The Hindu Business Line : Credit Policy: Fortitude in worrying times

Amid all the fulminations of ministers and Lef leaders over inflation and rising prices, all eyes were on the Reserve Bank of India (RBI). Never was the central bank’s annual monetary policy awaited with such bated breath as on this occasion. At the end, it seems a damp squib. While the RBI has retained interest and repo rates, it has raised the cash reserve ratio by 25 basis points.

To be fair, the RBI did raise the CRR by 50 basis points on April 17 and calmed the nerves somewhat. However, many analysts anticipated further changes, at the minimum in repo rates.

What is not appreciated is that the RBI has no magic bullet. The conventional tools available to the RBI (or any central bank) have lost their efficacy. Interest rate cannot be on autopilot driven by inflation. Globalisation has changed the context and wrecked the prices across the globe and blurred the historical distinction between long and short rates. Till recently, until the sub-prime crisis erupted August last, it was theorised that central banks were masters of the universe. The crisis has questioned this hypothesis. There is a raging debate on the role of the central banks. Two columnists of Financial Times described the situation faced by central banks in an incisive piece. (Lessons of the credit crunch, Chris Giles and Gillian Tett, February 11, 2008.)

As they put it, “The period has been the equivalent of a test-tube experiment in modern banking, and policy-makers now resemble a distinctly uneasy group of scientists.” They know what policies have been attempted; but do not know why markets reacted in certain ways. They are unsure that they have devised the perfect cocktail to stop markets erupting again. More than any central bank, the RBI has been modulating its approaches from quarter to quarter.

Even in the latest statement, the RBI recapitulates its progress from quarter to quarter and narrates how it factors in national and global developments. Its primacy is for the national economy and goals of growth and price stability. There is often a conflict between the two and emphasis has to be moderated depending on the context.

Multi-pronged approach

The RBI’s multi-pronged approach is rather known and globally applauded. In the current policy statement, the RBI is not overawed by fears of global inflation and rise in commodity prices.

Paras 53 and 54 capture the situation well. It recognises that persistence of high food and oil prices pose significant inflation risks for the global economy and for monetary policy worldwide.

It is more concerned about the ongoing crisis in western economies and the responses of the US Fed, ECB, etc. It is anxious about the US slowdown and uncertainty surrounding the financial health of the biggest financial entities and the resultant volatility in equity markets. These are indicative of uncertainties with implications for EMEs. In the mid-term Review for 2007-08, the RBI feared the flood of liquidity flowing into EME as a result of action by the US Fed and ECB.

In the current policy, as narrated in para 93, it feels that there could be reversals of capital flows due to global slowdown and the higher risks attached to EME investments. It expresses confidence that the RBI is equipped to handle both scenarios.

Impact on India

The most significant analysis is in Para 94. While taking note of global slowdown, heightened uncertainties and mounting inflationary pressures, it is not pessimistic about their impact on India. However, it takes the view that uncertainties in the Indian economy “appear less relative to those in the global economy.”

It foresees “moderation in growth rather than a significant slowdown.” In its view, domestic factors will continue to dominate the policy setting. It hopes to maintain inflation expectations and also the growth momentum. This may explain why the RBI has not chosen to increase the interest rate.

The current policy has suggested important regulatory measures. These have been thrown up by the sub-prime crisis and experimented in the “test-tube” to which a reference was made in the introductory section. Paras 105 to 110 refer to international consultations to prevent recurrence of financial crisis. These include areas such as derivatives, off-balance sheet items, etc., which created the crisis.

While western banks are battling with regulators or resisting them, it is a proud record that the RBI is ahead of many other central banks. It is this attitude which saved Indian banks from financial crisis in the past. It is also indicative of the fortitude shown by the RBI in facing an uncertain world. The policy is indeed a lasting (and last) testimony of Dr Y. V. Reddy as the Governor.

(The author can be reached at subrabhama@gmail.com)

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