The Reserve Bank of India (RBI) has been in the news again—this time, for having “allowed” the Indian rupee to appreciate against the US dollar significantly in such a short period. For some, RBI cannot get anything right. That is a mistake.
In my view, RBI is beating an original and unique path to monetary policy in these unusual times. First, let us establish the unusual times. America’s Federal Reserve lowered its federal funds rate from 6.5% to 1.0% in about three years from 2001. The Swiss National Bank had its interest rate lowered to 0.25% and Japan maintained 0.0% interest rate for a long time. Surely, these were extraordinary times. As if this was not enough, most Asian governments began to accumulate foreign exchange reserves with ravenous hunger, led by China. We have the case of the nation with the largest population exporting its way to growth. They invested their reserves in US Treasuries and kept the long end of the US yield curve from responding to monetary policy tightening. Another country with a current account deficit of nearly 10% has found its trade-weighted exchange rate appreciate to “levels...exceptional by historical standards and unjustified on the basis of medium-term fundamentals” (as the Reserve Bank of New Zealand said while announcing its latest monetary policy decision).
In the world of finance, hedge funds began to proliferate and banks, freed from their obligations to separate investment banking activities from commercial and retail banking, began to expand aggressively into financing and intermediating hedge fund investment activities. The implicit hedge fund leverage, which had gone down in the aftermath of the collapse of Long-Term Capital Management, reared its head again and that contributed to the remarkable collapse in the additional yield emerging market bonds used to offer.
It is in this unusual milieu that RBI has been forced to conduct its monetary policy, not to mention the lack of support from the ministry of finance in India. In the name of transparency and predictability, monetary policy in the US was largely rendered ineffective in this cycle. With the element of surprise and uncertainty lost, financial industry cranked up the level of risk it assumed and distributed it more widely than before, even to unsuspecting participants (even a believer is now openly sceptical*). It is neither a surprise nor a coincidence that the share of financial sector profits in the US as a percentage of overall corporate profits reached its historically high level in this cycle.
What RBI is trying to do is to introduce an element of risk or uncertainty into the market when complacency and risk appetite reign supreme. It is about restoring some balance to the runaway animal spirits. Indeed, in this, RBI is taking a leaf out of the old Bundesbank, which used to retract from rising or cutting rates when the market widely anticipated it to. It might be undesirable to use such an approach at all times. When confidence is low, it is wrong to add to uncertainty. It is wholly appropriate to do so when the main stock market index is trading at 20 times current earnings and when real estate prices have made housing unaffordable for a vast majority of the Indian population.
Regardless of whether the Indian economy achieves a soft-landing (growth not falling below 7.5% and wholesale price inflation settling between 4% and 5%), India will have served as a laboratory for an interesting and unusual policy experiment: Surprise and uncertainty as monetary policy tools in times of heady complacency.
In that regard, the latest monetary policy statement by RBI was not a surprise. It eased rules on capital outflows and reiterated its resolve to respond flexibly, using all instruments at its disposal to achieve price stability and contribute to lasting growth. The statement was a repeat of the statement made in January 2007. Yet, the Mumbai Sensex Index rallied more than 200 basis points on that day, only to give it all up by Friday and close below 14,000.
Any policy action that has the effect of knocking back asset prices is unlikely to be popular and that is why, on such occasions, both policy actions and methods come under increasing scrutiny. In a world of fiat money and financial innovation, the financial sector wags the “real” dog and hence cries foul when its party is spoiled. Greenspan, after wondering about irrational exuberance in asset prices, retreated into his shell in the face of strong criticism and became the leading cheerleader for asset prices. It appears that those who are in charge of monetary policy in India are made of sterner stuff. It is time to stand up and applaud.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Comments are welcome at firstname.lastname@example.org