Thursday, April 22, 2010

RBI’s Religious Approach to Monetary Policy

A strange title, I know, but it seems that the RBI’s approach to monetary policy is closer to religion than to economics.

The Trinity in Hinduism comprises of Brahma, Vishnu and Mahesh. Hindus believe that the key to a good life is to be on the right side of all three. If even one of the Trinity is upset or displeased, well, it just doesn’t make for peaceful existence. Of course, there are scores of other Gods as well. Some based on form, but most on function. However, the Trinity is supreme.

Fortunately, it’s possible to please all three of them simultaneously. One doesn’t have to choose between them.

In Monetary Policy, however, this approach doesn’t work. The trinity here comprises of Interest Rates, Exchange Rates and Inflation and it’s just not possible to control all three simultaneously. One does have to make choices. And that could be the key to RBI’s disastrous approach to monetary policy.

In trying to control all three aspects of monetary policy together, the RBI seems to be going around in circles. Managing one upsets another. And when the other gets too upset, the RBI switches sides and tries to manage it upsetting the former.

Interest rates are an instrument that every central bank uses to control inflation and the pace of its economy. However, since interest rates are the preferred tool, most mature Central Banks (as opposed to Central Banks in more mature economies) prefer to let the Exchange Rate float. But the RBI’s approach is to manage all three in the belief that “upsetting” even one wouldn’t support peaceful existence.

On the face of it, the RBI likes to portray that it’s primary objective is to contain inflation. And it’s true. As a issuer of the Indian Rupee, nothing should be more important than preserving its value. But, lets take a closer look at the RBI’s inflation fighting credentials.

Ever so often, we hear that the RBI has to increase interest rates because inflation has risen and needs to be tamed. But why does inflation rear its ugly head every now and then? And why doesn’t the RBI spend as much time and effort preventing inflation from rising rather than act after it has risen?

Its because when inflation is benign, the RBI spends far too much time and effort managing the Exchange Rate. And “managing” is a polite way of saying weakening or debasing.

What the RBI does, in order to ensure that an appreciating Rupee doesn’t cause sleepless nights for our beloved exporters(who account for just 13% of the Indian Economy), is to buy US Dollars and sell Indian Rupees. Since this transaction happens in India (The Indian Rupee cannot be legally traded anywhere else) the label given to it by the RBI is that of “FX Reserve Accretion”. But its impact is nothing close to the “feel good” connotations of the label. Its impact is to inject Indian Rupees into our banking system, which show up in the form of excess liquidity and have a direct impact on aggregate demand, leading to inflation. Also, a weak currency means that any product or commodity whose price is affected by the international market becomes (or stays) more expensive when measured in Indian Rupees. And this holds true not only for imported products like oil, but also domestic products whose price is decided by the international market, like iron ore or copper and even food-grains.

So when inflation is benign, rather than ensuring it stays that way, the RBI is actually working furiously to ensure that it rises. And when it does, the RBI acts as if this re-emergence of inflationary pressures happened by itself. It then starts to increase interest rates (which in an open market would result in rupee appreciation, as more foreign exchange would flow in lured by higher interest rates) and absorb the very liquidity that it injected. And god forbid, if this happens at a time when the economy is doing well, it keeps on buying the US Dollars that are attracted by this growth and injecting fresh liquidity at the same time. The period April-December 2009 could be a case in point. Inflation was high through this time, but this did not stop the RBI buying USD 11 bln in this period. The additional liquidity injected into the market due to this was close to Rs. 50,000 crs.

But a better case is made by the year 2007. Through 2007, the RBI added USD 94.74 bln to FX Reserves, close to 10% of the USD 1 trillion GDP for the nation. Of this, USD 35.36 bln were bought in the last quarter of 2007 alone. And inflation jumped up from just over 3% in October 2007 to a 16 year high of 12.44% in August 2008. The RBI then proceeded to increase CRR to absorb this liquidity and increase interest rates to cool down domestic demand created by this liquidity surge. In characteristic style, they went too far with this as well, and caused a liquidity crunch so severe that the country almost went into a recession. This was October 2008.

Based on the RBI Governor’s recent monetary policy statement and comments after that, we can look forward to a continuation of this confused regime. While inflation will come down, purely due to mathematical reasons, we can be sure that the RBI will be working hard to ensure that it increases again.

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