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Business News/ Opinion / Online-views/  One rate to rule them all
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One rate to rule them all

One rate to rule them all

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Judging by the mandate of the working group the Reserve Bank of India (RBI) set up this week to re-examine its monetary policy, the central bank is ready to start experimenting with a new policy. India now has to see whether its financial markets are ready.

It’s the financial crisis that exposed gaps in the current policy. Since 2000, RBI has used two policy rates: the repo rate at which banks borrow funds from RBI, and the reverse repo rate at which banks park excess funds with RBI. (There is a third, the bank rate, but it’s so defunct that the working group now has to assess its existence.) Actual short-term interest rates fluctuate in a “corridor" between the two key rates, with RBI transmitting its policies by changing the price of this short-term credit. Except, this transmission hasn’t worked as intended: During the crisis, banks didn’t always change their rates in line with RBI’s changes.

That’s why governor D. Subbarao has been intent on improving this process. He unveiled a base rate for pricing loans in July. He’s now taking another stab at improvement: The working group has been asked to see “whether there should be a corridor at all". The way Subbarao has been hiking interest rates, he seems bent on cutting the corridor out, and moving to a single policy rate.

How will this help transmission? A wide corridor means that if policy rates move up, say, 0.25 percentage point, the short-term interest rate has enough room to even go the other way. A single rate, well executed, can provide a simple one-way signal. Yet, for that execution, India needs vibrant money markets.

That’s the chicken-and-egg question. Without these money markets, its signals are ineffective. And without a solid signal, money markets will never get around to accurately pricing debt across different maturities —a true yield curve.

Our guess is that a single rate is one way to help stoke these markets to life. RBI currently acts as a ready place for participants to both withdraw the money they need (repo rate) and/or deposit what they have in excess (reverse repo), denying the market a fair chance to develop its own mechanisms and discover its own prices. A single rate is, then, a welcome step.

That by itself won’t be enough, though. India has a long road ahead—more derivatives, a bond market not dominated by the government, to mention a few stops on the road—in finding that functioning yield curve.

Are two rates better than one? Tell us at views@livemint.com

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Published: 07 Oct 2010, 09:17 PM IST
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