The suddenness of the international financial crisis and the speed of the contagion have taken most observers by surprise. This is a matter on which there will be a debate for years. The total international cost of the bailout is reportedly well over $1500 billion and as the crisis goes through its protean stages, this figure could be a gross underestimate.

The world over, the authorities are pumping in large amounts of liquidity. The central issue for India is should we also do so and take the consequences in terms of a major acceleration of the already very high annual inflation rate? There are no easy answers.

The Indian economy is at a different inflexion point of the cycle than the major industrial countries. The direct exposure of Indian financial institutions to failed or stressed units abroad is minimal but the contagion can spread with lightening speed and hence the crucial question is how best to insulate India from it. It is erroneous to argue that our inflation rate is a supply side issue; for this to be so, the inflation should be restricted to a few items. What we have is generalised inflation which is necessarily a monetary phenomenon.

The fiscal situation today is far weaker than is generally perceived. It is not meaningful to claim that the Fiscal Responsibility and Budget Management Act, 2003 (FRBM) targets are being met when, as per the Prime Minister’s Economic Advisory Council (EAC), the quasi fiscal deficit is around 5 per cent of GDP. As such, the Indian fiscal just does not have the wherewithal to bear the burden of a large bailout.

Currently, the year-on-year monetary expansion (M3) is way above the trajectory of 17 per cent, at over 25 per cent. This translates into an unsustainable incremental credit-deposit ratio of 81 per cent. Hence, an early slowing down of the pace of expansion is imperative to prevent a sudden total cessation of credit. In such a scenario, the reserve requirements (the cash reserve ratio and the statutory liquidity ratio), the Liquidity Adjustment Facility (LAF) and the Market Stabilisation Scheme (MSS) need to be modulated with great finesse.

The present international financial turmoil makes the case for unconventional measures. It may be necessary to prescribe bank-wise incremental credit-deposit ratios, consistent with reserve requirements; this would prevent over-extension of credit. Those banks which exceed the creditdeposit ratio stipulation should be subject to higher rates of interest at the RBI window. Lastly, appreciation of the rupee in nominal and Real Effective Exchange Rate (REER) terms in the context of the current inflation rate would be sheer harakiri.

The above steps are necessary as these will impinge on the future development of the Indian financial sector reforms as also the integrity of the system. There is a popular misconception that a tight monetary policy militates against growth without bringing down inflation. This is a misnomer. A strong monetary policy with a low rate of inflation is conducive to medium/long term growth. Per contra, a high rate of inflation with a permissive monetary policy will disrupt growth.Thus, inflation control should be the paramount objective of monetary policy. This does not mean that there should not be other objectives such as an optimal rate of growth, consistent with the investment rate and the capital-output ratio, and a reasonably stable exchange rate in real effective terms.

Critics of the present policies emphasise the theoretical construct that an independent monetary policy, an open capital account and a managed exchange rate are inconsistent and that the authorities should give up one of these objectives. Both the Percy Mistry and Raghuram Rajan Committees recommend that a managed exchange rate should be given up; a corollary to this is that the RBI should also give up managing forex reserves. It is argued that if the exchange rate were totally free volatility would decline. This is an article of faith and leaving the exchange rate totally to a fragile market could be disruptive and the authorities should not experiment with this recommendation.

The Committee for Fuller Capital Account Convertibility (FCAC) recognised the theoretical construct of the Impossible Trinity but recommended that rather than taking the extreme decision of totally giving up the exchange rate as a policy instrument, the RBI should balance the three objectives and endeavour to come as close as possible to the three ends of the tripod; in a sense the authorities should work towards the general theory of the second best. At the same time, frequent and random intervention in the forex market should be avoided. The Committee recommended that for an orderly market, the RBI should indicate when it would ordinarily intervene and when it would ordinarily not intervene.

Critics of the RBI exchange rate policy argue that speculators would be able to “Break the Bank”. To the extent the RBI ensures that it does not fight fundamentals, speculators would not be able to counter the RBI exchange rate policy. The critics argue that on a number of occasions the RBI has prevented an appreciation of the currency. It is one thing to appreciate the currency if there is a balance of payments current account surplus and quite another to appreciate the currency when there is a current account deficit and there are large capital inflows from Foreign Institutional Investors (FIIs).The history of capital flows, the world over, is that large capital inflows are followed by large capital outflows. Hence a “hands off” exchange rate policy would cause considerable avoidable distress to Indian industry by wild swings in the exchange rate. Moreover, the present exchange rate policy has, by and large, worked well and apart from refinements in the REER there is no reason to go in for an adventurist policy of totally eschewing from RBI intervention. Markets need many years to develop, more so when the “markets know best” halo has come under a cloud.

This brings up the issue of greater autonomy for the RBI. Today, the all pervasive role of government is so evident that apart from monetary and exchange rate policies, it has an overbearing role in every aspect of central banking activity. It bears mentioning that the law does not provide for government intervention in many areas, yet the government arrogates to itself the powers of the RBI Board. This is a vestige of the colonial regime which felt that the RBI was too close to the “Nationalist” interest and therefore had to be reigned in. Hence, unless the RBI Act is revamped to correct these historical anomalies, it is not meaningful to talk about total autonomy for the RBI. It is necessary to recall the old adage that autonomy is never given it is always earned and taken.

Monetary policy is an arm of overall economic policy and would need to be consistent with the overall policy framework. In this context there should be a transparent agreement between RBI and government on monetary policy. The agreement should be set out, as far as possible, in specific terms with a clear ordering of priorities. For instance, if inflation control is the central objective, the comfort zone should be clearly set out for say a three year period. For credibility, changes in the agreement should be undertaken only under rare exceptional purposes with a clearly set out rationale. If the next stage of financial sector reforms has to have any meaning such an agreement between the RBI and government would need to be implemented. Such an agreement would avoid the kind of blatant backseat driving which, in the recent period, has become the norm.

Indian public sector banks account for two-thirds of the overall banking system. Various Committees have recommended that public ownership of banks is not consistent with efficiency of operations. Furthermore, the capital needs of the public sector banks would put an intolerable burden on the system. None of the possible political configurations for the next 5-10 years would accept reducing the minimum majority share of government of 51 per cent. Thus, any reform has to be undertaken taking into account this major constraint.

It must be a desideratum of overall regulatory/supervisory policy that there would be no regulatory forbearance in terms of diluting the regulatory norms for public sector banks. Furthermore these public sector banks should not be allowed to dictate the regulatory process by resorting to regulatory capture. Also, the public sector banks should not continue to be part of the grants economy.

In the context of the unprecedented turbulence in the international financial markets, it is important that we do not take a nonchalant view that every thing is hunky dory with the Indian financial system. The contagion is most likely to spread like a tsunami and we should be putting up the storm shutters rather than going into denial mode.

Given the monetary excesses in the economy, we should not ape the industrial countries and liberally pump liquidity into the financial system. In the ensuing few years, we need Aristotle’s Golden Mean between developing the financial system and safeguarding ourselves from the contagion from international financial markets.