Finally, a credit policy worth writing about!

July 27th, 2010

In Tuesday’s credit policy announcement the RBI hiked rates as expected. But for the first time in years, it hiked the reverse repo and repo rate unequally. This can only be good.

In times of surplus liquidity, the RBI borrows from the market at the reverse repo rate, the lower of the two policy rates. On the other hand, in a deficient liquidity scenario, it lends to the market at the repo rate. The difference between the two rates, which was 50 basis points (bps) at the time they evolved into policy rates was relentlessly widened to 150 bps during the governorship of Dr Y V Reddy.

The reasons behind this change were never explained fully, but then, Dr Reddy wasn’t inclined to explain most of his monetary policy actions. In use, however, this gap became a potent monetary weapon which could be wielded at any time to change rates dramatically without any apparent change in monetary policy. It gave the RBI power to change market conditions without changing policy rates and was used frequently, often with devastating effects.

The use of this weapon was considerably easy, using RBI’s almost complete control on systemic liquidity. Small changes in CRR can make the difference between a liquidity surplus and a liquidity deficient market. Moreover, with government tax collections being periodic and chunky, it is possible to turn a liquidity surplus system to a liquidity deficient one without an action. Since advance tax payments will be made as scheduled, by not taking any action to compensate market liquidity for such outflows, banks could move from lending to the RBI at the reverse repo rate to borrowing from the RBI at the repo rate.

Since such lending and borrowing operations decide the overnight rate, which is the foundation for the term structure of interest rates, it was possible for the RBI to change systemic interest rates by up to 150 bps without any monetary policy action. This allowed the RBI to conduct monetary policy in a covert manner, unbecoming of a government institution in a democracy. It also introduced uncertainty in the overnight rates, which resulted in higher spreads and consequently, higher rates for long term borrowers. How does one price a five-year loan/bond if one isn’t sure whether the overnight rate is 3.5% or 5.0%?

This first step in reducing the width of what is colloquially called the LAF “corridor” needs to be lauded despite the fact that this corridor is still too wide. More such steps will be needed which will, hopefully, reduce the gap to either 25 or 50 bps. This will stabilise overnight rates across liquidity conditions, stabilise overnight rate expectations and result in finer pricing for the term structure. Ultimately, it will lend more credibility to monetary policy actions by improving their transmission to the banking system and the real economy.

It’s easy to say that more could have been done, but to my mind, even if the credit policy statement consisted of just this one sentence, it would still be a good policy. Well begun is half done, the saying goes, and it’s apt in this context. At this time, we need to celebrate RBI’s tacit acknowledgement that this is a problem which needs to be corrected.

Another issue that needs to be addressed is the use of CRR as an instrument of monetary policy. Encouraged by China’s success in using CRR to manage system liquidity, recent statements by senior RBI officials show the inclination to use it here is rising. The width of the LAF corridor, no doubt, added to its attraction with one monetary tool influencing both liquidity and interest rates. However, considerable challenges exist in its use in India when compared to China. The banking system in China is characterised by its homogeneity in ownership and to a certain extent, size. In this environment, an increase in reserve requirements impacts all banks almost equally resulting in efficient transmission. This isn’t the case in India.

With banks of all size and ownership structures co-existing, changes in reserve requirements have an unequal impact which can result, and has historically resulted, in occasional existential problems for banks disadvantaged by such changes. And if this tool is used in place of, rather than along with other liquidity intervention methods, it can disrupt normal functioning of the banking system. This has been proved in the past, with October 2008 being the most extreme manifestation of its impact.

It is expected that a reduction in the width of the LAF corridor would reduce the attractiveness of using CRR as an all-in-one tool and result in distinct monetary tools being used for managing liquidity and interest rates. But this is merely an expectation. As in the case of narrowing the LAF corridor, we need to wait for evidence in either words or action.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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The rise of hedonistic economics

July 1st, 2010

It’s been a while since my last post and its not because I’ve been busy otherwise. I’ve been working on a currency model that has the potential to resolve some of the global imbalances that exist. But like with any model, its throws up new problems and ultimately, one has to make a choice between the existing problems and new ones.

I have never seen a model or an economic school of thought that solves all problems without creating new ones. If that were possible, we would all be in economic utopia. There are times when the Libertarian model seems to work better and times when substantial benefits are to be had by following Keynes, and these aren’t the only choices available. In the end, economic decision making boils down to making a choice between immediate problems and future problems. Its the difference between being hedonistic and ascetic.

If one looks at individual decisions as well, there are obvious differences to be seen. There are consumption-oriented individuals and savings-oriented individuals. Hedonistic & ascetic respectively. A nation’s orientation is derived from its citizens and consequently, there are nations which are either hedonistic or ascetic. With the demise of communism (or at least its most powerful manifestations) the economic war has now changed. The war is now between Hedonists and Ascetics.

The choice between the two isn’t purely economic in nature. A nation can be capitalistic and still be ascetic, with Germany being a prime example. It is also possible to be socialistic and hedonistic, with Greece leading the charge here. The choice is cultural and affects almost all aspects of life. But it is economics where this divide becomes the most apparent and Gross National Savings is an indicator one can look at to determine this.

As things stand, Greece has the lowest Gross National Savings (GNS) rate in the world. It is followed by Portugal, the US and the UK amongst others.  Data for Greece and Portugal isn’t easily available, but estimated savings for 2010 are 6 per cent and 7.5 per cent of GDP respectively. For the 10 year period 2000-2009, average GNS rate for the world has been close to 22.50 per cent, the US and UK have managed an average of just over 14.75 per cent. The difference of close to 7.75 per cent grew to over 9.50 per cent in the case of the US and 8.9 per cent for the UK over the last five years. These nations can very easily be classified as the most hedonistic in the world.

Looking at the Euro Area in general, the average GNS rate over the last 10 years has been close to 21.25 per cent, lower than the global average by just over 1.25 per cent. For Germany these numbers are 22 per cent and 0.50 per cent respectively. The Euro Area (with the exception of Greece & Portugal) along with Canada  are ascetic in absolute terms, but on the margin in relative terms.

Turning to the  Middle East, Asia and the Commonwealth of Independent States. Savings rates in these regions has always been higher than the global mean, averaging 35.50 per cent, 31.85 per cent & 28.90 per cent respectively. These regions can be easily classified as ascetic, both in absolute and relative terms.

Net National Savings reinforce this point with Greece, Portugal and the US all in negative territory. The UK is marginally positive, but the recent budget with it’s much vaunted austerity measures may be the first step towards correcting this. Almost every other country in the world saves a portion of its Gross National Income for the future. Time series data for Net National Savings isn’t easily available as well for all nations, but occasional data indicates the above equally clearly.

All of us are born hedonists. As babies and children, we tend not to think about the future impact of our need for instant gratification. As we grow, we begin to worry about the future impact of our decisions and this is reflected in our actions, words and overall approach to life. Juxtaposing this to the global stage, it would be fair to conclude that today’s hedonistic nations are the children of the world. Like any child, they want their problems to go away now, regardless of whether this hurts their future. And now these children want the adults to follow their way of life. And are going to great lengths to ensure this.

The battleground for the recent war of words between New Keynesians like Paul Krugman, Mark Thoma, Martin Wolf etc) and “Austerians” (almost everyone else) seems to be continuation of the fiscal stimulus undertaken by most nations to tackle the recent crisis. But scratch the surface and one can clearly see that the war is, in effect, between Hedonists and Ascetics. New Keynesian economists believe that the only way out of the current mess the US finds itself in (unemployment @ 10 per cent-plus) is to continue spending money the government doesn’t have in the hope that it’ll create enough jobs and pay for itself going forward. The fact that this kind of profligacy added to the intensity of the recent crisis is but a matter of detail. And the possibility that this may result in a bigger mess is something that they will face in the future. The battle cry is to make things better now, no matter how it hurts the future.

Much like a parent giving in to a child’s tantrums, the actions of global leaders are being guided by this noise. And as is normal, the adults will pay for this as well.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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