Jamal Mecklai: No LAF-ing matter

MARKET MANIAC

One of the joys of writing this column is that from time to time I get buttonholed by people who ask me what I think about the market, often so that they can tell me what they think about the market. Last Saturday, I met an old friend, a generally fairly circumspect fellow, who, in the discussion, talked about an analyst he had spoken to who was totally convinced that the rupee would fall to 45 in the next couple of months. A little later that same night, I ran into another old friend, somewhat less circumspect as I understand, who told me he'd been hearing the rupee will strengthen to 38.

Quite a spread of views, don't you think?

So, let's try and understand what could be behind such completely divergent views. The first one could reflect the belief that the RBI has fallen behind the curve on inflation control, which means that sooner or later the rupee will have to compensate if export growth, which, in any case, has been slowing down sharply, is to sustain. The second view could reflect the belief that the RBI has fallen behind the curve on inflation control, which means they will not be able to intervene to support the dollar (which would result in a continuing increase in money supply), which will continue to fall under the pressure of continuing strong capital flows.

Interestingly, both conclusions stem from the same belief""that the RBI's inflation fighting credibility has lost a lot of ground.

Last week's repo rate and CRR hike, surprising only in its timing (the central bank acted after the market was closed on the last day of the financial year, after two weeks of market trauma, when call rates hit 70 per cent and the rupee rose to its highest intra-day level, of 43.075, since 1999) confirms that the RBI is now trying as aggressively as it can to rein in prices. But, and this is the rub, the cliche about inflation is that it is rather like a genie in a bottle""once it slips out it is desperately difficult to get it back in. Which is why another cliche is that the central bank is supposed to take the punch bowl away just as the party begins to heat up. Overheating, anyone?

Well, let's look at what the RBI has been doing. To its credit, it first started raising rates as early as June last year, when inflation, at 4.68 per cent, appeared to have sustainably crossed 4.5 per cent. Given that the central bank's articulated maximum comfort range was 5-5.5 per cent, this was a prudent move. Indeed, they followed it up in late July with another hike, again in both the repo and reverse repo rates, when inflation, still at 4.68 per cent, looked stubborn at this level.

All to the good. However, they maintained the bank rate steady, indicating""and, indeed, averring""that they felt they had things under control and did not believe that circumstances warranted a higher interest rate regime. Indeed, the government, basking as it was in India's growth story, was quite loud about there being no need for banks to raise borrowing costs.

The market""happily, of course""believed all this. Bank borrowing, asset prices and foreign inflow, which, because of the RBI's incompletely sterilised intervention (to protect exports), veritably poured into money supply, continued to rise sharply.

And, inflation, of course, obliged. Touching 5 per cent briefly in August, it crossed 5.5 per cent by the start of 2007, and there's been no looking back. In December, the RBI raised the CRR to tighten liquidity, which shocked the markets, with equities finally seeing the light. But the rhetoric continued upbeat, sentiment remained strong and asset prices recovered quickly. Inflation gathered pace, and by January end, the RBI finally increased its aggressiveness, not just moving the reverse repo rate up but also targeting the rising real estate and equity markets. Of course, it was too little, too late, and, despite one more CRR hike in February, the year-end liquidity tightening got so grotesque as to make the RBI's liquidity adjustment facility (LAF) a laughing stock.

To my mind, this valiant struggle by the central bank holds up the fact that it is time the RBI's multi-task mandate was redefined. In an increasingly open market, managing monetary policy""which means ensuring low inflation and inflation expectations with the minimum impact on growth""is not an easy task. Even the US Fed, with considerably more open market experience, has difficulty handling that. The RBI, having to manage so many inter-related functions, is unsurprisingly falling short.

To enable the economy to reach its potential in a globalised environment, the RBI's various functions""ensuring subdued inflation, managing the banking sector, regulating markets and acting as the government's investment banker""need to be run separately and independently. The good news is that the government recognises this, with one of the key Budget highlights being the plan to set up a debt management cell, separate from the central bank.

But, this is not nearly enough. We need aggressive privatisation of public sector banks (not least so that they can raise adequate capital to compete) and the creation of an independent and comprehensive market regulator""something akin to the Financial Services Authority in the UK. Perhaps then, we will see a meaningful development of a real yield curve and a liquid bond market, without which the RBI's LAF will, from time to time, break down as it did at the end of March.