A fresh mandate for RBI

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.

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