Any medical practitioner will agree that the first objective of emergency care is to keep the patient alive. All available means are to be used to achieve this; more conventional modes of treatment can wait till after. These days, central banks around the world increasingly find themselves in the role of providing emergency care to increasingly traumatised financial systems, more so because they have become so interlinked with each other. Since the announcement that Lehman Brothers would file for bankruptcy was made, the US Federal Reserve, the People’s Bank of China (PBOC) and the Reserve Bank of India (RBI) have all acted firmly, though in quite different ways, reflecting their respective perceptions about how the development will impact macroeconomic and financial stability in their economies. The Fed, which some people had expected would cut its benchmark federal funds rate in its scheduled announcement on Tuesday, eventually held steady. This is what it would have done anyway and suggests that it did not view the financial sector situation as detracting from its primary objective of managing inflation, which, though receding, is still a threat. Instead, it took a more targeted approach, helping put together a $85 billion package to bail out AIG, the next candidate for collapse. Why it did for AIG what it didn’t for Lehman is a question that will surely be debated in the days to come, but that is another story. At the other extreme, the PBOC took the view that the macroeconomic environment, already hostile, had become even more so. It chose to cut its benchmark rate to provide a broad-based stimulus to growth, motivated by the fact that inflation had come down rather sharply in recent weeks, while exports, a significant contributor to growth, had decelerated. In a still uncertain global inflationary environment, this can be seen as a risky move, but then, this is economic trauma care!
The RBI chose a middle path. It clearly does not have specific institutions to target, while a more aggressive interest rate move like the PBOC is clearly inconsistent with the current inflationary scenario. What the RBI will do in its October quarterly policy announcement is anybody’s guess as of now, but the recent developments clearly do not warrant a surprise deviation from the current course of policy. Instead, it sought to address the two immediate pressure points “the depreciating exchange rate and the possibility of liquidity pressures as foreign investors cashed in and exited the country. On the former, it clearly signalled its intention to resist further depreciation, using its foreign exchange reserves to the extent possible but also encouraging inward flows by raising permissible rates on non-resident deposits. It is doubtful whether this move will actually stimulate any flows in the immediate future, but what is important is that the Bank’s commitment to the objective is credible. In stemming the rupee’s decline, it will deter those capital outflows which are induced primarily by the expectation of further depreciation. On the liquidity front, the RBI has provided comfort by using its recently acquired powers to reduce the Statutory Liquidity Ratio (SLR) below the previously mandated 25 per cent. Again, the main goal here is to ensure that all the players believe that liquidity will not be a constraint. Overall, these responses are appropriate to the circumstances, keeping the system afloat while deeper threats are identified and understood.
