Inflation fighting RBI's `Shock and Awe' treatment

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In a recent media debate, economist Ila Patnaik suggested a radical alternative approach to tackling inflation a holistic policy mix that focuses on inflation control without too much emphasis on interest rates. S. VENKITARAMANAN believes there is merit in her critique which can help the central bank avoid a confusion of objectives and control inflation while maintaining growth.


The inflation fighters in the Reserve Bank of India have administered the expected and stronger than expected countermeasures to fight inflation. Inflation has been running at above 6 per cent measured by the wholesale price index and is above the comfort level adjudged by the RBI and the Centre.

The decisions announced by the RBI include a rise in repo rates (the rates at which banks borrow from the RBI), a rise in cash reserve ratio and a reduction in rate of interest on cash deposited by banks with RBI. The signals are intended to spur banks to raise lending rates and to reduce the amount of credit disbursed. The RBI's measures are expected to suck out a substantial sum from the banks. In effect, while the economy is booming and the credit needs grow, the central bank is tightening the availability of credit.

A cancer specialist does not or should not care too much for the comfort of the patient when he or she prescribes chemotherapy. Similarly, has the RBI proved too enthusiastic at prescribing severe chemotherapy to starve out the tumour that is inflation? It may weaken the healthy cells as well. The shocked market analysts and economists have been at pains to analyse the various implications of the central bank's action and the possible alternatives.

The markets have signalled their resounding reaction by a sharp fall in the Sensex by nearly 500 points. The impact on economic growth is also likely to be sharp, judging by effects of similar therapy applied with disastrous effect in the mid-1990s.

Did the RBI have an alternative to its `shock-and-awe' tactics? Could it not have waited for the crop harvests to come in and the effect of seasonal adjustments to play themselves out? It is admitted by all and sundry that the rate hikes will take some time to act on inflation. By then, the eagerly awaited wheat harvest would have come in and the effects of supply responses would mask the direct impact of RBI's actions.

It would, however, reduce the level of investment activity in the economy, particularly in the infrastructure sector. Big corporates may ask for, and get, access to external commercial borrowing, but not so favoured are the bulk of small and medium entrepreneurs. Governments will also face the risk of rising interest costs. Housing activity will suffer an impact because most loanees are on floating rates and will face increased equated instalments. Perhaps, an effect desired by the RBI a slowdown in housing expansion will come to pass.

Radical alternative

In a seminal interaction in a recent media debate, Dr Ila Patnaik has pointed out that the present policy problem demands a rethink of the framework of the monetary policy-makers. Dr Patnaik says the RBI pursues conflicting objectives in its currency interactions (which involve purchase of dollars for rupees) and its contractionary stance, as evidenced by recent measures.

The RBI buys dollars from banks and exporters, partly to prevent the dollars from flooding the market and depressing the dollar indirectly raising the rupee. In other words, the central bank's interactions have a desirable objective to keep the rupee devalued which will make India's exports more competitive, but they increase liquidity.

To combat this, the RBI does what it calls "sterilisation" it sucks out the rupees it pays out for dollars through sale of sterilisation bonds. It then sells these bonds to banks. Dr Patnaik points out that there has not been much success in such sterilisation attempts in India. The central bank's attempt to offload Government bonds on banks has not been too successful inasmuch as the banks sell the bonds and get rupees instead.

Dr Patnaik contrasts this with the successful experience of China, where the state-owned banks strictly abide by the central bank's dictates and absorb the sterilisation bonds. That discipline is lacking in India. The net effect is that the RBI has to resort to indirect methods of sterilisation, such as raising interest rates and raising CRR to contract liquidity. This makes India more attractive for foreign capital flows that seek better returns and a vicious cycle follows. RBI has to buy more foreign currency and sterilize. The cycle becomes worse.

Dr Patnaik suggests a radical alternative, viz. that RBI should rethink its currency policy, which results in flooding the markets with rupees. She admits that cessation from direct intervention in the foreign currency markets will lead to rupee appreciation, which may hurt India's exports. To this, she has an answer. The real effective exchange rate is nominal exchange rate minus inflation. Higher inflation mops up the competitive advantage of a weaker rupee.

In Dr Patnaik's opinion, the RBI should explore the possibility of a different policy mix, which leads to the central bank having a calibrated control over money supply as well as exchange rate. An appreciating rupee may also lead to lower inflation.

Dr Patnaik further points out that "while inflation is relatively high, at 6.5 per cent, it does not yet appear to run away completely out of control. In contrast, monetary policy, with call money rates going above 70 per cent, seems to have been lost control of. Neither is the policy able to provide stable conditions in financial markets, nor is it able to control inflation".


She explains this further, pointing out that "money gets created in two ways". First, when the RBI buys a dollar with rupees, it creates rupees. Second, when the RBI lends to the government, it creates rupees". For many years now, no rupees have been lent to the government by the central bank. The bulk of money circulating in the economy increases mainly by dollar purchases by the Bank. It is dollar purchases that created the bulk of liquidity between April 2006 and January 2007. The RBI has added liquidity through the sale of the order of Rs 56,000 crore.

Dr Patnaik is an experienced economist and reputed analyst of monetary policy. She pleads for greater transparency in the RBI's sterilisation operations. Basically, Dr Patnaik's alternative policy mix is a holistic one with a focus on inflation control without too much emphasis on interest rates. She believes that this change of emphasis will enable the central bank to avoid a confusion of objectives and control inflation while maintaining adequate growth. By all means, let the RBI's fight against inflation continue. But there should be a clear paradigm to adopt. The US Fed Reserve, which is the RBI's model, does not have resort to CRR. The control is through the price of money that is, interest rate, and not the quantity.

The Fed does not sequester resources of the banking system by raising CRR for it has zero CRR. Even if the Fed's monetarist model is followed, one has to allow borrowers to get credit at least at a price. Both quantity and price cannot be controlled at the same time, which is what the RBI is doing.

It is opportune for the RBI to respond to Dr Patnaik's critique. There are also other voices of reason that have pointed out the contradictions in the RBI's present policy mix-up. "Fight inflation, by all means. But do not destroy growth prospects of the economy". That seems to be the merit in Dr Patnaik's alternative.

(This article was published in the Business Line print edition dated April 9, 2007)
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