But if money growth has been so much faster than what was desirable, why did the RBI not slow down on intervention? Slowing down on the forex intervention would have meant that the rupee would have appreciated. An appreciation in the rupee can slow down India’s exports, and one argument for the continued intervention was that India needs to promote exports. This argument overlooks the fact that export competitiveness is not determined by the nominal exchange rate, but by the real exchange rate, which also takes into account the differences in the rates of inflation of other countries. If our trading partners or competitors have low inflation, their costs of production remain low. We lose export competitiveness when our inflation rate is higher than theirs.

So what we are gaining by keeping the rupee from getting stronger, we are losing through inflation. This would not have happened if we had successfully sterilised our forex operations and not got higher inflation. But while China may be able to force banks to hold higher levels of government securities to sterilise central bank operations, in India even public sector banks have been offloading government bonds and increasing their loan portfolios, resulting in the RBI’s loss of control over growth in money supply.

When hitting against constraints in sterilised intervention, two things are possible: either the central bank gives up on forex intervention; or it tries ‘indirect sterilisation’ (use of interest rate policy to reduce domestic demand). This is what has been happening in India for over a year. The RBI has continued its intervention, done direct sterilisation, found it inadequate, and has gone in for indirect sterilisation. But indirect sterilisation has an interesting property. Higher domestic interest rates attract more capital from abroad, as returns in India are higher. If the central bank continues with its currency manipulation, it faces even greater pressure on the rupee and ends up intervening even more. This means the need for sterilisation increases and interest rates have to be pushed up further, which of course further attract capital. The vicious cycle gets worse and worse until the central bank admits that it has lost control and gives up on intervention.

... contd.