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S. Balakrishnan

Interest rates should deter inflation but not investment, the exchange rate should foster exports and both should be effectively managed without fetters on capital flows.

The `impossible' trinity, it is called - you cannot simultaneously control the interest rate and exchange rate and have full currency convertibility. Complete freedom in any one of these restricts your freedom of action on the others.

Ambiguity and ambivalence are part of the Hindu way of life and existence. Even in economic (and political) decision-making, we postpone difficult decisions till the very end - often till it is too late.

Thus, it is not surprising that we gamely continue with the impossible act of finding the right balance of interest rates, exchange rates and capital mobility.

Central banks of the G-7 countries don't even attempt it. Their mandate is clear-cut - keep inflation low and do whatever it takes in terms of interest rates to achieve it. They hardly bother about currency movements, which is the province of governments worried about the trade effects of their currency appreciating (as the US has long about the yen and now the Chinese yuan).

In this sense, the job of a G-7 central bank is easier than that of the RBI, which must engage in multitasking and satisfy multiple goals. Interest rates should deter inflation but not investment, the exchange rate should foster exports and both should be effectively managed without fetters on capital flows. The RBI has a truly heroic remit.

It has managed the trilemma well. The price we pay is the high cost of servicing foreign investment, but that, clearly, is not the RBI's fault. It has to determine its interest and exchange rate coordinates within the framework of government policy on foreign direct and portfolio investment.

As economists like Joseph Stiglitz and Jagdish Bhagwati have pointed out, financial liberalisation is qualitatively different from trade liberalisation. The latter indisputably promotes competition and exports. Its effects are there for all to see - better quality products and services and cheaper prices in almost the complete array of industrial and consumer goods.

Most important, Indian manufacturers are beginning to make their presence felt in world markets and it wouldn't be a surprise if we emerge as a manufacturing export machine in the next few years.

The difficulty is with foreign portfolio funds (and not capital flight even if we have full convertibility). This often is a wall of money following Wall Street's latest craze and drives up asset prices of all descriptions. With India now being on every global investor's radar screen, high returns are being racked up. The side effect is exchange, interest rate and liquidity volatility.

Overall, are we better off? Data certainly show the economy growing at near double digits. Asset appreciation does have primary and secondary spending effects. But what is the mix of investment and consumption? And what is the forex intensity?

Clearly, deeper research is necessary to understand the net impact of even a well-managed trilemma.

More Stories on : Interest Rates | Forex | Economy | Financial Scan | RBI & Other Central Banks

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