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Monetary policy: Governor Rajan's imprimatur - Outside View by S.S. TARAPORE
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Monetary policy: Governor Rajan's imprimatur
Sep 23, 2013

Reserve Bank of India (RBI) Governor Raghuram Rajan's maiden monetary policy presentation reflects his unmistakable imprimatur, pedigree, panache and style.

Inaugural statement

Governor Rajan's thoughts were clearly set out in the inaugural statement of September 4, 2013. As enshrined in the RBI Act, 1934, the primary role of the central bank is monetary stability which he unequivocally interprets as low and stable expectations of inflation, whether the inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures. This is a major departure from mainstream thinking in India which bemoans that monetary policy cannot handle structural or imported inflation. Rajan comes out as an inflation fighter irrespective of the source of inflation.

Strengthening monetary policy framework

While setting up the Urjit Patel Committee on September 12, 2013, Rajan stressed that in a globalised and highly inter-connected environment, monetary policy and exchange rate management are intertwined and cannot be operated in separate silos.

In the search for an appropriate nominal anchor for the conduct of monetary policy, Rajan is seeking a focused indicator on to which the guns of monetary policy instruments could be aimed at. Furthermore, Rajan wishes to identify the impediments to the monetary policy process. In other words, Rajan's mission is to undertake a monetary policy soul search.

Sept 20, 2013 monetary policy measures

The measures, viz., (i) reducing the Marginal Standing Facility (MSF) from 10.25% to 9.5% (ii) increasing the policy repo rate under the Liquidity Adjustment Facility (LAF) from 7.25% to 7.50% and (iii) reducing the daily minimum maintenance of the cash reserve ratio (CRR) from 99% to 95%, reflect a well calibrated package.

Rajan obviously recognized that a three percentage points differential between the MSF and the repo rate could be justified only as a very temporary emergency measure and, as it was distortive, needed to be narrowed. By a combination of reduction in the MSF and an increase in the repo rate, he has narrowed the differential from 3 to 2 percentage points. The weighted effective cost of borrowing would come down very gradually, which is to be commended, given the uncertainties. Rajan has done well to clarify that any further change in the minimum daily maintenance of the CRR is not contemplated. The present CRR prescription at 4% is already low and in a lagged reserve requirement it should pose no hardship to banks.

It is stressed that the Wholesale Price Index (WPI) inflation could spike up in the ensuing period with the pass through of international commodity prices, particularly fuel. He also expresses concern that retail inflation has remained elevated for a number of years which has eroded consumer and business confidence. While the good kharif crop could moderate the Consumer Price Index (CPI), there is no room for complacency. He comes out clearly as an inflation control hardliner, in a cerebral sense, in that he is sensitive to developments in the real sector of the economy.

While there is, rightly, great concern on the exchange rate of the rupee, Governor Rajan does well to focus on the internal determinants of the rupee viz the fiscal deficit and domestic inflation.

Liberalisation versus controls

Presenting a refreshing approach to external sector management, he makes the pertinent point that the whole debate should not be one of liberalisation versus controls but of calibrating inflows and outflows.

Importance of communication

Rajan's press conference after the policy announcement on September 20, 2013 is a model of how communication should be undertaken. A common failing of policymakers and regulators, both in India and in other countries is to be patronising and give a sermon at the mount. In contrast, Rajan has perfected the art of levelling with those with whom he communicates. Kudos to Rajan.

Correcting the CAD

In correcting the Current Account Deficit (CAD), the RBI needs to focus to two issues.

(a) Inflation Indexed Bonds (IIBs): While the intention is to issue a Consumer Price Indexed (CPI) linked bonds for retail investors, close attention needs to be given to the terms of the bond. As in the case of the IIBs already issued, the capital value should be fully protected for inflation at the time of redemption. In addition, if the instrument is to strongly attract retail investment, the real interest rate and the nominal interest rate should be attractive. The real rate of interest could be say 2% but if the CPI inflation rate in a year is say 10%, the investor should be given a nominal rate of 12% (2% plus 10%). With an inflation rate of 10% it is stultifying to give a nominal rate of 2.2% as in the present scheme. With an attractive IIB there would be a quantum jump in savings which would result in a large reduction in the CAD and a decline in the inflation rate. But if the authorities baulk at paying a rate commensurate to the inflation rate, the authorities may just as well forget about an IIB for the retail segment.

(b) Mobilisation of domestic gold: Mobilisation of domestic hoards of gold and meeting the demand of users of gold would reduce gold imports and increase financial savings and thereby reduce the CAD. The most enduring solution would be to set up the Bullion Corporation as recommended by the KUB Rao Working Group. This would, however, take time and for the immediate ensuing period, a gold-for-gold bond could be issued for say 3-5 years. The gold bond could carry an interest rate of say 7% and the users of gold could be charged 10%. The banks should be effectively involved. In the absence of mobilisation of domestic gold, the import of gold through official and unofficial channels taken together would remain high and the CAD would also remain high.

Please Note: This article was first published in The Freepress Journal on September 23, 2013. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.


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