On the 75th anniversary of the Reserve Bank of India (RBI), governor D. Subbarao and his predecessors Y.V. Reddy, Bimal Jalan and C. Rangarajan spoke to CNBC-TV18 about the state of the economy and the road ahead.

Inflation threat

Bahl:

There is a fear that we may be on the verge of severe inflationary pressures, especially because there is such a flush of liquidity through the system.

Jalan:

I don't think this is really a liquidity issue. When you are talking about inflation this year, there are a lot of other issues to take into account. Liquidity growth and credit growth etc., has been quite modest. So I would not put my finger on liquidity as part of the inflationary problem. But this will take too long to go on into it--apart from the monetary issues, there are other issues that we have to think about.

Bahl: The extraordinary situation that the global economies are facing because of the extraordinary actions taken by the central banks--how do you see it panning out in the 12-18 months?

Subbarao: This was an extraordinary crisis and central banks around the world responded with unprecedented show of policy force. We know from history that if there is so much of liquidity loose in the system it can engender inflation. There is concern about inflation, but that threat is a bit exaggerated because there is excess capacity, unemployment is high. So the threat of consumer inflation is quite muted around the world. Having said that, if oil prices shoot up, for example, because of the recovery, there could be inflation from the supply side.

What is in fact a bigger threat (is)...if the liquidity goes into assets, there could be asset price inflation and that is what central banks should be guarding against.

Venkatesh: Dr Reddy, are you also as sanguine that inflation will not be such a big issue simply because there is overcapacity elsewhere or do you think that emerging markets maybe a different kettle of fish altogether--asset inflation first and thereafter the consumer price inflation could become a big demon?

Reddy: If there are unutilized capacities, if there are no supply bottlenecks, rigidities, then the threat of inflation is muted and there is no serious threat. First is that one has to make an assessment on these factors. As far as asset price inflation is concerned, that can be a combined effect of domestic liquidity and global capital flows. Capital inflows to emerging market economies and how the two work themselves out in terms of domestic liquidity. So in a way the threat of asset price inflation is serious, but it is contingent upon the way the capital flows and domestic liquidity are managed.

Capital controls Venkatesh: Brazil has shown us the way. They were faced by a real that appreciated 34% and they have enforced capital controls. Do you think that capital controls will have to be something central bankers will have to keep on the table?

Rangarajan: It has to be kept in mind that capital inflows are, generally speaking, welcome, particularly in a developing country. It goes to build the productive capacity and therefore, it is welcome...except when it goes to speculative activities like real estate...

It is also used up in the form of imports and it doesn't create a problem. But as far as the FII (foreign institutional investment) inflows are concerned, they could create a situation in that stock prices begin to rise to a very large extent.

That may not necessarily be a good reflection of the fundamentals. Therefore to some extent, some restrictions on the capital flows may be imposed...
Venkatesh: Let me hark back.

In the latter part of 2007, we did see the Indian government seriously prodded by RBI asking for capital controls. The entire idea of how the participatory notes situation had to be dealt with--getting them controlled, asking FIIs to be registered--would you, on hindsight, agree with those steps?

Subbarao: First of all, I was indeed part of the system. I was the (finance secretary in the Union) government asking the Reserve Bank. What I want to say--because this should be in the public domain--as much as there was discussion and debate between the RBI and the government on capital control, on the basic issue that there must be controls on capital because there was so much of a surge...and that is putting a cost on the economy and that was recognized both in Delhi and in Mumbai. There was of course, quite understandably, differences on what precisely needs to be done and when...but we acted in coordination.

Venkatesh: If the situation of quantitative easing continues even beyond March, which is the self-given timetable in some countries, do you think that those kinds of control will have to be contemplated?

Subbarao: Given the uncertainty in the world and given the number of scenarios in which the macroeconomic situation could evolve--no policy option, including Tobin tax, is off the agenda. In the long list all this is there. The question is what instruments do we use and when? People talk about quantity-based controls and price-based controls and Tobin tax is a price-based control. But we have even now both quantity-based and price-based control from bonds. For example, we have a quantity restriction on how much foreigners can hold and we have a price restriction by way of withholding tax and stamp duty. So we use both instruments; we use both types of instruments and going forward should there be a surge of capital flows, I think we should not rule out an active capital management that we did during 2006. However, I am not well placed at this time to debate on what should precisely be the instruments and timing because that depends on how the situation evolves. (The Tobin tax is named after the economist James Tobin, who suggested it as a penalty on short-term currency speculation.) Jalan: My take on it is that capital control, in principle, is the second best or third best solution. I think you have to think about why is it that capital flows are best but you are thinking about control, why?
This is the simple issue that you have to ask. Why is money not flowing into the banks, why is it going to mutual funds?

Venkatesh: So you are referring to the tax system? Your reasoning is that there is a deliberate tax advantage given to equities, to FIIs?

Jalan: Yes, I think so and we have to face it...
If you find something is going wrong, that you are thinking about capital controls, then don't think about capital controls except as Aspirin. Go behind the question--why is it that your country has $300 billion (around Rs14.01 trillion) of reserves and why is it that we cannot use $150 billion of it for capital investments?

Bahl: Dr Subbarao, what's your take, when these foreign exchange reserves swell--what does it show to you? Is it the inability of the system to handle it? Is it because the system is too conservative and not allowing deployment of that capital? Or is it arbitrage?

Subbarao: There are several issues; first between the real and financial sector. As Dr Jalan said, in India there has been a disconnect between the real and financial sector.

Around the world it's been more so because we all believe that value could be created by sheer financial engineering, now we know that is not correct.

About capital flows--what do capital flows indicate to us?
I tend to agree with what Dr Rangarajan said which is capital flows coming on the back of India's potential and India's promise. There could be bit of tax arbitrage but in a large sense capital flows are coming because India inspires confidence. Now when capital flows are up far in excess of the current account deficit, that shows the lack of absorptive capacity of the economy certainly because we are paying a cost holding those reserves. So I think in the long run or in the medium-term our task is to increase the absorptive capacity of the economy...but until then, we need to calibrate reserves roughly corresponding to current account deficit. Another law is that capital flows never come in precise quantity or the exact time you want them, they are completely different and we have to learn to manage them and that is something we a have been doing for a long time...