Policymakers around the world are faced with a dilemma on whether to control inflation or support growth. In the context of Covid-19, the onus fell on the government to take up deficit financing to keep the economy going. This activity was supported by central banks, which lent easy money through quantitative easing, thereby increasing money supply and lowering interest rates.

The Russia-Ukraine war has changed the global economic scenario. Higher commodity and oil prices coupled with supply-side glitches raised inflation. For India, which is a major importer of crude, consumer price inflation is inching towards the 8 per cent mark. The inflation scenario in the US is no different — recording 8.3 per cent in April, among the highest levels in four decades.

Apparently to contain inflation, the Reserve Bank of India (RBI) in a surprise move increased the policy repo rate by 40 basis points and a day later the Federal Reserve raised the benchmark interest rate in the US by 50 basis points. The objective of both these central banks is to manage inflation as well as exchange rates as a factor contributing to it.

Higher inflation expectations on account of the war, triggering higher commodity and fuel prices, has led to a fall in consumer purchasing power. This could lead to industry leaders not willing to invest, causing a further fall in employment generation and growth.

The present inflationary factor has more to do with the supply-side shock. In such circumstances, it does not make sense to follow tight monetary policy to control inflation. It would seem that central bankers are resorting to quantitative tightening to control the value of the exchange rate.

Quantitative tightening in the US is likely to reduce Fed purchase of government bonds, reducing the fiscal deficit and appreciating the US dollar against other national currencies. This may hasten outflow of capital from developing countries such as India to the US, depleting India’s foreign exchange reserve as well as further depreciating the rupee. The outflow is accentuated by the high inflation in developing countries.

In India’s case, the exchange rate is likely to depreciate in the future despite the reduced nominal interest rate differential between India and the US, following the rate hikes. This is on account of the high inflation rate in India, induced to a certain extent (besides the supply-side factors) by the liquidity pumped into the system during the Covid period.

It is to be noted that during the last eight months India’s foreign exchange reserves have fallen from the record high of $642.4 billion in September 2021 to below $600 billion in May 2022. Since October 2021, foreign portfolio investors have been net sellers in the Indian stock market, tanking both the Nifty and Sensex. And the rupee has been under pressure, having fallen below 77 to the dollar a few days back.

Money multiplier

The surprise move to hike the repo rate is an indication that RBI wants to arrest a further fall in the rupee. The size of money multiplier in India is around 5.5. It means for each unit of central bank money creation, the Indian private banks would generate more bank deposits, which effectively multiplies the money in circulation by at least five. Such multipliers effectively discourage the central bank from buying government debt. For each crore rupee of bonds they buy, at least five crore rupees would be injected into the system, primarily by commercial banks. This monetary expansion is highly inflationary, with an impact on depreciating the value of rupee.

But there is a better way to arrest this fall in the value of rupee and contain the fiscal deficit; that is through the use of digital rupee. Initially faced with the popularity of private cryptocurrencies, central banks are designing central bank digital currencies (CBDCs) that will completely revolutionise payment systems. China has begun experimenting with its digital yuan, the European Central Bank is designing the digital euro, and Fed is thinking of developing its digital dollars.

What if the RBI proposes to impose a 100 per cent reserve requirement on the CBDC? This will imply that commercial banks will not be able to multiply the CBDC and transform them into creating money with an inflationary pressure on economy.

The RBI can start selling government bonds and start absorbing the Indian currency in circulation. The withdrawal of traditional Indian rupees reduces the number of rupees in circulation by five times as much as the introduction of digital rupee increases it. The RBI would swap a money multiplier of five for a money multiplier of one. In Italy, Becchetti and Cozzi recently estimated that the digital euro may neutralise up to 75 per cent of government debt. This will help the RBI achieve the twin target of controlling the inflation and curtailing the slide of the rupee further.

Banik is Professor, Mahindra University, and Cozzi is Professor, University of St. Gallen, Switzerland