Last week, after an interest rate cut by the European Central Bank and market expectations of a cut in the repo rate, the RBI issued a statement saying that despite market expectations, it does not plan to cut the repo rate in the near future. The reason given was that inflation rates in India were higher than in Europe.
This statement gives rise to a a number of interesting questions. The first issue is RBI's reading of market expectations that it would cut the repo rate. Interest differentials with international rates are already high. With the forward premium being low, investors can be fully hedged and bring money into India. With the RBI already buying up dollars, as it struggles to keep movements in the exchange rate within small bands, anything that puts more pressure on the rupee to get stronger, should logically be countered by the RBI. In this case, an ECB rate cut at a time when the 91 day treasury bill rate had been pushed to below the repo rate, naturally raised expectations of a rate cut.
RBI has raised the issue of inflation differentials. In the case of short term fund flows this is not important. Does an NRI investing in a 6-month rupee account, an FII investing in a 3 month treasury bill or a fully hedged corporate borrowing abroad need to worry about the fact that inflation in India is higher than in Europe? The inflation differential is important either when it creates expectations of a nominal rupee depreciation due to an appreciation of the real exchange rate, or if the money is to be spent in India.
Or, it could be that the RBI meant that reducing interest rates, or an expansionary monetary policy, could be inflationary? There could be an argument that when our inflation rates are already higher than international rates, we cannot afford even higher inflation. But the credit policy claimed that the recent increase in the inflation rate is not a monetary phenomenon. Money supply growth in the last 12 months has been strictly under control. Despite the huge increase in its foreign exchange assets, the RBI's sterilization measures have kept reserve money growth and M3 growth in check. Supply shocks in the form of an increase in petroleum and edible oil prices is a more likely explanation of the recent inflation, than monetary policy.
So, if we are not convinced by the RBI's inflation differential story as the reason for not cutting repo rates, what else could lie behind it? Is it that the RBI is finally coming around to de-emphasising the policy of containing exchange rate volatility? Is this the first step towards not subjugating domestic interest rate policy to exchange rate policy? Or, is it merely that this time cutting the repo rate was not as easy an option as it seemed? It could also be that the RBI feels that it can continue to manage exchange rate volatility without necessarily having to change interest rates by continuing its policy of sterilised intervention, at least for another few billion dollars.
What is wrong with the policy of reducing exchange rate fluctuations by inducing interest rate volatility? First, the reasons for containing exchange rate volatility that may usually be quite convincing for an emerging economy, may not hold for India. In economies where the traded sector has a large share, and where exchange rate movements have a significant impact on prices, it may be prudent not to allow fluctuations in exchange rates. Fixed exchange rate regimes could be a means for emerging economies to implement inflation control. However, cross-country evidence does not unambiguously support the hypothesis that exchange rate policies are very effective. There is also no clear evidence to indicate that exchange rate volatility reduces trade. In India, while in the case of petroleum products exchange rate fluctuations may cause significant price volatility, in general this is not a major factor in the determination of prices, at least not so far. Thus, relatively higher exchange rate volatility is unlikely to directly affect the vast majority of the people.
On the other hand, interest rate volatility directly affects the majority of businesses and households. While changes in rates on loans may put into disarray a large number of business plans, households tempted into borrowing when interest rates are low (but often at a floating rate) may find themselves in trouble when rates go up. At the same time, retired folks dependent on interest income on their savings will find their incomes fluctuating with interest rates. If the fluctuations in income are higher due to interest rate movements, than due to exchange rate volatility, then there may be case for reducing the emphasis on containing exchange rate volatility. Higher volatility of interest rates also increases the risk exposure of banks and other financial intermediaries and could result in higher cost of capital as they try to hedge their risks.
The politics of the policies are no less important. The impact of interest rate changes is highly visible. Not surprisingly, the interest rate on the PPF has been a major political issue. Labour minister Sahib Singh Verma's recent decision to not cut the EPF rate, despite having to dig into reserves, is a result of such political considerations. The fact that BJP's constituency, the voters and the cadre, are the same ones who wanted Yashwant Sinha out of the finance ministry because he proposed to cut the small savings rate, would be a factor. A downward movement of interest rates would be unpopular with these highly vocal segments.
The impact of exchange rate volatility is not so visible and unpopular. This is even more true now when there is pressure on the rupee to appreciate. First, a stronger rupee is not associated with a false sense of loss of national pride, the way a depreciating rupee has often been. Second, appreciation reduces prices of imported goods. Oil has become cheaper with the rupee appreciating. Of course, there will always be exporters who will hurt when the rupee appreciates. In the last decade India needed to expand exports and keeping the rupee weak was important. But today it is time to re-examine this policy, especially when it could actually adversely impact the domestic economy and a large number of household incomes and business plans.
Until recently, the rupee has been exhibiting the lowest exchange rate volatility among the nations who claim to have a floating exchange rate (only after Malaysia) and the volatility of interest rates and reserves is 4 times that in the US. If the RBI is going to now shift emphasis away from exchange rate stability towards reducing interest rate volatility, the outcome is likely to be welfare enhancing.
The author is at ICRIER. These are her personal views.
Ila Patnaik
ila at icrier dot res dot in