How RBI imported high prices

Indian Express, 4 April 2008

Inflation has struck again. The government is back in firefighting mode. Ban exports, cut duties, issue warnings to steel and cement producers not to raise prices, and a plethora of distortionary measures are back on the agenda. The belief that government meddling in markets, product by product, market by market, is going to bring down inflation, is back with a vengeance.

Apart from the fact that such measures are rarely effective when inflation is an economy-wide phenomenon , an additional difficulty with this manner of tackling inflation is that it does not take into account the long term adverse impact of the measures that are taken. When the Finance Minster is under attack, when opposition parties are screaming, when the media makes inflation numbers into a mini-circus, the government responds to inflation in a knee-jerk manner, solving the here-and-now problem and not worrying about how to get India to a long run path of low and stable inflation.

Recall what happened last year. Inflation based on the Wholesale Price Index (WPI) rose to above 6 percent in Jan-March. When measures like banning milk powder exports and banning some commodity futures did not deliver, the rupee was allowed to appreciate. Inflation quickly came down. But once inflation was down, there was a lack of follow-through with deeper structural reforms.

Since the rupee appreciation through which low inflation was achieved was sharp and unexpected, exporters were an unhappy lot. The whole year was spent in trying to keep exporters happy by preventing further rupee appreciation. The government gave the RBI the unenviable job of keeping the rupee weak in the face of strong capital inflows. In its attempts to do so, the RBI bought USD 80 billion dollars since March, pumping liquidity into the system. While this was the true monetary policy stance being played out everyday in the the foreign exchange market, the RBI sold Monetary Stabilisaion Scheme(MSS) bonds, raised the cash reserve ratio (CRR) and hiked interest rates to contain inflation.

The crisis in the sub-prime markets led the US Fed to cut interest rates. This made it harder for India to run the pegged exchange rate, because it led to higher interest differentials with India and made India an even more attractive investment destination. From an average of USD 3 billion per month, net capital flows into India rose to USD 10 billion per month after July. This increased the pressure on the rupee to appreciate and led to more intevention.

After focussing on the rupee-dollar rate all year in a year when the dollar was depreciating sharply, it was to be expected that sooner or later inflation would be back. An increase in global commodity, oil and food prices in dollar terms acted as the trigger. By keeping the rupee in the Rs 39-40 range, any advantage India could have got, as Europe did, for example, of a strong currency was lost. We imported global inflation. And, worse, with all the CRR hikes and interest rate raises, households and firms also paid the price through higher interest rates.

The sudden and sharp increases in prices, the exchange rate and interest rates that we have seen over the last 12 months are a symptom of the lack of a clear framework for monetary policy. If the RBI were asked to do inflation targeting, and not spend the whole year trying to prevent rupee appreciation, it might have been able to deliver results. In the present system, it did not stand a chance. It lurched from objective to objective as inflation, exports and growth came under threat.

The long term solution to inflation is to give India a central bank that focuses on inflation control. For many years now there is a consensus in the economics literature all over the world that there is no trade-off between inflation and growth. Stable inflation encourages growth.

But what about the here and now problem? How will the government control this episode of inflation? Evidence from across the world and from India for the last ten years suggests that the quickest way to achieve a reduction in inflation is through a currency appreciation. If the rupee appreciates by 10 percent, inflation comes down by about 1.7 percent within a month and stays low for a few months. This relationship may be stronger if inflation is caused by global commdity price rise. On the other hand, if interest rates are raised, the effect on prices takes between one to two years. This time around the inflation is not demand driven, as was the case last year when the economy was overheating. A small hike in interest rates is unlikely to have much impact on inflation even over a year. To achieve a reduction in inflation the government will thus be making a choice between rupee appreciation and a big interest rate hike.

It is likely that in the next few weeks the government might make some more announcements that make it appear that it is trying to fight inflation. Various bans might been conjured. There will be talk of cartels, hoarders and speculators benefitting from price rise. When all this fails to bring down prices, rupee appreciation may appear to be the best choice. It will make exports less attractive and imports cheaper and work much better than the quantitative restrictions.

However, in the last few weeks the pressure on the rupee appears to have eased a little. If the market, left to itself, does not experience an appreciation, the government needs to move forward on easing capital controls. As an example, it could ease restrictions on capital flows such as on dollar loans eg. External Commercial Borrowings (ECBs). This would increase inflows of capital and help give a strong rupee. It would also help growth by easing financing constraints of firms. The second path to a strong rupee consists of raising interest rates. However, this would have an adverse effect on firms and households who have borrowed.

In the face of impending elections, the political pressure from firms on the already high cost of capital, from households on the high interest EMIs and the slowdown in growth seen in the industrial production, it seems unlikely that the government is going to cling to its present exchange rate policy even if it hurts some exporting industries. As a consequence, a rupee appreciation may be on the cards.

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