Monetary policy at a crossroads

Business Standard, 7 March 2007

Monetary policy in India is at a crossroads. There are nine signs of distress, which show monetary policy that is not consistent, with confusion on both means and ends. The familiar `operating manual' which was used by RBI for many decades has broken down. In a fast growing and fast globalising India, an inconsistent monetary policy regime is fraught with risk. A new monetary policy framework is now required.

What are these nine signs of distress?

  1. The first and most important sign of distress is inflation. Inflation measurement in India is bad, but the CPI-IW is the least bad measure. It accelerated from 3% in March-July 2004, to 6.81% in the last five months. Such an acceleration should be completely unacceptable. It primarily reflects macroeconomic supply/demand factors, since no sharp drought has taken place, and inflation is found in manufactures as well. The first task of monetary policy is to deliver low and stable inflation. While Indian monetary policy doggedly delivered on this from 1993 to 2004, it has failed to do so in 2004-2007. Interest rates remain too low to combat inflation.
  2. The structure of interest rates is shows signs of distress. Many banks are offering interest rates from 8-9 percent for 1-3 year deposits, which is higher than the repo rate. So RBI has become the lender of first resort.
  3. The large gap that has come up between the repo rate and the reverse repo rate is a sign of distress. For many years, there was an effort at bringing down this gap, to achieve a yield curve with one clear number at the short end. The short end of the yield curve is now a highly inefficient market, with two very different prices depending on whether you want to borrow or lend.
  4. The call money rate is no longer in the corridor. This is a clear sign of distress, one that implies a breakdown of the operating framework of monetary policy. Call rates have fallen sharply and fell to 5.39% yesterday - way below the corridor. Why are interest rates dropping in a time of high inflation?
  5. The CRR hike is a symptom of distress. In mature market economies, both CRR and SLR are near zero, and are never instruments of policy. For many years in India, there was an effort at driving down the CRR, in an attempt to signal a movement towards the operating procedures of monetary policy which are found in mature market economies. These years of credibility-building have been lost.
  6. A reflection of distress in the monetary system is the huge 75 bps hike in the SBI PLR. In a mature market economy, the biggest bank in the system does not suddenly raise rates by 75 bps! Mature central banks know how to conduct monetary policy in a way that gently affects aggregate demand, without discontinuities of this nature.
  7. The most striking contradiction that is found is the continued defence of the USD by RBI. High inflation requires a domestic monetary tightening. However, RBI has been buying USD on a large scale, which serves to drive down interest rates and thus give a loose monetary policy. Regardless of the rhetoric, the actions of RBI suggest it believes defending the USD is more important than fighting inflation.
  8. The RBI policy of guaranteeing that the INR/USD will not fluctuate exerts perverse effects on the behaviour of companies. RBI has a formidable war chest of reserves, and the facts on the ground are that the top priority will be given to ensuring that the INR/USD rate will not move. With this free currency risk management system being run by RBI, firms have powerful incentives to borrow outside the country and leave this borrowing unhedged. This cheap borrowing sustains demand conditions in the economy at a time when monetary policy should be curtailing demand.
  9. All this has added up to severe confusion in the minds of financial markets. What is the monetary policy? Nobody seems to quite know what is going on. The words and deeds of RBI are seen to be inconsistent. One lever is used on one day to tighten, and another lever is used on another day to loosen. When the ideas and mechanics of monetary policy and not coherently and transparently communicated to financial markets, monetary transmission is damaged, thus disempowering RBI. When monetary policy lacks consistency, capital flows become unstable.

Why such distress? Is it the case that this is a difficult time in the world economy and that any central bank would face such difficulties? A glance at dozens of mature market economies shows that this is just not the case. There are dozens of central banks the world over, who have full convertibility, who face no such problems, and are able to calmly deliver predictable and low inflation.

The difficulty we face in India is conceptual. For many decades, RBI setup and fine-tuned an internal operating procedure that was based on a closed capital account. In 1992, the opening of the capital account began. Capital account decontrol gathered pace in the post-1999 period. The most important ingredient of our open capital account is the open current account coupled with the presence of Indian and foreign multinational companies. The well known fact in modern macroeconomics is that once a country opens up to trade and has multinationals, capital controls lose effectiveness.

This shift from a closed economy to an open economy has invalidated the operating procedures of RBI which worked till roughly 2001. In the pre-2001 period, it was possible for RBI to control the exchange rate while running a monetary policy that caters to India's needs. It is increasingly clear that this is now impossible. The frenetic effort of tweaking the hundreds of levers of control in RBI's hands has given a monetary policy in disarray.

The instinct of the bureaucrat is to hang on to a familiar operating procedure, to avoid any change, to be able to live by precedent. RBI would love to force India back into the old capital controls, so that the old manual would work. What India needs is to jettison this old manual and the control raj that goes with it. A new manual would use the operating frameworks found in mature market economies so as to achieve low and predictable inflation.

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