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Renu Kohli: RBI's lost policy lever

The central bank's hands-off exchange rate strategy has resulted in a missed opportunity to curtail inflation

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The Reserve Bank of India’s (RBI’s) absence from the forex market when intervention would have come in handy to achieve a breakthrough in inflation shows how it has missed out on a dexterous policy tool owing to its hands-off exchange rate policy. The chickens have now come home to roost most dangerously: chronic and high inflation, large fiscal deficit with falling revenues, wide overtly dependent on short-term portfolio capital that’s reversed rapidly, slowing growth with no investment recovery in sight and a flat stock market overlooking earning downgrades point to a precarious macroeconomic situation. Monetary and fiscal policies are both overstretched. Intervention would have been an adroit move to get out of this blind alley. Yet, has been a mute spectator focused on increasing interest rates instead. Has it missed out on a useful policy lever by not accumulating foreign exchange reserves in recent years?

In a span of three months, end-July to October, the rupee has crashed some 13 per cent from peak to trough. This comes at a time when monetary responses have been exclusively geared to check inflation that is reigning high since 2009, is well-entrenched and till now shows no sign of abatement. Non-food core inflation, around which monetary responses are framed and much of which reflects imported input prices, including oil and commodities, has averaged 7.6 per cent for over eight months now.

During the same period, the price of imported crude (Indian basket) fell from a July peak of 112.4 a barrel to 106.4 a barrel in October 2011. Commodities, another key import that contributes to core inflation, fell too: the declined some ten per cent in this period.

Yet this bounty has not been exploited to guide the economy out of the cul-de-sac of high inflation, slowing growth and an investment standstill. For the rupee tanked. And how!

The rapid and sustained depreciation of the currency has not just offset the gains that a decline in crude oil prices would have had on inflation, but has added to price pressures by raising the costs of imported items. Two rounds of oil price increases have accompanied the rupee’s fall, which worsened the already-strained public finances by increasing the oil subsidy burden. And so an economy that traditionally benefits from falling oil and commodity prices – being a large importer (30 per cent of the current account reflects just oil imports)– regardless of other economic factors, has actually been pushed deeper into the spiral of inflation-low investment-slowing growth!

Meanwhile, RBI has plodded on the interest rate path in an effort to restrain inflation, raising rates in September and then again, in October! It has, thus, added further challenge to its job of inflation management apart from the adverse effects on the fiscal situation, investment and growth. Is it the hands-off or a shrunk capacity to intervene that explains such macroeconomic management?

Since 2009, RBI has largely kept its hands off the exchange rate, barely intervening in the currency markets; net purchases in this period add up to a bare $3 billion. Since capital inflows were good due to a combination of rising stock prices, growth and an appreciating currency, capital account surpluses from short-term portfolio flows generously financed a growing current account deficit as imports grew much faster than exports. Reserve accumulation came to a standstill as the rupee floated freely, whereas external debt, especially of the short-term variety, grew rapidly. According to the recently issued external debt report by the government and RBI, the total forex outgo on account of debt service payments in the immediate future, which is reflected by the indicator “short-term debt by residual maturity” stood at 44 per cent of foreign exchange reserves, or approximately $120 billion at end-June 2011; this compares with a 29 per cent ratio to foreign exchange reserves at end-June 2008. The reserves’ adequacy ratio – the extent of overall debt, long-term and short-term, backed by foreign exchange reserves – has fallen from a peak of 138 in June 2007 to 100 in June 2011. This reflects that the buffer against unanticipated external shocks has weakened relatively. One doesn’t need to, but must, mention that global risk, uncertainty and volatility following the 2008 crisis have not yet subsided; perhaps they have only increased.

Thus, even as foreign exchange reserves, excluding gold, SDR and reserve position at IMF, were a handsome $277 billion in June 2011, it would appear that the capacity to arrest a sudden and rapid slide in the currency’s value is significantly reduced.

Or is it, as RBI governor stated recently, that the exchange rate is not used to manage inflation?

If a hands-off exchange rate policy is the way for India, the question is whether the economy’s structure supports such a policy. The economy’s fundamentals remain shaky with two large deficits, one of which is heavily dependent on the fickle drip of portfolio flows. It is highly prone to inflation as a weak child to viral flu. And its financial markets are still not deep enough to disperse and dissipate the frequent shocks contracted from abroad.

With these characteristics, foreign exchange reserves served as an important lever for short-term management of cyclical winds. If this tool – a critical one – is no longer at our disposal, then what are the alternate props? Scrounging for foreign institutional investments in debt market to support the rupee? Or else, take it on the chin as we are.

The author is a macroeconomist based at ICRIER, New Delhi; she is a former staff member of the International Monetary Fund and the Reserve Bank of India.

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