Ajay Shah: Issues that the RBI did not tackle

From inflation to currency trading, there was a whole host of things to be done, and the apex bank did not somehow touch upon them.

Indian monetary policy is in an unprecedented quandary. The policies of the RBI are internally inconsistent, in a way that is obvious to the intelligent speculator. The apex bank is causing unstable capital flows, shock therapy for the economy with periodic episodes of sharp currency movements, and low interest rates that induce persistent inflationary pressures. We will lurch from one accident to the next until a consistent monetary policy framework is achieved. Yesterday's credit policy announcement has one small step in the right direction. For the rest, the quandary remains unresolved.

From the early 1990s onwards, India's globalisation has gathered speed. In 2006-07, 110 per cent of GDP moved across the boundary, summing across the current and capital accounts""a massive jump when compared with 50 per cent just seven years ago. Under these conditions, the recipes of macroeconomic policy that used to work in the early 1990s are untenable. Now, there is an unmanageable tension between achieving low and predictable inflation, versus the goal of running a pegged rupee-dollar exchange rate.

India's globalisation has given a more liquid currency market, and the scale of market manipulation required to move the price has become bigger. From 2005 onwards, the RBI has engaged in massive "unsterilised intervention" where dollar purchases by the RBI flood the domestic market with liquidity and give low real interest rates. As a consequence, the RBI has been increasingly out of control of monetary conditions, and inflation has surged.

The RBI first tried defending Rs 44 per dollar. A massive bout of market manipulation was done, which has consequences even today for liquidity management. Inflation surged, and the RBI had to back off.

The core task of all central banks is to clearly pin down the short-term interest rate so as to control inflation. In all mature market economies, there is no doubt about what the short-term interest rate is; it is defined by monetary policy. In recent months, the RBI had abdicated this responsibility, which amplified the sense of confusion about monetary policy. The RBI has two interest rates, not one: it borrows at 6 per cent and lends at 7.75 per cent. At 6 per cent, the RBI had capped the total outstandings at Rs 3,000 crore. This is a tiny number when compared against the size of India. This cap has now been removed, thus bringing the RBI back into monetary policy, with a floor on interest rates. This is a positive move.

In the credit policy, the RBI says: "Assuming that aggregate supply management will continue to receive public policy attention and that a more active management of the capital account will be demonstrated, the outlook for inflation in 2007-08 remains unchanged". The RBI is saying that if the government solves supply side issues, and if the Ministry of Finance brings in capital controls, inflation will be stable.

This is an astonishing attempt at avoiding responsibility for inflation. The impossible trinity gives three different alternatives: we can move towards capital controls or exchange rate flexibility or lose monetary policy. The RBI is silent about exchange rate flexibility and focusing the choice as being between capital controls and inflation. In addition, I believe this statement shows poor understanding of Indian politics. If inflation resurges, such protestations will not enable the RBI to get off the hook. At that point, the RBI will be forced to have high real interest rates, which will mean giving up on currency pegging.

Now the RBI is defending Rs 40 per dollar. There appears to be a consensus that the rupee will appreciate beyond this. The existing scale of currency trading by the RBI is inconsistent with the need of the UPA to announce elections in late 2008 or early 2009. Achieving low inflation by late 2008 requires that short-term interest rates in 2007 have to be at least 3 per cent in real terms. For this to happen, the defence of Rs 40 has to break, for the RBI cannot manipulate the currency market and simultaneously achieve a 3 per cent real rate at the short end. Speculators are sending money into India in the expectation of the rupee appreciation.

The RBI believes that financial globalisation is the problem; that capital flows are destabilising. However, it is the non-credible pegged exchange rate which is bolstering capital flows into the country. If the rupee were not a one-way bet, less capital would be coming into India.

In early 2007, there was eerie calm on the currency market. Then after that, suddenly there was a 10 per cent rupee appreciation. Exporters were naturally extremely upset. The RBI's decisions make it a risk factor.

The RBI needs to do better in gearing up for the coming difficulties by designing an exit strategy. The NSE and BSE need permission to trade currency futures""so that everyone gets a market for doing currency risk management. The RBI needs to talk honestly with the country, saying that Rs 40 is not going to last. A full-blown plan for shifting away from a dollar-rupee peg, with steadily increasing currency flexibility, needs to be drafted by an expert committee and discussed in public.

When anyone tries to understand the exchange rate, a key question is: Is this a market price, or is it a manipulated price? A critical input for forming a judgment about what is going on with exchange rates is knowledge about currency trading by the RBI. In India, we demand daily disclosure of FII trading on the stock market. But the RBI gets away with disclosure only once a month, with a lag of over two months.

This lack of transparency on currency trading is symptomatic of a deeper malaise of non-transparency on the part of the RBI. A recent NBER working paper, by Dincer and Eichengreen, scores the transparency of central banks.On a scale of 0 to 15, Asian central banks have been improving as a whole, scoring 5.1 in 2005, compared to 3 in 1998. China's transparency improved dramatically, to 4.5 from 1. The RBI has stagnated at a score of 2 all through. The RBI in 2005 lagged behind the Asian average of 1998.

This is inconsistent with the focus on transparency that animates the Indian government today: all arms of government are pushing in favour of greater transparency and greater accountability. The citizens of India are affected by the stance of monetary policy. In a democracy, they have a right to know exactly what is going on, in meticulous detail. A central bank is supposed to reduce risk in the economy. In India, the RBI has become a risk factor.