The virtues of silence

A former governor of the Reserve Bank of India used to warn his colleagues that they should never surprise the markets with bad news; if there had to be a surprise, then it should be about good news.

Dr Y V Reddy would have done well to heed that bit of advice, before speaking his mind at a function in Mumbai on Wednesday about how to deal with foreign investors in India's volatile stock market.

At the very least, he should have kept in mind that what central bank governors say have a huge influence on markets. And if his remarks on taxing foreign institutional investors were meant to be loud thinking rather than an indication of forthcoming policy, it was all the more ill-advised.

For, Dr Reddy should know that he has nothing to do with taxation, since that is in the finance minister's domain.

He should also know that remarks about putting a cap on FII investments would severely affect investor sentiment in a stock market that is hugely influenced by FII behaviour.

In short, Dr Reddy would have done well to hold his peace.

Instead, he has forced the finance minister to quickly issue a statement and then been obliged himself to issue what is for all practical purposes a retraction of his comments.

This is not the kind of public embarrassment that an RBI governor should subject himself to. For their part, investors do not expect someone in his position to say things that have the potential of sending both stock and currency markets into turmoil.

Fortunately, the damage was swiftly undone and the stock market even recovered some lost value on Thursday.

Going beyond this forgettable episode, the issue that the governor has highlighted remains before us. What is the extent of instability that is being added to India's stock (and currency) markets by the large financial inflows of recent months?

For what comes in on account of substantially extraneous factors can just as easily flow out for reasons that are beyond India's control, and the impact of sudden swings on both investors as well as importers/exporters can be more than what reasonable men would bargain for or that central banks can neutralise.

It is obvious, for instance, that most companies in India do not have the resilience to deal with a sudden and large change in the rupee's external value.

This is the old tension between the financial and "real" worlds. At one level, there is no getting away from the increasing opening up of the Indian economy in a globalising world.

But capital account convertibility brings with it risks that have to be managed, for the experience of several developing economies bears out that failure brings with it outsize costs.

But the government in India is still struggling with the fiscal deficit even as it remains wary of allowing the foreign currency market to develop depth""for fear of losing control of an important economic variable.

These dilemmas must have been occupying the governor's mind, but the solutions that he held out are not workable; perhaps tactical responses remain the only option at the moment.