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Some insights and plain speaking from Reserve Bank of India

A positive fallout of the trans-Atlantic financial crisis is that central banks have started becoming more transparent and doing some plain speaking. The Reserve Bank of India’s annual report for the year ended June 2010 is line with this trend. It contains some valuable insights into the nature of the Indian economy and into effectiveness of monetary tools in securing the policy objectives.

RBI’s macro economic assessment is somewhat predictable: while the growth outlook for 2010-11 remains robust, inflation has emerged as a major concern. Inflation containment may have to take precedence over other policy objectives such as economic growth and financial stability since domestic risks to growth have receded significantly. This is not new. However, the RBI goes on say that identification of sources of inflation is important for the conduct of monetary policy. When inflationary pressures are dominated by adverse supply shocks, monetary policy could be less effective in containing price pressures.

Another area where the RBI goes beyond current developments and raises deeper concerns is economic growth. High economic growth should not be taken for granted. The central bank has hinted at a possible slowdown in future growth and has come out with data that show reforms have helped little to raise productivity on shop floors and farms. India’s “potential output growth”, according to various estimates, would be 8 per cent for the post-global crisis period. While the growth for the current fiscal year would be 8.5 per cent, the rate at which the economy could grow in future has dropped.

The RBI has done some plain speaking on fiscal deficit. According to it, the emphasis in the current phase of consolidation should be on the quality of adjustment. The country cannot place undue importance on one-off gains (for example, spectrum auction proceeds) as they will not be available in the future.

The government received Rs1063 billion from telecom spectrum auctions, more than three times the budgeted expectation of Rs35,000 crore. However, it has already lined up a slew of new spending programs to gobble up almost all the extra revenue. India is back to a situation where government profligacy puts pressure on both monetary policy and macroeconomic management.

RBI also cautioned on the possibility of a return of another phase of capital flows into the country. Liquidity is easy in advanced countries and loose capital in search of higher yields may head for India in view of its superior growth outlook. Excessive inflows of foreign capital would exert appreciation pressure on the rupee, eroding competitiveness of Indian exports. In a way, the central bank report has pointed out limits to the effectiveness of the monetary policy. Thus it clearly states that inflationary pressures predominantly driven by supply shocks are less amenable to monetary intervention. Moreover, monetary policy has to take into account changes in global outlook and manage potential global shocks. Also, the government’s hefty borrowing programme has to be managed effectively amid high inflation and a possible increase in private sector credit demand. In short, the linear, mechanical link between inflation and policy interest rates may not always work.

Reading between the lines, one is left with an impression of a measured helplessness, a sort of “we will do our best but don’t be surprised if we don’t succeed much.” This sort of tentativeness may be accurate but brings no comfort. If the RBI, with all the technical expertise at its disposal (or is it because of it?) cannot come up with anything more definitive, would investors rush in?

Views expressed by the author are his own and do not reflect the newspaper’s policy.