The spectre of inflation has led the Reserve Bank of India (RBI) to raise interest rates and increase banks’ reserve requirements in classic monetary policy responses. The challenge it faces is that of simultaneously managing the exchange rate in the face of porous controls on international capital flows.
Some economists argue for the present policy of preventing exchange rate appreciation, and managing the inflationary impact of capital inflows by selling government bonds, thus soaking up excess liquidity. Others favour the “export-competitive” exchange rate approach, but also argue that monetary policy is irrelevant as the inflationary symptoms arise from temporary supply-side shocks. The “radical” position, representing the greatest departure from past and current practice, is that RBI should focus on fighting inflation, but give itself more room by allowing the exchange rate to adjust to market conditions. One version of this stance is that raising the interest rate is less effective as an inflation-fighting policy than allowing the rupee to appreciate, as financial repression and underdeveloped financial markets keep interest rate changes from rippling through the economy strongly enough. What does the evidence tell us?
There are several empirical analyses of the “monetary transmission mechanism” in India. These suggest that the interest rate channel of monetary policy has strengthened since 1998, which should not come as a surprise since there has been considerable financial liberalization, accompanied by a revision of RBI’s policy approach. This result comes out in an interesting fashion in a 2005 IMF study by A. Prasad and Saibal Ghosh, using firm-level data. The responses of firms to monetary tightening vary by size and, while greater in the period 1998-2003 versus the prior half-decade, seem to involve a reversal of initial cutbacks in corporate debt. Still, interest rates do affect firm borrowing behaviour.
A better feel for the aggregate impacts of monetary policy comes from an economywide analysis. Kanhaiya Singh and K.P. Kalirajan (SK) have provided one of the most sophisticated and recent empirical exercises. They model responses of the economy to changes in RBI policy variables, and RBI’s own reactions to changes in economic conditions such as the inflation rate and growth rate. In their model of the Indian economy, a positive shock to the interest rate results in a sharp decline of real broad money demand followed by an initial fall in output (growth), a fall in inflation, and a depreciation of the rupee. This suggests the interest rate is an effective inflation-fighting tool in India even though, as the authors say, “the financial market in India is not yet matured.”
The results even indicate that output recovers with a lag in the face of such interest rate increases. All this sounds quite good from the perspective of policymakers. In contrast, there is no long-run link between monetary aggregates and output, rendering such aggregates less reliable as targets or indicators for policymakers.
Some of the other results of the SK analysis are less intuitive and may raise concerns. Increasing the cash reserve ratio reduces output, but initially increases inflation and depreciates the currency, possibly contrary to the expectations of the monetary authorities. Inflation eventually falls below its initial level, and the currency appreciates, but only after a sufficiently long period (more than six months). If one accepts these results at face value, then some aspects of RBI’s current policy stance may need rethinking. Aside from the timing of policy impacts, which seems to be guesswork now for policymakers (unless they have a secret model of the economy not available publicly), the SK model highlights the tension between managing inflation and managing the exchange rate in an open economy. The authors also imply this in pointing out that a low interest rate regime would be better for managing inflows and the exchange rate. Whatever tool RBI uses to fight inflation, it makes its other task of keeping the exchange rate from appreciating more difficult.
Since the SK model incorporates observed RBI policy responses, it cannot answer the fundamental normative question: Is managing the exchange rate worth it in terms of output effects? But it helps to distinguish this issue from that of effectiveness of the interest rate as an inflation-fighting policy variable. And it highlights the bind created by exchange rate pegging. The argument for that policy tends to rely on China’s example. But the Chinese have recently allowed exchange rate appreciation precisely to make their inflation-fighting task easier. If, in the absence of hard empirical analysis, Indian policymaking is to be done by analogy, then maybe it is time to let the exchange rate creep up if market conditions push in that direction. If that allows an easing of interest rates, growth should be spurred again. And competitiveness can be tackled directly, by microeconomic reforms to increase productivity. Any takers?
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at firstname.lastname@example.org