Dr Reddy's reality check on Indian economy and policy

There is vast amount of coverage on Dr. Reddy’s tenure. (Hindu, ET). However, this last press coverage of Dr. Reddy is a standout for his insight on Indian economy and policy …and yes his humor.

On interest rates: According to Reddy, if he had it, his way monetary policy would have been tighter. He said charges that growth would be hurt because of RBI’s rate hikes have been belied. “While those with balance sheet interest do speak about the negative impact of higher interest rates, the decision has to be looked at analytically.”

I liked his take on those with balance sheet interest. Actually it is a puzzle. Usually, tight monetary policy leads to higher interest rates and lower corporate borrowing and industrial activity. However, in my research paperI have noted this is not really the case. Infact, both interest rates and industrial activity grow together. One of the main reason is that Indian firms rely more on internal resources for capital expansion and not much on debt/equity capital. (Read this Mint analysis as well; scroll down). Infact, this puzzle could also be the reason why credit has continued to expand despite Dr. Reddy hiking rates through out his tenure.

On exchange rates, the former governor made it clear that he is vehemently opposed to allowing the rupee to appreciate, even if a rising rupee adds to inflationary pressures. According to him, the rupee cannot be allowed to appreciate excessively in an economy, which runs a current account deficit, a wide trade deficit and a wide fiscal deficit merely because global capital, for the present, finds India attractive.

This is a challenge RBI has been facing for a long time (my paper on the challenges here). What should it do? Can we allow the rupee to appreciate and let the trade deficit widen? Or should it suppress the appreciation and allow some imported inflation and manage the sterilization? I would suggest problem is with excessive capital flows and there is a need to revisit them.

On making RBI a true monetary policy manager: Mr Reddy let out a secret on how initially, when he took charge as deputy governor, he was favoured the creation of a separate independent entity to manage government debt and how Mr Jalan was opposed to it on the grounds that it was unlikely that the fiscal deficit would improve. Given the Indian context, he said one should not go with an ideological approach, and the next step should be taken only after progress on fiscal consolidation. “The law of the land says that RBI should manage public debt. It was a mandate given to us by Parliament. Change the law. There is no empirical evidence that this function is not being managed efficiently.”  

This is an excellent anecdote from Dr. Reddy. You really can’t have a debt management office with such high fiscal deficit.

Financial markets: Mr Reddy said it is not possible to develop the financial markets without changes in policy and the real sector. According to him, it is not possible to have a market for interest rate futures when you have an inadequate and imperfect spot market, with different level of preparedness between foreign banks, public sector banks and corporates. “You have to consider how much of volatility the public can expect and handle. Foreign banks and private banks may have the capacity to manage it, but others might find it difficult to handle.

Lots of insight. This media hue and cry over absence of various derivative markets in India is simply not needed. We had success in equity derivative markets only when we had a very efficient spot market in equities. Debt and forex both being much more complicated and has taken time to develop. Same is the case with commodities….after much euphoria over the commodities derivatives launch, there was furore that the derivative markets are leading to an increase in prices. The expert committee found the problem is with efficiency of spot markets…I also liked his view on volatility….

On Percy Mistry and Raghuram Rajan reports: According to Mr Reddy, one cannot take a view on issues of such magnitude just because there is an expert committee report. “We are not only looking at Mumbai as a financial centre. Our own stance is a more comprehensive framework. If a table of the decisions were to be prepared with a column on who was required to take action, it would be clear that it was the government which had to act on most of the recommendations.”

This is an excellent comment on expert committees and where the problems lie. Apart from this, check out his humor as well:

The trademark humour was quite evident when he said there was no formal offer of an extension. “ I didn’t have the pleasure of saying no.”

Mr Reddy, who spent over ten years in Mint Street, including five years as governor, said it had been a learning experience. Only to add, “I hope that there was no major cost in educating me .”

Overall a very interesting insight from the man who was closest to all the ongoings. I think we need to have a similar outlook towards central banks policies as we see in growth and institutions literature. After much discussion we have come to the conclusion that no single formula works. Each economy is different and a result central bank would have to tune its policies accordingly. Infact this has been the experience in research as well with central bank operations differing widely.

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