The Hindu Business Line : Let us applaud the RBI

The rupee has been allowed to appreciate in tune with demand and supply, and the gains are immense. The strong rupee will spur demand. Consumption rises when interest rates fall. Rising supply and demand together induce growth. It is clear, therefore, that the RBI is on course to winning its battles robustly, and the central bank deserves a salute, says .

Central banking is among the toughest civilian activities in the modern world. And the work of the chief central banker among the most difficult of civilian jobs. It may be said that it is more demanding than the military jobs at the highest levels. Armed forces prepare for war all the time and actually get into battle once every 20 years or so. Many admirals, generals and air-marshals retire without ever being in a real battle.

By contrast, central bankers are in battle mode all the time though they are not warmongers. There are no mock battles. All battles are real. The Reserve Bank of India (RBI) has been in battle mode for a long time. Its big war began more than 20 years ago, when India chose to free up its economy. Later, it unshackled its currency policy and exchange rate system, even if only slightly.

But the war intensified about four years ago. The discerning world of investments was impressed by India’s strengths. It upgraded India from ‘slightly important’ to ‘vitally important’. Capital inflows began to surge. These inflows threatened to strengthen the rupee. And, they did do so indeed.

A strong rupee has been regarded a deadly disease and a severe threat. A weak rupee is seen as a source of export competitiveness. Believe it or not, a weak rupee is seen as a lifeline and as a cylinder of precious oxygen by exporters. It would be wise, therefore, to discount the numerous assertions of India’s excellence and global competitiveness.

So, the RBI had to keep the rupee weak. It had thought of imposing controls and taxes on portfolio investments. It was persuaded not to impose these (see Business Line, April 27, 2005). It then began accumulating massive foreign exc hange reserves. Therefore, it has had to print the rupee in a tearing hurry. It had, thereby, systematically inflated the economy to keep the rupee weak (see Business Line, February 28, 2007). It unconscionably overlooked the big benef its from a strong rupee (see Business Line, April 2, 2004).

Since April 2007, the RBI has come to terms with the dysfunctional impact of weakening the rupee. It thinks it is a bad idea to print the rupee and thereby create foreign exchange reserves. It has come to terms with the dysfunctional impact of raising interest rates to hold down inflation. It has also come to terms with the truth that high interest rates crush growth. Therefore, the rupee has been allowed to appreciate in tune with demand and supply. The RBI and the other policymakers seem to trust the currency markets. The inclination to intervene seems to have declined. The gains from this course of action — or inaction — are immense. The gains are beginning to show. Let us applaud the RBI for setting a new course.

Navigator’s job

The RBI is a navigator, like any other central bank. Calm or storm, it has to maintain price stability. At the same time, it has to enable the achievement of economic growth. Eyebrows are raised if growth targets are missed.

But voices and swords will be raised if inflation targets are missed. So, rain or shine, it has to keep the production economy and markets for distribution liquid — just liquid, no more, no less. So, it takes charge of money supply and interest rates. And, as it manages money supply, interest rates and inflation, the RBI has an impact on the value of the rupee vis-À-vis other currencies. But its impact on growth and inflation is the most important.

Sub-optimal compromise

Some economic participants are excited when the rupee gains value. Many others are excited when it loses value. Therefore, there have been celebratory comments when the rupee was weakened by the RBI.

Why? The weakening of the rupee is regarded as the smart and right thing to do. A weak, or a weakened, currency is seen as a means for gaining export competitiveness. The awfully adverse impact of the weak rupee — weakened by tweaking — on inflation, interest rates and growth has seldom been at the centre of public debate. The weakening of the rupee requires the RBI to raise interest rates to hold down inflation. These high interest rates may have choked investments aimed at expanding India’s supply capability. Expanding supply capability is a prerequisite for fighting inflation and supporting growth.

Therefore, high interest rates may have suppressed growth even while setting off a price spiral. The navigator so set course as to miss both growth and inflation targets. Eyebrows, voices and swords were raised at the same time.

Growth without inflation

The article “Shift in RBI strategy to fight inflation?” discussed two divergent arguments pertinent to the inflation-fighting credentials of a strong rupee (see Business Line, July 4). The first discards the idea that a stronger rupee will help in lowering inflation because the pass-through effect from exchange rates and import prices to domestic prices is weak in India. At the same time, exports will be choked by the strong rupee. This could undermine growth.

The second argument says that the strong rupee’s impact stems from the demand side. When the RBI refrains from buying dollars, there is lower growth of money stock aggregates and credit. This would hold down demand in the economy, which will then dampen inflation. But it does not say anything about growth.

Managing the economy is not all about containing inflation. It is about making growth possible. It is about pushing growth to full potential without inflating the economy. And growth requires the expansion of the supply capability. But both arguments are silent about the supply function. So, they are incomplete in analysing the comprehensive benefits of the strong rupee. Something real that is related to business — production, price and profits — is required for this analysis. Something robust and pulsating is required.

RBI’s new game

First, a strong rupee challenges the ability of domestic producers to hold prices down. Consider steel. Prices of imported steel have fallen by over Rs 2,000 a tonne as a result of the strong rupee. This has made it necessary for domestic steelmakers to slash prices of flat steel products, including hot-rolled and cold-rolled coils, so as to match import prices. Price cuts of Rs 1,000 per tonne have been announced. No import has been necessary, say, by automakers, to reap the benefit of lower prices.

When prices are slashed, steelmakers lose contribution (price less variable costs). Therefore, they have to produce more to cover fixed costs and to maintain profits. At the same time, lower prices push up demand. Thus, total output rises when prices are cut. This induces growth. The weak pass-through effect from exchange rates and import prices on to domestic prices becomes irrelevant.

Second, when the rupee is allowed to find its own strong level, the RBI will not find it necessary to suck out rupee liquidity after weakening the rupee. Sucking out rupee liquidity is usually associated with the raising of interest rates. So, a strong rupee keeps interest rates at lower levels. This makes it possible for steelmakers as well as other domestic producers to expand their supply capability.

But what is more significant is that the strong rupee will spur demand. Consumption rises when interest rates fall. Thus, both supply and demand rise when the rupee is not weakened by tweaking.

Rising supply and demand together induce growth. What is clear, therefore, is that the RBI is on course to winning its battles robustly. Let us applaud it.

(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)

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