The European Central Bank, the Bank of Japan and the US Federal Open Market Committee all meet in the fourth week of July. Those policy meetings could result in some central bank actions. The yen has hardened sharply after Brexit; the euro has cracked and the pound has taken a hammering. The dollar has hardened, too, while the yuan (not a hard currency) has dipped.
Two major hard-currency regimes - Japan and the eurozone - are running negative interest rates, and their respective versions of quantitative expansions. Both Japan and the European Union will quite likely, be forced to take action due to Brexit. Their options are limited, as they are already running negative rates. The Bank of England might also have to take action. The US Federal reserve, in contrast, could decide to hold off. Global growth will be affected if the Fed does raise rates, as it threatened to do prior to Brexit.
Apart from currency volatility, RBI has other worries. Inflation is moving up. The Consumer Price Index-based and the Wholesale Price Index-based inflations are climbing. Though Brexit will lead to subdued crude oil and gas prices, high food prices are a major cause of inflation. A good monsoon could help control food inflation. But, if RBI has to manage higher food inflation, its only weapons are cutting liquidity and keeping interest rates high. Money supply will rise, given the Seventh Pay Commission. So, it would be hard to cut liquidity. Raising rates would be politically difficult.
Most governments are sensitive about inflation as it influences votes. But, this government wants loose monetary policy and lower rates, even if this doesn't make sense when gross domestic product growth is supposedly roaring at 7.6 per cent. If RBI loosens when it should tighten, the 2017 inflation targets will be missed and stagflation could result.
Another problem is the incipient banking crisis. This is actually the most dangerous in terms of the potential long-term damage. Bad loans have skyrocketed to Rs 5.8 lakh-crore and more bad news is expected. Crisil has downgraded nine banks since March and expects stressed loans to rise to Rs 7.1 lakh crore by the end of 2016-17. The Financial Stability Report by RBI paints a gloomy picture.
Banks must be recapitalised after the write-offs and additional capital brought in to meet Basel-III norms. Since the bulk of the bad loans, roughly 90 per cent, are in public sector banks, how the recapitalisation is done is a political decision. But, it will be the central bank's headache to manage the recapitalisation. If mishandled, the consequences could lead to structural problems that cripple the entire economy.
The other thing is that a massive overhaul and reform of banking processes is required to prevent this sort of bad loan situation building up again. Again, such reforms would require political policy decisions. But the RBI must push for reforms. It would have to give sensible advice on how to do this, and it would have to give that advice in politically acceptable ways.
Any political establishment will always be reluctant to reform banking in a meaningful way. The major beneficiaries from poor loan appraisal and disbursal processes are always special interest groups with political connections. It will be up to the RBI to persuade the government that there is a genuine crisis, and reform is imperative.
There are many competent economists available. But the next RBI governor must not only deal with large technical issues. He (or she) must possess enough political acumen to manage a delicate relationship with the Finance Ministry and the PMO and, thereby, persuade the political establishment to swallow a bitter pill.
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