The real question, which I will address in this and a subsequent article, is whether RBI’s policy on very high real interest rates has been necessary to achieve the objective of either containment of inflation or in achievement of potential GDP growth.
To argue for central bank independence is to argue for motherhood—we all should, and do, believe in it. But does that mean that there should be no checks and balances on the regulator? If there are none, then the impossible question arises—who will regulate the regulator? And how can the demand for independence be assessed? Here, an old ad by former stockbroking firm EF Hutton from the US (in the mid-1980s) is helpful. The simple punchline of the ad was as follows: We make money the old-fashioned way—we earn it! Analogously, a central bank can earn respect through performance. But how does one measure performance? In the present Mexican stand-off between RBI and ministry of finance (MoF), legitimate questions have been raised about the performance of both the protagonists. But what underlies this tension, or open disagreement?
In the heated discussion about RBI’s quest for independence, very few analysts have pointed out the role of RBI in affecting the economy through its policies on interest rates. I understand that, technically, interest rate decision making is handled by an independent agency within RBI (the Monetary Policy Committee, MPC) and not by RBI per se. Thankfully, Acharya does not hide behind this technicality. His speech, absent the polemics, contains an excellent discussion surrounding the concept and practice of bank independence. He discusses the effects on the economy of a responsible central bank—from bank independence, to inflation, to financing of the fiscal deficit, to interest rates.
As an economist, it is my privilege, and independence, to disagree with substantial portions of Acharya’s substantive comments on the facts pertaining to the effects of RBI’s interest rate policies on the economy. If these policies have had an adverse effect on inclusive growth, without contributing much to the lowering of inflation, then we may want to think about this reality being the real McCoy, the raison d’etre for the differences between the government and RBI.
If there is one criticism I have against the academic portion in Acharya’s speech, it is that he speaks with the force of someone who believes he is 100% right. That is okay, and expected, of a politician. But not of an academic, or an academic policy maker. For example, Viral forgets to mention that there are reasoned economists and policymakers—such as former chief economic adviser, Arvind Subramaniam—who have a different take (than RBI’s) on the rules for the transfer of RBI’s surplus to the government. Nor does he mention even one critic of the formation of the MPC. He forgets to note that many of the experts he cites, and does not cite, do not believe that the MPC was a good idea. He forgets to note that New Zealand, which started the MPC movement, is now the first country to abolish it. In addition, Viral cites the example of Volcker defying president Reagan by keeping real interest rates high to contain inflation. He forgets to mention that, for three years (1979-1981), the US had experienced double digit inflation and hence it was necessary to keep real interest rates high.
The real question, which I will address in this and a subsequent article, is whether RBI’s policy on very high real interest rates has been necessary to achieve the objective of either containment of inflation or in achievement of potential GDP growth. I will present all the evidence for all of us to decide whether, in the words of AD Shroff, RBI interest rate policy has been for the “good of the country”.
Most of the problems plaguing the Indian economy—liquidity, NBFCs, NPAs to name a few—will not be solved if RBI had followed a constructive interest policy. But the problems would be much less. Monetary policy is about both the price of money and the quantity of money (liquidity). The primary concern of the central bank should be inflation. If inflation is high, almost any high interest rate policy (as Volcker’s in the late 1970s) is justified. The question remains: What justifies the high interest rate policy pursued by RBI, with average inflation at 3.8% for the last 24 months, and 4.3% for the last 36 months? In the very first MPC meeting chaired by Urjit Patel in early October 2016, the MPC cut the repo rate from 6.25% to 6.0%. The last three inflation numbers available to the MPC, for June, July and August, were 5.8%, 6.1% and 5%, respectively.
The MPC gave the following reason for the rate cut—based on August data, the real repo rate was now 25 bps above what the MPC deemed to be the “target” real rate of 1.25% (6.5% repo minus 5% inflation); hence, the rate cut of 25 bps to bring the real repo rate in line with the target of the MPC. Until this MPC decision, the belief was that RBI was targeting a real repo rate of 1.75% (mid-point of Governor Rajan’s range of 1.5-2%).
The graphic shows the evolution of the real rate since October 2016 (using the MPC definition). Several facts are worth noting. Firstly, in the 24 months since October 2016, the y-o-y inflation rate has averaged 3.9%, the nominal repo rate 6.2%, and the real repo rate 2.3%. Only in 3 of these 25 months has the real repo rate averaged below the MPC target of 1.2%—an average of 0.9% for the three months, January-March 2018. For the rest of the time, the real repo rate has averaged 2.5%, and this average is twice the MPC stated target. In the last 36 months, the real rate has averaged 2%; in the last 24 months, 2.4%. This with drought (in 2015/16), demonetisation in 2016-17, and introduction of GST in 2017-18. Any justification for pursuing the third highest real rate in the world?
Markets are not a random walk, but feed on perceptions and communication. When the MPC announced, boldly and for the world to know, that it was targeting a real repo rate of 1.25%, market participants (and presumably the MoF) took their policy conclusion at face value (as they should). This belief that MPC would follow its original statement (sin?) of real rates led to consequences. Domestic investors and foreign ones bought government securities in the belief that, given its own statements, RBI would cut policy rates. By doubling real rates, and implementing the third highest real rate of any modern economy (third behind Brazil and Russia), the MPC ensured that NPA assets will worsen over time (the banks now had bond losses on top of operational and corruption losses). Foreign investors fled, unable to rationalise RBI policies on interest rates (the same investors Viral Acharya, via his speech, wants to cultivate and attract—and the same investors he warned would punish threats to RBI independence. When oil prices started to rise, India faced a current account financing crisis—$25 billion of debt funds came in last year, and in 2018, close to $10 billion has left our shores. The difference is close to the current $35 billion current account deficit financing problem.
High real rates slow investment, hurt inclusive growth and worsen NPAs. If inflation is low, then why should the economy pay a price? What RBI has to show is that such high rates (again third highest in the world for the last 24 months!) were necessary to achieve low inflation—neither the MPC, nor RBI, has ever communicated this fact, let alone convincingly communicated it.
The point is very simple—the interest rate decision is one of the most important decisions made by any central bank; it is their primary responsibility. In Part II, I will discuss the large and systematic errors made by RBI in its inflation forecasts, something that forms the basis of the decision of the MPC. And in making these forecasts, and making wrong policy, there seems to be zero accountability. This is the real accountability that we should be concerned with.
Surjit s Bhalla
Contributing editor, Indian Express and part-time member of the PM’s Economic Advisory Council.
Views are personal. Surjit tweets @surjitbhalla