The “markets” and the corporate sector, the media
report, are once again disappointed with the Reserve Bank of India. With
growth slowing persistently and inflation thought to be less of a
concern than earlier, the RBI was expected in its Mid-Quarter Monetary
Policy Review in June to continue with its recent turn to reducing
rather than hiking interest rates. That shift, recorded in April (see
Chart), was seen as signalling a longer-term change in policy focus from
combating inflation to spurring growth. Prior to April, over a period
of two years and in more than a dozen steps, the RBI had hiked the base
repo rate by as much as 3.5 percentage points to its October 2011 level
of 8.5 per cent. The motivation was clear: inflation was seen as India’s
most important problem, necessitating measures to moderate demand by
discouraging investment and consumption.
However, in
April, the RBI was seen as sending out a strong signal with a full fifty
basis points reduction in the repo rate to 8 per cent. Since that has
had little visible effect either on demand and growth or on confidence
in the markets, expectations were that the RBI would persist with rate
cuts and monetary easing. What is more, even the outgoing Finance
Minister, Pranab Mukherjee, suggested in public that this was the way
the RBI would respond.
However, on June 17, the RBI
chose to stand firm, and leave the interest rate unchanged, inviting
media and corporate criticism. The argument advanced by the critics
sounds painfully obvious. Since, in their view, inflation is moderating
while growth is decelerating, the RBI should have stuck with the policy
of cutting rates. By adopting an asymmetric attitude with respect to its
two tasks of combating inflation (for which it continuously hiked
rates) and reviving growth (for which it must continuously reduce
rates), the central bank’s leadership has, it is argued, chosen to be
excessively conservative. In sum, the corporate sector is looking to the
“independent” central bank for a bail out.
One among
the many problems with this argument is that it presumes that inflation
and growth are the only two concerns weighing on the minds of central
bank officials. There are, however, other concerns in most contexts,
important among which is the management of the exchange rate in
countries with liberalised exchange rate systems. In India’s case, an
issue agitating the government and the central bank is the close to 25
per cent depreciation of the rupee via-a-vis the dollar over the last
year, which has brought its value to the current level of around Rs. 57
to the dollar. The sharp and persisting depreciation of the currency
makes the task of halting and reversing its decline crucial for both the
government and the RBI.
The rupee’s depreciation has
implications even for the task of addressing inflation. A falling rupee
increases the domestic prices of imports. Such increases, especially
those in the prices of imported universal intermediates like oil, tend
to aggravate domestic inflation. Seen in that light the objective of
stalling the rupee’s decline should take precedence over that of
directly addressing inflation.
Two sets of factors
are known to underlie the rupee’s depreciating trend. The first is an
increase in the trade and current account deficits on the balance of
payments as a result of the rise in the prices of oil and the sharp
increase in the imports of gold. The other is the decline in the volume
of net capital inflows into the country, largely as a result of the
outflow of FII investments in recent months. What has been particularly
disconcerting is that despite the moderate fall in oil prices in recent
weeks, which would have reduced the strain on the trade and current
account balance, the rupee’s depreciation has continued.
In
other circumstances a depreciating rupee would have helped shore up the
balance of payments by reducing the dollar prices of India’s exports
and increasing the rupee prices of imports. Falling export prices would
increase global demand for Indian goods and rising import prices would
restrict the domestic demand for imports. However, with the world
economy in recession, export demand has not risen in response to falling
prices. On the other hand, the domestic demands for commodities like
oil and gold, which account for a large proportion of the increase in
India’s import bill, are also not sensitive to prices. So the
depreciation of the rupee has not helped to correct the country’s trade
and current account imbalances. The effort to increase the supply of
dollars in the market must, therefore, rely on drawing down the RBI’s
foreign exchange reserves or on increasing the flow of capital into the
country.
The RBI has indeed opted to use its reserves
in recent months, resulting in a significant decline in the volume of
foreign currency assets it holds. But this has at most prevented a
sharper depreciation of the rupee than has actually occurred. It has not
helped correct the depreciating tendency. Continued reliance on this
means of enhancing the supply of foreign exchange in the market could
shrink reserves to a degree that risks triggering a speculative run on
the rupee. Not surprisingly, the RBI is seeking ways of enhancing
capital flows into the economy.
The rupee’s
depreciation does however affect foreign investor sentiment adversely.
Returns in the form of profits, dividends and capital appreciation
earned in rupees deliver fewer dollars to investors. As a consequence
the slowdown in foreign investment inflows induced by the global crisis
and the fall in domestic growth rates has been aggravated. This poses a
challenge to policy makers needing to enhance dollar availability in the
market to stabilise the rupee. The RBI’s reckless response seems to be
to encourage the inflow of foreign debt, since equity investments are
proving more difficult to attract. Interest rates on non-resident Indian
deposits have been hiked in the past and are likely to be hiked
further. Restrictions on the kind of foreign agents/entities that can
enter and the volume of foreign investor involvement in domestic debt
markets, including the market for government securities, have been
relaxed. And ceilings on foreign borrowings by different kinds of
domestic entities have been raised. Such measures the government and the
central bank hope would increase foreign investor interest in domestic
debt markets leading to larger foreign capital inflows that contribute
to stabilising the falling rupee. In a quirky response, increased
foreign indebtedness is being seen as a solution to the problem of a
weakening rupee.
However, since that seems to be the
official strategy, opting for a reduction in interest rates would be
self-contradictory. As noted earlier, even now the rupee’s depreciation
is eroding the returns in foreign exchange that foreign investors in
both equity and debt markets earn. If, in addition, a decline in
interest rates is engineered with the aim of spurring growth, it would
discourage rather than attract the debt that is seen as solution to the
problem of a shortfall in dollar availability. For lack of more prudent
alternative measures, that could leave the rupee floundering and convert
a problem into a crisis.
In sum, focusing on the
growth-inflation dichotomy to prescribe the appropriate interest rate
policy may be missing the point altogether. Understanding what the
central bank is doing or not doing requires examining the challenge of
exchange rate management as well. That may allow a realistic assessment
of how much help the corporate sector can expect from the central bank
as opposed to the government.
The Hindu
No comments:
Post a Comment