Appreciate the positive

Indian Express, 12 April 2010

After many months of staying away from currency intervention, RBI made headlines last week when it returned to the foreign exchange market to prevent rupee appreciation. The consequences of foreign exchange intervention by the RBI will create difficulties for monetary policy, especially because inflation is high, the government borrowing program is large, and growth is in recovery phase. In a recent speech Manmohan Singh said that the RBI should focus on inflation control. In policy action terms this requires RBI to stay away from currency markets.

Last month RBI raised interest rates in response to higher inflation. The clamour for doing something about inflation had been rising, especially with parliament in session. RBI responded by a hike in policy rates. The increase was small enough not to cause damage to the recovery, yet big enough to satify public opinion.

One way through which monetary tightening helps curb inflation is because higher interest rates attract capital and help strengthen the currency. In India, the exchange rate is the strongest channel through which higher interest rates help control inflation. A stronger rupee makes the price of tradables lower. Had the rupee not appreciated in the last few months, the higher inflation observed in global commodity prices would have resulted in much higher input prices for manufacturing. The strengthening rupee meant that the rupee value of commodity imports rose slowly. If, in addition to the food price rise, Indian manufacturing had seen input prices rising at 7 percent, the global commodity price inflation rate, WPI inflation would have been worse.

In the coming months even if food prices stabilise, there is a risk that inflation could still go up. There could be two main channels through we could see cost push inflation. Dearness allowances, salaries and annual wage negotiations are normally linked to the consumer price index, which stood at 14.86 percent in February 2010. This could result in higher cost of production as labour in manufacturing could become more expensive. The second risk is of further increase in global commodity prices. As the US recovery gains strength, and world demand picks up, this could mean higher input prices for manufacturing.

When a central bank raises interest rates in an inflationary environment, then allowing the exchange rate to appreciate is part of the policy package to control inflation. This is what was happening until recently as the RBI was slowly moving away from easy monetary policy. Tighter monetary policy in India compared to the US where rates are still very low helped to increase the flow of capital to India, strengthen the rupee and thus control imported inflation.

If the RBI were to prevent appreciation, it would lose one important channel through which inflation can be controlled. Not just that, buying dollars adds liquidity to the system, which is inflationary, and RBI will have to find ways to curb this increase in liquidity. It could do so by selling more government bonds and raising the cash reserve ratio. The former is difficult given the already massive government borrowing program. The latter might aim to sterilize the intervention, but since it would appear to be monetary tightening by the RBI in response to fears of inflation, it could hurt the growth recovery in credit growth.

The overall regime would be a muddle along. There is likely to be some rupee appreciation, some increase in liquidity, some sales of government bonds for sterilization (MSS), and some increase in CRR and interest rates. In the lack of clarity about the objective of monetary policy there will be knee-jerk reactions and policy uncertainty. When the opposition screams on inflation, there may be rate hikes. These could continue till there is significant rupee strengthening. The RBI could then respond to exporters interests by intervening. When sterilizing its intervention through sales of bonds becomes too hard, the RBI would raise the CRR or interest rates. Firms would scream about higher interest rates making credit more expensive.

Tired of making exporters, firms and the aam aadmi unhappy, the government could try to put some capital controls in place. Capital controls often change the channel through which money flows in, but do little to prevent currency appreciation in the longer run. The RBI will have a difficult job trying to manage all these demands. We have seen this story play out before in 2004 to 2007. But given the already high inflation, it is likely to be worse this time. Two more factors that will make RBI's job more difficult are the larger interest differential with the US and advanced economies and India's larger level of integration with international financial markets compared to a few years ago.

How can we avoid the above policy difficulties? While one can argue about the benefits of export growth, let us for the moment accept that promoting exports is part of government policy. In the present stage of world trade recovery when export demand is rising rapidly after the disruption caused by the global financial crisis, the impact of a stronger rupee will be mild. Even in the past, the response of export demand to changes in the rupee exchange rate have been small. Today the effect of rising world trade would far outweigh the effect of a stronger currency. The effect of rupee appreciation could, at worst, be slower growth, rather than a decline in exports. Jobs in the export sector are expected to grow even when the rupee is appreciating. In this environment, RBI should focus on inflation control (which would include allowing rupee appreciation).

The policy of promoting exports should be addressed through a separate subsidy policy. Subsidies through various channels acceptable under the WTO can be given. This would be transparent and not prevent monetary policy from focussing on controlling inflation. If the political consensus is to support exports, they should be supported through transparent subsidies instead of through imposing costs on all households and firms. Preventing rupee appreciation to promote exports must be avoided.

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