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Friday, July 27, 2007

Bringing some clarity and consistency to monetary policy?

Indian monetary policy is beset with problems; the recipes and policy reflexes which used to work in the olden days have become increasingly out of touch with the dynamics of a new India. Right now, the market is confused about what is going on with interest rates, exchange rates and the monetary policy rule. The market is unable to understand how a central bank would follow an inconsistent policy framework.

In this setting, the `credit policy statement' that is coming up on the 31st is unusually important. Many financial market practitioners are anxiously hoping that RBI will come up with plausible answers to the host of questions that are up in the air - questions about capital controls, exchange rate regime and monetary policy. What is monetary policy doing, and what comes next? I'll update this blog entry over the coming ten days, as events unfold.

Pre 31st: The setting

31st: What was done

The limit on Rs.3000 crore for reverse repo was removed, and the CRR was bumped up by 50 bps.

Post-31st: Implications

I wrote an article Still in a quandary in Business Standard of 1st. On the same day, the edit in Business Standard titled Predictable but partial says:

However, the most significant development over the last quarter has been the rise in the external value of the rupee. While expectedly not making any commitments on how it proposes to deal with the situation, the RBI has laid out the various pros and cons of the appreciation with respect to its impact on the real economy, and expressed a willingness to use all available instruments to deal with the situation. This seems to indicate that it will eventually return to its pre-April stance of resisting appreciation, with a consequent increase in capital inflows, accumulation of reserves and further pressures on liquidity. This could well become a never-ending battle. If monetary policy is to transit from merely dealing with immediate problems to creating a more enduring framework for high growth and low inflation, this issue must be squarely addressed. The quarterly announcement on Tuesday failed to do that, which is a pity because the problem is not about to go away. Indeed, most forecasts point to a further increase in the rupee’s external value. That’s a headache the RBI will have to deal with, sooner than later.

Financial Express has an edit titled Only halfway there which says:

What might appear to be a judicious mix of policies—some appreciation, some hiking of the CRR, some MSS issues and some interest rate hikes—only takes us deeper and deeper into this problem. What looks perfectly justified in the near term can look profoundly self-defeating in the overall context. Despite the need to confront all these difficult choices with due forthrightness, sadly, the RBI’s credit policy continues to be evasive on the big picture.

Andy Mukherjee notices the inflationary dangers of the present monetary policy framework.


  1. sir,

    Huge and sustained capital flows into emerging markets are a temporary phenomenon. When global investors begin to reprise risks, as the have last week, inflows will dry up. RBI currency policy should be seen in this context. The RBI, I believe, is engaging in unsterilized intervention in the hope that the capital flow will reverse this year and sterilization might not be required.

    And sterilized intervention need not have huge fiscal costs. Like china, we can simply pay banks an interest rate of, say, 3%. Whether this tax on the banking system is desirable is a different question.

    Capital flows can be controlled without Thailand style capital controls. Just scrap the India-Mauritius DTAA. Yes, there will be a knee jerk short-term reaction, leading to even a market meltdown. But it is unlikely to have a long term impact. India is too irresistible to any long term and serious international investor. In the long term, the move may even curb some of the speculative ‘carry trade’ type inflows.

    In any event, the liberal ECB regime and India-Mauritius DTA are instances of crony capitalism we can do without

  2. remember, sir, that a country can have an autonomous monetary policy and a fixed exchange rate. all it needs to do is control capital inflows. note that this is different from putting in capital controls.

    the MoF can reduce the ceiling on ECB and review the DTAA with mauritius. yes, there will be a knee jerk negative reaction but thigs will stabilize in the medium term.

    if domr compsnies continue to skirt the limits imposed by the law, by relabelling, it is because of the tacit support by the MoF.

  3. Suppose rupee appreciates to 36. Will the monetary problems be solved? For capital account inflows could still keep happening to take advantage of a currency that could appreciate further. But current account would have become deeply negative at that time. Once an industry is wiped out, it is not easy to bring it back. But capital account inflows - yes you can always bring them back, even if you impose capital controls in the short run.

    Keeping exports competitive should be the goal of RBI. That is what is driving the India growth story. If software becomes unviable, so does real estate, etc. And if real estate becomes unviable, capital account could easily become negative. At that time when rupee is 36, and when textiles and leather have been wiped out, and the country stares at negative capital account, one would argue that rupee should depreciate to 40. RBI should not let rupee appreciate disproportionately because of capital inflows.

    The problem that RBI has, which BOJ and Bank of China dont have, is that the cost of sterilization
    is high in India because of interest rate differential. BOJ actually makes money by sterilizing.

    I think that interest rates movements in India would have no bearing on capital flows - because they are higher compared to everywhere else. If interest rates go up, capital will flow in to rupee via carry trade. If interest rates in India go down, capital will flow in because of expectation of high stock market returns.

    So if capital is flowing in irrespective of what you do with interest rates, and you want to keep exports competitive, you do one thing - which is control capital account.

    That assumes capital will keep flowing in India. Capital could also start flowing out because of what is happening in US.

    I might not be arguing this correctly. But in competitive scenarios, you go for market share at expense of margins to remain viable in long run. RBI should go for export market share at cost of sterilizing

  4. (In continuation of the above comment). Capital controls would lead to less attractive financing conditions for India inc and reduce the targeted growth rate of 8.5%. That should be acceptable. I think instead of letting rupee appreciate, RBI should lower its targeted growth rate.

  5. Sir,
    Doesn't it look like a conspiracy that rupee appreciated by 10% just as sensex is peaking and we are at the top of business cycle and only way forward seems to be downward (read FII sell off and exit). It might have happened that to avoid losses while sell off, FIIs want some relief (profit) on currency front to offset declining equity prices. Am I cynical? May be.

    Second, why does't RBI keep sterilising rupees released while buying dollars to prevent rupee appreciation? Is it taht costs are prohibitive or interest rates will rise?

    Third, RBI determines short term rates in India by seeting CRR/Repo/reverse rep rates. But what determines long term rates (or shape of yield curve)?



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