A fresh mandate for RBI

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 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 changes in interest rates, consumers are now faced with sudden increases sharper than expected.

Data for RBI purchases only runs till January 2007. From April 2006 to January 2007, the 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. The 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. The RBI has been making pious statements about the need to control inflation and liquidity. But at the same time, the actual actions of the RBI have pushed huge amounts of liquidity into the system.

Why is the RBI focused on the rupee? Partly, there is sheer inertia, where the RBI keeps on doing what it has done for a long time. 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. But if 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 lower domestic prices. It pushes greater pain on the domestic consumer who must bear a greater burden of adjustment in demand.

Politically, this is a recipe 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. If we continue with the policy of trying to keep Indian goods cheap for foreigners, we will end up making them more expensive for Indians. Hiking interest rates will not tackle inflation when the RBI continues taking with one hand and giving away with another. What India requires is to comprehensively open up questions of how monetary policy is conducted and give a fresh mandate to the RBI.

The writer is senior fellow, National Institute of Public Finance and Policy, New Delhi