Y V Reddy: Indian economy - current status and select issues
Remarks by Dr Y V Reddy, Governor of the Reserve Bank of India, at the release of the India
Development Report 2004-05, Mumbai, 12 January 2005.
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Professor Parikh, Professor Radhakrishna and Friends,
I am thankful to Professor Radhakrishna for giving me the opportunity to be here for the release of
India Development Report 2004-05. The Report prepared by IGIDR, released today, is unique in
several respects. It addresses contemporary policy issues unambiguously and is more issue-based
than technique oriented. At the same time, it is based on thorough research with scholarly inputs.
Being issue-oriented, the Report captures both macro and micro aspects, especially the institutional
aspects of development and human welfare. While being highly analytical, drawing on theory, the
Report has no ideological biases and one should be delighted to note the India-centric nature of the
policy prescriptions. This Report is special in the sense that it lays significant emphasis on welfare and
the social sector. I have no hesitation in strongly recommending this Report to students and scholars
alike and to the policy makers and analysts as well. No doubt, there are some areas where the
observations in the Report do not fully conform to the policies being pursued by RBI, but such
differences in approach do help fine tune the policies better; though most of the differences arise from
the assumptions made: the assessment of risks in alternate paths, weights to be attached to relevant
factors, operational feasibility contingent upon the political economy, the institutional considerations,
etc. So, let me compliment all the authors, and in particular Dr. Parikh and Dr. Radhakrishna for this
illuminating volume.
I will take the opportunity, not to comment on the Report which is highly recommended for detailed
reading, but to supplement it with a few remarks on current status of the economy and refer to select
issues.
On October 26, 2004, we set out in the Mid-Term Review of Annual Policy Statement for the year
2004-05 that the overall GDP growth for the year 2004-05 would be in the range of 6.0 to 6.5 percent.
Subsequent developments indicate that while monsoon conditions and sharper rise in oil prices had a
moderating effect on growth, the manufacturing sector and exports have been performing better than
expected. With the economy growing at 7.4 percent in the first quarter and 6.6 percent in the second,
the GDP growth in the first half of the year works out to be about 7.0 percent. Unless there are totally
unexpected shocks, inspite of some adverse impact of Tsunami which is localised, the projected GDP
growth for the year in the range of 6.0 to 6.5 percent should materialise comfortably.
In response to the impact of Tsunami, RBI has adopted a three-track approach. First, ensuring supply
of currency, banking services with relaxations in procedures, as appropriate, liberal provision and
restructuring of credit for consumption as also resuming productive activities, finance for rebuilding
houses and coordinating with state governments, NABARD, NHB and commercial banks. This process
is still underway and the RBI's Task Force constituted for the purpose is directly in communication with
over 40 branches of commercial banks catering to the affected areas. Second, monitoring of financial
markets, which remain largely unaffected. Third, assessing the impact which indicates enormous
human suffering and considerable localised loss of assets in both public and household sector but with
marginal impact on overall growth and the external sector and manageable additional expenditure in
the Central and State budgets.
The Mid-Term Review devoted considerable attention to issues relating to price-stability and inflation
expectations. The WPI inflation, on a year-to-year basis decelerated to 6.4 percent during week ended
December 25, 2004. In view of several uncertainties and the fact that all indirect effects of increases in
oil prices domestically are yet to be fully transmitted, the projection at around 6.5 percent made in the
Review, continues to be valid. CPI (Industrial workers) inflation, year-on-year, rose to 4.2 percent in
November 2004 from 3.1 percent a year ago. In this regard, it is necessary to reiterate the serious
concerns expressed in the Review in regard to price stability and inflation expectations for three
reasons. First, inflation is a major problem for the poor. Second, stabilising inflation expectations is
critical to ensuring enhanced investment activity in the private sector, which is a crucial element of
current strategy for growth and welfare. Finally, our economy is now more integrated with the global
economy, and hence, maintenance of price-stability is critical for ensuring financial stability. In this
background, both monetary and fiscal policies give considerable attention to price stability, as part of a
growth-oriented strategy. The hard earned gains in this regard could be reversed if there is a
perception of dilution in commitment to contain undue inflationary pressures. In assessing the risks of
higher inflation it is, therefore, important to capture not only the probability and magnitude of adverse
impact of policies on inflation but also the damage that could be done both to price stability and
inflation expectations in the event, even with very low probability, the risks do materialise. Hence,
there is a need to continue to demonstrate, in a credible fashion, by words and deeds, commitment of
both monetary and fiscal authorities to stabilise inflation expectations.
The government finances present a mixed picture since the presentation of the Review, with greater
comfort in regard to the Central government's borrowing programme and some discomfort at the
trends in revenue deficit relative to Budget Estimates. The conduct of market borrowing programmes
of several States continues to be a matter of concern.
A distinguishing feature of the current year has been the strong growth in bank credit. Non-food credit
expanded by 18.1 percent in the current financial year up to December 24, 2004. The growth in credit
for housing and consumer durables continues to be a matter of some concern to the extent it reflects
on credit quality, but a source of comfort is that the overall credit growth of late is reasonably well
dispersed across sectors. Though credit growth has shown an uptrend, money supply (M3) growth has
remained subdued at 7.2 percent. By and large, the monetary trends are within the projections made
in the Review.
The financial markets generally remained stable. Though there was upward movement in interest
rates in money and government securities markets in November, the interest rates have since reverted
closer to levels in October 2004. The yield spread between highly rated corporate paper and
government securities increased. Furthermore, the spread between long term and short term
government securities has declined.
In the credit markets, the benchmark prime lending rates remain generally unchanged though interest
rates for housing have marginally firmed up. Public sector banks increased their rates for deposits of
over one year.
In the external sector, conditions in our forex market continue to be orderly. Global developments in
regard to output growth, currency markets, etc. have not been divergent from our expectations in the
Review and may continue to be so though uncertainties in regard to oil prices will continue, albeit in a
muted fashion. Since March 2004 the rupee has tended to appreciate against the US dollar and
depreciate against other major currencies, primarily reflecting the weakening of US dollar. There are,
however, some developments during the current year which are noteworthy. First, foreign exchange
reserves increased by US$ 18.2 billion, from US$ 113.0 billion at end March 2004 to US$ 131.2 billion
as at end December 2004. Nearly sixty per cent of the reserve accretion in the current financial year
has come in two months (November and December) - perhaps indicative of the volatility in portfolio
flows.
Second, the trade-deficit on the balance of payments basis doubled to US$ 12.3 billion in the second
quarter from US$ 5 billion in the first quarter - reflective of surge in imports - both due to increase in
oil-prices and pick up in investment activity. There is no reason to believe that the trend will not persist
for the rest of the year which may have a potential for a large trade-deficit during the year as a whole.
Third, the current account of the balance of payments which was in a surplus of US$ 3.2 billion in the
first quarter turned into a deficit of US$ 6.4 billion, reflective of not only surge in trade-deficit but also
moderation in the invisibles surplus. It is, therefore, possible that the current account for the year as a
whole may be marginally in deficit or very marginally in surplus. Despite the surge in trade-deficit, a
strong case for further liberalisation of trade and rationalisation of tariffs persists since the beneficial
effects of such liberalisation are evident.
Fourth, the capital account of the balance of payments shows that in the second quarter, external
commercial borrowings and short term credit moderated, while there were outflows under banking
capital. NRI deposits continued to register net outflows. Overall, however, the current trends do point
to continued surpluses in balance of payments, with possible marginal deficit in the current account
being more than compensated by continued strong inflows, particularly on account of inflows on
Foreign Direct Investment (FDI) and FII flows.
Our emphasis in management of capital account has generally been on external debt as
recommended by Rangarajan Committee, more than a decade ago, but there are several reasons, for
exploring an appropriately active but nuanced management of non-debt flows at this stage. The
magnitudes of FDI/ FII flows are tending to be large and volatility has perhaps increased. The impact
of such flows on the stock markets is discernible, but perhaps less evident at this juncture in corporate
ownership and control. The possible issues that need to be considered if one were to achieve a better
management of non-debt components of capital flows that will address emerging concerns are:
First, a view needs to be taken on the quantity and quality of FII flows. While quotas or ceilings, as
practised by certain countries, may not be desirable at this stage, there is merit in our keeping such an
option open and exercising it selectively as needed, after due notice to the FIIs.
Second, there is scope for enhancing quality of flows through a review of policies relating to eligibility
for registration as FIIs, and assessment of risks involved in flows through hedge funds, participatory
notes, sub-accounts, etc. Strict adherence to 'Know Your Investor' principle, especially in regard to
flows from tax-havens, including beneficial ownership would enhance quality.
Third, price-based measures such as taxes could be examined though their effectiveness is arguable
and hence may not be desirable.
Fourth, FDI flows, as currently defined, also include transfer of equity from residents to non-residents
and a disaggregated analysis of FDI through several routes could enable a policy-intervention, as
appropriate on quantities and quality.
Fifth, since there are several routes by which non-residents could hold shares and voting power over
Indian corporates, reporting and monitoring arrangements could be considered for assessing the
aggregate shares of residents (other than government) and non-residents in larger corporates and
those in sensitive sectors in particular. Such monitoring could help timely policy-responses on several
fronts.
Finally, consistent with the principle of hierarchy of capital flows, a view could be taken on relative
policy emphasis on sources and types of investment that need to be encouraged. For example, it is
well recognized that giving better incentives to foreign investors over domestic investors results in
scope for "round-tripping" and inefficiencies. Similarly, if avenues for portfolio flows or equity-transfers
from domestic to foreign investors are easily available and attractive, the flows under FDI defined in
terms of adding to domestic production-capacities will tend to be smaller. Attention to these may
simultaneously address micro or institutional issues relating to corporates, volatility issues relating to
capital flows and financial markets, and above all ensure high-quality inflows of foreign savings which
is more important to our country at this stage of development, to provide a healthy supplement to the
domestic savings.
Ultimately our unswerving objective has to remain a sustained growth rate, moderate inflation and
distributive justice, in an atmosphere of overall stability.
It has indeed been a pleasure listening to the illuminating remarks of Dr. Deshpande, Dr. Chandra
Mohan, Dr. Narsimha Reddy and Dr. Parikh. Let me conclude by expressing, once again, my deep
appreciation of the excellent and pioneering work undertaken by IGIDR on developmental issues.
Thank you.