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The challenge before RBI

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The RBI Governor, Dr Duvvuri Subbarao… If the authorities recognise that the worse is yet to come, would it not be prudent to allow the central bank to retain some ammunition in its arsenal?
The RBI Governor, Dr Duvvuri Subbarao… If the authorities recognise that the worse is yet to come, would it not be prudent to allow the central bank to retain some ammunition in its arsenal?
S. S. TARAPORE

The challenge for the RBI should be to resist monetary expansion as the need for tightening will be inevitable in the ensuing few months and the task should not be made more difficult by profligate policies at the present time, says S. S. TARAPORE.

For the first time in the history of the Reserve Bank of India, it has had to face overt pressure from the Government to ease monetary policy. One recognises the fact that the RBI has only limited autonomy on monetary policy. The dialogue between the RBI and the Government has all along been a private matter. In recent months, even this fig leaf has been brutally destroyed.

These pressures have now moved into the public domain. The Government has set up a Liquidity Monitoring Committee consisting of government officials and market players (banks). The Committee has been overactive in making public its conclusions. The “calculated leaks” from the Government set out the precise details of the measures which are to be announced by the RBI. Invariably, the calculated leaks are released before the RBI announces the measures.

Govt holding sway

One only hopes that this recent sequence will be broken. For instance, the calculated leaks in the newspapers on December 27 were: “Inflation is coming down sharply, and it should also give the RBI reason to cut rates in the next few weeks”.

The Ministry of Finance official who did not wish to be named indicated “that the RBI could cut the repo, reverse repo and the cash reserve ratio (CRR) by 50 basis points each…There is scope for further cut in policy rates and reserve requirements. It is possible that CRR may even come below 5 per cent”.

The Chief Economic Adviser, Ministry of Finance, Dr Arvind Virmani, speaking at the annual session of the Punjab, Haryana and Delhi Chamber of Commerce and Industry said: “When the trigger is an external financial crisis, monetary steps are the primary defence…My own view is that monetary policy (of the country) should have been much more proactive and aggressive than perhaps it has been”.

The Chairman of the Prime Minister’s Economic Advisory Council, Dr Suresh Tendulkar, has said: “It is desirable to reduce the repo and reverse repo rates by 100 basis points but the call has to be taken by the RBI Governor.”

Declining growth

In the 2008-09 mid-year review of the Indian economy it is indicated that: “A proactive monetary policy may be necessary if the global economic depression continues to adversely affect manufacturing.” It is not clear whether the word “depression” is infelicitously used or whether it means what it says.

If the Government’s view is that the global economy is going through a depression, it is universally acknowledged that this situation calls for a fiscal policy response.

Let us examine the Government’s stand that monetary policy has not done enough. It is not generally appreciated that the RBI has, since the end of August 2008, released Rs 385,000 crore by way of reserve requirement reductions, enhanced refinance facilities and drawdown of the Market Stabilisation Bonds, equivalent to a reduction of over 9.5 per cent of reserve requirements.

Could it still be argued that the RBI should have been more proactive? Surely, if the authorities now recognise that the worse is yet to come, a prudent policy would be to retain some ammunition in the RBI arsenal.

While commentators have been going gaga over the recent decline in inflation and some eager beavers are even talking of a 2-3 per cent inflation rate by March 2009, it is necessary to appreciate that, apart from international commodity prices declining, the monetary tightening prior to August 2008 would have had salutary effects.

On the other hand, the unprecedented wild release of liquidity since August will, over the next 18 months, earn the wages of sin in the form of an unprecedented high inflation rate.

It is now clear that we, in India, are going to go through a period of declining growth with accelerating inflation in 2009-10 and even in the immediate subsequent years.

Some percipient international analysts feel that the international slowdown could be much sharper than what the authorities are willing to accept in the major industrial countries. The fear is that we could see a decade of very slow growth or even an absolute decline. This should be of concern to the Indian authorities.

The Government is already conceding that the Centre’s visible fiscal deficit in 2008-09 could exceed 5 per cent of GDP. The Prime Minister’s Economic Advisory Council had earlier estimated the quasi-fiscal deficit at around 5 per cent of GDP.

The decline in crude oil prices would no doubt reduce the quasi-fiscal deficit, but with the pressure to keep down the deterioration in the visible fiscal deficit, there could be a tendency to push more expenditures into the quasi-fiscal deficit.

Since the monetary-fiscal spigots have been opened wide, inflation in the next 12-18 months is inevitable. The effective measure in the current context would be to undertake a well thought out strategy of selective labour-intensive government spending which would have strong backward and forward linkages and also have a short gestation lag.

Dos and Don’ts

Now what should be the stance and measures for the January 27 monetary policy review? The RBI would be well advised not to be too euphoric about the decline in the inflation rate, but should flag the possibility of a resurgence in inflation in 2009-10 and, therefore, stress the need for a cautionary monetary policy.

The RBI’s stance as far as monetary policy measures should be that enough is enough, and that there is merit in conserving the ammunition. The central issues which need to be considered are more on what the RBI should not do rather than what it should do! These are:

(i) In the ensuing period there should not be any further reserve requirement reductions.

(ii) The present repo rate of 6.5 per cent should not be reduced. The real growth rate in India is still high, though lower than in earlier years but it bears repeating that our growth rate would be the second highest in the world.

(iii) The reverse repo rate of 5 per cent should not be raised. In fact, there is a case for reducing it to the level of the savings bank deposit rate of 3.5 per cent. The widening of the corridor is a fact of life that the RBI will have to live with.

(iv) The reduction in the MSS outstandings should be calibrated not only to the borrowing programme but the overall liquidity position.

(v) The RBI refinance facilities against the general lending by banks should be priced above the repo rate and in any case be quickly phased out.

(vi) The RBI should peremptorily reject any pleas that interest be paid on CRR balances.

Le defi RBI (the challenge to RBI) should be to resist monetary expansion as the need for tightening will be inevitable in the ensuing few months and that the task should not be made more difficult by profligate policies at the present time.

(The author is an economist. blfeedback@thehindu.co.in)

(This article was published in the Business Line print edition dated January 2, 2009)
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