Reacting To Reddy

The Reserve Bank of India has surprised market operators somewhat by coming in aggressively through open market operations to quell what it calls speculation in the government securities market. In a scenario where the odds were increasingly stacking up in favour of a fall in interest rates and consequently prices of gilts were being pushed up, the monetary authorities have aggressively put cheaper securities on the market.

The open market operation has been accompanied by a comment by deputy governor Y V Reddy that there was some volatility in prices resulting from speculation and the aim was to put a damper on it. This is not another instance of the press reading the wrong message in a carefully balanced speech by Dr Reddy, as had happened earlier. So the RBI action must be taken to be carefully considered.

 

Dr Reddy has also added that by doing what it has done the RBI is not sending a signal on interest rates but only on securities prices which have gone up much too sharply. But the problem is that price and yield of fixed income paper are inversely related. If operators are bidding up prices then that is precisely because they foresee a fall in interest rates.

The clamour for a cut in interest rates has now been there for quite some time. The RBI governor had for a period refused to respond to this through a cut in the bank rate by both saying that the banks have not responded to earlier signals and also pointing to high interest rates on small savings. This tended to put a floor on interest rates and prevented banks from lowering deposit rates. But that has changed and slowly banks have started to cut interest rates. The latest and most prominent among them being State Bank of India which has just cut its deposit rates. By all accounts, a momentum was building up which would have logically culminated in a cut in interest rates.

The central bank is quite right in frowning upon volatility but there seems good reason for expectations to be built up in a particular direction and the speculation was a reflection of it. The RBI has chosen to put a damper on speculation by using a tool available to it. If it had not done so the market would probably have worked towards lower interest rates but in the process widened the spreads between risk-free paper and the bank's lending rate.

This is especially so when it was becoming apparent that banks were funding their seemingly incessant apettite for gilts by borrowing from the overnight money market. The situation was so stretched that any shock could have destabilised the money and gilt markets. It is probably towards this end that Dr Reddy has advised caution.

Instead of a resounding crash, what RBI has done is to ensure a soft landing. Not too much should be read into the open market operations beacuse the central bank has only drained excess liquidity, as was obvious in the Rs 6,000 crore oversubscritions in last Friday's twin auction of gilts. It will, therefore, be unfortunate to read into Dr Reddy's comment a reluctance on the part of the central bank to see lower interest rates.