The global financial system is amidst a crisis of unprecedented dimensions
It is not an exaggeration to say that the recent Reserve Bank of India’s monetary policy statement — the Mid-Term Review of the Annual Policy — was hijacked by the extraordinary circumstances under which it was presented. As the new RBI Governor D. Subbarao put it, the review is set in the context of several complex and compelling policy challenges. The global financial system is amidst a crisis of unprecedented dimensions.
Across the world, there have been severe disruptions in money markets, sharp declines in stock markets and extreme risk aversion in financial markets. Governments, central banks and financial regulators are responding to the crisis with radical, unconventional and aggressive measures to restore confidence and stabilise the markets.
If the preamble is easily understood, the RBI’s ‘inaction’ in the policy announcement — it neither reduced the CRR nor effected a cut in the repo rate — has disappointed many, including notably the stock markets.
Although there is a rational explanation in the policy statement for the central bank not touching the key rates, the market’s disappointment seemed to linger well into the following week.
Did the RBI miss the bus as most commentators suggest?
There is little doubt that the market’s appetite had been whetted: the RBI had, since mid-September 2008, brought down the CRR by a massive 2.50 percentage points and reduced the policy repo rate by one percentage point.
Buildup of expectations
The repo rate cut came barely four days before the scheduled credit policy announcement. In addition, the central bank had taken a number of other measures to ease liquidity.
What the government and the RBI considered to be aggressive pre-emptive action was only taken as the starting point — a plateful of appetisers may be — for other, stronger signals in the policy statement proper. The government was seen to be in a crisis mode and responding to the falling stock indices (among other indicators of a deep financial crisis) with monetary measures. From that standpoint, further easing of monetary policy was to be expected in the policy statement; hence the disappointment manifested in further decline in stock prices.
However, while such a view is extremely popular, it ignores the fact that a macro economic policy such as the monetary policy cannot be bent to address short-term concerns such as those posed by a rapidly falling stock market. If (further) interest rate cuts were deemed necessary, it is for the RBI to justify them. Stock market concerns, however sensational, cannot guide monetary policy.
But that is the impression the government — much more than the RBI — seems to have conveyed. It is true that an extraordinarily difficult environment calls for extraordinary responses. But there is nothing to be gained — and plenty to be lost — by correlating stock market behaviour to economic policies.
The collapse of the stock markets is due to the exit of foreign institutional investors which have come to dominate the Indian stock markets.
Risk of wrong moves
There is nothing that the government can do to influence them to stay invested in India in the present context. That India’s economic fundamentals are still strong is beside the point.
So is the distinct possibility of 7.5–8 per cent growth, among the highest in the world, to influence FIIs to stay on in India.
A wrong diagnosis of the causes behind the market meltdown will have unfortunate consequences. If reports are true, government-owned institutions such as the Life Insurance Corporation may be asked to provide funds to buy stocks in a bid to stabilise the market.
Not only is such a move unfeasible in today’s context, but at a later stage the public sector enterprises may have to answer for some dud investments.
Public sector banks have always been risk-averse. In the present juncture, even as the RBI, prodded by the government, seeks to provide liquidity, there is the danger that some of the measures aimed at attracting foreign exchange — thereby minimising the impact of the withdrawal of FIIs — may be counterproductive over the medium term.
Relaxation in external commercial borrowing norms and a hike in interest rates on NRE deposits are two such measures. These are debt creating inflows which official policy has earlier sought to discourage. Moreover, at the present juncture, tapping these two sources may not be such a sound idea. Credit markets abroad will take some time to unfreeze and, even when they do, not much credit may flow to emerging markets like India.
Monetary policy is in any case about the balancing of several often contradictory objectives. These include price stability, sustaining the growth momentum and financial stability. At present, financial stability ranks at the top of policy objectives. Inflation, though coming down sharply, is still in double digits.
Growth is definitely moderating. Central banks the world over have been cutting their benchmark interest rates. But the circumstances in those countries are vastly different from those in India.C. R. L. NARASIMHAN