A focus for the RBI

Indian Express, 24th September 2013

It needs a well-defined objective and policy instrument.

In his maiden monetary policy announcement, RBI Governor Raghuram Rajan unveiled a mix of easing and tightening measures. He raised the repo rate and lowered the bank rate. In July, the RBI had suddenly raised rates to defend the rupee. Since then, the bank rate, or the MSF rate, has become the operational policy rate, the rate at which commercial banks borrow from the RBI. It is too high for the economy today and needs to be reduced even further.

The decision to cut the MSF rate was obvious. That was the easy part. Rajan also raised the repo rate, which used to be the policy rate before the RBI's actions to defend the rupee in July. This was supposed to indicate the RBI's intent to target inflation by lowering inflationary expectations. Bringing such expectations down is a difficult task for any central bank. For the RBI, the problem is even more difficult since it must balance multiple objectives, has numerous instruments and is not independent.

Rajan will have to work hard to build the RBI's credibility as an inflation targeter. He will need to get rid of its multiple objectives and many instruments. He will have to focus on defining the objective of monetary policy and its instrument clearly, building credibility, being consistent and communicating his policy stance to the public. The success of his term will be measured by how well he is able to anchor inflationary expectations and bring down consumer price inflation. The growth slowdown and high food inflation will make inflation forecasting and targeting difficult. So far, the RBI has not managed to communicate clearly because it has too many instruments and unclear objectives.

In the credit policy announcement, Rajan increased the repo rate under the liquidity adjustment facility (LAF) by 25 basis points, from 7.25 per cent to 7.5 per cent. This was clearly intended only as a signal, since restrictions on borrowing from this window were not reversed. While banks can borrow 2 per cent of their liabilities at the MSF rate, after the RBI's July actions they can borrow only 0.5 per cent of their liabilities under the LAF. The target corridor for the overnight interest rate has the MSF rate on top, the repo rate in between and the reverse-repo rate at the bottom. The narrower this corridor, the clearer the RBI's policy stance is. Today, this corridor is too wide and the interbank rate has been moving beyond it.

Rajan's first task is to make the repo rate the operational policy rate. This means the RBI must stop using other instruments for easing or tightening monetary policy. Today, policy objectives are achieved through 10 instruments: foreign market intervention, open market operations, the repo rate (which will eventually become the only instrument), the reverse repo, the MSF or the bank rate, the CRR, the daily balance of the CRR, the amount that can be borrowed through the repo window, the amount that banks can borrow through the MSF window and the SLR. The RBI often suggests that interest rates (which are the price of money) are not affected by liquidity (the quantity of money in the market). The two, it believes, are somewhat independent of each other and can be manipulated to move in different directions. The origins of this framework go back to the control raj, where for many goods like steel and cement, it was assumed that the prices and quantities in the market moved independently of one another.

The RBI will need to clarify its measure of and numerical target for inflation to anchor expectations. In its most recent policy announcement, the target inflation measure was still unclear. In his press statement, Rajan said a WPI inflation of 5 per cent would be achieved by the operating framework put in place by the Urjit Patel committee. However, in his speech he had said he would focus on CPI inflation. Consequently, confusion about the RBI's measure of inflation remains. Ideally, the objective inflation measure should be in the monetary policy law, or stated by the government, as it is in other countries. The RBI should be made accountable to achieve that target. It is not the job of the central bank to define its own targets. This reduces accountability. It is likely that a change in the law will happen during Rajan's tenure, but maybe not soon enough.

Short-term pressures on the rupee may deflect the focus from a clean and transparent monetary policy framework for inflation targeting, as we saw in recent weeks. One option is to move to a fully floating exchange rate, while undertaking financial sector reforms to increase the capability of the private sector to hedge its exposure. This would give the RBI monetary policy autonomy, even though the capital account, de-facto, remains open. The other option is to interfere in markets, impose capital controls and mount interest rate defences in response to exchange rate movements. The extent to which Rajan will follow this path remains to be seen. This is not the appropriate direction for India to be moving in and he will undoubtedly be mindful of that.

Today, too much depends on the personalities in power. The way ahead is institutional change. The Indian Financial Code, recommended by the Financial Sector Legislative Reforms Commission, will require the government to give the RBI a clear target, to achieve which it will be given independence and made accountable. The enactment of the code will pave the way to making the RBI an inflation-targeting central bank with a well defined objective and policy instrument. Until then, Rajan will likely walk a tightrope and we may see knee-jerk reactions from the RBI, in its trying to achieve too many objectives with too many instruments. The outcome will also depend on the political pressure on the RBI. The next finance minister may not respect Rajan's decisions. Institutionalising the new framework should be his top priority.

Reverse liquidity tightening

Financial Express, 19th September 2013

Reserve Bank of India took a number of steps to tighten liquidity and raise rates in mid-July. As a consequence of these steps interest rates today are up to 400 basis points higher than they were in the beginning of July. While this rate hike is reminiscent of the rate hike of 200 basis points by Bimal Jalan on January 16, 1998, when he stepped in to defend the rupee in the Asian crisis, such a steep policy rate hike has never been done before. Moreover, it was implemented through non-transparent and quantitative measures that have damaged the operating procedure of monetary policy.

While some other emerging markets (EMs) have also defended their currencies with interest rate hikes, it has not been so brutal. It has also been done primarily by raising policy rates and not by breaking down the operating framework of monetary policy.

In its credit policy announcement RBI must first and foremost reverse these steps and restore the operating procedure of monetary policy. Only then can it discuss the stance of monetary policy. No monetary policy designed to manage expectations can deliver any meaningful objectives if rates are raised so sharply and so suddenly. The tightening was supposed to be temporary and so reversing the measures will not damage RBI's reputation for consistency. The current phase of lower pressure on EM currencies offers a window to correct the policy mistakes made in the last two months.

Mid-summer tightening

On July 15, Reserve Bank put in place measures in response to the pressure on the rupee to depreciate. They included raising the MSF rate by 200 bps to 10.25%, restricting the overall access by way of repos under the liquidity adjusted facility (LAF) to R750 billion and undertaking open market sales of government securities of R25 billion on July 18.

On July 23, RBI modified the liquidity tightening measures by regulating access to LAF by way of repos at each individual bank level and restricting it to 0.5% of the bank's own NDTL. This measure came into effect from July 24, 2013. The cash reserve ratio (CRR), which banks have to maintain on a fortnightly average basis subject to a daily minimum requirement of 70%, was modified to require banks to maintain a daily minimum of 99% of the requirement.

On August 8, the central bank augmented its measures to tighten liquidity by announcing the decision to auction GoI Cash Management Bills for a notified amount of R220 billion once every week.

Figure 1: Interest rate defence and breakdown of operating procedure

The announcement of the MSF rate hike sent inter-bank markets into a spin and the weighted average call money rate breached both the upper and lower bounds of the modified operating corridor of monetary policy. This is the first time the RBI has deviated from the ±100 bps fixed width corridor around the repo rate after it announced its new monetary policy in May 2011.

The policy framework

Figure 2: Structural liquidity deficit, rate hike pushes banks from LAF to MSF

RBI announced its current monetary policy framework in May 2011 to move to an explicit operating target, a single policy rate and a formal corridor system with a symmetric 100 bps spread on either side of the policy rate. The single policy rate as per the new operating procedure was the repo rate with the reverse repo being the lower bound of the policy corridor and the marginal standing facility (MSF)/bank rate being the upper bound of the policy corridor, distributed 100 bps below and above the repo rate. The explicit target according to the new operating procedure was the weighted average call money rate which would be targeted to lie within the policy corridor as determined by the prevailing repo rate. The LAF window was recommended to be used up to ±1% net demand and time liabilities (NDTL) of the banking system.The MSF or the penal bank rate was to be used for liquidity operations up to ±2% of NDTL of the banking system.

The LAF has never operated within the set bounds of ±1% NDTL throughout its operational history. Given this operational laxity, banks seldom accessed the penal MSF window. After RBI decided to tightly implement the LAF window operation on July 15 and cut it to ±0.5% on July 23, the entire borrowing from the LAF switched to the MSF given the structural liquidity deficit in the banking system. This correspondingly caused all other money market rates to rise

Figure 3: Decoupling of rates, breakdown of transmission

Will lending rates rise?

Figure 4: Lending rates

The secondary market 91-day treasury bill rate captures both the direction of policy rates and liquidity conditions. When compared to the movements of interest rates on bank deposits and lending, it is evident that there is no quick or full transmission of monetary policy. However, as the RBI has noted the behaviour of the banking sector is asymmetrical. When rates ease, banks do not lower rates, but when they rise, they are quick to raise rates. This suggests that if the recent high rates continue, lending rates of banks will rise.

Figure 5: Comparing India to EM peers

When exchange market pressure hit EMs following Bernanke's speech, countries such as Brazil, Turkey and Indonesia also raised interest rates. However, they raised them using policy rates, rather than through quantitative measures that tightened liquidity or by breaking down the operating framework of monetary policy and by much less than India did. India's interest rate defence has been a costly exercise-both, in terms of the up to 400 basis point increase in interest rates that we see today and in terms of the breakdown of the operating procedure of monetary policy that has been implemented by RBI in this effort. RBI must immediately reverse the steps taken and restore the operating framework of monetary policy.

Co-authored by Shekhar Hari Kumar

Some RBI dos and don'ts

Indian Express, 18th September 2013

It should slash interest rates, stop worrying about inflation or the rupee.

A few weeks ago, in a measure described as temporary, the RBI raised interest rates and tightened liquidity to defend the rupee. Today, interest rates are up to 400 basis points higher than they were in July. These should be reduced immediately, before they are transmitted to higher bank lending rates. That would mean a reversal of the RBI's measures.

Once the short-term steps are reversed, there can be a discussion on monetary policy and on whether the repo rate should be changed. The first argument for cutting rates is forecasts of lower non-food inflation. Demand conditions in the domestic economy are weakening. Not only have consumer and investment demand slumped sharply, the latest quarterly expenditure-based GDP data indicates a demand contraction. It shows a decline of 8.2 per cent in seasonally adjusted private final consumption expenditure, and of 14.2 per cent in gross fixed capital formation. The quality of this data is suspect, so we corroborate it with firm-level data, which also shows a sharp fall in new investment activity. All this points towards a lower non-food inflation forecast, because of declining demand.

However, it may be argued that there could be inflation due to an exchange rate depreciation. One measure of tradeables inflation is the US producer price index multiplied by the rupee-dollar exchange rate. This measure takes into account commodity prices, raw materials for industry, price of output when it can be exported or imported, as well as the exchange rate. Since commodity price inflation is low, it shows that even after including the most recent depreciation, tradeables inflation has fallen sharply. The trend suggests that in coming months, inflation is unlikely to rise significantly because of import inflation.

Most central banks, including the RBI, look at a measure of core inflation to forecast consumer price inflation. It is a measure that captures demand conditions in the economy. Core inflation excludes the most volatile part of inflation, caused by transitory factors that must be excluded while making inflation forecasts. In recent months, core inflation, whether measured by the non-food, non-fuel WPI or the non-food WPI, has declined to below 3 per cent. It has been below 5 per cent for most of 2013, creating confidence that this is not simply a one-off phenomenon. We usually see high persistence in this measure of inflation. It therefore suggests that core inflation is likely to remain low.

The second element in a discussion on the choice of monetary policy is the output gap. While there appears to be a decline in India's potential output, the actual fall in output appears to be much larger. This indicates that there is an increase in the output gap. An increase in demand can expand output even without an increase in capacity. This increase in demand can come from external or internal sources. In our case, there is not much of a case for fiscal expansion, since the deficit is already high and its increase can lead to other difficulties, such as a fall in the country's credit rating. Monetary easing can, however, help increase demand by households and firms.

An additional impact of monetary easing is currency depreciation, which can help increase demand for tradeables. Despite the recent data showing an improvement in exports, there remains a lot of pessimism about the price elasticity of tradeables, both exports and imports, in India today. While it may be true that in the short run the price elasticity of exports and imports is often low, it is rarely zero, and is clearly not positive. A depreciation serves the same purpose as an import duty combined with an export subsidy. As most people will agree, an import duty raises the price of imported goods. A depreciation also does this, across the board and without government interference or an army of customs officers, and without the smuggling and illegality that high duties often bring.

India is now seeing one of the worse declines in production and output. Regardless of the time that an exchange rate change will take to create an adjustment in the current account, the direction needs to be towards a weaker currency. If there existed measures of the real exchange rate which would help identify the precise long-run equilibrium, then at the present stage of the cycle, a weaker currency should be preferred for its expansionary impact.

We finally turn to the question of credibility of the central bank. Since 2008, the RBI has allowed the rupee to float and followed an independent monetary policy. It raised rates, even while the US lowered theirs, in response to domestic business cycle conditions, which then showed that inflation forecasts were higher than its targeted levels. While there was no specific inflation target, and the RBI sometimes made confused speeches about it, there was a shift towards indicating that inflation control was gaining superiority over exchange-rate targeting as the objective of monetary policy.

Earlier this year, in pursuit of monetary policy independence, within the constraints of the trilemma, the RBI indicated that its forecast for inflation and output gap now warranted a cut in interest rates. This was done even though there was a very high likelihood of interest rates rising in the US. The implication was that the RBI, by floating the exchange rate, had now created the space for a monetary policy that could respond to domestic business cycles. The fact that it failed to explicitly state the target, the measure and give up its other objectives appears to have come back to haunt it now. But when Ben Bernanke indicated that he would taper QE, the RBI appears to have lost its nerve. It tightened monetary policy in a needless defence of the rupee and not because domestic business cycle conditions warranted it. But one saving grace was that it was emphasised that the increase in marginal standing facility rates and tightening of borrowing rules on liquidity adjustment facility were only temporary. Undoing these and going back to the path of monetary easing would not undermine the RBI's credibility, but add to it.

The floating exchange rate has worked well for India from 2007 till now. In downturns, the rupee depreciates, and in good times, it appreciates. If we stay on course, the objective of monetary policy will be clear and consistent. In contrast, going back towards an exchange rate policy will raise a whole new set of uncertainties and hurt investment.

The road ahead for Rajan

Financial Express, 5th September 2013

Reserve Bank of India has a new governor, Raghuram Rajan. While Rajan's immediate job would be to determine the stance of monetary policy, and hand out banking licences, as RBI Governor for the next five years, his main task must be to transform RBI into a modern central bank.

The task of transforming RBI into a modern central bank consists of redefining the mandate of the central bank and its functions, clearly defining the objective of monetary policy and institutions related to conduct of monetary policy, and redesigning the role of RBI as a banking regulator.

These issues have been raised by a number of official committees, including the one headed by Rajan himself. Most recently, the Financial Sector Legislative Reforms Commission (FSLRC) made its recommendations. It has three major implications for RBI. First, the central bank should be a regulator only of banking and payments and the monetary authority. Second, the regulatory governance for regulation has to be significantly improved. Third, the objective of monetary policy should be clearly defined.

According to the FSLRC, RBI should have independence and accountability. It should set up a statutory monetary policy committee with powers to take decisions on monetary policy, unlike the present one that is advisory and where decisions are taken by the Governor, who is open to pressure from the ministry of finance. In addition, it recommended that RBI should give up some of its present functions such as those of the government's debt manager, the regulator of markets for securities such as government bonds, currencies and interest rate derivatives, of capital controls and of non-bank financial intermediaries.

Decisions about issues of regulatory architecture and governance would be made by the government. It involves decisions not just about RBI but other regulators as well. The most important task for Rajan will be to help define the objective and functioning of monetary policy.

The fall of the rupee has highlighted India's high inflation. In the last five years, under Governor D Subbarao the rupee was largely allowed to float. However, though policy shifted away from a pegged exchange rate to a floating exchange rate, monetary policy was left unanchored. There was no clear and well defined nominal anchor that could guide price expectations. Though the floating exchange rate gave RBI the opportunity to have an independent monetary policy, by failing to define the objective of monetary policy, and given RBI's multiple other objectives, the rupee was left unanchored. Worse, on a number of occasions, the central bank argued that inflation control was not the main objective of monetary policy.

RBI's commitment to inflation control has been episodic. Some governors like C Rangarajan believed that it was the main job of monetary policy, others like YV Reddy focussed on the exchange rate as the nominal anchor. Even though in the last 5 years there seemed to be some effort at price control, India has now witnessed years of consumer price inflation between 8-10%. In recent surveys, inflationary expectations of households have risen above 10%. The rising demand for gold is another indication of higher inflationary expectations.

The FSLRC has suggested that the RBI Act of 1934 be repealed and a new law more suitable for a modern central bank replace it. In most advanced economies, especially those with recent monetary policy laws, the objectives of monetary policy are contained in the law. The Commission has left it to the government to define what the objective should be. The law is proposed to only say that it will be a measurable nominal objective for which RBI will be held accountable. So, it could be an inflation rate, a price level, nominal GDP or even the level of the rupee.

In the consultations on the proposed Indian Financial Code, Rajan's role is to discuss whether FSLRC's proposal is a suitable proposition or whether the objective of the policy should be written down in the law. The present formulation in IFC is a non-standard one. The new Governor's job is to help the ministry of finance choose the best nominal anchor and, preferably, write it in the law.

His second task would be the constitution of the monetary policy committee (MPC), where again the IFC has a non-standard formulation. One plausible alternative composition, somewhat similar to the Bank of England, might be to have four members, from inside the central bank, including the governor, and three independent experts from outside who bring in diverse views. These members would then vote to choose whether the repo rate should be raised or lowered. Their individual voting stance would have to be justified and made public to prevent them from either being quiet yes-men or from being unnecessarily contrarian. Rajan will have to work hard on building a well functioning MPC.

Coming to the here-and-now, the stance of monetary policy is no doubt going to involve difficult decisions. The economy is faced with a stagflation. It would have been much simpler for him if it was either high growth and high inflation, or low growth and low inflation. Standard rules of monetary policy could have been easily used. To make matters worse for inflation the rupee is under acute pressure and monetary easing would increase the pressure.

The trade-offs are difficult. Ultimately, the only instrument in RBI's hands is the interest rate. While RBI may sometimes try changes to the CRR, sometimes foreign exchange intervention or sale and purchase of government bonds, or changes to some specific interest rates, ultimately it is bank interest rate that will be impacted and affect firms and households. As demonstrated in the last few weeks, trying to address these multiple objectives with a single instrument is impossible. Rajan will have to find the right balance between his emphasis on growth, inflation and the rupee, and choose whether to raise rates or lower them. There are no simple answers.

Fighting the taper

Indian Express, 3rd September 2013

Volatility is inevitable. India should prepare its response to the winding up of QE

The dominant theme at the annual meeting of central bankers and economists last week at Jackson Hole, Wyoming, was the impact of Quantitative Easing (QE) tapering on emerging markets (EM). Central bankers from emerging economies pressed Fed officials to consider the volatility in emerging economies arising from changes in the Fed's monetary policy stance. But Fed officials reminded them that their mandate was only to serve the US economy. Emerging markets would have to adjust.

Knowing that the world will be a more volatile place gives us time to prepare. India's policy response to QE tapering should be prepared in advance so that we do not see more of the kind of knee-jerk reactions that were seen last month. It is expected that September may see more forward guidance by the Fed, rather than actual tapering. The pace and timing of the tapering are likely to remain uncertain for many months. This could result in huge volatility in global financial markets. One important question for India will be whether to respond to the pressure on the currency and if so, how.

First, let us look at what lies ahead. The objective of the US Fed's monetary policy is to maintain price stability and achieve maximum employment. The Federal Open Market Committee is responsible for taking decisions on how to achieve these objectives. In normal times, this was done by cutting or raising the policy interest rate. On December 16, 2008 the policy interest rate was cut to the lowest possible level of 0-0.25 per cent. After this, there was no scope of cutting interest rates and the Fed eased monetary policy by purchasing financial assets, thereby stimulating growth, popularly known as QE. The Fed announced its first round of purchases in November 2008 and started buying bonds from March 2009. There have subsequently been two more rounds of QE, in 2010 and then in 2012, as the US economy did not show signs of recovery. The Fed is currently buying $40 billion of Mortgage Backed Securities and $45 billion worth of US treasury bonds per month. Tapering refers to a reduction in the purchase of such securities by the US Fed.

The US economy has recovered slowly in the first half of 2013, with the recovery expected to be faster in the second half. In Q2 2013, the US economy grew at 1.7 per cent. Growth in Q3 and Q4 is expected to be 2.5 per cent. Inflation is around the desired level of 2 per cent. The unemployment rate has fallen from 7.9 per cent at the beginning of the year to 7.4 per cent in July. The Fed has indicated that after the unemployment rate reaches 6.5 per cent, it may consider reducing the pace of its balancesheet expansion.

However, even though the Fed has indicated that it could reduce the pace of monetary expansion, an unemployment rate of 6.5 per cent will not trigger the tapering. One reason is that the US unemployment rate is falling not so much because jobs are increasing, but because of lower labour force participation. Less people say they are actively looking for jobs, something that is likely caused by the long recession. The Fed remains worried that merely a lower unemployment rate may not signal a healthier economy.

Even if the tapering starts in the next couple of months, it will only be the beginning of the process. There will be a reduction in purchases, then stopping purchases and later, at some point, sales of treasuries to reduce the size of the Fed balancesheet to tighten monetary policy. For the last five years, when the Fed was expanding its balancesheet, there was a large flow of capital to emerging economies in search for higher returns. Now the prospect of higher US interest rates is attracting capital back to the US. The top 20 traded EM currencies have depreciated on average 6.8 per cent since May 1, 2013. The depreciation has been most pronounced for countries which need more dollar inflows on the capital account to finance their current account deficits. The currencies of South Africa, India and Brazil have fallen more than 15 per cent against the dollar since May 1, 2013.

Looking forward, the markets may see more capital flow volatility. Flows respond to the probability of the timing and speed of QE tapering, which is estimated by market participants depending on their forecasts about the US economy. When US data is different from these forecasts, this probability changes. This results in inflows and outflows to the US, especially from EMs. This causes high volatility in EM currencies and markets. The data to watch for are those for US jobs growth, labour force participation, inflation, mortgage rates and new home sales, among others.

In August, in the face of acute pressure on the rupee, the government and the RBI valiantly tried to defend it, and reduce the current account deficit. They succeeded only in raising interest rates, increasing capital controls, encouraging gold smuggling, distorting financial markets, creating panic and damaging their respective reputations. Instead of silly policies like duties on flat screen TVs or restricting petrol pump timings to 8am to 8pm, as Veerappa Moily had proposed, the government needs to think carefully about its strategy.

Changing the economy's fundamental weaknesses overnight is nearly impossible. The weaker rupee is, however, good both for current account adjustment and for making Indian assets more competitive. Less friction for foreigners who invest in financial markets should be part of the strategy. It is also very important not to send out wrong signals. Only those short-term policies should be proposed that are consistent with longer term objectives of growth, global integration, rule of law and better financial regulation. The entire cabinet, all ministries, regulators and the bureaucracy must be on the same page about the government's decision to attract foreign capital so that innumerable unnecessary restrictions that are being placed today on foreign investors can be removed. The government must prepare a carefully coordinated, coherent and consistent action plan to adjust to the QE tapering and resulting volatility.