On
27th October the Reserve Bank of India released one
more of its routine quarterly reviews of monetary policy.
On reading the text, an interested observer would consider
this a non-event. The central bank has done virtually
nothing in terms of policy change. Interest rates such
as repo rates at which the RBI lends to the banking
sector which had been reduced in the wake of the global
crisis have been left untouched. And the cash reserve
ratio that impounds a part of the banks' deposits, which
too had been reduced, has not been hiked. The only change
even worth noting was the decision to restore the Statutory
liquidity Ratio (SLR) (or the ratio of investments by
banks in specified—largely government—securities relative
to their net demand and time liabilities) to its earlier
25 per cent level, from the 24 per cent to which it
had been reduced as part of the monetary easing resorted
to in the wake of the crisis. This could in principle
pre-empt a part of the banks' resources, but is without
any import because excess liquidity with the banks had
already encouraged them to invest in SLR securities,
with such investments amounting to 27.6 per cent of
their net demand and time liabilities on October 9,
2009.
Besides this, other changes are principally reductions
in enhanced refinance facilities for export credit provided
by banks and the discontinuation of a couple of special
refinance facilities aimed at increasing liquidity in
the banking system. Put simply, not much has been done,
especially given the RBI's own assessment that ''the
banking system has been awash with liquidity since November
2008'', so that ''the utilisation of the several refinance
facilities instituted by the Reserve Bank'' has been
low.
Despite the absence of anything new in this edition
of a routine quarterly exercise, it attracted much attention
in the financial press. Moreover, the major stock markets
and stock price indices sank on the day of and after
the announcement, and analysts attributed the dampened
sentiment to the monetary policy review. Clearly, for
the financial sector at least, monetary policy today
is far more important than it was in the past. So much
so that a review near-bereft of new substance is significant
enough to elicit a sharp response. There could be two
reasons for the latter. One could be that the financial
sector expected some ''positive'' initiatives which did
not materialise. The other could be that it gleaned
from the review signs of developments that it would
consider adverse. In fact, it possibly was a bit of
both.
The importance of monetary policy clearly derives from
its role in determining the availability and cost of
credit. In earlier times this mattered only because
of the influence this had on productive investment.
So long as the inducement to invest existed, the availability
of reasonably priced credit facilitated such investment.
However, with the onset of financial liberalisation
credit gained in importance because of its enhanced
role in two other areas. First, it supported credit-financed
housing investments, automobile purchases and consumption
of various kinds. Hence, easy and cheap credit spurred
demand, served as a stimulus to economic activity, contributed
to better profit performance and imparted a degree of
buoyancy to financial markets. Second, with liberalisation
increasing the number and types of financial agents,
all of whom are less regulated, credit and leverage
played a role in driving activity in financial markets,
including activity of a largely speculative nature.
Monetary policy has also gained in importance because
an abiding feature of the consecutive waves of ''economic
reform'' in the age of active finance, is growing fiscal
conservatism. Governments now accept in principle, even
if not always in practice, that a proactive fiscal policy
incorporating significant deficit-financed spending
needs to be abjured. They see such intervention as being
potentially inflationary and disruptive of financial
markets. In the view of finance, therefore, macroeconomic
management should rely more on monetary policies devised
by a central bank that should be made independent of
government.
One consequence of this privileging of monetary policy
relative to fiscal policy was that even when the global
crisis, precipitated by a speculative, mismanaged and
poorly regulated financial sector, forced governments
to accept the need for a ''fiscal stimulus'', most stimulus
packages included efforts to pump liquidity into the
system and keep interest rates low Such packages have
served finance well, since they not only benefited real
economy actors but the financial sector as well. In
fact, the scenario today in most developed countries
is one in which the financial sector which was near
collapse is faring better than the real economy, and
within the financial sector, those entities which are
focused on making and managing financial 'investments'
are faring better than those that are dependent on the
revival of credit demand from the real economy (such
as the typical commercial bank).
What the remarkable responses in post-reform India to
monetary policy pronouncements, including the most recent
quarterly review, suggest is that this country too has
seen post-reform changes that give monetary policy and
its consequences an important role in economic management.
In fact, there is reason to believe that the role of
monetary policy would increase substantially in the
immediate future. The reason for this is that a combination
of the outlays necessitated by the Sixth Pay Commission's
recommendations and the moderate fiscal stimulus resorted
to in the wake of the slowdown in growth induced by
the global crisis have substantially increased the government's
deficit-financed spending. The budget for 2009-10 had
projected the fiscal and revenue deficits for the year
at 6.8 and 4.8 per cent respectively, and figures for
the first 5 months of the financial year (April-August)
indicate that 46 and 55 per cent respectively of the
projected deficits have already been incurred. This
increases the pressure on a fiscally conservative government
bound by its own Fiscal Responsibility and Budget Management
Act to prune these deficits. Put otherwise, the fiscal
stimulus is likely to get weaker rather than stronger
in the future, since there is little additional headroom
available on the fiscal front. The reliance on monetary
policy is, therefore, bound to increase.
In fact, the reliance on the monetary lever has already
been substantial in recent months. Between October 2008
and October 2009, the RBI has reduced the repo rate
by 425 basis points from 9.00 per cent to 4.75 per cent,
the reverse repo rate by 275 basis points from 6 per
cent to 3.25 per cent and the cash reserve ratio by
400 basis points from 9 per cent to 5 per cent. In sum,
the central bank has already extended itself significantly
to increase the volume of liquidity and reduce interest
rates.
The financial sector has benefited from the monetary
largesse of governments, both foreign and domestic.
The massive infusion of liquidity into the economies
of the developed countries by their governments has
substantially increased the access of foreign institutional
investors (FII) to cheap finance, which they have been
leveraging to invest in their own equity markets and
in those of emerging markets like India. The net result
has been a remarkable rally in India's stock markets.
That FII-induced rally has, in turn, encouraged domestic
entities to access the cheap liquidity infused by the
RBI to invest in equity and exploit the stock market
boom, driving stock prices even higher. Nothing illustrates
this more than the fact that even banks have leveraged
the excess liquidity in the system to make substantial
investments (of around Rs.92,000 crore during the months
till October in the current financial year) in units
of mutual funds. What banks cannot do as regulated financial
intermediaries, they seem to be doing by finding proxy
investors for themselves.
However, the response to the recent monetary policy
review indicates that all this is not good enough for
financial players. The problem is that there is growing
realisation that markets have overshot the real economy
by a substantial margin, with price earnings ratios
touching uncomfortable levels. If the boom in the stock
market is not to unwind a more robust recovery of the
real economy is necessary. The RBI's growth projections
do not provide grounds for optimism on this front. Credit
off take by the private sector is low, and the growth
in scheduled commercial banks' non-food credit at 4.3
per cent is significantly lower than the growth of 10.5
per cent in the corresponding period of last year. And
the private banks have reined in retail lending which
supports demand, because of the risk accumulated by
their already high exposure to the retail sector. In
fact, foreign banks have reduced their aggregate exposure
to the retail sector. This deprives the system of an
important stimulus for recent growth.
Given all this perhaps the markets were looking for
a concerted effort on the part of the RBI to push credit,
cut interest rates, stimulate demand and the real economy
and provide the foundations for the recent rally in
stock markets. Instead what they have got is an expression
of concern that the government's fiscal deficit is far
too high and a declaration that the stage has been reached
where, given the excess liquidity in the system, a strategy
to exit from the easy money policy adopted in response
to the global crisis must be formulated and implemented.
A reduce fiscal stimulus and monetary tightening if
combined would have seriously adverse consequences.
Even though the quarterly review could do or actually
did little to advance these tentative objectives outlined
by the central bank, the fact that it did not do anything
to the contrary may have frightened markets. However
much they may rail against the State and its intervention,
these markets need either the Finance Ministry or the
Reserve Bank of India to support and increase their
profits. If these agencies even just hold back, disappointment
is intense and the results are intriguing.
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