Ever since the Reserve Bank of India (RBI) started nudging up interest rates, economists have been busy waving their fists at each other. One side believes that the central bank has been too harsh and it will trigger a severe economic slowdown. The other side insists that low interest rates will help the inflation virus to spread into every nook and corner of the economy, threatening stability and long-term economic growth.
It is time the bell rings to announce the beginning of another equally important debate—on the value of the rupee. The two issues are linked. Interest rates determine the internal value of the rupee. Exchange rates determine its external value. In other words, it makes little sense to discuss interest rates without discussing exchange rates as well.
The rupee has been rising, and is nearing an eight-year high against the dollar. The real effective exchange rate, which is an index of the inflation-adjusted value of the rupee against the currencies of our major trading partners, could be overvalued right now. Exporters are already crying foul. Analysts believe that a strong rupee will eat into the profits of the software companies. Should RBI intervene in the foreign exchange market, and push down the rupee in a bid to boost export competitiveness?
This sounds good in theory. But if RBI tries to prop up the dollar, it will have to buy the US currency and sell Indian rupees. These rupees then flood the domestic economy, feeding inflation. So there is another way of defining the policy dilemma—should the central bank protect exporters at the cost of consumers? Linked to this is another question. Which is the more serious immediate challenge: Inflation or exports? Inflation is the bigger political concern right now but a gaping trade deficit could be a harbinger of a more serious financial crisis in the future.
RBI’s dilemma is not unique. Central bankers need to come to terms with what economists call the impossible trinity. In simple words, this means that any country with an open capital account will either be able to control interest rates or exchange rates. You can’t have control over both.
In recent years, RBI has been targeting the exchange rate instead of interest rates. One major reason why money supply is now growing at a worrisome 21%-plus is that RBI has been buying dollars to keep the rupee down, and pouring liquidity into the domestic economy.
It is easy to criticize the central bank for doing so. And the criticisms have piled up in recent weeks. But most other Asian central banks have struggled with this dilemma in recent years as foreign capital has rushed into their economies. Most, including China, have chosen to keep their currencies down and bear the burden of huge liquidity -fuelled credit and asset booms.
That said, it is now time for RBI to regain control of its monetary policy by letting go of the exchange rate.
An appreciating rupee will be a carrier of disinflation, as the landed cost of imported goods and inputs falls. The issue then is, what happens to exporters? And, on a more macroeconomic basis, are we ready to tolerate a further widening of the current account deficit?
This is a significant risk, especially if global capital flows slow down. There is a way out. A current account deficit is an indication that investments are more than savings.
The sensible medium-term strategy is to increase domestic savings, especially government savings. It is unfair and unrealistic to expect RBI to single-handedly control a mildly overheated economy. This newspaper has often argued that India needs a tight fiscal policy to support a tight monetary policy. Unfortunately, there is no sign of it.
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