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Abheek Barua: Policy on the hop?

Understanding what lay behind the Reserve Bank of India's sudden cut in interest rates

Abheek Barua 

Abheek Barua

I am quite certain that I am not the only market-watcher who was flummoxed by the unexpected cut in the repo rate a couple of days after the Budget. However, I have been told that that I shouldn't really have been quite so surprised - after all, the Reserve Bank of India (RBI) had delivered an "out-of meeting" cut a little over a month ago on January 15 this year. However, I still wonder what the hurry was - the bi-monthly monetary policy is due on April 7 and the central bank could have waited a month before announcing the cut. Typically, a crisis either on the interest-rate or the currency front warrants such "surprise" moves. The last time I checked I couldn't seem to find one.

I am not entirely happy with this kind of reactive policy response. For one, making policy so literally "data- or policy-dependent" is an indirect way of saying that the central bank doesn't have much of a view on the medium term and is making policy on the hop. This has the risk of undermining the market's confidence in the central bank. It could also breed unrealistic expectations about rate moves, as the US Federal Reserve has begun to realise. Any "positive" data release would breed unrealistic expectations of an RBI response leading to an uptick in the markets. If the RBI does not deliver, it would cause markets to sell off. This might mean undesirable volatility in the markets.

The simplest explanation for this unanticipated cut is that the RBI feels that it has fallen behind the proverbial curve and has to make up for lost time by tweaking rates between meetings. That hypothesis isn't quite convincing since the central bank lost the opportunity to move on rates in the February policy. The other view on this is that the RBI wants to make its actions a little too literally "data"- or "policy"-dependent. It wants to cut rates only (but quickly) in response to more information flow on the various preconditions it has laid down for softer rates. In January, it cut the rate in response to remarkably soft inflation.

The early March cut was ostensibly in response to an improvement in the quality of targeted expenditure, particularly the improvement in the ratio of capital to revenue spending. This could mean that unless new information comes along before them, the bi-monthly policy statement will be more of a forum for regulatory announcements than monetary policy announcements, and cuts could happen anytime in between.

The third hypothesis doing the rounds is that there is a complex game being played between the finance ministry and the RBI. There are various structural changes on the anvil that draws from the copious Financial Sector Legislative Reforms Commission (FSLRC) report. A number of them effectively dilute the central bank's regulatory powers. This has triggered a bargaining process in which the RBI manages to retain some of its powers (control over the money markets, for instance, that the Budget threatened to take away) in exchange for a cut in rates.

I am not a great believer in conspiracy theories and so I am going to get carried away with this so-called "political economy" explanation of the central bank's behaviour. My sense is that the central bank has a clear strategy of front-loading rate cuts into the first half of the year. It then treads carefully in the second half for a couple of reasons. The first (and it has stated this quite categorically in the statement accompanying the post-Budget cut) is that it expects inflation to perk up in the second half. A data-dependent policy approach would, thus, tend to close the window for cuts.

The bigger risk is that the US Fed will hike rates either in the middle or in the last quarter of the year - and as the markets get increasingly convinced of this, money is likely to leave emerging market shores and seek safe haven in the United States. If there is pressure on the currency, the last thing a central bank governor would want to do is to cut interest rates.

This leaves one question: if it indeed wants to pack in rate cuts in the first half, why not cut rates in the February policy? One possible reason: it has raised too much of a stink in the past about fiscal irresponsibility to cut rates before at least doing a preliminary review after the announcement of the Budget. Once that was out of the way, it lost no time in cutting rates. Going by this argument, my tea leaves certainly portend a cut in rates once or at best twice more in the first half - and then all goes quiet on the RBI front.

As I said earlier, I am not a big consumer of the explanations based on the idea of quid pro quo between North Block and Mint Street. But I do find some of the "structural changes" in our monetary and public debt management structure intriguing. We often tend to fetishise the very notion of "independence" whatever its impact is. I think the idea of having an independent Public Debt Management Agency (PDMA) is a clear case of fixing something when it ain't broke - and actually ending up breaking something in the process.

We need to accept the fact that in our economy, monetary policy has and will continue to be conducted in the presence of large central and state government borrowings. Intervention in the currency market is imperative to ensure a certain degree of competitiveness. The impact on domestic liquidity has to be managed, and the timing and size of government borrowings can be an important tool in this. The RBI has done a commendable job in doing this. It has also handled state government borrowings (whose fate under the new PDMA remains uncertain) deftly in sync with central government borrowings. In short, any new agency will have to coordinate with the RBI almost on a real-time basis to do its job efficiently. Does it not make sense then to leave the RBI with this remit instead of adding another tier of bureaucracy?

The writer is chief economist, HDFC Bank

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First Published: Sun, March 15 2015. 22:50 IST