A troubling feature of the Indian economy today is the apparent arbitrariness of monetary policy-making and the ripples it causes in asset markets.
The short-term instability in the 10-year bond yield in India, measured by five-day standard deviations, is almost 23. This measure of volatility has climbed from less than two on 8 December, when the central bank announced the first of three increases in the cash-reserve ratio of commercial banks.
Responding to a liquidity squeeze, the overnight inter-bank call money rate, which was 5.4% on 15 March, shot up to 62.5% on 21 March. It plunged to 9.3% on 29 March, only to surge to 55% the next day. It’s now less than 7%.
The equity market, too, is nervous about what the central bank might do next. Following the latest round of unexpected monetary tightening on 30 March, the benchmark Bombay Stock Exchange Sensitive Index slumped almost 5%, its biggest one-day decline in 10 months.
“The central bank may like to consider that there is no harm in preparing the markets for its decisions in a manner that the element of surprise is reduced and unintended market reactions can be avoided,” R. Seshasayee, president of the Confederation of Indian Industry, the country’s biggest business lobby group, said in a 6 April press release.
There’s a grudging acceptance that a tight-money policy is a good thing for India right now because inflation, at a 6.4% annual rate, is almost two-thirds higher than a year earlier. What’s irking the markets is the unwillingness on the part of the Indian authorities to signal their actions in advance.
It’s a communication challenge that needs more than smarter words. A predictable monetary policy requires a publicly-disseminated macroeconomic model, as Delhi School of Economics Professor Partha Sen noted in a speech to Indian currency traders in Bangkok last weekend.
The Bank of England’s monetary-policy toolkit is available on its website; the Australian Treasury’s macroeconomic model is also available online. The Indian authorities closely guard their crystal balls. The official projections on economic growth and inflation are revealed, though the market hasn’t been let in on the mechanism used to derive those prognostications. As a result, official forecasts don’t have credibility and fail to guide expectations.
The macroeconomic forecasts in India are, as in every other country, a mixture of analysis and gut feel. However, the recipe of the concoction remains a secret in India. “It is difficult to judge from the predicted figures to what extent a particular projection has been influenced by the ‘superiority’ of judgment unless the models are publicly disseminated with all relevant data,” Kaushik Bhattacharya, a Reserve Bank of India economist, noted in a December 2006 paper, which he wrote in a personal capacity as a researcher at the University of Bonn in Germany. The study was published by the Bank for International Settlements.
Four decades ago, Jagdish Bhagwati and Sukhamoy Chakravarty, two of India’s finest economists, had lamented the absence of a short-term model for the Indian economy that would allow policymakers to make informed decisions. Since then, there have been a number of individual attempts at model-building, though what was really needed was a big institutional effort. That didn’t materialize.
A central-bank working group on economic indicators said in 2002 that Indian policymakers may not be able to respond to changes in the business cycle. “Contemporary information on the existence or non-existence of patterns of aggregate economic fluctuations in India is grossly inadequate for meaningful policy reaction,” the group said. “The state of research in this area is somewhat antediluvian and the database is insufficient.” Those deficiencies persist.
To begin with, one knows very little about the Indian labour market, which is surveyed in any depth only every five years. Similarly, the nature of aggregate demand in India largely remains a matter of speculation. The quarterly gross domestic product data does not provide a breakdown by expenditure sources; the most popular inflation series—the wholesale price index—excludes services. It, too, says next to nothing about consumer demand.
As a result, economists don’t have a very good idea of how demand and supply interact in India and prices and wages get set. These glaring gaps in data and reasoning are a liability. The economy is modernizing and there’s a growing constituency of middle-class borrowers that—unlike the subservient, largely state-owned banking system—will resist becoming cannon fodder in the central bank’s war against inflation.
These households are asking, and quite legitimately, why their mortgage rates must go up by 200 basis points in two months. Financial institutions say they can only deliver smoother outcomes if the monetary authority is more transparent. The market needs to be able to read the central bank’s mind. That can only happen when analysts, with no recourse to inside information, are able to replicate, on their own, spread sheets, a version of the official macroeconomic model. As long as tracking the model allows the market to forecast policy changes with reasonable accuracy, the credibility of the central bank will be enhanced, and financial market volatility will moderate.