Causes and no effects

Indian Express, 20 December 2010

RBI credit policy has given conflicting signals about the stance of monetary policy. The RBI has many instruments in its hands. Perhaps that is part of the problem. Faced with high inflationary expectations on one hand, and tight liquidity in money markets on the other, RBI has left interest rates and the cash reserve ratio unchanged, while announcing open market operations to ease liquidity. In recent months, it intervened in foreign exchange markets in amounts that could not possibly impact the rupee, and perhaps only help increase liquidity. The result is a state of confusion about the stance of monetary policy.

In the last one month RBI has announced three open market operations to buy government bonds. These were designed to inject liquidity into the system. This step is similar to that of the US Fed's recent quantitative easing, QE2, except that QE2 was undertaken after the US had run out of all other instruments for monetary easing. It had hit the zero lower bound on the policy rate, and could not reduce it any further. The only way to ease monetary policy in the US was through the Fed buying government bonds.

India, however, has not hit the zero lower bound. The repo and reverse repo which stand at 6.25 and 5.25 percent, could have been cut. But Indian money markets have a different problem. It is not that policy rates cannot be reduced, it is that cutting policy rates would not have transmitted to market interest rates. There are so many restrictions on the functioning of money, bond and credit markets that they fail to respond to RBI's policy rate changes. The market determined interest rate (the call rate) has been above the policy rate corridor for three months now. The operating framework of monetary policy, which works by keeping money market rates within the policy rate corridor of the repo and reverse repo rates, has broken down. This has rendered policy rates irrelevant.

When RBI started tightening monetary policy in response to inflation, then in order to give a strong anti-inflationary signal, it employed many instruments. These included policy interest rates and the cash reserve ratio. Today it is trying to use a third (SLR) and a fourth instrument (Open Market Operations) to address the liquidity situation.

After a sustained period of having a floating exchange rate, in October 2010, RBI purchased $0.9 billion on the currency market. It was a pointless gesture, as far as the exchange rate is concerned, to hit a market. The BIS has recently released data which shows that rupee-related transactions add up to $40 billion per day. The same data shows that as much as $20 billion (spot and forward) rupees per day are transacted outside India. In addition to this, a few billion dollars a day of currency futures and options are transacted on exchanges. These markets are, for all practical purposes, well linked together through arbitrage, making them effectively into one liquidity pool. Impacting the price of the rupee in this market requires a different magnitude of intervention. The rupee dollar market turnover in October 2010 is estimated at $800 billion. Transactions of $0.9 billion can achieve no impact on the rupee.

If RBI wanted to make a difference to the exchange rate, its trading would have been much bigger. On the equity market, we see that market manipulation generally happens in the small stocks. By the time we deal with the largest companies, market liquidity is so great, that a manipulator would require very large transactions in order to impact the price. If RBI wants to force the exchange rate away from the market outcome, it would need to undertake some pretty big transactions. With a market size of $800 billion a month, it would need to buy or sell perhaps $40 billion to $80 billion a month in order to achieve a significant impact on the price. Transactions of $0.9 billion in the month are pointless in terms of impacting the rupee. So one wonders whether the objective of the intervention was to increase the supply of rupees in the economy. RBI needs to come up with a clear set of monetary policy rules and a framework. The multiple objective, multiple instrument framework is essentially a lack of framework where on a day to day basis RBI reacts to the situation in the market. Even if inflation control is one of RBI's objectives, the index and the target rate needs to be stated. Lack of a framework results in policy reactions like the ones we see today where different instruments have been moving in different directions. Another serious consequence of this lack of framework is rising inflationary expectations. As an RBI survery in September that covered 4,000 households across 12 cities showed, households expect inflation to rise to 12.7 percent by October-December next year. India is one of the few countries in the world witnessing high inflation in the post recession period. The infaltion in China can be attributed to the dollar purchases and resulting increase in liquidity, but in India where the RBI has not intervened much in currency markets, the rise in inflation and in inflationary expectations, seems to be much more a consequence of the lack of a central bank committed to inflation control.

If a central bank is has a commitment to low inflation and is credible, then tighening the stance of monetary policy is a way to bring down inflationary expectations. But in India we are faced with a situation where, even though inflation has been high for many months, the tightness in the money market is not the result of a policy stance. Indeed, money markets are tight despite RBI's efforts to ease the liquidity situation. In this situation it is not inconsistent that inflationary expectations remain high. The RBI now needs a strategy to reduce inflationary expectations.

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