Many people are bewildered, wondering what is hurting them more, inflation or interest rate hikes, which are meant to address the problem of inflation. While inflation may be relatively high at 6.5 per cent, it does not yet appear to be runaway and completely out of control. In contrast, monetary policy, with call money rates going above 70 per cent, seems to have been lost control of. Neither is the policy able to provide stable conditions in financial markets, nor is it able to control inflation. Why has this situation arisen? Money gets created in two ways. First, when the RBI buys a dollar with rupees, it creates rupees. Second, when the RBI lends to the government, it creates rupees. For many years now rupees have been added to the existing stock of money circulating in the economy mainly through dollar purchases of the RBI. Indeed, dollar purchases have put so much money into the economy that the RBI has sold government bonds to banks to suck rupees out from the system. When banks buy government bonds from the RBI, the rupees that entered the economy through its intervention in the foreign exchange market leave the system. The impact of the forex intervention is thus ‘sterilised’. Sterilised intervention is sometimes used by central banks to stabilise conditions in the market. It rarely works as a long-term policy. Today sterilised intervention is hitting its limits. If the RBI had been able to fully sterilise its foreign exchange market operations, it would have been able to reduce the high growth of credit in the economy gently over the last few years. In the last three years bank credit has been growing at 30 per cent. The RBI talks of a 20 per cent growth in credit as one that would sustain demand at a level at which inflation would remain between 5 and 5.5 per cent. The policy has not worked, because banks have been reducing their holding of government bonds and giving out loans instead. Since the economy has been booming there has been enough demand for loans. With low appetite for government bonds, the rate of money and credit growth coming from the RBI’s rupee manipulation exceeds the contraction through sterilisation. But if money growth has been so much faster than what was desirable, why did the RBI not slow down on intervention? Slowing down on the forex intervention would have meant that the rupee would have appreciated. An appreciation in the rupee can slow down India’s exports, and one argument for the continued intervention was that India needs to promote exports. This argument overlooks the fact that export competitiveness is not determined by the nominal exchange rate, but by the real exchange rate, which also takes into account the differences in the rates of inflation of other countries. If our trading partners or competitors have low inflation, their costs of production remain low. We lose export competitiveness when our inflation rate is higher than theirs. So what we are gaining by keeping the rupee from getting stronger, we are losing through inflation. This would not have happened if we had successfully sterilised our forex operations and not got higher inflation. But while China may be able to force banks to hold higher levels of government securities to sterilise central bank operations, in India even public sector banks have been offloading government bonds and increasing their loan portfolios, resulting in the RBI’s loss of control over growth in money supply. When hitting against constraints in sterilised intervention, two things are possible: either the central bank gives up on forex intervention; or it tries ‘indirect sterilisation’ (use of interest rate policy to reduce domestic demand). This is what has been happening in India for over a year. The RBI has continued its intervention, done direct sterilisation, found it inadequate, and has gone in for indirect sterilisation. But indirect sterilisation has an interesting property. Higher domestic interest rates attract more capital from abroad, as returns in India are higher. If the central bank continues with its currency manipulation, it faces even greater pressure on the rupee and ends up intervening even more. This means the need for sterilisation increases and interest rates have to be pushed up further, which of course further attract capital. The vicious cycle gets worse and worse until the central bank admits that it has lost control and gives up on intervention. Actually the RBI has done even worse than the standard indirect sterilisation methods. It has applied the axe on credit by using the cash reserve ratio. This disrupts business activity all over the economy. Even when people are willing to pay more, they are unable to get credit. In the old days one way out would be to block foreign capital. Even today, the first response of a central bank that is used to a control raj for many decades might be to think that greater capital controls should be brought back and this would solve the problem. The difficulty with this approach is that the country’s political economy will not allow this to happen. Industry is happy to borrow cheap abroad. It will not sit quietly and accept a policy reversal on openness. Second, the trade account offers a channel through which money will flow in and out of the country. Yes, honest resident Indians will suffer, but the rich and powerful will find ways to move money as they always have. What needs to be done next? The only way out of this mess is to reorient the framework of monetary policy away from the focus on the rupee. Allowing the rupee to appreciate will help reduce inflation and put a stop to the need to raise interest rates. There may be a period of turmoil in forex markets, but it is better than putting millions of households and firms out of business by hiking interest rates and choking off credit. The writer is senior fellow, National Institute of Public Finance and Policy, New Delhi
