In the yellow and dog-eared manual that central bankers keep locked in their desks, there is a script on what to do when an economy is coming out of a downturn. And the script goes something like this: in the initial phase of a recovery one can get very strong growth without much credit expansion. And this is because firms hunker down and cut costs during a downturn, sitting on quite a bit of internal savings. Nonbank financing is also relatively cheap as equity markets lead the recovery. But that does not mean credit growth is unimportant. It is virtually impossible to sustain the recovery without the interest-sensitive parts of consumption and investment picking up in due course. Thus, too early a tightening runs the risk of derailing the recovery. Too late a tightening can, of course, ignite inflationary pressures. But as a central banker you want to see evidence of a broad-based sustained recovery and inflationary pressures before doing anything brave.
This script appeared to be spawning a sub-plot since the July policy review as the RBI added emphasis to financial stability as an objective of monetary policy, over and above the standard growth-inflation trade-off. The focus on financial stability is a direct reflection of the RBI?s (and to be fair other Asian central banks such as the Bank of Korea and the People?s Bank of China) interpretation of the causes of the global financial crisis. Apart from global imbalance, their argument is that with nearly exclusive focus on inflation, which was benign due to large productivity gains, Western central banks maintained easy liquidity for too long a period, which eventually fuelled a sharp asset price (real estate) bubble that eventually burst and brought down the financial system. To avoid repeating the same mistake, financial stability needs to be added to price stability as a salient objective of monetary policy. And, therefore, the RBI could exit earlier than other countries (read the US Fed).
But the subplot has the potential of over running the main script. Even if inflation is almost entirely driven by food prices, which is not dependent on bank credit and, therefore, monetary tightening would be ineffective to curb it, and non-food inflation is still negative, and even if the very sharp upturn in non-agricultural activity still hasn?t shown signs of sustaining, the RBI could still tighten. For example, if it feared that the excess liquidity in the banking system could fuel asset price inflation (read equity, real estate, and commodity prices). Relatedly, if the RBI did not exit after calling for an early exit, its credibility would be brought into question. The last thing a central bank wants to do is to call wolf too many times.
The RBI in yesterday?s policy review did not let the subplot acquire life of its own. It stuck to the main script and kept policy rates and cash reserve requirement unchanged. In the current circumstances exactly the thing to do. The economy still needs a lot of hand holding as private investment, the main driver of growth in the 2000s, is still floundering. Nonfood inflation, the only part of the inflation that can be curbed by squeezing credit, is still negative given the excess capacity in the economy. And in probably the least disruptive a manner, the RBI kept its focus on financial stability alive and its credibility intact by rewinding a bunch of ?unconventional? liquidity measures introduced in the wake of the October crisis?raising the statutory liquidity requirement back to 25%, returning the provisioning for commercial real estate to 1%, removing the special refinancing facilities for banks. Apart from the increase in the provisioning requirement, the other measures are unlikely to have any significant impact given that they were not binding.
Apart from what excites us in the market, the RBI did make some important structural changes to the functioning of financial markets. To increase financial inclusion the RBI will now allow domestic banks to open branches freely in tier 3-6 cities and will allow exchange rate futures in currencies other than just the dollar. These measures are less sexy than policy rate hikes, but are important small steps in developing India?s markets.
What happens now? My guess is that the threat of tightening has already had its desired effect in hardening rates and that the RBI?s even tougher exit language should be taken seriously. Any sign of the excess liquidity seeping into asset prices will elicit a quick reaction, perhaps even before the next review in January. The RBI will keep a close watch on credit growth to detect any emerging sign of inflationary expectations taking hold. It has reduced its expected annual credit growth to 18% from 20%, but given that credit growth so far has been languishing, anything close to 15% would be remarkable. Chances are that the RBI will begin tightening around the January policy review by raising the cash reserve requirement, but not before industrial growth shows more evidence that it is on a sustainable path and the global recovery is less of a rumour and more of a reality. In other words, the dog-eared script is still the best bet on trying to anticipate what the central bank will do next.
?The author is India chief economist, JP Morgan Chase. These are his personal views