Market Maniac

Three cheers for RBI’s rate cut
Jan 19, 2015

The first cheer is because RBI is obviously very comfortable with the path that inflation is following, and, importantly, that Dr. Rajan believes that the government is both willing and able to address the structural changes we need, including, most loudly, meeting its deficit target.

The second cheer is, again obviously, that the rate cut has galvanized sentiment, and not just on Dalal Street. This positive sentiment can skew the rupee stronger than the REER forecasts; of course, sustainability of this skew will depend on actual on-the-ground delivery and calm global markets.
 

The third cheer is a bit more arcane. It is for the surprise aspect of the cut. To be sure, it wasn’t a total surprise – on December 2, the governor had said he’d cut rates in the first quarter provided data remained favorable, which it has. The element of surprise was in the timing – off meeting and in the morning.

On reflection, of course, the timing made a lot of sense. It created the widest time gap between our first rate cut and the US’ first rate increase, reducing the potential for adverse impact; it also created a good backdrop for the PM’s major economic speech last Friday.

But, to me, the real cheer was for an apparent – hopefully – return to more classic central banking. Historically, central banks held their cards close to their chests so that market players knew that there was always a risk that the central bank would surprise – whether by raising/cutting interest rates or even in keeping them steady when sentiment loudly expected a change. This ensured that people who could directly benefit from market movements – originally, banks, and more recently larger parts of the financial sector – didn’t get a free hit. They had to take risk, and price it – hopefully correctly – and set aside capital for this.

However, soon after Greenspan became Chairman of the US Fed (1987), it became fashionable for central bankers to be increasingly transparent and expose themselves and their intentions as clearly as possible to the market. As a result, banks and other financial players were easily able to take positions which were as close to a sure thing as possible. If the Fed said it was going to take rates lower, they bought bonds; if the Fed said it was going to keep rates low for a long time, they’d borrow short and lend long (collecting the yield spread) since they knew they could refinance at the same low rate. This play became so entrenched that it was called the Greenspan put (followed right after by the Bernancke put).

This money for jam led, of course, to huge, disproportionate, profits for the financial sector – in the US, financial sector profits as a share of GDP doubled from around 4% in 1980 (which was about the average over the preceding 100 years) to over 8% in 2006. This dramatic increase in size and importance of the financial sector has been called the financialisation of the US (and global) economy, which many senior analysts have blamed for the 2008 financial crisis.

Lord Adair Turner, the then-head of the UK Financial Services Authority, in a lecture at RBI in 2010 said that the Asian financial crisis of 1997-98 was similar to the 2008-2009 crisis in that “...both were rooted in, or at least followed after, sustained increases in the relative importance of financial activity relative to real non-financial economic activity, an increasing “financialisation” of the economy.”

After this issue became apparent after 2008, regulators finally started to bite. Most large banks have paid huge fines during 2014 for various sins dating from the mortgage crisis to more recent market fixing action in LIBOR and FX. Their profits have taken a drubbing and with increasingly tighter regulation and more stringent capital requirements, being a banker just ain’t what it used to be – already the percentage of business school graduates opting for finance has fallen sharply.

To sustain these reforms, central banks need to revert to being what they were intended to be – regulators, rather than (unintentional, no doubt) aiders/abettors of financial position taking. The mini-tsunami that was released last week when the Swiss National Bank broke its 3-year old “promise” to keep the franc pegged at 1.20 to the Euro – the franc rose by 40% in a couple of hours – gives a picture of the scale of positions that can be taken.

Dr. Rajan’s mini-surprise will hopefully be the start of a more circumspect approach to communication with the market in India, and, given his global following, could be a lead for other central banks as well.
 

To quote a very old man who has seen financial markets for well over 60 years: The central bank should be like God; you know she exists, but you only see her in a crisis.



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