Outgoing RBI
Governor Subbarao delivered his last public speech in his capacity as the head
of India’s central bank. It will go down in the history as one of the important
speeches. It sounded much like his appraisal discussion, in front of a large audience J
His
finishing touch was fabulous:
A final
thought on this issue of autonomy and accountability. There has been a lot of
media coverage on policy differences between the government and the Reserve
Bank. Gerard Schroeder, the former German Chancellor, once said, “I am often
frustrated by the the Bundesbank. But thank God, it exists.” I do hope Finance
Minister Chidambaram will one day say, “I am often frustrated by the Reserve
Bank, so frustrated that I want to go for a walk, even if I have to walk alone.
But thank God, the Reserve Bank exists.”
I only
quote a section of his speech related to current problem about CAD and exchange
rate crisis.
//Remember,
I began my speech with the old Chinese saying - “May you live in interesting
times.” So, as inflation began to moderate yielding space for monetary easing
to support growth, we got caught up with external sector strains over the last two
years and a sharp depreciation of the rupee over the last three months. There
has been dismay about the ferocity of depreciation; there has also been a
growing tendency to attribute all of this to the ‘tapering’ of its ultra easy
monetary policy by the US Fed.
Such a diagnosis, I believe, is misleading. Admittedly, the speed and timing of the rupee depreciation have been due to the markets factoring in ‘tapering’ by the US Fed, but we will go astray both in the diagnosis and remedy, if we do not acknowledge that the root cause of the problem is domestic structural factors.
What are these structural factors? At its root, the problem is that we have been running a current account deficit (CAD) well above the sustainable level for three years in a row, and possibly for a fourth year this year. We were able to finance the CAD because of the easy liquidity in the global system. Had we used the breathing time that this gave us to address the structural factors and brought the CAD down to its sustainable level, we would have been able to withstand the ‘taper’. In the event, we did not. We therefore made ourselves vulnerable to sudden stop and exit of capital flows driven by global sentiment; the eventual cost of adjustment too went up sharply.
But what drives the CAD so high? Basic economics tells us that the CAD rises when aggregate demand exceeds aggregate supply. There is an argument that this logic is not applicable to us in the current juncture given the sharp slow down in growth. But we need to recognize that the CAD can increase substantially even in a low growth environment if supply constraints impact both growth and external trade as has been the case with us.
The only lasting solution to our external sector problem is to reduce the CAD to its sustainable level and to finance the reduced CAD through stable, and to the extent possible, non-debt flows. Reducing the CAD requires structural solutions - RBI has very little policy space or instruments to deliver the needed structural solution. They fall within the ambit of the government. Structural adjustment will also take time. In the interim, we need to stabilize the market volatility, a task that falls within the domain of the Reserve Bank.
It is the avowed policy of the Reserve Bank not to target a level of exchange rate and we have stayed true to that policy. Our efforts over the last few years, particularly the last three months, have been to smoothen volatility as the exchange rate adjusts to its market determined level so as to make the near-term cost of adjustment less onerous for firms, households and banks.
There has been criticism that the Reserve Bank’s policy measures have been confusing and betray a lack of resolve to curb exchange rate volatility. Let me first of all reiterate that our commitment to curbing volatility in the exchange rate is total and unequivocal. I admit that we could have communicated the rationale of our measures more effectively.
But our actions were consistent. Our capital account measures were aimed at encouraging inflows and discouraging outflows. Also, we tightened liquidity at the short end to raise the cost of short-term money so as to curb volatility. At the same time, we wanted to inhibit the transmission of the interest rate signal from the short end to the long end as that would hurt flow of credit to the productive sector of the economy. So, we instituted an Indian version of “operation twist”.
I must reiterate here that it is not the policy of the Reserve Bank to resort to capital controls or reverse the direction of capital account liberalization. Notably, the measures that we took did not restrict inflows or outflows by non-residents.
Such a diagnosis, I believe, is misleading. Admittedly, the speed and timing of the rupee depreciation have been due to the markets factoring in ‘tapering’ by the US Fed, but we will go astray both in the diagnosis and remedy, if we do not acknowledge that the root cause of the problem is domestic structural factors.
What are these structural factors? At its root, the problem is that we have been running a current account deficit (CAD) well above the sustainable level for three years in a row, and possibly for a fourth year this year. We were able to finance the CAD because of the easy liquidity in the global system. Had we used the breathing time that this gave us to address the structural factors and brought the CAD down to its sustainable level, we would have been able to withstand the ‘taper’. In the event, we did not. We therefore made ourselves vulnerable to sudden stop and exit of capital flows driven by global sentiment; the eventual cost of adjustment too went up sharply.
But what drives the CAD so high? Basic economics tells us that the CAD rises when aggregate demand exceeds aggregate supply. There is an argument that this logic is not applicable to us in the current juncture given the sharp slow down in growth. But we need to recognize that the CAD can increase substantially even in a low growth environment if supply constraints impact both growth and external trade as has been the case with us.
The only lasting solution to our external sector problem is to reduce the CAD to its sustainable level and to finance the reduced CAD through stable, and to the extent possible, non-debt flows. Reducing the CAD requires structural solutions - RBI has very little policy space or instruments to deliver the needed structural solution. They fall within the ambit of the government. Structural adjustment will also take time. In the interim, we need to stabilize the market volatility, a task that falls within the domain of the Reserve Bank.
It is the avowed policy of the Reserve Bank not to target a level of exchange rate and we have stayed true to that policy. Our efforts over the last few years, particularly the last three months, have been to smoothen volatility as the exchange rate adjusts to its market determined level so as to make the near-term cost of adjustment less onerous for firms, households and banks.
There has been criticism that the Reserve Bank’s policy measures have been confusing and betray a lack of resolve to curb exchange rate volatility. Let me first of all reiterate that our commitment to curbing volatility in the exchange rate is total and unequivocal. I admit that we could have communicated the rationale of our measures more effectively.
But our actions were consistent. Our capital account measures were aimed at encouraging inflows and discouraging outflows. Also, we tightened liquidity at the short end to raise the cost of short-term money so as to curb volatility. At the same time, we wanted to inhibit the transmission of the interest rate signal from the short end to the long end as that would hurt flow of credit to the productive sector of the economy. So, we instituted an Indian version of “operation twist”.
I must reiterate here that it is not the policy of the Reserve Bank to resort to capital controls or reverse the direction of capital account liberalization. Notably, the measures that we took did not restrict inflows or outflows by non-residents.
