The Telegraph
Since 1st March, 1999
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Reddy warns of gloom in bloom

Mumbai, Nov. 1: Reserve Bank governor Yaga Venugopal Reddy has flagged the possibility that the Indian economy — which grew 8.9 per cent in the first quarter (April-June) — may be overheating, but he isn’t looking to pull the trigger and unleash a set of policy responses that could trip up the Elephant Economy.

In an exclusive interview with The Telegraph a day after the mid-term review of credit policy, Reddy said an 8 per cent plus growth was a “rather exhilarating experience” but he had a nagging suspicion that there “could be elements of overheating” in the Indian economy that policymakers and the people at large were not even conscious of.

“I don’t have any conclusive evidence. My purpose was to flag the possibility of overheating in the economy. When growth is accelerating and there are inflationary pressures also, that is when any sensible central banker will have to look at it very closely. And that’s what we are doing now, ” Reddy said

Reddy is the first person to articulate the dark side of the boom which is predicated by two factors: the accelerating growth of the Indian economy and the build-up of inflationary pressures.

Both China and India — the two fastest-growing economies in the world — have now started to raise a wiggle of doubt in the minds of economists and academicians.

In China, the first doubts surfaced in 2004, forcing the authorities to clamp down on investments in real estate and steel sectors. The steam may have seeped out then, but the doubts are beginning to creep back with some economists in the Dragon Nation talking about the economy overheating again in early 2007.

In the mid-term review statement issued yesterday, the RBI had expressed deep misgivings about the surge in demand in the economy. At the moment, there are just a couple of straws in the wind but they are enough to worry Reddy and his coven of central bankers: these include the high growth in capital goods output, a surge in infrastructure investments, and a quickening of the capital expenditure cycle.

It would seem there is a difference between the way the Indian and Chinese economies are overheating. Economists use the term “overheating” to describe an economy that is suffering from excess demand, which could then spike up inflation. In that sense, India represents a classical case of overheating. However, China’s boom is being fuelled by investment, which means both supply and demand are surging.

Policy possibility

So, is the Reserve Bank preparing a raft of policy measures to douse an overheated economy'

“My purpose was to flag the possibilities of overheating in an
economy…I don’t have any conclusive evidence to show that there is overheating… When growth is accelerating and at the same time there are inflationary pressures, that is when any sensible central banker will have to look at it very closely and that’s what we
are doing”— Y.V. Reddy

Reddy is a lot more circumspect when it comes to talking about policy responses. “Policy responses have a lagged effect,” he says. It typically takes about 12 to 18 months before the full impact of a policy measure is played out.

Having already raised short-term interest rates thrice this year, Reddy would prefer to wait to see how things pan out before he decides to wade in again with corrective measures.

“Even assuming that there is high growth and inflationary pressure, the lagged effect (of policy measures) could serve as a correction,” he said.

Not too worried

Is he spooked by the fact that the economy that grew 9.3 per cent in the fourth quarter of 2005-06 continued to grow at a rather racy 8.9 per cent in the first quarter (April-June) of the current fiscal'

Reddy doesn’t want to sound as an alarmist and is at pains to state that high growth “doesn’t necessarily mean overheating.”

“There is no fixed figure anywhere in the world (that will indicate that the economy is overheating). If it were so, life would have been very easy,” the RBI governor said.

Going global

The Reserve Bank governor also said he had pressed the pause button on compliance with the Basel II prudential norms in order to give banks a little more breathing room to prepare for the transition.

The banks were supposed to comply with the Basel II norms by March 2007. The RBI has now broken it up into two stages: in the first stage, Indian banks with global operations and foreign banks will move to the Basel II regime by March 2008. The other banks will follow in March 2009.

“We did ask everybody to be ready, but we felt that we would be better off by learning from the experience of others,” Reddy said.

“Indian banks having global operations would have better expertise to manage the transition and other banks will have an occasion to learn from the experience of the globally active banks,” he added.

Reddy said even in the US the transition to Basel II was being sequenced with the lead being taken by the globally active banks. “Large emerging market economies like China and large market economies like the US are themselves not keen (to shift straightaway to Basel II). So, there is no need to rush it…We agree we need to be compliant but we can adopt a cautious path to Basel II,” he added.

He agreed that it would also give banks more time to beef up their capital structures during that period and would not lead to a crowding of public issues by banks in the run up to Basel II compliance.

Asset bubble

The RBI governor admitted that there was a sense of disquiet about the way banks were funnelling funds into the housing sector. “The housing market is less than perfect. There are high stamp duties with the difficulties of repossessing houses or selling houses. Bank transaction costs are high. But I think the market will mature; the housing prices and agreements will get more transparent,” he said.

Is he afraid that an asset bubble is beginning to build up in the housing sector' “I will be uncharacteristically heroic if I say that there is a bubble here or there. But well informed people like Deepak Parekh (chairman of HDFC) are expressing disquiet … they feel there are pockets where there is excessive enthusiasm. We cannot but take them on board,” the governor said.

Capital controls

Reddy said the capital controls would be eased in a gradual manner in line with the recommendations of the Tarapore committee. “If we can’t do something this year, we will do it next year,” he said.

He said capital controls would become less effective with a greater rate of trade integration. “A process of liberalisation is built into the process of growth,” he said.

Two other factors will determine the process of relaxing capital controls: first, the huge integration that is taking place in the sphere of non-capital transactions which cannot but have a spill-over effect on capital transactions.

Second, a lot will depend on the pace of domestic liberalisation especially in agriculture and commodities. “The domestic trade itself is not free,” Reddy said.

“A number of factors that determine capital account liberalisation are on the non-capital account side and very much in the real sector.”

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