Tubulent times, Dr Subbarao

Financial Express, 2 September 2008

The appointment of Dr Subbarao as the new Governor of the Reserve Bank of India should pave the way for financial sector and monetary policy reform. As its governor, Dr Subbarao will be leading the RBI at a time when the Indian economy is integrating with the world faster than it ever has. Over the next three years his biggest challenge will be to provide an enviroment and a regulatory framework that encourages and facilitates India's globalisation.

There are both immediate and long term issues that need to be addressed. High inflation is the most burning issue. In the longer run, the governor must focus on how to dismantle the licence control raj that still permeates Indian finance. Reform of the RBI to make it a central bank that is able to focus on low inflation will be among the tasks he faces. Further, in the face of a rapidly globalising Indian economy, as the RBI shifts focus away from the rupee dollar rate to the inflation rate, the governor will have to take the leadership in developing a new framework for monetary policy in India. The Mistry and Rajan reports have already indicated the direction in which the RBI should move. It is up to the new governor to chalk out the implementation.

Dr Subbarao's immediate challange is, of course, inflation. India is witnesssing the highest inflation rate it has seen in more than a decade. After many years of low inflation, double digit inflation has become unacceptable to the public. The fact that it has come at a time close to the general elections makes the job of inflation control even more difficult. It is not a time when unpopular decisions can be taken easily. Raising interest rates to tackle inflation will increase EMIs of households, slow down growth and raise the cost of investment.

The task of bringing down the inflation rate is also more challenging than ever because adjustment still needs to be made to domestic fuel prices. Double digit inflation has hit India even though we have not passed on the full extent of the increase in fuel prices. Increasing domestic fuel prices will put further upward pressure on prices, making the job of monetary policy even more difficult. While the RBI has often reiterated that the first job of the government should be to bring the fiscal deficit under control, were the government to actually ignore the political implications of raising fuel prices and do this, it would make the job of inflation control one of the most challanging in the world.

The issues of financial sector reform are equally, if not more, challenging. The first challenge is to dismantle the licence permit raj in Indian finance. While the present leadership, espcially Prime Minister Manmohan Singh, spearheaded reform in the real sector and got rid of the licence permit raj that characterised socialist India, this reform is yet to be undertaken in the financial sector. Capital controls are still firmly entrenched in the system. Even today, the old socialist ideology of control, more control and even more control dominates policy making and regulation in Indian finance. For example, in banking, our basic approach still remains protectionist where India continues with huge restrictions on foreign banks unlike our neighbours Pakistan and China who have opened up to foreigner to a much larger extent. However, the dismantling of capital controls and protectionism in banking is only a part of the problem. An equally difficult issue is the way entry of new banks, branches, financial products and financial regulation is currently being handled. There has, fortunately for the new governor, been a live debate on these subjects led by the Percy Mistry and Raghuram Rajan committees. Yet, the nitty gritty of implementing their recommendations still need to be worked out. The new governor will have to take a lead on the road map for reform.

The next front that needs attention is the reform of the RBI itself. A number of central banks around the world have led central bank reform. This was mainly because, like the RBI, they too were burdened with many conflicting objectives. As they understood the difficulties of trying to focus on low inflation, they pushed for reform that relieved them of their other responsibilities like public debt management, banking regulation and exchange rate policy. Again, the reform of the RBI, moving functions to new agencies, setting up agencies such as a new Debt Management Office and a new Banking Regulatory Authority and working out the path of transition, need to be thoroughly articulated.

Another crucial front on which the new RBI governor will need to take a leadership role has to be the creation of a new framework for monetary policy. Until now the RBI has focussed on the exchange rate. Again, as both the Mistry and Rajan reports point out, with India globalising at the very fast rate, focus on the exchange rate leads to a loss of monetary policy autonomy. The RBI now needs to develop a new framework for monetary policy compatible with the needs of modern India.

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