Saturday, August 18, 2012

>India's Monetary Conditions Index

While bond markets cheer the new finance minister’s comments regarding interest rates being too high, we thought it appropriate to highlight one more dimension to the debate. Even though for the purposes of general debate it is the RBI’s repo rate that gets focused on, the fact is that overall financial conditions are determined by many other variables including market interest rates and the currency exchange rate. Thus, for instance, it is well documented that INR depreciation is beneficial for net exports and hence stimulates aggregate demand. It is for this reason that economists also look at an overall monetary conditions index that gives weight not only to policy rates but market rates, exchange rate and general liquidity conditions as well.

Below we have drawn our own calculation of MCI for India. The blue line below represents the MCI. A rise in the line denotes easier monetary conditions and vice-versa. The red line is the repo rate.

As can be seen, the MCI currently is more representative of the overall financial conditions that existed towards late 2010. The repo rate at that time was below 7%. The easing in the MCI is attributable to a sharp rupee depreciation as well as the 50 bps repo rate cut in April. Also, what may not be fully captured in the MCI is the effect that RBI’s OMOs have had on term spreads of interest rates. Thus for instance while the effective overnight interest rates have risen by almost 500 bps since early 2009, 10 year bond yields are up only about 225 bps since government started revising up its borrowing numbers in 2009. The above only re-iterates the point that the RBI has been making for some time: that while higher interest rates may be partly responsible for growth slowdown; the bulk of the reason lies elsewhere. This also underscores why room for any significant monetary easing remains limited in the current context: not only would aggressive easing in a supply constrained economy be dangerous for demand side inflation but overall monetary conditions are really not as tight as the repo rate alone may indicate.