Suman Bery: Going beyond Kansas

Where next in monetary policy.

Forecasters are famously advised never to predict both an event and its timing. This was certainly the approach adopted by ancient soothsayers and oracles, who, like Alan Greenspan, added ambiguity and obscurity to their counsel.

In my column two months ago ("Animal Spirits"), I was foolhardy enough to violate these principles. I wrote then that "it could be time for sentiment to turn bearish again". Writing at a time when the stock market seemed unstoppable, I cited a range of domestic and international factors that could cause sentiment to change. These included political restlessness within the Congress and its allies and the testing of a new chairman of the US Federal Reserve as possible triggers.

I was, frankly, not expecting to be vindicated quite so quickly. But the sell-off in our stock market, amplifying trends in other emerging markets, and the political controversies and divisions on both reservations and hydrocarbon prices do seem to have produced a distinct shift in mood. Meanwhile, as I also noted, the real economy continues relatively unaffected. The good news continues, such as the strong GDP numbers and the announcement by IBM of its strengthened commitment to India.

In one respect, though, my forecast was premature. I had predicted that the governor of the Reserve Bank of India (RBI) would increase interest rates at the time of the announcement of the annual monetary policy towards the end of April. To the surprise of many, at that time he chose to stay his hand. Last week, to the surprise of even more, he announced an off-cycle increase in the main operational rates, namely the reverse repo and repo rates, the rates at which the RBI borrows and lends funds to the commercial banks.

Since Governor Reddy is an experienced and thoughtful man, it is worth reflecting on both the substance and the symbolism behind this recent move. Unlike the Fed and the Bank of England, there is no formal Board of Governors or Monetary Policy Committee that meets to vote on these changes, nor are the minutes of internal deliberations made public. So we will have to wait for subsequent documents of the Reserve Bank of India staff to get their detailed explanation of this move.

Substantively, my own guess is that the Governor was driven primarily by the need to ensure that the financing of the balance of payments remains robust even at a time of turbulence in domestic and international debt and equity markets.

It is well-known that India's balance of payments is in significant and increasing deficit on the current account. This is reasonable and in many ways to be welcomed. While the proximate cause of the widening deficit is the unchecked rise in oil prices, from the national accounts perspective the deficit indicates that domestic investment exceeds domestic saving. Since our domestic savings rate is strong and rising, and since most observers agree that, unlike, say China, we are probably under-investing, a current account deficit of between 2 and 3 per cent of GDP is not per se unreasonable, provided it can be financed.

However, the current account deficit would be much larger were it not for the massive support we get from workers' remittances (the great bulk of which is considered a receipt on the current, not capital, account). The financing of the deficit itself has also come to depend significantly on portfolio flows, the interest sensitivity of which are, at least for the moment, unknown. Much of the easing in policy interest rates that occurred over the last three or four years was made possible by the unprecedented reduction in nominal interest rates in the major OECD countries, notably Japan and the US. Given the financing pattern of our balance of payments (and the underlying vulnerability represented by our high public debt), it is not surprising that the RBI feels compelled to mirror interest rate developments in overseas markets, which have all been rising.

By virtue of being unexpected, the announcement also carried some symbolic weight. The Governor had indicated on several occasions that he would not be bound by the pre-announced quarterly review dates if there were need to take action in between. In the past, such emergency moves have typically been made in the midst of a speculative attack. By choosing this way, and at this time, the Governor was sending several signals: the independence of the RBI; the fluidity of the situation; the need for the commercial banks to prepare for rising rates; and perhaps, the need for more frequent reviews of interest rate policy, even more than the four that he himself has only recently introduced.

If the above interpretation is at all correct, then last week's move should be seen in the larger sweep of a process under way since the middle of the last decade, under three Governors (Rangarajan, Jalan, Reddy) to prepare our financial system for greater international integration. The journey was stimulated by the Harshad Mehta scam of 1992 and began with the agreement in the mid-1990s to phase out ad hoc Treasury bills. It extended to the gradual liberalisation of deposit and lending interest rates and the development of the government securities market. The whole process has been extensively described in a recent speech by Rakesh Mohan on liquidity management, published in the RBI Bulletin this year; so I will not belabour the point.

There does remain however room for improvement. Markets were surprised by this recent move. This is undesirable and could be dangerous. As Dominique Dwor-Frecaut of Barclays Capital noted in a piece last year, the range of policy objectives that the RBI attempts to juggle through its interest and exchange rate policy leads to lack of clarity in its communication. She points out that such clarity does not require an explicit inflation target: the US Fed's goals are multiple, but its trajectory is clear, allowing the markets to anticipate its move and reducing the need for it to take assertive action.

As was said in the movie The Wizard of Oz, we are not in Kansas anymore. We are beginning to play in the big league of international finance where missteps can be costly. Managing the markets through the media is now an essential part of sophisticated central banking. These are skills that the RBI now needs to strengthen.

The author is Director-General, National Council of Applied Economic Research. The views expressed here are personal

sbery@ncaer.org