In the last two years, while there was an increase in liquidity in the system due to dollar purchases of RBI, this liquidity was sucked out by selling Monetary Stabilisation Scheme (MSS) bonds. Here, the costs of running the pegged exchange rate regime were placed upon the ministry of finance which has to pay interest on the MSS bonds. However, after October 2007, RBI stopped selling MSS bonds.

The limit on MSS issuance, the amount of bonds that the government had permitted RBI to sell, is Rs 2.5 lakh crore, while the outstanding amount in October 2007 (and since then) was only Rs 1.7 lakh crore. In other words, RBI could have continued to sterilise its currency trading through the sale of government bonds. Hence, the shift in policy is surprising. As is typical of the non-transparency of RBI, there was no announcement that the mechanisms of monetary policy had changed.

When RBI buys dollars, but does not scoop up the liquidity using MSS, reserve money growth remains high. What matters to the economy, however, is broad money (M3) and not reserve money. The banking system takes reserve money as a “raw material” and converts it to broad money. The CRR influences this multiplication process. A higher CRR, where banks are forced to hold money with RBI, induces a smaller multiplication factor. Thus money supply (M3) growth is held back even though reserve money growth is very high.

When banks are forced to hold more reserves with RBI, they lend less, and this is how the central bank seeks to control liquidity, credit and demand, and thus inflation. By not selling MSS bonds, RBI managed to prevent the cost of borrowing for the government to rise. Instead, households and industry were faced with a credit crunch.

There is no free lunch. Someone has to pay for the dollar peg. As the finance minister, P. Chidambaram, correctly pointed out in his budget speech, the interest payment on MSS bonds in the budget constitutes a subsidy to exporters that is borne by the exchequer. By stopping MSS issuance and switching to CRR hikes, the cost of this subsidy was shifted from the government to banks and their users.

With a hike in CRR, banks have to hold a larger proportion of their deposits as cash with RBI. This means the interest earned by them on deposits goes down. The reduction in returns is borne either by banks or their customers. Either depositors get less interest income or borrowers pay higher interest rates. This cost, borne by banks and their customers, is the price of subsidising exporters.

In the ’90s, the long-term policy goal was to eliminate CRR or bring it down to a minimum level like 3 per cent, since it was viewed as a distortionary tool of monetary policy. This goal has been abandoned, with CRR at 8.25 per cent. Yet, India is not China, where CRR has been pushed up to 17.5 per cent. Even if RBI is not making progress on the task of eliminating CRR, there are limits to how much CRR can be raised. Hence, from January 2007 onwards, M3 growth has generally exceeded 20 per cent on a year on year basis.

What has this policy mix achieved? Inflation continues to be a problem, for M3 growth should not exceed 15 per cent if we are to have inflation of 5 per cent or below, with 8 per cent GDP growth. Industrial growth has decelerated sharply, thus “cooling down” the system. By shifting the cost of the dollar peg from the government, the fiscal cost has been lowered, at the expense of lower economic growth.

For long-term observers of the Indian economy, none of this is surprising. In the ’90s, we had a similar story unfold. RBI pumped liquidity into the system while implementing a dollar peg, in an attempt to help exporters. They then used CRR hikes to undo these effects. This helped generate a collapse in industrial growth.

Who is responsible for the decision to return to using CRR as the way to control liquidity? Was it the government that forced RBI to keep the fiscal cost of MSS low? Or, was it RBI, in its enthusiasm to protect the interests of the government in its role as banker to the government, that chose to hurt industry and households it is not answerable to?

RBI is non-transparent about its actions and about the rationale behind these actions. When MSS issuance was stopped, no announcement was made, nor was a rationale offered. With a lag of months, external observers are left trying to piece together the events from incomplete data. Today, there is no institutional framework in India that enables Parliament to question RBI and its policies. No one is going to answer the question as to who is responsible for the macroeconomic mismanagement that has led to slower growth and higher inflation.

Two prominent expert committees have advocated monetary policy reform, where RBI should shift to a world of transparency, with a focus on inflation. An effort in monetary policy reform today would come too late to save the UPA, but it would help protect future governments from a non-transparent central bank.

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

ilapatnaik@gmail.com