Trinity Trick

While Rajan’s monetary policy review did ensure to handle two of the trinity trilemma i.e. sinking rupee and rising inflation but the last one i.e. meek growth demands Government action.

With US Federal Bank postponing quantitative easing withdrawal and with debutant RBI-Chief Raguram Rajan coming up with pragmatic monetary policy, positivity seems to have enthused in Indian economy. On one hand the breather given by Fed-Chief Ben Bernanke has ensured that Foreign Institutional Investments (FIIs) will remain intact till December, on the other, RBI-Chief’s move to hike repurchase (repo) rate has signaled that notorious inflation will also be guarded. Consequently with external and internal stability, the rupee-volatility will soon be the thing of passé.

RBI has raised repo rate i.e. the rate at which banks borrow from RBI for short-term credit to 7.5% from 7.25%. Simultaneously, it has reduced Marginal Standing Facility rate, a special and expensive borrowing window for banks, to 9.5% from 10.25%. Usually hike in repo rate translates into increased borrowing cost for banks but considering that MSF is the effective policy rate since July which has been lowered, cost of borrowing for banks has actually come down. The idea behind this move is to provide fresh air to banks currently suffocated with cash dearth but at the same time prepare them for the ensuing normalcy when repo rate will regain its position as effective policy rate. In that case, during normal circumstances, even if repo rate is increased from current level of 7.25%, it will be less than the present rate of MSF, thus there will not be any dramatic impact on banks’ cost of borrowing.

Another positive implication of repo-rate hike is that the subsequent arbitrage advantage in interest rates will attract more foreign investors, something which is needed to shore up foreign reserves. Increase in repo-rate also suggests RBI’s hawkish stand on inflation front. Fighting inflation through increased rates is justified as it is undoubtedly notoriously high inflation which fuels the vicious cycle of economic slowdown. Though it will hurt the already languishing growth with expensive loans and all but lower inflationary pressure is required even if it comes at the cost of short-term growth.

The so called impossible trinity trilemma of sinking rupee, rising inflation and meek growth has to be dealt with now. While Rajan’s monetary policy review did ensure to arrest sinking rupee and control rising inflation but meek growth cannot be strengthened solely by RBI. It does need policy-push and legislative reforms something which demands Government action. Effective monetary policy will come to a copper as long as it is not backed by prudent fiscal and legislative policies and expecting fiscal and legislative prudence on the part of Government in an election year is like asking for moon. Therefore, thumbs up to Rajan, a question-mark on Government’s intent!