The Reserve Bank of India (RBI) finds itself in a pickle with wholesale price inflation touching a three-year high, industrial production and overall economic growth slowing down and the rupee strengthening against the dollar.
Wholesale price index (WPI) inflation has skyrocketed to 7%. The rupee stands at roughly 39.80/90 against the dollar. In the nine months ending in January 2008, industrial production growth slowed to 8.7%, compared with 11.2% in the same period a year earlier. And, a worsening global economic environment, coupled with a likely recession in the US, means India’s real GDP growth will slow in the coming year.
What is optimal monetary policy in such a situation?
The sudden spike in inflation will make it difficult for RBI to cut domestic interest rates. Because short-term US nominal interest rates are low, the interest differential between the US and India remains large. This is leading to more capital inflows and pressure on the rupee to appreciate.
An appreciating rupee has potential repercussions on economic growth in India. China is a growth competitor — and so, there is a strong argument for setting the rupee in tandem with the Chinese yuan. A large interest differential — on top of a domestic tax regime, which taxes foreign corporations at a higher rate than domestic firms — encourages portfolio capital and induces volatility. To wit, India’s stock market in 2008 has been one of the world’s worst performers. The BSE Sensex has plunged 24% in 2008 so far. Currently, India is heavily loaded in favour of portfolio investment. Portfolio capital just ends up in the stock market without having any “real” effects.
RBI can raise interest rates to contain the recent bout of inflation. This means that we will continue to attract net capital inflows. But, RBI also has an exchange rate objective. This means that it will continue to sterilize capital inflows and resort to capital controls to prevent the rupee from appreciating. However, RBI could also let the rupee appreciate. There may be good reasons for doing so.
There are a number of problems with sterilization. Sterilizing inflows means that the interest rate differential persists. Sterilization, therefore, becomes counterproductive and not sustainable. There are also budgetary costs. One estimate suggests that the stock of market stabilization scheme (MSS) bonds has gone up by Rs1 trillion. A broader measure of the fiscal burden — which includes government outstanding debt stock plus fiscal deficit plus MSS bonds — has also increased as a percentage of GDP. Budgetary costs related to sterilization are climbing. If MSS bonds are going to increase at the rate they are, this will be bad for the government’s budget targets in the future.
India already has a variety of capital controls. For instance, it has a very tight cap on the foreign purchase of rupee debt. Foreigners are also not allowed to put money into nominal rupee accounts, which means they cannot take advantage of the domestic banking system. However, people get around these controls. India also has many international banks, which negates the effects of high transaction controls. This leads to net capital inflows. The bigger point is that we cannot have interest rates in India exceed interest rates in the US if we want to keep the exchange rate stable. For instance, the short interest rate differential in India with respect to the dollar interest rate is much higher than many Asian and Asia-Pacific countries. Countries which have a higher differential (such as Indonesia and New Zealand) have floating exchange rates. So, RBI is maintaining a high interest rate differential, but keeping the exchange rate stable. This is leading to net capital inflows.
A third option is that RBI can rely on unsterilized intervention to smooth the exchange rate, but raise reserve requirements to cushion the net effect on the domestic money stock. However, reserve requirements will be a tax on the banking system as long as required reserves do not pay a competitive interest rate. Depending on the incidence of the tax, changes in this tax can have real effects on the exchange rate.
The recent bout of inflation is largely due to a supply-demand mismatch in domestic food production and a worldwide upturn in the commodity price cycle. One reason for the cyclical upturn in commodity prices is that many developing and emerging market economies — such as India and China — are in a resource intensive stage of development.
Growing middle classes in these countries are buying more consumer durables, leading to a demand for raw materials. In addition, as people get richer, they move to more protein-rich diets, raising the prices of food items such as grain, meat and edible oil. There are also the grow-ing needs of developing market infrastructure for commodities such as iron ore. These factors are pushing the prices of commodities to record highs. What is atypical of this commodity price cycle, however, is that commodity prices are rising globally despite a worsening global environment.
The government’s short-term response is to resort to its usual smorgasbord of administrative fixes to control the recent spike in inflation. These give little bang for the buck and have large deadweight losses. The more important issue is that a de facto open capital account with a stable exchange rate is leading to high capital inflows.
In the medium term, this will require RBI to reduce the interest rate gap and take a chance on the inflation objective by appreciating the rupee and correcting the supply demand mismatch in the agriculture sector in the long run. However, several open questions remain: What is the correct exchange rate, given that both capital inflows and the exchange rate jointly determine one another? Is there a model that can incorporate this? What theoretical framework should be applied to Indian exchange rate policy?
Unfortunately, no one seems to know.
Chetan Ghate is an assistant professor in the planning unit, Indian Statistical Institute, New Delhi. Comments are welcome at firstname.lastname@example.org