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S.Balakrishnan

IT'S an unusual situation for the Reserve Bank of India, the Government and the country.

Forex reserves are plentiful, liquidity is abundant, interest rates are low and inflation seems to be in control. We are far from the perennial fire-fighting that our policymakers are used to on the economic and financial fronts. The days of supplication at the doors of the IMF and World Bank are over.

Yet the Government and the central bank are a bit unhappy. What's gone wrong?

Once the economy and financial sector are opened up, the degrees of freedom of the central bank are significantly reduced. That is precisely what has happened in recent times. Interest rates in the First World have dropped to levels not seen for decades - 1% in the US, 2% in Europe and 3.75% in the U.K.

Scanning his screens, the international fund manager, desperately in search of better returns, has zeroed in on India, which offers the rare combination of above-average growth, high interest rates and low risk in all senses - economic, financial, and political. Investments - in real assets, stocks, bonds, bank deposits - and remittances from a prospering diaspora have flooded the country, causing rupee appreciation. But we want none of it. The Government and the industry worry about its effect on exports and the prospect of competition from cheap imports.

Thus after being only lately relieved of the burden of having to take Government securities onto its own books (because of a short-term improvement in the fiscal position) and creating more reserve money, the RBI has unexpectedly been forced to mop up the unrelenting flow of dollars into the country. In the process, it has opened up a new window of reserve money creation.

There is, of course, a qualitative difference between monetisation arising from "accommodating" the Government on the one hand, and forex market intervention on the other. The former is nothing but printing money while the latter adds tangibly to the central bank's assets.

The RBI thinks domestic interest rates are just about right in relation to inflation and the fiscal situation. But they are still very much out of sync with global rates. Even Pakistan, which must rank notches below India in economic performance and resilience, has overnight rates of 2% or thereabouts. The international investor cares not a wee bit about real rates of interest, but the effective return in his home currency after covering currency risk. And here we clearly offer the best deal in the world: 3% net in dollar terms on short-term money.

Our interest rate policy is an open invitation to arbitrage against us and earn three times the return in the richest country in the world.

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