Need to rebalance RBI’s interest structure

October 23, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

In its mid-quarterly monetary policy review last month, the Reserve Bank of India (RBI) made some hasty changes in the interest structure. The repo rate was raised possibly because of the rise in inflation and the marginal standing facility (MSF) rate was cut after the rupee recovered against the dollar. The interest structure is still lopsided with short rates exceeding long rates. This anomaly needs to be corrected.

It is believed that the economy is susceptible to a rundown when short rates exceed long rates. A further slowdown, in any case, needs to be prevented and is quite feasible since the compelling conditions that necessitated an interest hike have been contained. There is now enough room for the RBI to restore balance.

The rupee stress has eased and it is likely that the currency will not significantly fall for some time; exports have picked up and the current account deficit will be within manageable limits; FII investments have returned and remittances from abroad have gone up.

The external environment, which at one point threatened a crisis, has also improved. The Federal Reserve delayed the tapering of quantitative easing and after the 17-day shutdown of the U.S. government, operations are back to normal. The only barrier yet to be overcome is inflation.

Even so, the yield curve can be normalized. This is essential to revive the investment cycle and promote employment. Both had reached their bottom in the quarter ending September.

The RBI has to address three issues:
— Short rates are higher than long rates. Interest on 91-day treasury bills, for instance, is higher than the interest on 10-year government bonds. This indicates that liquidity has drastically dried up and puts pressure on equity and money markets.

— The MSF rate is higher than the repo rate by 1.5 percent. Both are policy driven rates. The MSF rate is a penal rate and has to be higher than the repo rate. The difference was increased to 300 bps in mid-September because of suspected speculation in currency market. Now that the rupee has stabilized, the MSF rate has to come down another 50 bps while the RBI has to go in for open market operations to enhance liquidity.

— The repo rate is higher than the September inflation rate by nearly 2 percent. In September 2012, both the repo rate and inflation were at 8 percent. This relation between repo rate and inflation is for the short term and does not really affect consumption and savings. Even with inflation at 6.45 percent, the repo rate can be scaled down. In some countries that have low growth, interest rates have been deliberately lowered below the inflation rate.

In its Oct. 29 review, the RBI has to redesign monetary policy keeping in view the long term and address issues of growth and employment more aggressively.

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