India - Change,With continuity

The general perception for some time has been that there are differences between the finance ministry and the Reserve Bank of India on key policy issues, including interest rates and exchange rate management. Observers will therefore read an extra significance into the fact that the serving finance secretary, D Subbarao, has been named to succeed Y V Reddy as RBI governor, in preference to the existing deputy governor. No one in the last three decades or more has made such a direct move from North Block to the top job in Mint Road. Whether Dr Subbarao’s positions on the critical issues differ significantly from his predecessor will be known soon enough. What is important is that the new dispensation at the RBI quickly comes to grips with the situation and responds effectively to both the structural needs of the financial sector and the immediate macro-economic challenges.
The first test will come with the quarterly monetary policy announcement, scheduled for end-October. Dr Reddy took an aggressive anti-inflationary stance in the past few months, with the stated intent of bringing inflation expectations firmly under control. Once embarked upon, such a stance must be followed through to its logical conclusion, which means that as long as the inflation rate is way above the comfort zone, policy rates must be raised. However, it has appeared on occasion that the finance ministry has not been persuaded about the merits of this approach and believes that maintaining a growth-friendly interest rate scenario is the priority. The question that the new governor must ask is whether a reversal of the current policy stance will hurt more by fuelling expectations than it will help by shoring up growth. If he decides that the former is the case, does he then risk a fractious relationship with North Block, as Dr Reddy did, or has the finance ministry been persuaded by the approaching elections of the need to give priority to inflation control? A second area of concern in the short term is the movement of the rupee, which has swung both ways over the past year and a half, leaving people confused about the nature, even existence, of exchange rate policy. With competing proposals for exchange rate management on the table, the RBI needs to make both the end-game and the transition path clear. On the structural issues, the 2004 road map for the opening up of the banking sector seems to have come up against the extreme inertia that characterizes the approach to consolidating and strengthening public sector banks. While one should not underestimate the political landmines that exist, a new government might have the will to push through an agenda that, ultimately, will increase both efficiency and penetration, while complying with prudential and disclosure requirements.
Dr Reddy’s tenure coincided with India’s growth surge and expanding international profile, and he could take some credit for managing monetary policy appropriately through this new phase. He leaves behind a banking sector that is healthier than it has ever been, with all scheduled banks adequately capitalized for the first time. He has begun the reform of the urban cooperative banks, and had the courage to rein in politically powerful financial players like Sahara. He also made the formation of monetary policy a consultative process by drawing in outside experts into a new monetary policy committee. But just as his predecessor had to deal with the fall-out of the Asian financial crisis (successfully protecting India from the virus), Dr Reddy has had to deal with unprecedented macro-economic circumstances, from the surge in capital inflows to the recent supply-side inflationary pressures. He responded by sterilizing the dollar inflows (which pushed up money supply, risking inflation), and then began moving aggressively on interest rates when the inflation surge of 2008-09 was not fully visible. In doing so, he ploughed a lonely furrough for a while, so it is ironic that his legacy should be an inflation rate that is way above what the RBI would like it to be. As often happens, therefore, his legacy is essentially an unfinished agenda. Dr Subbarao would be well advised to aim for a fine balance between continuity in fighting inflation and change on the structural side of the financial sector — for which two expert committees have laid out their road maps