It is an old trick for finance ministers to try and manage expectations before Budget day — so that the announcements on B-day have the maximum impact. It is also a good rule for central bankers to follow that, while markets can be treated to pleasant surprises, there should be no unpleasant ones. On all these counts, the new governor of the Reserve Bank of India (RBI) has something to learn. If he was planning to make no major policy announcements at the time of the quarterly policy review on Friday, he should not have set the stage the previous Monday with a 100-basis point cut in the repo rate, because that made the market expect more. If anything, he should have tempered the market’s expectations, in order to create a positive surprise at the time of the policy review. In the event, he failed to manage expectations — with the predictable results.
You can argue till the cows come home that the RBI’s job is not to manage the market, and that it has to address the real issues in the economy. But, like it or not, the stock market has become a barometer of the merits of any policy announcement. Markets had already softened before the policy statement was released, but their decline after that was unlike anything that has happened before. It would be facile to say that they had received their cues from similarly precipitous declines in the Asian markets. That was of course a factor, but disappointment about the lack of any measures in the monetary policy clearly reinforced the tendency.
Nothing of course prevents the RBI from responding in the coming days and weeks to an evolving situation, but this was Dr Subbarao’s first statement and people were looking for a confidence-boosting message. Instead, the new governor has said in interviews that he is learning on the job (which must be true) and has also conceded an element of self-doubt (which is a measure of honesty that many members of the commentariat do not have!). But even if the RBI is not omniscient, it must present an air of knowing what it is doing. If it was Dr Subbarao’s view that the market needed lower interest rates by 100 basis points and no more, he might have chosen to split the repo rate cut into two; one on Monday to provide some impetus at the beginning of the week and the other on the occasion of the announcement, when attention and expectations were at their highest.
The problem is that the RBI has made some odd assertions, and it is far from certain whether it has a clear view of what is the problem that it must focus on. Its action in the foreign exchange market (selling dollars) has sucked out rupee liquidity, after the government had already tightened the credit market by forcing oil and fertiliser companies to borrow from banks money that should have come from the government. In other words, the liquidity crunch has been substantially government- and RBI-manufactured. Belatedly, the RBI pumped back some of the money through lower reserve ratio requirements, but that may have done little more than undo the earlier damage. Then, the RBI sells dollars to cushion the rupee’s fall, but lower interest rates aid precisely such a fall — yet, in the RBI’s defence, who can argue that the rupee’s fall should not be cushioned lest it crash like the Korean won, or that credit should not be cheaper? Less defensibly, the RBI sees credit growth overshooting its target, and actually wants to reduce the rate of credit growth, even as it recognises the shortage of liquidity. Some (though not all) of these contradictions are perhaps unavoidable in a complex and fast-moving situation in which there are multiple objectives and different levers being used, but errors of judgment also seem evident. Even now, the central bank is probably being too optimistic in its growth assumptions, and too pessimistic in its assessment of inflation.
When all the analysis-paralysis is over, however, the RBI has to figure out why, even after it has infused liquidity into the system, the financial system refuses to pass it on to the ultimate users; if anything, after Friday bankers have been raising interest rates and talking of tightening lending! No one has readymade answers to these complex problems, but the system needs something more than the finance minister declaring that the fundamentals of the economy are sound, that share investors must not panic, and that bankers must lend.
