To internationalize the rupee or not?

Mint, December 2, 2015 (with Bhargavi Zaveri)

The recent decision by the International Monetary Fund to include the Chinese renminbi in the Special Drawing Rights basket and announcements by the Reserve Bank of India (RBI) allowing Indian companies to issue offshore rupee-denominated ‘masala’ bonds have triggered discussions on whether India is ready to ‘internationalize’ the rupee.

In popular discussions, rupee internationalization is often seen as a goal in itself. The notion that there needs to be a specific agenda for internationalizing the rupee is wrong.

To explain this proposition, it is necessary to understand what is an international currency. Rupee will be an international currency if non-residents are willing and able to trade in it and invest in rupee-denominated assets. For example, a Russian importer must be able (and willing) to invoice and pay for her imports from South Africa in rupees. Similarly, a UK resident must be able (and willing) to invest her savings in rupee-denominated bonds or shares. In these cases, non-residents take risks in the rupee as a currency.

The willingness and ability to transact and invest in a currency depend on three prerequisites. First, the issuing country must have sufficient scale, both in terms of nominal gross domestic product and volume of international transactions. For instance, while China is a $10.36 trillion economy, India is roughly at $2 trillion. For India to attain sufficient scale, the economy needs to grow at a sustainable average rate of 7-8% for the next five years or so. India’s current share of global trade is also relatively small and the bulk of it is invoiced in US dollars. Improvements in scale are linked to macroeconomic fundamentals, which cannot be changed through an internationalization-driven agenda.

Second, the value of the currency must be stable over time. A currency is considered stable when the general level of prices does not vary too much. Stability has multiple aspects: macroeconomic, financial and political. On macroeconomic stability, earlier this year, India undertook an important reform in the form of the Monetary Policy Framework Agreement that formally lays down inflation targeting as the objective of monetary policy in India. The proposed Monetary Policy Committee (MPC) Bill, if introduced and passed, will complete this reform by institutionalizing an accountable and transparent decision-making framework for monetary policy.

Not much progress, however, has been made on financial stability. The banking system continues to be overburdened with burgeoning non-performing assets. None of the attempts undertaken so far by either the RBI or the government to resolve banks’ asset quality problems seems to be yielding expected results. Improving financial stability will need urgent reform of the banking system and strengthening banking regulation.

In terms of political stability, the fact that India is a democracy, like issuers of most international currencies in the 19th and 20th centuries, goes in its favour. Democracy and associated checks and balances on the executive, instil confidence in foreign investors about the policy credibility of the government, thereby imparting stability to the national currency.

Stability is often confused with a managed currency that does not exhibit volatility. This is wrong. A currency is deemed stable when its value reflects underlying market forces. If market forces cause a currency to fluctuate, then artificially managing its price does not make it stable. One way to look at this problem is to think of administered prices. There was a time in India when prices of commodities such as steel and diesel were controlled and exhibited no volatility. Today, these prices freely fluctuate in response to supply and demand conditions. That is how a currency market should work as well.

Third, the currency must be liquid. A currency is liquid if significant quantities of assets can be bought and sold in the currency, without noticeably affecting its price. This requires depth in financial markets, a large stock of domestic currency-denominated bonds and adequate options to hedge currency risk exposures. India lacks a deep, liquid and well-functioning corporate bond market. Hedging opportunities for foreign investors are limited. On the exchange side, RBI and Securities and Exchange Board of India (Sebi) control the kind of currency derivative products that can be offered by exchanges, mandate underlying exposure requirements to buy those products and set position limits. Off exchange, there are entry barriers on who can offer and trade in currency derivative products, and on what conditions. Extensive regulatory reform is required to create a deep market that will offer foreign investors suitable hedging options.

Liquidity has been historically found to be less in countries that have capital controls. A large base of foreign investors adds to the liquidity in the domestic market. India has one of the least open capital accounts among emerging economies. Relaxing capital controls to attract foreign investor participation is crucial for enhancing rupee liquidity.

To conclude, any conversation on rupee internationalization dehors structural reforms is futile. Scale, stability and liquidity can be achieved through strong economic fundamentals and a process-driven regulatory environment. These, by themselves, are important policy goals to achieve for India. It is possible that once these are achieved, the rupee will come to be accepted as an international currency.

Road to insolvency resolution

Mint, November 26, 2015 (with Richa Roy)

The current corporate insolvency resolution framework in India fares poorly in terms of timeliness and costs of proceedings. The longer the time taken, the more the erosion in realizable value of assets and the lower the recovery rate—the ultimate parameter for evaluating the strength and efficiency of an insolvency framework. Inordinate delays in resolution arise from a lack of clarity regarding legal provisions, an overburdened judiciary, information asymmetry faced by creditors, absence of well-defined timelines stipulated in the law and an overall weak enforcement mechanism. Institutions that should support the resolution process such as dedicated tribunals, official liquidators and credit bureaus are severely capacity-constrained. All these culminate in a recovery rate of roughly 20% of the value of debt—among the lowest in the world. Bankruptcy reforms in India must therefore focus on minimizing delays.

The Insolvency and Bankruptcy Code (IBC) proposed by the Bankruptcy Law Reforms Committee (BLRC) addresses the timeliness issue by stipulating a strict timeline of 180 days for insolvency resolution and limiting judicial determination at the trigger stage. Triggering the insolvency process in India [under the Sick Industrial Companies (Special Provisions) Act (SICA) or Companies Act] currently involves judicial judgement. Under IBC, the insolvency resolution process (IRP) can be triggered at the first instance of default, requiring the adjudicating authority to merely confirm the existence of default. This will aid early detection and resolution of stress and also avoid clogging judicial bandwidth at the trigger stage. Also a default only triggers a resolution process, and not liquidation. This is unlike the extant situation where winding up proceedings can be triggered on account of a default of Rs.500, resulting in courts undertaking full hearings at the admission stage and causing delays.

The 180-day timeline is not an implausible one for several reasons. Across the world, firms in distress start conversations about their financial troubles with stakeholders much before initiating formal proceedings. Court-supervised resolution procedures are filed when out-of-court negotiations fail to generate desired outcomes. In the post-IBC regime, if IRP is triggered, it is assumed that the debtor has already undertaken out-of-court negotiations with the stakeholders concerned about possible reorganization avenues to keep the firm as a going concern, and has not arrived at a solution. Triggering IRP is hence considered a last-course effort after sufficient preparation and deliberation.

Once IRP is triggered, it offers a calm period during which a moratorium is imposed on debt recovery actions and existing or new lawsuits against the debtor. During this phase, all creditors come together to collectively assess the viability of the firm and vote on proposed resolution plans, within a well-defined framework of rules enforced by an insolvency professional (IP). The IP takes over management of the firm to prevent potential asset stripping and to continue operations of the firm as a going concern. The likelihood of a moratorium being misused and dilatory tactics applied by promoters is minimal because the debtor loses control. Also there is a credible threat of liquidation should the defined timeframe of 180 days lapse without 75% of the creditors’ committee consenting on a resolution plan.

In view of the above, completing the final round of conversation between the debtor and creditors within 180 days to resolve temporary insolvency as against structural breakdown is not infeasible.

Once the creditors’ committee approves a resolution plan, the adjudicating authority reviews the plan not from a commercial perspective but against touchstones of conformity with applicable laws and repayment of interim finance (on priority) and operational creditors. This will free up judicial bandwidth to focus on critical issues of justice, such as compliance with procedural requirements, overseeing the IP and adjudicating on voidable transactions and potential penalties against management and promoters.

Delays in the resolution process also result from opacity of creditors’ claims and related information. The system of information utilities (IUs) proposed by the IBC and the BLRC report will store all financial transactions between a firm and its financial creditors. This should significantly assist the IP in assessing veracity of claims, thereby saving valuable time.

It is important to underscore here the centrality of the institutional pillars upon which the entire edifice of IBC stands. While the draft bill contains provisions to reduce delays and improve efficiency of resolution, the de facto outcomes in terms of effective and timely functioning of the process are contingent upon building the supporting infrastructure. This includes developing a new class of IPs to conduct the resolution process in a time-bound and disciplined manner, an extensive network of IUs vital for reducing information asymmetry and speeding up the process of initiating IRP and collecting claims, a well-functioning regulator to govern the operations of IPs and IUs as also issuing delegated legislation and finally, an effective adjudicating infrastructure replete with a well-laid-out appeals mechanism.

For the IBC to deliver the desired economic outcome of high recovery rate, a robust implementation plan for building the aforesaid institutions and creating state capacity is essential to complement the enactment of the draft bill. None of these will happen overnight.

It will take time for firms and all stakeholders to get familiar with the new system and to understand the new rules of the game.

From non-performing to performing

Mint, November 25, 2015 (with Richa Roy)

The ministry of finance recently released the draft Insolvency and Bankruptcy Code (IBC), proposed by the Bankruptcy Law Reforms Committee. The government of India greeted this bill as among its biggest and most crucial reforms. To a person unconnected with finance, it may be unclear why this is important or what ails the current framework. A well-functioning insolvency resolution framework is fundamental for dealing with business failures that inevitably occur in any economy. Additionally, an effective insolvency resolution process is one tool, among others, for banks and other creditors to address low recovery rates.

This is particularly relevant for India where economic growth is contingent upon the financial health of the banking sector. Banks in India face acute problems of asset quality. Perceiving that laws did not sufficiently empower secured creditors to activate recovery by seizing security, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, and Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, were enacted to facilitate the enforcement of security by banks and financial institutions.

Asset reconstruction companies were constituted under SARFAESI to buy bad debts from banks and recover from defaulters. Domestic banks also have recourse to corporate debt restructuring and joint lenders forum mechanism to resolve stress in consortium loans.

None of these initiatives seems to have helped. Gross non-performing assets (NPAs) as percentage of total advances went up from 3.4% in March 2013 to 4.45% in March 2015. The picture is grimmer when volume of restructured assets is also considered in stressed advances. As a percentage of total advances, overall stressed advances increased from 9.2% to 10.9% between 2013 and 2015. Average recovery rate for secured debt is as low as 20%. One factor responsible for all this is a weak legal framework for resolving failure. Once debts go bad, creditors’ ability to realize value is predicated on a robust insolvency resolution mechanism.

Accumulation of bad debts in bank balance sheets has systemic risk implications for the entire economy. As capital gets tied up in provisioning for bad debts, banks get inhibited from extending fresh credit, slowing down the real sector. Absence of a well-functioning insolvency framework that protects creditors’ rights also thwarts the development of alternative lenders, such as corporate bond market. There are admittedly other issues systemic to the banking system and capital market that compound these problems. However, an insolvency law focused on preserving viable businesses as going concerns and liquidating unviable ones is the cornerstone of a mature financial system and India urgently needs one.

Aparna Ravi highlights in a paper titled The Indian insolvency regime in practice—an analysis of insolvency and debt recovery proceedings that the current framework in India is highly fragmented with decisions frequently stayed or overturned by judicial forums having overlapping jurisdiction. There is no clarity on whether the right of secured creditors initiating recovery under SARFAESI will prevail, or unsecured creditors initiating winding-up under the Companies Act or the company triggering proceedings under the Sick Industrial Companies (Special Provisions) Act, 1985, (SICA).

Substantive issues exist with even initiation of insolvency resolution or the process of winding up. SICA is triggered when more than half a company’s net worth has eroded. In Kristin van Zwieten’s paper titled: Corporate rescue in India: the influence of the courts, she examined over a thousand cases from a range of courts to demonstrate that the Board for Industrial and Financial Reconstruction (BIFR) and the high courts are reluctant to liquidate unviable companies. Ironically, the trigger for winding up a company is too low. The default is Rs.500. Courts, therefore, do a full hearing on merits at admission stage itself, limiting efficacy. Creditors, especially non-banks, do not have access to a mechanism to assess the viability of an enterprise and address the problem, without the threat of other proceedings initiated by the debtor or other creditors torpedoing them. Even when proceedings are triggered, debtor’s existing management retains control, thereby creating the risk of asset stripping.

Under SARFAESI, creditors are empowered to take over management of a company but only that part of the company connected to the secured asset. Since potential liability to creditors is high, this is rarely invoked. There is no corresponding provision for non-banks. There is also no linearity of proceedings. Under SICA, even if BIFR recommends liquidation, a reference is made to the high court, which would re-examine the recommendation and might even reverse it.

With the proposed IBC, the labyrinth of extant Indian laws dealing with corporate insolvency are being replaced by a single comprehensive law that (a) empowers all creditors—secured, unsecured, financial and operational to trigger resolution, (b) enables the resolution process to start at the earliest sign of financial distress, (c) provides a single forum overseeing all insolvency and liquidation proceedings, (d) enables a calm period where other proceedings do not derail existing ones, (e) replaces existing management during insolvency proceedings while keeping the enterprise as a going concern, (f) offers a finite time limit within which debtor’s viability can be assessed and (g) under bankruptcy, lays out a linear liquidation mechanism.

The proposed framework strengthens creditors, without discrimination. While this will not necessarily be a magic bullet that will make the mass of NPAs vanish from bank balance sheets, it can facilitate better recovery and faster closure of troubled assets. IBC will prevent new loans from getting added to existing stock of NPAs. It will aid development of alternative debt securities, spread the risk of corporate failure across larger sets of creditors, and lead to the double benefit of lower systemic risk as well as deeper debt finance for a rapidly growing economy of entrepreneurs.

Bankruptcy reforms: It's not the ranking that matters

Bankruptcy reforms: It's not the ranking that matters The Leap Blog, November 13, 2015.

In defence of the financial code

Mint, July 28, 2015 (with Vivek Dehejia)

The barrage of criticism of the proposed draft of the Indian financial code (IFC) released by the finance ministry last Thursday has, unfortunately, contained more heat than light, with ill-informed criticisms being passed off as accepted wisdom.

What has attracted the greatest ire of critics is the proposed seven-member monetary policy committee (MPC), which will be charged with setting policy rates to ensure that the inflation-targeting mandate, already enshrined in the monetary policy framework agreement between the Reserve Bank of India (RBI) and the finance ministry, is fulfilled.

Recall that the MPC would replace the current system in which the RBI governor effectively has absolute power to set policy and is not bound by recommendations of the technical advisory committee.

The most often repeated criticism is that, because four of seven members of the MPC will be appointed by the finance ministry, while only three will be internal to RBI, including the governor as chairperson, somehow the independence of RBI will be lost. Those who have been chanting this as mantra appear to be unaware of the fact that RBI at present lacks any form of statutory independence.

Under the RBI Act, 1934, an antiquated law that still governs the central bank, the 21 members of the central board of directors are all, directly or indirectly, appointed by the Union government, including and most notably the governor himself. Under existing law, the government may dictate policy to RBI, which the governor will be obliged to obey. Thus, in reality, any putative independence the RBI may currently enjoy depends entirely on the strength of character of the governor to resist political pressure. This is hardly a template for good governance and leaves good monetary policy to chance.

By contrast, under the proposed new system, the MPC—critically operating not with carte blanche but charged with ensuring that the inflation target is met—will bear collective responsibility for monetary policy conduct, and its individual members, including the governor, will therefore be shielded from political interference more than in the current single decision-maker scenario.

It is harder to pressure and influence a committee of several members as opposed to influencing only one person. It is a specious and illogical argument to suggest that its functioning will be impaired merely because a majority of its members are appointed by the government—when the current arrangement creates a far greater danger that the government could browbeat the governor into doing its bidding.

Also, an MPC formed with non-RBI members, appointed from various walks of life, will bring with it diversity of opinion and plurality of ideas, whereas internal RBI members are more likely to share similar views. Further, unlike the current arrangement in which the governor is not obliged to explain the rationale for a policy decision—although, in practice, he generally does—the new system will require each member to furnish a written explanation for his/her vote on any proposed resolution, and minutes of MPC meetings will be made available for public scrutiny.

This creates far greater transparency in monetary policy conduct than our current system, in which decisions are shrouded in secrecy and in which, therefore, there is considerable leeway for the governor to act with discretion. A basic tenet of modern theory and practice of central banking is that a system which is opaque and allows discretion will invariably deliver worse outcomes than a transparent and rule-governed system, which the MPC plus the inflation targeting regime will provide.

What is more, given that the MPC will not operate in a policy vacuum, but explicitly to achieve the 4% inflation target, with a tolerance band of 2% around it, there is automatically an accountability mechanism built into the system. The public, investors or anyone else can observe whether the MPC is doing its job or not.

Each member’s personal reputation will be on the line every time he/she proposes an action that ends up jeopardizing the inflation-targeting mandate. An MPC, which repeatedly fails to meet the inflation target, will lack credibility, and this is something no government would wish to happen. In a globalized capital market, the cost of an erratic and uncertain monetary policy, with attendant volatility in interest rates and exchange rates, would be damaging economically, and therefore politically.

It could be countered, if the mandate of the MPC will ensure accountability, then why not let RBI hold a majority on the MPC? The reason is that an RBI-dominated MPC will, inevitably, be an MPC dominated by the governor himself. Junior colleagues of the governor who sit on the MPC would almost surely be reluctant to disagree with him and end up voting with him—whether because of group think, or simply due to power imbalance.

In other words, the presence of four external members is, in fact, a check on an MPC, which otherwise might be dominated by the governor, and therefore, would not be very different from the current system in which the governor is all-powerful.

The bottom line is that our current arrangement is really a non-system that functions well only if a wise and sagacious individual is in the chair. What we need is to hard-code best practice and institutionalize it, and this is exactly what the IFC, including the MPC, proposes.

The nuances of inflation targeting in India

The nuances of inflation targeting in India Ideas for India, March 16, 2015 (with Abhijit Sen Gupta).

An Analysis of the Urjit Patel Committee Report on Monetary Policy

Yojana Monthly Magazine, April 2014

The Expert Committee formed under the supervision of Reserve Bank of India (RBI) Deputy Governor, Urjit Patel released their report to revise and strengthen the monetary policy framework, earlier this year. Since then the report has been heavily discussed and debated in academic and policy circles. It recommends a fundamental change in the way monetary policy is conducted in India. The one recommendation that has been the main talking point so far is the adoption of a flexible inflation target. In this article, we attempt to analyze this particular recommendation of the committee against the backdrop of the current Indian economic scenario.

Monetary policy in independent India has evolved substantially over the past several decades. India adopted widespread liberalization, privatization and deregulation reforms in the early 1990s. During the post liberalization period running up to the present time, the RBI has been following a multiple indicator approach for executing monetary policy. In this approach, information is gathered on various macroeconomic indicators such as output, trade, credit, inflation rate, exchange rate, capital flows etc. Thereafter, monetary policy is designed to fulfill the multiple objectives of increasing employment, closing the gap with potential output, moderating inflation, stabilising exchange rate and so on.

This kind of a multiple indicator approach however, lacks a nominal anchor or a specific target per se and hence it maybe argued that it is less likely to be effective in achieving all the objectives at the same time. Such an approach makes the monetary policy highly discretionary and runs the risk of sending confusing signals to market participants as well as corporations.

In India, the multiple indicator approach of the monetary policy worked relatively well especially between the late 1990s and late 2000s when Indian GDP was growing at a healthy and robust rate of close to 10% or more, and inflation (measured by the wholesale price index or WPI) was moderate at around 5-6%. This was also the time when all was apparently well in the global economy which was going through a phase of relatively low output volatility.

However, all of these ended with the outbreak of the Global Financial Crisis (GFC) in 2008. In the aftermath of the crisis, India’s own macroeconomic health and stability started showing signs of rapid deterioration. Over the last few years in the post GFC era, GDP growth rate has exhibited a sharp and dramatic decline from more than 10% to less than 5% in just 4-5 years, and inflation has been unprecedentedly and persistently high (close to 10% or more), primarily driven by sharp rises in the prices of food and fuel, both of which are crucial items in an average Indian household’s consumption basket. Retail inflation since 2008 has been in the double digits despite the sharp growth slowdown. This has also meant that inflation expectations have gotten entrenched and despite successive round of hikes in the policy interest rates by the RBI, inflation still has not been brought down to the comfortable levels of 5-6%.

Such persistently high inflation not only erodes the purchasing power of the common man, it also leads to low real interest rates on savings, which in turn reduces the incentive of households to deposit their savings in banks. Domestic financial savings have indeed gone down from more than 12% of GDP in 2007 to less than 9% in 2011. Consequently, during the last few years, demand for gold as an alternative saving instrument has sky rocketed. This of course has adverse implications for India’s current account deficit that has been at an all time high over the same period of time; it went up from less than 2% to more than 5% of GDP. A higher current account deficit leads to a weaker rupee, which in turn raises the price of imported items such as crude oil. This has a feedback effect into domestic inflation. As domestic savings go down, and interest rates are raised to control inflation, investment gets hampered thereby lowering GDP growth rate. In other words, high and persistent inflation and inflation expectations can destabilise the economy for a prolonged period of time and hence need to be controlled as quickly as possible.

One of the factors often cited as a reason for inflation becoming persistent and inflationary expectations getting entrenched in the Indian economy in the aftermath of the GFC, was the slow, timid and gradual response by the authorities in the initial years. In India we have almost always been pre-occupied with the objective of raising GDP growth rate rather than ensuring price stability. During 2000-2007, the spectacular increase in growth rate pushed up the rural wages, which raised the demand for essential food items. However the supply of these items continued to be constrained by institutional bottlenecks thereby creating an inevitable demand-supply imbalance, which only worsened over time as the pre-occupation with high growth rate camouflaged several underlying structural issues.

In the period immediately following the GFC when interest rates were lowered all over the world in response to a growth slow down, India followed suit as well, in addition to rolling out a massive fiscal stimulus program, to shield the economy from the adverse external shocks. However, even when the economy started recovering, the stimulus was not reined in leading to a sharp rise in fiscal deficit and neither was monetary policy tightened. Inflation began to increase around this time but authorities responded by raising interest rates with a substantial lag by which time inflation had become too high. Several economists are of the opinion that even then the response of the authorities was less than substantial and robust and at best can be characterised as mild.

One can argue that this kind of a delayed, and insufficient response to rising inflation might have been a direct fall out of a discretionary approach where the reaction is triggered only after a problem has emerged, rather than a distinct and well-defined monetary policy rule that needs to be followed under all circumstances.

Against this background, in principle, inflation targeting (IT) as proposed by the Expert Committee seems like a reasonable strategy to bring down inflation quickly and in a sustained manner and thereafter adjust monetary policy such that inflation remains within the flexible target band. According to the Committee’s Report, in the short run, RBI should try and bring down inflation from the current level to 8% over a period not exceeding the next 12 months, and to 6% over a period not exceeding the next 24 months “before formally adopting the recommended target of 4% inflation with a band of +/- 2%”.

IT is a monetary policy rule that prescribes to the central bank a target or a range of targets for inflation. It was first adopted by New Zealand in 1990 and Chile was the first emerging economy to implement it in 1991. Since then it has become quite popular among both developed and emerging economies. Major emerging economies such as Brazil, Colombia, Peru, South Africa, Indonesia, Turkey, and Mexico have adopted IT.

The IT strategy sets out a well-defined framework for monetary policy formulation and gives a clear way forward which may be a welcome change from the multiple indicator approach currently followed by the RBI that can be quite haphazard. A single variable approach clearly spells out the target and makes it easier for the RBI to follow a rule based monetary policy as opposed to the current discretionary approach. Also with a proper target declared, market participants are likely to get a clear signal regarding the RBI’s monetary policy stance instead of the endless confusion markets suffer now, especially before every monetary policy review meeting. This strategy is likely to bring greater transparency, higher accountability and more clarity, that are important not only for financial market participants, corporations and policy makers at the government level but also for the common man most affected by and least hedged against persistently high inflation rates. Furthermore for a central bank, a primary objective ought to be price stability and IT will help the RBI achieve this objective in a systematic manner. It also lends credibility to the RBI if it is successful in maintaining inflation at the targeted level.

According to the critics of this approach, a single-minded, exclusive focus on inflation may reduce the flexibility of monetary policy and divert RBI’s attention from other important policy objectives such as boosting growth, reducing currency volatility etc. However, a sustained trajectory of low and stable inflation by itself is likely to resolve several other issues the Indian economy is facing right now and create room for a broader agenda of reforms. For instance with inflation controlled and inflation expectations stabilised, monetary policy can become more effective, interest rates can be lowered again and hence investments boosted, which in turn can help to restore the growth rate. Also improved price stability is crucial for overall macroeconomic stability. Moreover, the recommendation of the committee is to adopt a flexible IT rather than a strict IT. The former implies that the objective would be to achieve the targeted inflation rate over the business cycle in the medium run whereas growth can continue to be the focus in the short run.

Overall, IT reduces inflation volatility, anchors inflation expectations, brings macroeconomic stability, helps achieve price stability, and also enhances the confidence of international investors in the Indian currency. Critics may well pose the question as to whether India is ready yet for IT. We may never know the actual answer to this question until and unless we implement the strategy and try to adhere to the announced inflation target and what better time to initiate the discussion on this given the persistently high inflation that has been plaguing the economy for a few years now. As regards the target rate that has been suggested by the committee, for the longest period of time post liberalization inflation has been around 5-6 % and in view of this, the target does not seem unreasonable.

A crucial element of the recommendation of the Committee is that Consumer Price Index or CPI be used as a nominal anchor for targeting inflation. Central banks in all advanced and emerging economies calculate inflation using the CPI. In fact, India is the only country in the world where the RBI does not focus primarily on the CPI but on the Wholesale Price Index (WPI), which however does not include food and fuel prices. WPI also excludes the service sector that now contributes more than 60% of the GDP. Food is a crucial item in an average Indian consumer’s daily consumption basket. Thus a monetary policy designed predominantly on the basis of WPI is bound to be ineffective in addressing inflation problems faced by majority of the country’s population. CPI on the other hand assigns more than 50% weight to food and fuel. Also consumers are affected by the inflation they face in the retail market, which is best reflected in the CPI index.

Having argued in favour of the recommendation so far, it is also important to point out that this strategy is not going be a panacea for all ills. It is true that the current economic crisis has raised questions about the effectiveness of IT given that it ignores asset prices. Moreover in a country like India, supply side bottlenecks play a big role in generating persistence in inflation and IT as a monetary policy strategy is unlikely to be able to address these issues. Also, this strategy alone while necessary may not be sufficient to achieve its objective given the myriad complexities of the Indian economy that make the situation unique and different from other emerging economies that have experimented with IT. There has to be corresponding corrective action in other areas of the economy as well so as to provide support to the central bank’s attempt at bringing inflation under control. For instance, it is important for the central government to practice fiscal prudence and lower fiscal deficit. A systematic fiscal consolidation by the central government can enhance the effectiveness of monetary policy transmission.

In other words, there are some obvious and clear obstacles to IT being effective in reducing the inflation rate to the targeted 4% in the medium run. In India food prices are heavily influenced by factors such as monsoons as well as a plethora of administered prices (such as Minimum Support Prices or MSPs) and subsidies, which are of course outside the direct control of the RBI. This may limit the ability of the central bank to affect inflation expectations in the current economic scenario. To what extent the RBI may succeed in bringing down food inflation by using interest rate as a policy instrument is hence debatable. Recurrent food inflation cannot be curbed by monetary policy alone. There are several underlying structural rigidities, and market inefficiencies that need to be simultaneously addressed as well. These are some of the limitations the central bank needs to be cognisant of as it discusses the merits of adopting IT.

Finally, even if we set aside these hindrances for the time being and assume that adopting IT will be effective in the short and medium run, the real test of the recommendation may come in the longer run. Given the multitude of institutional and political factors that add to the complexities of the Indian economic landscape, any failure on the part of RBI to maintain inflation at the targeted level can do irreparable damage to its credibility. So it must be made clear at the very outset, that deviation from the target is possible as no one can predict the changes in domestic and global economic landscapes, or sudden disruptions to macroeconomic stability owing to external shocks or political disturbances that have a strong bearing on the Indian economy. It must be communicated clearly that any deviation in future does not automatically imply failure to maintain price stability. Such transparency may be crucial to maintain the credibility and accountability of RBI. Needless to say formal adoption of IT comes with a lot of responsibility and commitment to adhere to the target under all circumstances and if it ever has to be abandoned, to have clear, concrete and credible reasons for doing so. Otherwise, it may do more harm than good by permanently jeopardising the credibility of the RBI and the confidence it intends to restore among the Indian people towards monetary policy through this very approach.

To conclude, in India, the efficacy of inflation targeting as recommended by the Expert Committee, will depend upon a multitude of factors and policies and is not going to be merely a function of announcement of a target and then changing the policy rates to achieve the announced target. In conjunction with a rule based monetary policy strategy, it is also important that steps be taken to create the necessary environment for such a monetary policy to be effective. Reduction of the twin deficits i.e. current account deficit as well as fiscal deficit is crucial to make room for effective monetary policy transmission. Furthermore, given the current Indian economic scenario, broad-based reforms are urgently needed to correct the macroeconomic imbalances arising from structural rigidities and to alleviate the supply side bottlenecks. Finally, there has to be a widespread and sustained political will to provide the necessary support mechanism, for this experiment with inflation targeting to be a success story.