Tuesday, April 20, 2010

RBI’s Monetary Policy Statement – A Critique

The RBI’s monetary policy statement did not surprise many people. Increases in the Repo, Reverse Repo rates and CRR were well within the markets expectations. While there was no urgency or clear need for these measures, there was, and is, an urgent & clear need for structural adjustments which the statement has ignored completely. These have been covered in earlier posts here and here.

In ignoring these issues, the RBI has made its task of managing the Indian Economy in coming days significantly tougher. Overnight Rates will remain choppy due to the large difference between the Reverse Repo & Repo rates. This in turn will prevent rational asset pricing in the Debt Market resulting in additional costs for all borrowers, including the Government.

Most significantly, however, the justifications given by the RBI for raising rates do not survive basic scrutiny. A few examples of this are given below.

“core measures of inflation in EMEs, especially in Asia, have been

With large scale currency manipulation resulting in weak currencies in the region, this is to be expected.

“Clearly, WPI inflation is no longer driven by supply side factors alone. The contribution of non-food items to overall WPI inflation, which was negative at (-) 0.4 per cent in November 2009 rose sharply to 53.3 per cent by March 2010.”

Non Food Items as described above include natural produce like Cotton, Rubber, Metals & Minerals. The prices of these haven’t been rising due to domestic demand pressures, but because of a pickup in global demand. Again, through a weak currency, we have imported inflation in this segment of the WPI.

“What was initially a process driven by food prices has now become more generalised.”

Clearly. Increase in Food Prices will lead to an increase in the price of processed food as well, which is a part of the Manufactured Products group in the WPI. Excluding this, inflation in Manufactured Products is 4.72% for the last 1 year.  Also, this would include the impact of increased transportation expenses due to higher fuel prices. Neither Food nor Fuel prices are demand driven, so how does one use this to justify higher interest rates?

“The Base Rate system of loan pricing, which will replace the BPLR system with effect from July 1, 2010, is expected to facilitate better pricing of loans, enhance transparency in lending rates and improve the assessment of monetary policy transmission.”

Well done! This will go a long way, I’m sure. But before you ask banks to set their house in order, why not look inwards, sir? Overnight rates under the current interest rate regime can move in a band of 150 bps due to minor changes in system liquidity. This isn’t a “corridor”, its more like a six lane expressway. With extreme volatility in overnight rates almost assured by this structure, how does one expect Banks to price their loans? No wonder the gap between the overnight rate and the 10 year GoI is 425 bps, close to twice the long term average.

“However, as the overall liquidity remained in surplus, overnight
interest rates generally stayed close to the lower bound of the LAF rate corridor.”

And on the few days that it moved away from the lower bound, it moved directly to the higher bound which is 150 bps points higher. If this were to continue, and it will as the RBI hasn’t addressed it’s cause, market participants including banks will price loans based on their estimate of liquidity along with RBI’s policy rates leading to inefficient transmission of monetary policy measures.

“Meanwhile, inflationary pressures have also made it imperative for the Reserve Bank to absorb surplus liquidity from the system.”

Wrong, inflationary pressures have made it imperative that the Reserve Bank stop injecting liquidity into the system through intervention in the FX market, which not only results in inflationary pressures through excess liquidity but through a weak currency as well.

“Consequently, on a balance of payments basis (i.e., excluding valuation effects), foreign exchange reserves increased by
US$ 11 billion”

That’s close to Rs. 50,000 crs. of liquidity that the RBI injected into the banking system. Now that we don’t need this liquidity, why not sell these USD 11 billion? Not only will it suck rupee liquidity out of the system which will serve to contain domestic inflationary pressures, it will cause the Rupee to appreciate reducing the impact of global commodity price increases. Right now we have an inflationary Exchange Rate Policy and a disinflationary Interest Rate Policy operating simultaneously. What’s the point?

As usual, the regulatory measures laid out in the document are good and cannot be faulted. This is consistent with the view that the RBI is an excellent regulator, but not much of success when it comes to the conduct of monetary policy.


  1. Well said, Rajiv. Alas, our RBI, like central bankers around the globe, think that they play a significant role in the economy. They are mere tools of a political party and dance to the tunes. They also have a delusion that monetary policies can repair an economy! God bless them.