Thursday, May 5, 2011

Vidva Mahambare: What Ails Indian Monetary Policy

Thursday, May 5, 2011

With inflation in India proving persistently high—data this month showed that wholesale prices rose 9% year-on-year in March—all eyes are on India's central bank. It's imperative for the Reserve Bank of India to get its broader policy and agenda on interest rates right. But for the RBI, this also means getting the nitty-gritty of its operations on track.

India's central bank is still figuring out how best to affect the financial sector and the economy with its policy changes. Across the world, central banks influence market interest rates through changes in a short-term rate, known as the policy rate. Movements in this policy rate initially reflect in inter-bank rates and then in retail rates such as for mortgages. The speed at which policy changes are mirrored in market moves, what economists call transmission, matters in tackling inflation and stabilizing the economy.

Historically, this transmission has been slow in India, as changes in the policy rate (the short-term repurchase rate at which commercial banks borrow from the RBI against collateral) are not fully and quickly reflected in market interest rates. The 2008 financial crisis brought this problem into focus: The RBI found the financial sector slow to respond to its rate cuts and then hikes. To suggest improvements, it constituted a committee in July 2010, which released a report last month.

What exactly is missing in the RBI's current approach? Many central banks convey their policy stance using a "corridor system," with a ceiling and a floor around the policy rate. The idea here is that commercial banks are typically unwilling to negotiate with each other on less favorable terms than those available with the central bank. So, the inter-bank rate is unlikely to fall below the rate at which the banks deposit their excess cash with the central bank or rise above the one at which they borrow from it.

Keeping this in mind, central banks use a pre-defined ceiling and floor to set a corridor around the policy rate, so as to limit fluctuations in, say, the inter-bank rate for overnight borrowing. This way the central bank can tightly control the cost of overnight funds close to its policy rate. However, if the corridor comes without a policy rate as anchor, but where the central bank keeps altering the ceiling or floor, it is natural the overnight rate will wildly fluctuate from one end of the corridor to the other, and often outside it.


The RBI's low effectiveness has tested governor Duvvuri Subbarao.

India also follows a corridor system, but it does not have a single policy rate as an anchor. It has two, a repurchase rate that acts as the ceiling and a reverse repurchase rate—at which banks deposit excess cash with RBI—which becomes the floor. The overnight rate naturally shoots above the ceiling or below the floor. The committee recommends, for one, a move to a single policy rate with a corridor around it. This would certainly reduce the sharp swings in the inter-bank rates. But it would not be sufficient to improve transmission.

Transmission tends to break down when there is too much or too little liquidity. If commercial banks have enough liquidity and don't need to borrow from the central bank, a rise in the policy rate will not push up market interest rates. India, like other emerging economies, faces a conundrum here: Thanks to a flood of foreign capital, it often experiences excess liquidity. Managing this is tricky and the committee does not make it clear how it can be done in the practice.

The RBI's task of managing liquidity gets interrupted in part by another job. The RBI is mandated to act as New Delhi's debt manager, auctioning government bonds and maintaining its cash balance. Last November, for instance, the financial system found itself suddenly squeezed because, among other factors, New Delhi chose to hoard a large amount of cash with the RBI—and the central bank was apparently unaware about the government's choice here. For now, then, the RBI will have to work with fiscal agents to forecast how much cash the government wants and when.

But it can't do so forever. The RBI has to stop acting as the government's debt manager, because this task complicates its other roles. The idea of creating an independent debt office is part of a package of financial sector reforms recommended by various bodies in the past few years. In September 2008, New Delhi set up a "middle office" as a precursor to the full-fledged debt management office, which should be operational within the next couple of years.

In fact, broader financial reforms are key to improving transmission. India suffers from an immature bond market, so there's no good yield curve for the interest rates on overnight securities to affect credit disbursed for, say, a 30-year period. Because the government bond market is dominated by state-owned banks and because all commercial banks are required to hold a certain amount of government bonds, a robust secondary market for trading bonds is yet to emerge. While last month's committee report touched upon some of these issues, it did not comment on the broader reform agenda.

Yes, developing a bond market will take time, but regulators still need to pay attention to the speed and sequencing of reforms. New Delhi's high stamp duty on corporate bonds coupled with the RBI's cautious approach to allowing new instruments such as credit-default swaps, for instance, haven't helped. What's more, special priority should be given to reforming the short-term securities market, or the money market. Consider one restriction that should be relaxed: The central bank only accepts government bonds as collateral for its repurchase loans. Since borrowers don't always have these, they turn elsewhere, causing sharp movements in the short-term rate and creating uncertainty about banks' funding costs and their lending decisions.

The RBI deserves credit for realizing the problem at hand. But the committee it appointed hasn't gone the whole way. Perhaps it was not within its purview to do so. Still, until India can boast competitive bond markets, its central bank will find it difficult to improve the effectiveness of its monetary policy.

Ms. Mahambare is a senior economist at CRISIL Ltd, India's leading ratings, research, risk and policy advisory company. The views expressed are her own.

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