Uncertain Interest Rate Regimes

Updated: Apr 22 2002, 05:30am hrs
With the Statement on Monetary and Credit policy for the year 2002-2003 to be presented within a week, the speculations among market participants and financial press have already begun about the intent and actions of Dr Bimal Jalan. As it happened with the budget, the discussions seem to surround on the same themes such as what will the credit policy do to boost industrial growth Will bank rates be cut further to support a lower interest rate regime Will it undertake measures to further enhance the liquidity in the system etc. Never mind the limited success the monetary policy measures such as cuts in Cash Reserve Ratio/Statutory Liquidity Ratio and interest rates in the past have achieved in terms of reviving the investment and growth process, the argument for further actions in maintaining low interest rates and excess liquidity seem to be becoming louder.

The finance minister and the Reserve Bank of India have been presenting a softer interest rate view to the market over last few weeks, thereby making policy actions in terms of cutting CRR and bank rate the most important aspect of monetary policy. While the resolve of the FM is clear in so far as reducing interest rates is concerned, the view among ruling political parties that interest rate cuts have not gone down well with the public and are in fact responsible for the erosion of the middle class vote bank, might put a pressure on him not to do further rate cuts, all in all making interest rate changes a contentious policy action.

What should the RBI do with respect to interest rates Before answering this question one should ask: Can RBI set the entire term structure of interest rates What has been the reaction of the debt market participants to the policy actions in this regard From the basic monetary theory we know that monetary authority can certainly control the short-term interest rates via its control on short-term liquidity, but the medium and long-term interest rates are to be primarily driven by agents expectations about future inflation and interest rates. The latter, in turn, are determined by fundamental factors such as fiscal deficits. Therefore, while the central bank can affect short-term rates, its control over the entire term structure is at best week. But, what happened over the last one year seems to be at odds with this logic. The downtrend in yields to the tune of 300 bps during the last fiscal year is equally significant both at the short and long end of the yield curve. While the decline in short rates could be attributable to the excess liquidity in the system, how can one explain such a downward rally in long-term bond yields when other fundamentals such as fiscal deficits do not indicate such a pattern Can we say that the market has become, as some traders would like to call it, a momentum market that trades on sentiment rather than on a rational analysis of factors affecting the term structure of interest rates

The irrational exuberance in the bond markets seem to be caused by the belief that the government and RBI would sustain a low interest rate regime with their concerted policy actions even if the fundamentals arent clearly supporting that. This over-reaction from the bond markets need to be checked through systematic policy actions, as any surprise increase in interest rates would lead to huge losses on the open positions on trading book of banks and financial institutions in turn having ripple effects through the financial system. One could argue that the unrealised gains that they have made during the boom time in bond prices should be booked and they could be used to compensate the losses resulting from increase in interest rates. Unless a mechanism is put in place that makes provision for a reserve fund to cover potential losses, the losses on the trading book could hurt the banks seriously. The Investment Fluctuation Reserve mentioned in the previous credit policy is meant to precisely tackle this, but one is not sure about markets are following the norms are not.

The RBI must use the monetary policy statement to deal with some of the problems associated with the bond market bubble and low interest rate syndrome. It should come out clearly with a vision statement that presents a view on interest rate regimes that are expected to prevail taking into account the high fiscal deficits and temporary excess liquidity. A recognition of the unsustainability of one-way movement in interest rates would alert a great deal of market participants to make preparations to face adverse conditions. In the same direction, the policy statement must highlight the need for IFR and put in place for an effective monitoring mechanism in this regard.

The policy statement must recognise the potentially conflicting signals the apex body conveys through its dual roles as monetary policy maker and manager of the public debt. Very often than not, and certainly in the recent past, it is being seen that the monetary policy is subservient to the fiscal and debt management policies. The policy statement must highlight that the primary objective of monetary policy is the financial stability, besides inflation control, and the consideration to finance government borrowings at low cost has to be, at best, of secondary importance. The idea of creating an independent public debt office, in this context, will significantly increase the scope for monetary policy and reduce the uncertainty related to the interest rate movements.

The writer is a consultant with the National Stock Exchange, Mumbai. Views expressed are his own and not that of the NSE. E-mail: gdarbha@nse.co.in