For Urjit Patel, A Moment Of Truth

Urjit Patel, the 24th governor of the Reserve Bank of India (RBI), will announce his second monetary policy review on Wednesday.

His first was momentous enough in that Patel was leading the first review undertaken by a monetary policy committee (MPC). The decision though, was not a difficult one. A good monsoon had provided comfort on the inflation front while growth was tottering along without much spark. A 25 basis point cut in the repo rate could easily be justified and that’s what the MPC went with.

In a short two months since then, the world, as viewed from the RBI’s South Mumbai headquarters, has changed dramatically, leaving us with more questions than answers. Some of these may be answered by the MPC’s decision and its statement but others must be addressed by the RBI and Patel himself.

A Question Of Rates

Following the October policy, most economists penciled in another 25-50 basis points in rate cuts from the current repo rate level of 6.25 percent. Many had expected a rate cut in the December policy, followed by one more cut early next year.

The government’s decision to demonetise and withdraw notes of Rs 500 and Rs 1000 has led to a change in expectations.

A cut of that magnitude, however, will signal that the MPC expects a medium term demand shock to the economy as a result of the demonetisation. This is contrary to the government’s narrative which suggests that the growth hit will be fleeting. So far, the only post-demonetisation data we have is the Purchasing Managers’ Index (PMI) data which shows that services contracted in November while manufacturing weakened but stayed in expansion mode. How quickly activity will normalize is anybody’s guess.

If the MPC chooses to go with a 50 basis point cut, it must also explain the channels through which it expects demonetisation to impact the economy. It must also tell us how a rate cut will help.

First, a rate cut will take time to filter through the economy. Second, if demand weakens, any pick-up in private investment will be delayed further. It’s unlikely that lower rates will prompt companies to invest when existing capacities remain under-utilized. The problem right now is not the cost of money but the availability of money. So, how does a rate cut help? The MPC must explain.

A Question Of Credibility

The MPC’s role will stop with explaining the rate decision. From here on, the RBI top leadership must take over. The one month since demonetisation was announced has been damaging for the RBI’s credibility.

The last four weeks have been marked by chaos (some of it expected), adhocism and lack of communication.

The RBI should also try and offer a more convincing explanation for seemingly elementary errors such as the change in dimension of new notes, which delayed the process of putting new currency into circulation through ATMs. While a large proportion of ATMs have now been recalibrated, the supply of cash has remained thin, said a senior official with a mid-sized private sector bank. The availability of Rs 500 notes, in particular, continues to be limited, this person added. The RBI has admitted that a tendency to hoard cash is creeping in and assured citizens that there is enough currency. It hasn’t backed up those assurances with data, though.

Also, anecdotally, there appear to be wide variations in the supply of cash across different regions. The RBI is supplying cash to currency chests and banks are distributing it from there, said the banker quoted above. Given that the RBI has granular data on currency usage across different regions, it could streamline supplies to match the needs of different parts of the country and limit economic damage.

Assuring citizens that the RBI is working as per a well thought out plan will go a long way in restoring the credibility of the central bank with the people.

A Question Of Independence

The final question, and perhaps the most important question, is one of the central bank’s independence.

As per the RBI Act 1934, a decision of this nature has to be approved by the central board of the RBI. There is nothing to suggest that due process was not followed in this case. If the central board did approve it, what was the rationale and the thinking that went into it? On 25 November, BloombergQuint reported that former governor Raghuram Rajan had expressed reservations about the move. If so, did Urjit Patel and the central board disagree with Rajan’s call? What, in their view, justified a dramatic move such as this? Was it the need to curb the black economy or the extent of counterfeiting or the need to reduce the use of cash?

Also was the limit for withdrawal and exchange of notes recommended by the RBI or the government?

A clear answer to some of these questions would help dispel any notion that this decision, which by law should be taken by the central board of the RBI, was infact pushed on it by the government.