A week after the Reserve Bank of India (RBI) surprised many with its interest rate and liquidity measures, confusion lingers about what it was trying to accomplish and whether it has actually achieved what it set out to. The inducement for the measures was undoubtedly the belief that tighter liquidity would make the rupee scarcer, thereby increasing its value vis-a-vis the US dollar. The fact that it would also make the rupee more expensive to domestic stakeholders was presumably seen as collateral damage. That this would be somewhat contrary to the policy direction warranted by growth and core inflation considerations was seen as a necessary price to pay for stopping the rupee's sharp decline. After a few days, the rupee does indeed seem to have stabilised, even if it has not moved up significantly. However, some other developments during the week suggest that the measures had some unanticipated consequences, forcing the RBI to react rather clumsily. This makes it appear that the measures had not been clearly thought through.
First, there was the issue of communication. Under its current governor, D Subbarao, the RBI has emphasised clarity and transparency in its communication strategy. But last Monday's announcement did not achieve either of these objectives. On the contrary, its terseness left everybody guessing how the measures were expected to work, and towards what end. Subsequent messages by other government representatives appeared to add to the confusion. For example, the prime minister in his address at Assocham's annual meeting said that the measures were "temporary" and that monetary policy would return to its normal trajectory once the rupee had stabilised. Of course, he did not specify how long this would take. The finance minister, meanwhile, indicated that banks would not raise their lending rates in response to tighter liquidity conditions. And so on.
Second, while the RBI's apparent intent was to conduct a "twist" - to flatten the yield curve by tightening at the short end while minimising rate movements at the long end - things did not pan out that way. The yield on 10-year government securities went up by about 50 basis points in the few days after the measures were announced. Apart from the potential impact on bank lending rates, this sharply reduced the net asset values of debt mutual funds, leading to a rush for redemption. Debt mutual funds are much more widely held now than they were a few short years ago, and many investors will have felt burned by the sudden and sharp loss in value. To mitigate the risk of default, the RBI had to assure these mutual funds special access to liquidity.
Third, auctions of both short-term treasury bills and longer-term securities did not realise the planned amounts because bids were rejected on account of high yields being demanded. When treasury bills are not rolled over, they put cash back into the system, increasing liquidity - which, of course, was precisely what the RBI had been trying to reduce through its various measures! In short, within a week of the measures being taken, there are more questions than answers about their rationale, their overall impact and how long they will be persisted with. Nor is this befuddlement being addressed in any fashion by spokespersons from the RBI. Perhaps the desired clarity will be provided in next week's quarterly review, but at least until then, the dominant impression will be that these were more a panic reaction than a well-considered response to a very difficult situation.
