The Hindu Business Line : Is the RBI inflating India?

There is evidence that the Reserve Bank of India may have been inflating the economy even while keeping the rupee weak and the rupee prices of imports high. It has made living an avoidable misery for the weaker sections. The bleak forecast is that interest rates will be kept high to fight inflation. This will choke investments and suppress growth, says G. RAMACHANDRAN.

Comments onthe rising inflationary pressures in India have been flowing in torrents. Leading economists think India has been hotting up for long. They think it is on fire. They are correct to point fingers at the not-so-robust aggregate supply function. It has not kept pace with demand.

India did not need notice that its aggregate competence and demand would rise. India's growth story has been on everyone's lips for long. But too little has been done to smoothly and continually boost the supply side of the aggregate economy. It is incapable of meeting rising demand without heating up the wires and causing fires. The analysis of rising prices as the result of supply-side shortcomings is absolutely correct. It may be absolutely incomplete as well.

The truth is the Reserve Bank of India (RBI) has been inflating the economy. Motor spirit and diesel are at unaffordable prices because the Indian rupee has not been allowed to appreciate. Motor spirit and diesel will have been more affordable at, say, Rs 33 and Rs 20 respectively per litre if the RBI had allowed the rupee to appreciate.

There is evidence that the RBI may have been inflating the economy even as it kept the rupee weak and the rupee prices of imports very high. It has made living an avoidable misery for the poorer classes. The bleak forecast is that interest rates will be kept high to fight inflation. High interest rates will choke investments and suppress growth.

Proud as a peacock

Pride fills many chests every time India adds a couple of billion US dollars to its foreign exchange reserves. The media stylishly calls it the `forex kitty'. The puff is built on a very wrong notion. This is the naïve notion that reserves are a badge of honour earned by the RBI.

Therefore, the popular view in India is that the RBI should accumulate foreign exchange reserves. The naïve then worship these reserves. There is a cruel irony here. While worshipping the accumulation of reserves, the common woman does not realise that the RBI sucks out her family's purchasing power in order to protect the purchasing power of families in the US.

Wrong as a weasel

Reserves are not a badge of honour. They are the result of intervention by the RBI. The RBI builds reserves with the sole motive of keeping the rupee weak. The rupee has to be kept weak because it is in managed float. The rupee is designed to move between a floor and a ceiling. The floor is its strongest allowable value against the dollar. The ceiling is its weakest allowable value against the dollar. The RBI sets these values.

The two laws

There are two inexorable laws of currency valuation. First, when foreign exchange inflows exceed the demand for foreign exchange, the rupee has to strengthen so that the market will clear at the stronger value of the rupee. Second, when the demand for foreign exchange exceeds inflows, the rupee has to weaken so that the market will clear at the weaker value of the rupee. An economy that is too worried about attaining currency stability and too distrustful of the currency market to rapidly propel itself to equilibrium will need its central bank to intervene. India is both worried and distrustful. So, the RBI intervenes to stop the rupee from becoming strong by buying a part of the foreign exchange inflows. Reserves rise. That is the third inexorable truth. India's reserves in February 2006 were estimated at $137 billion. The value of the dollar then was Rs 44.20. India's reserves rose to over $185 billion in February 2007. The current value of the dollar is around Rs 44.10. The RBI has held the rupee's value steadfastly for a year. Is this is a remarkable achievement? If currency stability were the measure, the answer would be yes. If economic prosperity were the measure, the answer would be no.

In order to achieve currency stability, the RBI has had to accumulate reserves of about $48 billion in one year. It has done this by buying the stream of dollars resulting from exports and inward remittances from non-resident Indians (NRIs). It has bought dollars resulting from portfolio investments, foreign direct investments and corporate borrowings. What should be clear is it has not earned the reserves.

Skinning of the lambs

When the RBI intervenes to keep the rupee at some weak value, it has to buy the dollar inflows from exporters and from NRIs. It has to buy dollars from portfolio and foreign direct investors. It has to buy dollars from companies that borrow abroad. In any case the sellers of dollars need rupees to conduct their businesses here. They do not lose. But domestic citizens lose, and they lose big. When the RBI intervenes, the rupee is held in a vice. It is prevented from strengthening to, say, Rs 35 per dollar. At Rs 35 per dollar, the landed price of crude oil in rupees would be significantly lower. The rupee price per litre of diesel would be, say, Rs 20. The Petroleum Ministry would not have had to step in to cut prices by a rupee or two. The market would have cut prices by Rs 15 per litre.

When the rupee is strong at Rs 35 per dollar, the costs of feedstock, fertilisers and transportation would be lower. Domestically produced foodgrains, vegetables, fruits, milk, eggs and meat would be cheaper. Imported non-ferrous minerals, metals, edible oils and pulses would be cheaper. India is not self-sufficient in these. Lower rupee prices of domestic produce would bring joy to the poorer classes. Cheaper imports would lift them from their misery.

Then the slaughter

The Hindu Business Line has correctly complained that the fruits of the much-touted economic growth have not reached large sections, especially in the rural areas (Weaponless in price war, February 16). It has also argued correctly that galloping inflation robs the poor.

First, it would be apt to regard a stronger rupee as the most dominant fruit of reforms and growth. Therefore, keeping the rupee weak stops the fruits of reform and growth from reaching the poor, wherever they are.

Second, the current bout of inflation and high interest rates are the results of intervention. When the RBI purchases foreign currency inflows, the domestic monetary base or money supply or both rise.

What this means is that the RBI prints rupees to buy out the dollars. The expansion of the monetary base causes inflation. Too much money chases too few goods. That is the fourth inexorable truth.

So, the RBI sterilises its purchases of foreign currency to nullify the impact of intervention. Sterilised intervention is an equal foreign and domestic asset transaction in opposite directions.

When the RBI buys dollar-denominated assets, it sells rupee-denominated securities to suck the rupees back. But when the RBI has to suck out a whole lot of rupees back, it has to raise rupee interest rates and the Cash Reserve Ratio.

End game

High interest rates are detrimental to expanding the supply function. This is the fifth inexorable truth. When interest rates are high, investments in real assets are tapered down or are put off altogether.

When investments in productive assets are held back, output is held back. The supply function lags demand. More inflation follows. Growth too is held back.

Both intervention and sterilised intervention produce bad results. But they are necessities of the managed float system in which the rupee is operated.

It may be instructive to state that the managed float allows the possibility for the RBI to face a trade-off between domestic objectives and exchange rate stability.

But the RBI may have wrongly traded away domestic economic objectives for the dubious comfort of exchange rate stability.

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

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