Dollar doldrums

Indian Express, 6 August 2007

The credit policy statement last week evaded the big issue of the difficult choice facing India today. Can the RBI deliver the "impossible trinity" -- an open capital account, a weak rupee and low inflation in the coming year? In recent months RBI has used a variety of monetary policy instruments, yet the outcome has been undesirable - a sharp appreciation of the rupee, high inflation and sharply rising interest rates.

First, we must recognise that the instruments that used to work in the 1990s are now failing to deliver. Until January 2004 while keeping the rupee weak by buying dollars, the RBI was simultaneously able to 'sterilise' its forex intervention by selling government bonds from the stock of bonds it held. In this way it kept control over rupees in the system and prevented inflationary pressure from building up in the economy. There was little conflict with the increasing openness of the economy and RBI could continue to liberalise the capital account.

The problem started when RBI ran out of its stock of government bonds. It then turned to the government to issue Market Stabilisation Scheme (MSS) bonds which were meant solely to sterilise its forex intervention. The pace of sterilisation slowed down as its cost became transparent. For example, in 2006-07 the goverment paid Rs 2600 crore as interest on these bonds. The last nine months have seen large scale unsterilised intervention by the RBI. As a consequence, money supply in the economy increased sharply as new money created (M0) grew at 29 percent compared to 17 percent last year.

High money growth was accompanied by high inflation. To counter the inflationary pressure the RBI stepped down its intervention in forex markets in March and the rupee appreciated sharply. Cash Reserve Ratio (CRR) and interest rates hikes meant to reduce the liquidity injected though forex intervention led to sharp interest rate shocks through the system. Higher interest rates began attracting more capital and also raised concerns about investment slowing down. Subsequently these were countered by lack of sterilisation that resulted in zero interest rates in the overnight market. There was complete confusion on monetary policy as RBI strugged to tackle one problem after another.

At every stage the fire-fighting caused fresh problems and more instability. Looking forward, as a policy framework it is ultimately futile because it is rooted in an inconsistent monetary policy framework. The central bank is being asked to deliver conflicting objectives which cannot be all obtained at the same time. To put it in a somewhat simplistic fashion, the picture looks like this: In one month politicians scream about rising prices and so the RBI keeps away from the forex markets and brings down the inflation rate. The next month exporters scream about losses due to rupee appreciation, and then the RBI steps back in and buys dollars to keep the rupee weak. This time it sterilises its intervention to prevent inflation and raises the Cash Reserve Ratio. But now interest rates go up. Households and firms scream about higher interest rates and the RBI stops intervening and liquidity hits the economy. The cycle starts all over again.

One way to manage both the exchange rate and inflation is to go back to being a closed economy. However, as the Prime Minister's Economic Advisory Council report notes, any restriction on foreign investment - FDI or FII - will be adhoc and "most unwise". Policy continuity is an essential element to initiate and maintain such flows.

Can restrictions on debt flows such ECB flows, which are allowed upto a gross limit of USD 22 billion help? In 2006-07, USD 473 billion entered India. Out of this 21 billion was on account of ECB. The impact of blocking ECBs can only be marginal. Today if India opts to restrict dollar inflows on a serious scale, it can be done only through very drastic restrictions on investment and trade. The high GDP growth of recent years is part of India's globalisation story and will suffer.

In addition to growth, globalisation has also meant a much larger flow of foreign exchange in and out of the country. India's annual foreign exchange market turnover has grown to a gross $6.5 trillion in 2006-07 from $1.4 trillion six years earlier. There has been a sharp increase in the average daily turnover in the foreign exchange market from USD 24 billion last year to USD 38 billion this year. This means that it has become more and more difficult to manipulate the rupee. The amount of dollar purchases required to make an impact on the price of the dollar is higher when larger volumes are involved. In end October 2006 the rupee stood at Rs 45.47/ USD. From November 2006 to July 2007 the RBI purchased about USD 28 billion in the forex market, an average of USD 3 billion per month. Despite this, the rupee moved to Rs 40. 77 by end July. If the rupee is to be kept weak an increasing amount of dollar purchase will be required. If this is unsterilised, it will result in inflation. If it is sterilised, it will result in higher interest rates and lower investment. Considering that investment (not exports) is the biggest engine of growth in the Indian economy today, intervention, whether sterilised or not, is a very costly option. Instead of helping GDP growth through higher exports, it could reduce investment and growth through higher macroeconomic instability.

The government must recognise that looking forward it cannot have it all. It must decide where it wants to be 2 years from now and take steps to get there with the least amount of pain. If investment and low inflation are to take precedence, it must move towards greater currency flexibility. A road map towards a consistent monetary policy framework needs to be created. RBI would have done the government a favour by laying it out in the credit policy. However, the responsibility lies with the government. These choices are after all political choices. Government must now act.

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