Keep up with the 'out of box' thinking: Shubhada Rao

The multiple policy framework adopted by the Reserve Bank of India (RBI) points to to a Catch-22 situation.

Consider the broad domestic macroeconomic landscape. Growth has halved in three years. Wholesale inflation, though elevated, is closer to comfort vis-à-vis the last three years.

The intended correction in current account deficit is underway.

Such an environment would have prompted monetary accommodation. However, extreme rupee volatility, accompanied by its record weakness since June, 2013 forced a volte-face in policy approach. In a bid to support the rupee, unconventional tools were deployed to tighten interest rates and liquidity in July.

The objective of arresting extreme currency volatility is beyond debate, as severe misalignment of a currency vis-a-vis its fundamentals can raise the spectre of inflation, put fiscal consolidation at risk and endanger financial stability in the economy.

However, the means do not always justify the end. The current tightening by RBI has delayed the recovery in growth raising the concomitant risks of deterioration in asset quality and fiscal slippages.

While the counterfactual can never be tested, the limited success of monetary tightening in curbing rupee volatility cannot be ignored. In fact, stability in the rupee over the last two weeks can be attributed to steps taken by RBI to provide a dollar swap window to oil companies, and more importantly, encourage capital inflows by incentivising non-resident Indian deposits and banks' overseas borrowings in an unconventional manner.

There is a learning to be derived from this. The first line of sustainable defence for currency should always be measures to attract capital. This could be followed by administrative and temporary restrictions on non-essential imports as well as on speculative trading positions. Interest rate defence ought to have been the last-resort measure, especially when the economy is at a cyclical low.

Fortunately, policy focus has now shifted towards attracting capital flows, through a mix of conventional and unconventional measures. However, we need more out of box solutions to enable RBI to reverse its recent tightening measures without compromising rupee stability. In this context, the option of a partial switch in the composition of government borrowing from long-dated securities to bills can be explored.

This will have the dual benefit of lowering long-term yields, while enhancing the attractiveness of T-Bill rates for foreign portfolio investors. It is, however, critical for RBI to continue with strategic intervention in the forward market, to ensure hedging costs do not dilute this yield premium. In addition, issuance of three-year bonds can also be looked at, to provide the banking system adequate investment avenue to park rupee funds generated from incremental FCNR deposits of corresponding tenor.

The author is chief economist of YES Bank