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Nobody can say for certain how this crisis will evolve, nor can policy reactions be prescribed in advance. Did anyone predict the demise of the giant US investment banks or the direct purchase of commercial paper by the US Federal Reserve?

That said, RBI has largely been able to ease the liquidity crisis among banks. Overnight rates are low; there has been substantial improvement in the three-month Mibor (Mumbai inter-bank offer rate) as well as in the three-month CD (certificate of deposit) rates.

RBI’s policy actions had the following objectives: easing rupee liquidity for banks, easing dollar liquidity, lowering risk, enhancing credit delivery, especially to targeted sectors such as exports, housing and small scale industries, and, recently, helping prevent a deterioration of balance sheets.

While they have met the first two objectives, they have not been successful in ensuring credit flows or lowering risk.

In its statement on the latest growth stimulus, RBI said: “Recent data indicate that the demand for bank credit is slackening despite comfortable liquidity." But that is normal during a downturn. In the late 1990s, for example, when we had a big domestic credit crunch and a slowdown in GDP growth, year-on-year (y-o-y) growth in bank credit fell from 27% in November 1995 to 10.6% in November 1997. At present, bank credit growth is 27% y-o-y, so there’s plenty of room for it to fall.

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Also, it’s very likely that bankers would prefer so-called lazy banking, making easy money by putting their funds in risk-free government securities (their prices rise when interest rates fall), rather than lending in an increasingly risky environment. Perhaps that is why the investment and deposit ratio of the banking sector has risen to 30.37% from 28.68% two months ago.

RBI has already been trying to push credit to certain industries by inclusion in the priority sector, extending refinance and so on, but it’s important to distinguish between a normal cyclical slowdown and a genuine liquidity crunch.

As economists Sumita Kale and Laveesh Bhandari of Indicus Analytics succinctly put it: “It has been argued that the interest rate regime created by the RBI was too high, and the controls put in place by the finance ministry were impacting the corporate sector and economy adversely in the era of international recession. These obviously needed to be relaxed. As long as the government sticks to doing that, it is fine. But we need to guard against measures that provide additional support. Net net, it is important to limit real-estate and wage bubbles for sustained and equitable long-term growth."

D Subbarao

With the EMBI+ index at above 700, which means emerging market bonds are on an average trading at 700 basis points over US treasurys of comparable maturity, international credit market are still extremely tight—the EMBI+ spread was less than 400 at the end of September.

RBI’s real policy rate is now well into negative territory. Nevertheless, HSBC economist Robert Prior-Wandesforde points out that, at more than 13% currently, the prime lending rates of major banks is still close to its highest since 1998.

He estimates the weighted average cost of capital is around 12.8% at present, close to its highest levels in a decade. He puts the trend nominal GDP growth at 12.5%, that is, the cost of capital is higher than the return. For an immediate remedy, and considering the disastrous Index of Industrial Production (IIP) numbers for October and November, more rate cuts are needed.

What else should RBI do? Well, RBI is not alone. If conditions deteriorate further, all it has to do is look at the host of innovations that central banks in the West have made.


Facing novel challenges

Saumitra Chaudhuri, Member of Prime Minister’s economic advisory council

Reforms in RBI remain

Ajay Shah, Economist

Even lonelier path ahead

A well-known former governor of RBI said his job was the loneliest in the country. Much like US president Harry Truman, the governor cannot pass the buck to anyone else (although he can sign it). The decision of RBI is called “his" decision. (Unlike Pakistan, we have not yet had a woman governor.)

His job is complex enough in the best of times, having to walk a tightrope between multiple goals of monetary policy, sovereign debt management, currency management, banking supervision and financial stability. But this year was not the best of times for a discontinuity in the chief helmsman’s seat.

Ajit Ranade, Group chief economist, Aditya Birla Group

On his tenth day, Wall Street became ground zero. Lehman Brothers declared bankruptcy, and insurer AIG (American International Group, Inc.) almost followed suit. Great investment banking dominoes toppled all over the world, inter-bank distrust multiplied and the chill of credit freeze soon spread to India.

RBI under Subbarao approached the liquidity problem with an uncharacteristic no-holds-barred policy. Some of us wondered whether, unlike his predecessor, the institution had started bowing down to the cheerleaders from the north and the industry.

But extraordinary times require extraordinary response, and so what if there is complete consensus between the ministry and the ministered (between whom lies Subbarao’s RBI).

In barely eight weeks, we got multiple and large reduction in cash reserve ratio (the proportion of deposits that commercial lenders in India must keep with the central bank as cash to protect the deposits) and repo rates (the rate at which RBI infuses liquidity in the system).

No monetary stone was left unturned, with special windows being opened for NBFCs (non-banking finance companies), mutual funds and dollar swaps. Even the holy SLR has been reduced, although it would be wise not to reduce it further.

Now that liquidity and signal rate comfort has been administered, the main task is to wait for bank lending to pick up.

In the days ahead, the governor may now need to furrow a lonelier path, since inflation fears are not over, fiscal and trade deficits are widening and further capital outflows cannot be ruled out.

So he may need to silence the crowd that brays for more monetary stimuli to prevent a bigger disaster later. He had plenty of like-minded company in his first 100 days, but the days ahead may be in solitude. His was baptized by fire in September, but now in these fiscally desperate times, his conviction will be tested.

PS: By the way the lonely former governor, went on to become finance minister and Prime Minister.

Beginning to make a mark

With his disarming style and ability to digest alternative views and options, D. Subbarao is already beginning to make a mark in his own distinctive softer, gentler approach. Indeed, he is bound to overcome the initial market fear that he will be a rollover governor, in contrast to his predecessor Y.V. Reddy’s independent style. Of course, the ministry of finance now reportedly not running a separate monetary policy must help matters for any governor.

Subbarao has already reversed nearly three years of monetary tightening. He will have no choice but to continue with the mother of all monetary easings, and cut policy rates, CRR (cash reserve ratio, or the amount banks have to keep with RBI) and SLR (statutory liquidity ratio, or the amount banks are mandated to park in government bonds) to cushion the hit to the economy, though he will probably be slow with SLR cuts.

Today, India is a house on fire, and the current backdrop should be used to push through some favourable changes, such as strengthening the quarterly policy review process and the policy framework. Subbarao’s maiden quarterly policy in October was nothing short of a fiasco, as the do-nothing policy seemed to be far removed from the evolving realities even at that time.

Rajeev Malik, Head of India and Asean economics at Macquarie Capital Securities, Singapore

The single greatest challenge that Subbarao faces is to avoid being pushed—or tricked—into undoing the painstaking gains made by RBI in several areas over the last few decades.

For example, there is no case for giving SLR status to oil bonds. Actually, these bonds should not exist, and it is up to the government to set its house in order by not differentiating between these and regular government bonds.

Also, the case for hiking FII (foreign institutional investor) investment in local currency government debt should be approached in a gradual and calibrated manner rather than being viewed as an easy lollipop for attracting foreign capital.

Subbarao must realize that there is far more individual accountability in being RBI governor than in being finance secretary. It would be a shame if the current crisis emasculates more financial sector reforms.

Subbarao’s main legacy will likely be ensuring financial stability is not compromised, even as he moves forward on financial reforms.

The views expressed here are personal.

Graphics by Sandeep Bhatnagar / Mint