Reserve Bank of India (RBI) governor Y.V. Reddy has made no bones about the fact that the flood of capital that has come into India in recent months worries him. “On the domestic front, the biggest challenge is the management of capital flows and the attendant implications for liquidity and overall stability,” he has said in the new quarterly monetary policy statement that was released on Tuesday.
And why not? The flood of capital has pushed up the rupee, sent money supply growth above its target and sent asset prices into bubble territory.
RBI has had quite a battle on its hands. It has been furiously buying dollars to keep down the rupee. Of the $62 billion that RBI has added to its reserves chest since the beginning of this year, nearly $48 billion has been added since the end of June. It has then been selling bonds to soak up the rupees it has put into the financial system in exchange of dollars. Issuance of these bonds has doubled since the end of June. Also, the liquidity mopped up through net reverse repos since the end of March is five times the amount in the same period of 2006-07.
Given the sheer size of its task, RBI has come up with a mild policy. Interest rates have been untouched and the cash reserve ratio, which is the proportion of bank deposits that the central bank impounds to cut lending, has been hiked by 50 basis points. The battle will not end here.
It is here that the government has to play a role. It is good that finance minister P. Chidambaram, who has publicly disagreed with RBI in the past, has also been flashing warning signals about the dangers posed by huge inflows of speculative capital. But the support of the government now has to go beyond verbal support.
RBI cannot run a tight monetary policy in isolation. It has to ideally work in tandem with a tight fiscal policy. “The burden on monetary policy is larger in view of the limited room for manoeuvre for fiscal policy,” Reddy said in his policy statement.
Capital flows will continue to pour into India in response to its economic boom. That is not a bad thing in itself. The problem is that this capital is pouring in at a time when inflation could soon be rising and the current account is in deficit.
These are problems that could be tackled by firm interest rate hikes, but that is bound to affect private sector spending, investment and long-term growth.
A better way to cool overall demand is by cutting government expenditure. In other words, the government needs to run a tighter ship. There has been too much self-congratulation in recent months about how the fiscal deficit targets are being met.
But there are three objections. First, India still has one of the highest fiscal deficits in the world. Second, the targets are being met due to higher tax revenues rather than spending discipline. Third, the published fiscal deficit numbers are misleading, since they do not take into account off balance sheet spending through the oil bonds that the government has issued in lieu of raising oil prices.
Running economic policy in times such as these is not simple by any stretch of imagination. It’s a bit of a walk on the razor’s edge.
A country with a large fiscal deficit, a wide current account deficit and an appreciating currency is at greater threat from sudden reversals in capital flows.
While the various attempts to stem the inflow of capital is welcome, it is time the government also does its bit in cooling down overall effective demand in the economy. Reddy would have greater freedom to operate his monetary levers if he knew that the government was being a little less profligate. Over to New Delhi.
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