There were three surprises in the Reserve Bank of India’s quarterly review of monetary policy last week.
First, the brevity of the policy document. Divided into three parts—introduction, outlook and projections, and policy stance —it was a 4,900-word, 12-page review. Such a short RBI policy document hasn’t been seen in the past.
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Second, the narrowing of the corridor between the repo rate, or the rate at which RBI infuses liquidity into the system, and the reverse repo rate, or the rate at which the central bank drains liquidity. Most bankers had been expecting an identical rise of 25 basis points (bps) in both rates, but RBI hiked the repo rate by 25 bps to 5.75% and raised the reverse repo by 50 bps to 4.5%. This has narrowed the gap between the two policy rates to 125 bps from 150 bps. One bp is one-hundredth of a percentage point.
The third and final surprise was the introduction of a mid-quarter or six-weekly review of monetary policy beginning 16 September. The quarterly reviews were introduced in fiscal 2006. Until then, there had been only two policy announcements in April and October—known as the slack season and busy season policies.
RBI governor D. Subbarao could have chosen to spring yet another surprise—a higher dose of rate hikes. A calibrated approach doesn’t necessarily mean that the central bank needs to raise its key policy rate by 25 bps even if that’s done once in six weeks, particularly when the wholesale inflation rate is running in double digits for five months in a row. The high inflation was an opportunity for RBI to go for an aggressive rate hike and the government would have had no choice but to digest it as inflation is a critical political issue at this point. While wholesale price inflation has been more than 10% since February, retail inflation has been even higher. Inflation measured by consumer prices paid by industrial and farm workers is now running close to 14%, the most after Venezuela’s 32%, according to Bloomberg data complied from 82 nations.
While most advanced economies are still facing the risk of deflation, inflationary pressures are mounting in emerging markets as they are staging a strong recovery from the economic slowdown. Many of them are raising rates, but the difference between the policy rate and the inflation rate is the highest in India.
Subbarao is well aware of this. Which is why the policy document describes the development on the inflation front as “worrisome”. “The dominant concern that has shaped the monetary policy stance…is high inflation… With growth taking firm hold, the balance of the policy stance has to shift decisively to containing inflation and anchoring inflationary expectations,” it says. RBI is also aware of the fact that the inflationary pressures have been “exacerbated” and become “generalized” with rising demand. “Capacity constraints are visible in several sectors and pricing power is returning to producers.” In this context, it would have been relatively easy for RBI to go for a higher dose of rate hikes than waiting until later when inflation peaks and starts its southward movement. To that extent, the July policy was a missed opportunity.
It’s now fairly certain that the next round of rate hikes will happen in September and the corridor between the repo and reverse repo rates will probably be further narrowed to 100 bps. This means the repo rate will be raised by 25 bps to 6%, while the reverse repo rate will go up by 50 bps to 5%. By the end of the fiscal year, the repo rate should be around 6.5% or so and the reverse repo rate 5.5%, if the central bank chooses to keep the corridor at 100 bps. Instead of playing catch-up and hiking rates every six weeks, RBI could have shown some boldness and narrowed the inflation-interest rate differential by some extent in July itself.
Had there been any choice, I am sure employees of the Indian central bank as well as the capital market regulator would have worn black badges on 27 July to protest the introduction of the Securities and Insurance Laws (Amendment and Validation) Bill 2010 in Parliament by finance minister Pranab Mukherjee. The controversial 18 June ordinance that settled the turf war between the capital market and insurance regulators and made it clear that the unit-linked insurance plans, or Ulips, will be supervised by the Insurance Regulatory and Development Authority, or Irda, is now set to become law.
Apart from settling the Ulip dispute in favour of Irda, the Bill also sets the stage for the formation of a statutory joint committee, headed by the finance minister, to settle all disputes among regulators in relation to hybrid products. How is this panel different from the existing high-level coordination committee on financial markets, or HLCCFM? There are two key differences. One, unlike the HLCCFM which has been an informal forum, the joint committee is a statutory body whose decisions are binding. Two, this is headed by the finance minister.
Some cosmetic changes have been made in the text of the Bill—the RBI governor is not a member of the joint committee, but its vice-chairman, for instance. The motive behind the Bill remains unchanged—making the finance minister the ultimate arbitrator in any dispute, the super regulator. This is despite the fact that the government has the power to direct any of the financial sector regulators on any policy issue. It was done by stealth and not all regulators were consulted before the ordinance was issued. I would love to see millions of people associated with the Indian financial sector wearing black badges the day Parliament passes the Bill. This will be a dark chapter in the nation’s financial history.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Comment at firstname.lastname@example.org