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Rajeev Malik: Between a rock and a hard place

Rajeev Malik  |  New Delhi 

The RBI's unexpected move to hike the cash reserve ratio (CRR) raises important concerns about how the policy makers are going about the business of tracking and flagging risks, guiding financial markets' expectations, and ultimately announcing policy actions. The hike also raises several key issues about the appropriate monetary policy setting for the booming Indian economy in the backdrop of flushed global liquidity.
To be fair, the RBI had signalled the possibility of an inter-meeting action in its October policy statement by including the word "promptly" in its statement in describing its reaction function.
Unfortunately, almost everyone missed the central bank's signal owing to the confusion caused by investors' attempts to understand the RBI's thinking behind the surprising repo rate hike.
Still, the choice of hiking the CRR instead of interest rates is surprising in the context of what the central bank indicated in its October policy statement, and the subsequent comments from policymakers, including the finance minister. Indeed, in that statement the RBI appeared to be turning "soft" on its desire and need for deceleration in the pace of lending, and did not think that inflation expectations warranted a hike in the operational reverse repo rate that currently signals the monetary policy stance.
Further, it is unfathomable that the RBI was not aware that WPI inflation was likely to rise in the coming weeks, that the central bank's forecast of 5.0-5.5 per cent over-year-ago was at risk of being breached, and that the reported over-year-ago WPI inflation would remain above the official range for several weeks even though a favourable base effect could bring it back to that range in the last week of the fiscal year. Still, the RBI maintained its inflation forecast in October.
The recent cut in petrol and diesel prices and the seasonal drop in food prices have prevented headline WPI inflation from rising meaningfully. Indeed, the finance minister and the RBI have reportedly emphasised that higher inflation was owing to supply-side issues. Thus, concerns about inflation now compared to what the RBI was thinking and signalling at the time of the October policy as one of the reasons for hiking the CRR are difficult to swallow.
Admittedly, real GDP growth of 9.2 per cent over-year-ago for July-September surprised on the upside, but the magnitude was only 0.3 per cent-point above market expectations, and the difference is not significant to tighten policy unexpectedly.
But perhaps the most puzzling aspect of the CRR hike is the RBI's own recent actions. The central bank likely left its intervention in the foreign exchange market unsterilised, thereby easing the tight liquidity in the local money market and causing call rates to decline. And now the CRR is hiked.
The exceptionally easy global liquidity conditions appear to have amplified the inflows, which in any case were attracted by the unprecedented strength of India's economic momentum. The RBI is correctly worried about the impact of capital inflows on the domestic monetary policy, but appears to be bound by the politicians' gung-ho approach for higher growth. The net result is that the central bank is forced to juggle its policy mix within the constraints imposed by the "impossible trinity".
The current accommodative monetary policy stance in light of easy global liquidity conditions, and Indian politicians' zealous approach to grow as rapidly as possible despite signs of excesses are not without risks. It is quite possible that there will be no mishap and the economic ride continues to be smooth, or even gets better. But those outcomes would be entirely fortuitous and not owing to pragmatic and appropriate policymaking.
The author is vice president and senior economist with JPMorgan Chase Bank, Singapore. The views expressed here are personal

First Published: Tue, December 12 2006. 00:00 IST
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