Paradoxes facing the RBI

As the Reserve Bank of India (RBI) prepares its quarterly review of the economy, it would have to contend with several paradoxes in the economic situation, with contrary policy implications.

First, is the increase in exports at a time when it should be the other way round, due to the appreciation of the rupee against the dollar. Second, is the central bank asking the government to expedite spending, whereas in the context of the current high level of inflation it should be pleased with the deceleration in government expenditure. Third, amidst the hype on the expected growth rate of the economy, the Index of Industrial Production (IIP) is on a roller-coaster. Fourth, food inflation is at the centre of discussion in policy circles despite a satisfactory monsoon, even as it is caused by vegetables. There are reasons for these anomalies, and there is scope for correcting them.

THE PARADOXES

In the first place, the so-called appreciation of the Indian currency is in reality a correction of its undervaluation in terms of its purchasing power in international markets. As regards the second anomaly, it is man-made (“Some truths about liquidity crisis”, Business Line , December 11, 2010). The continuous rolling over of repos tantamounts to the RBI issuing short-term loans, which banks can lend at a substantial margin. Cannot the RBI institute a system of auctioning its surplus government deposits to banks by way of relieving the shortage of money?

This is one of the standard practices of open market operations, followed successfully in some countries. The government will earn interest on its idle deposits with the RBI. During periods of auction repo operations should be suspended.

The third anomaly relates to the ups and downs in the IIP data. In fact, on the basis of the latest fall in industrial growth rate to 2.7 per cent in November 2010, there have been demands not only for not tightening policy, but even for relaxing it in terms of reductions in CRR and SLR.

The limitations of IIP are well known. Its inadequacies are brought out in a comparison with the results of the relatively more reliable Annual Survey of Industries (ASI). Thus, during 2008-09, industrial growth was 8.3 per cent, according to ASI, whereas the manufacturing sector recorded 3.4 per cent, according to IIP.

Inflation control

The current inflation rate, particularly of food items, calls for top priority in policymaking. The RBI is concerned with aggregate demand. It can only deal with the general level of prices caused by excess demand. The current inflation is the result of the monetary excesses of 2008-09, which is having its lagged effect, besides supply-side problems.

The excess money, for a long period returned to the RBI through reverse repos, has now been absorbed in the system. The process of rolling back the liberalisation measures should have started at a time when banks were returning the funds. Now, whatever is done will have its effect a year or so later. But that should not deter the RBI from doing the needful. A minimum increase of 25 basis points in repo rates should be a signal to the market.

Raising the reverse repo rate will reopen the floodgates of carry trade that has been quiescent for quite some time. If the RBI wants to control the situation by regulating liquidity, then it should be prepared for some deceleration in industrial activity. It cannot say that it wants to tighten policy and, at the same time, be liberal in its repo action that has become more less a refinance facility for banks.

The RBI should continue to concentrate on domestic monetary policy, leaving the exchange rate to the market. It can take a lesson from China. Its current problems are due partly to market intervention that has led to the accumulation of huge forex reserves.

Raising the cash reserve ratio to high levels (nearly 20 per cent in the case of some banks) has not helped it in curbing lending or inflation.

According to some experts, China is sitting on a mountain of debt of several trillion yuan, contracted by local authorities to stimulate the economy in the wake of the international financial crisis; this is not likely to be repaid. The RBI has to watch out for surprising developments in the Chinese financial situation. Another equally important event is the likely downgrade of US' rating as it reaches the ceiling of public debt of $14.29 trillion and asks the Congress for a further increase. If the downgrade has not happened so far it may be due to the ‘too-big-to-fail' argument that cannot be sustained for too long.

With a trillion dollar fiscal deficit in the current year that is likely to recur next year, the US is in for big trouble. It may well usher in the mother of all recessions and a return of stagflation to the world, with all the excess money circulating abroad.

The quantitative easing in US has not helped that country much due to considerable leakages. It is not easy to find out how much of each dollar created by the Fed remains in the country to boost demand. But the fact that unemployment rate in the US is stubbornly high despite all the money spent and the Asian nations are doing better in growth are enough preliminary indications to support the hypothesis that the US liberalisation has helped other countries and not itself.

The RBI would do well to have a stress test internally to know the consequences of a downgrading of the US economy by the rating agencies and be ready with contingency measures to minimise its adverse impact on India.

COMMENT NOW