India's benchmark interest rate bottomed at 3.25 percent during the financial crisis. In March 2010, the Reserve Bank of India (RBI) raised it by 25 basis points, becoming one of the earliest countries to tighten monetary policy. Since then, this benchmark reverse repurchase rate has been raised six times, hitting the current level of 5.25 percent in November 2010.

Dr. Duvvuri Subbarao, Governor of the RBI, is the man behind those moves.

He was educated at the Indian Institute of Technology-Kanpur, Ohio State, and was a Humphrey Fellow at the Massachusetts Institute of Technology. His résumé includes various high-profile posts in the Indian government as well as serving as the lead economist at the World Bank from 1999 to 2004.

Dr. Subbarao now has the enviable task of cooling down India's booming economy while his counterparts in the developed world are still mulling more monetary stimulus.

Nevertheless, controlling inflation -- particular food inflation -- is no easy task in this environment, given the ample amount of global liquidity and the natural disasters/poor weather conditions that have been negatively impacting the worldwide farming sector.

Indeed, during this same period (from March 2010 to November 2010), India's monthly wholesale price index for food articles increased from 163.6 to 180.2, a 10 percent increase.

In the context of this enviroment, Dr. Subbarao shares with IBTimes some of his views on the Indian economy and financial system.

Some interesting points he made include:

- India's food inflation is more due to supply and demand rather than excessive liquidity or speculation.

- Capital inflows to India recently has been predominately to the equity market, which authorities prefer over debt inflows.

- Developing countries can't decouple from developed countries in the long run.

- Financial stability may be in danger even if there is price and macroeconomic stability.

Below is the interview.

IBT: What is the RBI doing about food inflation? How much of it is due to excessive liquidity and speculation?

Subbarao: Food prices have shown an uptrend over the past weeks. Price pressures have amplified for certain non-cereal protein rich items like milk, eggs, fish and meat whose output is less responsive to monsoon. About one-half of the primary food inflation (y-o-y) currently emanates from two sub-groups, milk and ‘egg fish and meat’. Also, prices of some vegetables have gone up significantly in recent weeks.

Food inflation continues to be a big concern.

The sustained elevated level of food prices, especially of protein-based items, whose share in the consumption basket has increased in line with increased income, points to the risk that food price inflation could acquire a structural character (associated with demand-supply mismatches rather than excessive liquidity conditions) and remain persistent.

Given the tight demand-supply conditions in food at the global level and the prospects of firming up of commodity prices, the option of [the importing] of food is of limited value. The lasting remedy is an effective supply management in the medium term.

Meanwhile, monetary policy would need to undertake demand-side management whenever inflation turns high and begins to feed on itself through expectations.

As pointed out in the Reserve Bank’s Annual Report, 2009-10, some analysts saw speculation in commodity futures as a factor behind the high food inflation during 2009-10. Whether activities in commodity futures market reflect [the] genuine needs of hedging or speculation, and whether such activities systematically influence commodity prices and lead to increased price volatility, are questions that largely remain unsettled in academic and policy discussions.

Commodity prices in India seem to be influenced more by other drivers of price changes, particularly demand-supply gap in specific commodities, the degree of dependence on imports and international price movements in these commodities.

Insofar as liquidity is concerned, the system has been generally in deficit since the end of May 2010.

IBT: Do higher interest rates encourage or discourage hot money inflows? I've heard arguments for both ways.

Subbarao: Experience shows that capital flows into EMEs (emerging market economies) are influenced by both 'pull factors' and 'push factors.'

The typical pull factors are the promising growth prospects, the declining trend rates of inflation and improved governance in EMEs. The push factors are the abundant liquidity in the global system and the interest rate differential between the advanced economies and the EMEs.

It is the push factors which trigger volatile capital flows.

It has often been argued that the widening of [the] interest rate differential between the domestic and international markets will result in increased debt-creating capital flows. While it is true that [the] large interest rate differential makes investment in domestic debt instruments and external borrowings by domestic entities more attractive, we need to keep in view three aspects in the Indian context.

First, the economy’s capacity to absorb capital flows has expanded as reflected in the widening of the current account deficit. Second, despite the already large differential between domestic and international interest rates, capital flows in the recent period have been predominantly in the form of... flows into the equity market. This suggests that the interest rate differential is not the only factor that influences capital flows.

Third, in line with our policy of preferring equity to debt-creating flows, we still maintain some controls [with respect to] debt flows.

IBT: Do you think it's the central bank's role to address asset price inflation in addition to consumer price inflation? If so, through what tools?

Subbarao: In India, and in several EMEs, financial stability had been and has become increasingly important as an objective of monetary policy. And I am not talking just about asset price inflation, although it is a key consideration. The jury is still out as to what should be the role of monetary policy in dealing with asset price inflation.

India has been among the first countries to use countercyclical prudential measures as a supplementary tool. Although the basic objective of such measures was to protect banks’ balance sheets, such sector-specific prudential measures also helped modulate credit flow and ensure credit quality. Recently, the Reserve Bank announced some measures to check the growing exposure of the banking sector to the real estate sector.

IBT: What are your thoughts on the fact that India and much of the world has negative real interest rates?

Subbarao: In order to restore financial stability, advanced economies have assured markets that they will maintain low interest rates over an extended period. And in order to manage expectations, they have repeatedly emphasized that intention.

On the other hand, because of their earlier recovery, EMEs have begun to reverse their accommodative policies much sooner. In India, for example, because of our unique growth-inflation dynamics, we raised policy interest rates six times since March 2010. One of the issues that dominate public discourse in India is, in fact, whether the Reserve Bank has reached neutral levels of policy rates, whatever they may be.

It is important to note that the neutral rate of interest is a theoretical construct, and as such, unobservable. There are difficulties in measuring the neutral rate of interest, particularly for India, because of sharp structural and dynamic changes taking place in the economy.

The negative real interest rates in India have to be evaluated in the context of our unique growth-inflation dynamics.

The policy actions taken over the past three quarters have been partly motivated by the need to correct the negative real interest rates. This was sought to be accomplished by a combination of increasing policy rates in a non-disruptive manner to help anchor inflation expectations and by reducing actual inflation to a more acceptable level. Both factors are at work, but the process is still incomplete.

We should assess whether interest rates are positive or negative, not at a particular point of time, but over a period. Further, a realistic assessment of real interest rates should be based on nominal rate adjusted for inflation expectation and not the short term changes in the inflation rate. While deposit interest rates in India have begun to rise, inflation remains elevated.

Whether real interest rates will become positive by the end of the current fiscal year (March 2011) will depend on the calibration of monetary policy over the next few months.

IBT: What have you learned from the financial crisis? The global 'currency wars'?

Subbarao: This crisis has taught us several things. First, that in pursuit of growth and price stability, central banks cannot ignore financial stability. We have learnt that financial stability can be jeopardized even if there is price stability and macroeconomic stability.

Second, the crisis has taught us that in a globalizing world, decoupling does not work. In the long run, the futures of emerging economies are tied to the fortunes of advanced economies.

Third, [the] financial sector cannot get ahead of the real sector. The growth of the financial sector has meaning only if it aids the growth of the real sector.

Finally, we have learnt that in solving this crisis, we should not sow the seeds of the next crisis.

On what you call ‘currency wars’, it has been empirically demonstrated that the policy of beggar-thy-neighbour does not pay dividends in the long-run and indeed could be self-defeating. Central banks are quite aware of the futility of such a strategy, however compelling the situation may be. Our collective effort at all international fora, including the G-20, is to foster sustainable cooperation on issues of global concern.

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