Unmade in America

Financial Express, 21 April 2008

The setting for the credit policy announcement this quarter is very challenging. There are no obvious answers to what the RBI should do. The problem is bigger than meets the eye. Earlier this month the Raghuram Rajan committee on financial sector reform released its draft report where it said that the RBI should have a single goal. It should focus on inflation. This recommendation has come under criticism from a lot of economists who believe that India can continue to act as if it is financially closed, or almost closed, to global capital flows. The challenges faced by RBI in the forthcoming monetary policy announcement serve to highlight exactly the point that unlies the argument for a single goal made in the Raghuram Rajan report.

Looking back this year, in January there was an argument for cutting interest rates to reduce interest differentials with the rest of the world. Since July when the US started cutting rates, capital inflows into India tripled. This was to a large extent in response to the interest differential that had reached nearly 500 basis points. In its attempts to prevent rupee appreciation, the RBI was buying up dollars which it was then trying to sterilise. Monetary policy was being implemented through RBI intervention in currency markets and the sales of government bonds to sterilise the impact of its intervention. The rupee was pegged to the US dollar and kept flat between Rs 39 to 40, except for a brief period when the RBI tried to engineer a depreciation by purchasing a huge amounts of dollars.

The setting for the credit policy announcment later this month is similar, except for one big difference. A sudden and sharp increase in inflation has added a new dimension to the problem. At the same time US interest rates have continued to decline and the interest differential with respect to India has increased. The US 90 day treasury bill rate is 1.04 percent. The interest differential with Indian 91 day bill rates is 600 basis points. Any increase in interest rates in India will lead to a further increase in interest differentials. This will attract more capital inflows into India and put pressure on the rupee to appreciate. If the government and RBI decide not to allow rupee appreciation, RBI's trading will inject more liquidity in markets. In an inflationary environment that is not desirable. Even if raising rates was expected to be useful in combating inflation caused by global commodity price rise, given that foreign interest rates are much lower, instead of reducing liquidity in the system, it may actually increase it, and may therefore not be the best policy option.

This presents the biggest challenge for the RBI today. Raising rates will make it very difficult for the RBI to continue its currency policy. If it does so, then it will have to struggle with the increase in liquidity that comes into the market. One option the RBI could adopt in such a sitution is to raise the CRR. This would be able to mop up the additional liquidity that will come into the system whent the RBI intervenes in foreign exchange markets. But raising CRR will put pressure on banks to raise interest rates further.

There is no easy solution to the problem. The basic difficulty is the inconsistency of the monetary policy framework. If India wants to tighten monetary policy when the US is following a loose monetary policy, then India cannot peg the rupee to the US dollar. If we do so, then we import US monetary policy. The RBI's answer to this has been to do sterilised intervention to beat the constraints imposed by the impossible trinity. However, sterilised intervention maintains the high interest differential and money continues to come in, making it more and more costly for the government.

The setting for the credit policy announcement this month has served to highlight the difficulty in our monetary policy framework. The question politicians are addresssing is the here-and-now question. Even if over the next few weeks this question is solved and inflation goes down, what needs to be addressed is the larger question of how to achieve a low and stable inflation rate for India. Lurching from one inflation episode to another, and pulling out recipes from the days of the Emergency to distort markets, is no way for India to now behave.

What India needs is a new thinking on macroeconomic stabilisation in an open economy framework. While one may have a debate on whether the target should be inflation or as some economists believe, exchange rates, it is time that we accept the reality that the framework of monetary policy in India needs to change. It needs to be designed for a a financially globalised world where control and licence raj solutions will not work. Politicians in India have a dislike for inflation. They are right to abhor inflation. This energy needs to be channeled away from raiding traders or banning futures markets, to instead putting in place a better monetary policy framwork, which achieves reliably low inflation.

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