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Saturday, January 28, 2006

Why did RBI raise rates?

Many observers were surprised by RBI's recent rate hike. It appears to make no sense in terms of where the economy is going. As Ila Patnaik points out in an excellent piece in Indian Express today, it isn't hard to understand what RBI did, but you have to shift your mindset to a modern framework of open economy macroeconomics.

With a pegged exchange rate, and with a de facto open capital account, RBI doesn't actually have much autonomy to run a monetary policy that is crafted to suit India's interests. The weapon of monetary policy is getting used up to deliver low currency volatility, when it could instead be used to deliver low GDP volatility. So even though it just doesn't fit in the immediate context of Indian macro, RBI is responding to the interest rate hikes of the US Fed.

Some people think it's obvious that when the Fed raises rates, every country has to also do so. But as theory and evidence show, strong correlations of monetary policy across countries only happen when you peg or fix. Frankel, Schmukler and Serven have an excellent 2002 NBER paper on the loss of monetary policy autonomy for countries that fix/peg.

Open economy macro is a new field in India, and there isn't much out there. So here are some pointers to work in this field. What is India's exchange rate regime; why do we have such a huge reserves accumulation? Ila solved this in 2003. Does this hurt the implementation of monetary policy? I.e., is there `enough' openness on the capital account for a pegged exchange rate regime to come at the price of monetary policy autonomy? Ila did this in India's experience with a pegged exchange rate, which appeared in India Policy Forum (Brookings Institution & NCAER), Volume 1, 2005 (Here's a WP version). Finally, how can one interpret India's story with capital flows from this framework? Ila and I did a paper India's Experience with Capital Flows: The Elusive Quest for a Sustainable Current Account Deficit which is forthcoming in an NBER book.


  1. Hi Sir,

    With the RBI faced with two situations -

    1). Not hike interest rates (hiking rates is obviously not warranted in the current situation - no inflation worries, at 7-8% the phrase "Overheated" economy almost seems like a joke).

    2). Hike interest rates (as it has done). Reasons are possibly beyond my comprehension. But, simply to arrest a depreciation in INR is not a good enough reason, is it ?

    What about the effects of a hike in interest rates ?

    a).Increase in the cost of capital for Indian companies that too at a time when there is an investment boom.

    b).Pushing consumers back towards fixed income investments.

    c).Increase in the risk premium for India as a whole.

    I think the RBI is fearful of the following -

    a). Not hiking interest rates would mean that the economy will continue to boom, leading to higher imports and an ever widening current account deficit. This would eventually lead to a sharp depreciation of the INR or will atleast make INR very volatile. Volatile curreny movements will raise India's risk premium for global investors (as they can lose substantially on their investments in event of a sharp depcn in INR). The same can then stall the flow of FII money into India or atleast slow it down, either of the situations will lead to markets changing direction (and head down South) and boom ! We may have the three year rally going bust.

    Besides, not hiking interest will also close the window of arbitrage that all NRIs and other investors can take advantage of -

    But, what if

  2. Sir,

    Sorry for that "what if" hanging at the bottom of the write-up. Got left by mistake.

  3. I think the most interesting feature that we should observe, going forward, is to what extent will there be a reversal of global liquidity (which has been going through the roof over the last two years due to low interest rate regimes). With a US Fed policy of softening the landing of the US economy (which pundits expect to happen sooner rather than later, a regime of rising interest rates in the US is here to stay, atleast for the whole of 2006.
    Will this necessarily lead to a meltdown in the equity markets in India and Asia? Hard to say...Can pension funds/insurance companies afford to stay away from high risk-high return markets like India given their huge asset-liability mismatches? Iam not so sure that they can...

    PS: Is there any data source that gives a sophisticated analysis of "NRI Remmitances". Is there any way of tracking where these inflows are channeled viz.. real estate, stock markets etc...

  4. Sir,

    Is this is a conundrum ?

    a). Bank Rate - 6%
    b). Repo rate - 6.5%

    Does it mean, shorter the borrowing period, higher the rate a bank has to pay to the RBI ?


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