Riding the troika: RBI's Travails: Financial Express 10th September, 2007

The RBI must be the most harried institution in the country today. The irony is that this state of mind comes at a time when the FM is reiterating strong growth in the country which has been supported by the Economic Advisory Council of the PMO and the RBI itself. It does appear that the theoretical issue raised in textbooks on attaining internal and external equilibrium has resurfaced again creating a rather complex situation for the monetary authority.
There are presently three objectives before the RBI. The first is to maintain foreign exchange rate equilibrium — meaning a stable ‘currency rate movement’ regime. The second is to bring about growth with easy interest rates, and the third is price stability.
On the face of it there does not appear to be a problem with the rupee strengthening amid large forex inflows, stable inflation at around 4.4%, and demand for credit not picking up as yet. But, the monetary authority has to be forward looking and must assess potential inflation as inflationary expectations are more important than actual inflation; and these expectations are fed by the policy moves of the RBI.
Let us try and grasp as to what is happening presently. The rupee is appreciating due to large capital inflows. The trade deficit has widened but booming current receipts led by IT and software inflows as well as FDI, FII and ECB inflows have made the forex reserves swell. Last year, the foreign currency assets have risen on a point to point basis by $ 47 bn and the rupee strengthened by 2.3% with all the RBI interventions. But this year, so far foreign currency assets have risen by $ 26 bn and the rupee has strengthened by around 7%. Therefore, there is a concern here. One view is that the RBI cannot let the rupee appreciate too much, which though a theoretical solution would militate against exports and the IT sector. At the same time we cannot stop FDI or FII inflows as they are critical for the economy.
There has been some feeble attempt to curb the inflow of ECBs recently, ostensibly to check the possible carry-trade transactions being carried out given the interest rate differentials in India and the rest of the world.
Borrowings have been pegged to a band of up to Libor plus 250 bps limit, but the difference with Indian PLRs is still around 500 bps, which makes such trade attractive even after taking into account the other accompanying risks.
The result has been that the RBI is buying dollars in the market, which is creating monetary problems. When the RBI buys forex, then it has to provide domestic currency, which increases money supply. Rising money supply is inflationary as it has the potential to create excess demand forces. When money supply increases the RBI has to sterilize it with either market stabilization bonds (MSS) or curb the ability of banks to lend by increasing the CRR, which it has just done in the last policy, or increase interest rates. While this could have a soothing effect on inflation, it can create problems on growth. As of today this is not an issue, but with rising rates, investment would get affected. The reverse movement of interest rates in the late nineties will be in the RBI’s rear view mirror when monetary tightening led to a recession.
This situation is quite a contrast to what the Euro zone is facing today. The ECB has let the euro appreciate against the dollar, and has managed to maintain stable interest rates, though reserving the prerogative to raise interest rates to curb inflation if the rate starts to move up. Hence, it has been looking more inward than outward.
The case of China is quite different. China absorbs more dollars than India; so how does it manage the show. The central bank buys up dollars in the market and also virtually pegs the interest rate. This way there are no major issues when it comes to growth or inflation.
What are the solutions for the RBI? Logically, the rupee should be allowed to float and strengthen as markets are free and exporters cannot ask for protection and have to learn to be competitive. Besides, the RBI cannot and should not play favourites to any one group.
But, if this is not feasible, then attempts must be made to open up the capital account. While some measures have been taken earlier this year, this sounds a bold decision which could have severe repercussions if something goes amiss. Imagine a situation where we can invest freely in foreign capital markets or open a fixed deposit in a New York based bank instead of a domestic bank in Mumbai. This too appears to be far fetched presently. Besides, the liberalization of limits for investment is not really being used up and further action may not be useful. Putting curbs on ECBs cannot really be effective though it has had a good announcement effect.
Also we cannot stop other foreign flows from coming in.
The RBIs ride on the troika of exchange rate, interest rate and inflation is uneven. A decision needs to be taken or else the markets will be left conjecturing the next move, which could be unsettling. Therefore, a clear stance and targets need to be explained clearly to remove uncertainty.