India: untenable currency policy

Financial Express, 26 July 2007

Since the days when C. Rangarajan was Governor, the RBI has been very keen on sterilising its foreign exchange intervention. When RBI buys dollars on the market, this injects rupees into the economy. `Sterilisation' consists of trying to undo the damage and regain control of local monetary policy.

Between 1993 and 1995, sterilisation was attempted by raising the cash reserve ratio. From 2001 to 2004, fairly effective sterilisation was done by selling government bonds. When it ran out of bonds in early 2004, RBI approached the Ministry of Finance to setup the `Market Stabilisation Scheme' (MSS). MSS bonds are sold by RBI for the purpose of sterilisation. The money obtained from selling these bonds is immobilised in an RBI current account. Interest payments on MSS bonds are one explicit fiscal cost of sterilisation.

The remarkable feature of recent months is a huge scale of currency trading by RBI that is not backed by sterilisation. Every RBI staffer knows that large scale purchases of dollars without commensurate sterilisation will bloat reserve money growth and ignite inflation.

Why might it be that RBI is trading on the currency market without sterilisation? Without sterilisation, purchases of dollars injects rupees in the economy. The economy becomes flush with funds; interest rates go down. This would tend to reduce capital inflows.

In the language of modern macroeconomics, RBI is choosing to run a pegged exchange rate with a fairly open capital account - thus ceding control of monetary policy. The short-term interest rate is explicitly controlled by the demands of currency trading.

At first blush, it appears that RBI has a consistent solution to the problem of the impossible trinity: peg the exchange rate and stop trying to have a monetary policy. Such a path is, indeed, feasible in terms of the economics. The trouble is, this solution to the impossible trinity is not politically feasible.

The policy of unsterilised intervention runs afoul of the low inflation tolerance of the Indian voter and politician. The recent surge of reserve money growth will feed back into inflation with a lag of a few months. Even if the UPA leadership is benign about inflation right now, they will soon be on high alert when the inflationary consequences of the recent unsterilised intervention show up and elections are impending.

Can new ways for sterilisation be found? The fiscal costs work out to be untenable. The present run rate of purchases by RBI works out to roughly $50 billion a year. Without sterilisation, this involves adding roughly Rs.200,000 crore to reserve money, or an unacceptable 28 per cent growth rate. Suppose a growth rate of 14-15 percent was acceptable. Then this involves fresh MSS issuance of Rs.100,000 crore per year.

If this is done, then within a year, the stock of MSS would go up to roughly Rs.200,000 crore. The annual interest cost on this would be roughly Rs.15,000 crore. The politicians would not be amused at RBI imposing such a massive fiscal cost.

Further, this scale of purchase - of $50 billion per year - will go up over the years. India is globalising rapidly. The scale of trading required by RBI to achieve market manipulation grows bigger through time. The sale of MSS bonds drives up interest rates and attracts capital flows. Hence, MSS issuance of Rs.100,000 crore per year is only a starting point - things get worse beyond that. Hence, the intensification of sterilisation is essentially infeasible.

Unsterilised intervention induces inflation - the politicans will not accept that. Sterilised intervention requires wasting Rs.15,000 crore a year soon and much more beyond - the politicians will not accept that. Hence, the defence of Rs.40.25 per dollar by RBI is untenable.

If RBI was doing unsterilised intervention in the hope of allowing low interest rates in India to deter capital flows, this hope is proving to be wrong. Global currency speculators have watched many developing countries flounder when faced with the impossible trinity. They understand how India is unable to do sterilisation and that India will not tolerate inflation. They know that two moves ahead, we will have a disruptive and sharp currency appreciation - like that of March 2007 - from which they will profit handsomely. RBI's policy stance is actually sucking in a surge of capital flows.

A consistent monetary policy is one that is speculation-proof. The Bank of England never gets into a dogfight with speculators. It learned it lessons in 1992. Now it calmly targets inflation. An inconsistent monetary policy invites speculative capital flows. The policy mistakes of RBI are the source of risk; they are inducing unstable speculative capital flows.

The defence of Rs.40.25 per dollar is the root cause of these difficulties. The task of the credit policy announcement of the 31st is to show an exit strategy out of it. The goal must be to improve on the messy events of March 2007, where the rupee appreciation took everyone by surprise while RBI stayed resolutely non-transparent. This requires improved transparency and communication by RBI, and a program for increasing currency flexibility.

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