Reading Between The Rbi Lines

The Reserve Bank of India's (RBI) printed review for 1999-2000 and the backdrop in the policy document deserve close study by economists, market analysts and bankers. Reading the RBI's mind is always an uphill task, more so on this occasion!

The RBI has at last taken up the issue of potential output and actual output. Estimates of potential output in India are admittedly difficult. The RBI infers the behaviour of the output gap by looking at the trend in the permanent component of growth after filtering out the influence of temporary factors. In all probability, the 6.5-7.0 per cent growth rate projected for 2000-2001 would be above the filtered growth. This subject, which was taboo in India, has now been made respectable. The RBI should persevere with its work on potential output. Once it sights an output gap, it could gently put its foot on the brakes which would be smoother than when inflation rises to intolerable levels. One hopes that the RBI's Annual Report and future monetary policy announcements would take this into account. A prudent central bank should increase interest rates at the first sign of overheating well before inflation raises it ugly head.

 

A related issue is the segregation in the printed document on the analysis of primary liquidity into autonomous and discretionary components. While this would no doubt reflect the RBI's yeoman service in controlling the adverse impact of excessive reserve money creation, it must look at the eventual outcome of reserve money creation. It is one thing to have a certain level of reserve money creation and be gaining foreign exchange assets and quite another to have the same level of reserve money creation while denuding the foreign exchange reserves. It is in this context that the concept of net domestic assets of the RBI (reserve money minus the net foreign exchange assets) is important. The RBI in its Annual Report for 1998-99 and its latest printed review for 1999-2000 stubbornly refuses to take cognisance of this concept (the Currency and Finance Report mercifully does refer to this indicator). I am baffled that the RBI has a hang-up on this standard concept which is internationally recognised. In fact, the reserve money expansion of Rs 20,815 crore in 1999-2000 would translate into a net domestic assets contraction of Rs 7,112 crore. This reflects good monetary management. If India wants international rating agencies to give a correct perception of India's standing we should stop hiding this pertinent concept.

The RBI has successfully completed the large government borrowing programme for 1999-2000 while at the same time reducing interest rates and lengthening maturities, thus delivering the impossible. But the RBI is candid in its policy statement to remind the government that this was essentially because the economy was in a phase of the business cycle when there was no problem of excess demand or emerging inflationary pressures.

Governor Jalan is indeed right when he stresses that if the economy were in the upturn of the business cycle, it would have been difficult to meet the large borrowing requirement without a sharp increase in interest rates and crowding out private investment. Governor Jalan has issued a clarion call for a national consensus on an effective and time-bound programme of fiscal correction. The policy is forthright in that high levels of fiscal deficits are not sustainable over the medium term. While the gross to net borrowing ratio of the Centre was 1:0.89 in 1990-91, in 2000-2001 it is 1:0.65. Against a projected gross borrowing of the Centre of Rs 117,704 crore in 2000-2001, interest payments would be Rs 1,01,266 crore. This is the RBI's subtle way of telling the government unequivocally that it is running a Ponzi Scheme which is bound to blow up. It would be useful to refine these numbers to show, in the Annual Report, the ratio of gross borrowing (minus interest on market borrowing) to net borrowing. The figure of Rs 1,01,266 crore of interest payments is a gross interest payment and in fairness we should use only the interest payments on market borrowing. The public is entitled to know that there is a sinister nemesis lurking round the corner.

The RBI's printed review discusses headline inflation, core inflation and core-trim inflation. The headline inflation is the wholesale price as reported, while in core inflation commodities subject to supply shocks and administered prices are excluded. The RBI rightly points out that on this basis 47 per cent of the total weights in the index would be excluded and, as such, the core inflation as a concept would be of little relevance for policy purposes. Under the core-trim inflation indicator, an equal percentage of data points from the top and bottom tails of the inflation distribution across commodities is excluded from the actual inflation rate. While esoteric work on measuring inflation could be undertaken, the RBI would do well to recall the old dictum that while a discontinuity in supply or other shocks can result in sectoral inflation, generalised inflation, over the medium-term, cannot emerge without excessive money creation. In this context the authorities need to focus on medium-term inflation without any adjustments.

What is disconcerting is the cold water the policy statement throws on the suggestion that there should be a single objective like an inflation mandate or target. It is argued in the policy statement that there are several constraints in the Indian context in pursuing such a single objective. The first argument against an inflation mandate is that monetary management and internal debt management are inextricably linked and if these are separated, interest rates will rise. Second, it is argued that as financial markets are not integrated the transmission mechanism is weak. Third, satisfactory data are not available for targeting purposes. This stance of the RBI is clearly inadmissible. By arguing against the separation of monetary and debt management, the RBI is stunting the emergence of an effective monetary policy. The RBI has let the cat out of the bag when it argues that separation of these two functions would raise interest rates. It is thus clear that interest rates are not market determined and the RBI should give up the charade that banks can now determine interest rates. Again, at present, it is the avowed objective of the RBI to drive a wedge between markets so markets cannot integrate!

Finally, unless the authorities focus on inflation targeting they are not going to refine inflation monitoring tools. Having got rid of the idol of inflation targeting are we to wallow in the brilliance of equivocating multiple objectives with vague accountability? The battle of attrition cannot be over so soon. If the RBI does not lead the cause of inflation control others will. The RBI should not fight shy of its Dharma.