As expected, Reserve Bank of India (RBI) governor Y.V. Reddy has hit the pause button. He has left interest rates unchanged in the new monetary policy.
But there is enough in the policy statement to banish any thoughts about RBI letting its guard down in the battle against inflation. Reddy had already indicated earlier, on 31 January, that his main concern was inflation control. The subtext of his speech is clearly hawkish. It is now increasingly clear that the battle between the finance ministry and the central bank has been settled in the latter’s favour. There are, thankfully, no more attempts from New Delhi to deny that persistent inflation is a clear and present danger.
RBI had said on Monday, in its review of the economy, that real policy rates are still very low when compared with other emerging markets, an indication that monetary policy is still loose. The problem: it has been tough for the central bank to keep money supply and liquidity under control because of the sheer force of capital flowing into India. This has been the biggest reason why both reserve money and broad money have overshot targets.
Essentially, RBI has tried two alternative ways to manage capital inflows over the past few years. Both have had limited efficacy. RBI initially tried to buy dollars, but had to release rupees into the market. This added to domestic liquidity. A few months ago, RBI changed its strategy and stopped buying dollars. The rupee climbed against the dollar, and is now overvalued by around 12% on an inflation-adjusted and trade-weighted basis. The choice was either accepting excess liquidity or a strong rupee—unless an artificial wall was erected to stop capital flows.
There were expectations before the monetary policy that RBI would try to close the capital account in a limited manner, by bringing down the external commercial borrowing (ECB) limit. This paper has argued against such a step, since restrictions on ECBs would send Indian companies in search of other forms of global capital, such as foreign currency convertible bonds. We had argued that curbs on ECBs would do little to keep down capital flows; they would merely change the capital structure of Indian companies.
It is good that RBI has not gone down that path. Instead it has decided to encourage capital outflows, so that there is less pressure on domestic liquidity and the rupee. The various moves to encourage individuals and companies to invest more abroad are steps down the long road to capital account convertibility. But they also have a more immediate significance, since they could help RBI in its current battles on money supply and the exchange rate.
The RBI governor has also tried to deepen the financial markets, by encouraging financial products such as interest rate derivatives (that already exist) and laying the ground for the introduction of newer products such as currency futures and credit default swaps. These moves are welcome.
It is now quite clear that central banks cannot manage to adequately curb financial market volatility in a global economy, unless they turn their backs on deregulation. If so, then it is the task of the private sector to manage risks, and for that it needs deep derivative markets. In an interview with Mint published on 20 April, Harvard University economist Larry Summers had said that India is likely to “begin accepting more exchange rate volatility and developing more sophisticated financial market tools to enable producers, businesses and consumers to hedge…in the exchange market.”
So, by encouraging capital outflows and trying harder to build derivative markets, RBI is trying to adapt to the challenges of conducting monetary policy in an open economy. This could be the start of a radically new game.
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