Pricing the rupee

Indian Express, 28 July 2008

The Congress government, with the Left off its back, is now expected to undertake economic reforms. Among other things, these reforms include modernisation of the financial sector, institutional change in elementary and higher education, privatisation, etc. These efforts will influence the investment climate, and thus the well being of voters in the weeks leading up to the elections. One reform needed both for the long term and for its short term effect is a change in the monetary policy framework. For the long term perspective, both the Percy Mistry and the Raghuram Rajan committee have recommended this reform. But in the short term, it will help by combating inflation.

What is wrong with the present monetary policy framework?

In the present system RBI is mandated numerous objectives. These include managing public debt, the exchange rate, banking regulation and finding a balance between growth and inflation. These tasks often come into conflict with each other. When a central bank is asked to do other things, over and beyond delivering low and stable inflation, inflation often gets out of hand.

This is the story of the current inflation crisis. If the economy is growing at 10 percent and a 5 percent rate of inflation is acceptable then money supply can be allowed to grow at roughly 15 percent. In India, money supply growth rates of 16 or even 17 percent have been consistent with low and stable inflation. However, in the attempt to encourage export growth, the RBI ended up in buying dollars on a massive scale and pushing up money supply growth to rates above 20 percent. A central bank focussed on inflation would never have tried to prevent appreciation or let money supply growth be so high.

Gurudas Dasgupta asked a question in Parliament about why Europe sees an inflation rate of 4 percent while India witnesses inflation of 12 percent despite the fact that both import oil. The difference lies in monetary policy. While ECB focused on inflation and did not trade on the currency market, RBI fought to defend the dollar and ended up with a high oil bill and high inflation. The monetary policy framework needs to be amended to entrust the RBI with only one objective: that of delivering low and stable inflation.

If RBI merely says that it is concerned about inflation, it has no credibility, because it has chased other objectives so often in the past. A number of steps will need to be taken to make sure that the RBI reform is credible. RBI will need to be made accountable and the monetary policy framework will need to be transparent.

One key element of this is an executive monetary policy committee (MPC) whose minutes and voting behaviour are made public as in the case of the Bank of England. The MPC would meet regularly, on a clock, and vote on interest rate changes. Each MPC member would release a rationale statement showing how he voted and why.

As an example of how it would be different from the style followed today let us turn back to the change in monetary policy since October 2007. Until October 2007 the RBI would buy dollars in the forex market and sterilise its intervention by selling MSS bonds. In October 2007 the stock of MSS bonds stood at Rs 1.8 lakh crore. The ceiling that the RBI had asked for, and been granted by Ministry of Finance earlier in the year, was Rs 2.5 lakh crore. Suddenly, with no announcement that there was going to be a change in the policy, the RBI stopped selling MSS bonds. Since then it has been using the Cash Reserve Ratio of banks as the instrument to suck out the liquidity its foreign exchange intervention had pumped in. The resulting chaos in market, the massive increase in liquidity, the impact on banks and the great uncertainty this created led to huge confusion over the stance of monetary policy.

A key part of monetary policy reform is improved transparency. As an example, let us revisit RBI's trading in foreign exchange markets this year. Remember, a stronger rupee means lower prices of imported goods. In an enviroment of rising oil prices and a higher import and subsidy bill, in the first few months of this year the RBI started buying dollars aggressively to engineer a depreciation. While the oil companies fretted at the rising rupee price of oil, the oil pool deficit rose sharply and prices of all tradables rose, the RBI actually bought dollars and made the rupee weak! Nobody knew what was going on at the time, because of RBI's non-transparency. The data on RBI's currency trading is released monthly with a two month lag. RBI needs to come up to the standards of transparency that India has imposed on FIIs, where data on FII transactions are in the newspapers with a lag of one day. Greater transparency would yield greater scrutiny. RBI would be asked to explain why it was trying to force a rupee depreciation when this would worsen inflation.

How would a change in the monetary policy framework help the government in the short run? First, the RBI has even today a number of capital controls in place that prevent rupee appreciation. A central bank with a focus on inflation would not do that. In fact, it would do the opposite. It would ease constraints such as those on External Commercial Borrowing that would allow capital to come in for investment. When this capital comes in, it would help push up the rupee and bring down both prices. It would also contain the off-budget oil pool and fertiliser subsidy that is pulling down India's credit rating. The ceiling on the NRI deposits, now fixed at below the LIBOR would be removed. This would again pull in capital leading to a strengthening of the rupee. Increased accountability and transparency will give credibility to the RBI.

Today, inflation is the number one problem of the Congress. RBI talks about being concerned about inflation and about having a tight monetary policy. But the facts on the ground are that short-term interest rates remain negative in real terms. The market expects high inflation; inflationary expectations are increasingly getting woven into the economy. In order to break the inflationary spiral, the government needs to decisively undertake RBI reform.

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