Bureaucracy only attends to whatever it has been doing or available in office files. It has no desire or ability to review the effectiveness of its public duties to address new problems. It even disregards laws by following past practices. The monetary policy decision announced on February 22, 2019 is similar bureaucratic action where the press release is merely a composite of uncoordinated words.
However, as compared to recent policy statements, the Monetary Board (MB) this time has refrained from blaming the government for the fiscal slippage and lack of growth enhancing reforms to cover up the MB’s failures, possibly because the MB itself is bailing-out the government by printing money and having world tours to raise foreign currency debt to bail out both.
Why monetary policy is bureaucratic?
First, the MB by calling it as continuation of current neutral monetary policy relaxed the monetary policy by cutting the administrative monetary control, statutory reserve requirement (SRR), by 1% (from 6% in December to 5% now) effective from March 1, 2019 to release nearly Rs. 60 bn immediately to commercial banks.
The Reserve Bank of India also relaxed the monetary policy on February 7 by cutting policy rates by 0.25% and calling it as a change from calibrated tightening to neutral. None has clarified the meaning of neutral when monetary policy is relaxed. The general meaning of neutral is to remain static or non-action. Therefore, how a relaxed monetary policy becomes neutral is not known.
Second, the MB has not understood the pathetic condition of the monetary front and the economy as shown by conventional monetary numbers, its real cause and how it should be fixed to prevent destabilisation of the economy.
The pathetic monetary front is shown between March and December 2019 by considerable deceleration of growth of reserve money (printing of money) from 11.8% to 2.3%, money supply from 16.4% to 13% and net foreign assets of the banking system from 126.8% to negative 155.1%.
This commenced primarily from September 2018 due to foreign capital outflow and resulting currency turmoil as shown by the decline of net foreign assets of the banking system to negative Rs. 67 bn (foreign liabilities greater than foreign assets) in December from Rs. 106 bn in March. This shows a foreign capital outflow of nearly Rs. 173 bn. which has caused the immediate erosion of monetary liquidity in the banking sector.
If the repayment of sovereign bonds of US$ 1 billion (Rs. 180 bn) out of foreign reserve in mid-January is adjusted, foreign asset deficit would be more than Rs. 200 bn. by end of January.
This is shown by the decline in gross official reserves to US$ 6.2 bn by the end of January 2019 from US$9.3 bn as at the end of June 2018, despite the CB’s brave talk of foreign currency stabilisation and projection of a foreign reserve to be around US$ 11.3 bn.
Macroeconomic instability
The monetary data show that the instability has been caused by the foreign sector of the economy, i.e., foreign capital outflow. It has caused a significant liquidity crunch (reduced supply of liquidity/money) leading to a depressing monetary/banking sector. However, the demand for liquidity/credit rises pushing up market interest rates. Therefore, until the foreign capital is recovered, the instability problem will remain.
However, the MB prints money to fund money dealers and the government to fill the liquidity deficit in the money market. The daily average liquidity injected by the CB’s OMO (Open Market Operation) stood at nearly Rs. 122 bn from January 1 to February 28, 2019 and Rs. 117 bn for the last four months of 2018.
The total turnover of daily liquidity injected by the CB has increased to Rs. 3.9 trillion from January 1 to February 28, 2019 compared to Rs. 3.9 trillion for the last four months of 2018. The CB’s Treasury Bill holdings have increased to Rs. 186.2 bn as on Feb 28, 2019 from the level of Rs. 23.1 bn as at the end of September 2018.
The reduction in the SRR by 2.5% to release nearly Rs. 150 bn of bank money back to banks is another monetary relaxation which will augment credit and money in multiples in the near future. The liquidity provided free of interest under payments system facility also would be several trillions.
Such monetary relaxation will fuel imports and a further outflow of foreign exchange while foreign exchange inflows are discouraged by low interest rates artificially controlled by the MB through the supply of liquidity. In the last two policy statements, the MB accepts that import credit has risen irrespective of liquidity shortage and increased interest rates.
Recent import-control measures (200% LC margin and loan-to-value ratio on imports of vehicles) should have reduced such credit. However, the budget presented on March 5 has unilaterally removed the much-boasted independent monetary policy measure of 200% LC margin requirement on vehicle imports (similar to depreciation of currency by 3% in the budget presented on November 21, 2011) and given some duty concession on a few vehicle categories.
Therefore, the MB’s exchange rate/foreign sector stabilisation policy is suppressed by fiscal policy. The 50% curtailment of the threshold for foreign investments in the government securities market in January from 10% to 5% is another inappropriate bureaucratic measure that will discourage foreign investment inflow and sentiments.
Subsidised monetary policy
The correct monetary policy at this time should be to raise interest rates sufficiently to attract foreign capital/exchange in a short time as the growth momentum of the economy is foreign currency-funded.
For example, the 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 to prevent foreign exchange outflow were also imposed.
The present monetary policy with a marginal increase in policy interest rates by 0.50-0.75% in December 2018 and the colossal amount of printing of money to keep interest rates suppressed is a substantial monetary subsidy that further destabilises the foreign sector of the economy.
However, present international monetary and debt management experts believe that the interest rate is not an instrument to address issues on exchange rate and foreign investments.
They fail to understand GCE A/L economics of correlation between interest rates, investments and exchange rates.
Foreign investment is a part of the country’s investments that respond to changes in interest rates as plainly predicted in basic monetary policy.
Therefore, so-called transmission mechanism believed by the MB is not known now. The information on the extent of the long-term yield curve control by the regained private/direct placements of Treasury Bonds and Bills also is not available.
Therefore, the present monetary policy priority should be to reduce the demand for monetary liquidity to match the reduced supply of liquidity. The MB should print money only selectively and cautiously to fix systemic liquidity problems of banks to forestall banking problems that could arise from exposure to foreign currency, especially as the banking net foreign asset position is a deficit at present.
Instead, the suppression of market interest rates by printing money to control the cost of government borrowing is a completely irrational/bureaucratic monetary policy against basic monetary principles. Leading banks have cut down deposit interest rates to increase their profit margins while only a few liquidity-threatened banks have raised interest rates advertised as ‘ginipoli’.
Failure of MB’s inflation target (price stability) and economic stability
The MB’s press release cites administrative price revisions and projection of inflation remaining in desired 4%-6% target in 2019 and beyond.
First, the MB does not understand that inflation considered in the monetary policy is a macroeconomic phenomenon, and not decided by administrative prices.
Second, the MB’s inflation numbers (NCPI) have been way below its wide target range of 4%-6% during the past 12 months. Therefore, the MB has failed to push inflation to its target zone. In the next two years, there will be a lot of concessionary prices on account of national elections which will push the NCPI inflation persistently way below the target.
Therefore, the policy statement that “the economy is expected to gradually reach its potential in the medium term benefitting from the low inflation environment, competitive exchange rate and appropriate policies to support investment,” is only some meaningless words.
The medium-term, the economy’s potential and appropriate policies have not been specified. The protracted low NCPI inflation below the target is a sign of recession of the economy. Although the exchange rate is said to be competitive in the recent past, the economy has not benefited in view of the present plight of the economy. Therefore, the above three factors are missing in the economy which has been sluggish with quarterly growth below 4%.
Therefore, the MB has failed to maintain economic stability and price stability as set out in the Monetary Law Act along with a large number of policy instruments. Although the Government should finally accept the responsibility of the failure of the Monetary Board, it remains deaf and blind because the MB funds the government on a regular basis.
Policy solution
We need to have a lawful and productive monetary policy to promote distribution of targeted credit to the export sector, import substitution activities and domestic priority sectors if we need to fix the foreign sector problem.
In tight liquidity periods, banks also cut down credit to SMEs and non-performing loans also rise. Such monetary policy will be growth-enhancing that avoids concerns on inflation. However, the present bureaucratic monetary policy of funding the dealers and government at subsidised interest rates is unable to do this.The MB has printed money to cover almost all liquidity drainage based on dealers’ daily funding requirements, but the economy remains depressed.
The Government is implementing enterprise credit schemes through banks outside the monetary policy. At present, nearly Rs. 70 bn has been awarded. The general experience of such state-sponsored credit is large-scale default that leads to bank capital problems.
The foreign sector problem cannot be fixed by the present monetary model of domestic monetarisation. We do not need international economists with DSGE (Dynamic Stochastic
General Equilibrium) models to print money for dealers and the Government daily.
The Treasury also can do it. In the morning, inquire from the dealers how much money they need (liquidity estimate) for the day and print and credit the amounts to their bank accounts. Therefore, unless monetary policy is re-fixed to be a wider national credit delivery policy, the economic crisis caused by dealers and debt will not be remote. The US Fed also recently communicated that it would review its present policy instruments to suit the new economy.
As the monetary policy is claimed to be forward-looking based on macroeconomic modelling, the MB has to find better instruments as stipulated in the MLA to address te above concerns on economic and price stability.
- The writer is a former Deputy Governor of the CB.