Fewer degrees of freedom

Written by Ila Patnaik | Updated: Jan 29 2008, 04:39am hrs
Today, RBI Governor YV 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 liquidity injections by RBIs forex intervention. If Dr Reddy finds himself arm-twisted away from controlling inflation through rupee appreciation, then his choice is quite simple. The objectives of supporting domestic demand and containing liquidity can both be achieved by cutting interest rates. It is the easy optionboth households and firms will like it.

Further rupee appreciation is considered politically difficult. If this is the framework, a host of implications for monetary policy follow, some obvious and some more subtle. The central bank is normally comfortable with reserve money growth rates of about 15%. In the last six months, there has been a sharp increase in both reserve money and broad money growth. If the RBI tries to sterilise its intervention with its MSS tool, the government would be unhappy about the additional interest burden and banks would be unhappy about 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 reserve money growth from spilling over into extra broad money supply. Both India and China saw their CRR being hiked in 2007. Banks dont like it, and households hate higher EMIs.

Sterilised intervention is not a long-term solution. Today, such a policy is running into trouble even in China, infamous for extreme financial repression of the banking sector. High growth of reserve money at 25-30% rates is the first indicator that sterilisation is breaking down. In India, this has happened despite the ceilings on MSS bondsthat are used to contain reserve money growthbeing 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. The MSS path is running into a fiscal block.

In textbook monetary economics, when a central bank tightens, all interest rates respond. In India, the monetary transmission mechanism is dysfunctional. Blame an array of government policies for bond markets and banking. As an example, in the last six months, while the RBI was tightening, interest rates on auto loans actually dropped 2-4%. India has witnessed a strange phenomenon of liquidity sloshing around the economy in spite of high policy rates. Non-sterilised intervention is the proximate culprit. If the RBI cannot sterilise all its intervention, then it makes sense to cut rates. This will reduce liquidity in the system by reducing the need for it to intervene in the forex market. If Dr Reddy fails to reduce rates, there will be further pressure on the rupee to appreciate.

What about inflation, though Whether we think in a closed economy or open economy framework, concerns about inflation suggest that the real rate ought to be high. However, such complex management has been ruled out by the policy of a pegged exchange rate in an open economy. As any undergraduate textbook would explain, in an open economy with pegged exchange rates, the central bank loses its command of interest rates.

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 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 bleak, it will be impossible for the Indian economy to grow at 9-10%. Falling world demand, a strong rupee and slow growth in domestic consumption demand all converge to an 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 credit growth, which is now at 21%, lower than the target of 24-25%. Second, the interest rate corridor between the repo and reverse repo is now at 175 basis points. The Laf policy framework designed this to be 100.

Todays policy announcement ought to reduce both CRR and the repo rate to get back to the medium-term monetary policy framework. In the next step, the reverse repo rate should be reduced. With the interest differential between three-month treasury bills in the US and India reaching 400 basis points, and with expectations of a rising rupee, it will be a long time before rate cuts in India can reduce the arbitrage opportunity. Further, if the Fed continues to cut US rates over the next few months, Indian cuts required to reduce differentials will be even greater.

We should now see a few quarters of falling interest rates.

Ila Patnaik is senior fellow at National Institute of Public Finance and Policy. These are her personal views