Actually the RBI has done even worse than the standard indirect sterilisation methods. It has applied the axe on credit by using the cash reserve ratio. This disrupts business activity all over the economy. Even when people are willing to pay more, they are unable to get credit.

In the old days one way out would be to block foreign capital. Even today, the first response of a central bank that is used to a control raj for many decades might be to think that greater capital controls should be brought back and this would solve the problem. The difficulty with this approach is that the country’s political economy will not allow this to happen. Industry is happy to borrow cheap abroad. It will not sit quietly and accept a policy reversal on openness. Second, the trade account offers a channel through which money will flow in and out of the country. Yes, honest resident Indians will suffer, but the rich and powerful will find ways to move money as they always have.

What needs to be done next? The only way out of this mess is to reorient the framework of monetary policy away from the focus on the rupee. Allowing the rupee to appreciate will help reduce inflation and put a stop to the need to raise interest rates. There may be a period of turmoil in forex markets, but it is better than putting millions of households and firms out of business by hiking interest rates and choking off credit.

... contd.