Dr. YV Reddy: Governor of “Courage, Independence and Foresight”

In the question-answer session that followed the delivery of the first Per Jacobsson lecture held in 1994 at Barbican Hall, London, Baron Alexandre Lamfalussy, President of the European Monetary Institute, answering the question—“What indicators should central banks watch in order to take preventive measures against inflation, bearing in mind that consumer price indices, or GDP deflators, are lagging indicators?”—said: “Although I have doubts about the reliability of any single M, I still think that money supply does matter. Since the definition of money supply has become uncertain, central banks should certainly monitor a set of Ms, and also credit flows....”

Looking at the stewardship of Yaga Venugopal Reddy of the RBI, which he demitted on September 5, 2008, after the completion of his five-year term as Governor, one wonders if he has literally taken Baron Alexandre Lamfalussy’s answer as the dictum for his practice. With the gift of a rare ‘foresight’ Reddy—anticipating the impact of the huge capital inflows that the country has been witnessing right from 2004 on the dynamics of credit and asset cycle in the country and smelling that the credit cycle, which is at its peak, in association with high growth in economy, is simmering with inflationary pressures—took an anti-inflationary posture right from 2004. He, perhaps, with a concern for the increasing cyclical strength and the need for early move against inflation, hiked rates right from late 2004 onwards; when he became Governor, the CRR was 4.5%, which at the time of his retirement stood at 9%. And, intriguingly, he did not cut the interest rate during his tenure, on the other hand, during the last five months he raised it by 125 basis points to gradually tighten liquidity in the market. Perhaps, believing strongly that ‘easy money policy’ leads to high interest rates over time, he repeatedly and, of course, bravely and more rightly, resisted the pressures for lower interest rates. Despite his steadfast approach to managing inflation, it raised from less than 4% as at the time of his taking the reins of the RBI to an historical high of 12%—all in the last six months. This compels one to admit that his independent approach to management of price stability has ensured a ‘non-inflationary continuous expansion’ in the country for a considerably long time.

His handling of exchange rate, in the context of unprecedented growth rate that the country has witnessed and the resulting increased inflow of forex, is equally commendable. He contained real appreciation of rupee by ardently practicing sterilized forex intervention through sale of government securities, through liquidity adjustment facilities, intermittent rise in CRR, imposing restrictions on ECBs and inflow of capital through the participatory notes with concomitant well calibrated liberalization of capital outflows. It is this containment of real appreciation of rupee—except for a short while—that has helped exports grow rapidly. Equally, it is, perhaps, this resistance of the RBI, particularly during his first three years of stewardship, against appreciation of rupee that made India an attractive investment destination. 

Under his stewardship, banking system has become healthier than it ever was: banks are all adequately capitalized and are ready for adopting Basel II norms. Anticipating the likely perils that may result from the growth in retail credit, he tightened the prudential norms for consumer and home loans. In 2004, he made bank lending for housing and consumer goods expensive. Similarly, he directed banks to maintain capital against securitized assets. Though imposition of such prudential norms were criticized at the time of their imposition under the plea that they are restrictive of growth prospects in the country, today looking at the havoc wrought by the US subprime crisis, everyone realizes how important such measures are for asset price bubbles not to surprise us. In a courageous move, he extended the effective regulatory oversight of the RBI to non-banking financial companies. Similarly, he was instrumental in getting RBI sign a memorandum of understanding with 19 state governments coopting them into decision making relating to urban cooperative banks for improving their functioning.

Interestingly, in all these moves, Reddy ploughed a lonely furrow, as is evident from the flak that he attracted from various quarters. His treating of inflation as a monetary phenomenon, particularly when what we have been witnessing for the last six months is not India-specific, and many economists opine that it is after all a global phenomenon mostly driven by rising crude oil and food prices—a supply side problem, and shaping his monetary policy accordingly has irked many. His practicing the monetary model, instead of Keynesian model of targeting the real interest rate as a tool for inflation control, that too, when investments and savings in the economy are growing by 33.0% and 33.9% respectively, has made one school of economists accuse Reddy of steering the country into ‘monetary overkill’.

It is, of course, a different matter that despite the criticism, Reddy courageously stayed on his course, which should have, and obviously, prompted Prof. Shanker Acharya, former chief economic adviser to Government of India, to reward him with his personal award: “Best Economic Policy Maker.” Nonetheless, the success or failure of a central banker is often left to the assessment of the economic historians. And, interestingly, as Greg Mankiw said, “Luck plays a large role in how history judges central bankers.”

(October, 2008)