If one disregards the occasional lapse or two, Reserve Bank of India (RBI) governor Y.V. Reddy has been more vigilant in combating inflation than many other emerging market central bankers.
One such slip occurred on 29 April.
In his quarterly monetary policy announcement, Reddy left interest rates unchanged when traders’ expectations for a rate increase were somewhat stronger than predictions of no change. As inflation continued to soar, the currency market became nervous. The rupee lost more than 6.5% of its value against the US dollar in 16 days.
At times, and perhaps to compensate for the lapses, Reddy has been heavy-handed. This week, he raised the policy rate by half a percentage point and simultaneously squeezed liquidity in the banking system. Traders expected a quarter-point hike. If RBI did see the need for strong medicine, it did a poor job of communicating its diagnosis to the market.
Beyond these policy slippages, my major grouse against Reddy—whose five-year term ends in September—is that he has left unexplained too much of what he is doing. There is no monetary policy committee in India. The governor runs the show. And Reddy’s show, while satisfactory in outcomes, has been just plain inscrutable in terms of motives.
Take, for instance, the so-called policy rate corridor in India. Instead of using one short-term rate to influence long-term rates, India uses two. The reverse repurchase rate, which RBI pays commercial lenders to take their surplus funds for a day, makes the floor of the corridor. The repurchase rate, which it charges banks for adding overnight funds into the financial system, acts as the ceiling. The overnight interbank bank rate is supposed to move in the policy corridor. Inexplicably, the corridor has become increasingly wide. Reddy hasn’t raised the reverse repurchase rate for two years now, even as he has continued to charge banks more and more for borrowing overnight funds from the monetary authority.
When liquidity in the banking system is tight, the floor rate may not matter. As Reddy has said, the “operational rate” at present is the repurchase rate, which was raised this week to 9%. That, however, isn’t a satisfactory explanation.
The width of the corridor isn’t a meaningless indicator.
According to a technical group on money markets that the central bank set up in February 2005, “Ideally, the spread should reflect the society’s tolerance level of volatility in short-term interest rates.” And what is that tolerance level?
“In the Indian context, the RBI may find it difficult to tolerate daily fluctuations in call rates by 100 basis points (bps) over a sustained period,” the committee said. “Therefore, for all practical purposes, this spread of 100 bps should be interpreted as the maximum tolerance level under extreme one-off circumstance.” The spread between repurchase and reverse repurchase rates increased this week to 300 bps. One basis point is one-hundredth of a percentage point.
A central banker who makes surprise the biggest weapon of his armoury achieves his goals by causing abrupt adjustments in the markets. And that’s the other charge against Reddy: Traders find his penchant for introducing volatility in money and currency markets unnerving. In a period of four months last year, the interbank call money rate shot up to 62% and slumped to almost zero. Starting 30?March?2007, the rupee gained 7% against the dollar in just two months.
This was a big move for a currency that isn’t allowed to fluctuate freely by RBI. It caused Indian exporters to panic, with many of them choosing to “hedge” their currency risk by buying toxic structured products that banks were only too happy to sell them. Several of those transactions have gone sour and ended up in court.
Reddy is aware of the criticism against him, though he doesn’t accept it. “For some time in the past, the RBI acquired an unwarranted reputation of always surprising the market, prompting me to quip at one stage that ‘the financial markets always surprise me with their expectations from the RBI’,” he said at the Bank for International Settlements’ annual conference in Lucerne, Switzerland, in June.
More seriously, Reddy reiterated his doubt about the desirability of an entirely predictable monetary policy.
The debate about how much a central bank should communicate, when, and to whom, remains unresolved. Still, it’s possible for the Indian central bank to do a better job establishing the credibility of its interest rate corridor—its main policy tool—without giving away what the level of interest rates may be in the future. It should start by answering why the width of the corridor has been allowed to expand. Analysts suspect the real reason is mercantile. RBI doesn’t want to pay too much when it “sterilizes” accumulation to its foreign exchange reserves by issuing bonds. But what about the sanctity of what the width of the corridor represents?
Has Indian society’s tolerance for volatility in short-term interest rates tripled? Indian lawmakers are perhaps too busy to seek these explanations, though at least in theory RBI is accountable to Parliament.
What is more egregious is that the monetary authority’s submissions to parliamentary committees are official secrets. So, even if politicians are asking Reddy the right questions, the answers still elude the public. (Bloomberg)
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