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Independent RBI -- good policy!

By Surjit S Bhalla
February 16, 2008 13:37 IST
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Budget 2008 will be here in two weeks and pink newspapers and news channels are looking forward in anticipation of -- higher profits from more ads.

It is likely that the Budget this year, in a process that started a few years back, will be of little consequence to the economy, or the stock market. Policy is no longer made exclusively on the 28th of February and that is a good thing. In that context, can any investor or pink journalist point to any major country in the world where Budget day is a tamasha day?

Does this mean India does not need any more economic reforms? God knows that is patently untrue. Worse, the sector most in need of reforms is assumed to be, again especially by the pink journalists, to be least in need. I am talking about the financial sector.

The two most important economic variables in any economy on Planet Earth are the interest rate and the exchange rate. Both are set by the Reserve Bank of India with more than an occasional input from the finance ministry. That is a major problem.

Apart from the fact that the emerging policy is a hodge-podge of different interests and analysis, this fraternal approach leads to the undesirable situation of zero accountability -- when the economy is good, both sides claim credit and when bad, each blames the other.

With this match-up, the politician (the finance minister) is the ultimate loser, because she has to face the public in periodic elections. The finance minister, and her party, can be booted out, on grounds of non-performance. But the person occupying the RBI chair cannot, and should not (on grounds of technocratic independence), face any such consequence.

So the first reform that the financial sector needs is independence for the RBI. It should be an autonomous institution charged with the mandate of ensuring growth and price stability. But how does this independence bring about accountability and therefore better policies? By a requirement akin to the Humprhrey-Hawkins law in the US (better to learn from our elders -- they have been there before).

In the late seventies, faced with rising unemployment and rising inflation, the US enacted an Act which 'explicitly instructs the nation to strive toward four ultimate goals: full employment, growth in production, price stability, and balance of trade and budget'.

This Act empowers the political arm of the government (Congress or Parliament) to make the technocratic arms (e.g. the Federal Reserve) accountable to the public. This accountability is ensured via not direct orders from the Treasury (finance ministry) but via direct testimony, twice a year, by the FED chairman to members of Congress.

Transporting this system to India, here is how accountability can be/will be ensured. The RBI governor will be questioned by the Indian Parliament and it is likely that some members (most likely from the Rajya Sabha) will ask questions about the logical consistency of some of the recent actions of the RBI.

Politician: First, how is it, madam, that you have allowed the rupee to appreciate and lead to a near 10 per cent trade deficit and a current account deficit that is likely to be the worst since 1992!

Governor: Sir, if you look at what was happening in March 2007, you will observe that we had high inflation (near 6 per cent year on year) and we thought that exchange rate appreciation was necessary to bring down inflation. But Madam, as is well known, this inflation was caused by internationally high fuel prices and high wheat (and rice) prices. How will tightening of monetary policy in India affect the chances of a drought in Australia? Sir, my advisers. . .

Okay, madam governor, that is history. Let us come to your recent policy action of keeping interest rates high and higher than anywhere else in the world. Why are you following this unique approach?

Sir, all my advisers tell me that money supply growth is the prime and only cause of inflation anywhere and anytime in the world. If you don't believe me, read Milton Friedman -- he got the Noble Prize for stating that. And even though he gave up on it long ago, as did the rest of the world, we at the RBI are not so fickle.

We have to curtail money supply and credit growth and if that means highest interest rates in the world, then our Brahamanical higher technocratic knowledge means that Indian industry and Indian people have to pay the price for bad rainfall in Australia.

Madam governor, do you find any inconsistency in your high interest rate policy and the fact that you keep coming to us for more funds to buy the dollars from those who are buying the rupee to take advantage of your Australian Drought  policy?

Sir, pardon me, but you should know the facts. We have strict capital controls and prevent foreigners from taking advantage of our AD policy. Yes madam, but have you noticed that foreign remittances,  borrowings by Indian corporates, etc have doubled to a $60 billion level in just the last two years of your drought policy? Are they immune to your higher policy?

But let's move on. Madam, you and I have complained about China's exchange rate policy of keeping its currency massively undervalued. That hurts our economy and specifically our exports. Our prime minister and finance minister have also complained about this.

But Madam, (and the FM and the PM), isn't it the case that one country's overvaluation is another country's undervaluation? Why wouldn't the Chinese tell you (if they were not so Orientally polite) that Boss, if you are worried about your competitiveness vis-a-vis us, why don't you lower your interest rates to near our levels?

(In China the corporate borrowing rate is close to 6 per cent, in India 13 per cent plus!) And we hate to tell you our well kept secret but lower interest rate gaps with the US will help your competitiveness by making the rupee less attractive. It took a long while for us to figure this out but in the spirit of Hindi-Chini bhai bhai we are passing on this major economic secret.

Thank you, madam governor. Now face the press -- they have some more questions to report to their readers about the making, and unmaking, of policy in an independent, democratic India.

The author is chairman, Oxus Investments, a New Delhi-based asset management company.

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