Book Review: Repo And Its Masters

A RBI governor remembers his doughty fights, but cuts down on the math

WHO MOVED MY INTEREST RATE?
BY DUVVURI SUBBARAO
VIKING | PAGES: 323 | RS. 699

Central banks have been labelled exotic beasts: rarely seen in public, much less understood. Realisation of what central bankers do has been seeping in slowly. Over the past few decades, as bond and currency trading acquired gargantuan propor­ti­­ons, the arcane world of dealers kept a close watch on every statement coming out of central banks, parsing each phrase and analysing each nuance. Any action, or the faintest hint of a future one, had the potential to affect currency prices, bond rates and indi­vidual fortunes. This need for analysis and interpretation also produced a large tribe of writers called ‘central bank watchers’.

Over time, as societies overwhelmingly bec­a­me dependent on debt— for housing, education or buying their next television—larger sections of the population got interested in the central bank’s actions. Any increase or dec­­rease in interest rates, or liquidity conditions, had a direct impact on household incomes and lifestyles. And yet, despite this growing interface, cen­­tral banking remains shrouded in a mysterious and inscrutable cloak.

Former Reserve Bank of India governor Duv­vuri Subbarao makes a valiant attempt to lift this veil and demystify a central bank’s workings. This is a first and we hope this will enthuse others to share their views. But there are two ways of viewing the book’s purpose. One, in trying to explain a central bank’s operations, Subbarao creates an opportunity to justify his actions dur­ing 2008-13, a period of stubbornly high inf­l­ation, extraordinary exchange rate volat­ility and an unprecedented (and unbroken) spree of interest rate increases. A converse view is also possible: its primary function is to rationalise his actions and he uses it to dec­ode the RBI’s actions and working styles. Which set of lenses have been used? The narrative str­u­cture and the tenor seems to suggest it’s the latter.

This becomes clear as one ploughs thr­ough an otherwise eminently readable account. The book’s pre-launch publicity focused on the governor’s well-publicised conflicts with former Union finance ministers P. Chidambaram and Pranab Mukherjee. Central bankers have traditionally shared antagonistic relationships with fiscal authorities. The book dwells at length on Subbarao’s differences of opinion with Chida­m­baram and Pranab, and how rising prices and a slowing economy widened the rift between Mumbai’s Mint Street and Delhi’s Raisina Hill.

But, with due apologies to Shakespeare, met­hinks the governor doth complain a bit. This is not to imply he was wrong in his stand on interest rates. Subbarao stood up against the collective might of the government, Parliament, a misinfor­med finance sector and uninformed commentariat by defending his right to raise interest 13 times in quick succession. He explains quite expansively why the situation warranted such drastic action. The fiscal and monetary expansion post the 2008 trans-Atlantic financial crisis, without adequate investment in production and supply capacities, embedded inflationary tendencies in the economy. Given political leaders’ reluctance to tighten fiscal reins, it was left to the monetary authority to attempt demand compression through interest rate increases.

Face-offs between monetary and fiscal auth­orities are built into the design; Subbarao mentions as much in the book. In times of crisis, both work in lockstep, as was evident after the 2008 meltdown. But, the impact of an expansionary fiscal policy on inflation and economic growth was ignored by the political class and India’s cossetted business interests. Much of the book describes this clash of ideals.

But there are gaps in Subbarao’s acc­ounts—both when describing clashes with North Block or when recounting challenges faced during vital post-crisis moments. Here are two examples.

First, there’s no mention of his immediate predecessor’s track record. Subba­rao mentions Y.V. Reddy only in passing while mentioning how crisis forced him to rev­erse his predecessor’s string of interest rate increases. We are not asking for public display of dirty laundry. Reddy too had to contend with a frequently (and publicly) remonstrating finance ministry. Reddy’s interest rate increases, to burst speculative asset market bubbles, earned him unstinted praise from economists and observers worldwide.

But, here’s the thing. Subbarao was fin­ance secretary when Reddy was busy inc­reasing interest rates to stave off risks. Interestingly, even Chidambaram was fin­ance minister during that period and he made public his displeasures with Reddy’s insistence on rate hikes. It would have been interesting, and more honest, if the book also disclosed Subbarao’s role as Chidambaram’s finance secretary in his engagements with Reddy, and the lessons learnt from those interactions before moving to RBI. Subbarao limits his interface with Reddy to discussions on RBI’s balance-sheet; I am sure there must be more. If the governor is going to reveal all about his skirmishes with political authorities, his interaction with RBI as finance secretary should also be fair game.

Two, there’s not enough explanation about how the RBI managed its balance-sheet in the aftermath of the crisis. Or, enough inside dope about the crisis days following the closure of Lehman Brothers. Subbarao describes how the monetary tap was kept open at full tilt to give the financial sector confidence that funds were always available. This was largely a signalling and confidence-building measure to avoid payment imbroglios or defaults which get amplified into panic during crisis times. As part of the strategy, RBI kept repo rates (the interest rate at which RBI lends to banks against government securities) low; but the reverse repo rate (interest rate at which RBI accepts money from banks against securities) was always kept 1.5 per cent higher. This was particularly true of December 2008.

Interestingly, this rate difference converted RBI—usually known as a lender of last resort—into a borrower of last resort. Banks would occasionally use the repo window to smoothen temporary mismatches, but would dump far excess cash with RBI’s reverse repo window. Clearly, credit aversion in the immediate aftermath of the crisis forced banks to seek safe havens for their surplus cash. Given money’s fungible character, we also do not know if banks borrowed from the repo window, turned around and tipped over the same money at the reverse repo window, thereby earning a neat 1.5 per cent without breaking into a sweat. The central bank’s annual report for 2008-09 (June 30 year-ending) highlights this anomaly: outstanding repos shrunk to Rs 895 crore (previous year Rs 22,805 crore) and rev­erse repos swelled to Rs 88,335 crore (previous year Rs 300 crore). This surely had some consequences and it would have been interesting to know Subbarao’s views.

But, beyond this, Subbarao has done a superb task of shedding some light on a central bank’s specialised role, especially by making it accessible to a wider spectrum of readers. He uses simple language and infuses some humour when necessary. It stops short of being a complete masterclass because encounters with the political class keep intruding. But somebody needed to talk about these incidents because the public rarely gets to know how both institutions interact. Yet, it also doesn’t do full justice to the political economy of Indian central banking. So, what is it, a book on central banking or an expose? I see it as setting the record straight.

This book review first appeared in Outlook magazine and can also be read here

IMF And RBI — Lost In Transmission

The IMF’s 2014 review has some good GDP news but its reservations on interest rates bears closer attention. It can take 32 months for the effects of a an interest rate cut to be felt. What does this mean for the Indian economy?

Christine Lagarde International Monetary Fund (IMF) Managing Director was in India on 16 March for a two-day trip following the 11 March release of the IMF’s 2014 annual review of the Indian economy. The review has some good GDP news for India. Predictably, everybody focused mostly on the growth forecast for 2014-15 and for 2015-16 and (expectedly) missed out IMF’s reservations on a key ingredient that facilitates growth in any economy — interest rates.

There’s a bit of a story behind the IMF’s salubrious growth forecast. The original set of two IMF documents (in which Indian GDP was initially estimated to grow by 6.3% in 2014-15 and by 6.5% in 2015-16) had to be supplemented by two additional reports — one a transcript of the discussion between IMF officials and media, and, two, a copy of the IMF Survey which updated India’s growth forecast, in line with the government’s new methodology. Consequently, IMF now expects India’s GDP to grow by 7.2% during fiscal 2014-15 and by 7.5% during 2015-16.

Growth junkies celebrated this international endorsement for India’s growth prospects. They have been hankering for a rate cut, arguing that the only thing standing between them and double-digit annual growth rates were intractably high interest rates. The Reserve Bank (RBI) has rewarded them with two rate cuts — one in January and another in early March, soon after announcement of Budget. There are now demands for more, and deeper, rate cuts.

But, if they had read the IMF report a bit more closely, they might have been disappointed. The source of frustration is an accompanying document released with the India country report — called Selected Issues (as background documentation) — which includes a chapter on monetary transmission. On the basis of an internal model, this document reckons that the two-stage transmission between a repo rate cut to bank lending rate cut, via the weighted average call money rate, takes a total of 32 months. The impact on deposit rates is faster at 23 months.

Translated, that means RBI’s repo rate cut in January 2015 is likely to result in lower bank lending rates only by September 2017. The final impact on economic output and price levels, and hence growth impetus, will take even longer to feed through the relevant economic linkages. While that does seem a bit extreme, there is no denying that there is a large, looming problem in the room that nobody wants to acknowledge: transmission problems, or crimps in the financial pipeline.

RBI’s rate actions tend to take ages to travel through the economic system before they translate into lower borrowing rates for firms and households at the other end. In short, the transmission time between RBI’s rate action and banks cutting their lending rates is inordinately long, fraught with uncertainties and resistant to any mapping or measurement. Hence, nobody knows — with any modicum of certainty — how exactly this decision travels through the system, or how long this entire process will take.

The IMF report also refutes RBI’s estimates regarding transmission time, as well as dents the central bank’s confidence of improving lags and lead times under the new monetary arrangement it has signed with the Centre. The Urjit Patel Committee had mentioned that “…monetary policy in India impacts output with a lag of about 2-3 quarters and WPI headline inflation with a lag of about 3-4 quarters and the impact persists for 8-12 quarters.”

RBI has on numerous occasions — through working papers, speeches, media interactions and committee reports — acknowledged the problem of transmission leads and lags in India’s monetary policy. Most reports agree that transmission in India works through a number of channels — interest rate, credit markets, foreign exchange rates, asset prices (such as equity or house prices), expectations (about future shocks and belief in central bank ability to counter adversity) — with the existing fiscal and monetary system acting as final arbiters of the speed of transmission.

In each of the channels mentioned above, there are speed-breakers that slow down the pace of transmission. In the interest rate channel, for example, the existence of a large informal sector with largely inelastic borrowing rates, or high interest rates charged in the microfinance sector, impede transmission of rate cuts to output and inflation. Take government borrowing. Not only does it artificially dampen interest rates, it also forcibly appropriates a fixed amount of the banking system’s lendable funds, providing banks with a disincentive to heed market signals. This is one of the things that make it difficult for an RBI repo cut to materialise as a bank lending rate cut.

The Indian financial sector is dominated by banks, with public sector bank providing the bulk of banking services. The unusually large presence of state-owned banks

Hence, in the face of the conflicting transmission time periods provided by IMF and RBI, as well as the existence of innumerable structural road bumps that hinder smooth diffusion of monetary policy, there are legitimate questions about the efficacy of the monetary policy arrangement between RBI and the government.

Kind courtesy Gateway House (here) and Hindu BusinessLine (here)

Rx: Start With Consumption, Start Small

The trick to jump-starting the economy might lie in creating demand for basic goods, besides increasing liquidity and other revival measures

IN THE movie Batman & Robin, arch-villain Freeze gate-crashes into an antiquities exhibition and announces: “In this universe, there is only one absolute. Everything…freezes.” Credit markets across the world have frozen over, and though there’s no nasty piece of work yet (at least not on the scale of Freeze), there are no early signs of thawing. Spring may still be far away, but attempts by regulators and governments from across the world to end the economic chill don’t seem to be working. In India too, the government and the central bank, Reserve Bank of India, seem to be working hard to loosen winter’s cold grip over the Indian economy, but with little success.

The RBI has been infusing the economy regularly with large doses of liquidity ever since the system was beset with worries of money drying up. The RBI tried everything in the book — cut cash reserve ratio, freed up part of the statutory liquidity ratio, opened a special lending facility for banks to on-lend to NBFCs, housing finance companies and mutual funds, created a special refinance window from where banks could borrow without providing any collateral. Additional liquidity was pumped in by buying back bonds issued under the market stabilisation scheme. In all, since mid-September, the RBI pumped in Rs 300,000 crore through the sluice gates.

But, even that did not help hydrate the financial system. When banks were swamped with liquidity, they took the cash and dumped it with the RBI for a 6% return, even when lending it to prime borrowers might have fetched better returns. The central bank even cut its benchmark repo rate by 150 basis points (bps) to 7.5% on October 19 in an attempt to get some of that money moving out of the bank vaults. Still no go.

The RBI recently turned up the thermostat once more, this time to prod banks to start lending at reduced interest rates. It cut its benchmark repo and reverse rate by 100 bps. But, again, there’s hardly any movement. The banks are still carting their surplus cash over to the RBI and dumping it there for safe-keeping, for even as a low a return as 5%. Take a look at the money being tipped over at the RBI window.

For the first five days of the month, till the RBI cut the rates, banks plonked Rs 243,310 crore with the Reserve Bank, for a return of only 6%. Then on December 6 — a Saturday — it cut rates again. Over the next three working days, banks again deposited Rs 84,635 crore with the central bank, for a return of just 5%. The total — for just eight days — works out to over Rs 327,000 crore! In fact, the RBI was forced to comment, while announcing the new rate cuts, that the liquidity adjustment facility operated by the central bank, “has largely been in an absorption mode.”

In effect, this means banks are still wary of lending to corporates, despite the sea of liquidity and rate cuts unleashed by the central bank. This also then conveys how banks are still uncertain about the future and that they are doubtful about the ability of their corporate clients to pay up in time. In short, the vital glue of financial system — trust — seems to be missing and the authorities designing the various economic packages are unable to supply it in sufficient quantities.

Here's an example — a public sector unit was able to issue five-year bonds to banks with a coupon of 9.33%. Around the same time, one of the Top five India Inc companies also borrowed three-year money, but at 10.10%. Clearly, banks are willing to take a risk on the government, even if it is a subsumed sovereign guarantee, but not on even AAA-rated private companies. Banks have not forgotten the nightmares of the early 1990s, when bank NPAs ruled around 10-14%. This time, despite the prodding from the government and the central bank, they are unwilling to stick their necks out. The RBI has allowed banks to restructure loans — a euphemism for looking the other way when a loan turns bad — that might in ordinary times have been called for stricter treatment. But, the banks are still not biting.

The problem also seems to be in the system’s liquidity absorption capacity. Whatever steps the government takes at the moment — such as, providing cheap cash to corporates through a variety of refinance windows — not only are banks reluctant to lend, even corporates are loath to load up their balance sheets with fresh debt. Many of them are drawing down their existing credit lines with banks — emboldened somewhat by the new restructuring space — to finish existing projects but are unwilling to bet on new projects. With aggregate demand having fallen, India Inc is also contending with reduced topline and bottom line projections. In such a scenario, they may not be in a mood to pile up additional debt.

Therefore, the key to the current economic impasse might lie on the demand side. The government has tried addressing the issue by spending on infrastructure and by cutting taxes to boost demand. These are also not without their associated problems. Any investment in infrastructure will yield results only after a long lag, and the nature of improved technology does not allow for the higher employment generation that one saw a few years ago. Plus, to get an infrastructure project started is also time-consuming — financial closure in these days of clammy credit markets is a tough call.

Some economists say that the production orientation of the economy has changed in favour of expensive consumer products, a sector that might be slow off the blocks in reviving. In such a situation, reviving demand for wage goods might just do the trick. Even this hypothesis needs to be tested. The occasion might present itself soon — with experts forecasting a better-than-average winter crop, the government should facilitate hassle-free movement of the harvest to the markets and consumables to centres where the ensuing agricultural income can be spent. This may sound simplistic, but sorting the physical, infrastructural infirmities could be one of the first achievable steps on the long road to recovery.

Published as an Op-Ed in The Economic Times (December 15, 2008)