Money market traders are not a happy lot these days. Each Friday, they shudder in sheer trepidation of some extraordinary intervention by the Reserve Bank of India. Some of their fears may be justified when one looks at the greater active intervention by the RBI in recent times, both in its market operations as well as policy interventions.
These moves by the RBI have kept the markets guessing and pushed them into a corner. So much so markets see ghosts in every shadow and are perhaps over-stating the problem. Why have the markets become that much more fearful of the RBI? Is it good for the markets? What should they be doing about it?
There are two fundamental reasons why the markets have of late seemed to have turned nervous. One is the serendipitous development of the money and foreign exchange markets, which are forever evolving from the shades of control into greater market freedom.
The other is the dichotomy between not so strong fundamentals and the overly bullish technicals of these markets. These are not reasons that have sprung up suddenly. With the growth of the markets, stakes perhaps have now risen well past limits of tolerance in the RBI's books.
The market is at an important juncture in its evolution. Even though it is painful, these developments augur well for the sustained development of our financial markets, as the regulator tests its prowess and the players learn the new rules of the game.
Less than a decade and a half ago almost all the money market and exchange rates were controlled by the government or the RBI. They have been liberalised over the past 15 years, a journey that is as yet coursing its way through some systemic rigidities and narrow interests. Even now the interest rates on the small savings of the state governments and the provident funds are policy-determined and may or may not reflect market conditions.
And these do weigh heavily on other market-determined interest rates, and therefore it is fair to attribute quotation marks to the term "market". While some private and foreign players believe that markets forces are supreme, and have begun to aggressively play the market, there is the predominant traditionalists' school, primarily consisting of the public sector banks, which believes "markets" need to be conducted in an orderly fashion and which look to leadership to others and "signals" from the RBI.
The RBI's actions, while mainly determined by its view of the markets, could also be influenced by the some of the behaviours in the market place.
The RBI could be worried that some fundamental indicators such as current account deficit, balance of trade and inflation, which keeps rearing its head time and again, offer a risky picture of the environment.
On the contrary, the flush of liquidity that the system is awash with and the accelerating momentum of foreign inflows as reflected in forex reserves, the appreciating rupee, vertically climbing equity stock markets and softening interest rates are not doing anything to help the situation.
This dichotomy has deepened in recent times and made the RBI watch the situation ever more carefully. The contra-indicators are the most severe ever and any mis-step now can trigger fairly steep corrections towards a far more sedate fundamental valuation.
The RBI's initiatives may be directed towards moderating the market positions in such a way that potential hits are made tolerable. Clearly under the circumstances of extreme liquidity momentum, the RBI might even be exaggerating its actions to keep the markets guessing. At the least till the fundamentals and the technicals begin to converge, the market will do well to anticipate a continuation of the current paradigm.
From the markets' perspective, a greater predictability of the RBI's intervention will give them a space to operate in and take meaningful positions, which is important to develop a healthy and broader market. Clearly the RBI cannot tip its hands as far as its market operations are concerned.
However, there is scope for the RBI to clarify what it will do on the policy front, including CRR cuts or impositions, tinkering with overnight positions or indeed curbs on various activities. This would not so much deter the aggressive market players, but the sensible ones can set their own trading rules incorporating these possibilities.
Assuming there are more sensible players than not in the market, such a measure of transparency on the policy front will help markets' overall behaviour improve. Also it is important to realise that there are now genuine two-way movements in most markets, unlike in the past, when there was almost complete unanimity of unidirectional expectation of the market. The RBI will do well to reinforce this message by its actions.
It is surprising, however, that the markets have done little to adjust to the new reality. The RBI's current caution naturally favours the traditionalists, but challenges the aggressive players who feel they are being unnecessarily constrained.
Indeed, the traditionalists might even mistakenly infer that the RBI is favouring them and is against the market forces. On the contrary, the aggressive players continue to churn the markets with relative disregard to the RBI's growing concerns.
In fact any wild moves from the market will most likely see a greater and opposite reaction from the RBI! Moderation in action for a while might calm things down all around.
Markets might also formally add one more element called the "intervention risk" in their trading risk strategies. Each trading room might construct its own "band" of movement for each variable such as the exchange rate, interest rates or inflation that in its view might be the toleration limits for the RBI.
The traders might then anticipate an intervention if the variable breaches these bands persistently. That might make the situation a little bit more predictable. The shallowness of the market might also accentuate both the concern to the RBI and their actions. It is therefore important to widen and deepen the market with a collection of heterogeneous players holding diverse opinions.
Traditionalists need to play a more active role. Indeed by their very presence, they might lend the much-required stability to the market, reducing the pressure on the RBI as the only stabilising influence, which it by and large is at the moment.
Indeed it is in the RBI's interest to have a well-diversified and a true market with genuine participation from all sections so that natural counteracting forces will create the healthy market that will serve everyone well.
Therefore, one medium-term goal for the RBI has to be to push all players to become more active in the market. Then perhaps it would be time for us to call it a market without the quotation marks!