On Tuesday, the Reserve Bank Governor unveiled his busy season policy for 2004-05, now rather inelegantly called the "Mid-Term Review of Annual Policy Statement" (henceforth MTR). For connoisseurs of central banking, this comes at a fascinating moment.

Politically, the new government at the Centre has made it clear that its goal is to stimulate investment, both in the public and in the private sectors, and to do this quickly, in part by absorbing additional imports.

On the economic front, both the international and domestic scenes are at delicate transition points. Internationally, following a period of massive monetary stimulus led by the US, there is now a synchronised global boom under way.

The Monetary and Credit Policy 2004-2005

This has resulted both in a turn in the international interest rate cycle as well as in commodity price inflation, particularly in oil and metals.

Both these factors could carry the seeds of a global downturn. Domestically, headline inflation will be higher and GDP growth lower than projected at the beginning of the financial year, because of the poor monsoon, bulging liquidity, and international commodity prices.

Yet industrial production in India remains weaker than in most peer countries, private investment is still more in prospect than a reality, while the balance of payments remains strong, largely because of the strong performance of invisibles and remittances.

The Governor opted for a mild tightening of policy, represented by a 25-basis-point increase in the overnight repo rate, from 4.50 per cent to 4.75 per cent.

The repo rate (or, to give it its full name, the repurchase agreement rate) is the rate the Reserve Bank is willing to offer commercial banks for their surplus funds, and acts as a floor for the structure of domestic interest rates.

(Somewhat confusingly, the terminology is also being changed by the RBI, so that what has till now been called the repo will henceforth be called the reverse repo, to bring it in line with international usage.)

Judging by the market reaction, the way had been well-prepared and both bond and equity markets seem to have taken the increase in their stride.

As the Press has noted, this should not minimise the shift in stance that the new policy represents, from a long period of easing to the first indications of tightening. Given the economic context sketched above, was this increase necessary and justified?

Readers would be aware of the debate that has been under way about the appropriate policy response to an increase in prices of imported commodities.

As the MTR rightly observes, the sustained inflationary impact of rising prices of oil (and other international commodities) depends on the underlying cyclical position of the economy when such a price shock hits.

If underlying conditions are buoyant and monetary policy remains accommodating, the initial price shock can be the trigger for a generalised price increase, particularly if the economy is not fully open to international trade.

On the other hand, if underlying domestic demand is weak (as it has been in some other Asian countries), and the economy is open, the likelihood of such second-round effects is reduced, and the effect of monetary tightening can be to generate stagflation.

It is not easy to reach a judgment on where India is in the business cycle. As work done at the NCAER (by Ila Patnaik and associates) has shown, business cycles arising from fluctuations in investment and inventory demand are a relatively new phenomenon in the Indian economy.

Prior to the mid-1990s, economic fluctuations in India were largely related to weather or the balance of payments. The slowdown in industrial activity that started around 1996-97 lasted for an extremely long time.

According to NCAER analysis, the recovery set in only around July 2002, just over two years ago, as monetary policy eased and the world economy recovered.

As noted above, by the standards of our peers and competitors, manufacturing growth in India even today remains tepid, for a mixture of structural and cyclical reasons.

One indication of a business cycle becoming unsustainable, particularly in emerging markets, is pressure on the current account of the balance of payments, but in both India and the rest of Asia, current accounts have remained resolutely in surplus even as the recovery has strengthened, in part mirroring the huge current account deficit of the United States.

As the RBI's Annual Report pointed out in August though, the structure of India's current account is qualitatively different from the rest of developing Asia.

Our merchandise trade balance is in substantial (and rising) deficit ($16.7 billion in 2003-04 according to RBI figures), compensated for by a healthy services balance ($10.7 billion in 03-04), while the pattern for developing Asia is the opposite.

In addition, we received massive net private transfers (largely workers' remittances) of $18.9 billion.

The RBI's views on this current account structure, and its likely evolution, are set out clearly in the Governor's statement (para 44), namely that this is a relatively stable receipts structure, and that prospects remain for further accretions to reserves, implying that RBI intervention in the exchange markets will continue.

In this regard, the MTR argues that "in arriving at the desirable level of reserves. The potential for different magnitudes of current account deficit, as the GDP growth accelerates, should be recognised" (para 38).

On the exchange rate, the MTR refers to media discussion (including by the present author) on the need for exchange rate adjustment in response to capital inflows, but takes the view that "it is prudent to presume that such flows are temporary till such time that they are firmly established to be of a permanent nature".

Finally, in an indirect response to current proposals to "use" the existing stock of reserves for other purposes, the MTR notes that international financial markets "react asymmetrically to the same growth in forex reserves (positively) and to the depletion in forex reserves (very negatively)" [para 46 (e)], and goes so far as to say that they are likely to take particularly unkindly to a new, Centre-Left government de-acumulating reserves built up by its predecessor.

The debate on alternative growth paths, and risk management strategies, has therefore been clearly joined within the government. The RBI view is that there is considerable underlying momentum in the economy.

The biggest contribution it can make to assure medium-term growth with financial stability is to maintain the gains achieved over the last eight years in reduced inflationary expectations.

It intends to do this by continuing to build up its reserves war chest, pass the bill on to the finance ministry via the market stabilisation scheme, and avoid the political heat of an exchange rate appreciation.

The Planning Commission view, if one can call it that, appears to be that the cost of this reserves-based insurance is too high (more precisely that the return is too low), that the inflationary pressure is in part the result of an inadequate absorption of imports, and that money-financed, import-intensive public investment would be anti-inflationary both in the short run (by attracting imports) and the medium run (by increasing the supply of non-tradables and thereby boosting the economy's long-run growth potential).

The larger lesson to be drawn is the old one: intervention begets more intervention. We started with buying foreign exchange, then needed to sterilise it, then to issue market stabilisation bonds, now infrastructure finance. Will we ever learn to trust markets?

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