To loosen or not to loosen policy

A Seshan
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Faced with a falling rupee and stubborn inflation, the RBI needs to deal with two issues in its July 31 policy review: increase flows of foreign capital and build up its reserves.

As the Reserve Bank of India (RBI) takes up the formulation of monetary policy to be announced on July 31, 2012, it faces a situation similar to what it encountered one-and-a-half months ago at the time of the mid-quarter review. In fact, the economic environment has deteriorated further in some respects due to the delayed monsoon.

Inflation continues to be a major concern for the country. It is aggravated by the steep depreciation of the rupee over the year. The inter-bank exchange rates do not tell the whole story about their future direction.

For example, on July 3, when a dollar fetched around Rs 54.30 in the market, a bank quoted to a customer forward rates with guarantee at Rs 58.10, Rs 61.10, Rs 63.41, Rs 67.45 and Rs 70.10, for one, two, three, four and five years, respectively.

A refill pack (not a bottle) of 170 gm of the Golden brand of Nescafe (instant coffee), imported from South Korea, costs in Mumbai — hold your breath — Rs 600!

It means Rs 3,530 for 1 kg of the powder! This is only illustrative of the cost of imported goods — raw materials as well as the finished ones; there may not be many takers at this price.

But the impact of imported inflation gets reflected in the general price level, either directly or through the inter-industry transactions captured by the Leontief-type input-output matrix. Considering the persistence of inflation, the RBI needs to do basic research on the causes.

Is it a case of inertial inflation? If so, what is the shock to the dynamic equilibrium required to move it downwards? What is the role of money, administered prices and the depreciation of the rupee in the inflation trend? (For this exercise, see P K Pani’s macroeconomic model for India in Reserve Bank of India Occasional Papers, December 1984, pp 113-239.)

Building up reserves

The two challenges facing the RBI are to increase the flows of foreign capital and build up its reserves that have fallen substantially in the recent period due to market intervention.

As on March 31, 2012, the reserves constituted 85.1 per cent of external debt, against 99.6 per cent a year ago and 138.0 per cent, at the end of March 2008. It would be even less if one were to reckon with foreign currency assets only.

The central bank says that its intention in market intervention is to curb volatility and not establish any particular level or band for the exchange rate. Conceptually, it is self-contradictory.

Volatility is generally measured by the coefficient of variation. It is the proportion of the standard deviation to the mean of a variable.

If the objective is to curb volatility it means an attempt to reduce the standard deviation to a level close to the mean. Would it not then imply that it is the mean which is targeted, unless the RBI comes out with a specious argument that the mean is changing all the time?

The market is right in anticipating action from the RBI when a particular level is reached. Whenever market intervention was practised in the West, central banks used to say that their objective was to arrest appreciation or depreciation, not volatility in rates (eg, The Plaza and the Louvre Accords).

Unlike there, the exchange rate movements in India are affected by the flow of foreign funds into and out of the stock markets. The RBI may very well intervene in the stock markets, if it wants to stabilise the exchange rate!

lock-in period

The raising of the limits for FII investment in government and corporate bonds has not elicited the expected response due to the lock-in stipulation, behind which is the fear of short-term movements of money. But hot money flows of FIIs are allowed in the stock market, causing frequent roller-coaster rides and affecting the exchange rates.

The lock-in period should be done away with. The results of the auction of bonds by SEBI on July 20 provide support for this recommendation. The inflows due to gilts in the primary market can be used to strengthen forex reserves with rupee credit given to government in RBI books. Their sales could, however, be in the secondary markets. The FII limits for bonds could further be raised.

As for augmenting the forex resources of the banking system, I reiterate my earlier suggestion to deregulate the interest rates of FCNR(B) deposits and exempt the incremental inflows from SLR requirements (RBI: Hard Choices, Easy Options, June 12, 2012).

Banks can offer forex currency loans to Indian entrepreneurs on attractive terms that can be refinanced by the RBI. The current linking of the ceiling on the rate to Libor seems to be illogical. Libor itself is under a cloud.

The central bank’s dilemma is whether or not to loosen its policy. Commercial banks and the corporates look at monetary policy from their sectoral angles whereas the RBI has to take a macroview.

In this context, the statement of Aditya Puri of HDFC Bank is refreshing. He said: “'I don't think with this inflation rate you can expect a rate cut, ….. The monetary policy cannot be the basic panacea for all ills.”

Monthly seasonal indices show that prices of food articles rise till November. Given the delayed monsoon, the psychology of shortage will build up.

The convincing manner in which the Governor defended his ‘no-change’ policy in his address to the Indian Merchants’ Chamber on June 19, 2012, could very well be repeated on July 31.

(The author is a Mumbai-based economic consultant

(This article was published on July 25, 2012)
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