The Hindu Business Line : Tinker not with the markets

The basic question we need to ask is whether the country wants the operation of a fair market where price discovery happens automatically. There is no need to be obsessed with inflation.

Is the government obsessed with protecting the consumer? On first thought, yes, as in every sphere of activity, it is trying to combat inflation to protect the consumer. Though high, inflation is certainly not at a perilous level to induce panic, as was the case with Latin American countries. Unfortunately, in this obsession with inflation-control, the country seems to be drifting away from the ethos of liberalisation and sinking back into the era of controls. How deep-rooted is this fear?

The financial sector was probably the biggest success story in the country's tryst with economic reforms as the approach was gradualist, yet firmly forward. The banking sector underwent a metamorphosis as liberalisation typified the environment and the Reserve Bank of India progressively transformed itself from a `control organisation' to a `regulatory authority'. And the system has worked well so far.

Maintain distance

There should ideally be an arm's-length distance between the Finance Ministry and the RBI. The central bank should set the monetary policy based on its own perception of the state of the economy involving economic growth and inflation. Policy should be geared towards these fundamentals with predefined trade-offs. In a liberalised economy, banks, theoretically, need not follow what the RBI says, but only take a cue from the central bank's policies.

While the RBI can raise or lower the repo or the reverse repo rate to make borrowings by banks cheaper or dearer, banks need not adjust their interest rates. If they do, it should be purely an internal decision based on management judgment. This is the true spirit of banking in a liberalised framework and is different from the times when the RBI decided deposit rates. There was also the concept of minimum lending rates (MLRs), being announced to set the base level of interest rates along with a pre-specified band.

The country has travelled far from this controlled set-up in the last decade or so. However, what is visible today is interference in bank working from extraneous forces. The RBI has been pressured to raise the reverse repo/repo rates as well as the CRR (cash reserve ratio) to combat inflation. This done, the public sector banks have been told not to raise interest rates, which is really not quite right.

The Government seems to want to control the growth in credit so that inflation is moderate and at the same time does not want borrowers to suffer, and also wants deposit holders to be buffered against inflation with higher deposit rates so that their real interest rates remain stable. How can this ever be achieved, especially if banks have to remain profitable in a competitive environment? It was these same principles in the nationalisation phase that left the financial sector repressed where the prices, that is, the interest rates, did not reflect the economic value of scarce funds.

Cement distortion

Another example of price distortion in the face of inflation is the case of cement. Cement producers have been asked to keep their prices unchanged as the consumer would be hurt. The Government has raised the excise duty of cement in the Budget and expects corporates to take a hit and leave the prices unchanged. While the Government has the right to increase excise duty, it cannot, and should not, pass rules for the industry. If the concern was so much for the consumer, the duty rates need not have been increased and the Government could have lived with a higher deficit. The fact that the burden is being passed on to the cement manufacturers suggests interference with the operations of the cement sector.

Again, in the commodity space, despite all internal regulations being in place, a ban has been placed on the forward trading of wheat and rice (and earlier urad and tur). This decision is based on the misconception that the higher prices of commodities are due to futures trading. Futures prices are based on spot prices with adjustments.

It is analogous to the foreign exchange market where the forward exchange rate cannot be held responsible for the movement of the rupee vis-à-vis the dollar; that is dependent on the demand and supply for dollars. The market now appears to be in a state of flux as there is a serious apprehension that such measures could be extended to other commodities too.

Fair market

The basic question is: Does the country want the operation of a fair market where price discovery happens automatically? If the answer is yes, then the government must stop interfering with the market mechanism; it must merely put in place strict regulatory processes. This is the right way to let markets evolve for efficient solutions.

There cannot be free markets and government intervention; the result will not be palatable to the consumer. Remember, in a market there are always two parties and if one loses, the other gains. If the borrower pays a higher interest rate, the deposit holder benefits. Similarly, if the government gets higher excise collections, builders/home owners pay the price. The consumer pays more for his wheat, but the farmer gets a higher price/income. As long as the rules of the game are followed, let the market decide the gainers and, the so-called losers.

(The author is Chief Economist, NCDEX Ltd. The views are personal.)

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