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Monetary policy: quarterly reviews help

RBI is unlikely to chart a course very different from other central banks

ENLARGED SCOPE: New Delhi office of the Reserve Bank of India. — FILE PHOTO

THE RESERVE Bank of India will be reviewing the annual monetary and credit policy on July 25. A review by the central bank every quarter is a recent development. Among other reasons for bringing about this more frequent integration with the financial markets is the fact that monetary policy issues have a much enlarged scope today. Policy makers need to keep the financial markets posted with the developments not only in India but abroad too at more frequent intervals than in the past. Along with the mid-year review and another in the third quarter, the RBI will be communicating to the financial markets four times in a year.

As always, ahead of any policy statement, there are expectations, some of them exaggerated. An articulation of monetary policy issues may not have the same universal appeal that the Union budget — taxation proposals and all — has. Yet awareness of (previously) arcane monetary and credit policy issues is growing by the day. Globalisation and domestic reform have considerably enlarged the number of citizens affected — directly or indirectly — by official policies including monetary policy.

The impact of globalisation is such that domestic economic issues cannot be viewed in isolation from developments elsewhere. What happens to the monetary policy of the U.S., Japan or the European Union, therefore, has significance for us almost immediately. Not only is there a growing interdependence between the domestic and global financial markets, the various markets within India are also demonstrating a high degree of integration with one another.

That again is a logical corollary of the reform process. The previously controlled regime drew regulatory barriers, for instance between the share market and the money markets. In whatever form they exist now, it is due entirely to prudential reasons. In any case the influence of the one on the other is well recognised and analysed. To give another example, trading in commodities through the newly opened exchanges has caught on in a big way only after substantial financial sector reform. It was only after the more conventional stock exchanges, the NSE notably, gave a big push to automated trading in shares that it became possible to start the commodity exchanges.

Given the underlying interdependence between domestic and international markets on the one hand and between domestic financial markets on the other, it is not possible to view any policy measure (or its review) purely in terms of, say, the capital market alone. It is also doubtful whether any policy stance — to tackle inflation for instance — can be considered in purely monetary terms. The proof can be seen in the recent market behaviour.

Changed contours

Last week's developments in the stock markets and exchange markets are representative of the forces at work. They show how far globalisation and reform have changed the contours of the financial markets, necessitating holistic rather than piece meal solutions.

When the rupee fell to a three-year low of Rs.47.05 against the dollar on Wednesday, it brought into sharp focus not only external sector issues but the inherent volatility that has become a hallmark of all financial markets recently.

No one needs to be told of the way stock prices are gyrating, every day and even during individual sessions. Last week, share prices moved up and down in ways that have now become the norm. So much so hardly anyone is able to or willing to make intelligent forecasts of price movements.

Nexus with forex market

With so much of investor interest centred on the stock markets and their spectacular correction, it is easy to forget that financial markets take their cues from one another. As interest rates rise in the U.S. and other developed countries foreign institutional investors reverse their course and take back some of the money invested in India. The demand for dollars increases leading to pressure on the rupee.

How far the rupee will depreciate further does not depend on the FII demand for dollars alone. There are other factors at work but hardening interest rates in the developed world is certainly one reason.

Just ten days ago the Bank of Japan ended its nearly six-year-old zero interest policy. The new reference rate is just 0.25 per cent but clearly it is not the quantum but the change in policy that is significant. A deeper, wholesome message has been that the Japanese economy, the world's second largest, is growing after a long recession and monetary authorities are prepared to use conventional monetary measures to steer the economy. What this means immediately to India is not clear but certainly the fact of Japan joining the list of developed countries which have either increased or already have much higher interest rates (than Japan) should send a signal to the RBI to raise interest rates further.

Here again, the action of monetary authorities in the developed world alone will not make the RBI emulate them but it will be a potent factor. Last week there was headline making news from the U.S. where the new Fed chairman Ben Bernanke suggested that the series of almost continuous mark up, since 2004, in the reference rate — currently it is 5.25 per cent — was coming to an end.

This along with other supporting data is taken to mean that the U.S. economy will have a "soft landing" with all its positive consequences for the global economy.

No one can expect that on Tuesday RBI Governor Y. V. Reddy will be influenced solely by external factors alone. Yet they will figure high up in his analysis of the situation. And precisely because the goals of monetary policies everywhere seem to have plenty in common, it is unlikely that the RBI will chart a course very different from its counterparts elsewhere.

C. R. L. NARASIMHAN

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