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.

... contd.