Back Monetary Policy-making — Best time for a breakthrough
A. Vasudevan
| Real growth, external viability, large capital inflows, optimistic capital market, stable exchange rates all are so favourably situated that the RBI Governor can afford to take a leap into new horizons. Even the politics of coalition are in a facilitating mode. The sole concern is about inflation, mainly due to rising crude oil prices but it is a challenge that every central banker is prepared to take. Will the Governor break away from the tradition and adopt a new approach to the annual Credit Policy, asks A. Vasudevan |
Real growth, external viability, high investment rate, large capital inflows, low money growth, credit buoyancy, optimistic capital market, stable exchange rates and promise of fiscal restraint are all so favourably situated that the Governor can afford to take a leap into new horizons. Even the politics of coalition are in a facilitating mode. The one concern is about inflation that is mainly due to the crude oil price rise but it is a challenge that every central banker would any way be prepared to take.
Let us explore how the policy statement would shape under the new approach that the Governor, now under test by history, is perfectly capable of adopting. Under the new approach, two letters, T and R — T for transparency and R for reports as well as the rate of interest — would guide the Policy statement. The Governor would begin with a low-key approach to the growth outcome of 2004-05 and the prospects in 2005-06. The reasons for such an approach would be several.
First, the real sector data, in particular the consumption demand, would not be available. Then there is the Prime Minister's guess that only 7 per cent growth will be achieved in 2005-06. Besides, there are the embarrassing CSO data on saving and investment rates up to 2003-04.
The CSO data nail the belief that the recent growth gains were due to productivity gains. By implication, the growth outcomes reflect uneconomic use of capital, partly facilitated by the soft interest rate regime pursued since 2000. Finally, growth projections, trend-based as they have to be, are of no use since they cannot be related to money supply expansion that has now been unpredictable.
Fortunately for the Governor, there is no need to spell out the strategies to achieve even the growth guesstimate for 2005-06 because it is not a part of the central bank's dharma. But it is essential to explain in clear terms the connection between credit and growth. The new approach would require the statement to contain many details of credit flows by sectors, activities, `size' of the borrowers, and rates of interest charged not only in 2004-05 but also the details of what is planned for 2005-06.
It would be particularly insightful if credit to small and medium enterprises (SMEs) and agriculture — the sectors most likely to absorb relatively large employment — are given special focus in the statement in line with the Prime Minister's contention that achievement of high (potential) growth on a sustained basis would hinge upon creation of employment.
But it is not enough to provide data on credit flows from banks alone. For, activities are financed to a significant extent by non-banking institutions as well. The analysis should also be conducted in the context of the growing mutual funds industry and buoyancy in the new issues market and of the incentives for banks to prepare themselves to meet the Basle II norms. Such an analysis would give an idea about financing gaps, if any and the policy thrusts that are required for the development of different financial markets.
The Policy statement would give enhanced attention to fiscal outcomes and Budget Estimates, given the need for improved coordination with fiscal policy, the recent move to relax SLR (statutory liquidity ratio) restrictions and the promised fiscal restraint. Details, therefore, would be given on how the net bank credit to government has been managed in 2004-05 and on how it would be handled in 2005-06. Besides, details as to who among the non-bank investors has held government securities in 2004-05, the investors' motives for holding the securities, the differences if any between the motives of banks and other investors in holding the securities, the terms of holdings, the use of bank credit, if any, by non-bank investors to hold the securities, and the implicit incentives, if any, that exist for holding the securities by non-bank investors, would give clues about the official thinking as to how to develop the gilt-edged market in the medium term. Transparency also requires that details be provided about the modus operandi of government securities auctioning system now in vogue and the changes, if any, that need to be introduced to it.
Further widening the participation in the government securities market would be secured if there were transparent communication of information on the number of bids, the bid-ask spreads by individual investors, the rationale of the decisions underlying the determination of cut-off prices and quantities to be auctioned. Such transparency would help secure orderly expectation formation processes and evolving an appropriate term structure of interest rates.
The Governor would also spend a part of his statement on how transparency would help overcome the pressure of some interested groups to make India an `inflation targeting' (IT) country. `IT-nutters', as the Bank of England Governor referred to inflation targeters, are advocates of rules for monetary policy pursuit. The RBI Governor, on the other hand, would prefer discretion to rules. Discretion would be acceptable to markets if the decisions were rationally explained and if inflation as a problem is not given a back-seat in the order of policy priorities.
In view of the growing concerns about inflation, one should not be surprised if the Governor announces on April 28 that the RBI would put out periodic inflation reports as in `IT' countries. The Indian concerns about inflation pertain not only to uncertainties about how the crude oil prices would evolve in the near future, but also to uncertainties about farm production cycles and about the incomplete competition in the markets for manufactured products.
The announcement about inflation report would be widely perceived as a self-imposed constraint on discretion and as reducing, what economists call, the `time consistency' problems associated with discretion. The Governor would also take the logical step of announcing periodic releases of financial stability reports in the light of the growing openness of the economy and in order to improve inflation expectation processes.
Besides the announcement of the two reports, the `R' word would imply the RBI taking a policy stance on the rate of interest. Given the objectives of the Policy and the prevailing uncertainties in the industrialised world, the central bank would transparently signal an upward shift in the interest rates. The rate of increase would, however, be small, in line with the thinking on interest smoothening.
The Bank Rate would not be mentioned but the inter-bank call market would get added attention under the new approach. The Governor would make the call market a pure inter-bank one. This would be consistent with the overarching aims of broadening investor participation in the gilt market and of expanding market financing. However, this would mean downgrading of the `repo' rate as the signalling rate and asking some hard questions about preserving the liquidity adjustment facility (LAF) in its present form and about bestowing increased importance than hitherto to the standing facilities.
To ensure that these policy shifts do not provoke concerns about the availability of liquidity, it should not surprise any one if the cash reserve ratio (CRR) is reduced by 25-50 basis points, subject to a review at the end of June. The combination of interest rate increase and liquidity provision would help the RBI to continue with the current flexible exchange rate policy.
The Monetary Policy changes would, of course, be supplemented by announcement of structural measures concerning issues of bank consolidation, foreign ownership of private banks, divestment of public sector banks, asset quality of banks, risk management in accordance with Basel II and coordination mechanisms with other regulators and cooperatives and NBFCs. But the statement would be hesitant about the quality of the Boards of Directors of banks and the standardisation of accounting and auditing standards for all categories of financial institutions including banks.
The new approach can be put into effect without facing any serious limitation. If the Governor does not act in the living present, even the angels, as the saying goes, will weep. Will the Finance Minister and the Prime Minister support the Governor's initiatives?
(The author, a former Executive Director of the Reserve Bank of India, can be accessed on at asurivasudevan@hotmail.com)
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