Urjit Patel’s challenge of currency and inflation

The RBI is legally committed to an inflation target. It cannot aggressively intervene in the foreign exchange market to keep the rupee down

Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

September 2013: Fears abounded that India would not be able to get enough foreign capital every year to fund the estimated $85 billion annual current account deficit that it was running at that point in time. The rupee was in free fall. India had to offer sweeteners to attract hard currency deposits from overseas Indians. This was perhaps the worst external stress since the summer of 1991.

September 2016: India came very close to announcing its first current account surplus in more than a decade. The data released by the Reserve Bank of India (RBI) on Wednesday showed a small gap of $300 million in the June quarter. That is around $1.2 billion on an annualized basis. There are more than adequate capital inflows to fund such a current account deficit. The balance of payments for the quarter had a $7 billion surplus.

The dramatic turnaround in external accounts is welcome. The parallel decline in the fiscal deficit as well as the gradual easing of inflationary pressures shows that macroeconomic imbalances are no longer a serious threat to stability.

What now? The first major policy challenge will be on how to react to the growing balance of payments surplus. There will naturally be pressure on the rupee to appreciate against the dollar at a time when exports are shrinking. The Indian central bank can decide to buy dollars to prevent currency appreciation, but while such a move will add billions to its foreign exchange reserves chest, it will also mess up its ability to conduct monetary policy.

Every dollar bought will entail releasing rupees into the domestic economy. Some of that can be sterilized through open market operations. Yet, the learning from previous such episodes is that even sterilized intervention has its limits, and trying to manage the rupee under conditions of large balance of payments surpluses does compromise the ability of the RBI to pursue its domestic inflation goal.

Also, it is good to remember that a current account surplus is not necessarily good news in a country such as India. It shows that savings are far higher than investments. Or, the inability of the domestic economy to absorb savings forces the capital to be invested abroad. Such a result is perverse in an economy that needs to grow rapidly. An eventual current account surplus this year is also an indication that investment activity is weak right now.

India had reported a current account surplus in some quarters under the previous National Democratic Alliance government led by Atal Bihari Vajpayee. A few economists had then predicted that this was a structural shift in balance of payments thanks to booming software exports. Actually, it was a reflection of the economic slowdown and weak investment activity in those years. The RBI under Bimal Jalan had to deal with the consequences—an appreciating rupee, high levels of excess domestic liquidity and eventually, a shortage of government bonds to carry out traditional sterilized intervention.

Many treat such economic numbers as some sort of morality play. But a current account surplus is nothing to boast about. Nor is a high current account deficit. It is the same in the case of the exchange rate, or the international value of the rupee. A lot depends on the underlying economic situation. The traditional view within the policy establishment has been that India should run a current account deficit of around 2% of gross domestic product. That is a sustainable level. There is as yet no reason to dump this assumption.

The Indian central bank under Urjit Patel will need to figure out what to do in the coming months. It is legally committed to an inflation target. So it cannot aggressively try to intervene in the foreign exchange market to keep the rupee down, since such intervention may interfere with its main task. But it cannot ignore the exchange rate either. The new governor may have to look at what his predecessors did when there were large external surpluses—especially Jalan and Y.V. Reddy.

The impossible trinity just does not go away. An inflation-targeting central bank in an open economy will find it challenging to manage the exchange rate. Maybe it is just as well that some $25 billion of dollar deposits are about to exit India this quarter. How times change.

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