Fewer degrees of freedom
Financial Express, 29 January 2008
Today, RBI Governor Y.V. Reddy will unveil the credit policy for the rest of 2007-08. His mandate is to balance the objectives of maintaining growth and controlling inflation. Growth is high but at risk, given a possible global slowdown. Inflation is under control but at risk due to the growing liquidity in the system due to RBI's forex intervention. If politicians prevent Dr Reddy from controlling inflation through rupee appreciation, then his choice is actually quite simple. The objectives of supporting domestic demand and containing liquidity can both be achieved by cutting interest rates. It is the easy option - both households and firms will like it.
In India today, the politicans do not want to see further rupee appreciation. If this is the framework, a host of implications for monetary policy flow, some obvious and some more subtle.
RBI is normally comfortable with reserve money growth rates of about 15 percent. In the last 6 months, there has been a sharp increase in both reserve money and broad money growth. If the RBI tries to sterilise its intervention through more MSS, the government is unhappy with the additional interest burden and banks are unhappy with holding more government debt.
When a central bank is unable to sterilise its intervention and finds that reserve money is growing, one path that can be taken is to raise reserve requirements, so as to prevent the growth in reserve money from spilling over into higher broad money supply growth. Both India and China saw the CRR being hiked in 2007. Banks don't like it, and households who have to pay higher EMIs are unhappy.
It is well known in the empirical literature that sterilised intervention is not a long term solution. Today, even in China where there has been extreme financial repression of the banking sector, sterlised intervention is running into trouble. High growth of reserve money at rates between 25 to 30 percent is the first indicator that sterilisation is breaking down. This has happened despite the ceilings on MSS bonds that are used to contain reserve money growth being raised many times during the year to reach Rs 2.5 lakh crore. This year so far, MSS borrowings are roughly as big as the fiscal deficit - this suggests that the MSS path is running into fiscal constraints.
In textbook monetary economics, when a central bank tightens, all interest rates respond. In India, the monetary transmission mechanism is dysfunctional, owing to a broad array of government policies on the bond market and banking. As an example, in the last six months, while RBI was tightening, interest rates on auto loans have actually dropped 2 to 4 percent. There is a strange phenomenon of liquidity sloshing in the economy coupled with "high" policy rates. Non-sterilised intervention is the proximate culprit. This is the consequence of partial sterilization of RBI intervention. If the RBI can only partially sterilise then cutting rates will reduce liquidity in the system by reducing the need for RBI to intervene in the forex market.
Whether we think in a closed economy framework or in an open economy framework, concerns about inflation suggest that the real rate should be high. However, such complexities have been ruled out by the policy of a pegged exchange rate in an open economy. As any undergraduate text book shows, in an open economy with pegged exchange rates the central bank cannot fix the interest rate. So if Dr Reddy does not reduce rates there will be further pressure on the rupee to appreciate.
Finally, and not in the least bit less important, is the global economic situation. If the US economy slows down, the world is going to slow down too. India will not escape the impact on exports and GDP. The negative growth of consumer durable goods, despite their bad measurement, has been causing concern that tight monetary policy has led to contraction in retail credit and thus a cooling of this sector. With prospects for both exports and domestic demand being bleak, it will be impossible for the Indian economy to grow at 9 - 10 percent. Falling world demand, a strong rupee and slow growth in domestic consumption demand add strongly to the argument in favour of rate cuts.
What are the best instruments for cutting rates? First, there is a need to cut the CRR. It was hiked to lower the rate of credit growth, which is now at 21 percent, lower than the target of 24-25 percent. Second, the interest rate corridor between the repo and reverse repo is now at 1.75. The LAF policy framework designed this to be 100. In today's policy announcement can reduce both CRR and the repo to get back to the medium term monetary policy framework. In the next step, the reverse repo should be reduced. With the interest differential between 3 month treasury bills in the US and India reaching 400bps, and with expectations of rupee appreciation, it will be a long time before a many step rate cut in India can reduce the arbitrage opportunity. Further, if the Fed continues to cut rates in the next few months, the cuts required to reduce interest differential will be even greater. We should now be seeing a few quarters of falling interest rates.
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