THE NATION'S BANKER

The Reserve Bank of India has a finger in every pie of the financial system. Its responsibilities span a host of economic parameters and objectives, and the demands of its multi-point agenda frequently create contradictions and internal conflict s. How well does the central bank manage the balancing act? In the context of the recent developments in the currency market, a look at the challenges and opportunities before the RBI under Governor Bimal Jalan.

T.B. KAPALI

IT is not easy being the nation's banker even in an economically advanced and prosperous country. The Bank of Japan, which has locked horns with the Japanese government over its interest rate policy, would quite easily testify to this. It is more difficu lt being the central bank in a developing nation, if the experience of the Reserve Bank of India (RBI) is any indication.

Indeed, given a chance, it is quite possible that the RBI would opt for a radical re-ordering or even downsizing of its responsibilities and functions. For in the current scheme of things, it has a finger in every pie in the financial system and is not a ble to do full justice to any of its responsibilities. The RBI has a multi-point agenda, and frequently the demands of that agenda pose serious contradictions and internal conflicts.

Consider, for instance, the RBI's roles as guarantor of financial system stability (involving supervision and regulation of banks and other financial companies) and as the government's debt manager. As debt manager, it conducts the government's market bo rrowings and naturally wants to borrow for the longest possible maturities. But being responsible for the soundness of the financial system, it should be quite concerned if the borrowings are for long maturities. For banks' resources comprise mainly of d eposits with maturity up to three years. It is quite clear that any loan or investment made for longer than that period with liabilities which have to be paid back in less than that time pose grave financial risks for the investing institutions (the bank s) and for the financial system.

Here lies the conflict of interest. How is the RBI going to resolve this?

The larger environment

These are challenging times for central banks the world over. They not only have to grapple with economic uncertainties which have become more complex and which could render ineffective many of their traditional policy tools, but also contend with more c onventional and long-standing issues such as the nature of their relationship with the political executive, and in deciding where the buck stops insofar as economic policy-making and its consequences go.

The spat between the Bank of Japan and the Japanese government on the appropriateness of an interest rate hike highlights the tense nature of the relationship between the political executive and a central bank. This unease between the elected establishme nt and an "unelected" body of officials, is a well-known feature of the overall environment in the advanced countries. And, over a period of time, both governments and central banks seem to have perfected the art of co-existence.

The situation has so evolved that governments now largely restrict themselves to laying down the ends or some concrete economic objective - for instance, inflation to be maintained in a range. Central banks are then left to adopt and pursue whatever poli cies/strategies are necessary to attain those objectives. In a way, this arrangement simply reinforces the supremacy of the political executive but provides a large measure of professional freedom, clarity and focus to the central bank's policy-making.

In harmony with government but contradictions galore

Closer home, the RBI has not embarked on any strategy to defy the government. Far from it, its policy objectives mesh with that of the government, as the Governor of the central bank says in the accompanying interview. In other words, there is no uneasin ess and tension in the relationship between the government and the RBI.

And in this task of working alongside the government (and not independent of it, the RBI has been more than successful in fulfilling its responsibilities, fairly heavy ones at that. Indeed, very few central banks in the world have the kind of responsibil ities that the RBI, so gamely and without complaint, shoulders in so routine a manner.

While being admirable in one sense, the present arrangement in which the RBI is responsible for a host of economic parameters/objectives also poses tremendous problems in reconciling them. Quite frequently, the inherently conflicting nature of the arrang ement lands the RBI in some kind of a paralysis. In such a situation, a particular policy move with respect to one objective could be seen to be directly undermining progress in the attainment of another. The result: half-hearted measures in respect of b oth objectives.

The RBI is not only a monetary authority with a responsibility to determine the price and adequacy of credit facilities in the economy but it has broad (and loosely defined) responsibilities with respect to checking inflation. More demanding are the resp onsibilities thrust on it as a public debt manager and as manager of the external sector of the economy.

On the right side of the inflation curve

A fortuitous combination of circumstances - a series of good monsoons, a tame international price environment for the past years and the increasing exposure of the Indian economy to global price trends - may have contributed to the country's satisfactory performance on the inflation front in the past few years. The wholesale price inflation has on average ruled around 5 per cent in the past five or six years compared to the double digit increases previously.

The RBI may not, therefore, get all the credit for the not-so-poor performance on the inflation front. A more important issue here, from the viewpoint of assessing the bank's performance, is when the overall economic environment relating to prices change s for the worse. Since the central bank does not have any clear-cut mandate on inflation, will the RBI be held responsible for any uptick in inflation and will it be given the leeway to undertake whatever policy measures necessary to counter inflationary pressures?

Conflicts in public debt management

A study of the RBI's public debt management and how it has executed that responsibility highlights the institutional rigidities and constraints within which it is functioning.

It is well known that governments in independent India have run budget deficits. While earlier, bridging the budgetary gap was easy (the government merely asked the RBI to print fresh currency to the extent of the deficit and also took recourse to prescr ibing high reserve requirements for banks making them invest Rs.38.5 of every Rs.100 of deposits in government securities) the government now has to compete in the broad market with other users of funds for borrowing money. The RBI's task has become more demanding with the proportion of market borrowings in the total financing requirement going up (Table 1). No more printing of currency to bridge the gap, although, given its onerous responsibilities, the RBI has provided itself some leeway to skirt an a greement which forbids currency printing.

Public debt management involves the issue of government securities in the market and the mobilisation of funds to bridge the budgetary gap, and more crucially extends to issues such as the terms on which the government borrows - the cost of borrowing and the period for which the government borrows.

Borrowers would normally want to borrow for the longest maturity and at the lowest rates possible. While this was possible and quite easy for the government earlier (when currency was printed to bridge budgetary gaps and even later till the introduction of the auction system of floating government loans), it is not so easy in the present market-related system.

The RBI therefore faces tremendous challenges in pushing through (selling) a large and rising government borrowing programme in the market. It has to lengthen the period for which the government borrows and do so at the lowest possible rates. This is an extremely difficult combination of outcomes to achieve.

Tables 2 and 3 indicate that while the RBI has had some success in lowering the rates at which the government borrows, this has come at the cost of a sharp shortening of the periods for which borrowings are made. More recent experience with respect to pu blic debt management, though, has been quite favourable for the government. In 1999-2000, there was no issue of government securities for a period less than five years. Also, around 65 per cent (Rs.56,630 crores) of the total amount of securities issued (Rs.86,630 crores) during the year was for above 10 years.

The RBI would like to keep the borrowing costs for the government down. But if inflation is a concern and the market demands higher rates on lending to government, will the RBI accede to such a demand? Would the RBI subject the government also to higher interest rates as will be the normal market response to any borrower seeking to raise funds in a rising inflation scenario? Institutional reforms are crucial to relieve the RBI of its public debt management responsibilities.

External sector

The RBI's role with respect to the external sector of the economy is another key policy area bristling with challenges and conflicts. Here again, the bank has been bravely holding out against tremendous odds. Although the global economy has gone through economic and political upheavals in the past few years, the performance of the external sector causes much concern.

Institutional reforms seem imperative in this area too. For, while grave challenges have been successfully met in the past, that does not necessarily pave the way for a comfortable and trouble-free future. One definite step to ensure better management of problems would be to provide institutional freedom to the RBI.

Conservatism, particularly since the balance of payments crisis of 1990, and deft management of recurring problems could be identified as two factors that largely enabled India to come out relatively unscathed from the South-East Asian currency and econo mic crisis.

Conservatism with regard to opening up the financial sector to external participation ensured that India did not face problems such as large-scale flight of capital, the kind that forced the South-East Asian economies to make extremely difficult policy c hoices. Indian banks and companies do not run up huge liabilities in foreign currency (a factor responsible for making larger economy vulnerable to capital flight) and their borrowing in the international markets is still subject to restrictions. The RBI has, however, gradually eased some of the restrictions. The large overhang of repatriable non-resident Indian (NRI) deposits is another vulnerable area, if the experience of 1990-91 is anything to go by.

The inherent conservatism in financial sector policy therefore dramatically shrunk the dimensions of problems in the external sector even as the economy of Korea and Thailand almost went down because of financial excesses. India did not escape totally fr om the crises that spread across from East Asia. Deft management by the RBI at this stage has, however, meant that the Indian economy and markets project a picture of relative stability in the face of continuing uncertainty in other economies.

A comparative study of the movements of three currencies - the Indian rupee, the Korean won and the Thai baht - in the past three years would seem to provide some evidence of the relatively higher degree of stability obtaining in Indian financial markets .

The baht is now at around 41 units to the dollar. It ruled around 26 units in July 1997. That works out to a total depreciation of around 58 per cent. Much of this depreciation came about in a few months after the currency crisis in July 1997.

The won at around 1,115 units to the dollar now is down by around 33 per cent from its July 1997 level of 840 units to the dollar. The won, in fact, was ruling even lower in early 1998. At around 1,460 to the dollar, it had then lost almost 75 per cent o f its July 1997 value. The won's current levels therefore represent a good gain from its early 1998 depths.

But what stands out in the case of both the baht and the won is the huge volatility. Won, down 75 per cent at one point, has clawed its way back to be only 33 per cent down now.

The rupee in the same period - July 1997 until now - has also lost some value. At 45.80 to the dollar, it is down around 30 per cent from its July 1997 rate of 35.70 to the dollar. But unlike the wild swings noticed in the case of the other two currencie s, the rupee's fall has been more gradual and more evenly spread out. The rupee, on average, has lost around 8 to 9 per cent of its value in the past three years.

A graduated and controlled fall has its own implications. It could, for instance, enable better economic planning (say at the level of an individual company) and help avoid or lessen the magnitude of other economic shocks.

THE RBI's handling of the external sector in the past few years does show the central bank in good light, especially when compared with the external sector performance in other emerging market economies.

The challenges, though, are formidable. Much of it has to do with what role the RBI sees for itself in the external sector, which is steadily integrating with the world markets. With rapidly disintegrating controls and barriers to linkages with the globa l markets - both goods and financial - the ability of the RBI to deliver a certain "rate" of performance on the external sector (in terms of ensuring only gradual falls in the rupee) would also come under severe strain. Indeed, the macro-economic environ ment relating to Indian external trade appears to be evolving in such a way (a case in point being commitments under the World Trade Organisation (WTO) to end quantitative import restrictions) that the RBI's ability to control the flow of foreign exchang e could be seriously impaired. The central bank cannot build enough foreign exchange reserves to be able to take care of imbalances in demand/supply of foreign exchange in the market as it is doing now. The adjustment mechanism in such an environment wil l necessarily have to only operate through the exchange rate.

The present level of responsibility that the RBI has with respect to the rupee's exchange rate also quite frequently brings it in conflict with its public debt management concerns. The recent developments in the currency market (with the rupee under stro ng downward pressure) and the public debt market have clearly brought out the contradictions inherent in the RBI's multi-point agenda.

Maintaining status quo in the institutional arrangements relating to the central bank does not appear that easy in the evolving economic environment. More important, the status quo also does not seem capable of delivering optimum economic r esults. The sooner the government and the RBI work on this issue, the better it would be for the overall economy.