Central bank misrules
Indian Express, 3 July 2008
The double barreled attack on inflation is more posturing than good economic policy. In the last four years preventing rupee appreciation and risking high inflation was a policy choice made by the government and RBI. Today's inflation is the natural consequence of this political choice. Fire fighting inflation with sharp hikes in interest rates will now do more harm than good. What is needed is long term reform. We have seen this movie before. In the mid 1990s, RBI fought a grim battle to prevent the rupee from appreciating in an attempt at subsidising exporters. From March 1993 to September, the rupee was kept between Rs 31 to Rs 32 to a dollar. Over this period, RBI added USD 12.6 billion to reserves in the effort of preventing rupee appreciation. Dollars were purchased, rupees were injected into the domestic economy, and growth in the monetary base rose to 20 percent per annum. Not surprisingly, inflation took off. Interest rates were used to combat inflation. The 91-day rate went all the way up to 13 percent by November 1995 in this fight against inflation. RBI won this fight. But many people believe that this increase in interest rates led to souring of a remarkable phase of high GDP growth.
Now we have a second edition of the same story. Once again, currency pegging has fouled up domestic monetary policy, and ignited inflation. RBI fought a grim battle to prevent the rupee from appreciating in an attempt at subsidising exporters. After 3 years of high liquidity growth, even after early 2007 when the first signs of inflation started appearing, RBI added USD 110 billion to reserves in its effort to prevent rupee appreciation. Dollars were purchased, rupees were injected into the domestic economy, and growth in the monetary base rose to 31 percent. With a huge stock of liquidity in the system, a shock in global commodity prices ignited high inflation in the domestic economy. RBI's monumental mistake was then to engineer a rupee depreciation that pushed up prices even further. It then stood by passively and watched as the rupee depreciated and prices spiralled.
The first and most obvious question to ask in this story is about RBI's focus on inflation: Why does RBI not learn from history? Why does RBI obsess with currency pegging, even though it has led to such costly distortions of monetary policy? Why is subsidising exporters more important than delivering low and stable inflation? Why does RBI have a greater loyalty to exporters than it has to the local economy? Or, it it that since the RBI is not an independent central bank, was the 'prevent appreciation, risk inflation' loose monetary policy the policy choice of the government? Would RBI have focussed on inflation if it was an independent central bank? To address this issue the Percy Mistry and Raghuram Rajan reports on financial sector reforms in India have recommended that RBI be made an independent central bank with a focus on inflation.
The second and more subtle question to ask is: Why do central banks in mature market economies manage to combat inflation by gently nudging rates up? When interest rates are used to combat inflation in India, why are savage hikes required?
This brings us to the `monetary policy transmission', the term used for the process through which an increase in the short-term interest rate by the central bank propagate into changes in interest rates all across the economy, thus pulling back demand and slowing inflation. In India, the monetary policy transmission is largely dysfunctional. Because monetary policy is enfeebled, if a certain reduction in inflation is required, very large changes in the policy rate are required. Central banks in mature market economies have a more powerful monetary policy transmission. Hence, they are able to control inflation through small changes in the interest rate.
Why is monetary policy enfeebled in this fashion? The answer lies in two parts. As Nachiket Mor and Paul Levine have independently pointed out, the large informal sector has been cutoff from formal finance. Changes in the policy rate do not impact upon this group. Over half of the economy, then, does not participate in the monetary policy transmission.
The second story is in the formal sector. In mature market economies, the `bond-currency-derivatives nexus' (BCD Nexus) is the complex system of markets through which a small change in the policy rate propagates across the economy into interest rates for corporate bonds, interest rates charged by banks, etc. This BCD Nexus is lacking in India. There is no corporate bond market to speak of. The large corporations are largely equity financed. Changes in interest rates by banks - for either borrowing or lending - do not quite track changes in the policy rate by RBI.
Through a combination of financial exclusion and the lack of the BCD Nexus, monetary policy in India has been weakened. As a consequence, if interest rates have to be used to combat inflation, savage increases in interest rates are required.
Why is there such financial exclusion, and what can be done about it? The Raghuram Rajan report has eloquently diagnosed how after 50 years of preaching about carrying banking to the poor, the supposedly pro poor policies of the government are the cause of financial exclusion. Fundamental reforms are required on issues like priority sector credit and the regulation of micro finance institutions to overcome financial exclusion.
Why is the BCD Nexus absent, and what can be done about it? The Mistry and Rajan reports have both diagnosed how RBI's policy framework has systematically prevented the rise of an efficient and liquid BCD Nexus. Fundamental reforms are required on issues like regulatory structure for the BCD Nexus, breaking down of entry barriers, removing capital controls, and reforming bankruptcy procedures, in order to achieve a well functioning BCD Nexus.
In other words, there are no short term solutions.
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