Flexible inflation mandate vindicated

The Monetary Policy Committee of the RBI needs to be congratulated for taking a timely and appropriate decision to keep rates unchanged, something that surprised markets as the majority expected an interest rate hike of 25 basis points (bps). The change in stance from neutral to “calibrated tightening” also puts to rest any speculation about cut in rates and clearly sends the message that the pause in the rate move is just that — a pause.

The rationale for a “flexible” inflation mandate has been fully vindicated by this decision. While not losing sight of the inflation mandate, the “flexibility” allows the MPC to respond to other important objectives like financial stability, extremely relevant to the RBI’s role as a full service central bank. More insight was gleaned however from the RBI Governor’s press interface than from the monetary policy statement. There are many reasons that justify the action taken by the RBI.

Pause justified

First, the data on growth and inflation — actual and projected — justified the decision to pause and the risks to inflation justified the change in stance.

Second, the fact is that there have already been two successive rate hikes and the current turmoil in debt markets needed a pause. Interest rate differential and stable exchange rates (because of huge inflows) had led to carry positions that needed to get unravelled.

On exchange rates

Third, the markets needed a clear signal on the exchange rate front. By allowing the rupee to adjust to terms of trade shocks, the real sector competitiveness has been provided a much-needed support. The sell-off in the stock and currency markets clearly showed that the decision was not welcomed both by residents who have large un-hedged debt exposures and by foreign portfolio investors in the debt and equity markets.

It is also noteworthy that there is a confident signal, that the level of reserves is sufficient to ensure there is no undue volatility. This hopefully puts to rest any speculation about an NRI bond. Such a bond comes at a high cost and usually originates from leveraged funds. The RBI Governor reiterating that there is no target or band for the exchange rate clearly places inflation and growth as the objectives determining monetary policy.

Fourth, at times of worrying concerns over the ability of NBFCs and HFCs to meet their liabilities, the assurance of stable rates and sufficient liquidity was required to calm the markets. In fact, the bond markets have reacted positively.

Finally, the action and the messages should put speculation at rest. One would have, however, liked the communication on exchange rates and financial stability in the press conference to have found a place in the MPC statement. What is not very clear is whether the MPC factored in the impact of duty cuts on oil products on the fiscal deficit. The MPC has assumed that the government will stick to the deficit target as recently assured, despite the duty cut.

Shifting of government borrowing from the market to small savings may have some impact on bond yields but the impact of overall borrowing on crowding out will be the same. Moreover, the government will have to pay the higher cost of moving market borrowing to small savings. It is good that Deputy Governor Viral Acharya in the press interface highlighted the asset-liability mismatch in the NBFC sector, especially those financing the infra and housing sectors.

This has got exacerbated as long-term yields rose and there was increasing recourse to CPs to maintain the balance-sheet size and market share. It is desirable that NBFCs are subject to Basle-style liquidity and leverage ratios as standalone entities and as a group.

Voluntary retention

On the regulatory side, the concept of a voluntary retention route for foreign portfolio debt investors is an interesting one. Under the proposed route, FPIs will have more operational flexibility in terms of instrument choices as well as exemptions from regulatory provisions such as the cap on short-term investments (less than one year) at 20 per cent of the portfolio size, concentration limits, and caps on exposure to a corporate group (20 per cent of portfolio size and 50 per cent of a single issue).

To be eligible to invest under this route, FPIs would need to voluntarily commit to retain in India a minimum required percentage of their investments for a period of their choice. The details are not yet available, but one hopes that these funds are intended for long term infrastructure funding or for acquiring stressed assets. Will there will be any takers?

(The writer is a former deputy governor of the RBI)