The Hindu Business Line : Why the RBI did not bite

Perhaps because its earlier monetary-tightening measures were beginning to bite or other central bankers had stayed their hand, the RBI decided to leave all key rates untouched, but with the caveat that it would not hesitate to act if the situation so warranted.

The capital market, which has been at the receiving end since the unexpected hike in the Cash Reserve Ratio and repo rates in end March to contain the rising inflation rate, has cheered the Reserve Bank of India for leaving unchanged all the key rates in the April 24 Annual Policy Statement.

The policy response to the rising inflation and the overheating of the economy has been to hike the repo rates five times in FY-07 from 6.50 per cent to 7.75 per cent. As the RBI had already intervened recently via market operations, this time around the central bank appears to have stayed its hand.

The market correctly did not expect any rate to be raised, reflected in the Bank Index being up 1.4 per cent just before the Policy announcement. Further, in a CNBC poll before the policy announcement, 67 per cent of the respondents predicted `no change' in interest rates.

Predictably, the market welcomed the Monetary Policy wholeheartedly, as evident from the equity index ending approximately 1.4 per cent up, and the Bank Index rising more than 4.5 per cent. The bond market also gave a thumbs-up to the policy, with 10-year yields falling more than 10 basis points.

No cause for cheer

The equity market may be cheering the no-interest-rate-hike policy, but for others there is no cause for such revelry what with the central bank lowering the GDP growth target to 8.5 per cent for the current financial year from 9.2 per cent for FY 06-07.

Reduced numbers are acknowledgement that global growth is slowing, and perceived higher risks in financial markets emanating from behaviour of crude oil prices, adverse developments in the US market, large leveraged positions and partly also the lag effect of monetary tightening at home. Indeed, the equity market should pay heed when the banker to the economy predicts a possible drop in GDP numbers, implying a negative impact on earnings expectations, in contrast to the equity market's optimistic expectation of double-digit growth rates.

The Annual Policy unexpectedly reduced the expectations of inflation to 4-4.5 per cent going forward from the current rate of 5-5.5 per cent, acknowledging that it remains the key downside for the evolving macro-economic outlook. The lower inflation rate prediction is unexpected because the central bank acknowledges that in India primary food articles have contributed significantly to inflation and also because the full effect of the petroleum price rise is yet to be passed on to the consumer.

With global agricultural production under pressure, the Government would have to do a lot more to curtail the prices of goods, especially as the economy is also showing signs of overheating.

So, even if the RBI is comfortable with higher Money Supply from 15 per cent to 17.5 per cent and credit growth from 20 per cent to 25 per cent, it is quite certain that it will not tolerate higher levels of inflationary expectations which can hinder sustainable growth of the economy, and that it would take measures to contain this problem.

Even though the real interest rates are low vis-à-vis the policy rates (Repo and Bank Rates), the RBI could have spared the market this time because central banks have also stayed their hand, or due to the moderation, both in money supply and credit growth in India.

Another reason could be the liquidity generated by foreign capital flows which the RBI is finding it difficult to control and an interest rate hike at this stage would exacerbate the position by way of increased arbitrage flows from international markets.

A New Approach

Also, perhaps, the RBI wants to achieve the interest rate targets with minimum intervention. Such "talking to the media and markets" can be called "Open Mouth Operations" (OMO), wherein the central bank does not intervene directly in the market but drops enough hints that, if required, it will act tough to ensure that market follows its diktats. Thus, the market is on notice that if it goes overboard the regulator will come down hard on it.

`OMO' is becoming the norm with regulators voicing concern whenever the market is seen to be deviating from the policy direction; strong corrective measures are resorted to only if required. But for the OMO to be effective, the central bank should be perceived to be credible seen as an entity that can take decisive action as and when required.

Post the Monetary Policy announcement, the comments by the central bank precisely convey that it will act whenever it is required to to contain inflationary expectations.

Given the RBI's actions in recent times, it may pay to heed the wording of the Policy and be prepared for high levels of short-term rates for some more time.

Even if there is a talk of peaking of interest rates in the US, the RBI appears set on lowering the inflationary expectations and, to this end, has conveyed to the market that it will keep monetary conditions tight.

This means the central bank will keep tabs on the liquidity position and maintain the pressure on short-term rates. To this end the RBI has already revised upwards the Market Stabilisation Scheme issuance ceiling from Rs 80,000 crore to Rs 95,000 crore to be able to mop up any excess liquidity.

The Monetary Policy may have spared the market a hike in the Repo rate and the CRR, but there is a need for it, and others, to listen closely to the RBI's `OMO'. Else, the central bank will not hesitate to strike.

(The authors are Consultants with the Domain Competency Group of Infosys Technologies Ltd.)

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