RBI must do a Fed

Indian Express, 14 December 2007

Earlier this week, the US Federal Reserve Bank cut the Fed's benchmark interest rate for the third time since September. The rate cut signaled the Fed's concern about a slowdown in the US economy. For India this may lead to greater capital inflows. With expectations of a global slowdown, and high interest rate differentials that make India an attractive investment destination, this could lead to further pressure on the rupee to appreciate.

While the government works in parallel towards developing the financial markets and a monetary policy framework for an open capital account with a flexible exchange rate, the interim policy response should be consistent with the larger aim of creating a modern open economy and financial sector. Imposing capital controls is exactly the wrong response; it pushes India away from the goal of becoming a mature market economy.

If political compulsions imply that the government must prevent rupee appreciation, cutting interest rates is now the right path. I argue below that recent developments and political compulsions require a change from the present policy framework. If the government wants to prevent rupee appreciation, it must do so by cutting interest rates, not imposing capital controls.

What is the present policy framework? India's growth story and interest differentials with the US have made it very attractive for Indians to borrow abroad and for foreigners to buy Indian equity and lend to Indian companies. Not surprisingly, we have seen large capital flows to India. This has put pressure on the rupee to appreciate. As a response, the government has been trying a policy mix of three elements - sterilised intervention, rupee appreciation and capital controls. The policy of sterilised intervention is one in which the RBI buys the dollars entering the economy and then sells Monetary Stabilisation Bonds (MSBs) to buy back the rupees it has injected into the market. When it has difficulties in controlling liquidity in the system and inflation starts rising, it allows the rupee to appreciate. And when the appreciation becomes politically unacceptable, the Ministry of Finance, RBI and SEBI step in with capital controls hoping to curb the inflow and reduce the pressure on the rupee to appreciate.

Muddling along this path must mean that there will be some amount of rupee appreciation in the next few months. But ever since the rupee crossed the Rs 40 per dollar mark, political pressure from exporters mounted. The government has, on many forums, expressed concern about the rupee. The policy path that it has undertaken involves trying to reduce capital inflows by imposing restrictions on them. However, neither the restrictions on External Commercial Borrowings nor the restrictions on Participatory Notes have delivered the results that were hoped.

There are now a number of reasons to change the above framework. First, the policy of imposing controls has not reduced total inflows. This has meant that the RBI has continued with the sterilised intervention. Higher intervention means higher sterilisation. But that keeps the interest differential between India and the rest of the world high and keeps pulling in capital. The policy runs into a never ending vicious cycle and requires higher and higher amounts of intervention and sterilisation. Second, a global slowdown will pull down export growth. At a time when export growth is suffering it will become politically even more difficult to let the rupee appreciate. Third, if there is a slowdown in the US economy, it is naive to think that India will escape a slowdown altogether. Merchandise exports to the US are 2% of GDP, and our software exports, the bulk of which go to the US, are 7% of GDP. Exports to the rest of the world will also suffer since all countries will slowdown owing to difficulties in the US. A cut in interest rates will help push up investment and consumption demand, and reduce the likelihood of a slowdown in the Indian economy due to slower export growth. Finally, inflation in India, measured by both the WPI and the CPI has come down in the last couple of months, which makes space for lower interest rates.

While I continue to believe that the path laid out by the Percy Mistry report -- of modernising financial and monetary policy -- is the correct one, I believe that it will take at least one year to execute this strategy. While that is being done in parallel, and given the low possibility of serious monetary policy reform under the present RBI team, the second best option of following the US Fed on interest rates will be less costly for India than imposing capital controls.

But will such a policy not be inflationary? It is important to contrast it against the present situation. Capital controls have failed to make a serious difference to RBI's trading on the currency market. With forex reserves rising by USD 58 billion after capital controls started being imposed in June 2007, there has hardly been a slowdown in the inflows. In Novermber, while FII flows turned negative by USD 1.2 billion, RBI was still buying and reserves rose by USD 14 billion. Despite sterilising its intervention at a rising fiscal cost, the RBI has not been able to keep money supply under control. As I have argued before (Aam admi in the hot seat, Indian Express, 16 November 2007) there is evidence to show that higher money growth produced by RBI's forex intervention is fuelling inflation. A reduction in inflows would mean less interverntion and less money growth and therefore will not be as inflationary as feared.

Deeper reforms to financial and monetary institutions are surely required in enabling India's tryst with globalisation. However, in the short run, reducing interest rates is a superior option than capital controls. The difference between the imposing capital controls and reducing interest rates to reduce capital flows is that a price mechanism will replace the licence and quantitative controls raj. At the same time it will bring down the fiscal cost of the exchange rate regime. A rate cut assists overall investment and consumption demand in the country, which will counteract the effects of slowing exports. Moreover, since everyone loves a rate cut, it is an easy option.

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