The Hindu Business Line : Living with `impossible trinity'

The surge in capital flows has complicated monetary policy management and the RBI seems to have decided to tackle the menace over time by balancing it through capital outflows.

The increased level of globalisation has become a cause for concern to central bankers across the world, as the performance of the domestic real economy is now increasingly driven by external factors.

The policy of low interest rates followed by leading economies in recent years helped kick-start the global economy, spawned global risk-taking and flooded the emerging economies with surfeit of capital flows.

These capital flows now form a significant chunk of the increase in our monetary base and has helped fuel the longest ever credit growth cycle. The excess money has resulted in increased demand-led inflation, a phenomenon witnessed globally with the rise in the `core' or manufacturing-led inflation.

The central bank is now faced with the responsibility of maintaining the current growth momentum, but ensuring at the same time price stability and orderly financial market conditions.

A sort of `impossible trinity' in RBI's own admission, "... dealing with the impossible trinity of fixed exchange rates, open capital accounts and discretion in monetary policy has become more complex than before."

Ensuring Price Stability

The recent increase in CRR and the repo rates, aimed at addressing the issue of excess liquidity and containing inflation, had already indicated the RBI's stance of ensuring price stability, and not much was expected in the latest Credit Policy.

The pattern of inflation in India points to severe demand-led forces and necessitates monetary policy action.

The RBI's move to lower inflation tolerance level to 5 per cent for FY 2008 and 4-4.5 per cent in the medium term is significant in intent, choosing long-term price stability in sustaining the growth trend. The RBI's stated targets of GDP growth of 8 per cent, money supply growth of 17.5 per cent and credit growth of 25 per cent for FY 2008 in today's environment of high inflation and global uncertainty are quite encouraging, communicating its intent of sustaining the current growth momentum in an orderly manner.

Managing the External Account

The surge in capital flows has complicated monetary policy management and the RBI seems to have decided to tackle the menace over time by balancing it through capital outflows.

The steps taken towards Capital Account Convertibility are laudable but might not solve the immediate problem of containing an appreciating rupee and managing the associated excess liquidity.

In its dilemma to balance the `impossible trinity', the RBI has chosen to maintain growth and anchor inflation expectations and left its options on the external account open.

(The author is CEO, Quantum Asset Management Company.)

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