If the Indian governments -- central and state -- master their debt and learn to manage their own finances, then it will become possible for the Reserve Bank to concentrate, like more advanced central banks, on running monetary policy on its own. Then -- and that is at least five years away, even if the governments start reforming their finances straight away -- the Reserve Bank will face a choice -- it could either target money supply as the Bundesbank does, it could target interest rates as the Federal Reserve does, or it could target the exchange rate as it has tried with dubious success to do in the past few months.
The dangers of targeting the exchange rate should be obvious to everyone after the East Asian debacles. Exchange rate intervention must mean stabilisation; no one would argue for deliberate destabilisation of the exchange rate (although it may be a good idea at times of excessive foreign trade or foreign investment). Thailand in particular stabilised the dollar value of the baht at a time when capital was flowing in. As a result, traders and investors underestimated exchange risk; considerable foreign capital came in, and a high proportion of it was short-term. At a certain point, investors became dubious about the ability of the Bank of Thailand to sustain the exchange rate. There was a rush of funds out of Thailand, and the exchange rate plummeted.
Wherever different currencies exist, exchange risk exists; it is never a good idea to reduce it. Exchange reserves should always be treated as insurance against unexpected adversities. They may be used to drive the exchange rate up or down on macroeconomic grounds. But they should never be used as a means of exchange rate stabilisation.
In my second article I described how the Fed Reserve uses interest rates and the Bundesbank control of money supply to restrain inflation. Which of the two is better? In my view, it is better to manage interest rates, for it is in the national interest to maximise reserve money -- and hence money supply -- consistently with a low rate of inflation. For reserve money is an interest-free perpetual loan to the government; an increase in it is pure profit for the government. The gain is reduced insofar as issue of money causes inflation; hence it is sensible not to go beyond limits. But subject to price stability, issue of money gives the government non-tax revenue, and should be maximised.
Here there is an opportunity, and a risk. The opportunity lies in making foreigners use our currency. This may sound fanciful, but there was a time when Indian currency was in common use in West Asia. Even now it is bought and sold on the pavements in Dubai and Qatar. If a currency is unstable, if it loses value rapidly, even nationals of the country that issues it will rush to get rid of it. In inflation-prone countries of Latin America and Eastern Europe, people commonly keep 15-20 per cent of their money in dollars -- apart from the deposits they keep in banks abroad. Conversely, a low rate of inflation and a stable or appreciating exchange rate will induce even foreigners to store and use a currency. We only have to reduce inflation and build up a strong balance of payments to ensure that rupees will be used by nationals of our neighbouring countries. We can begin this process even now by allow them to invest freely in our capital market and to keep accounts in India.
The risk is that currency will be replaced by electronic money. This process is well advanced in the United States, and is progressing in Britain. First there were credit cards. Issued by specialised companies, they bulked transactions between them, their clients, and the clients' suppliers. Next to enter were banks; by introducing debit cards, they cut out even the monthly cheques required by credit cards. Now chain stores are issuing their own cards, thereby cutting banks out of intermediation between them and their clients. The way is open for smart cards, which would instantly transfer money from their owners' bank accounts to their suppliers' accounts.
Electronic money is the terminator of fiat money issued by governments; it destroys seigniorage. The government -- and the Reserve Bank -- should be worried about its spread. If it gets scared, it will want to ban electronic money. That would be stupid. Instead of banning electronic money, the Reserve Bank should issue its own. It is already being talked about as an Electronic Fund Transfer System. But what I mean is not just electronic fund transfer, but electronic fund management.
What I have in mind is a cash depository, working exactly like the depository for securities, run by the Reserve Bank, which would maintain the depository's accounts in a giant computer. It would open accounts for anyone who can keep a certain minimum balance -- say, Rs 100 million. Amongst its account holders, it would give licences to some to be custodians of cash for others. To qualify as custodians they must maintain their own computers which would keep cash accounts for their customers, which would be connected to the Reserve Bank's central computer, and which would be able to transfer cash between clients' accounts and accounts with any other custodian in the country. Custodians would have to undertake not to make any use of funds in their clients' accounts except on their express instructions.
What would be the difference between these custodians and the present banks? The banks mix up the business of keeping their customers' balances with investing them. The custodians would not invest their customers' balances; they must maintain the balances in accounts with the Reserve Bank. They may charge for keeping the balances and managing transfers.
What then would become of the present banks? They may take custodial licences, but they must strictly separate custodial business from the business of lending. They would bundle the loans they give into investment opportunities, and sell to cash-holders. They must promise a rate of interest based on what they earn, and pass on the entire bad debts to the investors. In other words, the risks would be passed on entirely to investors. But the cash-holders would not be confined to investing in those bundles of loans. They may invest in any financial asset -- shares, bonds, mortgages, company deposits -- or may entrust their money to asset managers.
Thus I envisage a family of depositories: the Reserve Bank would manage the cash depository, and others would manage depositories for various types of financial assets. There would be another family of financial intermediaries, who would package investment outlets into different combinations of risk and return and offer them to cash-holders, always passing on to them the entire risk. And there would be a third family of information processors, who would judge the quality of the investment outlets being offered and sell their advice to cash-holders or to media who live by selling words and figures to cash-holders. The Reserve Bank would pull the strings in this system, and call it monetary policy.
