A Touch Of Class In Monetary Policy

The Southeast Asian currency crisis has increasingly been talked about in terms of the contagion effect and it was felt that sooner or later India would also become a casualty. So far, the Indian rupee had, relatively speaking, weathered the storm effectively with a nominal depreciation vis-à-vis the US dollar of about 13 per cent between July 1997 and January 16, 1998 compared with a 50-70 per cent depreciation in some other countries. The Moodys noises of a possible downgrade of Indias rating and ridiculous claims that even a 1.5 per cent of GDP current account deficit could be difficult to finance encouraged punters to turn their luck in a speculative spin on the Indian rupee. The Reserve Bank had already lost over $3 billion from the peak of $30 billion and, moreover, there would be forward commitments.

 

The authorities wisely thought it best to signal a change in tactics away from forex intervention to a sharp dose of monetary policy measures. The 2 percentage point bank rate increase, the hike in the cash reserve ratio (CRR) by one half of 1 percentage point, the sharp cut-back in refinance, and the doubling of the interest rate surcharge from 15 per cent to 30 per cent had the desired effect. The ardour of the speculative forces immediately cooled and call money rates and near forwards went into a predictable frenzy.

Now, how does one evaluate the efficacy of these measures? When there is mild turbulence in the forex market, it is appropriate to stabilise the market by forex sales from the reserves. But it is also essential to evaluate the position of the currency vis-a-vis the lodestar of the real effective exchange rate (REER). On the basis of the 36-country model, the REER had appreciated by about 13-14 per cent in August 1997. Since the nominal rupee exchange rate has depreciated about 12 per cent vis-a-vis the US dollar since August 1997, a quick calculation undertaken by resourceful market analysts shows that on a five-country model the REER would, at the present time, show an appreciation of, say, around 4 per cent. The actual 36-country REER figure for January 1998 would be published in the May 1998 bulletin which, for all intents and purposes, would be of no use either to the RBI or market analysts or forex operators. The RBI would now do well to publish the five-country REER in the Weekly

Statistical Supplement and also publish the net forward commitments along with the weekly reserves figures.

One could conjecture that the bulk of the adjustment of the rupee has already taken place and any free fall would be counter productive from the viewpoint of the real sectors. The rupees defence against a market psychology would require a large frittering away of the foreign exchange reserves.

The RBI had been attacked in the recent period of reneging on reforms and going back to the bad old ways of a controls economy. The recent monetary policy measures should dismiss such doubts. The measures are not only well-timed but superbly blended. The monetary policy has been activated after it was recognised that a good part of the REER adjustment had been put through. Also, while putting through the new policy initiatives, the measures were blended with some relaxations of the measures on nostro balances and the square/near-square positions in the forex markets. It is true that the earlier forex market measures were not the best of measures to take but when one is dousing the fires one does not debate between the relative merits of using the garden hose or the kitchen tap.

Banks and industry have predictably howled. But as McChesny Martin of the US Fed said almost 50 years ago, the job of the central bank is to take away the punch bowl just as the party gets going. Governor Jalan may have lost a few friends by his monetary policy measures, but these are sacrifices a governor like him would no doubt make in the noble cause of stability of the Indian monetary system. It is also satisfying that Dr Reddy, who has signed the circular has, in a sense, scored the winning run in a battle that has raged since his Goa speech of August 1997. It is important for all participants to understand the immediate fallout of the measures and react sensibly.

First, the RBI should not roll back the measures till it is satisfied that the objectives have been achieved. When relaxations are warranted, the first measure should be CRR reduction. The indicators for a relaxation should be a clearly sustainable REER. It should ensure that while the measures become effective (or too effective) it does not allow any significant appreciation of the rupee over its current level. The temptation to do so to prove the measures are right is admittedly great, but in a statesman like manner, the RBI should not look for this kudos. In other words, it should renew its purchases early to prevent any large appreciation. Per contra, it should recognise that very high call rates will reflect in high forward premia and the RBI should let the forwards and call rates cool on their own.

Second, banks should recognise the short-term nature of the measures and would be well advised to restrict their deposit rate increases, to the short end of the structure and likewise should carefully assess the situation before raising the medium-term loan rates.

Third, industry must recognise that crying hoarse against the measures is not to their best interests. In fact, industry associations should urge their exporter-importer members to follow sane policies. Covering forward, particularly at phenomenally high premia, does not make sense and if importers avoid a panic reaction, the forwards would come down very quickly to more reasonable levels to reflect the interest rate differential. Per contra, exporters should recognise that the present high forward premia are fleeting and they should encash on them early. The visceral memories of exporters should remind them that in February 1996, the spot rate was Rs 38 and the premium was as high as 20 per cent; exporters who with avarice failed to encash on these premia had to reconcile to spot rates of Rs 34.

The monetary policy measures of January 16, 1998 show that when the chips are down, it is the central bank that pulls the chestnuts out of the fire. The country owes Dr Jalan a debt for safe-guarding the country from the Asian contagion. I hope hot-headed critics will not react in a Pavlovian manner and scream that the monetary tightening reflects mindless monetarism which will hurt the real economy. Nothing could be farther than the truth. Far from hurling unwarranted criticism at the RBI, all economic agents should recognise that Dr Jalan and Dr Reddy are the true saviors of the system.