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No. 184, 11 Octobre 2017

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Comments on Y.V. Reddy's "Advice and Dissent"

by Yılmaz Akyüz

The comments below were made at the launching of the new book Advice and Dissent written by Y.V. Reddy, former Governor of the Reserve Bank of India and Member of the Board of the South Centre, held at the South Centre, Geneva, on 9 October 2017.     Yılmaz Akyüz is the Chief Economist of the South Centre.   The book is published by Harper Business.

Speakers during the book launch of Dr. Y.V. Reddy's book Advice and Dissent (L-R): Mr. Vicente Paolo Yu, Deputy Executive Director, South Centre; Ms. Evelyne Tall, South Centre Board Member; Dr. Y.V. Reddy, Author, South Centre Board Member, Former Governor of the Reserve Bank of India; Ambassador Abdul Minty, Convenor of the Council of Representatives of the South Centre; and Dr. Yılmaz Akyüz, Chief Economist of the South Centre.
I enjoyed very much reading this book and learned a lot about India and its reserve bank. I was impressed by the clarity and sincerity with which Dr Reddy expressed his views and experience.  The book contains many lessons in central banking and in “making of a wise man” particularly for those born without many privileges. 
On the book I’ll confine my comments to areas within my competence – monetary and financial policies.  I make these comments not only on the basis of what is written in the book but also of observations I made both in UNCTAD and the South Centre as someone who watched macroeconomic and financial developments in the developing world.
Central bankers are generally conservative people.  They do not like their monies going down in value against goods and services and they often practice inflation targeting.  Most of central bankers also dislike their currencies losing too much value against other currencies because that could also lead to inflation.  But they do not always worry about their currencies gaining too much against other currencies even though this impedes exports and poses the risk of a sharp correction and instability.  Not many of them worry about their monies losing value against financial and real assets – bonds, equities and property – that is, about asset price inflation or bubbles even when markets clearly display irrational exuberance, as remarked by Greenspan in 1996 during the dot-com bubble. 
In these respects this book describes an unconventional and, I daresay, an unorthodox central banker; someone who is pragmatic not doctrinaire in managing inflation, the exchange rate and financial stability. 
We are told that in India monetary policy was designed and indeed delivered price stability. But inflation targeting was rejected because the Reserve Bank of India (RBI) “felt that arguments in favour of inflation-targeting were not relevant to India”.  In other words, India was not broken in that respect and hence did not need fixing.
Monetary policy in India traditionally kept a close eye on employment and the real economy.  The book talks about the developmental role of the RBI in matters related to credit. Thus the RBI watched not only the aggregate volume of credit, but also its distribution among different sectors and activities, particularly to rural areas.  Dr Reddy’s previous involvement as a civil servant in development planning was evidently important in giving a new twist to this traditional mission of the RBI. 
Exchange rate stability was also a major concern but the RBI did not practice exchange rate targeting of one sort or another.  At a time when the mainstream viewed currency interventions as ineffective, the RBI used them successfully.  In August 1997, soon after the onset of the Asian crisis, the RBI felt that the rupee was overvalued and faced the possibility of a sharp correction.  Dr Reddy, as a deputy Governor, advocated an induced correction despite opposition from the government which favoured overvalued rupee as a sign of national pride. In the event the induced exchange rate depreciation played an important role in moderating the impact of the Asian crisis on India.
During the Asian crisis India used “several administrative measures of control and command types over [capital outflows] to manage exchange rate volatility” when the rupee came under pressure. However, in the new millennium the Indian government did not favour restrictions to curb excessive capital inflows because they went against their “reform credentials” while the RBI was in favour of restraints on capital inflow and its Governor, Dr Reddy was talking about Tobin tax. Thus occasionally, as interventions became expensive and difficult, India had to allow the currency to appreciate or resort to liberalization of capital outflows by residents.  Both were risky and I am sure the RBI was aware of that.  Appreciations risked a sharp correction while liberalization of outflows as a countercyclical measure tends to lead to a one-way traffic; assets piled up abroad by private residents in good times do not return when capital flows are reversed.    
The RBI under Dr Reddy was quite unorthodox in its view of and intervention in asset markets. It seems that financial stability was a main concern to the RBI while the government exhibited a benign indifference. In the 1990s Dr Reddy had argued against extending the involvement and exposure of banks to equities to provide a boost to equity markets because of the risks involved for the stability of the banking system. In retrospect this was judicious after the Japanese experience where equity exposure of banks was an important part of the difficulties faced after the bursting of the equity bubbles of the 1980s.  In the new millennium when lazy banking in India was transformed into crazy banking, starting to fuel asset bubbles, the RBI watched credit growth not only with a view to inflation but also to asset prices, notably property markets.  It stood ready to raise interest rates even in the absence of any acceleration of inflation.  They did not permit the kind of derivatives that proved fatal in the making of the subprime crisis in the US.
Dr. Reddy appears to have been even more unorthodox when it came to foreign banks.  He writes: “Foreign banks … were keen to penetrate deeply into our system. However, we successfully resisted premature onslaught”. For, “instead of removing the constraints on our banking system and improving its efficiency through reform, we were inviting foreign banks to run our system”. For several years the World Bank had been actively promoting foreign ownership of banking in developing countries on grounds that they would bring competition, improve efficiency in intermediation and generate resilience to external shocks.  The RBI stood against the wind for many good reasons explained in the book.  International banks are known to practice regulatory arbitrage, shifting large deposits to offshore accounts in order to avoid high reserve requirements.  They have also advantages over local banks in supplying letters of credit through their head offices with better terms.  These put local banks at a competitive disadvantage.  Furthermore, rather than increasing resilience to external shocks, foreign banks can become instruments of transmission of shocks from their home countries, as seen during the Eurozone crisis.   
The record of the RBI under Dr Reddy in building foreign exchange reserves was also notable.  When many others were focussing on short-term debt in assessing reserve adequacy, the RBI pursued a national balance sheet approach (which I also used in my recent book), noting that since reserves were not earned from export surpluses, there were all kinds of liquid external liabilities associated with them. There was no rationale for building a Sovereign Wealth Fund with borrowed reserves, as suggested in some quarters, or divert them to investment in infrastructure.
Mr. Reddy’s pragmatism as well as benign global conditions were certainly responsible for what he calls “a governor’s dream – high growth, low inflation most of the time, stable rupee and a robust banking system”. He was aware that these were not only due to good policies and structural changes as advocated by many people in the government.  There were important positive cyclical, temporary elements that were closely associated with favourable global financial conditions and these called for caution in policy making at all levels.  
I fully agree with Dr Reddy that the RBI has been highly skilled in managing several externally induced shocks and in preempting the transmission of global uncertainties such as the Asian Crisis and US sanctions after the nuclear tests and so on.  Economic if not political shocks are likely to continue in the period ahead given the financial excesses we have had in many parts of the world, notably in the US, Europe and China since 2008.  Shocks ahead can be much more durable than those generated by the collapse of Lehman Brothers in 2008.  That shock was temporary, immediately followed by a significant monetary easing in the US and a rapid recovery in capital flows to emerging market economies (EMEs).  But the next one could be intense and more permanent.  India is also financially much more open today than it was during the Asian crisis.  The IMF warned in July that excessive reliance of India on debt finance and portfolio flows could create significant external financial vulnerabilities.  Furthermore, India has come to be mentioned alongside China as a potential source of instability. For instance the World Economic Forum argued last month that “Debt Boom in India and China threatens new financial crisis.”
Finance is a major driver of recent Indian expansion.  Financial companies now account for 36 percent of the country's publicly traded companies, an increase of 11 percentage points during the past five years.  Bad loans have doubled in the past two years, largely on account of public sector banks, albeit still low compared with some other EMEs.  All these are serious matters of concern since Indian external sustainability hinges on three not-so-reliable sources of foreign exchange flows – services exports, remittances from workers and capital inflows, including occasional borrowing from non-resident Indians.  Now that Indian growth is slowing, it is not clear how all this might play out particularly if global financial conditions tighten.   Still, the likelihood of the Indian boom ending with a bust cannot be dismissed.
The last time India had a balance-of-payments crisis was in 1991.  At the time when we looking into it in UNCTAD we found it quite puzzling.  Dr Reddy tells us in the book that the crisis happened for many reasons, political and economic, as well as global and domestic.  The sharp rise in the oil bill due to the Gulf war is mentioned as the main cause.  But price hikes were limited.  Oil prices were around $18 at the end of the 1980s.  They went up to $23 in 1990 but came down to $20 in 1991-92.  These cannot really explain the sharp rise in the oil bill from $287 million per month in June–August 1990 to $671 million in the next six months. On the other hand a current account deficit of 3 per cent of GDP itself is not a reason for loss of creditworthiness and a balance-of-payments crisis. Furthermore, following the Brady initiative for debt relief in Latin America, the global financial environment became benign in the early 1990s and interest rates were cut sharply in the US with the bursting of the Savings and Loans bubble.  Indeed money started pouring in emerging economies so much so that starting in 1991 we in UNCTAD cautioned them, notably Mexico, for consequent difficulties.   All these suggest that it is not obvious when and under what conditions the international finance can hit you.  This gives all the more reasons to be extra cautious -- this is also one of the key messages of Dr Reddy’s book.

Yılmaz Akyüz is the Chief Economist of the South Centre.
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