Another policy dilemma

Another policy dilemma

India today is perhaps the only major emerging economy to face a high inflation rate and a surge of foreign monetary inflows. In addition, for an economy of its size, fiscally, it is quite imbalanced. The last problem is growing acute by the day. This poses severe policy dilemmas for the Reserve Bank of India (RBI).

RBI governor D. Subbarao said as much on Wednesday at a seminar in Mumbai. He said: “Intervention in the forex market to prevent appreciation entails costs. If the resultant liquidity is left unsterilized, it fuels inflationary pressures. If the resultant liquidity is sterilized, it puts upward pressure on interest rates which, apart from hurting competitiveness, also encourages further flows."

So what is creating the problem? The upward march of interest rates in India, with advanced countries planning to hold their interest rates close to zero for a “foreseeable future" is the driver of these inflows. Were India a “normal" country, the obvious remedy would be to bring down the policy rates. These would have ensured that the interest rate differential between the source of the inflows and their destination, India, would have been unattractive.

That option is not available to RBI. Inflation continues to be close to the double-digit mark at 8.6% and food inflation refuses to cool. For the week ending 16 October it stood at 13.75% (year-on-year). This is not about to decline anytime soon. The government’s efforts to universalize the public distribution system (PDS), while not complete, will entail a food subsidy bill of close to Rs78,000 crore, an increase of approximately Rs22,500 crore over the existing bill for the PDS. This is close to 1% of India’s gross domestic product. It has been argued that this level of expenditure for ensuring food security is hardly unsustainable. That may be so but the amount of money it puts in the hands of citizens eager to purchase is akin to throwing alcohol on fire.

It has been suggested that given this problem, RBI would be wise to take a pause in “increasing" interest rates. For if rates are raised now, they will only fuel further inflows, making the policy dilemmas even sharper. In any case, it is argued, growth is cooling and hence an aggressive monetary policy stance is uncalled for, at this moment.

That is a mistaken argument. Even if RBI does not raise its policy rates next week, the interest rate differential will continue to make India an attractive destination for foreign money. And not doing anything will fuel further inflationary expectations. Even if one does not subscribe to the theory of the original sin, it’s clear that India is paying for fiscal recklessness.

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