Reserve Bank of India governor Y V Reddy talks on key issues before the Indian economy. CNBC-TV18 shares with domain-b an exclusive interview with Reddy

The Reserve Bank of India announced its mid term policy on Tuesday. Key rates like the reverse repo rate, the bank rate and the Cash Reserve Ratio have been left untouched while the repo rate has been hiked by 25 bps to 7.25 per cent Inflation rates have been left unchanged as well between 5 to 5.5 per cent and the GDP target has been upped to 8 per cent.

In an exclusive interview with CNBC-TV18, RBI governor, YV Reddy gives his perspective on key issues that poses before the Indian economy.

The RBI governor says that inflation targeting has gone out of fashion and is not as iconic as it was before. He also adds that repo rate hike was not a pre-emptive step but it was a move to sensitise markets.

Reddy does not see the need to take full range of steps to control inflation. He further adds that there are no definite indications for a full-fledged interest rate signal. According to Reddy, the appreciation of the rupee was not a reason for the half-action on rates.

He aims to expand the role of FIIs in corporate bonds after infrastructure is in place. Reddy sees scope to increase the role of corporates and FIIs in the debt market. According to him, buyout of foreign companies by Indian companies has not lead to big forex outflows.

Reddy also affirms that he wants to stick to the 2009 roadmap on foreign banks' role in India. Moreover, Reddy mentions that bailing out banks is RBI's fiduciary responsibility.

CNBC-TV18 shares with domain-b its exclusive interview with Reddy:

Most central bankers target inflation, but you have chosen to target credit growth. Any particular reasons for the same?
It is not correct to say that we are targeting credit growth. In terms of basic objective, some Central Banks say that their objective is price stability and that is a single objective, single institution type of situation. But our mandate is both growth and price stability. So in some ways, we are closer to the US situation in terms of our objectives, which are both growth and stability.

Now as far as what we are targeting is concerned, while inflation targeting was very popular in the recent past, they are re-looking at it and are not being able to establish an appropriate correlation between price stability and the central banks, which have adopted inflation targeting.

So simply stated, inflation targeting is perhaps slightly going out of fashion in any case; it is not as iconic as it was before. And in terms of mandate as well as functioning, we are never focused simply on inflation targeting. And at our stage of development, both growth and price stability are important for our society. We have to keep balancing the two and the relative emphasis will depend on the circumstances.

You have highlighted a lot of dangers of overheating or likelihood of overheating. Inspite of all these dangers, you have chosen not to hike the operational rate, the reverse repo tate. Would there be political compulsions that you cannot go on hiking four times in one year?
Let me first answer about overheating. If I recall, you had said that overheating was a bogie, which I created and then destroyed or something similar to that. It's not entirely right, but not entirely wrong either.

In the limited sense that we have generally been for the last 40 or 50 years so keen about growth that when it came to inflation till a few years back, you felt that if inflation is contained within 10 per cent, it is reasonable.

In the last three-four years, we felt it should be less than 5 per cent and that is the situation now. In this situation, everybody is craving for growth and when growth is happening we are all happy.

But some times, the situation can come in two senses - one, there is a cycle and everybody recognises that there can be business cycles or economic cycles. Second and more importantly, sometimes growth can occur to an extent which is slightly over the inherent capacity and that generally has a tendency to either result in higher prices or in a crisis.

Now what we felt is that we are having several clear signals, though not conclusive evidence, which focus on this possibility. So all we are trying to say is that if the growth has been consistently that high and at the same time there are inflationary pressures, what should we look at? I say, we have to look at both, the supply side and demand side.

We recognise that there are supply elasticities, capacities are increasing, there is a certain amount of globalisation, but still there are obviously some inflation pressures, along with demand pressures. Therefore the limited issue is that, the word I use is prevalence and relevance of overrating, which we must recognise, even if we are not able to measure it; in fact we have to therefore monitor it.

Second, there are lagged effects. We have already taken a number of measures and they may take time to impact, but could as well impact in the next few months to come. So these two factors are both relevant and prevalent.

Having considered this, the question is what action should be taken? So while there is no conclusive evidence, at the same time there could be a lagged effect as we move along. In that situation, we have to make a judgment whether taking full set of strong interest rates signal is fully justified or not.

When there is such a question mark, our answer is simple; keep the question mark and keep looking at it to make sure that there is credibility in some way, where everybody is alerted and everybody tries to adjust to the possible evolving circumstances and be prepared to act.

So, that is the type of thinking that went into picking on one rate. And this rate becomes more important because when there is something like excess demand pressure, this should spillover liquidity. And if that liquidity happens, it is quite possible that the liquidity pressure will force them to come to the central bank. I am telling now itself from the Central Bank side, that you may not get money and even if you get it, it maybe more expensive.

I don't even call it a pre-emptive action, it is an action to sensitivise the system and in particular savings investments balanced as well the banks balanced. Also in terms of economic debate in the country, I think we have to recognise that as we grow faster, we must make sure that inherent strengths in the economy, productive capacities as well as productivity are matching them.

An economist said that the dollar rate of GDP growth was actually 13.5 per cent in the current year, while another econometric extrapolation says that investment to GDP ratio is probably 41 per cent. So can you be more relaxed about the credit growth at 29 per cent or M3 at 19 per cent?
On the first issue, the very fact that growth is very strong means that to make it enduring, we have to make sure that the productivity and the productive capacities are catching up. So what you are really saying is that if I am trying to be careful at 8.9 per cent, I should be even more so at 14 per cent.

So whether it is 8.9 per cent or 14 per cent, the limited issue is recognising that productivity and production capacities are increasing and we have to make sure that they are increasing in tandem with actual GDP growth. That is the limited point to which we cannot contribute more with the type of data that we have.

There are other issues as well. Let me give you two or three simple examples. In other countries, one signal of overheating is wage pressures. In our country, we have a situation where there is a lot of unemployment or under employment. But in some sections there are already wage pressures so the signals are mixed in our case and therefore, not that easy to find.

Similarly, there are very good data in other countries with regard to unutilized capacity. We don't have that much of unutilized capacity and improvisation is also possible.

So I would say that the circumstances for the reason that you mentioned are such that there is no definitive indication of a full-fledged interest rate signal. But certainly ignoring the existence of these and the pressures would mean that we are shrugging our responsibility for noticing and lack determination to act.

In April, when you did not hike the rate, you put the economy on notice saying that you have the option to raise rates before the next review and warned the market that you have option, you didn't give such a clear signal this time.
Actually it was not in the statement. When some people ask me, I had indicated, it is not necessarily in the statement. But there was an impression because we introduced this system with a committee. There was an impression that every time it will be only at the time of the meeting.

Do you still think that there is an option?
The way I would look at it is if you see the words, I will again explain the difference between last time and this time. The words we said is, "all possible measures promptly". So, one is all possible measures and "promptly". The word is "promptly".

Last time, if I am not mistaken, we used the word "swiftly". When we use the word "swiftly", we are half anticipating a problem. And if such a problem or such a risk arrives, we are not going to waste any time.

So this time, if you ask me at this juncture, it is not that I am half-anticipating. Therefore I said evolving circumstances but 'promptly'. That is the main difference.

Would the appreciation of the rupee, and considerable appreciation over the last two months, the one reason why you have refrained from going whole hog on rates and rate hikes?
I don't think that has been a consideration at all. As far as our exchange rate is concerned, exchange rate is determined by the market. We are looking at basically volatility. So it is not appropriate to say that the monitory policy stabs.

That's what I tried to indicate clearly that as far as the global factors are concerned, they do not warrant any change in the monitory policy stance, it is only the domestic factors that fueled this particular alert action and if necessary, possible action in the future.

Coming to convertibility, the steps taken were that FIIs can invest more than $2 billion in government securities, but there was no mention of corporate debt. But the reality is that FIIs have not even hit the $2 billion limit on government bonds but they are full up on corporate bond limit and want more. Any reasons why you kept this one out?
First let me emphasise that we believe that development of corporate debt market is very important. But there are certain microstructures in the institutional structure that are to be put in place.

It has been recommended by the RH Patil Committee report. And we have to quickly implement RH Patil recommendations and as we implement that, it would certainly be possible to expand the scope for FII investment in corporate debt market.

Do you have any timetable in mind?
I would say as soon as we start implementing the RH Patil recommendation with regard to the trading desk and the infrastructure, there will be a lot more comfort, with expansion in the scope in money market operations for the corporates as well as the FII entry.

You have deepened the markets considerably by allowing short-selling for a five-day trading cycle. What about future interest rates? Some other products will perhaps eminently be needed since Basel is on our head?
Yes, indeed. But we are now having a lot more intensive interaction with the Indian Banks Association even with regard to derivative guidelines we had these questions. With regard to securitisation they wanted some refinements.

So we are in continuous touch with them. But our policy has always been to go steady, slow but a solid step and let me tell you that recently one of the professors of Columbia University met me and I asked him what he thought and he said that two words are used normally for describing the finance and external sector of India -"strong" and "solid". We may appear to be slow but we always prefer to be strong and solid.

The capital account convertibility steps that you have announced are welcome and are perhaps sticking to the timetable the CSC committee has recommended for 2006, could we not go ahead faster? After all it is an extremely comfortable forex situation, an extremely comfortable India-export story. So why should it be only $300 billion prepayments a year? Why should there be permission needed at all for prepayment, are we not already in that situation?
Let me first refer about whether we can go forward more than what has been indicated in the timetable. Frankly I think yes it is possible and it has to be done carefully. It has been desirable, for one reason, in the sense as there is greater trade integration and immigration services integration, you are going to have a problem of effectiveness of the capital controls which itself is coming down.

Therefore all capital controls have to remain more or less the type of capital control that are widely practiced in other developed countries also. Therefore if you ask me since the integration is taking place in other sectors, it is desirable.

Caution is needed for two reasons, which have been highlighted by Tarapore Committee also. So the lessons of experience that we have on the fiscal position should be reasonably comfortable and hopefully it will be alright. The second is that there should be sufficient elasticity and flexibilities within economy in the real sector and if these two happen to go faster then I believe it is possible to expedite the timetable. On the same logic, if they are too slow then we may have to be more cautious.

There has been significant buying of companies abroad, especially the $9-billion deal by a steel company being bought out. Do you think that sooner or later you would be worrying about a FDI outflow being more than FDI inflow?
I'll put it in perspective. Number one, in the FDI outflow that is happening there is no question of incentives. There are no questions of tax incentives, it is purely driven by the market sentiment and we will put an overall cap to that extent that there is a lesson for all of us.

Allow the markets to perform and have limited restrictions.

Second, the way it is happening in terms of real economy from what we understand is that they are trying to make up for two things. We did not have the scale. Countries like China had scale.

They are making up for scale by moving out. And they are able to have synergies in the process. Second, they don't have domain knowledge because many of our companies were not having presence outside. Now they are making up for lack of domain knowledge quickly by acquiring. So, these two are being appreciated by people who are financing the acquisition. What's happening is that the leverage is very high and the outflow is very low.

So this is happening because people who are funding the acquisition are aware of the type of strengths that the Indian companies are able to bring. Therefore the impact of VOP is minimal whereas benefit is significant. And in terms of magnitude, actual outflow, the first signal that you will find of outflow is that forex reserves are not there and you mentioned that I should be worrying about rupee appreciating. If I have to worry about rupee appreciating I should not be worried about this outflow, isn't it?

There has been a lot of discussion and perhaps some heartburn as well on banking regulations. Steel companies, the ones we discussed or most Indian industries, used to take licenses way back in the ' 80s. Most industries have stopped asking for licenses for expansion. Why should banks still have to come to the RBI for branch licenses, ATM licenses, back office licenses, there can be some let go on that front?
There are many countries where you require a license for ATMs.

But how about when we compare it with India?
Let's compare it with India also but banking is different from other business. A license for ATM is not unusual even in so-called very free financial centers of this world. As far as branch licensing is concerned that's a requirement under law itself, so this is the reality.

Now how to go about branch licensing? That has to be contextual and if you recall an important instrument of public policy after 1969 is the branch licensing policy.

The question is that the way it is being used in our context, in the more recent past is that we are trying to balance between banked and unbanked areas. So in a way we are encouraging more and more people to go to unbanked areas along with the bank areas, which is one instrument of public policy.

More important is the way we look at it now for the banking system as a whole, that system, which is most important for large segments of population is the cooperative credit system.

The highest on the agenda today is the cooperative credit system, the urban cooperative banks and the regional rural banks; there is lot of attention being given to it. At the same time, we find that the banking system particularly in terms of prudential regulation etc, we are moving forward. So I think from a system point of view, there is appropriate priority. But if your point is we could be more liberal in the branch expansion, both for local and foreign banks, the point is well taken.

Since you have spoken about foreign banks, how sacred is the 2009 review? Will it really mean a change considering that others have not been too liberal? Is 2009 really so sacred?
I wouldn't like to say anything predictive or speculative but the dynamics in which it is happening, we have to recognise the circumstances so the very purpose of having a road map is to go in stages and each stage will be determined by the various factors both global and domestic. So far, some consolidation in the domestic industry has occurred. Some have kicked off.

Hopefully, things will go forward and the idea is to stick to the road map. On the contrary, every effort has to made to stick to the road map and in doing so if any nuance has to be made will be made unless there are extraordinary circumstances way ahead.