The Central banker’s high-wire act is always an interesting one to watch. Reserve Bank of India governor Y.V.Reddy had his task cut out for him—to bring inflation below 5.5% without harming an economy that is growing at more than 9% a year. It is how he has gone about his task that makes the monetary policy he announced yesterday, most noteworthy. He has settled for a modest interest rate hike for the economy as a whole, but has been more harsh with certain parts of it.
Much of the recent discussion on India’s monetary policy has centred on the core issue of inflation and interest rates. More specifically: By how much should interest rates be increased to bring inflation under control? There has also been ample discussion on the specifics of rising inflation, especially which goods and commodities are wreaking the most havoc with the Central bank’s recently—breached inflation targets. The fact that money supply and bank credit are rising a tad too fast for comfort is also a well—recognized fact.
Reddy has thrown another ingredient into the analytical stew: asset prices. Since October 2005, the RBI has been making some welcome noises about the threat posed by rising prices of assets like equities and real estate. Reddy was very blunt in the statement he made yesterday: “It is essential to recognize the links between accelerating inflation and escalating asset prices.”
The governor has not said that there is an asset price bubble. He has merely pointed out that bull markets also create macroeconomic risks. A rapid rise in equity and real estate prices can feed inflation in a self-perpetuating cycle. Rising asset prices make people feel wealthier. They spend and push up prices. Investors then buy even more assets to hedge against this rising inflation. Asset prices climb even higher. And so on.
The challenge was to cool down asset prices without harming the rest of the economy— to shoot at an enemy without causing too much collateral damage. The way Reddy has gone about the task is by trying to make bank loans to real-estate investors, capital market players and credit-card users more expensive. In contrast, the actual interest rate hike for the rest of the economy has been modest.
The use of such direct interventions is not out of the ordinary. Over the past few months, many central banks in Asia have been using ever-blunter and sector-specific tools to manage liquidity and inflation. South Korea and China have been encouraging their citizens to invest abroad. Thailand imposed curbs on foreign money flowing into its economy, though the subsequent market crash forced its military government to keep equity investors out of its net. In December, India, too, used regulations on the cash reserve ratio to cut back bank lending.
These Asian central banks have been struggling with large inflows of global capital that could create asset bubbles and volatility in the future. India, too, is facing a similar problem—there have been large inflows into domestic equities and real estate. More generally, strong capital inflows are adding to domestic liquidity.The government is keen that foreign capital keeps coming in to boost growth.
Ideally, public policy should be based on general rules rather than discretionary actions. The RBI, too, accepted this proposition in the 1990s, and moved towards a less discretionary regulatory regime. The use of strong sectoral curbs on lending to real estate, capital markets and credit-card borrowers is, in a way, a retreat from this principle. But though it is not the ideal option, sectoral tinkering is perhaps the most practical way to manage the problem today. That is why we are ready to give our tentative approval to Reddy this time around.
India has stronger banks and more efficient regulatory systems than most of its Asian peers. As capital flows keep growing, the only way to prevent them from creating the sort of panic that they did in Asia in 1997 is to ensure that the banking sector has more capital and is even more efficiently regulated.
In other words, a further round of financial-sector reforms are needed to enable India to absorb foreign inflows into its asset markets. That is the real long-term challenge—better financial intermediation.
By making bank loans in specific sectors more expensive, will the RBI governor be able to meet the challenge of checking the threat of inflation without harming the rest of the economy? We welcome your comments at firstname.lastname@example.org