The ball is in RBI’s court

In a scenario of a large fiscal deficit, high inflation, low growth and a large current account deficit (CAD), an over-valued rupee exchange rate and a soft monetary policy, a blowing up of the pressure valve was inevitable The exchange rate depreciated to $1 = Rs 61. Of course, all this was blamed on the US Fed’s intention to taper off the quantitative easing (QE), and not to our inconsistent policies.

The initial response of the Indian authorities was to undertake soul-stirring ‘Open Mouth’ policies to reassure the people that the fundamentals of the economy were sound and that all would be well soon.

The immediate response was to put in place a number of administrative measures in the nature of ‘throwing sand in the machine’, such as curbs on various transactions in the forex market and making transactions in gold difficult. Such measures are temporarily effective, but create major distortions which worsens the malady in the medium-term.

Ways to reduce CAD

The Government, with commendable speed, unleashed a battery of measures to encourage foreign direct investment (FDI).

While this will, no doubt make the financing of CAD more secure, it will not reduce the deficit. Reducing the CAD requires measures in monetary-fiscal policy --- capital controls and exchange rate adjustments and, above all, a reduction in the gap between investments and savings.

In the present Indian context, however, the options are monetary policy and exchange rate adjustments. There are rumblings of a sovereign bond (we use flagship borrowing by public

institutions such as the State Bank of India) and non-resident Indian (NRI) bonds. These are best avoided, as all that happens is round-tripping of existing investments but at higher cost.

The question of the exchange rate guarantee comes up and, inevitably, it would be put on the RBI. Exchange rate guarantees are one of the mortal sins of central banking and having extricated itself, the RBI should fight a battle of attrition.

Positive fallout

It is unfortunate that the rupee exchange rate is embroiled in political economy tangles. The Indian authorities refuse to accept that secular inflation rate differentials require a sustainable exchange rate of $1= Rs 70.

The authorities need not listen to the ‘Maverick View’ of the present columnist but, surely, they cannot dismiss the view of seasoned advisers such as Shankar Acharya, A. V. Rajwade, Rajiv Malik and a host of others.

A positive fallout of the pressure on the exchange rate of the rupee was the measures announced by the RBI on July 15 and 27.

The raising of the interest rate on the Marginal Standing Facility from 8.25 per cent to 10.25 per cent, the rationing of the repo facility to Rs 75,000 crore, and the facility for mutual funds of Rs 20,000 need to be assessed.

Assuming that the total usage of these facilities is Rs 150,000 crore, the effective cost of RBI accommodation would rise from 7.25 per cent to 8.25 per cent. A straight one percentage point increase in the repo facility would have been a stronger signal.

While the intention to undertake open market operation sales of Rs 12,000 crore was sound, this was aborted as only Rs 2,500 crore was accepted; the failure was because the authorities were not willing to face a rise in the government securities’ interest rate.

Given the reluctance to raise the government securities’ interest rate, a few stocks could be on tap for sale; this would avoid the ignominy of failure. Given the overall difficult milieu in which the RBI is operating, the RBI deserves to be complimented for its pre-July 30 measures.

What RBI should do

The policy measure announced on July 23, curtailing the Liquidity Adjustment Facility (LAF) access from one per cent of net demand and time liabilities (NDTL) to 0.5 per cent of NDTL, would reduce the LAF access from Rs 75,000 crore to Rs 37,500 crore. Furthermore, the tightening of the daily cash reserve ratio (CRR) maintenance from 70 per cent to 99 per cent would tighten overall liquidity.

These are salutary measures which will strengthen those already announced on July 15.

Given the multiple macroeconomic problems, the RBI would be well advised to undertake unequivocal monetary tightening on July 30.

First, the repo rate should be raised by 0.50 percentage point from 7.25 per cent to 7.75 per cent; this is all the more necessary given the July 23 measures curtailing the LAF access. Second, the cash reserve ratio should be raised from 4 per cent to 4.5 per cent; this is unavoidable in view of the OMO failure.

Interest on CRR

The issue is being repeatedly raised about interest payment on CRR balances. The history of the 1980s needs to be studied. The RBI paid higher and higher interest on CRR balances and to maintain the effectiveness of the CRR, it had to be repeatedly raised.

Ultimately, the instrument got totally blunted. The RBI then opted to slash the interest rate on CRR balances and reduced the CRR, eventually abolishing the interest on CRR. A low CRR with zero interest is preferable to a high CRR with interest. Bankers pleading for interest on CRR should reflect on this issue. Years ago, I called payment of interest on CRR as one of the mortal sins of central banking.

In the ensuing few months, political economy constraints would prevent the Government from taking strong rectification measures.

Hence, the Government should give the RBI a free hand to crush inflation with unequivocal monetary tightening.

The Government must recognise that when there are political economy constraints, it is only monetary policy which can hold up the rear.

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

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