Banker’s Trust: Is the Reserve Bank chief fighting a losing battle?

Banker’s Trust: Is the Reserve Bank chief fighting a losing battle?

The inflation rate has dipped to a five-year low of 3.23%. It’s the lowest since December 2002 and less than half of its level seen in January 2007. This should be good news for the Reserve Bank of India (RBI) governor Y. Venugopal Reddy. The Indian central bank’s inflation projection for the year is 5% and, in the medium term, it wants the inflation rate to veer around 4-4.5%. The current level is even lower than this.

Reddy can simply watch the rise of the rupee without doing anything as an appreciating local currency can help keeping the inflation low. This is because the cost of import goes down when the local currency appreciates. The rupee has appreciated around 15% over the last one year. But Reddy is not too keen on a runaway appreciation of the rupee as a rising local currency hurts the exporters.

He is following a policy of continuous intervention in the foreign exchange market, accompanied by measures to encourage dollar spend by corporations and individuals. He is also allowing the market forces to play by continuously shifting the internal target at which the local currency is defended. For instance, early this year, RBI was defending the local currency at the Rs40.40 level. With the rise in dollar inflows, the level was shifted to Rs40.20 and now possibly Rs39.80 to a dollar. Foreign exchange dealers say even this target cannot be kept for long and the rupee will pierce the Rs39 level by the end of the financial year.

Market intervention is only one part of the story. The central bank is also encouraging higher dollar spend and lesser overseas borrowing by Indian corporations. In August, it imposed restrictions on external commercial borrowings (ECBs) and banned overseas borrowing to meet rupee expenditure by corporations. This has not eased the pressure on the rupee to appreciate as ECB is not the only source of overseas funds. The net portfolio investment by foreign institutional investors (FIIs) in the first nine months of 2007 is $12.7 billion (Rs50,419 crore) against $7.8 billion in 2006 and $10.79 billion in 2005.

So, RBI again came out with a fresh set of measures last week, raising the limit of investment by Indian companies in overseas ventures, portfolio investment abroad by listed Indian entities, prepayment for external commercial borrowings, overseas investment for mutual funds and annual remittance for individuals. The objective behind the relaxation in the overseas investment norms is to encourage capital outflows and to some extent offset the massive capital inflows, being attracted by its fast growing economy and relatively high interest rates.

A similar set of measures were announced in April, but capital outflows have not picked up yet. And it is highly unlikely that there will be any sharp increase in outflows immediately, since existing overseas investment limits have not been fully exploited.

So, RBI will continue to be present in the foreign exchange market to drain the flood of dollars and channel them into India’s ballooning foreign currency assets chest. Since April, the foreign exchange assets have gone up by $36.6 billion to $228.6 billion. For every dollar RBI buys from the market, an equivalent amount of rupee comes to the system, fuelling money supply and stoking inflation. This completes the cycle of monetary management that Reddy has been following for past years.

RBI is distinctly uncomfortable using currency to fight inflation. It uses the wholesale price index (WPI) to measure inflation as this is available every week, with a lag of two weeks, while consumer price index (CPI) is released three weeks after the end of every month.

An HSBC research paper on India’s export downturn, written by Manas Paul, says an appreciating rupee should not be blamed for an export slowdown. Theoretically, a rising rupee can affect the exporters in two ways. If there is no change in the price of a product then its value comes down in rupee term and affects the profit margin of the exporter.

On the other hand, if the exporters decide to pass on the burden to the importers then it hits the demand.

The HSBC study says that indeed an appreciating rupee does affect India’s export performance, but the impact is relatively small in case of merchandise exports. The rise in export credit, according to the study, has a far higher impact on exports with every percentage point rise in credit cost knocking off 4.5% export growth with a lag effect. The impact on services exports is, however, relatively higher with every percentage point of rupee appreciation shaving off 0.9% services exports. The comparative figure for merchandise exports is 0.3%

So, RBI should not be present in the foreign exchange market every day to soak excess dollar. By doing this it is sowing seeds of higher money supply and ultimately higher inflation. If this is indeed the case, then the RBI governor is probably fighting a losing battle. But not everybody subscribes to the HSBC theory. And these people say that Reddy has perfected the tight-rope walk, balancing both inflation and currency movement.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Please email comments to