Policy rates need to rise, RBI to take monetary tightening to logical conclusion

Written by P. Vaidyanathan Iyer | Updated: Jun 1 2010, 01:55am hrs
It is another eight weeks before the Reserve Bank of India presents its first quarter review of the monetary policy on July 27. But given the volatility in the domestic financial marketsbe it exchange rate or the stock market indicesthe monetary authoritys job is getting only tougher. It is keeping a close watch on monsoon in India and the debt crisis in Europe, besides monitoring key economic indicators such as the inflation rate. Six months into his new job as deputy governor, Subir Gokarn who is neither from within the RBI ranks nor from the bureaucracyhas quietly and surely brought in fresh thinking in Mint Road. Having just returned from Poland and in between meetings with the finance ministry on G-20 issues, he tells P Vaidyanathan Iyer that the process of monetary tightening will likely continue given the trajectory of the process that started last year.

While inflation may be gradually falling, core inflation (excluding food and energy) has started climbing. Is it not bothering you

If you go back to our policy statement in January, we did point out that the non-food manufacturing inflation accounting for almost 52% of the wholesale price index (WPI) baskethad started to pick up little bit. It was 0.7% for December 2009. It wasnt significant then. We said we were watching this number. Capacity utilisation was getting better and companies were getting back pricing power. But it hadnt crossed the worry threshold and we started to roll back the liquidity put into the system in 2008.

But between December 2009 and February 2010, this number or non-manufacturing inflation rate shot up sharply. In January it stood at 3.3%, February 4.5%and March 4.7%. This necessitated the mid-cycle action in March. There has clearly been an acceleration in non-food manufacturing inflation. The April number is 6.1%. There may be a little bit of distortion in April data, as it factors in the tax changes in Budget. We will get the May numbers on June 14, which will tell us if the trend is consolidating.

Our actions are consistent with the accelerating non-food manufacturing inflation. But, we also have to keep in mind liquidity considerations, government borrowing and growing credit demand. And of course there is global uncertainty. On that front, things can reverse course dramatically. One thing that we are conscious about is that the global stability is not a done deal yet. Events of the past weeks have vividly demonstrated that.

How do you tackle such sharp fluctuations in exchange rates.

The stated policy is that the RBI steps in when volatility is high. But we are not in the business of determining the level. In the last statement, we added a structural element that a significant disruption of economic activity may evoke a response from the RBI.

At present, the liquidity situation is complicated, especially after the recent 3G auctions by the government. We have taken steps in the last couple of days to ensure there is no disruption. (The RBI allowed banks to draw additional funds from it to meet the expected cash crunch due to corporate demand. Withdrawal of money from the system also has implications for liquidity.) As far as the rate itself is concerned, we are managing the volatility, but not the level.

But, arent corporates complaining about the sharp appreciation during the year making India uncompetitive in the global market

There is a dilemma here. A floating exchange rate regime is being viewed as a key component of any financial sector reform agenda. However, there are also significant voices from business and analysts suggesting that we are not in an ideal situation and some management is warranted.

Actions have to be viewed in the context of what is happening globally and in the current situation, exchange rate management is a legitimate policy action. We have to be careful in what we do. Our actions should not give the sense that there is a reversal in the policy stance. If the pressure on the real economy is significant, there will be an argument in favour of management.

Recently, the IMF seems to have had effected a fundamental change in its stanceit has suggested that emerging economies can resort to capital controls if need be.

There is continuity of scenarios here. It is not a black or white situation. Many call it a change of heart, but we do not go that far. The IMF is saying if there is pressure from temporary capital flowssay, from portfolio investmentyou can consider the option of control. The operational issue is: what is the capacity of the system to absorb the inflows. We do have something of a benchmark in terms of our experience of 2007, when we had net capital inflows of over $100 billion. Analysts have said capital inflows will be large this year, and we have to be watchful. But no one has said it will be of the levels of 2007. If inflows are large, but not to that extent, and also over this period absorptive capacity of our economy has grown the pressure on the rupee may not be that significant. We have to look at capital control when you run out of other options. As far as controls are concerned, we will be pragmatic. If the need arises, we will obviously consider them.

Given the global uncertainty, capital inflows into emerging economies do look certain.

There is a time dimension to this from what we have seen in the last few weeks. If there is a global shock, the first reaction of investors is flight to safety vividly demonstrated here. People still believe, when in trouble, run for the dollar, for US securities. US treasury yields have started going downthis may be a short term response to financial turbulence. In the medium term, money will come back to safe markets. But this is a prediction. What is certain is the flight to safety. We have to balance these things out. When flight to safety begins, it can cause enormous instability and liquidity problems. We want to avoid that. Both our adjustment path and our short term approach to liquidity management have to take this into account.

It is here that our learning from 2008 is important. Liquidity constraints can cause serious damage even when the fundamentals of the economy are good.

So, you are saying that these are temporary issues, but you will continue with the tightening policy.

A number of factors have gone into deciding this trajectory. There are two considerations that we have to keep in mind. It is very difficult to reverse policy, there is no do over. If we have to take action, which given the environment, requires reversal, it will be difficult. Even though non-food inflation becoming more visible, the economy is still recovering and there is still some slack in the system. Based on these factors and keeping the global uncertainty in mind, we acted moderately on interest rates. We realise that we are far away from normalcy where our policy rates are concerned. There has to be a correction. We are on a trajectory to achieve this, but this is subject to enormous uncertainty, such as the Greek crisis and how it evolves the performance of the monsoon in terms of timeliness and spatial distribution, etc. Lets not underestimate the degree of uncertainty that exists. Many who argued that our April 2010 actions were too mild, are now saying the opposite. Many have scaled down their recommendations of tightening. The global tightening cycle is seen as getting postponed. Liquidity shocks can emanate from anywhere and transmit right across the globe. So, we dont want to get into a situation, where we over-tighten and then have to retract because of short term developments. We have to move steadily towards a neutral position.

So, are you suggesting a pause on further action before these uncertainties pass through the test of times

There again, a stop-go sequence, sends out very mixed signals. The ideal situation when you are maintaining a trajectory is to take it to its logical conclusion. But, this has to be done in a way that doesnt put you in a situation where you might have to reverse your action without having completed the task, or stop in the middle. The circumstances on the day of the policy review may warrant a deviation, but you dont want to put yourself in a situation, where these deviations are inevitable.