Today when I was reading this article, CAPITAL IDEAS from Mr. Patnaik, I thought its good article share with you guys, where in he talks about the Monetary Policies with respect to Inflation. The way he analyzed the things is very educative. I am posting part of the article, interested people can read from Indian Express. Here is what he says...
First, there is a case for RBI to cut rates even further. RBI can go all the way to a zero short-term interest rate, as some other central banks have done. To understand the case for cutting rates let’s focus on the real rate — the short-term policy rate minus the expected Inflation rate. What do current trends show? WPI inflation, based on point-on-point calculations using seasonally adjusted data, was above 8 per cent (annualized) for each month from November 2007 till July 2008 which was a high inflation environment. But in September, WPI inflation was about 0, and in October it was -7.4 per cent, on an annualized basis.
Suppose we think that in the coming three months, annualised inflation will be -5 per cent. In this case, a short-term interest rate of +5 per cent implies a real interest rate of 10 per cent. This is a highly restrictive stance of monetary policy which is not appropriate in a downturn. A scenario of -5 per cent inflation with even a 0 per cent policy rate giving a high value of the real rate at 5 per cent is tight monetary policy. RBI needs to continue aggressively cutting interest rates.
However, unfortunately, while high interest rates can do damage, a sharp easing of interest rates is not going to have a large or immediate impact on the economy. The way monetary policy works is that the central bank makes changes to the short-term price of money. Through the “monetary policy transmission” these decisions reach out and influence the entire economy. This process requires the BCD (Bond Currency Derivative) nexus, the intricate system of markets through which small changes in the policy rate propagate out to influence rates across the economy. Unfortunately in India, the BCD nexus is basically malfunctioning. The Patil, Mistry and Rajan reports have recommended actions for creating a BCD nexus. But as of today, not many of these recommendations have been implemented.
As a consequence, monetary policy is largely ineffective. So while RBI should cut rates further, we should not be particularly optimistic about its effectiveness. In general, banks are a poor source of financing in a downturn; they find it difficult to absorb the shocks that come from companies going bankrupt. Further, banks in India generally lend to companies that are doing well. They do not have the expertise for examining companies which are presently facing difficulties but have the genuine strengths to thrive in the long term. This is usually the domain of private equity (PE) firms.
The first is the removal of capital controls on NRIs. NRIs are Indian citizens, holding Indian passports. They are the vanguard of India’s globalisation. It is in India’s interest to give them a welcoming environment where they are able to bring money into the country. Today many NRIs actually think of India as a safe harbour. Putting controls on NRIs bringing money into India is bad policy in general, but at a time like this, it is absurd policy. RBI’s response of tinkering with NRI deposit rates is woefully inadequate.
The second area of urgent action is the capital controls imposed on private equity and venture capital funds. These are investors capable of taking a close look at firms and injecting risk capital into good businesses while monitoring the outcome. In a downturn their role is particularly important. While banks will not take the risk of lending to poorly performing businesses, such companies offer good investment opportunities to PE firms and to those who believe in India’s long-term growth story. Of course, the role of bank finance for working capital will stay, but PE funding can be crucial for saving many firms that might begin to be distressed in the coming year.
The third area for rapid action is the corporate bond market. If banks are not willing to lend to companies due to their own constraints, there is a case for disintermediating banking and allowing individuals to buy corporate bonds. The regulatory framework must encourage this. Along with that, to help individuals, mutual funds and others lending to companies hedge their credit risk, a credit default swap market should be developed; in such markets, one can buy insurance against a company going bankrupt. We must not repeat the mistakes of other countries; in India, such a market should be well-regulated, exchange traded, and with high transparency.
RBI’s move on raising the limit for FIIs investing in Indian corporate bonds is on the right track. But much more needs to be done to get a corporate bond market going. Every day of delay in this hurts.
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