RBI opts for flexible policy financial scene

The Reserve of India’s decision not to change any of its policy rates — the Bank Rate, the repo rate and the reverse repo rate — in its third quarter review of monetary policy (January 29) has become the focal point of discussion on the subject. With the cash reserve ratio too unaltered, the RBI has clearly opted for status quo in so far as interest rates are concerned. Individual banks have, however, been exhorted to lower lending rates. Moral suasion he lps up to a point while even overt signalling devices, for instance a reduction in CRR or repo rate, need not always work.

However, public sector banks, as a rule, have been responsive to suggestions, especially if they come from the Finance Minister. On one widely publicised occasion in mid-October last year, the Finance Minister ‘persuaded’ banks to reduce their interest rates on car loans. Slackening auto sales was given as the reason for the intervention.

Hopefully, such instances will become part of history as they reflect adversely on the autonomy of the monetary authorities.

‘Non- events’

This time, the Finance Minister has publicly endorsed the RBI’s stand of not changing the policy rates. Inaction though it may be, it does give the central bank the flexibility to increase or decrease the rates depending on the emerging domestic and global situations. Besides, through a conscious decision, the RBI has sought to convert monetary policy statements into ‘non-events’. Even while increasing the frequency of policy pronouncements from two to four in a year, the central bank had made it clear that headline — making rate changes need not always be a part of each policy pronouncement. Such delinking gives flexibility to the central bank.

Yet, on the eve of its latest policy review, there was more than the usual level of speculation as to what the RBI would do with its rates. Many thought that it would reduce the rates. There were several reasons why their expectation was not baseless.

A week earlier, the U.S. Federal Reserve (Fed) had cut its federal funds rate by a massive 0.75 percentage points primarily to stimulate the U.S. economy that was seen as sliding into a recession. On stock exchanges across the globe, prices had crashed. In the aftermath of the rate cut, there was some recovery but that proved short-lived. On January 30, after the RBI announced its review, the U.S. Fed reduced the fed funds rate by another 0.50 percentage points.

Such massive interest rate reductions have several implications for India and other emerging economies too. The expectation among a large section of market analysts was that other countries, including India, would follow suit, perhaps not to stave off a recession as in the U.S. but to remain competitive and stimulate growth.

In India, economic growth continues to be robust but there have been signs of a slowdown in manufacturing and to a lesser extent in services. Almost all recent gross domestic product (GDP) forecasts for the current year have been less upbeat suggesting that the second half of 2007-08 will see a much slower growth than the average 9.1 per cent recorded in the first six months. Two sectors, consumer durables and transportation equipment, have been slowing down and an interest rate reduction in India would help in their recovery, it was thought. The case for not changing interest rates looked equally strong but was based almost entirely on considerations of price stability. Inflation, always a major worry for most central banks, is right back at centre stage of monetary policy.

Although inflation numbers have been below 4 per cent they have been climbing in recent weeks. Global oil prices remain high though Indian consumers continue to be insulated. Then there is the ‘food inflation’ caused partly by record prices of wheat, corn and other cereals.

Money supply and bank deposits have been growing ahead of targets while non-food credit from banks is sharply lower. The surfeit of liquidity is a cause for worry. The RBI hopes to contain inflation within 5 per cent this year and anchors expectations in the region of 4-4.5 per cent over the medium term.

As always, the RBI has to tackle several — often conflicting — objectives simultaneously. Maintaining price stability while providing for the credit needs of the economy has always been a dilemma. There is also the question of balancing short-term considerations with those of the medium term. The RBI is clearly indicating that the complexities of monetary management are such that it requires substantial flexibility to deal with the emerging situations both in India and abroad. Besides, fiscal policies should supplement monetary policies even for achieving monetary goals.

Role for fiscal policy

For instance, steady accretion to the RBI’s forex assets has contributed to the huge growth in reserve money. A major portion of the assets build-up is attributable to large portfolio investments in the stock market. The RBI’s actions in sterilising first the dollar flows and then trying to mop up domestic liquidity — through market stabilisation schemes and so on — are the classic monetary policy dilemmas. Fiscal policy evidently comes into play in several ways. The debate over better utilisation of forex reserves cannot be viewed in isolation from the quasi-fiscal costs that are incurred in keeping the reserves in safe, but low yielding instruments such as U.S. government paper.

Finally, in sticking to its GDP growth target of 8.5 per cent for the current year, the RBI is not necessarily conservative. Days after the monetary policy review, the Finance Minister, expected the economy to grow at closer to 9 per cent which will be not substantially higher than earlier official forecasts.

C. R. L. NARASIMHAN The RBI’s recent monetary policy review is an exposition of the several policy dilemmas and the increasing complexities faced by the central bank.