India & China on same policy footing

Tue, 19 Nov Pre-Open

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Monetary policy is an important tool to control the supply of money and credit growth in the economy. A tight monetary policy will make liquidity hard to come by and cost of capital will rise. A loose monetary policy will ease the liquidity flow into the system and the cost of money will fall.

Apart from this, monetary policy also influences growth rates. A tight monetary policy inhibits growth as rising cost of capital leads to a slowdown in the investment cycle and vice-versa. Hence, central banks have to be pragmatic about their monetary policies. This is especially true when the economy is trapped in the vicious circle of high inflation and slowing growth. If rates are increased to curb inflation, growth suffers and vice versa. This is the case with India and China currently. Growth has slowed in both countries and inflation is eating into the purchasing power of the common man.

However, it can be said that both central banks are doing a commendable job in this regards. While the results are still not visible the steps taken to tide over the situation is noteworthy.

Both the central banks are using inter-bank rates to control the supply of money in the economy rather than the orthodox tool of tinkering with reserves or direct policy rates. Increasing reserve requirements or policy rates has a negative impact on GDP growth. This can have a greater impact on the slowing growth of these economies as opposed to toying with inter-bank rates. Knowing this, both the central banks are a bit cautious in increasing reserve requirements or direct policy rates. For instance, China is predominantly using open market operations to curb money supply rather than directly increasing reserve requirements or policy rates.

Most economists pointed out that this is a step towards market based pricing as inter-bank rates indicate borrowing and lending between banks and not between banks and central banks (RBI and PBOC in this case). This is likely to deepen markets, liberalize them and make both the countries move towards market based pricing. However, despite that, some controls are required. Also, moving towards market based pricing can lead to extreme volatility in rates as is witnessed in India and China. Thus, it would be interesting to see whether the market based pricing approach or the traditional tool of controlling money supply through orthodox policy rates is more successful in the long run.