As D. Subbarao begins his last month as the 22nd governor
of the Reserve Bank of India (RBI), it is time to take stock of his tenure.
A vital aspect of this was his relationship with Finance Minister P. Chidambaram. The intense media speculation about differences between the two amounts to more than analysing the equation between two individuals. It encapsulates an important challenge India faces in monetary policy making.
Two markers will give a sense of what happened during the Subbarao governorship.
A few weeks after Subbarao took over on September 5, 2008, a meeting was held at the National Institute of Public Finance in New Delhi. By then, the effects of the financial crisis in developed markets had started showing in India. The meeting was called to get a better idea of what was going on. A prominent invitee was Montek Singh Ahluwalia, the Deputy Chairman of the Planning Commission.
The most striking aspect of the meeting was that Ahluwalia seemed as dazed as the others in the room - bankers, economists and a few journalists. It was a sign that many comfortable assumptions would have to be junked.
The second relates to a day after Subbarao announced his last monetary policy on July 30. In an interview with The Economic Times, Chidambaram openly expressed his annoyance with the US Federal Reserve Chairman Ben Bernanke's recent communication about his unconventional monetary policy. "Mr. Bernanke need not have made that statement," Chidambaram said.
It may well have been the first time an Indian finance minister had criticised an aspect of the US Fed's monetary policy. Mere words from another central bank's head could rattle India's economy.
A simple way of quantifying what's happened is to take a look at the changing pattern of India's integration with the world.
In 1965/66, the size of the current account and capital account (receipts plus payments) as a percentage of gross domestic product was 14.1. A few months after the financial year ended (June 1966) India devalued the rupee at a single stroke by 36.5 per cent from Rs 4.76 to a US dollar to Rs 7.50.
By 1990/91, the magnitude of current plus capital account had increased to 31.5 per cent of GDP. Soon after, the value of the rupee moved in phases to being market determined. By 1999/2000, the size of the current and capital account increased to 46.8 per cent of GDP. In 2011/12, it stood at 109.6 per cent of GDP.
It is evident that the Indian economy is significantly influenced by what happens elsewhere. The interconnectedness makes economic management more challenging than it ever was before. If the Indonesian government tinkers with its coal mining sector or if the US Congress debates tightening visa laws, India's economic policy makers have to deal with the fallout.
The growing integration has led to a paradoxical situation. India's economic policy makers have to give up control on the one hand, but on the other remain more in control. The slightest deterioration in economic performance implies foreign investors could vote with their feet in financial markets. It's not just foreigners, even India's big industrialists seem ready to move overseas when it comes to new investments.
For the RBI, integration means more deftness in dealing with the 'impossible trinity'. It is a trilemma which says a country cannot simultaneously maintain three policy goals: free capital flows, fixed exchange rate and an independent monetary policy.
The only way a central bank can deal with the trinity is to prioritise its goals as they can temporarily be at odds. For instance, the RBI's current primary goal is to stabilise the rupee, and policy has been re-tooled to meet this goal even if it comes at the expense of boosting growth.
That's the economic transition that served as a backdrop for Subbarao's governorship. Chidambaram's policy making too is situated in the same context. Yet, the task of facing a common challenge was not enough of a bond. Instead it stoked differences. That's mainly because the finance ministry's actions suggest it does not want to acknowledge the way monetary policy has evolved over the last two decades.
Arguably, the single biggest change globally in monetary policy making since 1994 has been the way in which communication has evolved as a key tool of monetary policy. Monetary policy, today, is about managing expectations of the future.
Take the RBI's case. When it changes interest rates, the only ones directly affected are banks which want to borrow short-term. The RBI doesn't tinker with any of the rates offered to depositors or borrowers who take home loans. The RBI's policy has an effect on the economy by changing expectations.
The RBI's actions are dissected for what it says about future rates. As a result, other rates fall in line. For instance, after the RBI indirectly nudged up interest rates last month to stabilise the rupee, it tried to signal that the measure was temporary. However, the bond market did not buy it and interest rates on 10-year government securities hardened. Why?
The RBI's communication is not underpinned by enough credibility. It is credibility that makes communication a potent tool. It has transformed monetary policy into a precision instrument rather than a sledgehammer.
Janet Yellen, Vice Chair of Board of Governors of US Federal Reserve, and, according to the US media, one of the favourites to replace Bernanke, has great faith in communication.
According to Yellen, the Fed established its credibility as an inflation fighter in the early 1980s when it triggered a recession to quell inflation. The long-term pay-off came in terms of credibility.
In 2005, even a large increase in oil prices did not trigger sustained inflation and, in turn, an aggressive Fed response in terms of higher interest rates. The Fed's hard earned credibility provided a relatively painless way of influencing expectations and headed off a sustained price rise.
By end-2008, when the Fed had pushed short-term interest rates down to near zero in an attempt to fight recession and unemployment, it had to resort to unconventional monetary policies to keep its loose monetary policy going. One aspect of the policy was quantitative easing, or an attempt to stimulate the economy by constantly injecting liquidity through the purchase of securities. The other was communication which went under the name 'forward guidance.'
The RBI too provides its version of forward guidance as it seeks to shape expectations. It could be argued these have met with limited success, given the bond market's reaction to its latest policy. Forward guidance by the RBI is still at an early stage as the central bank hasn't made the transition to quantifying its guidance, without which words like "temporary" can be interpreted in more ways than one.
A bigger problem here lies with the finance ministry and Chidambaram. Some of Chidambaram's public statements over the last year suggest he hasn't figured out the extent to which he undermines monetary policy with needless candour. It doesn't help bolster the RBI's cause of establishing credibility if the finance minister thinks he needs to walk alone.
One of the most damaging statements made by Chidambaram
came after the October 2012 monetary policy when Subbarao did not bring down interest rates.
"If (the) government has to walk alone to face the challenge of growth, well, we will walk alone," said Chidambaram. Although it was difficult to figure out what the damage was, it raised questions about the kind of backing the RBI was going to get.
To get an idea of the extent to which the public show of difference stayed in the mind of the market, take a look at the questions Subbarao was asked
this year by a magazine in Mauritius when he visited the country. Repeatedly, he had to sidestep the fallout of the "walk alone" statement.
Compare Chidambaram's behavior with that of his chief economic advisor Raghuram Rajan after the latest policy announcement. Rajan issued a media statement within a few hours. The headline read 'RBI and the government on the same page.' No room for ambiguity here.
If Chidambaram's statements last October were made in a moment of frustration, they could perhaps have been overlooked. Some recent statements on monetary policy suggest there is a larger problem.
This is what Chidambaram had to say about the RBI and its mandate towards the end of his approximately 72 minute engagement with the media to mark one year in his current stint as finance minister: "I believe that (the) mandate of the RBI is indeed price stability. But that mandate must be understood as a part of a larger mandate of promoting growth. There is no hierarchy among these goals. How do I prioritise between my left eye and right eye or between my son and my daughter?"
That was a bewildering statement.
If there is no hierarchy among goals, doesn't it mean the 'impossible trinity' is, well, impossible? That price stability and growth are always compatible as goals? If that were the case, Subbarao must have the easiest job in the world.
Chidambaram approvingly, but inappropriately, cited US President Barack Obama as saying the next governor of the Fed would have to both maintain price stability and maximise employment. Obama was stating the obvious. Since 1977, the Fed has been mandated to pursue maximum employment and stable prices. It is often referred to as the Fed's dual mandate.
Even if Chidambaram could choose RBI's policy goals, he would have to prioritise. The Financial Sector Legislative Reforms Commission
(FSLRC) has recommended that the central bank must be given a quantitative monitor-able objective by the central government for its monetary policy function.
For argument's sake, let us assume this comes into effect tomorrow. Chidambaram, as finance minister, would have to help choose a primary goal. If necessary, there could be a secondary goal. Implicit in this is prioritisation. There's no way to avoid prioritising in monetary policy.
Even the US, with its dual mandate, prioritises. The monetary stimulus exists because employment is the Fed's current priority.
All of this takes us back to the first question. Why does Chidambaram not get Subbarao? It is because he comes across as one who is confused about the realities monetary policy has to confront.
Someone has to tell the finance ministry that the world has changed since the early 1990s. We are in the 21st century.