Prologue
The Reserve Bank of India has surprised markets (once again) by announcing a slew of monetary measures. It includes
- Increase in the Cash Reserve Ratio (CRR) by 0.50%. This impounds approximately INR 155 bn of funds from the banking system. This is teh third time in the last four months that RBI has increased the CRR.
- Increase in the repo lending rate (the rate at which the central bank lends to banks against collateral of government bonds) by 0.25% to 7.75%. This widens the LAF corridor to 1.75%.
- Halved the interest paid on cash balances maintained with the RBI by banks to 0.50% per annum from the 1% per annum (also announced only as recently as mid February)
These measures can only be described as using a sledgehammer in the conduct of monetary policy.
This post has been written by KRG, a guest author. KRG is head of treasury at a leading financial institution in India. He is based at Mumbai.
I had also expected to put up a post on the RBI measures. However, KRG’s writing below brings up related and important issues and also highlights the path of monetary policy in India, in recent times. Do read. It’s a gem.
- Dheeraj
Dheeraj’s post on why we need new thinking on monetary policy had me thinking. And I wrote this a week ago, but held it back as it sounded too much of a policy bashing. After the RBI announcements, this does not look unrealistic at all and hence, here it goes…
The current monetary situation has an interesting sequencing. Initially, RBI (and may be other Central Banks too) had been quite indulgent in the first phase of rate tightening. They have perhaps underestimated the underlying inflationary pressures (may be by looking at the headline WPI and CPI numbers). Or perhaps overestimated the strength of the monetary transmission mechanism (notice the Fed style 25 bps action).
At the second stage came indirect controls. Increased risk weights on capital adequacy for select sectors, higher provisioning for exposure to select sectors and so on. Even though, RBI seemed to be bothered about the strong credit growth, the language was however quite balanced and contained some gems. Witness for instance the October policy stance on overheating
…..very strong credit growth may not be overheating the economy.. and…in any case the measurement of concepts like output gap and overheating are fuzzy in the context of developing world……
Another theme that found favour in that period was that the flat yield curve….
is a pointer to the anchoring of inflationary expectations…
Yet another favourite theme was that a large part of inflation is supply driven and hence monetary tightening is not of much use.
As this also didn’t produce fast relief (..WPI and CPI seem to have a way of their own…), we started getting very DIRECT methods of monetary action like CRR, MSS, allowing Rupee appreciation etc. Though, why the LAF corridor is being widened is a huge bouncer to me…I mean the same effect would have been achieved with both the rates rising??
To summarize, initially RBI tried out a new style viz., series of calibrated monetary action and thereafter, selective credit pricing. When these did not seem to work out, then came the old style bludgeoning (CRR & controls).
Along with the bluntness, the language turned tough; Supply side inflation, worldwide flat or inverse yield curves (including ours) are at best paid lip service. And whatever happened to avoiding exchange rate volatility (that earlier meant fast Rupee appreciation) as a policy objective?
To my mind, the monetary policy has been typically reactive (and of late hyper-reactive) in nature. One would have liked to see more policy action based on anticipated movements in economic variables. Unfortunately, when things seem to settle down elsewhere (read global liquidity, risk aversion, asset price corrections), the panic has set in here. And pundits like us will fail to appreciate the new found (or re-discovered) monetary aggression that cares a dime for niceties such as Mibor levels or LAF spreads, Inverse Yield Curves, stable forex rates et al
An issue that may be linked to this is the composition of the Expert Monetary Committee that does not seem to have (in my opinion) any market experts. While it is expected that the committee considers a variety of factors and in any case the RBI Governor will and should have a substantial say, it does help if persons with some market background are in these committees. And I suspect that the committee could be of persons not much oriented towards the new economy (this is guesswork based on the type of policy responses we are seeing and I am open to be corrected on this). The new economy CEOs are in 30’s and 40’s. What is the average age of the Expert Committee? The problem with experience is that it usually resorts to old, tested methods for any recurrent symptoms, even if it were a different malady. And unfortunately, in India, experience also means a cultural bringing up in a controlled economy that may or may not be suited for the current situation.
Witness for instance, few days after the FM says that there is no overheating in the economy, an Advisor to RBI says that 9% growth is not possible without 6% inflation.
….[I will settle for 6-7% growth with 4% inflation; but to get there do we have to first go to zero inflation? and in the process give up all pretences of free markets?]….
At the same time the Advisor talked about supply and demand widening. Pray; in what areas? The example he had given is that real estate and stock market are overheated…Overheated? I feel equities are gearing up for a C wave down (our targets being 9000 on Sensex and 2600 on Nifty. Pls see comment on Rao’s post) with or without these shockers from RBI. And to curb a real estate “bubble”, why should RBI bother to have generic monetary measures like CRR; why cannot they use the good old sector-wise controls of margining, provisioning etc
At the expense of repetition, let me list down the commissions and omissions of monetary policy
(a) hiking CRR (this is a blunt instrument with longer term impact)
(b) broadening LAF corridor (effort should have been to narrow it further so that eventually we can get to a single targeted rate)
(c) volume controls (risk weights etc… no..I won’t mention cement, sugar etc)
(d) Ignoring Mibor as a target and not having any policy instrument to keep Mibor within LAF corridor
(e) failure to do yield curve intervention [and demonstrating confidence to the system on longer term inflationary expectations at the same time controlling demand pressures on short end]
(e) failure to study inflation in its gory micro detail and then prescribe policy rather than repeatedly resorting to conjectural and anecdotal evidence (that should be left to people like me who at best project inflation by taking previous averages)
(f) avoiding blow-hot-blow-cold approach, changing rates in between policies
(g) providing elaborate policy explanations that leave enough scope for interpretation and subsequent opposite action
It is the duty of the Markets to do price discovery based on various demand and supply factors. However, many a time it is the sentiment that drives the markets to extremes and contributes to additional volatility. It is for this reason, that many Central Banks do not like surprise the markets. Till such a time that we can get there, our markets will continue to run significant policy risks
The current situation has started to resemble the great money squeeze of 90’s in many ways, the major difference being the Rupee (that has gone the other way so far!). Let us hope that the monetary policy lessons were learnt well at that time and the squeeze does not result into a deathly grip.
Previous posts by KRG can be found here (1, 2)
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