The Hindu Business Line : A multi-dimensional Monetary Policy

The Monetary Policy is not one-dimensional but is seen more as a vehicle that enhances various segments of the financial market, improves credit delivery, nurtures credit culture and enhances the quality of financial services.

No fireworks were expected on June 25 when the Reserve Bank of India Governor, Dr Y. V. Reddy, presented the First Quarter Review of the Monetary Policy (Review). For weeks, the market was readying itself for an interest rate hike though the Governor had clarified earlier that hikes would not be dependent on quarterly reviews. He added that the Bank would respond to changes in domestic and international markets as and when necessary.

In fact, the RBI did not increase the rate in April during the Annual Review. It surprised the market by increasing the repo rate on June 9 by 25 basis points. In repeated interactions with the press, Dr Reddy responded that the RBI's decision was not related to action by other central banks such as the European Central Bank or the US Federal Reserve.

Unique framework

The RBI has a unique policy framework. It has been adopting a broad-based multiple indicator approach whereby interest rates or rates of return in different markets (money, capital and government securities) along with the data on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, exchange rate and forex transactions are juxtaposed with the output figure for drawing policy perspectives.

The RBI relates the Monetary Policy to several factors such as macroeconomic prospects, global development and the balancing of risks. The Review, attempts a summary of several positive factors in domestic developments. More significantly, it poses them against an array of emerging risks listed in two paragraphs.

On the global side, it is concerned about "global imbalances, emanating mainly from the twin deficits of the US and reflected in misalignment of major currencies," which widened during 2006 in an environment of rising interest rates worldwide and prospects of contraction of global liquidity in the global financial markets.

Not one-dimensional

The Monetary Policy is not one-dimensional, but is seen more as a vehicle that enhances various segments of the financial market, improves credit delivery; nurtures credit culture and enhances the quality of financial services.

This policy frame distinguishes it from most other central banks that are currently wedded to Inflation Target Framework (ITF). Dr Ben Bernanke, Chief of the US Fed, is one of the leading advocates of the ITF. Surprisingly, the US is not one of the countries tied to the ITF. Partly, this is due to the Humphrey-Hawkins Act of 1978, which sets long-term growth, minimising inflation and price stability as the mandates for the Fed. Mostly it was due to the personalised style of Mr Alan Greenspan who held the office for 18 years.

There has been a good deal of academic exegesis on the ITF. Notions governing inflation and expectations of inflation have turned abstruse and theological. Only the hardcore monetarists stand by it now. Some studies have established that in terms of performance the difference between countries which adopt ITF and those that do not is negligible. As The Economist puts it, "The point is that there is more to monetary policy than trying to achieve a single policy objective," (August 30 2001).

In a recent article, Prof Paul de Grauwe of the University of Leuven exposed the futility of rational models for central banks. (Central banking model for neither gods nor monkeys, Financial Times, July 25 ). The ITF model had its sway in an era marked by very low inflation. "The uncertainty that central banks face today is very different from the one found in the rational agent models." There is a great deal of unpredictability concerning the effects of interest rate policies. More importantly, the economy is subject to shocks and cyclical changes and the central banker is at a loss to comprehend the developments and decide upon the corrective action. Mr Greenspan owed his success to action based on intuitive perception and not on preset models. Recent reports suggest that Prof Bernanke may also be learning the art.

More transparent

The RBI Review needs to be seen in the light of the speech made by Dr Reddy at the Central Bank Governors' Symposium in London on June 23 . He indicated that unlike the Bank of England, the RBI would provide detailed information and share analysis fully to influence expectations and hesitate to give inferences or forward guidance. He emphasised that though the focus of many central banks is on short-term interest rate and considerations relevant to it, the RBI has switched to the multiple indicator approach.

Lastly, he explained that financial stability considerations require the interest rate tool to be used in conjunction with other prudential measures. What the RBI attempts in the Review is to set these objectives against the panoply of domestic and global circumstances and highlight the flash points. By and large, the interest rate structure remains in place with incremental changes. Increase in bank rate was avoided, as in the past, as it could curb growth of industries across the board.

There are concerns about `credit quality' impacting on `financial stability'. For instance, there is the fear of the credit cycle slowdown. One analysis reveals that about 50 per cent of banks' loan books was created in the past three years and banks' credit risk pricing curve is flattening. During the same period, the banks reduced the provisioning of loans. Analysis suggests that this is `credit boom' in terms of the IMF definition and spells financial instability.

Similarly, the commercial banks' exposure to the real-estate is an area of concern. Outstanding loans rose from Rs 13,3102 crore at the end of March 2005 to Rs 24,527 crore by January 2006, an increase of 84.4 per cent. The market is fuelled by the entry of venture capital funds and by the fact that it is now open to 100 per cent foreign direct investment (FDI).

Prudential measures

The Review does not deal with these issues specifically. This may be because the Bank has been taking action independently. The Governor referred to them as `prudential' measures. The RBI has issued guidelines seeking to restrict these loans by increasing risk weighting for commercial-estate-related loans from 100 to 150 per cent, for housing from 50 to 75 per cent and consumer loans from 100 to 125 per cent.

In sum, it is a Monetary Policy without tears. It is better seen as a reformulation of the RBI's strategy in evolving monetary policies with clearly stated objectives. It is not to be seen as an exercise in interest rate changes per se.

As explained earlier, these changes may be brought about any time. Again, prudential measures are taken independently from time to time through directives to banks. What the Review does is to reiterate the Bank's monetary policy strategies. If this procedure is continued, there may be no need for quarterly reviews.

(The author, a former Finance Ministry official, has extensive experience in international, finance and trade issues.)

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