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Prime Minister Manmohan Singh’s suggestion for fresh thinking on monetary policy in a globalized economy, correct as it is, is not only belated but has also been made at an inappropriate time.

Three years earlier, this column, “Open economy, closed minds", Mint, 10 July 2010, discussed the need for change in the design and practice of monetary policy.

To quote: “...the defining policy question that needs to be debated today is how to make economic policy in general, and monetary and fiscal policy in particular, react explicitly and systemically, to new domestic structures as well as international variables, be it the sources of growth, inflation or the exchange rate. This has to go beyond the influence that these variables have on the domestic output gap via external demand and domestic inflation via import price. For this, a new macroeconomic framework needs to be evolved."

Singh’s suggestion, coming as it does in response to the ongoing currency crisis, has been made at the wrong time. When currency and foreign exchange issues become a bigger concern than the slowdown in domestic economic growth, then surely structural constraints are a problem rather than some distortion and aberration in the foreign exchange market that can be alleviated by market intervention.

This is all the more important because the foreign exchange constraint is now becoming a binding from the demand side. This is unlike in the pre-reform period, when foreign exchange shortage was a supply side issue.

Of late, it is the adverse flow variables that are distorting the stock variables and causing macro instability. For example, the falling savings rate has spilled internal imbalances onto the external account. This is increasingly being financed by a surge in the foreign portfolio investment, resulting in the stock of external debt having a high short-term component to the extent of it being at the highest level in nearly three decades. Fundamentally, it is the misalignments in India’s investment and financial flows that are the source of the unacceptable level of its current account deficit.

However, it is not foreign exchange market pressures that can be or should be the reason for a macro-monetary review. If it is, then it will be reactive and distortionary.

Monetary policy needs to be reviewed and redesigned for structural growth reasons. It must be aligned to the macroeconomic growth strategy, of the economy, which for the last two plans has been focus on “inclusive growth". It is only then that monetary policy will become developmental oriented rather in addition to being stability and regulatory oriented.

As suggested in the column referred to earlier, “...engendering inclusive growth poses serious economic policy challenges which are not being addressed. Take the case of monetary policy. Traditionally, monetary policy has been and continues to be driven by rate of growth and is insensitive to the sources and structure of growth; be it by sector, industry, class or asset type. With the sources and spread of growth and distribution becoming important, new conceptual elements have to be introduced into monetary policy aiming to integrate these two strands. Operationally, the problem is that over the years monetary and financial practices, institutions and structures have been developed based on a certain type and pattern of growth; these are increasingly becoming incompatible with the desired type of inclusive growth. If indeed this is so, then institutional changes of a far-reaching kind in the monetary policy mechanism are called for."

To be fair, when the credit policy statement was rechristened in 1998 as the monetary and credit policy statement, it was a belated acknowledgment of the change in policy from a planned and administered interest rate system to a market-oriented financial system.

Till then, in line with the closed economy concern, the focus of the Reserve Bank of India’s (RBI’s) policy was the fixing of prices of credit or interest rate, the quantum linked to end use and pre-empting liquidity for government’s exclusive use. RBI did try to change its frame of mind at the right time. But then fiscal policy tied its hands and blocked its vision. We need to take it up and redesign issues from this point.

Towards this end, monetary policy should not be only about regulations for the behaviour of market participants. What’s missing are the standards for structure of these markets and market participants.

Given the fact that a whole set of new market participants—domestic and foreign—have now emerged in the financial markets and that the dominance of government is on the wane, specific standards need to be formulated. Regulators need to impose high and exacting standards on participants and impose only few critical but simple regulatory restrictions on their activities. At the moment, it is the other way round.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice.

To read Haseeb A. Drabu’s earlier columns, go to www.livemint.com/methodandmanner

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