India’s monetary policy is reverting to the 1980s, the age of acid-wash jeans and Duran Duran. This week, the Reserve Bank of India (RBI) asked commercial banks to set aside another half a percentage point of their deposits as cash. With this increase in the cash reserve ratio, the proportion of preempted funds has risen by 1.5 percentage points since India’s monetary-tightening campaign began in 2004.
Stocks slumped as much as 2% on Wednesday before recovering some of the losses. The slide in Indian bonds was the steepest among all sovereigns during Asian trading.
Policy makers had asserted by the end of the 1990s that impounding banks’ money would be a last-resort action and not the main monetary weapon, as was the case in the 1980s. They claimed that RBI, like other central banks, had enough muscle to tame inflation through one of the two types of OMOs (open-market operations).
OMO, or selling and buying bonds, would curb liquidity. “The medium-term objective is to bring down the cash reserve ratio to its statutory minimum level of 3% within a short period of time,” Y.V. Reddy, current RBI governor had said in January 2002.
The ratio fell to 4.5% by June 2003, from 5.5% at the time of Reddy’s remarks. With the increase announced this week, the reserve ratio is back at 6%.
Until the 1980s, when India had a closed economy, the monetary policy was compromised by government profligacy. RBI funded the shortfall in revenue by printing money. Whenever it looked like money supply and inflation would get out of hand, it impounded commercial banks’ funds.
The story is different now. The government is no longer forcing RBI to keep its printing press running. It’s the overseas hedge funds that are forcing the hand of the central bank. The rupee is a managed currency. RBI increased the reserve ratio because it had bought $3.5 billion of foreign exchange in the past two weeks to stem the appreciation in the home currency, according to JPMorgan Chase & Co. figures.
By raising reserves, it forced banks to set aside almost exactly the same amount it had given them in exchange for the dollars. The idea was to pre-empt the cash before it was lent to mortgage borrowers in an overheated property market.
From 24 July to 6 February, the Indian currency appreciated 6% against the dollar. If RBI hadn’t started buying dollars in November, the rupee might be 5-10% higher than it is today.
A stronger currency might have helped tame inflation, which at 6.6% is way above RBI’s tolerance level of 5.5%. However, had the rupee risen 15% in seven months, exports might have stalled.
More importantly, if the rupee was perceived as a one-way bet, it would become a magnet for yet more capital from overseas.
Increasing interest rates more markedly would have had a similar result by boosting returns from speculative carry trades. The benchmark rate at which the central bank adds liquidity to the banking system has risen by 150 basis points since October 2005. It now stands at 7.50%.
It would be debilitating for the Indian banking sector if it were slapped with a higher reserve ratio every time the central bank ended up buying a few billion dollars for reserves.
Yet, there are few real choices. Until the government and the central bank find a sensible way to manage liquidity, it’s going to be the 1980s all over again.
Foreign investors can only hope that Reddy isn’t trying to turn the clock back to a time when British pop group Duran Duran ruled the charts and only locals were allowed to buy Indian stocks. After Thailand’s capital controls, hedge funds will be hoping to hear a different tune from policy makers.
Andy Mukherjee is a Bloomberg News columnist. The opinions expressed here are his own.