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Two roads diverged in a wood and I …

I took the one less travelled by,

And that has made all the difference.

-Robert Frost

The Annual Report of the Reserve Bank of India (RBI) does not say anything new. Only a few weeks ago, the Bank had issued its quarterly reviews of policy and developments in the economy and had adequately covered all aspects comprehensively. There has not been much change in the situation since then.

Thus, one cannot be faulted if one gets the feeling of déjÀ vu. At the same time, the Report is important as it bears the official stamp of the Central Board of Directors. It is one of the two statutory reports mentioned in the Reserve Bank of India Act. The RBI’s most immediate concern is the rising inflation rate. The Report discusses the various concepts of inflation, including or excluding certain goods.

Dr Ben Bernanke, the US Fed chief, made a statement to bankers in the US in June 2006: “This year’s core inflation has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability.” “Core inflation” sets aside volatile food and energy prices and measures inflation in relation to the price trends in respect of the rest.

Floyd Norris of the New York Times, described as a practised Fedspeak cryptologist by William Safire, made a telling comment on this view of Bernanke. He said: “The ‘core inflation rate’ is relevant for those who neither eat nor use energy.”

In the Indian context what is excluded in core inflation is perhaps more important than the rest because of the extensive prevalence of hardship among a large section of the population with reference to the prices of basic goods and services. And that is why fiscal subsidies aim at food and energy. There is a tendency among policy-makers to work out the inflation rate taking various periods and measures of price rises. It could be the fiscal year, year-on-year or calendar year.

Earlier, there used to be a measurement during busy and slack seasons also! Again, the rate may relate to point-to-point or the average of the monthly figures. Often, when the authorities indicate the likely level of inflation for the year, they are not transparent; they do not indicate whether it is average or point-to-point. Either can make a lot of difference to inflation expectations.

The basic idea is to hit at some measure which would demonstrate that things are not as bad as they are made out to be by the observers. This writer had argued in his earlier articles in this daily that a simple device such as a Price Index for the Poor (PIP), covering only a few items of importance to the poor and lower middle class, including food-grains, milk, sugar, edible oils, etc., could be constructed from out of the Index for Wholesale Prices, adding their weights to constitute a total of 100, so that the inflation rate can be worked out.

This was a temporary solution to the problem of the inadequacy of the WPI to measure inflation till such a time a better index was devised. The Ministry of Finance appears to have noted the suggestion and started working on such an index but adding a few more commodities, perhaps to make it look like a new idea. The Government is using the data thus compiled to show that inflation rate is much less than what is perceived in the WPI. It does not help.

The poor, including the neo-ones, used to paying Rs 2 for a dozen bananas, have to shell out the same amount for a single fruit now. A cup of coffee in a Grade III Udupi restaurant in Mumbai costs Rs 12, against Rs 8 a year ago, due to the rise in prices of the ingredients. There is no index for the large sections of single persons in big cities who depend on hotels for all their meals.

The problem lies in increasing productivity and production in the economy. But that is a medium-term approach. One quick solution is supply management. The Government has large surplus stocks of wheat and adequate rice stocks.

It also has arrangements for the import of pulses. If these are unloaded in the markets at prices lower than the prevailing ones there will be a favourable psychological effect on market sentiment. The Government has been thinking on these lines after suggestions were made to the effect a few weeks ago but the official machinery has not moved fast in implementing the idea. It is still in the planning stage.

In the past, the Bank said that its objective was to smoothen the movements in exchange rates, leaving them to the market to decide, and intervene only in cases of volatility. However, this has created problems on the domestic monetary front. Having decided on the primacy of tackling the inflation rate, the RBI needs to stop intervening in the market, either when the rupee appreciates or when it depreciates.

Despite all the interventions last year, the rupee appreciated steeply against the dollar. This year, there has been a substantial depreciation so far, in spite of the Bank selling dollars from its kitty. There is enough empirical evidence to show that when market intervention by way of purchase of forex is followed by sterilisation of excess domestic currency thus generated, it has no effect on the exchange rate.

A symmetric factor operates on the sale of dollars to halt rupee depreciation while, at the same time, liquidity shortage is met through repo operations. The trend in the exchange rate is back to Square 1, in either case. It was for this reason that the central banks of the developed countries stopped intervening in the market long ago despite volatility in rates.

The RBI’s strategy of stabilising the market through intervention does not help in achieving the ultimate objective of preventing appreciation or depreciation. It has also failed often in preventing volatility. The data on exports show that despite the appreciation of rupee in the past, exports performed well. This is basically because, as this writer has argued frequently over the years, the Indian rupee is undervalued in terms of purchasing power, as anyone who has travelled abroad would vouchsafe.

Exports from some sectors, such as textiles, were no doubt affected. It was tackled correctly by fiscal relief. The adverse price effects of depreciation have to be met by improving the efficiency in the use of inputs. When oil prices were rising, there was some relief from the appreciation in the rupee. Now oil prices are showing a declining trend and rupee depreciation should not hurt as much as it would have otherwise done.

The concept of Real Effective Exchange Rate was conceived in the context of the purchasing power parity theory and the predominance of current account transactions in the balance of payments. But today it is the capital account which is dominant. It is time for the new Governor of the central bank to break with the past and avoid the well-trodden road to opt for the one less travelled so far. It is the road of total attention to the stability of the rupee domestically, abandoning the exchange rate to market forces.

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