Whose policy is it anyway?

CREDIT POLICY: ISSUES & INSIGHTS

Both finance minister P Chidambaram and Prime Minister Manmohan Singh have been taking about interest rates more often than the Reserve Bank of India governor Y V Reddy these days.

While Chidamabaram feels that the central bank should adopt a measured approach towards interest rates, Singh finds no reason for a rate hike when the inflation rate has been rising primarily on account of supply shocks.

Another voice one has heard is that of finance secretary D C Gupta, who makes no secret of the fact that the government favours benign interest rates.

Gupta had his say on a day when the Reserve Bank of India sent a signal to the market that the rates could indeed go up. On October 11, at a Rs 6,000 crore auction of 11-year paper (7.38 per cent 2015 bond), the RBI set the cut-off yield at 6.99 per cent when the secondary market yield of the same paper was 6.82 per cent before the auction result was announced.

Instead of settling for a lower yield and accepting a devolvement "" at least partially "" on itself, the RBI chose to up the yield, making it clear that there was no discomfort in raising interest rates. The finance secretary, however, had other ideas. He felt that any rate hike at this juncture could crimp industrial growth.

To be fair to the government, both Chidambaram and Singh always qualify their statements by saying the RBI is the best judge about taking the final decision on interest rates.

But nobody can deny the pressure these statements put on the country's top money man. Till last year, the pressure on the RBI was to cut rates to spur growth. Now, the pressure is on not raising rates "" and to put it off for as long as possible.

Former RBI governor Bimal Jalan had perfected the art of hearing but not listening. The upcoming credit policy will show whether such pressure works on Reddy or doesn't. But it's obvious that sometimes the RBI and the ministry talk in different languages.

In the last week of March, for example, when the rupee suddenly gained strength against the dollar, former finance minister Jaswant Singh described this as an inflation control exercise; the RBI insisted that the rupee went up against the dollar on account of a sudden spurt in foreign exchange inflows. At that point of time, the central bank had probably run out of securities to sterilise the inflows.

Similarly, when the inflation rate started rising in August, the ministry was believed to be actually pushing for an interest rate hike. The RBI, however, resisted it and governor Reddy took pains to explain that the rise in inflation was predominantly a supply shock.

Later, however, the central bank admitted that the overhang of liquidity would also need to be carefully monitored in view of its potential to pose demand pressures on prices. This was followed by a hike in banks' cash reserve ratio (CRR).

There is nothing new about such divergent views on interest rates. Still fresh in public memory is the sustained battle of wits between former finance secretary Vijay Kelkar and Bimal Jalan on which way interest rates should move "" south or north "" in 1998.

Both sides tried to downplay the "differences" of perception, but the tension between the ministry and the central bank was quite palpable. The tussle between the RBI and former commerce minister Ramakrishna Hegde on the export credit front is also well known.

In 2000, the RBI governor did pay attention to what the government was saying and cut interest rates, but three months later it had to do an embarrassing rollback.

This time the pressure on the RBI is not to raise the rates even though the inflation rate is still high and there are signs of demand pull contributing its might to the spike. Even so, Prime Minister Singh has gone on record to say that the rise in inflation was largely driven by supply shocks and no rate hike is required.

Does this mean that the PMO and North Block will have a larger hand than Mint Road in drafting the next monetary and credit policy? There is, of course, no straight answer to this question.

But the fact is that the overall macro-economic policy continues to be dominated by the fisc, both in terms of the numbers as well as the decision-making process.

The way the fisc is managed "" the quality of fiscal adjustment and not just the level of the deficit, the quality of revenues, the quality of expenditures, and the nature of adjustment both at the Centre and states "" has a significant bearing on growth.

Since monetary policy is operating on a given fiscal determinant, it is quite clear that within that framework monetary policy cannot deliver much.

Under former RBI governor C Rangarajan, the central bank gained substantial freedom to conduct monetary policy primarily by getting the government to agree to pay market rates of interest for its borrowings and also by reducing its right to monetise deficits at will.

Thediscontinuation of the automatic monetisation of central government deficits was a giant step towards fiscal correction as well as giving the RBI functional autonomy in the conduct of monetary policy.

But following the liberalisation of the external sector, capital inflows are increasing, which has meant that foreign currency assets have been playing a larger role than the domestic borrowings in the RBI's balance-sheet.

Now, if a central bank has to maintain macro-economic stability, in particular stability with regard to the external sector, there has to be some freedom available to the RBI with regard to the creation of reserve money.

There is none available. Even though the entire economic regime has changed, the RBI has freedom to manoeuvre only in one area "" the ways and means agreement.

Jalan got the finance ministry to see the lack of alignment in the overall interest rate matrix and coaxed the government to cut administered interest rates in politically-sensitive areas like small savings and public provident fund.

But this time around, the stumbling block is the high government borrowing programme. One of the reasons why the government is against any rate hike is the fact that it will increase the cost of the government borrowing programme.

The RBI thus doesn't have adequate operational freedom for monetary policy management and the lack of it is getting in the way of efficiency in monetary management.

The government also employs another "" more subtle "" way of controlling the mind of the central bank. This is the Trojan horse strategy. It is no coincidence that a majority of RBI governors have been ex-finance secretaries. Be it Manmohan Singh, S Venkitaramanan, R N Malhotra or I G Patel.

Jalan had his mandatory training at North Block (he was finance secretary under V P Singh)) and so has Reddy. Rangarajan was the only recent governor who wasn't part and parcel of the finance ministry at some time or the other. Not that working at North Block is a disadvantage. Influence works both way. The next credit policy will tell who influenced whom more.