The Hindu Business Line : Monetary Policy Review

Though the Monetary Policy Review feels that the recent gains in bringing down inflation and stabilising inflation expectations should support the current expansionary growth cycle, it foresees risks transmitted from abroad to their continuance, and cautions banks to safeguard against such risks, says K. SUBRAMANIAN.

The First Quarter Review of Annual Monetary Policy for 2007-08 released by the Reserve Bank of India on July 31 created hardly any flutter. Many financial dailies and analysts had predicted the contours well in advance and were not disappointed.

While the basic bank rates remain unchanged, the ceiling on the daily reverse repo of Rs 3,000 crore under the liquidity adjustment facility (LAF) has been withdrawn with the caveat that it could be re-imposed at the central bank’s discretion. The cash reserve ratio (CRR) has been increased to 7 per cent, up by 0.5 percentage point. These may appear to be tinkering with minutiae. But it is in line with the strategy the RBI has been pursuing in recent years.

The strategy is to use selectively multiple options and move away, as much as possible, from direct to indirect instruments. As the RBI Governor, Dr Y.V. Reddy, put it in a lecture delivered in Mumbai in March (“Globalisation and Monetary Policy: Some Emerging Issues,” RBI Bulletin, April 2007), monetary authorities in emerging economies have to take into account the toll globalisation takes on their countries, such as domestic inflation becoming less sensitive to domestic output gap and more sensitive to the global.

The impact varies and each country has to take a holistic approach to the so-called trinity. They have necessarily to manage the impossible trinity in close co-ordination with monetary and other public policies.

In the earlier Quarter, the RBI attempted to manage price stability (read, inflation) in two ways: one through its own instruments and other through government’s initiatives to improve supply. A sub-theme, which was a Siamese twin to check inflation, was to manage foreign currency inflows. Instead of operating on rates and repos, it widened the repatriation windows to facilitate outflows. It resisted the pressure to increase interest rates as it would heighten the possibility of further inflows. Thereby, it lightened the need for sterilisation, which has inflationary potential.

The Review may be seen as a continuation of the same strategy. The RBI has again resisted pressures to increase the interest rate and documents the rate rises in advanced and emerging economies. Except the US Fed, all others have fallen in line.

Some Western economists referred to the ‘overheating’ of the Indian economy and gratuitously advised monetary tightening. The Economist (June 9, 2007) referred to the overnight lending rate having fallen in real terms cl ose to zero. “Without more tightening, expect the sweltering heat to continue.” Some others have been more dismissive in their comments.

The Review’s assessment of inflation belies these critics. It notes: “A heartening feature of recent macro-economic developments has been the decline in headline inflation from the late January 2007 peak to within the policy tolerance threshold by end-May.” Inflation declined from 5.9 per cent at end-March 2007 to 4.4 per cent as on July 14.

It attributes this to the pass-through of monetary, fiscal and supply-side measures in conjunction with seasonal factors, especially the moderation of food prices with the arrival of the rabi harvest. It is modest in its assessment and gives as much credit to the central bank’s measures as to the Government initiatives.

The Review, however, is not over-optimistic about the future. Though it feels that the recent gains in bringing down inflation and stabilising inflation expectations should support the current expansionary growth cycle, it foresees risks transmitted from abroad to their continuance. These are high and volatile international crude prices and uncertainties attached to the continued firmness in key food prices. As grimly narrated in an OECD-FAO Report (Global Agriculture Outlook 2007-2016) there are uncertainties surrounding the evolution of demand-supply gaps, globally and in India.

The Review is rather upbeat over the performance of the banking system. It feels that it has responded positively to sustain policies and ensure credit quality and financial stability. It observes a deceleration in bank lending to such sectors as real estate, housing, computer software, etc., in response to rising lending rates. Though sceptics may frown, it cannot be denied that banks in the country have matured and shown greater competence than foreign banks in India. Further, the RBI’s prudential hand guiding them has become stronger.

As suggested earlier, the Review is a continuation of the RBI strategy. This time again, it has pitched upon CRR as the indirect instrument to ensure price and financial stability. An increase in interest rate is not an option under the current scenario, as the RBI cannot contain portfolio flows. Higher interest rates would result in further inflows and create more problems of sterilisation.

Perhaps, we have reached the limits to sterilisation. Studies done by the Bank for International Settlements (BIS) establish the risks to monetary stability in emerging economies of excessive sterilisation. Given the roadblock created by the Finance Ministry policy on FII flows, the RBI is left only with the option of varying appropriately the CRR. As in April, the RBI has hitched upon it again.

No issue has generated more heat in recent months than the one on rupee appreciation. Exporters with an exposure to the US market, especially the IT companies, have been vocal in their attacks on the RBI. Economists and academics have also discussed the issue at length. Wharton has a document on it. (“Currency Conundrum: Is the strong rupee Good or Bad for India?” July 26, 2007.)

The jury is already out on the issue. The rupee has to reflect the market forces or be market determined. Large value foreign exchange inflows would naturally impact on the value of the rupee. For long years, the country has been used to rupee under-valuation and exporters are unable (or unwilling!) to bear the risks attached to their global operations. The trade-off is between short-term gains for certain sectors and longer-term financial imbalances, which a fixed exchange rate would create. Indeed, there are limits up to which the RBI can sterilise inflows.

If there was any expectation that the RBI would deal with the exchange rate issue in this Review, it was misplaced. In Para 44, the RBI briefly summarises its exchange rate policy. It does not work to any fixed or pre-announced target or band. It intervenes to correct excessive volatility. Most economists, even those belonging to the rightist group, have appreciated this policy. Incidentally, the IMF Executive Board endorsed this policy, saying: “Directors concurred that India’s policy of a market-determined exchange rate is appropriately promoting flexibility, preserving monetary independence, and giving private sector incentives to manage currency exposures as the capital account opens.” If the RBI did not allow the inflows to increase the value of the rupee, it would have to intervene excessively with concomitant inflationary impact. It has offered exporters hedging facilities to safeguard their future earnings.

In a lecture delivered on June 4 at Buenos Aires in a conference on “Monetary Policy under Uncertainty”, Dr Reddy dealt with the issues central banks in emerging economies have to face. Referring to the global situation he added how they “have an inbuilt potential for uncertainties, possibly some volatility” which get “exacerbated by international capital flows, particularly when the changes in such flows happen to be unrelated to domestic fundamentals.”

The RBI has to battle against these on its own turf. The Review reflects many of these uncertainties acutely, especially the sub-prime and mortgage credit risk collapse looming large on the two shores of the Atlantic.

Even as it manages the credit and monetary policies, it flags those risks both to caution the public and advise banks to ensure proper safeguards against them. Sadly, these do not get much coverage in the press.

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

More Stories on : Credit Policy | Insight

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Positive signs for Indo-Pak trade

Shipping firms ride the TDS wave

Gifts from abroad

Monetary Policy Review — Managing the tide

Accredited Loan Providers — A placebo for Rural India?

Why have a new I-T Act at all?

Dispensing with TDS certificates

CRR hike