The Reserve Bank of India, over the last few months, has not exactly lived up to the high standards of communication and transparency that former Governor D Subbarao wished to set. It has for some time maintained that its monetary policy stance has shifted towards easing money supply, in order to support growth. However, the sharp decline of the rupee over this calendar year rang alarm bells in New Delhi and Mumbai; and in response the RBI took certain steps in July in an attempt to raise the cost of holding dollars. It raised short-term interest rates; the amount that banks could borrow from its liquidity window was capped; and the daily balance of the portion of deposits that the banks needed to leave with the RBI was raised, cutting their freedom to manoeuvre. Naturally, these served to tighten liquidity in the system - the very opposite of the RBI's stated overall policy.
These measures didn't work as planned. The attempted "twist" - keeping short-term rates high while expecting long-term borrowing costs to fall - didn't pan out, as long-term rates also rose. Banks found liquidity constraints had began to bite. Meanwhile, there were lots of government bonds in the market, just as liquidity was tight. Naturally, bond prices fell sharply. And, to top it all off, there was no noticeable impact on the rupee. Worst of all, the communication as to the RBI's aims that accompanied its announcements was found wanting -- merely that they were attempts to control "speculation". Thus the RBI was forced to conduct open-market operations, buying back large amounts of government bonds in August, in an attempt to ease the supply of rupees in the market - but whether this meant it had abandoned its earlier aim of attacking "speculation", or whether it was an ever more short-term liquidity measure than those tightening liquidity in July, was left unclear.
As the new RBI governor, Raghuram Rajan, prepares his first monetary policy review statement, he should keep this confusion in mind. It has always been Dr Rajan's stated belief - and the consensus in the macro-economic profession - that central banks should focus on one instrument to control monetary policy, and that good communication and transparency are crucial to achieving a central bank's ends. The RBI's recent actions have not been satisfactory when judged from that point of view. A plethora of confusing and contradictory instruments have been used, some of which have unknown consequences; and transparency has suffered alongside. If instruments such as retrospective hold-to-maturity valuations, daily borrowing limits and so on are being used by the RBI off-cycle to tighten and loosen liquidity, what is the value of the signal provided by the repo rate and the credit-reserve ratio?
Dr Subbarao's welcome movement towards simplicity and clarity has been compromised by these complications. Worse, these instruments may become part of the structure of monetary policy. Naturally, unwinding their use may be complicated, since they may have more of an effect in being removed than in being enforced. However, Dr Rajan's first policy review statement must make a start towards doing so.
