Let the rupee climb

Reserve Bank of India Governor Y.V. Reddy has announced a tightening of monetary policy just ahead of the credit policy statement for the quarter. Inflation is high, and there is a justified clamour from the general public to combat inflation. But raising the cash reserve ratio (CRR), as the RBI has done, will not help matters.

In fact, a monetary tightening at this time is a bad idea. First, this round of inflation, unlike Inflation last year, is not demand-driven. When the objective is to reduce inflation by reducing demand, it is a good idea to raise rates. But now, when demand has moderated, when credit growth is down to 22 per cent and industrial growth is lower, when the signs of overheating are gone, raising rates would not help in pulling down inflation. Instead it would hurt an industry facing a slowdown.

Moreover, it would attract more capital inflows into the country. More dollars come in and as the RBI continues its policy of preventing rupee appreciation, it buys up more dollars. This results in more liquidity in the system. A tightening of monetary policy, whether through a CRR hike or through an interest rate hike, is counterproductive in an environment where our interest rate differentials with the world are high, and we are trying to prevent a rupee appreciation. It will not result in inflation control. Instead it will result in even greater liquidity in the system, more CRR hikes and more interest rate hikes as the RBI struggles with the impact of these hikes.

By the textbook, a tight monetary policy has an effect on inflation when credit becomes more expensive. Industry and consumers borrow less and spend less, demand goes down and goods become cheaper. This process, however, from the central bank’s tightening monetary policy to inflation coming down, takes about 1.5 to 2 years. Further, as many economists have emphasised over the last few days, the recent bout of inflation is led by global commodity prices. And interest rate or CRR changes are unlikely to have a significant impact on food price inflation.

If the hike in CRR is not going to control inflation, why did the RBI do it? The primary purpose is to sterilise the increase in liquidity injected into the system as a consequence of its foreign exchange intervention. This year, the RBI’s purchase of dollars has added Rs 1.5 lakh crore to the monetary base. The RBI has to constantly find ways to mop up this liquidity. Inflation has provided the RBI an excuse to use the CRR, the worst instrument in its hand, to sterilise its intervention. It imposes the cost of sterilisation on banks and their customers. If the RBI was serious about reducing inflation, then instead of trying to control the impact of its forex interventions through a CRR hike, it would have stayed away from the market. Strangely, we see that even after inflation started rising, the RBI contintued to buy up dollars. From $290 billion on March 1, India’s foreign exchange reserves grew to $301 billion by April 5.

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