Commentary by Andy Mukherjee
July 31 (Bloomberg) -- If one disregards the occasional lapse or two, Indian central bank Governor Y.V. Reddy has been more vigilant in combating inflation than many other emerging- market central bankers.
One such slip occurred April 29.
In his quarterly monetary-policy announcement, Reddy left interest rates unchanged when traders' expectations for a rate increase were somewhat stronger than predictions of no change.
As inflation continued to soar, the currency market became nervous. The rupee lost more than 6.5 percent of its value against the U.S. dollar in 16 days.
At times, and perhaps to compensate for the lapses, Reddy has been heavy-handed. This week, he increased the policy rate by half a percentage point and simultaneously squeezed liquidity in the banking system.
Traders expected a quarter-point increase. If the Reserve Bank of India did see the need for strong medicine, it did a poor job of communicating its diagnosis to the market.
Beyond these policy slippages, my major grouse against Reddy, whose five-year term ends in September, is that he has left unexplained too much of what he's doing.
There's no monetary-policy committee in India. The governor runs the show. And Reddy's show, while satisfactory in outcomes, has been just plain inscrutable in terms of motives.
Take, for instance, the so-called policy-rate corridor in India.
Two Rates
Instead of using one short-term rate to influence long-term rates, India uses two. The reverse repurchase rate, which the Reserve Bank of India pays commercial lenders to take their surplus funds for a day, makes the floor of the corridor.
The repurchase rate, which it charges banks for adding overnight funds into the financial system, acts as the ceiling. The overnight, interbank bank rate is supposed to move in the policy corridor.
Inexplicably, the corridor has become increasingly wide. Reddy hasn't raised the reverse repurchase rate for two years now even as he has continued to charge banks more and more for borrowing overnight funds from the monetary authority.
When liquidity in the banking system is tight, the floor rate may not matter. As Reddy has said, the ``operational rate'' at present is the repurchase rate, which was raised this week to 9 percent. That, however, isn't a satisfactory explanation.
The width of the corridor isn't a meaningless indicator.
According to a technical group on money markets that the central bank set up in February 2005, ``ideally, the spread should reflect the society's tolerance level of volatility in short-term interest rates.''
And what is that tolerance level?
`One-Off Circumstance'
``In the Indian context, the RBI may find it difficult to tolerate daily fluctuations in call rates by 100 basis points over a sustained period,'' the committee said. ``Therefore, for all practical purposes, this spread of 100 bps should be interpreted as the maximum tolerance level under extreme one-off circumstance.''
The spread between repurchase and reverse-repurchase rates increased this week to 300 basis points.
A central banker that makes surprise the biggest weapon of his armory achieves his goals by causing abrupt adjustments in the markets. And that has been the other charge against Reddy: Traders have found his penchant for introducing volatility in money and currency markets -- without even a hint of a warning -- unnerving.
In a period of four months last year, the interbank call- money rate shot up to 62 percent and slumped to almost zero.
Starting March 30, 2007, the Indian rupee gained 7 percent against the U.S. dollar in just two months.
Exporter Panic
This was a big move for a currency that isn't allowed to fluctuate freely by the central bank. It caused Indian exporters to panic, with many of them choosing to ``hedge'' their currency risk by buying toxic structured products that banks were only too happy to sell them. Several of those transactions have gone sour and ended up in court.
Reddy is aware of the criticism against him, though he doesn't accept it.
``For some time in the past, the RBI acquired an unwarranted reputation of always surprising the market, prompting me to quip at one stage that `the financial markets always surprise me with their expectations from the RBI,''' he said at the Bank for International Settlements' annual conference in Lucerne, Switzerland, in June this year.
Predictable Policy
More seriously, Reddy reiterated his doubt about the desirability of an entirely predictable monetary policy.
Reddy isn't alone in that camp. Other observers, too, have asked if the U.S. Federal Reserve's ``measured,'' quarter-point interest-rate increases from June 2004 to June 2006 contributed to the housing bubble as investors used the transparency to pile on risk. The bubble burst and threatened to take down the global financial system with it.
The debate about how much a central bank should communicate, when, and to whom, remains unresolved.
Still, it's possible for the Indian central bank to do a better job establishing the credibility of its interest-rate corridor -- its main policy tool -- without giving away what the level of interest rates may be in the future.
It should start by answering why the width of the corridor has been allowed to expand. Analysts suspect the real reason is mercantile. The Reserve Bank doesn't want to pay too much when it ``sterilizes'' accumulation to its foreign-exchange reserves by issuing bonds. But what about the sanctity of what the width of the corridor represents?
Has Indian society's tolerance for volatility in short-term interest rates tripled?
Indian lawmakers are perhaps too busy to seek these explanations, though at least in theory the Reserve Bank of India is accountable to parliament through the federal government.
What's more egregious -- and this isn't the central bank's fault -- is that the monetary authority's submissions to parliamentary committees are official secrets.
So even if politicians are asking Reddy the right questions, the answers still elude the public.
(Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Andy Mukherjee in Singapore at amukherjee@bloomberg.net
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