I wrote a piece for DNA after the release of the quarterly review of monetary policy by the Reserve Bank of India yesterday. This has been published in the Money section of DNA today
Given below is the full text of the piece
While governor Reddy has answered some questions through his policy actions, several others remain unanswered.
The hike in cash reserve ratio and removal of cap under the reverse repo facility is an implicit acknowledgement by the RBI of the futility of trying to manage exchange rates by keeping the money markets oversupplied with local currency.
The central bank has been unusually tolerant of near-zero short-term rates for long periods, hoping that it would ease its job of exchange rate management.
The policy moves announced are an implicit acceptance of the failure of such a policy regime.
The withdrawal of the second liquidity adjustment facility window, which was introduced after persistent demand from bankers, would mean that banks would now have to bear the burden of intra-day liquidity management.
Expect more intra-day volatility in overnight rates.
These measures clearly bring out the primacy of liquidity management in the revised scheme of RBI’s policy formulation.
It also enables the RBI to get back control of the short-term interest rate, something generally considered sacrosanct in central banking circles.
In other words the central bank now at least has a semblance of control on monetary policy.
The experiment of abdicating monetary control has lasted a little over three months. Purely for the sake of policy clarity, it’s a good thing that this experiment has now come to an end.
What remains unanswered though is the type of exchange rate policy that the central bank would now pursue.
While all indications are that the policy of active intervention to protect a particular level of the rupee against the dollar would continue, the market would have expected the governor to dwell on this with a little more clarity and frankness.
Under normal circumstances a 50 basis point hike in CRR would have led market men to cry blue murder.
However, such is the nature of times that it barely registered as a whimper. However, using the CRR as a tool to impound liquidity has severe drawbacks. It imposes a banking system wide penalty and would generally add to the cost of funds for banks. To those, who are predicting a drop in short term interest rates, I say this is wishful thinking. And let’s not forget the RBI itself had a medium term target of moving the CRR to 3%.
A much more efficient method of liquidity pre-emption is through open market sale of bonds. This ensures that the costs, if any, are borne selectively. However, supply of bonds on RBI’s books have dwindled significantly and thus limits its capability to conduct these operations.
The MSS scheme, which was conjured to tide over this, involves fiscal costs, something that the government may not wish to bear endlessly.
Unusual situations require out-of-the-box thinking to generate out-of-the-box solutions. It may be time to think of allowing RBI to issue its own bonds.
This would require legislative change, but in the end may be worth the effort.
It would provide the central bank would another tool to carry out its policy prescription. Additionally, it would relieve the government of the burden of bearing the costs of monetary and exchange rate policy.
It would also serve to shift the costs to where they duly belong. There are examples of such central bank bonds in the global context.
The People’s Bank of China (PBC) regularly issues bonds to pre-empt funds. What’s more, the PBC bonds are compulsory purchase bonds for commercial banks. Of course, one does not need to go to that extent in India.The central bank issuing its own bonds would also provide the true meaning to the current misnomer, “RBI Bonds”.
recommendations on the Yuan Carry trade made by an investment bank, which if implemented, has an impact on the Indian fx markets too.
