The Reserve Bank of India (RBI) needs to think out of the box in the formulation of its forthcoming annual policy statement. Whatever the decision, it is going to have an impact after a year or so. What we are seeing today is the lagged effect of the excessive quantitative relief measures effected in the wake of the Lehman crisis. After a brief period, the reverse repo (RR) operations of RBI that showed a marked decline from the heady heights of the previous year are back to square one. There is a clear evidence of arbitrage operations taking advantage of the interest rate differential between the West and India. Since the beginning of the calendar year, net FII inflow has amounted to about $5 billion. The rupee is under pressure of appreciation, leading to customary noises of agony of the export lobby that thinks only of a “cheap” rupee and nothing else to promote business.
Raising the rate for RRs, something which has been conventionally followed, would aggravate the problem. Short of closing the window, RBI should think of reducing the rate drastically to a level that would make arbitrage uneconomical after taking transaction and hedging costs into account. One consequence will be a fall in rupee value. It would be a disincentive to speculative capital inflows, including those in corporate debt. It is preferable to any costly market intervention to stop rupee appreciation. A hike in cash reserve ratio (CRR) could be considered later if there is still any liquidity overhang. Banks should not think of the RR operation as a source of strength for their balance sheets. The repo rate can be raised to signal the hardening stance of the policy. RBI would do well in refraining from making forecasts on the growth in money supply and inflation. It does not help in anchoring price expectations, as claimed. RBI can see for itself how many countries in the world make such forecasts. It can just reiterate its commitment to a medium-term inflation rate of 3 per cent. It can, however, predict the growth in GDP along with other economic astrologers. There are suggestions to raise the ceilings on foreign investment in government and corporate debt. If implemented, it would worsen the problem of capital inflows.
A Seshan, on email