Limited Options Of Monetary Policy

Updated: Apr 17 2002, 05:30am hrs
The countdown for the monetary policy of April 29, 2002 has already started and punters are putting their money on guessing both the timing and specifics of the measures. There are no cookie points for guessing right that the authorities declared intention is to ensure a non-event and likewise there are no rewards for guessing right that April 29, 2002 will be a gala day for the Reserve Bank of India. The policy document will be predictably long, reflecting great erudition and will produce a status report on a large number of operational/structural issues. The RBI, however, appears to have limited options on what can be labelled as essential monetary policy measures.

One question which would come up is whether a change in the bank rate and/or the cash reserve ratio would be effected before April 29, 2002. Since it is nobodys guess that the RBI will make an upward movement in these instruments, it could be safely assumed that any goodies will be reserved for April 29, 2002.

In taking a view on these measures, it would be necessary to draw a distinction between what the RBI may possibly do and what the RBI should be doing. Again, on the three macro measures - bank rate, CRR and liquidity - the measures are necessarily intertwined.

Given the surfeit of liquidity it would, prima facie, appear that a reduction in the CRR would not be warranted. What does, however, need to be considered is that the RBI is increasingly moving away from the blunt instrument of the CRR to open market operations or OMO. Again, the RBI has veered round to reducing the extent of exemptions on CRR and simultaneously reducing the level of CRR. Although most of the exemptions on CRR were eliminated in the October 2001 policy, there are still some significant exemptions. There is the enervating issue of inter-bank liabilities. It is erroneous to believe that exemption of inter-bank liabilities from CRR would develop the term money market. In the recent period, the RBI has been concerned about the large reliance of some banks on the call market and the appropriate measure would be to reduce the level of CRR and bring all liabilities within the ambit of the CRR. The way the CRR maintenance is constructed, banks are allowed large swings in their day to day positions and therefore, there inevitably is heavy reliance on the money market by a few banks and this has attendant systemic risks.

While relating money market borrowings to some other indicator such as Tier I Capital would be legitimate, there would be a need to also moderate the day-to-day fluctuations in the CRR balances. Wild swings in CRR balances from one day to the next are totally unwarranted and should be discouraged and as such the permissible swings should be tightened. The CRR is a first charge on banks resources and it should not be met through last minute scrambling for funds. If these two measures, ie, removal of all exemptions for CRR and stricter daily maintenance of CRR is prescribed, it would be possible to undertake a one percentage point reduction in CRR from 5.5 to 4.5 per cent which would release Rs11,000 crore, but at least one half of this could be clawed back by changes in the coverage and procedures for maintenance as set out above. The use of OMO could ensure that there is no aggravation of the excess liquidity in the system.

As regards the bank rate, the anticipations are that it would be reduced from 6.5 to 6.0 per cent. We need to recognise that the forward premium on the dollar is around 5.5 per cent and a signal through the rank rate would only fuel expectations of a further round of interest rate decreases. World over, it is recognised that the bottom of the interest rate cycle has been reached and that the next move would be upward. It would be unwise to believe that we are immune to movements in international interest rates. Thus, the prudent course would be not to decrease the rank rate. It should be cautioned that the preferable course would be to reduce the CRR and keep the bank rate unchanged. Not reducing the CRR, but yet reducing the bank rate would be contradictory and would cost the authorities dear.

Given the continuing developments in the financial market, it would only be appropriate to pursue with the development of the Liquidity Adjustment Facility or LAF. A concomitant of a fully functioning LAF is the cessation of assured facilities from the RBI to market players. The time is now apposite to cut back the standing liquidity facilities for banks and primary dealers. In the kind of market envisaged, assured facilities have no place. Given the comfortable liquidity position, the time is appropriate for a deep cut in the assured facilities, both the Collaterised Lending Facility or CLF and export credit refinance. The CLF for banks could be abolished and export refinance reduced from 15 to 10 per cent of outstanding export credit. For PDs, the collaterised liquidity support needs to be reduced by one-half. I am aware of the wrath of my brethren PDs, but we have to think in terms of the longer-term development of the financial sector and not be driven by narrow sectional interests. As such, it is only appropriate that the normal facilities at rank rate should be phased out rapidly and a variable rate system be fully in place. It must be remembered that a LAF was mooted by the Narasimham Committee four years ago and the financial system has to get out of its swaddling clothes.

The RBI must adhere to its tryst to move to a pure inter-bank call market and the four stages to this end should be scrupulously adhered to. Now that the Clearing Corporation of India Limited has become operational, non-banks call notice money market lending should be reduced from 85 to 70 per cent of their average daily lending in 2000-01 and this should be reduced in quarterly phases successively to 40 and 10 per cent and totally phased out by March 2003. Market participants should absorb and not resist the adjustment process to a more efficient market mechanism.

There is a big question mark about the future developments in the debt market, particularly the government securities market, but that requires separate consideration.