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Wednesday, July 30, 2008

Responding to the credit policy announcement of yesterday

Inflation, growth

I have an article Parsing the credit policy in Financial Express today in response to RBI's credit policy announcement yesterday.

How can we change this boom and bust cycle?

Towards the end of this article, I argue that we need to see that this kind of shock therapy is not what a mature market economy does. In recent years, we have gone through a sequence of first having loose monetary policy (capital inflows + exchange rate pegging); this ignited a nasty inflation; now we are going through a belated response of raising rates in order to combat this. None of this would happen with a properly structured central bank. With monetary policy reform, we would substantially change the boom and bust cycle that afflicts India.

There is no short rate, there is no monetary policy rule

I am mystified by the 300 bps gap between the repo and reverse repo rates. Why would this be optimal? Suppose the government starts spending (or if RBI buys USD). The call rate will then suddenly crash from near 9% to near 6%. This is no good in terms of fighting inflation. In addition, it makes the job of the financial sector in general and banking in particular extremely hard.

The task of monetary policy is (a) to pin down the short term rate, and (b) to write down and transparently communicate a monetary policy rule, so that expectations about future values of the short rate can then trace out a yield curve. In India we are doing neither. There is no monetary policy rule. There is no short-term policy rate - there is a yawning gulf of two policy rates separated by a 300 bps zone of uncertainty.

Such behaviour on the part of the central bank comes at a cost to the economy. It is not surprising that we then have problems obtaining liquidity on the bond market. Ultimately financial firms including banks charge households and firms in the economy more, to pay for these risks and difficulties. Bad monetary policy induces bad financial intermediation.

RBI regulated entities have no freedom of speech

Watching bankers on television was distressing. CRR had just been raised - this is a tax on banking. Banking stocks had just been damaged: the CMIE Banking services stock price index dropped 7.92% on a day when the broad market fell 3.04%. But bankers on television were above all this. They were praising the wise RBI for having been drafted a Most Optimal Monetary Policy. It was a scene out of a communist country. As the Indian Express editorial says:

However, one unfortunate element of the regulatory regime in Indian banking, clear from the coverage of credit policy, is how little freedom of speech is afforded bankers. With the hike in the CRR, banks have to put additional resources in non-remunerative deposits with the RBI and this hits their profits. When in response to the policy statement bank stock prices were falling, most bankers were standing by saying that they agreed with everything that is being done. Few objected to the announcement that the RBI would set up audits and committees to control the credit growth of banks. In the licence and permit raj that rules the Indian banking system few are willing to say openly how this would affect them.


  1. Ajay,

    I can guess your eye is on the financial sector reforms which can be executed by PM/FM now, so you are talking up the connection between exchange rate and inflation scenario.

    But this statement is completely and absolutely false.

    "In mature market economies, this kind of boom and bust cycle does not arise."

    In any fiat regime, boom and bust cycles always arise, because central banks cannot anticipate where to turn the switch, and by how much. Why, the boom and bust would also arise in a gold standard based economy. What's happening now is not pretty with the US, Euro, Australia, Canada, NZ. Watch for a demand for the Swiss Franc and Japanese Yen.

    It is pointless to monitor bank balance sheets for lending practices after RBI has allowed the Real estate market boom of the past 5 years.

  2. Although I agree with your broad thrust on monetary reforms, please don't go overboard while trying to explain. :-)

    I fully agree about current lack of bond liquidity in Indian markets.

    Please forgive my frankness at times.

  3. Ajay,
    Your points are right on target.

    Just to add - RBI is not working in silos. Finance ministry has been historically been involved with monetary policy decisions. With elections looming large - Politics is one reason I can think of.


  4. This is a very interesting post, and the comments are also fantastic to read. I’ll have to have a little re-think about my own contact form on our new website


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