Let the rupee climb

Indian Express, 21 April 2008

Governor Reddy has announced a tightening of monetary policy just ahead of the credit policy statement for the quarter. Inflation is high, and there is a well justified clamour from the general public to combat inflation. But raising the cash reserve ratio (CRR), as the RBI has done, will not help matters.

In fact, a monetary tightening at this time is a bad idea. First, this round of inflation, unlike inflation last year, is not demand driven. When the objective is to reduce inflation by reducing demand, it is a good idea to raise rates. But now, when demand has moderated, when credit growth is down to 22 percent, and industrial growth is lower, when the signs of overheating are gone, raising rates would not help in pulling down inflation. Instead it would hurt an industry facing a slowdown.

Morevoer, it would attract more capital inflows into the country. More dollars come in and as the RBI continues its policy of preventing rupee appreciation, it buys up more dollars. This leads to more liquidity into the system. A tightening of monetary policy, whether through a CRR hike or through an interest rate hike is counter productive in an environment when our interest rate differential with the world are high, and we are trying to prevent a rupee appreciation. It will not result in inflation control. Instead it will result in even greater liquidity in the system, more CRR hikes and more interest rate hikes as the RBI struggles with the impact of these hikes.

In textbooks, a tight monetary policy has an effect on inflation when credit becomes more expensive. Industry and consumers borrow less and spend less, demand goes down and goods become cheaper. This process, however, from the Central Bank's tightening monetary policy to inflation coming down takes about 1.5 to 2 years. Further, as many economists have emphasied over the last few days, the recent bout of inflation is led by global commodity prices. And, interest rate or CRR changes are unlikely to have a significant impact on food price inflation.

If the hike in the CRR is not going to control inflation, why did the RBI do it? The primary purpose is to sterilise the increase in liquidity injected into the system as a consequence of its foreign exchange intervention. This year RBI's purchases of dollars has added Rs 1.5 lakh crore to the monetary base. RBI has to constantly find ways to mop up this liquidity. Inflation has provided RBI an excuse to use the CRR, the worst instrument in its hand, to sterilise its intervention. It imposes the cost of sterilisation on banks and their customers. If the RBI was serious about reducing inflation, then instead of trying to control the impact of its forex interventions through a CRR hike, it would have stayed away from the market. Strangely, we see that even after inflation started rising, RBI contintued to buy up dollars. From USD 290 billion on March 1, India's foreign exchange reserves grew to USD 301 billion by April 5.

Since global inflation is high in dollar terms, a stronger rupee will actually be beneficial as it would give us cheaper food and raw materials. Today, the global increase in prices is so much that a 10-15 percent appreciation can only have a small impact and not counter the entire increase in prices, such as in rice prices. However, it would make exporting a less attractive option and importing cheaper. When import duties of one or another item are changed or exports are discouraged, it can only have limited impact. A stronger rupee will impact all tradable prices right away. Hence, a stronger rupee will have an immediate impact on prices.

If so, then why does the government not allow an appreciation immediately? If the RBI stepped away from currency markets and imposing capital controls to curb rupee appreciation there will be enough pressure on the rupee to appreciate. If it the fear of hurting exports? Recall that despite all the noise exporters made, exports did exceedingly well after the rupee appreciation last year. Total exports of goods and services in the first quarter of 2007-08, after the rupee appreciation in April 2007, grew by 19 percent, in the second quarter they grew by 23 percent and in the third quarter by 35 percent.

The decision to let the rupee move or not, has always been a political decision, as it is today. A choice will have to be made between the interests of a very vocal lobby of exporters, who as a whole have not suffered, and between the mass of the population is getting hurt by inflation. This is much like the political economy of cutting customs, where the general economy benefits and a focussed lobby loses.

It is also time to reconsider the dual role of RBI as banking regulator and monetary policy authority. As the country's banking regulator RBI should be ensuring a healthy banking system. If bank risk was high, the cash reserve ratio, money that banks have to hold with the RBI, should be raised. Now, instead we find the RBI using the CRR as an instrument of monetary policy. Banks are justified in protesting about the costs of RBI monetary policy being imposed on banks. If the government believes that to protect the interests of exporters is more important than protecting the interests of the public, they should have to pay a fiscal cost for it. If RBI had been only the monetary policy authority and not a banking regulator, it would have sterilised its intervention through greater sales of Market Stabilisation Scheme bonds, where the government pays the cost, rather than through raising CRR, where banks pay the cost. It is allowing its objectives as the monetary authority to override its objectives as the banking regulator.

The current episode of inflation has sharpened the conflicts of interest among the different objectives of RBI i.e managing the rupee, controlling inflation and regulating banks. The government should use this opportunity to address this larger question and implement fundamental changes in the policy and regulatory framework.

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