Tuesday, August 27, 2013

A bridge to nowhere

The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage." The central bank, of course has other functions in addition to this, such as the manager of foreign exchange, acting as the banker to the government and a lender of the last resort to the banking system. Maintaining price stability however, has always been seen as the primary objective of any Central Bank in the world. As the incumbent Governor of the Reserve Bank Dr. D. Subbarao prepares to demit office after an eventful tenure, I took a look at his monetary policy actions and the impact they have had on some key indicators in the country.

Subbarao’s tenure at the Reserve Bank has been one of the most challenging of any RBI Governor’s in recent times. Within days of his taking office, financial crises struck the economies of the West. Giant institutions collapsed.  Credit markets froze. World trade came almost to a halt. Stock markets crashed. Commodities plunged. The recession that followed in the U.S. and Europe has been described as the worst since the Great Depression of 1932. Though not a direct party to the tumultuous events unfolding in the developed world, a rub-off effect on India was inevitable.

Subbarao’s tenure has also coincided with a leadership crisis at the centre in New Delhi. In the last few years, a profligate UPA-II sunk itself neck deep in corruption, mega scams hit the headlines, crony capitalism peaked, “policy paralysis” became the buzzword and economic reforms that started in the 1990s reversed, ironically by the same man who was hailed as the architect of those reforms earlier. A welfare state has emerged.

In such an environment, managing the country's monetary policy can be no easy task. The policy under Subbarao followed alternate bouts of easing and tightening liquidity in 'baby steps' of 0.25 to 0.50 percent each at intervals of a few months at a time.

Over a period
Eased liquidity, lowered rates
Oct 08 – Feb 10
Reduced CRR by 4 %
Reduced Repo by 4.25 %, Reverse Repo rate by 2.75 %
Squeezed liquidity, raised rates
Feb 10 – Jan 12
Raised CRR by 1 %
Raised Repo, Reverse Repo rate by 3.50 %
Eased liquidity, lowered rates
Jan 12 – May 13
Reduced CRR by 2%
Reduced Repo, Reverse Repo rate by 1.25 %

What effect, if any, have these steps had on the key indicators stated while embarking on these policy actions? Let us take a look at some of them

Consumer prices have risen more than 50 % in less than five years
Consumer prices have risen continuously, at almost a uniform rate in the last five years. Between October 2008 and June 2013, prices (as indicated by CPI-IW) are up more than 50 % i.e. more than ten percent per annum compounded. Whether Subbarao was tightening credit or easing liquidity, it has clearly had little impact on consumer prices. 

The Rupee has depreciated from Rs. 48 to a $ to Rs. 65 in less than 5 years 
After an initial period of stability, the currency has collapsed. Especially from August 2011 when it was trading at Rs.45, it has been a one way street for the Indian Rupee, trading at around Rs. 65 to a dollar at the time of this writing. It is instructive to note that the Rupee broke its long term trading range (between Rs.45 to 50) in end-2011, when it was clear that the tightening cycle has ended and rates would be lowered going forward. Subbarao reversed the rate cycle with a CRR cut in January 2012.

Industrial production has gone nowhere in the last three years
If the rationale for cutting interest rates starting January 2012 was to promote industrial growth, it has clearly not worked. The Index of Industrial Production has gone nowhere in the last three and a half years - it stood at 163.60 in January 2010 and stands at 164.3 in June 2013. Whether Subbarao was raising rates or lowering them, industry has stagnated. 

In retrospect, vacillating between the demand from industry for lower interest rates and the imperative to tame inflation, monetary policy went nowhere under Subbarao. The cycle of liquidity tightening was abandoned abruptly in January 2012, ostensibly under the pretext of taming inflation. But even the meager mitigation in wholesale inflation rate never reached the end consumers. By lowering interest rates too early, Subbarao clearly jumped the gun, aiding, if not entirely causing the currency collapse. 

A prolonged period of negative interest rates is the primary cause of India’s financial crisis today. Negative interest rates promote investment in hard assets like gold and real estate at the cost of financial assets. Negative interest rates induce excessive borrowing and investment in unviable projects. Negative interest rates cause a flight of capital and depreciate the currency. The high inflation in recent years, and the sharp depreciation of the Rupee is a direct consequence of the RBI’s reluctance to raise rates when the situation demanded. A hawkish RBI is necessary to counter government profligacy.

Ironically, and unfortunately, Subbarao has been blamed for precisely the opposite – for not lowering rates enough. In the media, he is often portrayed as the one taking on the mandarins of the North Block, on issues ranging from interest rates reduction to new bank licences. But the symptoms of the current crisis - high inflation and a depreciating currency - prove that interest rates need to be higher and not lower than what they are. Subbarao probably knew this, but in the wake of the misleading clamor for reducing rates from the industry, politicians, influential economists and the media, could not stand up to his beliefs with conviction. In the end, his policy actions could neither control inflation nor promote growth.

Subbarao took office in the midst of a global crisis. He is now leaving in the midst of a domestic one.

(Also read a related article here)

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