Reserve Bank of India governor Raghuram Rajan’s maiden monetary policy announcement has evoked contrary responses. India’s financial markets and a section of the business community have reacted adversely to his decision to increase the repo rate in his policy statement. This is understandable. Dr. Rajan had been in favour of lowering interest rates during his brief stint at the Finance Ministry. That and the terrific buzz that accompanied his assumption of office had led to expectations in some quarters that a rate cut was likely. Others in the business community and many in the media, who had pilloried Dr. Subbarao for his anti-inflationary stance, have made something of a volte face . They have been quick to portray Dr. Rajan as an inflation hawk.
Reading of the policy
Both Dr. Rajan’s detractors and admirers may be wrong in their reading of the monetary policy statement. It appears more plausible that Dr. Rajan’s policy stance is aimed at shoring up the rupee ahead of a change in the U.S. Fed’s policy about three months from now. The RBI may find it prudent not to say so for fear of adding to nervousness in the currency markets. It may choose to couch its stance in anti-inflationary terms. But currency stability seems to weigh more heavily on the RBI than its statement would suggest. Sustaining growth also appears to be a consideration.
Consider the changes effected in the policy statement. Banks can today borrow from the RBI in two ways. One is the repo route but only to the extent of 0.5 per cent of their liabilities. Any requirement in excess of what can be financed by repos can be met through the Marginal Standing Facility (up to 2 per cent of liabilities). In its policy statement, the RBI cut the MSF rate by 75 basis points and raised the repo rate by 25 basis points. The governor claimed that the net effect would be to “reduce the cost of bank financing substantially.” This is debatable.
Analysts estimate that the MSF and the repo account for about 55 per cent and 45 per cent respectively of bank borrowing from the RBI. Factoring in the changes in the two rates, yes, the cost of bank borrowings from the RBI can be expected to decline. The cost of certificates of deposit (CD), which are of maturity of one year or less, has also fallen. However, a cut in the MSF rate only impacts short-term interest rates. Long-term rates are influenced by the repo rate. We should expect long-term rates to rise following the RBI statement — and this is already reflected in a rise of about 30 basis points in 10-year government securities.
It is not just yields on long-term government securities that will rise. When the RBI raises the repo rate, it is a signal that rates across the spectrum will go up, including rates on term deposits. The overall cost of a bank’s deposits will be determined by the composition of its deposits — how much of these are short-term and how much long-term. Once long-term yields rise, deposits will veer towards the long end.
It is more than likely than the total cost of deposits will increase and that this increase will overwhelm the decrease in the cost of borrowing from the RBI. The overall cost of funds for banks may, therefore, be expected to go up. Several bankers have been quoted as saying that they see the overall cost of funds rising for their own banks. Indeed, an anti-inflationary stance, in order to be effective, must necessarily mean a rise in banks’ aggregate funding costs and hence in lending rates. There is a contradiction in claiming that the recent moves are intended to fight inflation but will end up lowering banks’ cost of funds.
For banks, short-term costs of borrowing had risen sharply following the RBI’s tightening of liquidity in July. It was only a matter of time before long-term rates began to catch up. If fighting inflation was the overriding priority, the RBI might have simply persisted with the status quo . What considerations, then, underlie the measures in the latest policy statement?
One is maintaining the present tempo of growth. The sharp rise in short-term rates was having a big impact on firms’ working capital costs. There was the danger that this could cause growth to fall even below the modest 5 per cent that is expected in 2013-14. Moreover, the MSF rate was in danger of becoming the de facto policy rate. This could have caused long-term rates to rise to stratospheric levels. It was important, therefore, to lower the MSF rate and bring it closer to the repo rate.
Inflation and growth
The hike in the repo rate has been positioned as an anti-inflationary stance. Of course, it is so. What is overlooked, however, is that the measures announced last July, put together, were even more anti-inflationary in their potential impact. What is attempted now is a better balance between inflation and growth.
The more important consideration in hiking the repo rate appears to be to push up yields on long-term government securities. This will help maintain a desirable differential with respect to U.S. interest rates ahead of the tapering of QE (quantitative easing) due in about three months from now. Evidently, the RBI takes a serious view of the impact the impending taper could have on the rupee and the Indian economy.
The RBI’s caution is well-merited in light of the debate on the taper in the U.S. itself. It is becoming evident that the calibrated reversal of QE, which the Fed would like, may not be easy to accomplish. Financial markets are forward-looking in nature. Once they know that taper has begun, they will immediately price in the final outcome. This means that the gradual increase in interest rates, which the Fed would like to engineer, may not happen. Instead, yields will rise sharply right away to reflect the end of the taper. It appears that the Fed is trapped in a Chakravyuha of its own making.
A sharp rise in interest rates in the U.S. is bad news for emerging markets, including India, which the rating agency, Moody’s, sees as among the most vulnerable. It spells a sudden and large exodus of funds and a sharp depreciation in the currency. This is the contingency for which the RBI would like to keep the Indian economy in readiness. It would like to nudge the rupee to a level that it feels comfortable with in preparation for the buffeting that may lie ahead.
What would that level be? Well, the Economic Affairs secretary has said that the right level for the rupee today is Rs 59-60. The rupee today is close to Rs 63. The RBI may want to move it up to Rs 60 before the taper begins. It is banking on two initiatives to achieve this outcome. One is the swap facility it has provided to banks to bring in foreign currency NRI deposits with a minimum tenure of three years. The RBI is offering the swap at a cost of 3.5 per cent, which is well below the hedging cost in the market.
The other is the swap facility for banks’ foreign currency borrowings up to 100 per cent of their tier I capital at a concessional rate of one per cent below the market rate. The two schemes together are estimated to bring in about $15 bn -20 bn in the next six months; $1.4 bn has already come in. This inflow of foreign exchange, if accompanied by signs that the economy is moving towards the current account deficit target of $790 bn, has the potential to cause the rupee to move closer to Rs 60.
The RBI’s monetary policy statement is not only or even primarily about inflation. It has more to do with currency stability, and it also has to do with growth. It does not address another important objective, financial stability, but Dr. Rajan has promised to do so in the weeks ahead. Many will find the RBI’s stance altogether reassuring. It reinforces the RBI’s commitment to multiple objectives for monetary policy, as distinct from the single objective of price stability. It is a welcome assertion of the RBI’s distinctive perception of the current economic situation.
It has been said of many who joined the RBI from the ministry that the RBI has a way of quickly converting them to its own view. If Dr. Rajan has indeed been subject to a quick conversion, it bodes well for the autonomy for which the RBI has come to be respected.
(The author is professor, IIM Ahmedabad. ttr@iimahd.ernet.in)
