The Hindu Business Line : RBI decides to keep its powder dry

The Review, while reaffirming the basic tenets of multi-indicator approach to monetary policy, goes over newer threats and uncertainties posed by the global situation. It flags them and captures the situation in which the Indian economy finds itself. It reiterates the central bank’s ability and readiness to act, says K. SUBRAMANIAN

The chorus from the chambers of commerce and the banking community was for a reduction in interest rates by the RBI in its third quarter review of the Annual Monetary Policy for 2007-08 (Review). Financial analysts and economists joined the fray and argued their case.

What added strength to their demand was the action of the US Federal Reserve (Fed) to reduce its rate. The Fed cut the rate in September and, again, on January 22 in an unprecedented manner by 75 basis points a week ahead of the Federal Open Market Committee meeting. It further cut rates by 50 bps on January 30.

FM favoured cut

Mr P. Chidambaram, Finance Minister, did not hold back his support for lower interest rates. While addressing the quarterly performance review meeting with the chiefs of public sector banks on January 4 in New Delhi, he said he would like both lending and deposit rates move down by 50 basis points to stimulate investment and consumption.

Much to the disappointment of the chambers and bankers, the RBI has decided to retain all the rates unchanged.

Global ‘threats’

It may be more appropriate to suggest that the Review, while reaffirming the basic tenets of multi-indicator approach to monetary policy, goes over newer threats and uncertainties posed by the global situation. It flags them and captures the situation in which the Indian economy finds itself now. It reiterates its ability and readiness to act. It clearly sends the message that it will keep its powder dry.

Reacting to Fed rate cuts, the RBI Governor, Dr Y.V. Reddy, had said in the first week of December, “RBI has its monetary policy where a number of factors are taken into account, and Fed rate cut is a relevant not necessarily determining factor in this regard.”

Distancing from Fed

It is significant that many central banks, including the European Central Bank (ECB), have distanced themselves from the Fed’s precipitate cuts. As The Economist (January 26, 2008) said, “Almost as striking as the scale and timing of the Fed’s rat cut on January 22nd was the coolness with which other central banks reacted.” The Review provides details of the responses of other central banks.

Recent months, especially since August 2007, have seen the collapse of the Western banking system leading to the stark realisation that western banking with all its later day embellishments of the New Financial Architecture by the IMF, etc is in a shambles. The financial crisis which struck initially the housing loans in the US has since spread to other segments such as mortgages, loans, asset backed commercial papers, credit default swaps and a whole range of other exotic instruments subsumed under the rubric of collateralised obligations.

No sub-prime effect

Due mostly to the RBI’s approaches to financial opening and liberalisation, India has not been affected by the sub-prime crisis.

As the RBI’s Third Quarter Review of Macroeconomic and Monetary Developments released on January 28, a day ahead of the release of the Review, explained: “The money and credit markets in India has so far remained relatively insulated from the international financial market developments.

India’s exposure to troubled sub-prime assets and related derivatives is negligible in comparison with many other economies.” While releasing the Review, the RBI Governor could have been in a celebratory mood though he seems to have avoided it.

Crisis remains

The second quarter Review provided a detailed analysis of the turmoil, how it spread and the tail risks posed to emerging economies. The present Review carries it further, explaining the policies and actions of central banks in advanced countries. What is clear is that it is still a crisis that is evolving, and all the dimensions are yet to be unravelled. Excessive liquidity has been pumped in both by the US Fed and the ECB, and these will navigate in time to emerging economies.

Decoupling from US

On January 22 and 23 when stock markets collapsed globally across Europe and Asia, and the Fed intervened in panic by reducing its rate, there were reports in many Western papers denigrating the earlier view that emerging economies, especially India and China, are decoupling from the US. They tried to suggest that the US was still the centre of the universe and other economies might ill-afford to unhinge. This debate on decoupling was carried on in the Economic Forum at Davos recently.

Sadly, these reporters and analysts had knowingly or unwittingly mixed up the issues. Para 81 of the Review provides an incisive analysis of the phenomenon. While there has been financial integration to a greater degree, this is less so in the real economy. As the Review says, “the extent of decoupling will depend on the impact of developments in the financial sector in general and real sector developments in the US economy in particular.”

EMEs and risks

EMEs face risks in the near term when credit standards are tightened. Dependence on imports and higher energy intensity of output expose them to inflation shocks. Financial markets respond differently to EMEs vis-À-vis advanced countries. The Review cautions that EMEs have to follow a more pragmatic and contextual policy.

It also draws attention to the rigidities in EME structures and efficacy of the mechanisms in achieving desired results. It is against these odds that the decoupling of EMEs from the US has to be tested. This analysis is rather disturbing but applicable to India. Perhaps the RBI is conveying the message that there is no room for optimism, as expressed by the Commerce Minister, Mr Kamal Nath, at Davos.

Excessive inflows

There are repeated references to excessive financial flows coming through foreign institutional investors. Para 32 describes the situation at length. It details the rise in Sensex since March 2007 and how Sensex registered an increase of 40.5 per cent from end-March 2007 to January 25, 2008.

Net investments by FIIs were significantly higher at $12.1 billion compared with $4.1 in the previous year. It notes in particular how the volatility in flows has increased despite restrictions imposed on participatory notes. Paras 66 and 67 detail the variety of measures employed byl other central banks to manage and stabilise capital flows. The intention perhaps is to highlight other options to moderate inflows. There are several other areas where the Review draws attention to the excessive flows and the problems faced in managing them and in ensuring financial stability. In this review, the issues relating to LAF (liquidity adjustment stability) are more comfortable. Yet, the fear of instability lurks all through.

Managing flows

Para 95 and 96 pose the issue starkly. It cries out for a public policy to manage capital flows consistent with macro fundamentals. Para 96 refers to the stock market gyrations in January and the potential for massive reversals in future.

“Strategic management of the capital account would warrant preparedness for all situations, and the challenges for managing the capital account in such an unexpected turn of events may be different.”

The message to the Government may be that there are limits to sterilisation through current mechanisms and it may no longer be prudent to continue with them without foregoing other objectives like growth and financial stability.

Outlook still positive

While making the analysis and its suggestions, the RBI is not defeatist. Given the current situation and all the parameters, which go to weigh an economy, the RBI has a commendable record.

Inflation is well within the threshold, though there are risks attached to the rate flowing from food and fuel prices, especially the pass-through of fuel price.

There is business confidence with some signs of demand deceleration. Credit is available and excessive credit has been curbed selectively. Liquidity is available in fact, somewhat in abundance. Interest rates have not hindered growth and banks are able to offer lower rates.

The case for interest rate was sealed when the Fed cut its rate. Given the global turmoil and asset petrifaction, the RBI would be ill-advised to increase it without creating massive inflows and attendant problems. Thus any expectation of rate reduction in the review was misplaced. The Review has flagged the RBI’s concerns eloquently. It expects policy support from the Government in major areas, especially FII flows. The review sends the message that it is ready to act and keeps its powder dry.

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

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