Monetary easing, on the sly

Is the Reserve Bank of India “knowledge arbitraging” financial markets (saying one thing and doing something else)? A careful perusal of the Reserve Bank of India’s (RBI) statements, actions and anecdotal experience of this writer indicates it is not far from the truth, though such arbitraging could be unintentional. By the way, arbitraging in financial markets as such is vital, though “knowledge arbitraging” does not seem proper, at least for a central bank.

Therefore, as a transparent central bank, the RBI should set right even such unintentional anomalies. For, it is highly probable that whatever the RBI seeks to achieve would be undermined if the financial system does not understand what the central bank is doing.

For a start, it could help if the RBI’s communications are unambiguous, and accompanied by a good deal of training and continuing education in the corporate finance world too.

‘Rupee’ fuel to fire

During the rupee crisis of 2011-2012, more than one corporate (client) told this writer that the RBI was taking steps to support the rupee by buying government bonds in the open market! ( Note that they were not even questions but definite statements that the RBI bond purchases would aid the rupee ).

Now, one wonders at the low level of awareness in the corporate world about the RBI’s actions, its methodologies and their its on other financial market variables. At the non-technical level, if we can understand that the rupee’s FX market problems are due to too much of it floating around in relation to the demand for it, we will know that the RBI’s open market operation (OMO) bond purchases would only add more “rupee” fuel to the fire. The rupee would, then, only come under greater downward pressure in the FX market.

Indeed, so it has happened in the past two years and more, as the RBI has relentlessly bought bonds in the open market, pumping more rupees into the financial system, which then gets sold down relentlessly in the FX markets.

And, for whatever it is worth, we can predict that such continued RBI OMO bond purchases would only pack greater damage potential for the rupee in the FX markets in the months to come.

Bond purchases…

The focus on OMO bond purchases incidentally brings us to another aspect of the RBI’s market operations that is grossly misunderstood — intentionally or otherwise; a misunderstanding the RBI also seems keen to strengthen.

The point in focus here is the RBI’s conviction that its large bond market purchases are only to relieve liquidity strains in the financial system and should not be construed as monetary policy easing.

For the record, between March 2010 and March 2013, the RBI’s holdings of government bonds rose from Rs 165,000 crore to Rs 700,000 crore – up more than 300 per cent. In the same period, the RBI’s FX assets (in rupee terms) posted only a modest increase to Rs 14,00,000 crore from Rs.11,50,000 crore.

( Note: The increase in rupee terms of the FX assets on the RBI balance sheet is primarily on account of rupee depreciation. But, in the case of government bonds, there is actual base money creation ).

Now, how in the world can you make this neat distinction that the bond purchases are for “liquidity management” and not actual monetary easing?

…and monetary easing

After all, one thought that altering the conditions — quantum, price, tenor — of financial market liquidity and through that, interest rates, is the essence of monetary policy operations itself. And that is done only through operations in the money and bond markets.

Indeed, a close analysis of the market would show that investors can, without hesitation, buy Government of India bonds at yields around 8.50 per cent — for the RBI is not going to allow yields to rise above that level. That is, the RBI “writes” a free put option on GoI bonds at 8.50 per cent yields.

Therefore, how does the RBI continue the fiction that bond purchases and monetary easing are two different concepts?

The poignant thing to note here is that this misunderstanding about the true nature of RBI bond purchases (and their impact on variables such as inflation and the exchange rate) seems to be completely uninfluenced by even the prevailing global environment.

In fact, anybody following global economics now would know that the US Fed, the Bank of England, the Bank of Japan (and possibly the European Commercial Bank in future) are implementing monetary policy through large-scale bond (and other financial assets) purchases only. In normal times too, monetary policy is implemented through bond operations only, though the amounts involved would be vastly smaller.

Weak monetary policy

Another major long-term lament of the RBI is that monetary policy transmission in India is weak. It says that its monetary tightening moves are not effectively transmitted to the general structure of interest rates.

Now, we cannot even say that the RBI has adopted a tight money stance –– for its small repo rate moves are completely overwhelmed by the large bond purchases.

The RBI compounds this weakness by providing large liquidity support to the banking system on a daily basis, preventing banks’ deposit rates from reacting to the financial system’s and overall macro-economic imbalances (low financial savings, stubborn inflation, high and rising CAD) in the only manner they should — going up.

The RBI, in fact, has publicly been saying that it cannot do much about the CAD. That appears quite disingenuous. Then it says it would factor the CAD in its policy decisions. Could there be a better example of policy and communications ambiguity?

(The author is a Chennai-based financial consultant.)

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