Rakesh Mohan, who was appointed Deputy Governor of the Reserve Bank of India in September 2002, moved to North Block two years later as secretary, department of economic affairs, during P Chidambaram’s tenure as Finance Minister, only to return to RBI after eight months. Mohan, who is taking retirement from the central bank seven months before his tenure is due to end, will take up a professorial appointment at Stanford University from June 15. In this interview, he spoke on a range of issues about the challenges he faced during his stint at the central bank and the journey from handling the real economy sectors to monetary economics. Edited excerpts:
Why are you leaving RBI before your term ends?
My term as Deputy Governor will end in another seven months and the Stanford University offer was too good to refuse. So I had to take a call. It would be quite satisfying to guide doctorate students and be associated with Stanford’s Centre for International Development.
How do you look back at your tenure in RBI?
Prior to joining RBI, I never really had any particular interest in monetary economics. I was mostly involved in real economy sectors such as urban development, industrial and technology policy, petrochemicals, infrastructure, and the like. I was also part of various committees on diverse areas such as small and medium scale industries, railways, infrastructure, competition policy, etc. Later, I got involved in fiscal policy making and the Budget as the Chief Economic Advisor in the Finance Ministry.
A substantial part of some of the reports I was associated with was devoted to financing of projects. For example, the Abid Hussain Committee report on SMEs had talked in detail on financing of SMEs. Among the key problems of financing SMEs has always been the high transaction costs incurred in risk assessment. Hence the report recommended setting up of credit information companies. That was in the mid-1990s. But it is only now that we are actually in the business of licensing such companies.
My time in RBI has therefore been a voyage of discovery since I didn’t have a background in monetary economics earlier. Understanding the functioning of monetary policy has been a great learning process.
The best way to figure out whether what we have done was appropriate is to look at the outcomes. We have measured the outcomes from 2003-4 to 2008 and feel quite gratified with the results. During this period, we have had the highest growth and lowest inflation for any five-year period since independence, a reasonable degree of financial stability, high credit growth, and sustained improvement in the quality of our banking institutions on all metrics. We must have done something right.
But the period you talked about saw high growth, high liquidity and low inflation in other parts of the world as well.
Please also remember what RBI does is not pure monetary policy. We do regulation of banking and non-banking finance companies, regulation of the government securities market, running of the government’s debt management and also what is now called monetary policy in the garb of only interest rate-setting. To my mind, the outcomes we have had are a confluence of all these functions along with reasonably sensible fiscal policies over this period. I have always maintained that we can achieve satisfactory results only if we have close cooperation between the monetary and fiscal authorities.
But this period also saw increasing tension between the finance ministry and RBI.
That’s been there in every country and in every period, though the issues may have been different. So I don’t think that was anything new. If you read RBI’s history, the whole issue of ad hoc issuance of bills and automatic monetisation has been a constant source of tension between the fiscal and monetary authorities. One of the RBI governors in fact resigned in the 1950s because of extreme tension on this issue between him and the then finance minister. This is normal because these two segments have different functions.
Should you shed some of those functions? For example, there has been a view that RBI should shed the banking supervision role.
We are fortunate that RBI does carry out all these functions. One of the most fascinating things of central banking is that there have been different views on the same issues in different times. There is nothing wrong with that as one has to react to the changing context. For example, before Gordon Brown decided to give autonomy to the Bank of England, the country’s monetary policy was made in the Treasury. This is an example of how views change.
Banks haven’t listened to RBI on interest rate cuts – at least not to the extent the central bank would have liked them to. What’s your view?
It is not proper to say that banks are not listening to RBI as we don’t operate under an administered interest rate regime. Banks don’t have to listen to RBI, which has to work through the monetary transmission mechanism. So the question is to see how effective this transmission mechanism has been. The answer to that is interest rates have come down to a certain extent.
But this has not been to the extent of the policy rate cuts.
I agree, but the RBI policy statements have clearly explained why that has been the case. It is true that there is room for further cuts in bank lending rates, but one shouldn’t forget that banks have to consider their own cost structure and their risk assessments of borrowers.
You are saying you can’t force the banks, you can only signal. So why don’t you signal harder and cut the policy rates more?
I can’t comment on whether RBI should or should not cut rates further as we don’t give forward guidance. What I would say is that when there is a large difference between the prevailing deposit rates and the floor, it takes time for the transmission mechanism to work. However, we have seen deposit and lending rates coming down over the last six months. At the same time, we should also understand that given the economic slowdown, it’s not unnatural for banks becoming more prudent in their risk assessment.
What do you do if what you wanted as an end-result in terms of interest rates hasn’t materialized?
I can only say similar efforts haven’t succeeded even in the most advanced countries where policy rates have come down to zero or near zero and the central banks have increased their own balance sheets by a factor of 250 per cent. All the banks have done is to put more money in their reserves with the central bank.
Would you agree with the statement that we have one of the highest real interest rates in the world?
It’s not very easy to measure the real interest rate in the country. It’s different for borrowers and for depositors. For example, if you talk about industrial borrowers, their real interest rates are connected with the wholesale price index. For them the real interest rate can be deemed to be high at present. For depositors whose inflation measure is nearer the consumer price index, the real interest rate is negative at present. Another way of looking at it is this: Judging from the experience in the last 10 years, the expected inflation rate is 4-5 per cent. From that perspective, the interest rate for both depositors as well as industrial or commercial borrowers is not high.
What rate do you think commercial borrowers are getting their money at?
The weighted average lending rate is around 10 per cent. This has usually been below the Benchmark Prime Lending Rate. Please remember that over 70 per cent of lending is being done at rates below the BPLR. Lending to the agriculture sector has been fixed by the government at 7 per cent; similarly, the interest rate can’t be more than BPLR for all loans up to Rs 2 lakh; export credit has to be BPLR minus 250 basis points etc. If you take all these things into account, then the weighted average lending rate is nearer 10 per cent. But it’s true that there are some borrowers who get loans at much higher rates. I have said quite often that I don’t quite understand the very wide dispersion in lending rates in India.
So what are the changes you would like in the monetary policy framework to make it more effective?
I would answer that in two ways. One is that the process that we went through in the 1990s of more and more interest rate deregulation has to continue. The fewer the distortions in the system in terms of administered interest rates, the more effective monetary policy will be. However, in our system, administered interest rate interventions take place since you don’t have enough information for adequate risk assessment. That problem on the lending side has got to be solved by credit information companies.
Then you go to the depositors’ side. There is a similar issue there. With the lack of adequate social security, people with low to middle incomes want an assurance of some kind of risk-free rate. So, two issues arise from that. As you improve social security, pension systems etc, you will presumably have less of a need for administered interest rates. The second part is we have moved from long-term inflation rates of 7-8 per cent (in those days the minimum expectation on administered interest rates was above10 per cent) to 4-5 per cent. Consequently, the government was able to cut the administered interest rates to the lower levels prevailing now at around 8 percent. After initial resistance, now no one complains about the current administered rates for small savings. To my mind, we can move forward on this as we succeed in bringing down the inflation rate further on a medium to long term basis, as the world has done, to 2-3 per cent. But that will take a long time.
The sense one gets from your comments is that there is a general degree of satisfaction over RBI’s performance. But at least two committees on financial sector reforms have expressed a high degree of dissatisfaction with RBI’s functioning. How do you square the two?
The mandate of one of the committees was to see how Mumbai can be made an international financial hub. But the report put more emphasis on monetary policy and financial market regulation than on what was needed to be done for Mumbai city. Basically, what that report advocated was a duplication or replication of the British system because that was regarded at that time by many observers as some kind of a state-of-the-art financial or monetary policy. That has all come into question now, and with good reason. They themselves are seriously questioning their old assumptions and operating frameworks. Rather, what we had said at that time is the flavour of the day today. Maybe they got misled by world opinion at that time rather than really examining what was really needed in the Indian economy for maintaining high growth along with financial stability.
The other committee on financial sector reforms was more nuanced and more balanced. But they advocated inflation targeting and I continue to be puzzled on how they could do that given that distortions that exist in our system. I also did not see any evaluation of actual outcomes. There are also errors in facts. For example, both the reports talked about the missing bonds, currency and derivatives market. The fact of the matter is, as the BIS (Bank of International Settlements) has documented, we had the fastest growing currency market in the world during 2004-07, when the latest BIS Survey was conducted. It seemed to me that the two reports didn’t focus on the actual issues confronting the development of financial markets in India.
Are you generally happy with the pace of changes that RBI has brought in?
Yes. A number of the problems in terms of further progress are really political economy issues. One, there isn’t any kind of consensus on the privatization of public sector banks. But some of the progress on financial sector reforms depends a great deal on progressive privatization of PSU banks. But I should also say in retrospect that there are also some virtues to having some presence of PSU banks along with domestic private sector banks and foreign banks which provide competitive pressure in their own ways.
You can then talk about what the relative weights should be. When people talk about the slow pace of financial sector evolution in India, they tend to forget that in the last 10 years, the weight of private sector banks has gone up from zero to 18-20 per cent. And if you look at the branch expansion of new private sector banks, their pace would be among the highest for any banks anywhere in the world. And yet some of the reports talk about not enough branch expansion. To the credit of the new private sector banks, they have done exceedingly well on all parameters – efficiency, credit growth, capital adequacy etc -- despite their fast pace of expansion.
So why don’t you license some more private sector banks?
You need to be cautious on this. The new private sector banks took sometime before they attained some size to give competition to PSU banks. This is more desirable than to constantly license new banks. However, what is the ideal number of private sector banks is a matter of judgment.
Is there a case for branch delicensing?
If you look at the actual expansion of private sector banks, it’s the fastest in the world. You have to look at the balance of branches in urban, rural, semi-urban areas etc. So as long as we have priority sector lending – the kind of things you needed on a political economy basis -- then you have no choice but to have some form of licensing of branches. You can then argue about how liberal one should be; the form of licensing etc.
You have acquired a reputation among your critics that you are anti-reforms, anti-change etc. What’s your comment on this?
Well, my record should be an answer to your question. I don’t want to go into details as that would be like blowing one’s own trumpet.
But we would like you to elaborate.
Well, consider the industrial policy reforms in 1991. I had a hand in framing what may be called the first industrial sector reforms agenda in the country, which included industrial delicensing, opening of the economy to FDI, abolition of monopolies part of the MRTP Act, opening to foreign technology, and de-reservation of activities reserved for the public sector. As the head of the petrochemicals committee in 1993-94, our recommendations on the customs tariff structure in that industry had a huge effect on its future growth. Our projections were on target till 2004. You will remember the India Infrastructure Report of 1997: it changed the whole discourse on infrastructure in the country. I was also a member of the Competition Policy Committee, which led to the Competition Bill. While I was in NCAER, we drafted the Electricity Bill, which is the most reformist Bill of any power sector in the world. As member of the committee on the small scale sector, we recommended immediate de-reservation of the small scasector. That took about 10 years to do. So I have no view on what my critics say, as my record stands. If this is being regarded as being anti-reform and anti-change, so be it.
These were in the pre-RBI days. What about your stint in the monetary arena?
The invention of the market stabilization scheme is something unique in the world. In the period that I have been in RBI, you had the highest growth and lowest inflation in the economic history of our country. You had financial stability, highest credit growth; we had the introduction of new products – again more than any other period to my knowledge. We have managed the highest capital flows volatility that has ever been experienced and the financial sector has deepened very considerably in the period that I have been here. I am not saying I caused it, but I certainly didn’t hinder it.
There were other innovations. All the dynamic provisioning in terms of increasing risk weights, increasing provisioning norms, or reducing them, as the case may be, is now a received wisdom for reform in financial regulation in other parts of the world, but we did these things three years ago. In terms of monetary policy-making itself, we have been doing work on seasonal adjustment of inflation before anyone else started even talking about it and started the actual use of surveys and objective data in monetary policy making. In short, we have brought much more empirical data and its analysis in monetary policy making.
The discussion on the introduction of interest and currency futures was taken up by RBI in 2003 and 2005, much before any external committee said so. As I said, interest rate futures were introduced in 2003, although they didn’t succeed because of implementation problems. A great deal of work has also been done on developing the government debt market, the payment and settlement systems, consolidating urban cooperative banks, and so on. I can go on but that would take too long!
There was a whole period when people were critical of your intervention to sterilize inflows instead of letting the currency rise. There was an argument that you are slowing down growth.
Look at the facts. You are talking about a time when you had low inflation and unprecedented 25-30 per cent credit growth, and overall 9 per cent economic growth. Does currency appreciation aid growth or slow it down?
There was a criticism that RBI intervenes in a manner that adds to volatility in the currency market.
The fact of the matter is that any kind of measurement has shown that our currency flexibility is not too different from many countries whose currencies are not managed, who don’t have a managed float, and others who do have a managed float. But it also depends on what period you take. It is true of course that, as the forex market has deepened, greater flexibility has been allowed in the exchange rate on a daily basis. In my view, to preserve financial stability, intervention in the forex market is essential in the face of extreme capital flow volatility that we have observed over the past few years.
What’s the single biggest crisis you have faced in these five years?
I think the management of the volatility in capital flows has been the biggest challenge – both in 2007 as well as 2008. While 2007 saw heavy inflows, post-September 2008 saw heavy outflows. I regard them as symmetric.
If the net resource flow to the corporate sector has fallen by 20 per cent in this period, can we argue that RBI has not sufficiently addressed that problem?
In the context of the current global financial crisis, when money markets, credit markets, bond markets etc, have all got frozen in the advanced economies, the almost 20 percent credit growth achieved in this country last year was very creditable. Moreover, the money markets have functioned absolutely normally during the whole period, as have the forex markets. Despite the more than doubling of government market borrowing in the last quarter of last year, the government securities market has also functioned normally. You would be hard placed to find another country that has managed its credit markets and financial markets as creditably.