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BATTLE ON OTHER FRONTS
- Changes form the backdrop of the RBI’s new monetary policy

Y.V. Reddy, the governor of the Reserve Bank of India, is a much-feared man in many circles. Bank chairmen, particularly of private sector banks, entrepreneurs in several industries, and large numbers of individuals whose fortunes depend on the daily movements of share prices in the Bombay stock exchange, have been severely affected by the RBI governor’s efforts to contain money supply. He has raised interest rates and the cash reserve ratio — which affects the amount that the banks can lend — several times during the course of the last year in order to restrict money supply and hence contain inflation. These measures have slashed bank profits, raised the cost of borrowing and brought down share prices quite considerably.

Since the rate of inflation refuses to slip below 6 per cent, these men and women were probably expecting at least a moderate dose of the same medicine in the RBI’s annual monetary policy for 2007-08. However, Reddy has given them a most pleasant surprise by leaving the entire structure of interest rates unchanged. This ‘passivity’ is not an admission of defeat or helplessness, but merely an awareness that the battle has to be fought on other fronts.

Reddy has identified the surge in net inflows of foreign exchange as the main concern of monetary policy today. In order to get some idea of the magnitude of the problem, consider these figures. The RBI had to buy foreign currency worth almost $12 billion in February this year. This is almost the same amount that the RBI bought in the previous ten months. The situation prevailing in 1991 — when our foreign exchange reserves were barely sufficient to pay for a couple of months of imports — seems a chimera. The burgeoning reserves now constitute an embarrassment of riches because it presents the RBI with two stark options.

The RBI can ‘sit back’ and allow the demand and supply for foreign exchange to determine the ‘price’ of rupees. The inflow of foreign exchange increases the demand for rupees, and consequently puts a strong upward pressure on the value of the rupee. The naïve nationalist may view an appreciation in the value of the rupee with jingoistic pride. Unfortunately, this completely ignores the more practical consequences. In particular, any increase in the external value of the rupee increases the price of Indian goods in foreign markets, and so makes Indian exports less competitive. In areas where price competitiveness is not an issue, the software industry being an obvious example, rupee profits of Indian exporters fall in step with the appreciation of the rupee.

So, sitting back is not an attractive option, and the RBI typically intervenes in the foreign exchange market repeatedly in order to prevent any significant appreciation of the rupee.

It does so by buying up dollars. Unfortunately, this intervention is not costless. Every dollar purchased by the RBI releases additional rupees into the system. Given the scale of intervention, the excess liquidity will normally create severe inflationary pressures. This is clearly not a viable option in the current scenario when fighting inflation is the key concern of public policy.

That is why the RBI also carries out the process of ‘sterilization’. This is the sale of government securities in the RBI’s portfolio in the domestic market to counteract the supply of money in the economy. However, since there are limits to the volume of government securities that the public is willing to buy, other solutions need to be found when there are huge inflows of foreign exchange.

The new monetary policy contains two broad measures to curb the net inflow of foreign exchange. First, it has allowed greater outflow of foreign exchange from the country. The ceiling on foreign investment by domestic companies has been raised from 200 per cent to 300 per cent of their net worth. There have also been corresponding increases in the ceilings for both mutual funds as well private individuals. These measures will surely bring some benefits. Companies can also pre-pay their foreign currency borrowings freely up to higher limits.

Second, the RBI is also trying to restrict inflows by enforcing a lower ceiling on interest rates on deposits by non-resident Indians. It is debatable whether a reduction of 0.5 per cent in interest rates will really discourage NRIs from parking some of their savings in NRI deposit schemes. Apart from the rate of interest on these deposits being slightly higher than corresponding rates abroad, the major advantage of NRI deposits is that they do not attract Indian taxes. Of course, the RBI itself cannot change the tax status of NRI deposits. But, it could have persuaded the finance ministry (surely, they would not need much persuasion to levy a new tax') to bring these deposits under the tax net.

A secondary effect of these measures is that they advance the rupee further towards full convertibility. The overall impression is that quantitative restrictions on foreign transactions are being relaxed. Even the fear that new restrictions would be imposed on external commercial borrowings in order to contain inflows into the country seems to have been misplaced. More attempts at a liberalized regime may follow since working groups have been set up to explore the development of interest rate futures and currency futures.

Is the monetary policy too passive' Could Reddy have adopted a more proactive role in promoting growth while at the same time ensuring some modicum of price stability' The new policy must be judged against the backdrop of the changes initiated by the RBI in the recent past. There have been several increases in the entire structure of interest rates, with the last one being implemented only a couple of weeks ago. The recent increase in the cash reserve ratio actually comes into effect only from May.

So Reddy may have taken a judgment call that further attempts to restrict money supply could be counter-productive. Indeed, the fear that additional restrictions on money supply may fail to have any effect on prices while at the same time reducing gross domestic product growth is a very real one. Large increases in the prices of food items have been a major reason for the current bout of inflation. There is very little that monetary policy can do to curb the rise in food prices — the only reasonable solution is to increase the supply of food.

At the same time, any further reduction in bank credit or increase in interest rates may hurt the genuine needs of industry and thus impact on growth. It is significant that the RBI has forecast a GDP growth rate of 8.5 per cent for the coming year — this is lower than the 9.2 per cent growth rate projected by the government. This is an admission that the RBI recognizes the deleterious effect of its tight money policy on growth. Also, as recent evidence suggests, the RBI can always change the crucial monetary parameters during the course of the year. Moderate inaction is typically vastly superior to foolhardy action.

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