Still in a quandary
Business Standard, 1 August 2007
Indian monetary policy is in an unprecedented quandary. The policies of RBI are internally inconsistent, in a way that is obvious to the intelligent speculator. RBI policies are causing unstable capital flows, shock therapy for the economy with periodic episodes of sharp currency movements, and low interest rates that induce persistent inflationary pressures. We will lurch from one accident to the next until a consistent monetary policy framework is achieved. Yesterday's credit policy announcement has one small step in the right direction. For the rest, the quandary remains unresolved.
From the early 1990s onwards, India's globalisation has gathered speed. In 2006-07, 110% of GDP moved across the boundary, summing across the current and capital accounts - a massive jump when compared with 50% just seven years ago. Under these conditions, the recipes of macroeconomic policy which used to work in the early 1990s are untenable. Now, there is an unmanageable tension between achieving low and predictable inflation, versus the goal of running a pegged rupee-dollar exchange rate.
India's globalisation has given a more liquid currency market, and the scale of market manipulation required to move the price has become bigger. From 2005 onwards, RBI has engaged in massive `unsterilised intervention' where dollar purchases by RBI flood the domestic market with liquidity and give low real interest rates. As a consequence, RBI has been increasingly out of control of monetary conditions, and inflation has surged.
RBI first tried defending Rs.44 per dollar. A massive bout of market manipulation was done, which has consequences even today for liquidity management. Inflation surged, and RBI had to back off.
The core task of all central banks is to clearly pin down the short-term interest rate so as to control inflation. In all mature market economies, there is no doubt about what the short-term interest rate is; it is defined by monetary policy. In recent months, RBI had abdicated this responsibility, which amplified the sense of confusion about monetary policy. RBI has two interest rates, not one: it borrows at 6% and lends at 7.75%. At 6%, RBI had capped the total outstandings at Rs.3,000 crore. This is a tiny number when compared against the size of India. This cap has now been removed, thus bring RBI back into monetary policy, with a floor on interest rates. This is a positive move.
In the credit policy, RBI says:"Assuming that aggregate supply management will continue to receive public policy attention and that a more active management of the capital account will be demonstrated, the outlook for inflation in 2007-08 remains unchanged".
RBI is saying that if government solves supply side issues, and if the Ministry of Finance brings in capital controls, inflation will be stable. I would interpret this in a few ways:
- This is an astonishing attempt at avoiding responsibility for inflation.
- The impossible trinity gives three different alternatives: we can move towards capital controls or exchange rate flexibility or lose monetary policy. RBI is silent about exchange rate flexibility and focuses the choice as being between capital controls and inflation.
- This sentence signals the lack of commitment of RBI to fighting inflation - it fails to anchor the inflationary expectations of the reader.
- It shows the depth of their commitment to running a pegged exchange rate - capital controls and inflation are negotiable; the exchange rate regime is not.
- I believe the statement shows a poor understanding of Indian politics. If inflation resurges, such protestations will not enable RBI to get off the hook. At that point, RBI will be forced to have high real interest rates, which will mean giving up on currency pegging.
Now RBI is defending Rs.40 per dollar. There appears to be a consensus that the rupee will appreciate beyond this. The existing scale of currency trading by RBI is inconsistent with the need of the UPA to announce elections in late 2008 or early 2009. Achieving low inflation by late 2008 requires that short-term interest rates in 2007 have to be atleast three percent in real terms. For this to happen, the defence of Rs.40 has to break, for RBI cannot manipulate the currency market and simultaneously achieve a three percent real rate at the short end. Speculators are sending money into India in the expectation of the rupee appreciation.
RBI believes that financial globalisation is the problem; that capital flows are destabilising. However, it is the non-credible pegged exchange rate which is bolstering capital flows into the country. If the rupee were not a one-way bet, less capital would be coming into India.
In early 2007, there was eerie calm on the currency market. Then after that, suddenly there was a 10% rupee appreciation. Exporters were naturally extremely upset. If there is a conflict between inflation and the peg, then another such episode could be around the corner.
RBI needs to do better in gearing up for these coming difficulties by designing an exit strategy from the defence of Rs.40. NSE and BSE need permission to trade currency futures - so that everyone gets a market for doing currency risk management. RBI needs to talk honestly with the country, saying that Rs.40 is not going to last. A full-blown plan for shifting away from a dollar-rupee peg, with steadily increasing currency flexibility, needs to be drafted by an expert committee and discussed in public.
When anyone tries to understand the exchange rate, a key question is: Is this a market price, or is it a manipulated price? A critical input for forming a judgment about what is going on with exchange rates is knowledge about currency trading by RBI. In India, we demand daily disclosure of FII trading on the stock market. But RBI gets away with disclosure only once a month, with a lag of over two months.
This lack of transparency on currency trading is symptomatic of a deeper malaise of non-transparency on the part of RBI. A recent NBER working paper, by Dincer and Eichengreen, scores the transparency of central banks. On a scale of 0 to 15, Asian central banks have been improving as a whole, scoring 5.1 in 2005, compared to 3 in 1998. China's transparency improved dramatically, to 4.5 from 1. RBI has stagnated at a score of 2 all through. RBI in 2005 lagged behind the Asian average of 1998.
This is inconsistent with the focus on transparency that animates the Indian government today: all arms of government are pushing in favour of greater transparency and greater accountability. The citizens of India are affected by the actions of RBI. In a democracy, they have a right to know exactly what is going on, in meticulous detail. The non-transparency of RBI renders citizens unable to understand the meaning of the price on the rupee-dollar market. The non-transparency implies that its decisions come out of the blue as a surprise to all. A central bank is supposed to reduce risk in the economy. In India, instead, the central bank has become a risk factor.
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