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Financial sector reforms - III

The report trashes the assumption that switching to an objective of price stability entails a loss in output growth. There are residual concerns about the RBI��s transparency when compared to international best practices in some dimensions!

CJ: S Shivakumar

Sun, Apr 13, 2008 16:21:47 IST

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Financial Report Review :

ACCORDING TO the report, there is evidence that a central bank that is focused on price stability can be most effective at delivering good monetary and macro outcomes. Low and stable inflation has large macroeconomic benefits. It would stabilise GDP growth, help households and firms make long-term plans with confidence and increase investment. It would also have financial market benefits – for instance, by enabling the development of a long-maturity bond market, which would assist in infrastructure financing and public debt management. (That the long-term maturity bond market in India is in a pathetic state in our country is common knowledge. Elsewhere in the developed economies, the debt market is far ahead of the equities market in value terms; in India, it is the opposite; we also realise now that the absence of a long-maturity bond market has made it difficult to raise resources for the country’s infrastructure development). The Report does not believe that the process of switching to an objective of price stability entails a loss in output growth. Nor does it believe that making low and stable inflation the objective of monetary policy creates an anti-growth bias.

Transparency and predictability of monetary policy are essential ingredients for achieving liquid financial markets, reducing fragility of financial firms and stabilising capital flows. Since long-term interest rates are more important than short-term rates for aggregate demand management, there is a temptation to manage different points of the yield curve for government debt (the return on debt instruments at different maturities) rather than just setting the short-term policy rate, as is typical in most mature economies. This has three deleterious effects. It hampers the development of the government bond market. It stymies the development of a corporate bond market since a market-determined yield curve is needed to serve as a benchmark for pricing corporate bonds. It also limits the information and market feedback from the yield curve about inflation expectations and the market’s assessment of monetary policy actions.

The report does well to point out that according to the Dincer-Eichengreen index (of transparency), RBI does not stack up well. It gets a rather measly score of two. The report wants the RBI to refrain from using the CRR or SLR as a standard tool of monetary policy in the interest of transparency. More regular policy meetings on a pre-announced schedule would be helpful in giving markets more direction at predictable intervals. The RBI should make the main policy documents and statements put out by it (especially the quarterly review) much shorter and more focused. In addition, the RBI could provide more information to the public about its forecasting and simulation models, which could in fact be useful for the central bank in getting feedback from the academic and market communities that could help improve the models. All the same, there are still residual concerns about the RBI’s transparency, however, especially when compared to international best practices in some dimensions. From here, the report proceeds to suggest the changes needed to the current framework, which will be explained in the next part.

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