The start of a monthly column is a good occasion to review the substantial changes that have taken place in financial balance sheets over the past year and a half.
We all know that the government is running a large deficit; we also know that the Reserve Bank of India is accumulating reserves apace; and we are told that credit growth of banks has been relatively sluggish.
How, if at all, are these phenomena related? What role does and should policy play? What vulnerabilities are building up?
In looking at these questions, three sets of accounts are helpful: the balance of payments; the monetary survey; and variations in reserve money. Two recent publications of the Reserve Bank, the Mid-Term Review of Monetary and Credit Policy for 2003-04, and the Annual Report of late August give one the necessary background.
From the Annual Report we learn that over the course of 2002-03 the RBI acquired foreign exchange assets in the extraordinary amount of Rs 94,000 crore (Rs 940 billion).
This was offset by a reduction in net domestic assets of more than two thirds, roughly Rs 63,000 crore (Rs 630 billion), such that the increase in reserve money was a modest Rs 31,000 crore (Rs 310 billion), or 9.2 per cent.
The reshaping of RBI's balance sheet over the last two years has been dramatic.
On March 31, 2001 net foreign assets constituted about two-thirds of reserve money. Two years later, the ratio is up to 97 per cent.
While at the end of March, the RBI still had gross holdings of government debt of Rs 1,21,000 crore (Rs 1,210 billion), this was almost completely offset by its net non-monetary liabilities, presumably its net capital position.
The story is updated in the mid-term review. There we learn that the RBI's net foreign currency assets increased by a further Rs 64,000 crore (Rs 640 billion) in the period from March to October 24 this year.
This build up was again largely neutralised by further net sales of Central Government securities of Rs 46,300 crore (Rs 463 billion).
To all intents and purposes, RBI financing of government deficits, both Centre and states, are at an end. Yet the government sector continues to have large net financing needs, which are being met wholly from the market.
To trace this story, we need to look at the monetary survey (variations in money stock), where we see that 'other banks' credit to government in 2002-03 increased by Rs 1,20,000 crore (Rs 1,200 billion), an amount in excess of the net market borrowings of the central government.
And according to the mid-year review, this trend has further intensified, with scheduled commercial banks' investment in SLR securities increasing by a further Rs 88,000 crore (Rs 88 billion) in the year till October 17.
As the Review notes, the effective SLR investment is now 41.6 per cent of net demand and time liabilities as versus the statutory minimum of 25 per cent.
Looking next at the balance of payments for the year ending 2002-03, we note that there was a surplus on capital account of $12.6 billion, of which the largest item was an inflow of banking capital of $8.2 billion (Rs 40,000 crore).
Private transfers were another $14.4 billion, although these are classified as a current account item.
While the aggregate flows are relatively sizeable, the main change over the past couple of years has been in the banking capital item, which has gone from under a billion dollars at the end of 2000-01 to the eight billion referred to earlier.
This overseas borrowing by banks shows up as a sharp reduction (Rs 30,000 crore on March 31, 2003) in the net foreign currency assets of the commercial banks.
While money is fungible, at least a portion of the additional purchase of government bonds by commercial banks has been financed through overseas resource mobilisation.
Finally, the RBI (and others) tell one that the market is extremely liquid, in part because of the inflow of capital. It is difficult to know what to make of this statement.
As already noted, the increase in reserve money had been a relatively low 9.2 per cent last financial year, and a very modest 3.5 per cent till October 17 (although part of this may be seasonal).
Whatever one means by 'liquid', the source does not lie in the Reserve Bank's balance sheet.
In understanding these developments, we should be clear that they represent conscious choices of the monetary authorities, and not some passive response to global developments.
While it is difficult to differentiate autonomous and induced elements in the balance of payments, the actual changes in such presumably autonomous items as foreign investment, commercial borrowings and external assistance in the last financial year were relatively modest.
The acquisition of reserves on the scale we have seen is therefore a deliberate decision, as is the decision to shift the financing of the government deficit onto the domestic markets.
The latter seems to be motivated by the desire to control the growth of liquidity to achieve a targeted interest rate.
Despite the rhetoric of a soft interest rate regime, by the evidence of what the balance of payments is telling us (through both banking capital flows and private transfers), the targeted interest rate still seems too high.
We are witnessing a live demonstration of what economists call the 'impossible trinity': the attempt to reconcile an open capital account, an exchange rate target, and independent domestic interest rate.
It could be said that the Reserve Bank has returned to its colonial financial roots, with reserve money backed entirely by foreign exchange.
But this is neither necessary, nor particularly wise. It is not necessary, because the evidence suggests that there is an unsatisfied demand for money locally which is in part powering the capital inflow.
This demand could be met by a more relaxed attitude toward the growth of reserve money, achieved through less aggressive open market operations.
It may not be wise, because, as Mr Tarapore has pointed out, what comes in across the foreign exchanges one day may leave. That would be an awkward time to be scurrying around trying to buy government debt.
What conclusions can one draw? First, the integration of India into the global financial system is proceeding apace, with both the opportunities and risks that such integration implies.
Second, low interest rates abroad, coupled with an appreciating rupee, provide an opportunity for selected domestic private entities to restructure their balance sheets, and the evidence is that they are doing so.
Third, the build up of government debt in commercial bank balance sheets is the logical consequence of other policies pursued by government. These include the attempt to fix both the exchange rate and the domestic interest rate, and the decision to fund government almost wholly in the domestic market, including the prepayment of external public debt.
In general, primary issues of government debt should not be subscribed to by the Reserve Bank in the future, but it should continue to maintain a sufficient intervention stock to conduct its monetary policy.
Fourth, there are risks in having financial integration proceed more rapidly than trade integration, since this increases the risks that external resources, at least some of which have to be paid back, will be invested in the wrong activities.
So accelerated trade policy reform must be an integral part of the economic management agenda, with or without the Doha round.
The writer is Director General of the NCAER. The views expressed are personal.
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