On 27th October the Reserve Bank of India released one more of its quarterly reviews of monetary policy. Despite the absence of anything new in this edition of a routine exercise, it attracted much attention in financial markets. Clearly, for the financial sector at least, monetary policy today is far more important than it seemed to be in the past.

In earlier times the central bank’s monetary stance mattered only because of the influence this had on productive investment. So long as the inducement to invest existed, the availability of reasonably priced credit facilitated such investment. However, with the onset of financial liberalisation credit gained in importance because of its enhanced role in two other areas. First, it supported credit-financed housing investments, automobile purchases and consumption of various kinds. Hence, easy and cheap credit spurred demand, served as a stimulus to economic activity, contributed to better profit performance and imparted a degree of buoyancy to financial markets. Second, with liberalisation increasing the number and types of financial agents, all of whom are less regulated, credit and leverage played a role in driving activity in financial markets, including activity of a largely speculative nature.

In fact, there is reason to believe that these roles of monetary policy would increase substantially in the immediate future. The reason for this is that a combination of the outlays necessitated by the Sixth Pay Commission’s recommendations and the moderate fiscal stimulus resorted to in the wake of the slowdown in growth induced by the global crisis have substantially increased the government’s deficit-financed spending. This has reduced the headroom available for fiscal policy initiatives aimed at pushing growth. The budget for 2009-10 had projected the fiscal and revenue deficits for the year at 6.8 and 4.8 per cent respectively, and figures for the first 5 months of the financial year (April-August) indicate that 46 and 55 per cent respectively of the projected deficits have already been incurred. This increases the pressure on a fiscally conservative government bound by its own Fiscal Responsibility and Budget Management Act to prune these deficits. Put otherwise, the fiscal stimulus is likely to get weaker, since there is little additional headroom available on the fiscal front. The reliance on monetary policy is, therefore, bound to increase.

In fact, the reliance on the monetary lever has already been substantial in recent months. Between October 2008 and October 2009, the RBI has reduced the repo rate by 425 basis points from 9.00 per cent to 4.75 per cent, the reverse repo rate by 275 basis points from 6 per cent to 3.25 per cent and the cash reserve ratio by 400 basis points from 9 per cent to 5 per cent. In sum, the central bank has already extended itself significantly to increase the volume of liquidity and reduce interest rates.

The financial sector in India has also benefited from such monetary largesse of the central bank, both foreign and domestic. The massive infusion of liquidity into the economies of the developed countries by their governments has substantially increased the access of foreign institutional investors (FII) to cheap finance, which they have been leveraging to invest in their own equity markets and in those of emerging markets like India. The net result has been a remarkable rally in India’s stock markets. That FII-induced rally has, in turn, encouraged domestic entities to access the cheap liquidity infused by the RBI to invest in equity and exploit the stock market boom, driving stock prices even higher. Nothing illustrates this more than the fact that even banks have leveraged the excess liquidity in the system to make substantial investments (of around Rs.92,000 crore during the months till October in the current financial year) in units of mutual funds. What banks cannot do as regulated financial intermediaries, they seem to be doing by finding proxy investors for themselves.

By more or less maintaining the status quo with regard to interest rates and liquidity the Reserve Bank of India has indicated that it would persist with the easy money policy in the foreseeable future. Yet, surprisingly, the major stock markets and stock price indices sank on the day of and after the announcement, and analysts attributed the dampened sentiment to the monetary policy review. This response to the monetary policy review indicates that markets are not satisfied even with the maintenance of the easy money policy. The problem partly is that there is growing realisation that stock markets have overshot the real economy by a substantial margin, with price earnings ratios touching uncomfortable levels. If the boom in the stock market is not to unwind a more robust recovery of the real economy is necessary. The RBI’s growth projections do not provide grounds for optimism on this front. Credit offtake by the private sector is low, and the growth in scheduled commercial banks’ non-food credit at 4.3 per cent is significantly lower than the growth of 10.5 per cent in the corresponding period of last year. And the private banks have reined in retail lending which supports demand, because of the risk accumulated by their already high exposure to the retail sector. In fact, foreign banks have reduced their aggregate exposure to the retail sector. This deprives the system of an important stimulus for recent growth.

Given all this perhaps the markets were looking for a concerted effort on the part of the RBI to push credit, cut interest rates, stimulate demand and the real economy and provide the foundations for the recent rally in stock markets. Instead what they have got is an expression of concern that the government’s fiscal deficit is far too high and a declaration that the stage has been reached where, given the excess liquidity in the system, a strategy to exit from the easy money policy adopted in response to the global crisis must be formulated and implemented. A reduce fiscal stimulus and monetary tightening if combined would have seriously adverse consequences. Perhaps this explains the adverse response of the markets.