R Jagannathan
Firstpost.com
The news on the rupee front may be good, even flattering to Dr Raghuram Rajan, the latest incumbent to become the country's banker-in-chief. There is some cheer on the trade deficit front, with exports picking up. He could even have a friendlier US Fed Chairman, with Larry Summers opting out of the race; Ben Bernanke's replacement could now be someone less inclined to roll back the stimulus, the USD 85 billion monthly bond buying plan.
However, that doesn't mean all's well. For the domestic situation could not be worse. Despite a bountiful monsoon and a small uptick in the Index of Industrial Production (IIP) in July-more the result of a data blip than anything else - growth is tapering down. Worse, despite the slowdown, inflation is gathering momentum, as yesterday's spike in the Wholesale Prices Index to 6.1 percent showed.
So what should Rajan do on 20 September? Three things principally.
First, and foremost, he has to put the saver at the forefront of his concerns. India’s savings rate is falling and this is one of the reasons why the external current account deficit (CAD) is ballooning (when you save less at home, you borrow more from abroad, and the CAD rises).
Currently, all savings products- without exception- offer negative real interest rates after accounting for inflation. In short, the saver is being penalised. This is a sure recipe for disaster. It goads people to invest in physical assets such as gold and real estate - with the latter now clearly in bubble territory.
Rajan made a
good start on 4 September by promising an inflation-indexed bond based on the consumer price index. However, most consumers are wary of listed bonds where prices rise or fall daily. If your bond behaves like a stock, ordinary savers will not invest in them.
However, there is another way to make inflation-indexing attractive for ordinary users: bank accounts. Bank fixed deposits are universally used as savings instruments and trusted too. All Rajan has to do is offer an
inflation-indexed fixed deposit and his proposal will fly better than bonds.
If he wants to boost the savings rate, this would be a better step that offering inflation-indexed bonds.
Second, Rajan must raise the signal repo rate by a significant amount. Currently the rate, at 7.25 percent, has no meaning after the RBI raised short-term rates under the marginal standing facility to 10.25 percent in July. Rajan has always believed that the central bank must not only indicate its intent clearly, but must also use one basic signalling rate for the markets. This logic dictates that the repo should be the main signal rate. Given high inflation, he should raise the repo rate by 1 percent to 8.25 percent and simultaneously abolish the higher rate of 10.25 percent on the marginal standing facility at which banks borrow overnight from the RBI. This will send a clear signal that Rajan means business on inflation, even while easing liquidity. Banks are currently borrowing more than Rs 1,07,000 crore daily from the RBI.
This is the only way he can live up to his statement that "the primary role of the central bank…is monetary stability, that is, to sustain confidence in the value of the country’s money."
Third, another signal Rajan needs to send is one of independence from the government – and that the latter cannot live a spendthrift life and still be able to borrow cheaper than more credit-worthy citizens. The main instrument that allows government to borrow cheap is the SLR-the statutory liquidity ratio-under which banks have to invest 23 percent of their deposits in government bonds. This is cheap money for the government. But banks are willing investors, for this is money against which they need to provide very little capital. And there is no risk of default.
A good move would be to reduce the SLR from 23 percent to 20 percent at one go, or even in measured steps. This will both free resources for lending, and force banks to find worthwhile borrowers. It may also push up government borrowing costs in the short run, but that is P Chidambaram’s problem. If he wants to borrow like there is no tomorrow, let him at least pay more for it.
If Rajan cuts SLR, he would have lived up to a part of his promise where he said: "One of the mandates for the RBI…is to ensure the flow of credit to the productive sectors of the economy. In this context, we need to reduce the requirement for banks to invest in government securities in a calibrated way, to what is strictly needed from a prudential perspective. This cannot be done overnight, of course. As government finances improve, the scope for such reduction will increase."
The government is not a "productive sector" that needs mollycoddling.
Rajan could also consider the opposite point: as long as he keeps giving government cheap money, what is the incentive for the government to borrow less? He has to cut SLR to ensure that government is saved from this moral hazard.
The rest of the monetary policy can be used to set long-term goals for freeing all interest rates, inducing more competition, and making life easier for banks by reducing restrictive policies on branches, ATMs, new financial products, et al.
The writer is editor-in-chief, digital and publishing, Network18 Group 
