Bankers without borders
Indian Express, 9 February 2008
The present RBI leadership is clearly finding it increasingly difficult to cope with the fast pace of India's financial globalisation. In its attempts to keep up with the challenges of India's financial globalisation, the RBI has failed to create a consistent framework for monetary and exchange rate policies. This difficulty has been highlighted through a series of contradictory measures it has taken over the last two years.
A report published earlier this month as part of the background material for the IMF's country study on India, discusses the role of communication in enhancing the effectiveness of monetary policy in India. The report reveals how badly the RBI is fumbling in facing the challenges facing the conduct of monetary policy today.
Four years ago, in 2004 the RBI announced a framework for monetary policy. This consisted of quarterly announcements, two key interest rates, a medium term policy of reducing the cash reserve ratio and a framework for managing liquidity in the market. This framework appeared to have been adequate until about October 2006. Since then however, the RBI appears to be running into difficulties. Perhaps that is why it has altered the conduct of monetary policy on several occasions, each time confusing the markets.
Trouble began in the middle of 2006 when net capital flows to India suddenly doubled and RBI's framework ran into trouble. At the heart of the problem lay the exchange rate policy. In its attempts to prevent appreciation, RBI intervened heavily in the market. To cope with the effect of its intervention, it implemented arbitrary, unannounced and sudden discretionary changes in its monetary policy framework. To address the increasing liquidity in the system, the RBI hiked rates, raised the CRR and abandoned its liquidity management framework.
As the examples below show, the confusion it created did not even appear to be necessary. For example, first, in October 2006, the RBI delinked the two key policy rates, the repo and the reverse repo, which until then used to move together with a corridor of a 100 basis points between them. It was never clear why this was done. Since then the RBI sometimes changed one rate, sometimes the other, and different people have interpreted it differently, with a huge amount of air time spent on what it meant.
Next, in December 2006, the RBI moved away from two more pillars of the new framework. One, it departed from its medium term policy of moving towards a cash reserve ratio (CRR) of 3 percent. Since then the CRR has been raised several times and has moved to 7.5. Under the new framework the CRR was not even meant to be an instrument for liquidity adjustment. The RBI was supposed to use of the Market Stablisation Scheme (MSS) and the Liquidity Adjustment Facility (LAF) to adjust liquidity in the market.
Moreover, this was done in a post policy announcement. It is not that modern central banks make policy announcements only on pre-announced dates. As we saw in January, the US Fed cut fed rate sharply following a global stock market crash. But such steps are taken in an emergency, unlike the RBI's CRR hike.
In another unexplained decision on March 2 the RBI put a cap on its liquidity absorbtion through the exising framework. Until then it was absorbing as much liquidity as necessary through the reverse repo. Suddenly it said it would absorb only Rs 3000 crore per day. As should have been expected, with the huge liquidity being pumped into the system, this led to call money rates crashing to near zero. This decision was correctly seen as RBI easing monetary policy. But other steps to tighten policy continued, and confusion prevailed. Then, in July, the decision was reversed.
Quarterly reviews and the reports on the macroeconomy that run into over 50 pages each add to the problem. The discussion is grossly descriptive and the big picture is buried in excess detail. Instead of clarifying the stance of monetary policy, RBI's reports only create more confusion. The reports lack content. There is no discussion of the inflation projections, no clear idea of the framework. Unlike modern central banks, RBI does not share its forecasting models with the public. The RBI website lacks even a basic description of the monetary policy framework that most modern central banks have. RBI is, consequently, far below on scales measuring central bank transparency. More pages have not meant better communication.
Today the monetary policy framework stands in a state of utter confusion on objectives, instruments, short term and medium term goals, approach to foreign exchange intervention and currency policy. The recent credit policy of no change did nothing to reduce this confusion. Looking at the broader picture, it is not surprising that this confusion prevails. How can a policy desiged for an economy where net capital inflows were at 2 to 3 percent of GDP cope with an economy in which 14 percent of GDP (in the second quarter) is coming into the country? Dr Reddy would clearly be much more comfortable with a closed economy. His policy statement actually suggests as much. No wonder the RBI still lives under the illusion that India can have an interest differential of 5 percentage points and effectively block capital flows!
It is extremely important for India today to have an RBI that understands that India's financial globalisation will only increase and not decrease in the coming years. In pressing for capital controls it is fighting a losing battle. Neither the real sector not the financial sector will permit the political class to close India down again. The political economy of today's India does not support a closed economy. Tinkering with capital controls, Tobin taxes or reserve requirements do not fit into the long term design for a monetary policy framework for a rapidly globalising economy. What will have to change is not India's level of globalisation to suit the abilities of RBI staff, but the abilities of RBI staff to suit India's needs.
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