Who is accountable for country’s economic stability?

By P. Samarasiri

The monetary policy press release on 28 December informed of policy rates unchanged at 8% and 9% at levels decided on 13 November. No public briefing on new policy decision was held although announced.

Information reveals highly-subsidised policy interest rates maintained although monetary conditions further deteriorated since the last policy decision requiring more hikes in policy rates.

1. Currency and official foreign reserve further deteriorated although the Monetary Board (MB) repeatedly assured of the stability.
2. Outflow of foreign investments and increase in private credit to finance imports, despite the controls of LC margins and loan-to-value ratios, continued.
3. Despite release of Rs. 90 b of liquidity by cutting the SRR by 1.5% in November, the CB continued to print money to inject new liquidity to keep low interest rates. Total turnover of overnight liquidity injected was Rs. 2.4 trillion from 13 November to 28 December. The volume of daily liquidity injection also rose.

Therefore, the rising demand for liquidity for outflow of foreign investments and import credit continued due to low interest rates subsidised by the CB’s money printing. The only solution now available with the MB to stabilise the currency turmoil and high demand for liquidity is the further hikes in policy rates in a short time. This is simple economics.

For example, currency turmoil in 2000 was resolved by raising policy interest rates to 20%-23% (by 10%-11%) by March 2001 from January 2000. Several direct controls also were imposed. However, already delayed hikes in policy rates and extended injection of the liquidity cause headwinds, given financial tightening in global markets, pending another two rates hikes by the US Fed and policy tightening by the European Central Bank in 2019.

Recent policy actions

The present economic instability is a result of irrational phase of tightening of the monetary policy since January 2016 as follows.

• January 2016 – Increase in SRR by 1.5% to 7.5% to address concerns over high credit growth and rising BOP trade deficit. Nearly Rs. 52 b of bank liquidity was absorbed and the interbank market became hugely illiquid as the policy was implemented without any pre or post-impact assessment. Money market/Treasury bills rates immediately rose by 50-75 bps and the CB started injecting liquidity to keep inter-bank interest rates within the policy rates corridor (6%-7.5%).
• February 2016 – Increase in policy interest rates by 50 bps without waiting for transmission of SRR cut. Further rate hikes were communicated if necessary. As huge funding requirement of around Rs. 125 b for the Government was pending on 1 April 2016, all markets were disrupted. 
• July 2016 – Increase in policy rates by 50 bps with comments that commercial/market interest rates had increased. The reason for elevated interest rates, i.e., the fast-monetary tightening since January 2016, was not noted. As a result, the declining trend of market interest rates that prevailed since mid-April 2015 was reversed and markets were destabilised.
• March 2017 – Further increase in policy rates by 25 bps. 
• April 2018 – Cut in standing lending rate by 25 bps. This was meaningless as the US Fed had already started policy tightening and capital outflow had commenced.
• November 2018 – Increase in policy interest rates to 8% (by 75 bps) and 9% (by 50 bps) and cut in SRR by 1.5% back to 6% (2016 January level). This was communicated as neutral monetary policy without knowing the net transmission of SRR cut and policy rates hike. 

MB’s policy failure

In July 2017, the MB reintroduced direct bond placements to control interest rates within the monetary policy, despite it being a bond issuance window, where no information is released to the public as in the past. The CB continued to heavily subscribe to weekly issuances of Treasury bills outside primary auctions as in the past practice to control yield rates/money market rates without any regard to developing currency turmoil. The MB thought that interest rates with earlier hikes (without any valid reasons) were already high and kept them unchanged until November in view of depressing economic growth and low inflation (measured by weather and subsidy-driven cost of living index).

Therefore, the present currency turmoil has got its way and the MB could not control both exchange rates and market interest rates (see Chart), despite wide duties stipulated in the Monetary Law Act. 

The MB continues with the current model of monetary policy based on targeting overnight inter-bank interest rates and liquidity to satisfy bank/money dealers without any research on its connection/transmission to liquidity and credit needs of sectors of the wider economy such as exports, agriculture and SMEs.

It appears that the MB has now given up the exchange rate stability (depreciation more than 18%) but follows subsidised interest rates to satisfy liquidity needs of the inter-bank market and government securities market. However, the economic growth continues to depress while actual inflationary pressures are built up from excessive currency depreciation, money printing and concessions-based budget deficits (expected in next two years on account of pending elections). 

Therefore, risks of stagflation (low growth with high inflation) in next one to two years are seen high. If the MB had not unnecessarily tightened the monetary policy in 2016 and 2017, it would have the policy space to handle the present turmoil at the early stage in 2018. 

The Monetary Board is responsible for the economic and price stability of the country. It can’t wash its hands by passing the blame to the Government for the instability.  Evading statements like “growth enhancing structural reforms are carried out within a coherent and transparent framework, rather than relying on unsustainable short-term monetary and fiscal stimulus, which leads to overheating of the economy” as stated in the November press release and “the need for implementing broad based structural reforms without further delay” as stated in December press release are meaningless as the MB itself has failed in its public duties.

The Government must be finally accountable for the economic loss to the public due to the duty failure of the MB. How the Government of India handled its ideological Central Bank since September 2018 is a good lesson. 

 (The writer is a former public servant as a Deputy Governor of the CB and a chairman and a member of six public boards who authored five economics and financial/banking books published by the CB and more than 50 published articles.)