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Does the RBI know what it wants?
Ila Patnaik

The RBI no longer seems to have any clearly defined objectives,

The purpose of the statement by the RBI on recent developments in the foreign exchange markets was, it said, to clarify some issues that have been raised on the recent developments in forex markets and the RBI’s role. Rather than merely defend its actions the statement should have provided a perspective on the objectives of RBI’s policy. Unfortunately, it entirely failed to do this. Instead, the statement focused on stating that the RBI was not targeting a specific rate. But then no one had suspected it of doing so. Further, it pointed to trivial details such as that it had made a statement when the value of the rupee was 44.29 rather than a round number representing a “Lakshman Rekha”. How absurd can it get? It failed even to state, as was done often under C Rangarajan’s governorship, that the objective of the Reserve Bank of India’s exchange rate policy is “to keep the rupee in line with fundamentals” implying that the real exchange rate would not be allowed to appreciate. Was this because despite the downward pressure from the fundamentals — inflation differentials, export and import demand and the current account deficit, the Reserve Bank of India was trying to keep the rupee strong? The Reserve Bank of India, it appears from the latest episode, no longer has any clearly defined objectives-unless, of course, preventing speculation can be the cornerstone of a Central Bank’s exchange rate and monetary policy! But, surely, that would be ridiculous. It seems that though the Reserve Bank of India continued to prevent the rupee from falling for a while, it was more from inertia than with a clear vision of how this would impact on the Indian economy. It is, after all, clear that in the present situation it seems nothing can be gained by keeping the rupee strong, while industry stands to gain significantly if it depreciates. So why did the Reserve Bank of India try to defend the rupee initially? Often text books on macroeconomics have a chapter on the objectives of monetary policy. Usually the objective is defined as fairly straightforward — keeping down inflation as in the case of New Zealand, maintaining the exchange rate within a band as in the case of UK under the exchange rate mechanism or, in a more general case, maximising a social welfare function with weights given to inflation and growth. Macroeconomic models of the economy often include a ‘reaction function’ of the Central Bank that defines the way the bank would react if a certain thing happens. Such as if the inflation rate rises beyond x per cent, the Central Bank would tighten money supply. Many a time this reaction function is found to be unstable. In other words, the objectives of monetary policy do change over time. Yet, at any point of time at least, it is possible to say what the Central Bank is trying to achieve. In the case of India, however, the objectives of monetary policy seem to be shrouded in mystery. Not only is the objective not clearly stated even RBI’s actions do not make it obvious. Market players, researchers and analysts have a full time job of trying to guess what it is. One day the Central Bank defends the rupee. The following day when it fails to do so it comes out with an explanation saying that it wasn’t really defending it, it leaves everyone guessing about what it was really trying to do. Yet, even as one wonders why, it seems that defence of the rupee does feature high on the Reserve Bank of India’s agenda. Despite the need for lower interest rates by government and industry, last year Reserve Bank of India’s inflation phobia prevented it from lowering interest rates even when inflation was low. After a lot of persuasion it did lower interest rates in April this year but the rates were raised as soon as pressure built up on the rupee to depreciate. One reason to defend the rupee would be to keep FIIs confidence in the rupee and prevent them from fleeing for fears of further depreciation. But this objective can be pursued only so far without undermining the interests of domestic economic agents. For the majority of domestic producers there is nothing to be gained from defending the rupee. A depreciated rupee helps exporters. A weaker rupee also helps domestic producers of goods that have seen the removal of quantitative restrictions. When the market, thanks to the forces of demand and supply — in this case the rising import bill, both oil and non-oil — is pushing the rupee down at a time when the recovering manufacturing sector needs it, it makes no sense to keep the rupee from depreciating. Not only that, when the defence of the rupee cannot be achieved by the direct foreign exchange intervention and the Reserve Bank of India tightens money supply and raises interest rates to achieve it, which would clearly hurt industry, the policy makes even less sense. In this case even the policy instruments used by the Central Bank did not work. This is because the interest rate instrument is effective only in so far as it determines capital movements. The effectiveness of changing the differential between domestic and foreign interest rates depends upon the importance of the capital account in the forex market. In India the trade account still continues to dominate foreign exchange movements. The fundamental determinant of the exchange rate can still be found not in the money market, which was being targeted by the use of the interest rate change, but by the goods market. Since the trade deficit is rising as import demand is picking up faster than the growth of exports, the RBIs intervention failed to have the desired effect. Clearly, the RBI needs to rethink its objectives and perhaps give a greater weight to the growth objective. It needs to be much clearer on what the requirements of the economy are and how its exchange rate and monetary policy can help to achieve them. Neither inflation control nor the strength of the rupee can be the mantra of the Reserve Bank regardless of what the needs of the Indian economy are. Further, it has to realise that in an economy with restricted capital flows instruments of monetary policy that work well in an open economy will have only limited effectiveness. In other words, as trade still continues to dominate the movement of foreign exchange in India, interest rate changes will not be as effective in determining the exchange rate as the RBI seems to believe. In the fullness of time one hopes that the RBI will feel confident enough to encourage public debate on its policy objectives and adopt objectives that are both transparent and in consonance with the needs of the Indian economy. Ila Patnaik is a senior economist at NCAER

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