A central bank that has tightened the Cash Reserve Ratio by 100 basis points in just four months and raised interest rates twice in the New Year already cannot, under normal circumstances, be said to be lagging behind in its quest to bring the cost of funds in line with reality. Reserve Bank of India is that central bank. It has a stellar reputation in keeping inflation, by and large, on a tight leash, in a country that has become very firmly addicted to huge and mostly unproductive fiscal deficits. But, the problem is that RBI has made its task a lot more difficult than it already is. That is what this post is about.
From the website of the RBI, these are its main functions:
Formulates, implements and monitors the monetary policy.
Objective: maintaining price stability and ensuring adequate flow of credit to productive sectors.
Regulator and supervisor of the financial system:
Prescribes broad parameters of banking operations within which the country’s banking and financial system functions.
Objective: maintain public confidence in the system, protect depositors’ interest and provide cost-effective banking services to the public.
Manager of Foreign Exchange
Manages the Foreign Exchange Management Act, 1999.
Objective: to facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.
Issuer of currency:
Issues and exchanges or destroys currency and coins not fit for circulation.
Objective: to give the public adequate quantity of supplies of currency notes and coins and in good quality.
Performs a wide range of promotional functions to support national objectives.
Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker.
Banker to banks: maintains banking accounts of all scheduled banks.
As a monetary authority, it is only responsible for ensuring adequate supply of credit to productive sectors. Government is not one of them!
Now, let us fast forward to April 2010. From the third sub-paragraph of the paragraph no. 40 of the recently released Annual Policy Statement 2010-11,
Third, notwithstanding lower budgeted government borrowings in 2010-11 than in the year before, fresh issuance of securities will be 36.3 per cent higher than in the previous year. This presents a dilemma for the Reserve Bank. While monetary policy considerations demand that surplus liquidity should be absorbed, debt management considerations warrant supportive liquidity conditions. The Reserve Bank, therefore, has to do a fine balancing act and ensure that while absorbing excess liquidity, the government borrowing programme is not hampered. [Link]
However, I am not sure that this policy would not prevent this from happening:
Second, inflationary pressures have accentuated in the recent period. More importantly, inflation, which was earlier driven entirely by supply side factors, is now getting increasingly generalised. There is already some evidence that the pricing power of corporates has returned. With the growth expected to accelerate further in the next year, capacity constraints will re-emerge, which are expected to exert further pressure on prices. Inflation expectations also remain at an elevated level. There is, therefore, a need to ensure that demand side inflation does not become entrenched. [Second sub-paragraph of paragraph no. 40].
There is a potential for conflict of objectives here with the central bank running a monetary policy that is aligned with fiscal policy instead of counteracting it. That is what Paul Volcker did in the early 1980s. That acts as a check on the government’s spending tendencies. But, keeping interest rates low (or, lower than they should be) when the government is borrowing and keeping it high when the government is not, risks making monetary policy pro-cyclical.
But, then it is dangerous to think that they do not know what they are doing. They must have done their cost-benefit analysis of this policy versus a counter-cyclical one. We have to wish them luck and a good monsoon ahead. India needs both.