Economy slowed due to supply side constraints and governance, not just tight monetary policy: D Subbarao

Indian economy made itself vulnerable by not using the breathing time it got—with the global liquidity which followed the easy monetary policy soon after the 2008 financial crisis—to rein in its high current account deficit (CAD), RBI governor Duvvuri Subbarao said on Thursday.

Delivering a speech at the 10th Nani A. Palkhivala Memorial Lecture in Mumbai on August 29, 2013 (for full text click here)  the outgoing chief of the central bank said the only lasting solution to the country’s external sector problem is to reduce the CAD to its sustainable level and to finance the reduced CAD through stable, and to the extent possible, non-debt flows.

“Reducing the CAD requires structural solutions—RBI has very little policy space or instruments to deliver the needed structural solution. They fall within the ambit of the government,” said the RBI governor.

Subbarao said the diagnosis attributing all of the depreciation of the Indian currency to the tapering of the ultra-easy monetary policy of the US Fed is misleading and we need to acknowledge that the root cause of the problem is domestic structural factors.

He acknowledged, “Structural adjustment will also take time. In the interim, we need to stabilise the market volatility, a task that falls within the domain of RBI.

Too slow to tackle inflation build-up; too hawkish to tighten policy?

Terming his tenure as RBI governor as an intellectually vigorous period, he responded to the twin criticism that RBI did not take adequate measures to contain inflation as the economy bounced back after the financial crisis and later went too hawkish on monetary policy which stifled growth.

To those who picked on the regulator for not tackling inflation, he asked to recall the context of the years 2010 and 2011. “With the benefit of hindsight, of course, I must admit in all honesty that the economy would have been better served if our monetary tightening had started sooner and had been faster and stronger,” Subbarao said.

Responding to those who complain that RBI was too hawkish in its anti-inflationary stance thereafter, he said attributing all of the moderation in growth to tight monetary policy would be inaccurate, unfair and importantly, misleading as a policy lesson.

“India’s economic activity slowed owing to a host of supply side constraints and governance issues, clearly beyond the purview of RBI. If RBI’s repo rate was the only factor inhibiting growth, growth should have responded to our rate cuts of 125 bps between April 2012 and May 2013, CRR cut of 200 bps and open market operations (OMOs) of Rs 1.5 trillion last year,” he argued.

He acknowledged that monetary tightening was one of the reasons for slowdown but said the objective was to compress aggregate demand, and so some sacrifice of growth is programmed into monetary tightening. “But this sacrifice is only in the short term; there is no sacrifice in the medium term,” he said.

Subbarao went on to point out the loose fiscal stance of the government during 2009-12 and said that if the fiscal consolidation was faster, it is possible that monetary policy calibration could have been less tight.

He also defended himself against the criticism that monetary policy is an ineffective tool against supply shocks and the move to tighten policy in the last couple of years was misplaced. Subbarao said when food is a large fraction of the expenditure basket, food inflation quickly spills into wage inflation and therefore into core inflation.

“If ever there was a potent cocktail for core inflation to rise, this was it. And it did - rising from under 3 per cent at the start of 2010 to almost 8 per cent by the end of the next year. It is against this backdrop that our anti-inflationary stance in 2010 and 2011 needs to be evaluated,” he said.

Defending the central bank on criticism that its policies have been confusing and betray the resolve to curb exchange rate volatility, he said the commitment to curbing volatility in the exchange rate is total and unequivocal. “I admit that we could have communicated the rationale of our measures more effectively,” he said.

Subbarao said RBI’s capital account measures were aimed at encouraging inflows and discouraging outflows. The central bank’s move to tighten liquidity at the short end to raise the cost of short-term money was to curb volatility but it wanted to inhibit the transmission of the interest rate signal from the short end to the long end as that would hurt flow of credit to the productive sector of the economy.

“So, we instituted an Indian version of ‘operation twist’,” he said referring to the policy stance taken by the US Fed where it bought and sold short-term and long-term bonds twisting the ends of the yield curve.

Lessons in crisis management

Talking about the lessons in crisis management, Subbarao said in a global environment uncertainty, policy action has to be swift, certain and reassuring.

“Second, we learnt that action is important, but communication is even more important. When the economic environment is uncertain, market players and economic agents look up to governments and central banks for both reassurance and clarity,” he said.

The RBI governor said another lesson was the need to adapt to domestic conditions even in a multi-nation crisis.

Subbarao said, “Crisis management is a percentage game. We have to do what we think has the best chance of reversing the momentum. At the same time, we have to weigh the short-term benefits against the longer-term consequences, including moral hazards.”

He referred to the year 2008 when massive infusion of liquidity was seen as the best bet. “This strategy was effective in the short-term, but with hindsight, we know that excess liquidity may have reinforced inflation pressures,” he said.

Way forward for RBI

Talking about the way forward for RBI, Subbarao counted few challenges that it needs to address starting with managing policy in a globalising world.

He stressed on the challenge related to autonomy and accountability. This is with respect to whether the mandate of RBI should be narrowed on the argument that its broad mandate is diluting its focus on price stability, the core concern of monetary policy.

He said the jury is still out, but a consensus is building around the view that central banks now need to balance price stability, financial stability and sovereign debt sustainability. “How this is to be achieved is the big question,” he said.

The RBI governor said the crisis has made a strong case for a more expanded role for central banks.

He admitted that RBI has a wider mandate than that of most central banks but said this has served the economy well.

Subbarao said that the existing mechanisms for accountability are both inadequate and unstructured and mooted a proposal that the RBI governor goes to the Parliament Standing Committee on Finance twice a year to present a report on the regulator’s policies and outcomes and answers questions from the members of the committee.

“In my view, this will not only secure the accountability structure but also protect RBI from any potential assaults on its autonomy,” he said.

A message for FM

The RBI chief also made a remark on the expectations of the Indian finance minister on RBI’s policy stance, borrowing an observation made by a former German Chancellor Gerhard Schroeder.

“I do hope Finance Minister Chidambaram will one day say, ‘I am often frustrated by RBI, so frustrated that I want to go for a walk, even if I have to walk alone. But thank God, RBI exists’,” he said.

(Edited by Joby Puthuparampil Johnson)