RBI's 79-page misreading

Financial Express, 30 April 2008

RBI chose to hike the Cash Reserve Ratio (CRR) by another 25 basis points in its credit policy announcement on April 29. This is expected to suck out an additional Rs 8,000 crore of liquidity from the economy. RBI kept the repo and the reverse repo rates unchanged. Since the repo window has hardly been used by banks in recent times, raising the repo rate would not have been an effective instrument for reducing credit growth. An increase in the reverse repo rate from 6 percent to above the bank rate, which is currently at 6 percent, was also not expected. Any interest rate hike would have increased the interest rate differential against the US further. This has already been pulling in huge amounts of capital since the US Fed started cutting interest rates in July 2007.

On April 17 the RBI had already announced an unscheduled CRR hike from 7.5 to 8.0 in two stages. The credit policy announcement now raises it further to 8.25. RBI's macroeconomic assessment says that reserve money growth was 31 percent last year. This growth has been due to the high growth in RBI's foreign exchange assets resulting from its intervention in the forex market. In other words, the credit policy and the CRR hikes just preceding it were attempts to soak up the liquidity increase caused by RBI's currency trading.

It is unfortunate that banks, and ultimately their customers, have to bear the brunt of sterilisation. If the RBI had not been so busy keeping the rupee weak to satisfy the exporter lobby, today banks and their customers would not have been forced to pay this tax on the banking system. A higher CRR forces banks to hold more money at unremunerative rates with the RBI.

On a broader note, the RBI continues to disappoint, as usual, in failing to make progress on improving transparency or communication. A 2 to 4 page concise and clear policy statement that cuts down on excessive detail and focuses on the challanges and difficulties before the RBI, the options it had and the choices it made, would have been very welcome. Instead, what one got was a massive 79 page long-winded excessively detailed report that misses the woods for the trees. Now, even after the credit policy announcement, the market is still left guessing and is no wiser about what the RBI wishes to do next.

In 79 pages of text, Governor Reddy fails to clearly point out the conflicting objectives on inflation, growth and rupee management and instead, appears to suggest that all these are being effectively dealt with by RBI. The huge increase in liquidity that has resulted from RBI's interveention in currency markets in its attempt to peg the rupee to a weakening dollar are hidden away in terms like "sizable accretions" to the Reserve Bank's foreign exchange assets. The report does not discuss why the net issuance during the year of MSS bonds of Rs.1,05,691 crore during 2007-08 has proved to be inadequate to contain liquidity growth. It fails to clearly articulate why, instead of more open market operations the RBI has chosen to hike the CRR. While there is a lot of discussion about global liquidity conditions, there is no clarity on the impact it has had on interest differentials with India, on RBI's responses in terms of capital controls, on the effectiveness of capital controls and ECB and PN restrictions. In other words, there is excessive details on things that do not matter, and little clear discussion on those that do. This is consistent with RBI's policy of not being transparent or giving clear signals to the market to allow their expectations to be shaped. It is consistent with the RBI's belief that monetary policy is effective when the central bank surprises the market.

So what might lie ahead? The CRR hikes indicate that the RBI is finding it more and more difficult to sterilise its forex intervention using the preferred instrument of MSS bonds. In such a situation any central bank would prefer to pump in less liquidity into the economy. However, this will necessarily be a political decision. If the exporter lobby remains politically influencial we might see continued intervention in the forex market and more of the current difficulties. This could mean more CRR hikes for banks. However, if the politics of elections comes to dominate the discourse, the RBI may be able to step away from the forex market. While the direct impact of a rupee appreciation on prices may be limited to 1 to 2 percentage points, not having to buy up dollars will make the RBI's job of managing liquidity easier. Since the main source of liqudity is currency intervention, the RBI would not be spending all its time and focus on trying to mop up liquidity.

For almost five years the RBI hoped that the problem would go away on its own. That is, the pressure on the rupee to appreciate would go away and RBI would be left to be the monetary policy authority and the banking supervisor in peace. The policy of sterilised intervention that it has followed for more than five years suggests that it sees capital inflows as a short term phenomenon which are addressed by a short term solution. This policy is now showing cracks but unfortunately this credit policy too was a lost opportunity when this issue could have been addressed transparently and decisively.

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