A touch here, a tweak there

As the Reserve Bank of India governor said in his press conference after the release of the bi-monthly review, the only surprise about the policy announcement was the lack of surprise.

The markets expected no major change in policy as the Election Commission’s Code of Conduct is in operation. Any reduction in policy rates would have attracted criticism from the Opposition. As a result the policy remained the same, except for some tweaking in the banks’ access to the Liquidity Adjustment Facility.

Generally, the first review of the financial year is the Annual Policy Statement. Perhaps, this year it was not so labelled because the Budget for 2014-15 is yet to be presented. One hopes the contours of the next Budget will be available after the election and before the next review due on June 3.

Neither the policy paper nor the governor’s statement made any reference to the estimates of money supply, credit or deposits in the coming year.

I took the view in the past that the RBI should not provide estimates of money supply, with room for 5 per cent inflation after reckoning for GDP growth and income elasticity of demand for money. Instead, it should say that it will ensure that no productive activity will suffer for lack of credit. What the governor said in his reply to a question at the press conference more or less echoed this idea.

It is also clear that the Consumer Price Index will be the touchstone in formulating policy. But habits die hard. There is a reference to inflation trends, excluding food and fuel. Is it the core inflation in CPI?

The entire CPI should be considered for measuring ‘core’ inflation, which should be the same as headline inflation. The enormous increase in food prices, especially those of vegetables and fruits is due to the excess money generated through such schemes as the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS).

While we are glad that the poorer sections can afford to buy protein-rich food items, the government should have worked out a scheme to increase their production before introducing the extension of the MGNREGS throughout the country.

After the idea of core inflation in the Wholesale Price Index was trashed by critics, the RBI started using the expression “non-food manufactured products inflation”.

The changes in the liquidity adjustment facility (LAF), shifting the emphasis from the daily repos to term repos, are well thought out. But there is no official definition of liquidity that guides the bank. During the time of YV Reddy the concept of “overhang of liquidity” was in vogue. But it is no longer used for reasons not known.

There are outstanding “liquidity aggregates” (L1, L2 and L3) presented in a table in the Reserve Bank of India Bulletin . One does not know which one of them is used by the RBI as a criterion for deciding the surplus or shortage of liquidity. It needs to link its concept to the standards prescribed in Basel III Liquidity Coverage Ratio and Liquidity Risk Monitoring that will come into effect from January1, 2015.

The RBI has promised to issue guidelines in adopting these Basel standards by end-May 2014.

The bank recognises that forex transactions are part of the open market operations and intervention should not be thought of only to stabilise the rupee.

In its forex intervention and through swaps with banks on their FCNR(B) deposits the bank has built up a good amount of reserves amounting to $298.6 billion as on March 21,2014, of which $271.4 billion constituted foreign currency assets (FCA).

A few months ago, I had suggested the Bank should aim at building up the foreign currency assets to $300 billion by the end of March 2014.

Eventually, it is the FCA that provides the bulwark against any forex crisis. The other components of reserves will be utilised only in a desperate situation.

The market’s confidence in the rupee can be enhanced if the target of $300 billion is reached before the US Fed starts winding up its quantitative expansion by the end of September, as expected now.

There is not much that the Central bank can do in the current situation. But it can certainly control money supply.

The replacement of the daily repo by the term repo does not make a difference to the excess creation of money supply since, for all practical purposes, the daily repos have served the purpose of term repos by being rolled over.

The bank says that the daily injection of liquidity through LAF and other facilities has been about Rs ₹1 trillion. It has no economic rationale when growth is on a declining trend. The RBI should pause and reflect on whether the money creation is helping GDP or inflation.

The writer is a Mumbai-based economic consultant

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