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RBI’s do-nothing credit policy is disappointing and could be costly

Written by The Indian Express |
January 28, 2009 3:44:55 am

The second credit policy announcement by RBI Governor D. Subbarao is disappointing. While clearly acknowledging that the world economy was in deep trouble,that the Indian economy was showing visible signs of slowing down and that inflation has fallen sharply,the RBI chose to do nothing. Most importantly he did not cut the reverse repo rate even though banks are parking excess funds with the RBI. Since mid-October the RBI has cut the repo rate from 9 per cent to 5.5 per cent — that is,by 350 basis points. However,even public sector banks which have been cajoled into cutting rates have cut their prime lending rates by not more than 150-175 basis points. The RBI appears to have taken this to mean that there is no point in doing much more — it has already done its bit.

However,when banks do not follow the RBI in cutting rates,it implies that the monetary policy transmission mechanism is broken. The policies the RBI has followed for many years have hampered the development of the bond — currency — derivatives markets that would have provided such a mechanism. The way to handle this situation is two-fold. One,to implement changes which would make the monetary policy transmission work (such as removing the administered interest rates on saving deposits,small savings,removing restrictions on the government bond market,on currency derivatives,etc). The other,to aggressively cut rates. If it needs a 300 basis point rate cut to achieve a 100 basis point cut in bank lending rates then,instead of a discussion of whether it is public or private or foreign banks who have cut interest rates,the need of the hour was to cut policy rates sharply. With the way output and price growth are decelerating on a month on month basis the RBI should have taken action rather than waiting and watching.

The unfortunate part is that even on the data used for conducting monetary policy the RBI is making a mistake. Instead of the focus of monetary policy being on forecasted output and inflation,it is looking at year on year figures that tell us about the past 12 months. As the situation worsens it will be more difficult to come out of the slowdown. Saving ammunition for the future makes little sense if monetary policy actions today take a few months to have an impact. The same rate cut would be more effective now rather than later when the situation is much worse.

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