The Hindu Business Line : Perfecting the monetary policy

The RBI’s use of multiple weapons to control monetary expansion has paid off, even if, in the process, the objective of optimality of exchange rate could not be protected. The latter has to be addressed separately.

M.Y. Khan

The Reserve Bank of India deserves kudos for its attempts to tame inflationary expectations without disturbing the tempo of economic growth, estimated in the 9-10 per cent range. Inflation, reflected by the wholesale price index (WPI), has fallen to 4 per cent (year-on-year) as on July 14, 2007 from 5.9 per cent at end March 2007. The hypothesis that changes in the money stock will have a strong and predictable effect on aggregate demand for goods and services has indeed been proved.

The Quantity Theory of money has been used vigorously. Curtailing the inflation rate is a welfare measure or a humanitarian response to the plight of poor masses 80 per cent of whose income is spent on food and related items, such as edible oil. The RBI Governor, Dr Y.V. Reddy, has pursued the objective of inflation control since 2005-06 when he undertook policy measures to squeeze excess liquidity out of the economy.

The current increase in CRR is also aimed at further cutting down the inflation rate. Dr Reddy has consciously looked at the 21.6 per cent increase in money supply on a year-on-year basis on July 6, much higher than a projection of 17-17.5 per cent, which can be considered optimum from the viewpoint of 9 per cent GDP growth in 2007-08. This rise should have been controlled by selective credit controls; the Cash Reserve Ratio is a macro weapon and can harm those not contributing to high liquidity.

An analysis of the sources of monetary control is interesting. The decline in liquidity in the form of money supply was caused by a reduction in the RBI’s holding of dated securities and a fall in the level of the Central Government’s cash balances with the central bank.

These two sources brought about a reduction of Rs 46,614 crore in reserve money. The total overhang of liquidity under the Liquidity Adjustment Facility (LAF), the market stabilisation scheme (MSS) and cash balances of the Central Government, taken together, declined from an average of Rs 97,449 crore in March 2007 to Rs 72,823 crore on July 27.

The above analysis shows the role of RBI, the intervention of which largely contributed to decline of liquidity. However, the RBI used multiple weapons to control monetary expansion and this is an evidence of the sharp central banking skills available in the country.

Flip side

However, in the process of liquidity management, the objective of optimality of exchange rate could not be protected. There is a hue and cry from experts as well as exporters regarding the slide of dollar and appreciation in rupee exchange rate, exerting downward pressure on export growth.

Monetary control as an instrument was meant to achieve only one objective and that is to bring down the inflation rate. There has been no RBI announcement on the depreciating rupee. There is a conflict in policy objectives. Prof Tinbergen forwarded a theory that in order to secure a stated number of objectives, authorities need to operate at least an equal number of different policy instruments.

Monetary policy, if used to deflate exchange rate, would result in monetary expansion and higher inflation. As such, more than monetary policy it is fiscal policy including exports/imports taxes and other incentives that can take care of international trade, etc. Monetary policy should have the sole objective of controlling inflation and, indirectly, interest structure.

Monetary changes

Monetary changes have generally tended to overshoot or shoot down the exchange rate. We have seen that the rupee exchange rate has been volatile following even credible changes in monetary policy. But there are other factors that influence movement of exchange rate.

For instance, exchange rate can change due to difference in inflation rate between domestic and other countries, differential productivity growth or exogenous changes in the terms of trade, changes in rate of foreign inflows, changes in real income, interest differentials and relevant policy changes.

At the present juncture, the dominant factor destabilising the exchange rate is foreign inflows, which are controlled by government policy. So, finally, it is the fiscal policy and those policies relating to foreign inflows which are more important in moderating the exchange rate.

The Government should use draw-back rates to compensate the exporters. Exporting units need not to be subjected to usual corporate tax and the tax amount should be reduced by the rate of appreciation of the rupee so long as it is appreciating.

(The author is Chairman of Inter-connected Stock Exchange of India Ltd. and Former Economic Advisor of SEBI.)