The Hindu Business Line : One face of the impossible trinity

The perceived irreconcilability of the three objectives — capital freedom, exchange rate maintenance and independence of monetary policy — disturbs some development economists. However, many believe emerging economies can manage them adroitly, says K. SUBRAMANIAN, explaining how the RBI views these challenges.

If there is a dominant motif which captures the Annual Monetary Policy Statement for 2007-08 released on April 24, it is this: To manage surging forex flows and contain inflation. In recent years, the Reserve Bank of India (RBI) has been battling both — sadly, without much cooperation from the Finance Ministry.

These are important policy areas where co-operation and policy convergence between the government and the RBI is vital. First, there should be a better understanding of the relationship between inflation and economic growth and also of the need to target their levels through appropriate fiscal and monetary policy measures.

The other, more intractable, relates to the management of "the impossible Trinity." Academic narratives on the irreconcilability of the three objectives — capital freedom, exchange rate maintenance and independence of monetary policy — disturb some development economists. However, many believe that emerging economies can manage them adroitly.

The RBI Governor, Dr Y. V. Reddy explained it in a seminal lecture delivered in Mumbai in March ("Globalisation and Monetary Policy: Some Emerging Issues," RBI Bulletin, April 2007). Monetary authorities are concerned as much with output and employment levels as with price stability, especially in developing countries. Globalisation takes its toll and domestic inflation has increasingly become less sensitive to the domestic output gap and potentially more sensitive to the world output gap.

This impact varies and each country has to take a holistic approach to the trinity. "The impossible trinity has often to be managed in the emerging economies and this is ensured by close co-ordination between monetary and other public policies," he said.

Para 86 of the Annual Policy elaborates how globalisation has brought fuzziness in reading underlying macroeconomic and financial developments, obscures signals from financial prices and clouds the monetary authority's gauge of the performance of the real economy. Consequently, dealing with the impossible trinity has become more complex than before. How does the RBI view the challenges to monetary policy?

Policy Challenges

The primary concern indeed is price stability. When an economy such as India's grows at a rate higher than that witnessed in the earlier decades, there are concerns about overheating. The Quarterly Review of Monetary Policy issued on January 31 argued that "the policy challenge is to manage the transition to a higher growth path while containing inflationary pressures" to sustain growth at current level and facilitate higher growth.

It did claim that the monetary initiatives taken by the RBI would continue to maintain conditions of stability that contribute to sustaining the momentum of growth on an enduring basis. Perhaps, it did convey a Goldilocks view of the economy and a psychology shared by other central banks.

By early February, inflation measured by wholesale prices touched 7.3 per cent. Though it came down in later weeks, it was well above the RBI's threshold of 5-5.5 per cent. It has crossed 6.1 per cent in the last few days. There were fears of a further rise. The Government also woke up to the situation created by the rising inflation, especially in the context of defeats in a couple of State elections and the ongoing Assembly election in UP. Even as the Government took certain initiatives to improve the supplies of such commodities as pulses, the RBI stepped in and increased the repo rate to 7.75 per cent and the Cash Reserve Ratio (CRR) to 6.5 per cent.

The sudden tightening of liquidity by the RBI and fears of further tightening depressed the market's morale. There were worries of further tightening in the current review. Fortunately, the trade and the chambers of commerce will heave a sigh of relief that the RBI has left all the rates untouched. As in the past, the RBI's proposals are hidden in the detail in many other parts of the Annual Policy.

Approach to Inflation

What are the RBI's approaches to inflation? It acknowledges that, globally, monetary policy authorities regard inflation as a major risk and are vigilant about threats to inflation expectations.

Unlike in the January Review, the analysis of inflation in the Annual Policy is cautious and restrained. It provides a rich analysis of the phenomenon of inflation in emerging economies such as India. Perhaps, the implied message is that it cannot be contained through mere monetary measures.

It takes note of upward shift in the growth trajectory of GDP in recent years, averaging 8.5 per cent. Alongside structural changes in the economy, there is a cyclical component. It refers to the improvement in productivity brought about by structural changes during the period 1996-2003. Cyclical pressures are observed in the steady increase in prices of manufactures, resurgence of pricing power among corporates, of wage pressures in some sectors, strained capacity utilisation and elevated asset prices. Infrastructure constraints result in supply constraints and, as the Annual Policy says, "Managing the supply situation is emerging as a formidable challenge, especially as constraints on the supply response to the momentum of growth have become more binding than before."

As detailed in Para 76, the rise in prices of manufactures, which accounted for 50 per cent of the inflation, was due to capacity constraints in basic and intermediate goods. In short, a longer lead-time is required if inflationary pressures have to be kept under check.

No Quick-Fixes

Against these developments, the RBI is modest in its expectations. Its message is that these constraints are not cured by monetary policy. However, it hopes to maintain liquidity in the banking system to sustain growth and, at the same time, take steps to improve the quality of credit.

What is significant about the Annual Policy is its realism and unwillingness to press the panic button, which the political class may want. The RBI is conscious that there are no quick-fixes. It resists pressures for an increase in interest rates, as: "Such monetary policy responses, however, increase the possibility of further capital inflows, apart from the associated costs to growth and potential risks to financial stability."

The central bank is acutely aware that "foreign exchange inflows can potentially reduce the efficacy of monetary policy tightening by expanding liquidity."

In short, it leaves aside, for the present, conventional monetary instruments and pays attention to the ugly face of the trinity — foreign exchange management. The wounds inflicted by the recent increases in repo and CRR are still raw and another dose may be ill advised. Further, there is a time lag for rate increases to take effect. Thus, the RBI devotes more attention to reduce the foreign exchange inflows. All the measures proposed may be seen in this light.

Remittance limits have been raised on several accounts. Individuals can send $100,000 against $50,000 earlier. Companies can invest 300 per cent of their net worth against the current limit of 200 per cent. The limit for portfolio investment has been raised to 35 per cent. Foreign investment by mutual funds has been raised from $3 billion to $4 billion. Companies are allowed to remit up to $10 million for consultancy for infrastructure projects. There is a slew of other liberalisation, such as protection of debt and equity through hedging, forward contracting, etc.

Non-resident Indians may be unhappy over the reduction of interest rates on their deposits. But it has become necessary to contain speculative inflows. In its last Review, the RBI had set limits on loans against NRI accounts. It has been pleading for a restraint on FII flows but has not been able to secure North Block's support. There are limits to the extent to which the RBI can sterilise forex inflows. Even the present levels of sterilisation pose threats to the financial system through excessive liquidity and inflated asset prices.

The liberalisations proposed are better seen as a continuation of the earlier process, which is to calibrate capital remittances in a gradualist mode short of full convertibility. It follows the spirit of the Tarapore II Committee Report. Overall, the Annual Policy plays on the old familiar tunes as in a fugue. However, the themes change in keeping with the compulsions of the Trinity.

(The author, a former Finance Ministry official, has experience in international, financial and trade issues.)

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