Kudos to Mint Street mandarins

RBI's adept role in India's recovery deserves greater recognition

India's post-pandemic economic recovery appears to be well underway, with gross domestic product (GDP) growth in FY24 expected to exceed 7.5 per cent — substantially above earlier projections of 6-6.5 per cent. This comes after a growth of 7 per cent in FY23 and 9.7 per cent in FY22.  While there is some unevenness in growth, particularly with agriculture still struggling, overall, the recovery has surprised on the upside.

The crucial role played by the Reserve Bank of India (RBI) in this recovery has received less attention than it deserves. Like a duck moving across a pond effortlessly while paddling furiously under the water, the RBI has navigated India through major global shocks that have knocked many others back.

Three things stand out for me. First, India has managed a recovery post-pandemic without unleashing massive inflation, which we suffered after the global financial crisis. Some of this is due to global prices. Oil prices rose much more in 2012-13 than in recent years, and India was able to satisfy its need with larger shares of discounted Russian crude. A significant part of the answer, however,  also lies in monetary policy, which was loosened to help with the pandemic but not allowed to go completely out of control, as was the case after the global financial crisis. Then, the real repo rate — the RBI’s repo rate minus inflation — was allowed to reach -5.0 per cent in 2009 and -6.2 per cent in 2010 (see table). It remained negative, ranging from -2.2 to -2.7 per cent, for another three years.

Along with high fiscal deficits, which also were kept high for too long, it ensured massive inflation for five years from 2009 to 2013. In contrast, while monetary policy was loosened to deal with the economic downturn due to the pandemic, and real repo rates went negative from 2020 to 2022, when inflation rose, the repo rate was swiftly adjusted upwards to 6.5 per cent, and the real repo rate turned positive. As a result, India’s inflation rate was contained, and is now declining. 

Second, the current RBI has not forgotten that its mandate is growth and inflation. When inflation targeting was introduced in 2015, the RBI at that time maintained real repo rates above +2  per cent for too long, spanning from 2015 to 2019. The RBI then, perhaps overzealous with its new inflation targeting tool, became an inflation hawk, and neglected economic growth. The RBI’s inflation expectations, which guide the Monetary Policy Committee, were consistently above actual inflation. As a result, the RBI kept repo rates too high, averaging +2.5 per cent in the three years from 2017 to 2019 even as actual inflation fell. Consequently, GDP growth fell from 8.2 per cent in 2016 to 3.9 per cent in 2019.  Keeping the real repo rate around +1 per cent  in normal times is the right balance between growth and inflation and the RBI lost that balance.

Third, the RBI’s management of inflows has been markedly different between the period after the global financial crisis and now. When the US Fed and subsequently other central banks adopted quantitative easing (QE), inflows increased into India and other parts of the world, complicating macro-management. In anticipation that one day these inflows will become outflows, the RBI should have built up foreign exchange (FX) reserves. India did increase FX reserves from $264 billion in 2009 (112 per cent of external debt) but only modestly to $305 billion in 2011 (89 per cent of external debt). Then it stopped, and by 2013, FX reserves were down to $292 billion (only 70 per cent of external debt). Even worse, an RBI seemingly clueless about the imperatives of open-economy macroeconomics allowed the rupee to appreciate from Rs 51.8 to the dollar in March 2009 to Rs 44.4 to the dollar by July 2011. This hurt exports and encouraged imports, and rising oil prices combined to increase the current account deficit (CAD) from 2 per cent of GDP in 2009 to a dangerously high 5 per cent of GDP by 2012, putting India into the Fragile Five. 

When the US Fed announced its taper — simply a slowdown in its QE programme — the Indian rupee went into a tailspin and crashed, forcing the RBI to issue expensive exchange guaranteed bonds. No such tantrum occurred in 2022 when the US Fed raised interest rates to contain inflation, because, this time, the RBI management used the inflows to build up reserves significantly, from $413 billion in 2019 to $607 billion in 2022. When flows reversed, it was able to manage a more gradual decline in the rupee from roughly Rs 75 to the dollar to Rs 83 to the dollar, thereby moderating inflation, and containing CAD to under 2 per cent of GDP.  Since then it has rebuilt FX reserves, reaching  $617 billion, and CAD is currently at a comfortable 1 per cent of GDP.

Looking forward, as the macroeconomic situation normalises, the RBI may want to look at other institutional reforms issues, such as its conflicted role as the debt manager of the government and the use of statutory liquidity ratio (SLR), both of which hurt the development of a bond market. But for now, hats off to the RBI for its deft and admirable handling of monetary, FX and exchange rate policy, helping India navigate through the crisis and global shocks. Its recent tough action on a recalcitrant Paytm also sends a good signal as a regulator.

The writer is distinguished visiting scholar, Institute for International Economic Policy, George Washington University, and co-author Unshackling  India, Harper-Collins India