I am fairly sure that Reserve Bank of India (RBI) governor Yaga Venugopal Reddy is not surprised by the recommendations of the Raghuram Rajan committee’s draft report on financial sector reforms, released last week.
Two key recommendations of the committee are: RBI must start targeting inflation and use only interest rate to manage its monetary policy. Traditionally, the twin pillars on which the monetary policy of Indian central bank rests are price stability and growth. There is yet another objective of which no governor talks openly—managing the exchange rate. RBI buys and sells dollars in the foreign exchange market through a clutch of state-run banks, in accordance with an internal target set for the local currency.
The official stance of the central bank has all along been that the rupee-dollar rate is market-driven and RBI only intervenes in the currency market to curb excessive volatility. But in reality, it feels uncomfortable when the rupee rises against the dollar substantially as that hurts the competitiveness of Indian exporters. With the rise of the local currency, exporters’ dollar income, translated in rupee term, goes down.
But RBI’s intervention, or the lack of it, in the foreign exchange market is not as simple and uni-dimensional as it seems to be. For instance, the central bank also uses the currency to fight inflation. If it allows the rupee to appreciate against the dollar, the cost of import comes down and that helps contain rising inflation.
RBI has traditionally managed an extremely complex balancing act of managing inflation, interest rates (that have a direct impact on growth) and exchange rate. Reddy could be one of the most gifted trapeze artistes around and any Russian circus would love to have him lead its team of acrobats.
If RBI makes inflation targeting as the sole objective of the monetary policy, as has been the case with many of the world’s central banks, its job will become less complex. Ditto about using interest rate as the only monetary tool. At this point of time, the interest rate is one of the many tools that RBI uses to manage its monetary policy. Others include cash reserve ratio, or CRR, which defines the balance commercial banks keep with RBI and market stabilization scheme, or MSS, bonds that RBI floats to soak up excess liquidity from the system.
Over the past one year, RBI has not raised its policy rate but tightened liquidity in the system by using CRR and MSS. For instance, CRR has been raised by full 1 percentage point from 6.5% to 7.5% last year, stamping out more than Rs32,000 crore worth of liquidity from the system. Similarly, the overall limit for MSS has been increased from Rs1 trillion to Rs2.5 trillion in stages.
RBI uses both tools deftly to stamp out liquidity, generated through its dollar buying in the foreign exchange market. It buys dollars from the market to rein in the runaway appreciation of the rupee and for every dollar it buys, an equivalent amount of rupees flows into the system. At the second stage, RBI sucks out excess liquidity by raising banks’ CRR and/or floating bonds under the MSS. These bonds are not part of the government’s annual borrowing programme. They have been specially created, with the nod of Parliament, to drain excess liquidity from the financial system.
It is indeed true that the presence of so many monetary tools gives RBI a lot of flexibility in its monetary policy management as it does not need to use only the interest rate to signal its stance. And, they are there because of RBI’s multi-tasking and multidimensional approach. If it does not “manage” the exchange rate, there won’t be excess liquidity in the system and hence the use of CRR and MSS to drain the liquidity won’t arise.
Inflation targeting and use of interest rate alone as a signalling device will simplify RBI’s job, but it can do these effectively only when it has complete independence. The Rajan committee, which has three eminent bankers as members—K.V. Kamath of ICICI Bank Ltd, O.P. Bhatt of State Bank of India and Uday Kotak of Kotak Mahindra Bank Ltd—is fully aware of that. Which is why it says: “The committee would like to stress the importance of leaving the determination of monetary policy and interest rates entirely in the hands of RBI.”
The root of the problem in India is an over-interfering finance ministry. In its January review of the monetary policy, RBI left the key policy rates and CRR unchanged amid expectations of a rate cut from some quarters but finance minister P. Chidambaram in his meeting with bankers after the policy announcement made it very clear that credit growth has slowed down because of high interest rates and they must cut their rates. He was, at that point, more worried about growth than anybody else (now, of course, his worry has shifted to inflation). In no time, public sectors banks rushed to pare their rates to please the government—the majority owner of these banks—but Kamath and his tribe who run private banks kept quiet and watched the fun. Those banks will now be forced to raise their lending rates as RBI is expected to tighten the monetary policy with the inflation rate shooting to 7.41%, its highest since November 2004.
Unless the government starts following a hands-off policy, no central bank can do its job effectively. It can give an inflation mandate to RBI and hold the central bank responsible for any slippage, provided it does not interfere in any way and influence the decisions of individual banks even when the RBI governor is sending a different signal. We cannot have a situation where growth is the government’s worry and inflation RBI’s.
(Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org)