The question for the next RBI governor

Financial Express, 27 August 2008

Initially, India's pegged exchange rate coexisted with autonomy of domestic monetary policy since the capital account was closed. Over the years, as the capital account has gradually become more open, exchange rate pegging has increasingly hijacked monetary policy. The worst expression of this was seen in recent years, where RBI ran money supply growth rates in excess of 20%. With a lag, this has given an inflation crisis. The next RBI governor has to put Indian monetary policy on a sound footing, by refocusing monetary policy away from the exchange rate towards the task of delivering low and stable inflation.

Rangarajan's RBI began with India as a closed economy. A currency `market' was created but the rupee was tightly pegged to the US dollar. A narrow chink of convertibility was opened up with portfolio flows. The pegged exchange rate implied that the money that came into the country had to be bought up into reserves. This gave an expansion of money supply and ignited an inflation. This inflation had high political salience, and Rangarajan's RBI fought valiantly to wrestle inflation back to low numbers. This was India's first taste of the impossible trinity: as capital account opening takes place, targeting the exchange rate leads to unpleasant monetary policy decisions.

Bimal Jalan's RBI faced the Asian crisis. In this period, exchange rate pegging required raising interest rates in order to prevent rupee depreciation. Even though business cycle conditions were weak, in January 1998, interest rates were raised sharply. This was India's second lesson in the impossible trinity: targeting the exchange rate leads to unpleasant monetary policy decisions.

After the Asian crisis subsided, capital flows resumed. Now exchange rate pegging demanded buying dollars in order to prevent an appreciation. Bimal Jalan's RBI enjoyed a long run of `sterilised intervention'. This was made possible by the large stock of government bonds that RBI had at the outset. Month after month, exchange rate pegging was implemented by purchasing dollars. The rupees injected into the economy were taken back by selling off RBI's stock of government bonds. This led to a happy period where it was felt that we could have our cake and eat it too. This period ended in late 2003 when RBI's inventory of government bonds ran out.

Exchange rate pegging was in disarray when Y. V. Reddy took charge of RBI. The most important call that he made at the outset was that of not questioning the exchange rate peg as the monetary policy framework. Once this call was made, his years were hijacked in the Sisyphean effort of fighting for capital controls, being outmaneuvered by the private sector which found ways to get money into the country despite these controls, buying a lot of dollars for achieving exchange rate pegging, suffering the embarassment of doing speeches about inflation (emulating good central bankers abroad) while actually pouring fuel on the inflationary fire, and watching it all come apart in the last year as the monetary expansion ignited the worst inflation of post-reforms India.

The most damaging period started in March 2006, when reserves were at $134 billion. From there, reserves expanded to $300 billion in March 2008. Over these 24 months, on average, RBI purchased $7 billion a month. This distorted monetary policy. Reserve money growth shot up to 31% in July 2007 and was at 28% in July 2008. M3 growth shot up to 22% in February 2007 and was at 20% in July 2008. Short-term interest rates were negative in real terms owing to the injection of liquidity into the system. This expansionary monetary policy induced inflation with a lag.

Rangarajan's period had average WPI inflation of 6.1% with a standard deviation of 12.2. This large standard deviation reflected the spike in WPI and then the effort of wrestling it down. Bimal Jalan's period had average WPI inflation of 4.8% with a standard deviation of 6.8%. On both the level and instability of inflation, this was an improvement over the previous period. Y. V. Reddy's period had average WPI inflation of 6.4% with a standard deviation of 7.3%. In terms of the mean inflation, it was the weakest performance of the three. In terms of the instability of inflation, it was inferior to what was delivered in Bimal Jalan's period.

PeriodAverage WPI inflationVolatility of WPI inflation
C. Rangarajan6.112.2
Bimal Jalan4.86.8
Y. V. Reddy6.47.3

The most important call that the next RBI governor will make is about the monetary policy framework. Will he perpetuate the monetary policy framework of exchange rate pegging? The difficulties in this path will be worse than those experienced by Y. V. Reddy, given India's deepening globalisation. Or will he take up the monetary policy reforms proposed by the Percy Mistry and Raghuram Rajan reports? This would involve focusing monetary policy upon the task of delivering low and stable inflation, of getting average WPI inflation of below 4% with a standard deviation of below 6.

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