding challenges. Reddy earned his spurs as governor during a challenging period where a lot could have gone wrong. Now, it is Subbarao’s turn to bat. India is a reformer’s delight, and a combination of what Reddy did and did not do has raised expectations from the new governor. He should deliver in full measure.
Apart from dealing with high inflation and moving ahead with reforms, Subbarao will need to be hawk-eyed on the googly of potentially weaker rupee he is facing. Reddy spent most of his tenure preventing the rupee’s appreciation. Subbarao’s first few months (at least) will likely be spent fighting the rupee’s depreciation.
The author is head of India and ASEAN economics at Macquarie Capital Securities, Singapore. The views expressed are personal.