The author is former governor, Reserve Bank of India
The annual report of the Reserve Bank of India for the year 2001-02 presents a credible story of debt and financial management by the central bank. While the story is particularly creditable on the external front, domestic economic activity during the year 2001-02 had recovered momentum, thanks to better monsoons.
India was one of the strongest growing economies of the world among emerging economies, notwithstanding a weak international environment. Particularly the buoyancy of software and other services exports contributed to a turnaround. The current account registered a surplus a historic first after 24 years. Added to this came the continuing strength of capital flows, including the largest net inflows of foreign direct investment recorded so far for any single year. These developments have contributed to a relaxation of the balance of payment constraint on growth. The year was marked by a sharp growth of foreign exchange reserves and a relatively steady exchange rate.
The domestic situation has, however, changed with the first quarter of 2002-03, particularly because of the unfavourable prospects of monsoons. Agricultural production will be adversely impacted by the drought. Adverse consequences on the fiscal situation are also to be expected as a result of increased expenditure on relief. However, supply shortages, which normally accompany drought, will be ruled out because of the abundant food stocks and the availability of foreign exchange reserves, which will take care of any needed imports.
The RBI report stresses the need to review the policy of support prices for foodgrains, which have led to large stocks. It cites a report of the Administrative Staff College of India in favour of a multi-pronged approach for orderly disposal of stocks, which would avoid possible major implications at harvest time, a minimum support price policy adjusted in relation to market price and a long-term strategy of diversification of agricultural production. Such diversification would necessitate adequate additional investment by government, particularly in irrigation and generally in agriculture. A holistic approach to food and agriculture, which corrects the errors of the past and takes into account the increasing production of foodgrains encouraged by high support prices is indicated.
Following the significant turnaround in the BoP situation, the external debt of India declined by $ 1.6 billion (1.6 per cent) to $98.1 billion during the year 2001-02. Almost half of Indias external debt is owed to multilateral and bilateral agencies only. One-fourth of this is on external commercial borrowing. External debt to gross domestic product ratio declined from 22.3 per cent at the end of March 2001 to 20.8 per cent at the end of March 2002. The size of short-term debt remains modest. Its proportion to total debt declined to 2.8 per cent at the end of March 2002 as compared to 3.5 per cent in March 2001. More significant is the fact that short-term debt in relation to foreign exchange reserves stands at a low level of 5.1 per cent compared to 8.2 per cent at the beginning of the period. In relation to total current receipts, the ratio of debt to total current receipts remained roughly at the same level of 122 per cent at the end of the year compared to 126.2 per cent at the end of March 2001.
Foreign exchange reserves increased by nearly $ 11.8 billion during the year the highest accretion in a single year so far. India today stands among the top reserve-holding emerging market countries. A frequently asked question is whether the reserves are too high. True, deployment of forex reserves involves a loss in terms of interest earned as compared to interest expended. The report, however, restates the observation in its previous versions that the reserves have to take into account the various liabilities on account of short-term debt and volatile capital flows and also unanticipated pressures on the BoP. The policy objective remains unchanged. The present level of foreign exchange reserves is adequate to cover 11.3 months of imports, as against the low level of three weeks of imports in the crisis year, 1990-91.
The RBI report cites the improvement of ratio of net foreign exchange assets to currency in circulation, which is normally interpreted as an indication of the strength of the monetary condition. This ratio has increased from 14.4 per cent at the end of March 1991 to 105.2 per cent at the end of March 2002. The level of foreign exchange reserves, which stands today at more than $ 60 billion, is definitely comfortable. The RBI has rightly allowed corporate organizations to repay costly tranches of external commercial borrowings and also further relaxed the rules on forex payments.
Inflation has been kept at a relatively low level in the last year. The ebbing of inflation in India has been symptomatic of the prolonged weakness of the aggregate demand in the economy and is in line with the pace of disinflation characterizing the world economic cycle. The annual rate of inflation in India during the year fell from about 5.0 per cent during the first five months of 2001-02 to 1.1 per cent in February 2002, the lowest in the last two decades. It came to 1.6 per cent by the end of March 2002, as compared to 4.5 per cent at the end of March 2001.
The report notes that the significant fall in inflation represented a combination of factors, particularly the fact that international crude oil prices fell and agricultural production improved. Absence of demand pressure due to sluggishness in investment demand, presence of excess capacity and inventory accumulation all contributed to this drop in inflation.
In this context, the RBIs report refers to an issue of some significance: whether the fight against inflation may have been carried too far. It states that while inflation can be unjust, deflation is inexpedient and the worse of the two. The Chakravarti committee concluded in 1985 that the tolerable level of inflation in India would be around 4 per cent. Subsequent empirical studies have shown that the threshold of inflation which could be tolerated in India is in the range of 4-7 per cent. The report refers to the concept of sacrifice ratio: the reduction in the output as a consequence of the pursuit of reduction in inflation.
Studies show that a reduction of one per cent in inflation in India may contribute to a reduction of output by two percentage points. This reference to sacrifice ratio would indicate that there is need to be concerned about an overstress on the fight against inflation. If one reads the report right, it would seem to show a tilt in the stance towards growth rather than a blind pursuit of fighting inflation as such. Growth obviously scores over inflation-fighting.
The RBI has continued to manage the overall monetary magnitudes with care. Particularly, it has helped to keep public debt management on an even keel. Its improved skills and techniques on public debt management are shown by the relatively low interest rates, which it has enabled for gilts. A worrying suggestion in the report is that public debt management should be transferred from the RBI to another agency, preferably with a view to distancing the monetary authority from the conflict of interest, implied in its management of public debt. While this suggestion has merit, in terms of practicality, it would seem to be an unnecessary exercise in ritual separation of functions. Experience in the subject is irreplaceable.
The level of reserves as well as the high debt of the government of India have directly contributed to the healthy accounts of the central bank. For the year 2001-02, the RBI had a total income of Rs 24,690 crore, made up of its income on foreign assets as well as interest income from domestic assets. Out of this, nearly Rs 9,986 crore is accounted for income from foreign assets, which yield a return of 4.1 per cent as compared to 5.8 per cent in 2000-01. Out of the total income of Rs 24,690 crore, the RBI has transferred nearly Rs 7,800 crore to reserves, for contingency reserve and for asset development reserve. The net total income is thus brought down to Rs 16,866 crore. After allowing for an expenditure of Rs 6,542 crore, the net disposable income comes to Rs 10,324 crore, out of which Rs 10,300 crore is to be transferred to the government. This is a much-needed boost to the battered revenue of the government of India.
Overall, the annual report for 2001-02 of the RBI carries forward the excellent tradition of its predecessors. It presents a credible story of substantive and creditable achievements on financial management. The RBI deserves credit for managing the economy of the country pragmatically and in a manner which has ensured that India remains an oasis of stability in a troubled world. Growth should now be the target of both the RBI and the government.