RBI’s Standstill Policy: Charting Its Own Course

True to its tradition the Reserve Bank of India (RBI) has once again surprised the market. Looking at the Fed rate cut by an unprecedented 75 basis points, and the overall slowdown witnessed in industrial growth during the current year from 11.6 to 9.2% and a fall in growth in non-food credit, India Inc. anticipated a cut in domestic interest rate by the RBI. But the RBI has left all policy rates unchanged at its quarterly review of the Credit Policy.

The RBI has, of course, its own reasons: it expects the GDP growth in 2007-08 to be maintained at around 8.5% subject to no further escalation in international crude prices and barring domestic or external shocks; economy will continue to grow at the same rate even in FY09 despite global slowdown; and the modest deceleration in output growth witnessed in the second and third quarters of FY08 shall be taken care of by the ongoing investment boom as reflected in the sustained demand for domestic and imported capital goods.

Driven by this philosophy, the RBI stayed focused on managing inflation and liquidity risks. According to the RBI, the growth in money supply increased by 22.4% on a year-on-year basis, which is well above the projected trajectory of 17.0% to 17.5% indicated in the 2007-08 Annual Policy Statement. Reserve money too increased by 30.6% on a year-on-year basis as on January 18, 2008 as against 20% prevalent a year ago. Thus, liquidity management has become its prime concern so that it could contain inflation close to 5.0% in fiscal 2008, while “conditioning expectation in the range of 4.0 to 4.5%”, so that inflation can be maintained at around 3% as a medium-term objective.

The current review of monetary policy categorically states that the growth drivers of Indian economy are intact and performing well. And what, therefore, the RBI addresses itself to is managing the price stability without it, of course, tanking growth significantly. After all it’s the inflation that impacts everyone, while growth is evasive for many.

There is, however, a section of economists who opine that the interest rate differential between the policy rates of the US Fed and the RBI may lead to increased capital inflows into the country further worsening the liquidity overhang in the market. Of course, the RBI Governor holds a different opinion: “US rate changes are important but not a determining factor.” Indeed, according to him, there are several other factors such as exchange rate expectations, macroeconomic fundamentals, etc., that impact capital inflows and outflows. At the same time, he avers that it is essential to offer an interest rate to the market, which best optimizes savings and investments in the country. In such a conundrum, the RBI Governor felt that giving more weight for the domestic needs, rather than the overseas data, is more important for him.

As even the Finance Minister observed—though for his own reasons—no  one can say for certain whether the widening ‘interest rate differential’ leads to increase or decrease in capital flows.  But, theoretically, such ‘rate differential’ shall lead to increased inflows of foreign capital, for investors often rush in to encash the arbitrage gains. Nonetheless, in today’s globalized economy where many known theories are faltering, the RBI governor may be right in assuming that in the context of the falling dollar vis-à-vis major global currencies such as pound sterling, euro, and yen, increased interest differential alone may not lead to increased inflows of foreign exchange, just as narrowed interest rate differential in the past failed to arrest increased capital flows.

That aside, when there are no ready-made answers for questions of this nature, it makes great sense to stay glued to the real economy rather than the expectations of the market. And, another noteworthy feature of current review proceedings is that the RBI, perhaps, for the first time, does acknowledge the fact of certain sectors of economy witnessing slowdown in growth. Against this background, RBI’s ‘standstill’ policy will only highlight its firm commitment to manage inflation expectations without sacrificing growth prospects. Over it, the RBI has also made a resolve to monitor the global economy, particularly its heightened uncertainties, and respond swiftly to the emerging situations. Such an intention to stay glued to ground realities is sure to enable the RBI to act readily, if turbulence in global markets threatens growth process in the country.

Interestingly, the RBI, while conceding  that “monitory policy per se can essentially address issues relating to aggregate demand”, has proposed that the “associated policies in the financial sector could, to the extent possible, take account of the evolving circumstances as reflected in the disaggregated analysis.” As a sequel to this, it almost gave a subtle direction to banks, which, in its opinion, are today enjoying sustained profitability as reflected in their net interest margins, to initiate necessary changes for enhancing credit delivery to sectors known for offering intensive employment as the prevailing liquidity conditions in the market do call for such entrepreneurship.

Yet, there is dissension to RBI’s refusal to cut interest rates in certain quarters of the economy, which, in their opinion is likely to inflict recession on the economy. But given the uncertainties associated with the US subprime meltdown, it certainly makes great sense for the RBI to adopt a policy of wait and watch rather than blindly mimicking the Fed’s rate cut. And the RBI has done just that. Bravo RBI!

(March, 2008)