Abheek Barua: Monetary policy - To a new paradigm?

If the RBI wants to accelerate the shift to a market-determined regime, it has to simultaneously accelerate the process of deregulation.

I am sure that there is some method in the apparent madness that prevails in our money and currency markets but not too many of the market participants I know seem to be aware of it. This has spawned speculation and a host of theories, ranging from the somewhat sensible to the bewilderingly bizarre. On the "sensible" list is the view that the RBI is using exchange rate appreciation as a tool for inflation management and is willing to overlook the cost that it entails in terms of reduced export competitiveness and the pressures on its own balance sheet. This may sound a trifle simplistic but at least it is analytically consistent. On the other extreme is the theory (I suspect this is someone's idea of a joke) is that on a strange whim our central bankers want the rupee to catch up with the Thai Baht""that is, trade at roughly 33 to the US dollar.

The momentum in the markets and the RBI's passivity are likely to breed a specimen of behaviour among market players that can only serve to heighten volatility. Some borrowers that are taking dollar loans have stopped hedging their currency risk in the simple belief that the rupee will continue to appreciate somewhat infinitely. If at some point, the rupee turns around sharply against the dollar, the consequences could be disastrous. Coming to the money markets, if the Liquidity Adjustment Facility (LAF, that was designed to hold call money rates in a corridor flanked by the reverse repo and repo rates) continues to malfunction as it did recently, it is likely to lead to "cash hoarding" by cash-surplus banks. In phases of tight liquidity this would push overnight rates up to stratospheric levels. By the same token short-term rates would plummet when there's a glut of funds.

Market participants (I count myself as one of them) are aware of the loss of independence in domestic monetary policy that increasing integration with the international markets means. They are, however, clear about the fact that at this stage we are far from the kind of capital convertibility regime that would compromise autonomy in monetary management to any significant degree.

For one, we continue a number of restrictions on capital inflow""these can be tightened further if necessary. Second, the RBI still has enough tools in its arsenal to prevent excess volatility in the financial markets and keep price in a range. A bout of dollar buying, for instance, by the RBI sterilised through monetary stabilisation bonds (or perhaps another hike in the cash reserve ratio) can easily check the untrammelled rise in the rupee. This would also make borrowers, importers and exporters a little more cautious in taking risks. The bottom line, as the markets understand it, is the following. If the RBI is not using these mechanisms of control, then it reflects conscious choice and is not a symptom of diminished ability to change the course of markets.

The questions that follow are somewhat simple: is the RBI making a permanent transition to a more "laissez faire" model that necessarily involves greater volatility? Is there any pressing need at this point in time to accelerate this transition? Is it comfortable with the associated risks or will it put regulations in place to mitigate this volatility""for instance, will full hedging of foreign exchange exposures become mandatory? Is it likely to provide periodic liquidity support to banks in times of acute liquidity shortage or will banks be left to fend for themselves? Finally, is it this merely a temporary phase driven perhaps by concerns on imported inflation? Will we return to the paradigm of forex intervention and range-bound money market rates soon?

Whatever the RBI's decision, it is imperative at this stage to communicate this to the markets if it is to put an end to the flux that currently prevails. If indeed, we are on the cusp of structural change in monetary management, the markets need to prepare for it. Second, if a less interventionist structure is indeed a short-term objective, the RBI has to recognise the imperfections and asymmetries in market structure that currently exist. These imperfections make a section of the banking system more vulnerable to the enhanced volatility that comes with a freer regime. Until the financial system moves to a new equilibrium, the central bank could perhaps provide these banks some succour.

Let me take an example .There is significant asymmetry in the liquidity positions of banks. Some are heavy on government bonds and this enables them to access repo funds. Others are short on bonds and heavy on dollars. Given a structure like this, periods of rupee shortage hurt the latter. A market mechanism where the liquidity-rich lend to those in need isn't functioning too well. Overnight rates are frequently breaching the LAF ceiling. The short-term solution is for the RBI to intervene in the forex market, mop up dollars and provide rupee liquidity. If there is a liquidity overhang that follows it can use stabilisation bonds to mop it up.

This is at best a short-term solution. In the medium term, a more liberal monetary order is incompatible with some of the regulations that curb banks' freedom to manage their books. The SLR norm that forces banks to park a quarter of their deposits in government bonds is an example that comes to mind immediately. For banks that have chosen to deploy their deposits in credit rather than government bond, this effectively limits their access to central bank refinance. A cut in this mandated ratio is overdue. If the RBI wants to accelerate the shift to a market-determined regime, it has to simultaneously accelerate the process of deregulation.

The author is chief economist, ABN Amro. The views here are personal