The RBI should look beyond short term

The first bi-monthly Monetary Policy Review for 2014-15 is scheduled for April 1, 2014, with horses taking to courses for general elections. As the election code of conduct will dampen active government policy measures, at least for the next eight weeks there will be a disproportionate burden on the monetary policy. A viewpoint is it would be prudent to postpone the monetary policy till the elections are over or till the Union Budget for 2014-15 is presented by the new government in June 2014.

For the past 50 years, monetary policy has never been inhibited by impending general elections. As such, the Reserve Bank of India (RBI) should conduct its monetary policy unfettered by any thought about the polls.

Macroeconomic backdrop The Interim Budget is postulated on an increase in nominal GDP of 13.4 per cent in 2014-15, which would point to an 8 per cent inflation rate and a 5.5 per cent real growth. It does point to fiscal stress.

There are many uncertainties on the current macroeconomic front. First, the El Nino effect can adversely affect the ensuing monsoon which would, in turn, impinge on agricultural output. Secondly, it is uncertain as to how strongly investment would revive in 2014-15. Thirdly, raising of administered prices cannot be deferred.

Finally, there can be wild swings in the perceptions of Foreign Institutional Investors (FIIs), which could reflect in sudden large capital inflows or outflows.

The year-on-year Consumer Price Index (CPI) for February 2014 shows a lower rate of 8.1 per cent, while the Wholesale Price Index (WPI) shows a year-on-year increase of 4.7 per cent, which could be considered moderate. Recently, however, the RBI has rightly been stressing the CPI as the more appropriate indicator of retail inflation.

With international uncertainties and the need to raise administered prices, there is no assurance that the battle with inflation is anywhere close to being won.

External sector The latest data point to a balance of payments current account deficit (CAD) for 2013-14 of around $40 billion (2.3 per cent of GDP).

While the CAD in 2013-14 is much lower than the previous year, the recent decline in exports is of concern as the CAD could once again widen as with an uptick in activity, imports could surge.

With the volatility of FII flows, there could be very large and destabilising outflows. The control of ‘volatility’ of the exchange rate has been the bedrock of the RBI’s policy, but ‘volatility’ is perceived differently at different points of time. In the foreseeable future, the RBI would need to spell out its philosophy of exchange rate management as mere control of ‘volatility’ does not set out a clear objective.

The appropriateness of an exchange rate has to be viewed in relation to the inflation rate differential between India and major industrial countries, which would point to the need for depreciation over time.

In the more immediate two months, however, the delicate political economy situation would warrant that the RBI ensures that the nominal dollar-rupee exchange rate remains within a range of, say, $1=₹61-63.

If, as in the recent period, there are sudden large capital inflows, the RBI should undertake active forex purchases, which would obviate any large nominal appreciation of the rupee.

Equally, the RBI should stand ready to counter any excessive depreciation triggered by large outflows. This approach needs to be followed only for the next two months as market expectations can run wild and destabilise the external sector. Such an approach cannot, however, be viable in the long term.

The slowdown in the year-on-year CPI inflation could generate a clamour for reducing policy interest rates.

The present policy repo rate of 8 per cent is low, given the current inflation rate. At present, there are too many windows for RBI accommodation, with the overnight repo, the 14 day, 28 day, and 21 day term-repos, the Marginal Standing Facility (MSF) and the Stand-by Liquidity Facility.

The recent 21 day term-repo auction for ₹50,000 crore (which was at a weighted average rate of 8.79 per cent and a cut-off of 8.69 per cent) not only helps banks tide over the March 15 advance tax payment, but aids and abets the March 31window dressing by banks. The RBI should never be a party, directly or indirectly, to window dressing of banks’ balance sheets.

As already recommended by official groups and committees, the 14-day term-repo, as part of the April 1, 2014 monetary policy, should be made the key policy interest rate.

The MSF, which stands at 9 per cent now, should become the overnight repo facility at bank rate. Other term-repo facilities should be discontinued. The RBI would do well to work towards a system where the key repo policy rate is somewhere between the one-year deposit rate and the base lending rate.

New framework Governor Raghuram Rajan has already mentioned the need to develop a consensus between government and the RBI on the new policy framework. This can be worked out by a fusion of the Financial Sector Legislative Reforms Commission Report and the Urjit Patel report.

While this issue has to be debated at length, Rajan would do well to give it a focused direction by articulating, in the April 1 monetary policy, the broad thrust of how such a consensus could be developed.

The writer is a Mumbai-based economist

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