The Hindu : RBI's stance points to larger issues

Online edition of India's National Newspaper
Monday, Nov 10, 2003

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RBI's stance points to larger issues

Structural reform measures relating to the central bank's role and responsibilities have not kept pace, if at all, with the other segments of macro economic policy, says T. B. Kapali

"IT IS the duty of the Fed to take the punch-bowl away just when the party gets going,'' remarked a former U.S. Federal Reserve Chairman. He was alluding to the imperative need for any central bank to nip in the bud any incipient inflationary pressures and keep aggregate demand in the economy broadly in equilibrium with aggregate supply.

Globally, central banks are in such a situation now. There are early signs of economic recovery taking root and aggregate demand strengthening, and soon, the world's most watched and important central bank, the U.S. Federal Reserve, will have to take a decision on the punch-bowl. Initial moves have already been made by other less important (in terms of their impact on the global economy) central banks such as the Bank of England and the Reserve Bank of Australia.

U.S. move under watch

To be sure, any Federal Reserve decision is not going to be easily made. For one, the U.S. is shortly getting into an election year. Incumbent politicians are not going to favour interest rate hikes just as the campaign gets going. For another more fundamental and structural reason, any inclination to a rate hike has to be balanced with the Fed's employment mandate also. Unlike, say, the BoE (which has a sole inflation mandate), the Fed has a mandate to support maximum employment in addition to its objective of price stability. In other words, it has to support job recovery (faint signs of which are available now after two years of job losses) while also keeping a watch on prices. On balance, it appears that the Fed could be on hold at least till the end of the second quarter of next year.

The contradictions and tensions inherent in the above institutional framework in the U.S. came out quite sharply in a recent episode. A chance remark on higher market interest rates in line with a recovering economy was immediately countered by the White House, which argued for continued monetary accommodation.

Nearer home, a somewhat similar dilemma appears to have forced the Reserve Bank of India to hold its hand in its recent monetary policy review. Despite what it sees as a favourable macro-economic environment — a revival in overall agricultural and industrial activity, inflation expected to remain under control, high forex reserves and so on — the RBI probably feels that the monetary stimulus already in the system would suffice to take care of any rising demand for credit. Also, the RBI is clearly factoring in the nascent recovery in the global economy and the prospects for global interest rates in that backdrop.

Staying ahead of the curve

In technical parlance, staying ahead of the curve. That is what the RBI seems to be attempting with its status quo decision on rates. At another place, it has pointed out the need for caution given that financial markets could overshoot.

The RBI has not indicated any specific financial market variable when it used the term "overshooting." But one can reasonably infer that benchmark government bond yields around 5 per cent have caused quite some concern in the establishment. The RBI has repeatedly, over the past two years, talked about the need for financial market players — mainly banks — to be prepared for an unexpected direction reversal in interest rate movements. It has advised banks to create reserves out of current profits to counter interest rate shocks.

It has gone on to state that banks, generally, have not heeded this advice and the level of reserves built-up over the past two years has not been commensurate with that recommended.

Conflicting roles

In a way, the RBI's counsel in this area has not gone home in full measure. To a great degree, this is because of the constraints which the extant legislative framework imposes on the central bank as the public debt manager. No financial market participant can ignore the fact that as debt manager, the RBI will try its best to lower borrowing costs for its principal, elongate maturities, re-finance maturing debt and so on. Again, no financial market participant can ignore the fact that this role as public debt manager directly conflicts with the RBI's role as interest rate arbiter.

Now, this conflict in roles for the central bank is not amenable to easy resolution, to say the least. Given that, the RBI has been gamely carrying on all these years — trying to deftly balance the obligations of being debt manager, guarantor of the stability of the financial system, monetary authority, exchange rate manager and so on.

This deft balancing act has probably reached its limits now. The critical point here is: structural reform measures relating to the central bank's role and responsibilities have not kept pace, if at all, with the other segments of macro economic policy. Therefore, in an open capital account environment, surging capital inflows, substantially reduced trade barriers, weak domestic industrial performance (and all this implies for revenue buoyancy for the exchequer which in turn impacts the Government budget) and therefore weak demand for credit, the RBI's balancing act itself appears to have pushed benchmark interest rates steeply lower.

Another important issue here is the efficacy of the monetary policy transmission mechanism. This is one more reason why a commensurate level of countervailing credit demand is not emanating from non-government borrowers in the Indian economy.

For lack of choice, most, if not all, of the monetary stimulus created by the RBI in the past several years has gone to soften government bond yields.

One does not see any significant change in the above configuration of India's financial market economy in the immediate future unless there is a big and rapid outflow of foreign capital. Therefore, it is quite possible to say that at 5 per cent, Indian government bond yields have not bottomed out.

(The author is Associate Vice President (Treasury) in ING Vysya Bank. These are purely his personal views.)

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