The sheer force at which foreign money is gushing into India is creating unprecedented challenges for the Reserve Bank of India (RBI). This rising tide of money has helped lift the prices of goods and assets. Hence, the fears of growing inflation and an asset-price bubble.
The central bank said on 15 February that M3, the broadest measure of money supply and the most closely-watched monetary aggregate, is growing at 21.3% a year. This is way above the 15-16% level that RBI has traditionally been comfortable with, and close to a 10-year high. Governor Y.V. Reddy is not a strict monetarist who believes that inflation is always the result of excess money, but has good reason to worry. There is a strong link between money and inflation.
RBI has been busy trying to mop up dollars. It says it added $5 billion to its reserves in the first week of February. When the central bank buys dollars, it releases rupees into the system in exchange. It then tries to mop up these rupees in a process called sterilization. The most common way that RBI has done this is by selling bonds. Banks buy these bonds and surrender cash in return. Domestic liquidity is thus curbed.
This strategy is becoming less effective for two reasons. One, the volume of foreign inflows is huge. Two, banks are no longer interested in buying bonds from RBI. They did so when the economy was in the slow lane and they had few commercial lending options. Now banks would rather lend to companies and consumers. With its bond market operations losing their bite, RBI has been mandating banks to lend less, by raising the cash reserve ratio (CRR).
The important question is, what options does RBI have? There are two, and we believe both are laden with problems.
First, it can let the rupee appreciate. RBI is buying dollars to prevent the rupee from appreciating, and pumping more money into the domestic financial system. Thus, exchange rate policy is taking precedence over monetary policy. The problem is that rupee appreciation will attract further inflows of short-term foreign capital. China is facing this problem. The anticipated appreciation of the yuan, a result of the huge pressure China faces from the US to curb its trade surpluses, makes that currency a one-way bet for currency speculators.
Second, RBI can discourage inflows either with stricter controls or by taxing these. It has often loosely talked about the attractions of a Tobin tax, named after economist James Tobin who suggested that a small tax on short-term capital flows could throw some sand into the wheels—not enough to stop the engine, but enough to slow the pace. Thailand tried to curb inflows in December, but retreated in the wake of a savage sell-off in the financial markets. Extra controls could scare off all sorts of foreign capital.
These are textbook options, and a central bank has many other tricks up its sleeve. But none of these forms the base of effective long-term monetary policy. In the wake of rising capital flows, the two options for RBI (to restate in more technical terms) are not to let monetary policy take precedence over exchange rate policy, or to partially close the capital account. But, as we have argued, neither is practical right now.
That is why we believe that RBI needs a comrade in arms in its fight against inflation—the finance ministry. A loose monetary policy can be balanced with a tight fiscal policy, so overall demand does not run ahead of supply. The latest tax and spending numbers suggest that the government will announce on budget day that it has cut the fiscal deficit more than it had promised. Assuming that tax hikes are not on the agenda, the only way to further tighten fiscal policy is to discipline spending even further.
Despite its pro-growth bias and its difference of opinion with RBI on interest rates, the finance ministry should realize that the only way to keep growth on track without pushing up rates is tighter fiscal discipline. One more reason to watch the forthcoming Union Budget very closely.
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