Subbarao's mid-course correction

At a time when banks are cutting rates, RBI signals policy tightening

It was only a few days back that public sector banks reduced their base rate -- the benchmark rate to which all loans are linked to -- for the first time in about an year or so, which signaled downward trend in interest rates.

State-run banks reduced interest rate after a meeting with the Finance Minister P Chidambaram, a meeting -- to review the lenders' quarterly performance-- but in the post meeting news conference, the Finance Minister said he expects banks transmit monetary policy.

RBI reduced the policy rate by 75 bps in 2013, but banks were reluctant to cut base rate. RBI critics said in private circles that what the central bank could not do, the owner has done it, that is, induce banks to cut lending rates.

For the record, not a single major private bank has cut interest rates so far, in response to public sector banks.

Private banks capture about 25% of the loan market as compared to more than 70% market share of public sector banks.

So everyone thought that a softer interest regime has finally ushered in, from a corporate CEO who wants to start a new project to a salary earner to pays his or her home loan in EMIs. They were expecting it for the last 15 months when RBI reduced the policy rate for the first time in three and half years, in April 2012. This time, they thought, the downward cycle is here to stay for a while.

But RBI Governor Duvvuri Subbarao, thought otherwise.

Notwithstanding a decade low economic growth amid high interest rate, last night the central bank, in unequivocal terms, made money dearer -- a step which is in complete contrast with what RBI has done in the last 6 months, that is, reducing policy interest rate to make resources available at relatively lower prices.   

RBI has also made market players ponder whether these steps are a prelude to increasing the cash reserve ratio -- the proportion of deposit that banks keep with RBI as cash -- if not increasing the policy rate.   

In short, RBI has decided to adopt a contractionary monetary policy as is evident from the announcement of conducting a bond sale in open market as compared to what it was doing earlier, which is bond purchase known as expansionary monetary policy.

Also, banks' borrowing from RBI is now capped and if they want to borrow more they have to shell out 300 bps extra, up from 100 bps of the no-cap era.

According to economic theory, expansionary monetary policy is conducted to spur growth and contractionary policy is to tackle inflation. Growth and inflation are the two opposite forces which both governments and central banks always aim to keep in balance.

While India's economic growth --at 5% in 2012-13-- is at decade low, WPI inflation has finally come below RBI's comfort zone of 5% only recently after more than two years.  Headline inflation, though inched up in June, as compared to May, figures released yesterday showed. However, inflation still remained below the central bank's comfort zone.

The  rupee -- which has weakened about 11% since the financial year and is the worst performing currency in Asia -- is exerting pressure on inflation as the country imports more than 70% of its crude oil requirements. Oil prices have shown an upward bias recently though some analysts have termed it temporary citing political uncertainty in Egypt.

So, what made the former bureaucrat turned central banker who was appointed during Chidambaram's previous stint at North Block, to undertake mid-course correction? And at a time when lending rates have just started easing?   

The press statement issued last night justifies the action on the ground of a volatile rupee.

Subbarao has often been criticized for been behind the curve. In his first three years in RBI, even an housewife would have known what to expect from the monetary policy, critics said. Bond market always factored in a rate cut barring an occasion or two when RBI had delivered more that consensus estimate like the annual monetary policy of 2012-13.

"Handmaiden of finance ministry"... "Finance ministry's extension counter" ... were some of phrases attributed to Subbarao  by the media when he took charge in September 2008 amid collapse of investment bank Lehman Brothers -- an event which triggered a global financial meltdown. India which was facing a liquidity crunch that time responded with sharp cut in both policy rates and cash reserve ratio -- the latter unfroze cash from banks for deployment in the productive sector. India had fared the global financial crisis well, with economic growth going back to pre-crisis level of 9% in the following year, everyone acknowledged.

Problem started since then when the inflation genie came out of the bottle and became stubborn for more than two years despite 13 policy rate hike by Subbbarao in a span of two and half years.

The 'baby steps' theory of the governor, that is to increase interest rate slowly as growth was yet to stabilize, was vehemently critisised as inflation stayed high.

However, in one move today, Subbarao -- who now has two and half months left in central bank to end a five year tenure  (neither he is interested in continuing nor there is any indication from finance ministry for an extension till now) -- has silenced both,  'behind the curve' and 'baby steps', critics.

 
When the debate was to whether a status quo or rate cut, RBI now decided to squeezed liquidity -- a giant step which reverses the monetary policy. Bond dealers, which boasted to be ahead of curve, now have to do a catch up job.

The press statement also came on a day when the Finance Minister hurriedly called the Governor yesterday ( Subbarao had to cancel his public speaking programmes in Mumbai to attend a meeting at North Block, where the finance ministry is based) to consider steps that are out of larger monetary policy purview like issuances of sovereign bonds to arrest the sharp fall in rupee.

Last night's press statement was on the pretext of rupee weakness.

Whether making rupee dearer will make it stronger against the dollar will only be known in the next few trading sessions.

Similarly, to know whether repo rate or the cash reserve ratio -- instruments used to signal policy stance -- goes up or not, one will have to wait for 30 July, when the central bank will meet to review its policy stance.  

What is clear is that RBI has declined to be Finance ministry's extension counter.

But, the timing of RBI decisions during Subbarao's five year tenure will always be debated.