A fresh mandate for RBI

Indian Express, 20 March 2007

A sharp hike in borrowing and lending rates took place in recent weeks. With inflation up at 6.4 percent and RBI saying it will take "all the necessary monetary measures", further hikes in interest rates could come. But will raising interest rates bring inflation under control? Does India have the markets and institutional framework in which raising interest rates is an effective instrument for inflation control? Does India have a central bank that has successfully learned how to conduct monetary policy in an open market economy? Unfortunately, the answer to these three questions is: No. In this one sphere, India still lags behind modern practices.

One striking feature of monetary policy in India has been the element of surprise. When inflationary pressures appeared in 2004, central banks all over the world responded by controlling inflationary expectations. The US Federal Reserve Bank raised the `federal funds rate' in a slow and calibrated manner, 17 times by 25 basis points each since July 2004, every time accompanied by statements that indicated where the Fed would go next. This policy framework kept inflation in the US under check. India, in contrast, lacked a coherent monetary policy. Changes in the repo rate, the reverse repo rate and the cash reserve ratio have repeatedly surprised the market, and have failed to keep inflation under check. Instead of calibrated small changes in interest rates, consumers are now faced with sudden increases that are sharper than expected.

Why has monetary policy in India been so different from that in more mature economies? The most important factor that has come in the way of smooth movement of interest rates has been currency policy. In trying to manipulate the rupee-dollar rate, the RBI has purchased dollars in the market. When the RBI buys dollars, it pays for them using freshly printed rupee notes. This leads to greater money supply, higher credit growth and inflation.

Data for RBI purchases only runs till January 2007. From April 2006 to January 2007, RBI purchased USD 12.6 billion. In other words, the RBI quietly added Rs.56,543.05 crore to the domestic monetary base. It has not been able to fully "sterilise" these dollar purchases, so money supply has gone up. RBI then turned around and tried to take steps to suck this liquidity out of the system. These steps included raising interest rates. Many borrowers now face higher loan rates and others, especially SMEs, have little access to bank credit.

The pain could have been justified if the increase in liquidity had been due to past mistakes that had proved to be inflationary, and now the RBI had no choice, other than to dispense the pain of stabilising prices and the economy on the people. It might have been justified on the grounds that raising interest rates was the only way to control liquidity and growth in credit in the system. But this is not what has been happening. RBI has been making pious statements about the need to control inflation and liquidity. But at the same time, the actual actions of RBI have quietly pushed huge amounts of liquidity into the system.

Why is RBI focused on the rupee? Partly, there is sheer inertia, where RBI keeps on doing what it has done for a long time. In part, there is an erroneous belief that by manipulating the rupee dollar rate, the RBI can keep Indian exports competitive in the world market. This is erroneous because the global competitiveness of Indian exports reduces when prices of Indian goods go up through domestic inflation. The "real exchange rate" is determined by both the nominal rupee dollar rate and the inflation rate. In recent months the real exchange rate of the rupee has appreciated, making Indian exports less competitive: not because the nominal exchange rate has appreciated, but because inflation in India has gone up.

Currently, the Indian economy is producing at almost full capacity. Domestic demand plus net export demand is growing at rates which have generated sustained inflation. Inflation control requires reining in either domestic demand and/or reining in net export demand. Exchange rate policy allows the government to meddle with which element of demand is curbed. The fundamental policy question in Indian inflation control is: Should we slow down export demand or should we slow down domestic demand?

If the rupee appreciates, we curb net export demand by making Indian goods more expensive for foreigners and foreign goods cheaper for Indians. If, on the contrary, we prevent rupee appreciation and have higher domestic interest rates, we curb domestic demand. The present currency policy is trying to keep export demand growing while curbing domestic demand by pushing up interest rates. Keeping export growth high when the economy is at full capacity utilisation is not going to give us lower domestic prices. It will push greater pain on the domestic consumer who has to bear a greater burden of the adjustment in demand.

Politically, this is a receipe for disaster. The attempt to keep Indian goods cheap for the American consumer has made Indian goods more expensive for the Indian consumer. Effectively the Indian consumer subsidises the American consumer. Given that the constituency of Indian politicians is the Indian voter, this policy is not sustainable. If we continue with the policy of trying to keep Indian goods cheap for foreigners, we will end up in making them more expensive for Indians. In this context, hiking interest rates will not prevent inflation when the RBI continues taking with one hand and giving away with another. What India requires, at this point, is to comprehensively open up questions of how monetary policy is conducted and give a fresh mandate to RBI.

Back up to Ila Patnaik's media page
Back up to Ila Patnaik's home page