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Vivek Moorthy: How a rupee rise will curb inflation

Vivek Moorthy  |  New Delhi 

When the RBI stops buying dollars, the resulting large drop in money and credit growth will lower inflation significantly.
Should the RBI let the rupee rise to fight inflation, or should it peg the rupee to prevent our exports from getting hit? The debate rages on, with many more joining the fray. This article mainly critiques the view that a rising rupee (when the RBI stops forex intervention) will not significantly lower inflation. Such a view has been expressed by Ajit Ranade, (Hitting Exports to Curb Inflation is a Bad Idea, April 19) and also Shankar Acharya, "...the finance ministry (and RBI?) may be giving undue weight to a recently fashionable and (simplistic) view that the appreciation of the rupee helps contain inflation. Actually, in India, it has modest impact at high cost....". (Exchange Rate Policy, April 26). This criticism of their views is solely to facilitate constructive policy analysis.
Ajit Ranade states that "the choking impact of a stronger rupee on inflation is itself debatable". He argues that unlike the US, our import basket is such that the pass through from exchange rate changes to inflation is limited. The three largest items are crude oil (33 per cent), gold and gems (14 per cent) and capital goods (17 per cent). "The latter two have an insignificant impact upon inflation". As for the biggest item, crude oil, these are administered prices that can be "... tweaked without reference to the exchange rate simply by reducing import duties ..."
However, such arguments are not applicable now. Some basic macroeconomics is needed to explain why. Inflation is the difference between nominal GDP growth and real GDP growth. If nominal GDP grows at 15 per cent and real GDP at 8 per cent, the difference of 7 per cent is inflation. What determines nominal GDP growth? Basically, broad money and bank credit growth which are influenced by the central bank. Suppose money and credit grow by well above 20 per cent. Allowing for time lags and slippages of a few percentage points, nominal GDP growth will exceed 15 per cent, and inflation will rise and stay above 7 per cent.
Over the last two fiscal years 2005-06 and 2006-07, the relevant measures of money and credit have been growing too fast. Why? Because to prevent the rupee from rising, the RBI has been printing (reserve) money to buy dollars. Then to control reserve money growth, the RBI has been massively sterilising this dollar inflow by offsetting domestic money market operations that reduce Domestic Credit, called Net Reserve Bank Credit to Government, or NRCG, in India.

Rupee Crores


Rate Rs/$
Net Foreign
Assets (NFA)
Net Reserve Bank
Credit to Govt.
$ bn
2002 March 48.80 263,969 141,384 54.11
2003 March 47.51 358,244 112,985 76.11
2004 March 43.45 484,413 36,920 112.96
2005 March 43.76 612,790

Minus 17,975

2006 March 44.61 672,983 8,138 151.62
2007 March 43.59 866,153

Minus 2,802

2007 May 4 40.90 832,717 15,929 204.00
Notes: NFA is mostly Foreign Currency Assets. Exchange rate is year end.
Source: RBI.
In the last three years, NRCG has been close to zero or negative. It is unusual for a central bank to have negative NRCG. Despite such 'over sterilisation' in fiscal year 2006-07, Reserve Money grew by 22.4 per cent, the broader money aggregate M3 including bank deposits grew by 20.7 per cent and bank credit grew by 27.6 per cent. For the previous fiscal year 2005-06, the growth rates are respectively 17.2 per cent (Reserve Money), 21.2 per cent (M3) and 30.8 per cent (Bank Credit). Due to an easy money policy reflected in such high growth rates, the largely ignored CPI inflation measures have risen sharply, hurting the poor. The RBI has been failing in its most basic task of controlling inflation.
Calculating the direct cost side impact of the rupee rise on inflation is fallacious. Such calculations ignore the crucial demand side impact of the rupee rise (when the RBI stops buying dollars) on money and credit growth. The cost side approach to inflation would be somewhat valid if the rupee rose solely due to private supply and demand for forex, that is, without any forex intervention to begin with.
However, when the RBI stops 'printing money' to buy dollars, the magnitude of the rupee rise and the share and type of imports lose their importance. Instead the resulting drop in money and credit growth by several percentage points is likely to lower inflation significantly. The RBI lost control of money and credit growth solely due to its rupee pegging policy, as the 80 per cent rise in NFA between fiscal years 2004-2007 indicates.
Policy choices have to be based on the well known impossible trinity. The condition states that a country can choose only two of the three policies below:
  • An independent monetary policy, which translates to a domestic interest rate independent of the foreign or world interest rate,
  • A fixed exchange rate (in India, a real exchange rate target that allows the rupee to fall gradually), and
  • Full capital account convertibility.
  • Wanting to prevent a sharp rupee rise from hurting exporters is laudable. However, those in favour of some sort of exchange rate peg to support exports have not accepted the overpowering reality, at present, of the impossible trinity. To the best of my knowledge, those against a full float have not preemptively stressed the need for controls on capital inflows. They now seem to suggest that a few controls, when needed, will do the job.
    Ranade states that "at the moment, with our relatively closed capital account, it is possible to control interest rates and currency independently." Not so: The rupee is effectively fully convertible on the capital account, at least for inflows. The result of the increase in policy rates by the RBI during over FY 2006-07 has been an uncontrollable surge in external commercial borrowings, especially in February 2007, due to lower interest rates abroad. This is a powerful illustration of the impossible trinity in practice.
    Rajwade states that the rupee "has become seriously overvalued" (April 30). Nevertheless, he criticises recent RBI measures to reduce inflows and increase outflows! Ironically, Rajwade in his dissent to last October's Fuller CAC Report, has been arguing for more inflows (in particular, raising the limits on FII purchases of government debt) and continuing curbs on individual outflows. Ranade, also a member of the Fuller CAC Committee, did not express any misgivings about the likely consequences of fuller convertibility upon the rupee's value.
    By contrast, for the record, just before Finance Minister Chidambaram set up the first Capital Account Convertibility Committee in his Budget speech on February 28, 1997, I wrote as follows, "....the prevailing exchange regime, in which inflows are allowed, but not outflows by Indians, induces the rupee to rise too much.... The overseas investors can check in any time they like, and they can always leave, while we are just prisoners of our own device" (Capital Account Convertibility, Part III, Business Line, Feb 26, 1997).
    Ten years later, have controls on inflows even "half a chance of half success?" (a phrase from the acrostic in Vikram Seth's Two Lives). Probably not. Nevertheless, a basically flexible exchange rate, with no target or band, coupled with stringent curbs on inflows, and smaller inter-bank position limits (as a natural hedge against volatility) may be worth a try. If the stock market takes a hit as in Thailand in December 2006, so be it. The policy makers must be willing to stick to their guns.
    The author is Professor, IIM Bangalore. He can be reached at

    First Published: Mon, May 14 2007. 00:00 IST