In pandering to market expectations and playing to the corporate gallery, the latest monetary and credit policy may have just made the macroeconomic situation much more difficult and uncertain than it already was.
To start with, slow off the blocks, the Reserve Bank of India (RBI) fell behind the interest rate curve by at least three quarters because of its now fabled “baby steps”. By the time a 50 basis points (bps) increase was administered, it was a trifle too late to catch up. Now, when other central banks across the world are looking to stand still, if not soften, RBI is still busy crawling the interest rates up.
Between the last repo rate raise and this one, RBI virtually used the exchange rate as a means for monetary management. In an economy with a current account deficit, currency depreciation works like liquidity tightening. With the sharp exchange rate depreciation, foreign institutional investor (FII) equity outflows have amounted to more than $2.7 billion. FII debt inflows at $890 million have meant that the net outflow is around $1.6 billion. The liquidity outflow is just about the same that would have been drawn out from the system by a 25 bps increase in the cash reserve ratio.
However, this time around, more than the baby step, what is of immense concern is the giant leap of faith that RBI has taken in giving an undertaking not to hike rates anymore.
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Under the garb of guidance and transparency in policymaking, RBI has traded the integrity and seriousness of its policymaking process for instant accolades from market participants and private firms.
This so-called transparency actually violates a basic methodological tenet of economic policymaking: monetary policy can’t be formulated on the basis of what is “likely to happen”. It must be formulated on the basis of “what could happen”. As such, even if RBI’s rather definitive call on inflation receding in the months ahead turns out to be correct and it manages to save itself the blushes, it has seriously erred.
The essence of formulating policy on the basis of “what could happen” is conservative and minimizes risk. It ensures that the downside risk is limited, even as the full benefit of the upside advantage may not be captured. In other words, this approach is the obverse of being speculative: speculation is betting on what is likely to happen. In contrast, policy intervention is designed to hedge against what could disrupt the likely outcome.
By betting on and formulating policy on the basis of what could happen, RBI has turned itself into a speculator. When the regulator becomes a speculator, the economy is not safe anymore.
The call that RBI has taken on inflation is not even a good gamblers’ bet because the odds are heavily against it. Not only is the domestic economic situation anaemic, the political situation, too, is a bit fragile; the international economic system is in disarray and trade and prices of global commodities are witnessing a paradigm shift, and underlie inflation. All these are not within the control of RBI.
As far as savings bank deregulation is concerned, even if it is a desirable move, it is not entirely clear what has triggered its freeing up at this time. Why go deep-sea fishing in the monsoons? Unless, of course, the situation is desperate.
The freeing of the saving rate, which was not just a transactional rate but also a benchmark rate for government and quasi-government funds with administered rates, will have a far-reaching impact on the banking sector as well as the larger financial set-up.
To start with, it increases the threshold for the cost of funds in the financial system. By deregulating it at this point, it has given a push to the basic cost of funds for banks and, through that, to the system as a whole.
Savings rate deregulation will result in the entire liability management of banks undergoing a change at a time when the asset side is under considerable stress. This will be a shock to the balance sheets, and not just a matter of margins coming under pressure.
For instance, the behavioural pattern of savings will undergo a major change for banks. No longer can saving deposits be seen as stable, indeed virtually, quasi equity. This will impact the structural liquidity management, and quite a few banks (those with high current and saving accounts ratio) will be faced with serious negative matches in the stipulated liquidity buckets. This will in turn affect their risk rating. A liquidity problem can quickly graduate to a solvency issue in adverse times.
Had deregulation been carried out when the interest rate regime was low and softening, its positive impact would have been the same, but the negative impact would have been much less. By doing it at this point, the negative impact has been amplified.
Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at firstname.lastname@example.org